Should I Invest in Emerging Markets?

Over the last few decades, the hot investing sector has been emerging markets.  You couldn’t read a business magazine without falling over BRIC: Brazil, Russia, India, and China.    Given the popularity and the diversification aspect, should you invest in emerging markets?

The Bull Case for Emerging Markets

So let’s start with the bull case for emerging markets.    Every major developed country started as an emerging market.  Not only that but most of those countries experienced a bit of a hockey stick type improvement when they made that transition.  That hockey stick period brought vast riches to those who were invested there.

Developing Countries have an Easier Path to Upside?

In essence, those countries that are the lowest on the totem pole financially have low hanging fruit for improvement.    Minimal progress towards improvement would result in a significant percentage improvement in finances. Also for countries with larger populations, like many of the BRICs, the opening up of the region and improvement of finances presents millions of potential consumers not yet exposed to western company goods.

The US, an Example of a Developing Nation becoming Developed

Need an example, how about the US?  The US largely rose onto the scene economically during the 20th century.  During that period the US had on average higher financial returns then it’s peers in the western world.    The US had economic performance not far off a hockey stick during much of the 20th century.   

No Change is without Set Backs

 Now that is not to say that the US didn’t have big dips and hurdles during this period.  Obviously, events like the great depression put a serious bite on stocks for a long period.  But still, during that period of transition, the returns made a lot of people very wealthy.    

So if an emerging market country were to follow the US path then you would expect emerging markets to have periods of above-average performance coupled with some periods of difficulty.  Perhaps the current shift away from BRICS is just one of these down periods???

Why I Don’t Invest in Emerging Markets: My Trip to India

Now that I have told you the reason you might want to invest in Emerging Markets, it’s time to tell you why I don’t invest in them.  We will start with a story.  About a decade ago I took a work trip to India, yes one of the BRICs.  During that time I was running a project to install a logistics center there.

During this project, my coworkers were horrified at the conditions the locals lived under.  They also marveled at how quickly high rise buildings were popping up around the city.  On the surface, it was very easy to get excited about the future economic prospects in the country, with the locals quickly moving into those high rises.

The Hurdles to Emergent Markets can Be Systemic

But that image was quickly shattered for me by two experiences.  The first was a trip I took from Dehli to the Taj Mahal.  I took a taxi for the 3-hour drive across 2 Indian states to go see this wonder of the world.  It was beautiful and worth the drive.  But it also opened my eyes up to the reality of emerging markets.

Hurdles to Travel in India

You see each time we crossed a state line we had to stop at a little building.  My driver had to get out of the car and go pay the local tax so my car could pass through that state.  This happened at each state border crossing.  If you’ve ever seen a map of India you know there are quite a few states.    Extremely inefficient and time-consuming.

Hurldes to Shipping in Emerging Markets

Even worse, when you went to ship a package from the logistics center the same process occurred.  Each time a packaged passed through a state on the way to its destination taxes had to be paid.  Each customer had exemptions for taxes in some states and not others.  That meant just routing a package around a customers tax exemptions was a logistical nightmare.

That wasn’t the limit of the difficulties either.  Importation of goods was ultra expensive at the time.  Customs charged many multiples of the fixed price to import as compared to say the US.

Byzantine Bureaucracy and Unstable Governments Kill Economic Growth

In essence, the tax schemes and complexity would choke any business that wanted to work in India.    What took 20 dollars and was completely automated 5 seconds in the US took 400 dollars and 2 people hours manually due to the bureaucracy.

Lest you think I’m picking on India, I’ve seen the same things in Russia and Brazil.  To be fair I would remiss if I didn’t comment that India reformed it’s tax laws a few years ago. I am told things are now significantly better.  But the general point still holds for the majority of these countries.

In order to really have growth regulations and rules need to be made efficient.  They need to be clear and evenly enforced.  Anything less just chokes the improvements needed for that growth.  Quite frankly few of these countries have taken the real steps needed to remove those hurdles.

China, Efficient but Opaque Emerging Market

Which brings us to the one that has streamlined their rules and regulations, China.  In some ways, it is hard to argue China is even emerging anymore.  Some of the technology deployed in everyday life is more advanced then we have here.  Their economy is now the second largest in the world.  In a way, they are a true success story of emerging markets.  Much of that success can be traced to streamlining the rules and regulations to which I previously referred (though sometimes perhaps too loosely.).

Lack of Transparency and Debt in China

So why if I feel China has solved most of its bureaucracy issues do I not invest there?  Well, frankly that has to do with transparency.  In the US we have clear rules that make things like debts visible to investors.  China has no such regulations.

Add to this the presence of ghost towns and new abandoned buildings and this transparency becomes a real issue.  I’ve seen these first hand.  From a large number of abandoned facilities from the Bejing Summer Olympics to the high rises with no tenants.  Those things actually exist.  

What is the Extent of China’s Debt?

 I don’t know, nor does anyone else outside China, the extent of the debt situation.  Nor do I know how much is business owned or sovereign in nature (given the nature of their economy is there a difference?).  What I do know is with that much debt floating around the lack of transparency as to whether my investment target is a significant holder of that debt makes it a no go for me.  

No Free Lunch With Investing, More Return Means More Risk

Which really brings us to the point.  There is no free lunch with investing.    In order to truly get a higher potential return, you must take on more risk.   After all, if the BRIC performance was a foregone conclusion they’d already be priced to include that outcome, eliminating the value of the hockey stick in the first place.  So to have all that potential upside requires a higher risk that it won’t be achieved compared to the developed world investment.   

Quite frankly we all need some risk in our portfolios, but the amount of risk in emerging market stocks exceeds my personal risk tolerance for my primary portfolio.   I can achieve high enough return without the added risk by avoiding this particular asset class.  Chasing risk most often leads to sub-optimal returns.  As such I would only ever intentionally consider an emerging market investment as part of my play portfolio.    It is possible I could pick up a small exposure to emerging markets through a diversified international fund, but that is not one of my requirements for such a fund.

Play Money Still Only Invested in Things I Understand

I don’t invest in emerging markets as part of my play portfolio either, but honestly, that’s more a factor of my rule of only investing in something I understand. I have been to China about 4 times. That doesn’t mean I truly know the place, the culture, the industry, or the government. That makes picking a stock or industry there nearly impossible. Remember just because the economy soars in China doesn’t mean every stock does.

Do you invest in emerging markets?

Full Time Finance is for entertainment purposes only.  Any actions you take are solely yours.  Remember to do your own due diligence on any investment you make.