By Jeff Shen and Rodolfo Martell
Last year was no trophy year for emerging market stock indices. These developing markets indicators underperformed their developed counterparts by a considerable margin.
It appears the pervasive "risk-off" sentiment that gripped markets around the globe and across asset classes weighed most heavily on those deemed the riskiest of the risky. Performance also languished amid tightening monetary policy, most notably in China, which was enacted to combat inflation concerns and ultimately served to inhibit growth.
Clearly, however, markets do not equal economies. There is no denying that despite lackluster stock market performance, emerging market economies are growing at a much faster clip than those of the developed world. In fact, we expect emerging markets will remain the fuel for world growth, consumption and wealth creation over the next decade and beyond, translating into attractive long-term investment potential. What's more, a successful investment strategy for these markets doesn't demand "swinging for the fences"-some well placed hits can be all it takes.
Big League Opportunity
The potential in emerging markets is exceptional. For example, investors might not realize that emerging markets' share of world stock market capitalization greatly lags these countries' contribution to the global economy. Equity markets in the developing regions represent less than 15% of total world stock market capitalization. Yet, these nations account for nearly 50% of world gross domestic product (GDP), more than 50% of world energy consumption, more than 70% of total land mass and greater than 80% of world population. In other words, there is great capacity for growth in emerging markets stocks.
Additionally, given that the average U.S. investor is considerably underweight the sector, with only a 2.5% allocation, demand for emerging markets assets should remain strong for some time.
Several secular themes underpin our optimistic view, including remarkable population growth and expansion of the middle class, both of which are powerful drivers of economic and consumption growth. Rising exports and increasing commodity production in emerging markets also serve as notable tailwinds for GDP growth and wealth accumulation in these regions.
Game Changers
Though fundamentally appealing, emerging markets investing comes with heightened risk, including political, regulatory, foreign currency and liquidity risks, to name just a few. However, we would argue that the playing field today is a far cry from what it was two short decades ago.
In the past several years alone, emerging market countries have undergone considerable financial, economic and political development. This not only tempers the risk profile somewhat, but also changes the way investors should approach emerging markets investment.
As the middle class grows and wealth increases, we are seeing dramatic lifestyle changes and infrastructure development across many emerging economies, with different products, services, industries and businesses benefiting in different ways. As such, investing in emerging markets is no longer just an exercise in country selection. Today, these markets have become more like their developed counterparts, in that performance is not derived from a specific country or even a specific sector. Increasingly, fruitful investing in emerging markets involves digging deeper, doing your homework and looking beneath country-level factors to choose individual companies with the potential to outperform.
Consider Brazil. Once unstable, the country dramatically turned the page in the new millennium, gaining fresh political and economic stability. Transparency and reporting standards have been upgraded since the late 1990s when the country emerged from hyperinflation and deep economic crisis. Brazil's investing infrastructure has been modernized and, as a result, investors are able to access a wealth of stock-specific information. And that's critically important today, because choosing a country based solely on its GDP growth rate or other macro-level factors does not ensure a win. In fact, Brazil has generated only average GDP growth in recent years, but has enjoyed high market capitalization growth. Investors who shunned it, focusing instead on countries with higher GDP growth rates, would have paid the price of lost opportunity.
Bottom line: Success in emerging markets investing today requires more of a micro view and the ability to access and analyze data all the way down to the security level.
Inefficiency = Opportunity
While emerging markets have modernized, gaining information on the individual securities is not necessarily easy. The fact is that reliable, good-quality data can be scarce, particularly compared with that available in developed markets. On the surface, this appears a clear negative and, without a doubt, it can be an Achilles heel for inexperienced or unprepared investors. However, investors able to scrub and clean the data to prevent a "garbage-in, garbage-out" scenario have a notable advantage.