This Is Why You Need To Be Invested In Emerging Markets

November 6, 2017

This Is Why You Need To Be Invested In Emerging Markets

  • In investing, having a strong tailwind is perhaps more important than picking the right stocks.
  • Finding good stocks in emerging markets isn’t that difficult, and plenty of them trade on U.S. exchanges.
  • It all boils down to fundamentals. Rebalance accordingly between developed and emerging markets.



Introduction

I’ve talked a lot about investing in emerging markets, but I’ve never assessed emerging markets from an holistic perspective.

Today, you’ll read everything you need to know about investing in emerging markets. It’s extremely important to know why to invest in emerging markets, and then to understand the best way how to do so because not every investment in emerging markets is going to do well.

Understanding the economic and demographic trends and opportunistic buying will help you take maximum advantage of the good investing opportunities out there.

Why You Should Invest In Emerging Markets

As humans, we have a natural tendency to do those things that are familiar to us and in our comfort zones. This unfortunately means we usually have a strong domestic bias when it comes to investing which can have severe consequences on our long term returns and financial wellbeing.

Jack Bogle, the founder of Vanguard, recently said the he expects long term returns to be around 4% from stocks and 3% from bonds. Now, if you aren’t happy with 4%, or even just 3% returns, you have to look elsewhere. But the question is, where should you look? I say, emerging markets. Why? Because the expected returns are much higher as stocks are simply cheaper. The fact that stocks are cheaper is completely irrational because the economic trends are skewed in favor of emerging markets.

Let me start with the population. More people means more customers, more consumption, and more business, more travel, more infrastructure, etc. The population in Asia will grow by about a billion people in the next 30 years. In Europe, the population is expected to decline. The population will grow in North America, but that’s only because North America includes Mexico which is an emerging market.

Figure 1: Global population trends. Source: European Environment Agency.

On top of the population growth, many emerging market economies are booming. This will change the way the world looks from an economic perspective. In just a few decades, China, India, and other emerging markets will have the largest share of the global economy.

Figure 2: Share of global economy – past and future. Source: World Economic Forum.

What’s even more important is that the percentage of poor people in Asia has been shrinking rapidly. This means that all those billions of people will enjoy a normal life that includes shelter, electricity, food, health, schools, etc., all of which increase development and consumption.

Figure 3: Percentage of population living in extremely poor conditions. Source: World Economic Forum.

All of this leads to something incredibly important for every global business. The booming Asian middle class will ignite unstoppable trends in the global economy which means higher demand for commodities, global inflation, and higher demand for developed countries’ products and services, tourism, etc.

Figure 4: The Asian middle class is about to boom. Source: World Economic Forum.



The 20th century belonged to the United States with Europe tagging along for the last 50 years. But the 21st century will undoubtedly welcome the Asian renaissance, and there’s nothing anyone can do to stop it. So, why not be invested in it?

How To Invest In Emerging Markets

Thankfully, investing is a global activity, and a good broker can allow you to invest on the Hong Kong exchange if you really want to. You can also expose yourself to many emerging market companies traded on the New York Stock Exchange or NASDAQ. To find them, just look at the NASDAQ company list and you’ll find stock lists of companies operating abroad but traded on domestic exchanges.

Figure 5: NASDAQ regional stocks lists. Source: NASDAQ.

With emerging markets, I wouldn’t advise investing through ETFs because they buy the most expensive stocks in a given emerging market based on their market capitalization weighting. What to look at instead are the fundamentals of companies in emerging markets. It’s still possible to find stable companies with much better fundamentals than what U.S. or European stocks offer.

Let’s look at an example.

Alibaba (NASDAQ: BABA) has been growing at a rate similar to Amazon (NASDAQ: AMZN) if not even a bit faster. However, BABA’s metrics are much cheaper than AMZN’s. The difference? The difference is in the demographics of China versus the U.S. Given what I’ve shown above, where would you rather be invested?

Figure 6: BABA and AMZN fundamentals. Source: Morningstar.

Further, if we look at global price to earnings ratios knowing that long term investment returns are perfectly correlated to underlying earnings, we can expect much better returns from emerging markets.

The current price to earnings ratio in China of 7.6 leads to an earnings return of 13% while the PE ratio in the U.S. will give 4.5% returns. The difference over the next 20 years will be huge.

Figure 7: Global price to earnings ratios. Source: StarCapital.

Another example of how cheap can something be in an emerging market is Norilsk Nickel (OTCPK: NILSY). Norilsk is the biggest producer of nickel in the world and is about to explode as many are starting to get the picture that nickel will be in high demand with the rise of electric vehicles.

Figure 8: Norilsk Nickel fundamentals. Source: Morningstar.

The price to earnings ratio is based on the previous year, and is extremely low as nickel and copper prices have just reached multi-year highs after a slump in 2016. Thus, future earnings will be much higher. The reason the stock is so cheap is because it’s in an emerging market, Russia.

Diversify – Domestic Companies Also Provide Exposure

Now, this doesn’t mean you should sell all your developed world stocks and buy emerging markets. Compare what you already own with other potential investments knowing that the most important thing right now is to be exposed to emerging markets.

But investing in emerging markets can also be done by investing in domestic companies with significant emerging market exposure. Starbucks—which plans to have 5,000 stores in China by 2021—is a great example. Of course, domestic companies are more expensive, but that will probably level out over the long term.

It’s important to understand that you shouldn’t just invest in something because it’s a blue chip, emerging market, or whatever else. Good underlying fundamentals will be what determines long term returns.

Figure 9: Long term returns between the S&P 500 and the MSCI Emerging Market index. Source: Wisdom Tree.

Over the last 16 years, emerging markets have outperformed the S&P 500 by 3.3 percentage points per year. Thus $1,000 invested in the S&P 500 would now be worth $2,312, while the same amount invested in emerging markets would now be worth $3.799. That’s a huge difference, if you ask me.

The following chart will confirm how future performance is all about valuations.

Figure 10: MSCI Emerging Market price to earnings ratio compared to S&P 500. Source: Wisdom Tree.



If the S&P 500 had an equal PE ratio as emerging markets, you should always buy the higher quality, thus the S&P 500. However, when the discrepancy is huge, emerging markets are the better option. Right now, there are so many bargains in emerging markets, a pretty large exposure would be wise.

Conclusion

I hope you’ve enjoyed this straightforward summary of why it’s important to invest in emerging markets and how to do so.

Many pundits will tell you that investing in emerging markets is risky, but when I see the current valuations of the S&P 500, I tend to think otherwise.

The world is shifting toward Asia. Don’t find your money stuck in the last century.

© 2017 Investiv