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Emerging Market Investments: Diversifying into the Future

When investors look to diversify their stock portfolios, they often look overseas. Unfortunately, the choices they make are often limited to developed markets, thereby bypassing one of the most interesting and potentially profitable opportunities in global investing. There are compelling reasons to believe the most spectacular growth of the next few decades will come from emerging markets and the companies that are in the middle of this growth curve seem poised to deliver spectacular returns for the informed investor.

Here’s the bad news for many developed economies
Not to be too simplistic, but most developed world markets are laboring under the twin burdens of slow to no population growth and burgeoning numbers of elderly citizens whose need for social services threatens to compromise or even collapse their economies. Think…retiring “Baby Boomers” here in the U.S. and abroad, and you’ll quickly see what we have observed.

Now, here’s the good news about emerging market investments
In emerging markets, by contrast, large and growing populations of healthy young people are driving the market for consumer and industrial goods, increasing the demand for energy and infrastructure, and consuming vast quantities of raw materials. The companies that are delivering what this growing population wants and needs, stand to out-perform their established brethren by a multitude of Xs. And it stands to reason that the stocks of these high growth opportunities will out-perform as well. Read that as potentially out-performing by many, many times the investment potential of larger cap companies.

The downside…there’s usually a downside to most every opportunity, and here’s this one
Emerging market stocks are nothing if not volatile. Let’s emphasize that point…they can be very volatile. It’s not unusual for emerging market stocks and funds to be up 60% one year and down 40% the next. Some individual market issues can be even more volatile; up 200% to 500% and then losing close to 80% or 90% in the following months. Therefore, if the potential for such a roller coaster ride makes you break out in hives, you might want to consider something a little more conservative; albeit, definitely less rewarding.If, on the other hand, you have a relative amount of resolve, some patience and a source for good information,, the rewards of well-chosen emerging market stocks and/or funds could easily outpace many other investment choices…no guarantees, but the opportunity is certainly there.

Let’s talk strategy
You definitely don’t want the majority of your portfolio subjected to such extreme volatility, so determine in advance the proper percentage or investment limit. This is also not the place for funds you will need in the near to mid-term future (for conversation’s sake, let’s say that’s 24 to 48 months).And, if you catch the market as it’s turning south, it may take some time to ride out the bumps before you enjoy the returns you are expecting. You can buy a little safety by dollar cost averaging into an emerging markets fund, which simply means buying the same dollar amount at regular intervals over a period of months or years. This method ensures you’ll buy fewer shares when prices are high and more when they’re low. It can also mitigate the risk of putting all your money in at what could turn out to be a near-term high.This same dollar cost averaging approach works for individual stocks too…which brings us to this question:

Individual stocks or mutual funds?
While some emerging markets stocks are traded on senior exchanges, many are not. You may find it more convenient or easier to diversify a portfolio, therefore, by purchasing an emerging markets fund. There are emerging markets index funds, offered by companies like Vanguard, as well as actively managed funds offered by American Century Funds and others.While actively managed mutual funds often fail to justify their higher fees, the case of emerging markets may be an exception. Because there are more anomalies in the prices of emerging markets stocks, a good manager might, and we say might, be worth the extra cost.If you choose active management, look for a manager with a long track record of outperforming the emerging markets indexes in good times and bad. If you have a strong conviction about a particular part of the world, you can also find funds that limit their investments to specific countries or areas.For the most part, we have a bias toward individual stocks. In our experience, it’s been more fun and rewarding to analyze individual companies, figure out what sectors to focus on and then dig out the potential winners…those stocks that seem poised to deliver the types of returns we’re looking for…3x, 5x, even 10x gains.

When to sell
The simple answers might be:When you reach your return target, orWhen the market takes you out…like on a Stop Loss that was protecting your downside.A more detailed reason to sell might be:When you can lock in an appropriate amount of gains (only you know what’s appropriate for your objectives) by selling part of your position…and then hanging on to the balance and playing with the “House’s Money” because you believe there is still substantial upside.With individual stocks, the fundamental performance and financial condition of the company can be the primary determining factor…additional triggers can be news about accounting problems, supply chain interruptions, board turn-over, a CEO, CFO or auditor resigning for unclear reasonsWith funds, it may be worth waiting for an up-cycle to sell. They can swing wildly from one year to the next. So, before you hit the sell button and lock in a loss, consider hanging in there until the fund has moved back into positive territory. Usually, this coincides with the global economy as a whole being on an upswing.

CONCLUSION
Emerging markets stocks generally have a place in the portfolios of all but the most conservative investors, or those with relatively short time horizons. High growth, emerging economies will likely provide the catalyst for outsize rewards to investors with medium to longer-term investing objectives.We believe that from late 2011 through 2012 emerging markets will not grow as fast as they have over the past five years; but Asia has the best opportunity of returning to double-digit growth and outpacing the rest of the world.Additionally, we think growth is in the smaller emerging economies called ‘frontier markets;’ the non-BRICs (not Brazil, Russia, India and China) which now represent 20 percent of the world GDP; that means they are bigger than the U.S. economy. Everest Capital said, “That’s where the growth is.”Qatar and Bangladesh are two examples of frontier markets.Taiwan, South Korea, South Africa, Mexico, Israel and 20 to 30 others are among the largest and more recognized countries that fall into the classic “developed” emerging markets category.Scott Kalb, CIO of Korea Investment Corporation, is a sovereign wealth fund manager invested in emerging markets. He said, “The most important thing about emerging markets is their current account surpluses. In general, we need to have a strong presence in those markets because it is important to have diversification.“Twenty years from now, I think that emerging markets will represent 70 percent of GDP; now it is 15 percent.”As we mentioned earlier and as Travis Flenniken, CFA, and vice president of investments with DeMoss Capital, said in the closing comments of a posting on timesfreepress.com,“The volatile nature of stocks in the emerging market category may make it difficult for many to stomach [as] an investment; however, the prospects for growth are hard to ignore.”
Posted by the Research Staff
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