Emerging Markets May Help Your Portfolio, Here's Why

Emerging Markets May Help Your Portfolio, Here's Why

September 2016


Here I’ll explain the major factors why I believe emerging market exposure is important for long-term investment portfolios.

Emerging markets offer long-term opportunities to investors because of the size of their populations. China and India both have populations close to 1.4 billion people, and for comparison the population of the US is just under 320 million according to population data maintained by the International Monetary Fund World Economic Outlook Database. Of the ten largest countries ranked globally by population, nine generally are considered emerging or frontier markets.

Over the longer term many economists expect the standard of living in these countries to progressively catch up with those in developed economies. That would lead to the US economy becoming the world’s third largest as India overtakes it. Today, on some economic measures the US is already second in size, behind China.

With 80% of the world’s population living in emerging markets, and their purchasing power increasing, they will become an increasingly important component of the global economy. Investors can gain exposure to what I believe is a long-term favorable trend, by investing in emerging market equities.

Not only do emerging markets account for 80% of the world’s population today, many emerging markets are growing comparatively fast, with relatively young working age populations. This is often referred to as attractive demographics.

Population growth is positive for economic growth, because increases in population are generally a significant and predictable contributor to economic growth. For example according to IMF estimates, in 2014 the Indian population grew 1.2% and the Chinese population grew 0.5% whereas in the developed world, population growth was generally lower. For instance, the Japanese population declined 0.2% and the population of Germany grew 0.3%. These higher rates of population growth in some of the largest emerging market populations can translate into greater economic growth because as a population grows, more workers ultimately enter the workforce increasing production and consumption. For example, for 2016 the International Monetary Fund projects developed markets to grow at 2.2% and emerging and developing economies to grow at 4.5%. It appears that demographic factors are an important contributor to that growth differential.

In addition, studies, such as the research by the academic Amit Goyal, have shown that population structures can impact stock market returns. These are often called lifecycle models, where having an older population can cause net outflows from the stock market.

The economically strongest and most developed countries don’t necessarily provide the best stock market performance.

The idea that you should invest in the US because it’s the largest and best economy in the world, though intuitive, is not an argument that has lead to the best investment outcomes looking back over history.  Indeed, often in investing it’s not always what is apparently the highest quality investment that offers the best returns.

For example, in 1899 the same argument could have been made of the UK, which had a dominant economy and empire. In 1899 the UK represented 25% of global markets and is now 7%. Conversely today the US is over half the value of all the world’s stock markets combined and economists have argued that the growth rate of the US will decline over coming decades.

To take a second example, in the 1980s Japan was the envy of the world, a fast growing and technology reliant economy, causing the Japanese stock market to soar. Only to then subsequently crash to less than half of its former level.

In fact in his book Style Investing, Richard Bernstein highlights that quality as a trait of investments varies over time. If you’re investing only at the high quality end of the spectrum, that exposes you to risk, because what is high quality now could always deteriorate, whereas investments perceived as moderate quality could deteriorate but also have an opportunity to improve. As a result with high quality investments there’s some downside risk, but little chance for improvement. That creates greater risk for investors over time than they may realize.

Much of prudent investing is counter-intuitive, and often the best and strongest economies don’t deliver the investing results that you might expect. The UK and Japan both offer historical examples of this as does Richard Bernstein’s broad insight. As I discuss below, relative valuations are more impactful for long-term returns to investors than the relative prestige of an economy.

You would expect emerging markets to improve country diversification in a portfolio by adding exposure to hundreds of companies from a diverse set of countries from South Africa to Qatar. In addition, various important industries are underrepresented amongst US stocks such as alternative energy, mining and leisure goods.  International exposure doesn’t just offer exposure to different countries, it can offer exposure to entirely different industries together with different weighting to existing industry exposure, and this can be important in managing portfolio risk.

The US stock market may also be somewhat expensive relative to historical norms. This is something that academics and investors such as Robert Shiller, William Bernstein and John Bogle have all recently noted as documented by the financial writer, Ben Carlson here. For example on Robert Shiller’s measure of valuation, the US market is approximately 50% more expensive than its median historical level. Of course, no one knows what the markets will do in the short-term, but all have argued that international diversification can be useful, especially at a time when emerging markets appear inexpensive on the same valuation measures.

The chart below shows that when averaged over 10 years, the earnings of emerging markets companies represent 7.3% of their stock market value. The yields of the US and developed markets are substantially lower at 4.1% and 5.0% respectively.

These values have been shown to be predictive of subsequent market performance based upon the research of Nobel Prize winner Robert Shiller. Other valuation metrics such as dividend yield and current earnings yield though not shown in the graph below present a similar picture, with emerging markets appearing less expensive than the US and other developed markets.

One of the best performing markets over history is an emerging market

Finally, it’s also worth noting that according to Dimson, Marsh and Staunton the best performing market on the basis of stock market returns from 1900 to 2014 is actually not the US, but South Africa, an emerging market that began with a relatively low valuation and experienced high population growth.r developed markets.

Emerging markets equities are one important, if volatile, component of well-constructed portfolios. Emerging markets can diversify a portfolio on multiple fronts from country to industry exposure. In addition, long-term valuation metrics, combined with demographic trends that indicate population growth in the Western world is slowing, suggest the coming years may be positive for emerging market equities.

This article was written by Simon Moore from Forbes and was legally licensed through the NewsCred publisher network.

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