Where The Growth Is: How To Invest In Emerging Markets

July 5, 2017

Where The Growth Is: How To Invest In Emerging Markets

  • Emerging markets haven’t been the best investment in the last 10 years, but economic developments met expectations.
  • Long term analysis shows that emerging markets have just started to develop and the fundamentals are extremely cheap for the expected growth.
  • Each emerging market is different and one has to individually analyze political, currency, demographic, natural, and other risks in order to make proper investment decisions.

Introduction

There is a huge difference between short-term and long-term effects on financial markets.

In the short term, anything can happen and sentiment is what mostly drives short term trends. If we take a look at the long-term chart for the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM), we can see how it’s still 24% below its 2007 peak.


Figure 1: iShares MSCI Emerging Markets ETF since 2003. Source: Google.

The reason behind this bad performance is because from 2003 to 2007, everybody was crazy about emerging markets due to high expected economic growth and huge potential. As always on financial markets, such states of euphoria lead to terrible results.

The EEM ETF was down 63% during the 2009 financial crisis. Since then, there have been many market corrections and a bear market of 35% in 2015. Since 2015, emerging markets have recovered and in order to see whether they are a good investment at this point or not, we have to take a look at fundamentals and the economic situation.

Emerging Market Economics

The funny thing is that despite the terrible performance emerging financial markets had, the economics have been nothing short of spectacular.

China was growing at above 8% for a long time. Other emerging markets and developing economies are still growing at a rate above 5%. Only commodity exporters saw a small recession in 2009 and stagnation in 2015. However, the economies of commodity exporters are also expected to pick up in the next few years.


Figure 2: Staggering growth in emerging markets and developing economies. Source: IMF.

So, we have a situation of immense economic growth and most emerging market countries are still expected to grow at rates above 5% for the foreseeable future.

This means that the 2003-2007 euphoria was justified as economic development met expectations. The only problem is that investors got burned in 2009 and 2015 and are very careful about investing in emerging markets today. The majority of market participants don’t even look at fundamentals or economics as they are only interested in, and afraid of, volatility, which, due to the relative low liquidity in emerging markets, is very high.

However, this gives us the opportunity to find irrationally priced investments and seize the benefits of the above described economic trends. Thus, from high economic growth in China, India, Indonesia, and other similar countries, and from the economic reversal in commodity exporting countries.

Just to show how huge the economic growth in emerging markets is, it’s important to compare it to the developed world. Emerging markets growth is, and will be, more than double the growth in developed economies in spite of the huge monetary stimulus going on in Japan, Europe, and the U.S.


Figure 3: GDP growth comparison, developed economies vs. emerging markets. Source: IMF.

So where do you want to invest? In economies that barely grow at 2% with huge monetary stimuli, or in economies that grow at 5% and more?

Fundamentals

It’s difficult to get proper valuation metrics for emerging markets, so here’s a quick comparison to give you an overview. The EEM ETF has a P/E (price earnings) ratio of 14.59 (excluding loss making companies) while the S&P 500 has a P/E of 21.65. On the book value side, the S&P 500 has a price to book value of 3.07 while the EEM ETF has a price to book value of 1.64.

To conclude on the comparison, we have emerging markets that grow faster, have better valuations, and better book values than developed financial markets. For me, this is a clear sign of market irrationality and if your portfolio isn’t exposed to emerging markets, you really should consider it. However, there are many ways to invest and one has to choose the best option for themselves.

How To Invest In Emerging Markets

The obvious way is to just buy the EEM ETF we’ve already discussed. I personally don’t like ETFs because they are usually a basket of both bad and good companies and highly overweight stocks or markets that are euphorically priced because ETFs and index funds have to automatically buy stocks with higher market capitalizations and sell those with lower market capitalizations.

On top of it, there are huge differences among emerging market countries, be it in political risks, currency risks, economic perspectives, demographics, etc., that it really pays to look at individual countries and then at individual stocks.

What’s also extremely important is to look at emerging countries from the perspective of your own currency. How is your currency going to do against an emerging market currency in the long term? This is an essential piece that will have a huge impact on future returns. An analysis of productivity growth and the country’s debt levels usually helps.

While it’s still possible to find bargains on the U.S. stock market, it’s even easier to find them in emerging markets because there are very few analysts that look into specific stocks as the majority invests in index funds or ETFs and thus analysis and research are a waste of money and time.

Therefore, with a bit of effort, it’s easy to find low risk, high reward investments in emerging markets with a tailwind coming from fast economic growth.

Conclusion

In order to provide as much value as possible, I’m going to summarize my research on emerging market countries, sectors, and some individual stock investments here on Investiv Daily, so be sure to continue reading.

Today I’m going to conclude with a comparison of the demographic development of emerging markets and developed economies, and expected global consumption share evolution. Just another factor to add to the above economic growth and fundamental cheapness. The below figures speak for themselves and need no comment.


Figure 4: Global demographics, developed vs. emerging. Source: Business Insider.

Figure 5: Productivity will be huge as 90% of the working population will live in emerging markets by 2040. Source: Oxford Analytica.

Figure 6: Expected share of global middle class consumption. Source: New Security Beat.