Emerging Markets (updated 12 Oct 98)

'"Emerging markets" may be a euphemism but it is also a declaration of hope and faith. Although some of the stock markets of developing nations may sometimes seem "submerged", they are generally emerging into bigger and better things.'  - Mark Mobius

Such a definition of emerging markets expresses the typically optimistic view of people specializing in this branch of equity investment. Certainly, this relatively new focus of investor enthusiasm is always exciting with something happening all the time, somewhere in the world and the opportunity for huge profits. Investment returns in some emerging markets have the potential to exceed those in the developed world.

But equally, for the dedicated emerging market investor, there are considerable challenges: the frequent frustrations of a lack of common standards and a lack of information, grueling travel schedules, language problems and cultural suspicions. And, of course, as the Asian crisis and subsequent global economic events have confirmed, stock markets and currencies in the developing and formerly communist worlds can be highly volatile, reacting strongly to international investor sentiment and economic and political changes.

Investments in emerging markets can result in spectacular returns, positive or negative. But picking potential winners, at the level of either country or company, is very difficult. There are frequently problems in comparing the relative merits of companies across markets: financial reporting and accounting standards vary, and indicators such as price/earnings ratios are often unreliable for international comparisons. Countries employ a variety of accounting conventions in their treatment of corporate profits.

It is clear that emerging markets carry considerable risks, including illiquidity, lack of transparency, and sharp swings in prices. Individual investors seeking a stake in these markets should be either thinking long-term or prepared to take substantial risks. They should also consider carefully what proportion of their portfolios they can reasonably afford to commit to such markets.

Emerging markets guru: Mark Mobius

As a category of equity investment, emerging markets may be considered to have begun in 1986 under the sponsorship of the International Finance Corporation, an arm of the World Bank. David Gill, then head of its Capital Markets Division, convinced the IFC to invest in equities in some of the strongest countries the World Bank was financing with debt, initiating private involvement in what had largely been a public domain. The Emerging Market Fund, which Gill started, gave its investment mandate to Capital Group, Los Angeles, a firm that now manages xx billion in these markets. David Fisher has successfully managed this group since the early days.

But no one epitomizes the emerging market manager better than Mark Mobius of the Franklin-Templeton Group. Mobius meets the requirement for physical stamina of an emerging market investment guru. Now in his sixties, he is in top physical shape to maintain the pace of 15-hour days, seven days a week. From a childhood in the States, he has worked and lived in Hong Kong since the 1960s and travels on a German passport. His scope is global with more emphasis on the fast-growing economies, like Asia, that especially challenge an investor when reminded that volatility is two-way.

Mobius is a hardheaded investor in markets that do not usually inspire confidence. His tough valuation bottom-up discipline demands that investments sell at no more than five times earnings five years hence. And the cheaper the better for him. He is a fundamental investor who visits companies and studies the businesses, while fretting little over the country's macro-issues. Since his techniques are common to the well-schooled analyst, he has to find different markets and different industries than other analysts. He is often out of step, buying investments that look like they may continue to decline. It is discipline - the old-fashioned kind.

Mobius is a frequent commentator on emerging markets investing and has written a well-received book, Mobius on Emerging Markets, which summarizes his 'keys to success':

· Hard work and discipline: the more time and effort put into researching investments, the more knowledge will be gained and wiser decisions will be made.

· Common sense: the clarity and simplification required to integrate successfully all the complex information with which investors are faced.

· Creativity: it is necessary to look at investments from a multi-faceted approach considering all the variables that could negatively or positively affect an investment. Also, creative thinking is required to look forward to the future and forecast the outcome of current business plans.

· Independence: when making investments, it is most unlikely that committee decisions can be superior to a well thought-out individual decision.

· Risk-taking: investment decisions always require decisions based on insufficient information. There is never enough time to learn all there is to know about an investment and even if there were, equity investments are like living organisms undergoing continuous change. There always comes the time when a decision must be taken and a risk acquired.

· Flexibility: it is important for investors to be flexible and not permanently adopt a particular type of asset or selection method. The best approach is to migrate from the popular to the unpopular securities, sectors, or methods.

Mobius also describes five central 'investment attitudes':

· Diversification: this is particularly important in emerging markets where individual country or company risks can be extreme. Global investing is always superior to investing on only the investor's home market or one market. Searching worldwide leads an investor to find more bargains and better bargains than by studying only one nation.

· Timing and staying invested: as Sir John Templeton says, 'the best time to invest is when you have money'. In other words, equity investing is the best way to preserve value rather than leaving money in a bank account. As a corollary, an investment should not be sold unless a much better investment has been found to replace it.

· Long-term view: by looking at the long-term growth and prospects of companies and countries, particularly those stocks that are out of favor or unpopular, the chances of obtaining a superior return are much greater.

· Investment averaging: investors who establish a program from the very beginning to purchase shares over a set period of intervals have the opportunity to purchase at not only high prices, but also low prices, bringing their average cost down.

· Accepting market cycles: any study of stock markets around the world will show that bear or bull markets have always been temporary. It is clear that markets do have cyclical behavior with pessimistic, skeptical, optimistic, euphoric, panic, and depressive phases. Investors should thus expect such variations and plan accordingly.

In assessing emerging market investments, Mobius stresses the importance of constantly being aware of influences and biases. These are strongest in the places where one spends most of his or her working and leisure hours and from where a person obtains most information. For this reason, the emerging markets investor must continually visit all the countries in the emerging markets areas and read news and research reports originating from all over the world. (Although as a counterpoint, the web now makes available a wealth of information on individual markets and countries - perhaps better and less costly in time and effort than that obtainable on the ground.)

For wise portfolio decisions, Mobius suggests, two important perspectives are necessary:

· The global outlook and experience that comes from having invested in many countries.

· The more detailed and intimate knowledge that comes from a local presence.

It is important to combine both perspectives by having local and country-specific information collated, digested, and compared with other global data. This kind of analysis yields much more powerful results, which enhance the locally gathered information by, for example, providing insights into a particular company as a consequence of comparisons with similar companies in another country. The end results are much more valuable insights that must yield far better long-term investment returns.

Mobius outlines the five types of risk involved in emerging market investment::

· Political - instability, regulation, foreign investment restrictions

· Financial - remittance/exchange control, convertibility, currency devaluation

· Investment - disclosure, ownership, minority shareholder culture

· Transactional - brokers, fees, computerization, settlement, custody/certificate exchange

· Systemic - liquidity, regulatory enforcement, transparency, operational structure of stock exchange

Counterpoint

It is no accident that Mobius describes 'perspiration more than inspiration' as one of the most important features of his investment approach, starting from there with a strong dash of independent thinking. But where does it break down and how can it go wrong?

The ability to move from market to market assume that investments and their environments are disconnected, that market movements are not strongly correlated. But in these days of global banking and instant communication that condition is less likely. Markets and investments in those markets may be increasingly synchronized.

In the past two decades, the period when emerging market investment rose from x billions to y billion, globalization permeated our financial systems. Now there are some clues that a cyclical return to local and national interests. If so, investments by foreigners in any market may be treated harshly.

For example, some now argue that the rapid expansion of emerging stock markets in recent years is likely to hinder rather than assist faster industrialization. According to this view, while stock markets may be potent symbols of capitalism, paradoxically, capitalism often flourishes better without their dominance. The inherent volatility and arbitrariness of stock market pricing in developing countries make it a poor guide to efficient investment allocation. Portfolio capital inflows from overseas lead to interactions between two inherently unstable markets: the stock and currency markets. Such interactions in the wake of unfavorable economic shocks may exacerbate macroeconomic instability and reduce long-term growth.

Emerging market investment depended upon steadily growing liquidity to be able to pay back investors at higher levels in a foreign currency. It works when it is going up and money is coming in. But in the reverse, liquidity is tight; ability to pay foreign creditors is lacking and confidence plummets.

Thus, emerging market investing may be a long-term cyclical phenomenon and not a steady, one-way path to riches.

A common theme of this volume is that investment success is most often observed where the market requirements and investor personality are one. The old shibboleth that "investors don't pick markets, markets pick investors" is more true in emerging than elsewhere. And Mark Mobius' style, hard-work and tough mind is exactly what was needed in emerging markets. These markets may undergo a change. Will he?

[Guru response, if any]

Conclusions

Since the beginning of the Asian crisis in July 1997, there has been an approximately 50% decline in emerging markets (see chart). It started in Asia, became most visible and most illustrative in Russia, with about a 90% decline - approximately the same as in Indonesia, the fourth largest country in the world in terms of population - and has been quietly going on without a great deal of popular press publicity in Latin America throughout this period. The publicity on Latin America is building up.

What is all this about? The mixture of rising nationalism and deflation is very potent negative medicine for emerging markets. Reform of banking systems means banks have to recognize bad loans. Interconnectivity means that when something happens in one part of the world, the rest of us all feel it. This is not necessarily a dramatic buying opportunity except for those people who can watch the hourly news. And yet, we are setting up the conditions by which the long struggle of the workout period can take place. It is probably some distance into the future, but the early dramatic decline has certainly been felt.

Read on

In print

Mark Mobius, The Investor's Guide to Emerging Markets (Richard D Irwin Inc. - US; FT-Pitman Publishing - UK, 1995, second edition entitled Mobius on Emerging Markets, 1996)

On the net

for example, www.emgmkts.com