Investing in Emerging Markets: Growth for your portfolio and the world over

Today we're going to talk about investing in emerging markets, what exactly that means, how to do it, and some of the risks involved.

First, let's get out of the way what emerging markets are: developing economies that may still have relatively high rates of poverty, but are growing rapidly. Examples include China, India, Brazil, Mexico, and South Africa. (For the sake of comparison, countries such as the U.S., Canada, U.K., France, Germany, and the like are all considered "developed.")

There are also "frontier markets," which are even riskier than emerging markets because they are generally less economically and politically stable, but still have potential to grow into emerging, or even developed, nations. These include countries such as Argentina, Ghana, Colombia, and Vietnam.

The key thing to note about emerging and frontier markets is their incredible growth potential. In the early part of the past decade, investors were lured by these countries' huge economic growth rates, anywhere from 7% to 10% per year or more. In contrast, the U.S.'s and other developed economies' gross domestic products (GDP) only grow about 3% per year, and that's during a good year. (GDP is typically what people are referring to when they talk about the "economy" more broadly. It's basically the value of all the goods and services made in the country.)

While the global financial crisis slowed almost all countries' economies, some emerging nations proved more resilient. For example, although China's growth has slowed, it is still grew more than 7% in 2012 (compare to the U.S., which grew only about 2%. Final numbers on U.S. GDP growth for 2012 will be out soon).

Because of this outstanding growth potential, investors stand to make a ton of money. Think about it: think about people who invested in U.S. railroads, for example, in the 1800s -- those families are still wealthy today! Emerging and frontier markets investors can take essentially the same stance. Incredible!

However, where there is significant reward, there is significant risk. Note again some of the countries I mentioned: Mexico, Argentina, Vietnam. While they make for great adventure vacation spots, they are not known for being the most politically stable. Democracy and capitalism are working their way around the world, but in many places, governments control (and often inhibit) countries' growth. This adds a lot of risk for investors.

For example, let's say an investor has found a way to fund infrastructure building in Argentina, but new government leadership comes in and decides that alleviating proverty through social programs will be the new priority and all infrastructure building will come to a halt. Panicked, the investor looks to sell her investment, but no one wants to buy it now that everyone knows that infrastructure has gone kaput. During all of this, the value of Argentina's currency declines, so she now owns even more of an investment that no one wants. So, the value of the investment tanks and the investor loses her money. 

This is a very elementary (and likely unrealistic for Argentina) example, but I want to highlight exactly how risky investing in emerging and frontier markets can be. Not only are there the risks we discussed previously about individual companies, but there are also political and currency risks.

Know that investments in other countries will likely be made in that country's currency, not in U.S. dollars, so there may be money gained or lost during the translation. Additionally, one has to pay taxes on these investments as well, which will eat into returns even more. These investments can also be less liquid, or harder to sell, than developed markets equities (stocks).

So why on earth would anyone invest in emerging markets after all that?

Because of faith in the growth stories.

Emerging markets investors get to be a part of helping build roads, factories, and maybe even schools around the world, giving people jobs, educations, and livelihoods. And, as I mentioned earlier, these countries generally grow much more rapidly than the U.S., so investment values go up very quickly. They also tend to go up when U.S. equities go down, and vice versa, so they can add a layer of diversification to a U.S.-based stock portfolio. (This excludes recent times of economic decline around the world. We live in a very unique time that I pray will get much better soon.)

So, if you are not overly risk averse, and if you are young, then you should be investing in emerging and/or frontier markets. As stated in previous posts, time has a way of ironing out wrinkles brought on by volatility.

If you have a 401k or 403b, see if there is a mutual fund that invests specifically in emerging and/or frontier markets and add it to your portfolio. You can also likely find index funds or ETFs from your brokerage to invest in, such as the Schwab Emerging Markets Equity ETF.

Only make these investments if they fit your risk appetite. Next week, we'll talk more about risk and how to determine how much of it you can stomach.

Investing Insights from China

I'm back from the trip of a lifetime in China. While it was an interesting experience for many reasons (primarily because I'm African-American and was quite the spectacle, apparently), I learned ton more about how business is done in China and I know understand much more why investors get so jazzed about sending money to the East.

Upon arrival in Shanghai, I was greeted by this huge Coach ad, right outside my hotel window:

 

It is a country of both extreme wealth and extreme poverty, but investors have jumped on the former as a money-making opportunity. The Chinese middle class is burgeoning and, like Western countries, this means that the population is consuming more luxury goods. I saw an impressive number of Coach, Tiffany, and Louis Vuitton stores in Shanghai alone.

 

But, before you march off to buy shares, note one thing. Many purchases of luxury goods in China were the result of a business and government culture of gifting. Some might call it "bribing," but I think that's too strong a term. Business partners exchange gifts after a deal is closed as a way to thank each other for doing the transaction. Following my team's presentation, we gave our company representatives small tokens of our appreciation, and the they did the same for us. Of course this can lead to many abuses, especially bribing. To that end, the Chinese government is cracking down on this type of corruption. Unfortunately, this may take an unforseen toll on luxury brands in China. A new government was inaugurated only in the last few weeks, so only time will tell what will actually happen. But investors in luxury goods companies who are relying on growth in China should beware.

 

Another thing to note is the major housing boom in the big cities, especially Shanghai, Beijing, and Xi'an. China is the world's most populous country with 1.36 billion people, and all of those people need to live somewhere. However, I was taken aback at the rapid real estate development. It seemed to me that houses (well, apartments, mostly, as result of high population density) were being built long before demand could fill them. This could also play a role in the future on the incomes of the Chinese middle class. If housing values fall, so will their net worths and ability to spend on luxury items. The Communist government can likely keep some damage from occuring if there is a bubble burst like that of the US in 2007. But I would caution investors to be careful of a situation that appears to be growing more precarious.

 

 

 

It's not all bad news, of course! I saw a lot of growth potential in China, particularly in terms of infrastructure. As they continue to build homes, they will need roads, electricity, and public transportation. There is also a bit of a pollution problem that will have to be tackled. Investors can take advantage of these things by putting money toward building out these roads and investing in companies that will put electrical wires underground. Some of my classmates also joked that, once it becomes required to wear a bike helmet, helmet makers will clean up!

 

 

 

Some people say that China is "out," as if it were culottes or harem pants. The world's largest nation definitely has opporunities, but I would shake things up a bit by looking at Brazil or India, or in even riskier frontier markets, such as Mexico. Next week, I'll explore how one would invest in emerging markets.