Brent Sheather: Forays into emerging markets risky

I reckon if you were able to eavesdrop on 10 investment strategy meetings between private bankers/stockbrokers/financial planners and their clients this week, nine out of the 10 would involve the advisers extolling the virtues of investing in emerging markets.

The sector is extremely popular at the moment: everybody is talking about the higher economic growth rates of China, India, Russia and Brazil, the demise of the West, the weak US dollar, blah blah blah.

Then there is the red-hot performance of the emerging-market stock markets. In the 12 months to the end of February the sector is up 90.3 per cent in US dollar terms.

Over 10 years, emerging markets have recorded compound growth of 10 per cent a year versus zero for the world stock market. It seems like "you've just got to have some exposure in your portfolio".

Well, admittedly I am still working, but for what it's worth, my guess is there may be some good reasons to delay buying into the sector, not the least of which is the fact that it is so popular.

For another, the great performance from emerging markets is historic - they have almost doubled in the past 12 months so prices are now much higher and important things like dividend yields are lower.

The dividend yield on the largest emerging market index fund is only about 1.5 per cent. What's more, we know that shares exhibit serial negative correlation - good years tend to be followed by bad.

In the past month several authoritative and independent sources have published papers saying that high rates of economic growth don't mean strong stock market performance.

Let's look at what the academics are saying. The 2010 version of the Credit Suisse Global Investment Returns Yearbook (GIRY) notes the excellent recent returns of emerging markets but asks whether their better performance than developed markets can continue and what role emerging markets should have in investors' portfolios.

The article notes many emerging markets have grown more slowly than expected and others have suffered their fair share of setbacks, including corruption, bad economic policies, communism, civil strife and wars. In fact, it is by no means certain that an emerging market will make the transition to a developed market.

An example is Argentina, which in 1900 had a GDP per capita higher than that of Sweden and Norway, yet today, because of a combination of setbacks, is considered to be a frontier market with a GDP per capita of less than $25,000 a person.

The GIRY observes that one also needs to remember emerging markets are more risky than developed markets, so should legitimately offer higher returns. Although China and Russia are producing excellent returns for investors at present, it hasn't always been like this.

Investors in Chinese equities and government bonds lost everything when Chairman Mao Zedong's Communist Party took power in the late 1940s.

Similarly, the communist revolution in Russia early last century wiped out government bonds and equity investors.

The article notes the longer-term performance of emerging markets back to 1975 is, at 9.5 per cent a year in US dollar terms, less than that of the developed markets at 10.6 per cent a year.

Arguably this longer-term performance of 35 years is more indicative of the future than the past 10 years. In this regard the GIRY's authors write "many investors chase past performance and buy an asset after its valuation has risen".

It also costs a lot more to deal in emerging markets. Commission and bid/offer spreads are typically far higher than for more liquid markets like the NYSE.

What this means is it might be more difficult to match index returns in emerging markets than developed markets because of higher transaction costs.

Just about everyone is forecasting strong GDP growth for the emerging markets but, perversely, according to the GIRY and Andrew Smithers of Smithers and Co in London, analysis of the facts shows high GDP growth does not necessarily mean high returns. The GIRY makes the following points:

GDP growth represents the level of real activity in an economy which could take place in the absence of a stock market. Until recently Germany and Japan had excellent GDP growth financed through banks rather than the stock market.

Increases in the value of the stock market are not the same as increases in your share portfolio. Stock market values can grow through more shares being issued by existing and new companies.

Many large, emerging market companies may have limited free-float. While government, family or domestic investors may enjoy value increases, global investors are sometimes unable to share fully in these companies' performance.

A good example is the second largest oil company in the world, PetroChina, which has a free-float - that is, the percentage of shares available to the public - of just 2.5 per cent.

There is no clear correspondence between a company's nationality and its economic exposure.

"Emerging market companies that trade internationally may be dependent on growth in the developed world."

The strong projected economic growth is well known and is thus likely to be factored into prices.

Still feeling bullish? Well, now I play my trump card.

In early 1994, following a near-doubling of the biggest emerging market of the day, Hong Kong, the broking firm for which I worked listed Templeton Emerging Markets (TEM) - probably the largest and most popular listed emerging-market fund in the world - on the New Zealand Stock Exchange, and we got its legendary manager, Mark Mobius, to come to New Zealand to give presentations to clients.

This all went down well, except that this coincided with a huge bubble in emerging-market share prices.

TEM listed in New Zealand at about $3.20, got as high as about $3.80, but four years later had almost halved in price. Even 10 years down the track, in 2003, TEM shares were below their original New Zealand listing price.

Thereafter the price trebled to where we are today.

So how is this relevant to us in 2010? Well, the remarkable Mobius was back in New Zealand last month, so I'm wondering whether, with all the present euphoria, history is going to repeat. There may be a better time to buy emerging markets.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.