“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” - Warren Buffett (Trades, Portfolio)
The economies of developing countries, or emerging markets, are projected to grow at a higher rate than the developed world. This was reiterated in the World Outlook report released by the International Monetary Fund (IMF) in mid-2019.
Source: The International Monetary Fund
Despite the common belief that developing countries will eventually provide greater returns than U.S. equity markets, many investors remain on the sidelines due to the inherent risks of investing in companies in these regions, including currency risk and credit default risk.
According to the latest 13F filings, a few investing gurus, including Ray Dalio (Trades, Portfolio), Mark Mobius and Prem Watsa (Trades, Portfolio), have invested in emerging market funds, or in companies that have significant exposure to underdeveloped regions. In the remainder of this analysis, five possible reasons behind these investments will be discussed.
Attractive economic growth prospects
According to the IMF, developing countries contribute more toward the global economy than developed regions of the world, which comes as a staggering revelation. Statistics show that emerging markets now account for 59% of the global GDP, and this number is expected to further improve in the future.
Contribution to the global economy
Source: The International Monetary Fund
As the gap between these two regions widens, there should be ample growth opportunities for companies in developing countries. It would not come as a surprise if a few companies from China or India stand out as leaders of certain industries. From being just cost-centers, these countries could become the growth drivers of the world economy.
Continued economic growth inevitably leads to attractive returns from capital market investments, which might be one of the reasons behind the investments of a few gurus.
The growth of tech companies
Emerging markets are home to some of the world's most powerful and fast-growing tech companies, including Samsung, Huawei, Taiwan Semiconductor and Tencent. As the tech-savvy population grows along with developing infrastructure in these regions, companies that cater to this market could eventually provide attractive investment returns.
For instance, China is home to 9 out of the 20 of the world's largest tech companies, which is a clear indication that the helm would finally transfer from countries like the U.S. and UK to China, India and other Asian nations.
Source: MarketWatch
This favorable outlook for the tech sector has correctly been identified by many institutions that provide exchange-traded funds with a focus on international markets.
For example, according to data from Legg Mason, the share of information technology stocks in the benchmark MSCI Emerging Markets Index has more than doubled since the turn of the decade and now has the largest technology weighting of any major global index. This higher allocation for tech stocks could be one of the reasons why investing gurus are bullish on such funds.
Favorable demographics
According to data from Ashmore, more than 6 billion people live in emerging countries, accounting for nearly 85% of the global population. In addition, 90% of people under the age of 30 live in these countries. The availability of a massive workforce in itself is a driver of an economy. However, what stands out is that a higher number of people in emerging countries are pursuing educational qualifications, indicating that the quality of this labor force is high.
Source: International Finance Corporation
The growth of professionals in these regions will provide a boost to economic growth in the future.
In addition, increasing disposable income will also be a catalyst. For instance, in their respective earnings conference calls in the last 12 months, executives from Apple, Netflix, Walmart and Disney confirmed that countries such as India, China and Brazil are viewed as the markets that could provide them with the biggest growth opportunities. Many other multinational companies will likely start operating in developing countries to drive their revenue along with the increasing levels of income in these countries. The overall effect would be positive for both the economies and capital markets.
Favorable demographic trends might be a reason behind the emerging market investments of influential investors.
Attractive valuation
The trade war between the U.S. and China had led many investors to believe that companies in Asia would come under massive pressure due to sanctions and the loss of customers. This resulted in net outflows from equity markets in this region and as a result, the performance of major stock indexes lagged that of U.S. markets, with the exception of the Mumbai Sensex Index (India).
| Index | Performance in the last 12 months |
| Nikkei 225 (Japan) | 4.59% |
| Hang Seng Index (China) | 7.71% |
| Sensex Index (India) | 16.51% |
| Dow Jones Industrial Average | 8.5% |
| S&P 500 Index | 12.35% |
| NASDAQ Composite | 13.66% |
Source: Reuters
This underperformance has now created an opportunity for investors, and there’s a possibility of the trade war coming to an end sooner than expected.
The return on equity (ROE) of emerging market companies is comparable to that of the rest of the world, but stocks are trading at a price-book ratio that is well below the global average. This mismatch provides the opportunity to invest in highly profitable companies at a cheap price.
Source: Bloomberg
When the geopolitical tensions surrounding Asian countries subside in the future, the price-to-book multiple would ideally converge with that of the world average, suggesting the possibility of a 50% capital appreciation return. Even if a partial convergence occurs, the investment return would still be double-digit.
This undervalued nature of emerging markets could be a reason for investing gurus to be bullish.
Diversification benefits and the potential to earn higher returns
Generating a sufficient return from an investment portfolio under any market condition is a key objective of many investors, and exposure to emerging markets could prove to be one way to do so.
The common notion that equity markets around the world are perfectly correlated to each other is a misconception. Historically, emerging market equities have had a correlation of 0.8 on average to developed markets, which confirms the diversification benefits.
Source: Bloomberg
A study conducted by Vanguard in April revealed that adding international stocks to an existing portfolio of U.S. stocks could reduce the overall volatility in the long term. As the below graph exhibits, the key is to strike a balance between the two types of investments.
Source: Vanguard
Even though U.S. markets have provided superior returns compared to other international markets in the last couple of years, long-term investment returns indicate that emerging markets have easily outperformed the average return of world markets. One of the primary reasons behind this attractive performance is the persistent economic growth of developing countries.
Source: Vanguard
The diversification benefits coupled with the potential for higher returns is most likely a reason for gurus to invest in these markets.
Conclusion
Despite inherent risks, emerging markets provide value for an investor's money over the long term.
Developing countries have been prone to political instabilities in the past and will remain to be so in the future, which is one of the biggest risks for investors. There is currency risk as well, which could result in the volatility of returns along with foreign exchange movements. However, despite these risks, emerging markets are likely to provide attractive returns in the long term, considering the undervalued nature, growth prospects and favorable demographic developments. It’s a good time for investors to “put out the bucket” as Buffett suggests before stocks in these regions become too expensive.
Exchange-traded funds (ETFs) such as Vanguard Emerging Markets fund (VWO, Financial), iShares MSCI Frontier 100 fund (FM, Financial), iShares MSCI Emerging Markets fund (EEM, Financial), and the Schwab Emerging Markets fund (SCHE, Financial) provide a simple way for investors to gain exposure to these growing regions.
Disclosure: I am long EEM.
Read more here:
- 4 Possible Reasons Behind Ray Dalio's Big Bet on Gold
- A Recent Regulatory Change in India Has Improved Apple's Growth Opportunities
- Kraft Heinz: A Warren Buffett Holding Trading Below His Purchase Price
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
