Growth and Value in Emerging Markets
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Ignoring emerging markets when it comes to building a portfolio is one of the worst mistakes an investor can make. Developing markets are becoming an increasingly bigger part of the world economy, so from a diversification point of view there are very good reasons to have a healthy proportion of your holdings exposed to these countries. Furthermore, their economic fundamentals are much better than in most developed nations, and valuations are looking quite attractive too.
Instruments like ETFs provide a convenient way to invest in emerging markets while at the same time controlling for company specific risk: the risk that the individual company could disappoint investors in the long run, ruining in that way the positive features of emerging markets growth. Diversification can be the preferred way to emerging markets for risk adverse investors, especially for those who don´t have the necessary knowledge about individual companies to select them.
When it comes to risk, avoiding emerging markets can be more hazardous to long term performance than dedicating a considerable portion of the portfolio to those markets. After all, emerging markets are nearly 50% of world economic activity nowadays, and that proportion is expected to continue rising in the following years. Those who avoid developing nations are not only disregarding a big part of the world, these economies have very strong fundamentals, which should provide the fuel for outperforming returns in the following years.
It’s not only a matter of growth rates, which are obviously higher in emerging markets; these countries also have sustained balanced fiscal budgets and a net creditor position in the international front: the US and Europe owe money to emerging markets, which is something that would be unthinkable a decade ago.
Since 2007, 182 of the 185 sovereign upgrades have gone to emerging nations; European countries and even the US have seen their credit ratings downgraded in the last years. Considering this situation, the widely held belief that emerging markets are riskier than developed ones doesn´t seem to find a lot of backing in current economic trends.
It is true that these assets are usually more volatile than stocks in countries like the U.S., and investors tend to fly away from emerging nations when their risk appetite is not elevated. The financial crisis in Europe and other factors like concerns about a possible hard landing in China have produced disappointing returns for emerging markets investors during the last year, especially in comparison to the US.
In the following charts we compare the performance of Vanguard Emerging Markets (NYSEMKT: VWO) which is a very popular emerging markets ETF with S&P Depository Receipts (NYSEMKT: SPY) which tracks the S&P 500 index over the last year. The outperformance of US markets over this period is particularly attention drawing because it has happened in a positive year for stock prices in general.
When prices are on the rise, emerging markets usually outperform developed nations, since risk appetite is typically quite healthy during those periods and investors feel tempted by the profit opportunities that emerging markets provide. The same comparison between these two ETFs since 2005 shows much better numbers for the emerging markets ETF. If the long term trend for the general markets is up, emerging countries have a big chance of out-performance.
The recent underperformance in emerging markets could provide a buying opportunity in these assets for long term investors. When analyzing the long term prospects of these countries, valuation ratios and growth opportunities look quite interesting.
The following chart from Smith & Barney shows dividend yields and five year annualized growth in dividends for the S&P 500 versus the MSCI Emerging Markets Index. The fact that emerging markets have higher dividend growth is generally expected, however, many investors would be surprised to see higher dividend yields in these countries too. Not only growth prospects, but also valuation ratios look quite interesting in the emerging world.
Besides from the popular Vanguard Emerging Markets ETF, which many investors use for exposure to big capitalization emerging market stocks, other alternatives could provide a more focused approach and very interesting ideas for investing in these kind of markets. WisdomTree Emerging Mkts Small Cap Dividends (NYSEMKT: DGS) invests in a basket of almost 550 small and medium sized companies with attractive dividend yields.
This instrument avoids some of the drawbacks of other emerging markets ETFs, like too much exposure to the heavily regulated industries like public services and energy. Sectors like consumer, industrials and technology, which make the biggest sectors of this fund, provide a better way to capitalize the exciting dynamics of emerging markets growth. The ETF provides investors with a 3.5% dividend yield while waiting for long term capital gains.
EGShares Emerging Markets Consumer (NYSEMKT: ECON) doesn’t have the same dividend yield, it pays less than 0.5% in dividends, but this instrument offers exposure to the rising middle class in emerging markets, a very attractive proposition. The consumer sector is more than 80% of the portfolio of this ETF, and that provides truly extraordinary potential over the long term.
In countries like Brazil, India and China people are starting to have access to goods and services they couldn’t afford a few years ago. The trend is still in its first stages, so investors have a lot to gain by targeting these opportunities. Also, governments usually stay away from business like retail and consumer staples, and this reduces the possibility of undesirable interventions or excessive governmental regulation.
The rise of emerging economies in the international arena is a process that will take decades to fully develop. This is a very interesting time to look beyond an investor´s home country and venture into the exciting lands of emerging nations in search of the best long term opportunities.
acardenal has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.