Turn on CNBC, Bloomberg News, or any other business news channel and you’re likely to hear at least one market pundit explain why emerging markets have outperformed recently and give a prediction about their continued leadership. The basis for this discussion is the fact that over the last three and six months, EM indices have bettered those of the U.S. and other developed markets. But all emerging markets are not the same—making country selection important—and drilling down to the company level can often bring additional opportunities to portfolios.
For six months through the end of February the MSCI Emerging Market Index rose 0.3%, while the MSCI U.S. and EAFE (other developed markets) still show meaningful declines of 3.3% and 3.6%, respectively. Rarely covered in news reports, however, are the components driving an index’s return. Instead, viewers are given the impression that emerging markets move as a block. The MSCI Emerging Market Index includes 24 country constituents which spans the Far East of Asia to the Western Americas, so homogeneity is unlikely. Its 0.3% increase over the last six months was driven by the very strong performance of just one country, Brazil. While Brazil accounts for just 7.3% of the index, it gained 36.7%. Exclude Brazil and the Index would have been down 1.9%, much closer to developed market performance. On the other end of the spectrum, comparably weighted India (‑8.4%) and Taiwan (‑7.6%) significantly trailed developed markets and almost half, of the 24 markets in the Index were down in the period. Those making a bet on the emerging markets through a single ETF are losing out on an opportunity to benefit when individual countries—and even companies in them—offer better value.
Remarkably, there’s no universally accepted criteria for classifying an emerging market as emerging. The characterization of a country as an emerging market is a starting point for investment analysis, but in some cases the moniker can be misleading, and one should guard against making a set of assumptions about a country merely because it is labeled “emerging.” South Korea, for instance, with income per capita over $26,000, should be classified as a developed market, at least on this metric, but is still listed as a constituent in the MSCI EM index. Emerging markets can differ substantially from one another in political systems, stages of development, and physical and financial infrastructure. Those differences can be used to determine the investment attractiveness of each market or an equity within that market. Ideally, a country will have low levels of inflation, moderate levels of external debt, prudent fiscal policies with a light tax burden, the ability to implement counter-cyclical fiscal policy, a relatively young and skilled workforce with an entrepreneurial spirit, a stable political system providing markets free from government control, a strong court system and society norms observing the rule of law, unfettered access to international markets, and an independent central bank capable of maintaining stable prices and a free-floating currency. Most markets – frontier, emerging, and even developed – fall short of the ideal in one or more of these categories, but this provides the opportunity to find mispriced assets. We look for countries with investment environments where companies can at least overcome or, ideally, thrive despite the challenges in the local business climate. We find scoring countries in the above and other criteria helpful in not only finding investment candidates, but also important in identifying what can go wrong with an investment. Sometimes that allows us to find a diamond in the rough.
On the weaker end of the country characteristics spectrum, Turkey suffered one of the poorest returns in 2018, and despite its recent recovery, is still down ‑35% in U.S. dollar terms for the 12 months ending February 2019. As highlighted by Dr. Charles Lieberman in his August 2018 commentary, “Turkey’s Goose is Cooked,” the country was guilty of several sins against the criteria above. Imprudent fiscal finances, excessive external debt, and unstable politics created a toxic mix causing both the lira and equities to plummet. Investing in the entire Turkish market at that point would have been unadvisable. However, our one Turkey position, an airport operator, defended relatively well in this ugly environment. Having largely U.S. dollar revenues, lira-based expenses, and volumes not significantly impacted by the coming recession, the company was able to keep most of the gains we accumulated in the position. This investment has, to date, been able to swim upstream against the tide.
The problems with Brazil are numerous and the country still has much to correct, but with new political leadership, investors expect the investment climate to improve. This led us to a Brazilian water company in Paraná state and we secured an investment in a company we thought could execute well in a variety of political and economic scenarios given its very low valuation and steady growth. The stock prospered in the rising equity environment, outpacing the index in the six-month rally, and we think it would have done well even if the politics had turned out differently.
Investing in emerging markets is difficult and making blanket statements about how these markets react to a single or small set of variables is not a winning strategy. As my colleague, Dr. JoAnne Feeney, highlighted in her commentary last month entitled “Stock Selection is More Important than Ever,” picking winning investments can be challenging in a deteriorating economic environment. Moreover, challenging environments almost always exist in one or more emerging markets, but opportunities can still be identified with intensive macro, industry, and company analysis. Combining this analysis with disciplined valuation criteria provides for a winning long-term emerging market investment strategy.