© Copyright 2000 Rogers Media. The following article first appeared in the June 2001 edition of BENEFITS CANADA magazine.

Emerging opportunities

There is volatility and instability in emerging markets. But there is also a world of long-term opportunity for pension funds.

By George Hoguet

The year is 2010. The place is Ottawa. After concluding a bi-monthly review of economic and financial conditions in the North American dollar zone, representatives of the North American Monetary Council (Canada, Mexico and the U.S.), are hosting a conference, Enhancing Investment Returns in the Age of the Centurions.

Delegations from the Eurozone countries (which include the former Soviet satellites and Russia), China (which now has the world's fifth largest stock market), India (a leading software power) and Japan, among others, will examine the financial implications of increases in longevity brought about by recent developments in biotechnology and organ cloning. The discussion will focus, in part, on demographic developments, and on enhancing the free movement of peoples around the globe. A representative of the World Climate Organization will attend as an observer.

Sound farfetched? Perhaps. But who would have thought 15 years ago that the Berlin Wall would fall? Or that the Soviet Empire would collapse? Or that democratic regimes would take permanent hold in Latin America? Or that Continental Europe would have one currency? Or that South Africa would see a peaceful transition to majority rule?

The emerging markets are for investors who wish to combine the insights of modern portfolio theory with the belief and hope that the path of history--in terms of mankind's technological, political and social progress--moves erratically upward. As the German philosopher Immanuel Kant wrote: "Out of the crooked timber of humanity, nothing straight can be wrought." Two massive cataclysms in the 20th century attest to that.

Despite all the devaluations, crises and shocks since its inception in 1989, the Morgan Stanley Capital International's (MSCI) emerging markets free (EMF) index has returned 12.5% per annum in Canadian dollars through December 2000. This compares with -1.4% for the MSCI Japan index over the same period, and 8.4% for the Toronto Stock Exchange 300 index. Over long periods, global equity returns tend to converge to a similar mean. It is precisely because it is so hard to forecast which asset class will perform best in the near term, that an investor should be broadly diversified and take a long-term perspective on investing.

Capital market theory suggests that investors own the world market portfolio because it can be expected to produce the best Sharpe ratio. Emerging markets represent about 4% of the world market portfolio. This weighting is a good starting point for investors to consider as an initial stake in emerging markets.

HEAVY WEIGHTS

As of Dec. 31, 2000, the MSCI EMF index consisted of 26 countries and 830 securities. The Institutional Brokers Estimate Service universe contains no fewer than 6,700 emerging market securities, although a large number of these companies have modest capitalizations and are effectively uninvestable. At year end, the capitalization of the MSCI EMF stood at $1.1 trillion (see "It's a big world after all," left).

Companies located in just six emerging countries (Taiwan, Brazil, Korea, Mexico, South Africa and India) accounted for approximately 61% of the EMF's capitalization at the end of last year. The top 300 stocks represent 89% of the MSCI EMF capitalization. The largest stock in the EMF is China Mobile, a wireless telecom. Its full capitalization is larger than 95% of the stocks in the Standard & Poor's 500 composite index.

Contrary to popular belief, there is not a shortage of earnings estimates for emerging companies. On average, after adjusting for companies that have a capitalization below $100 million (which are effectively uninvestable), there are 10 estimates per security. For the top 200 securities representing roughly 81% of the capitalization, there are, on average, 14 estimates per security.

ATTRACTIVE FEATURES

Traditionally, there have been three main arguments for investing in emerging markets:

1. Portfolio diversification.

2. Return enhancement.

3. Broader investment opportunity set.

When it comes to portfolio diversification, the emerging markets exhibit several risky characteristics. But these risks must be viewed in a portfolio context (See "History lesson," page 52). By allocating a portion of one's wealth to emerging markets, an investor can create a more efficient portfolio--one with the same expected return but less risk.

As for return enhancements, the long-term return to equities is closely linked to growth in output and profits. For the past several years--the Asia crisis notwithstanding--output in the emerging markets has grown, on average, by at least 1.5% a year more rapidly than in the Organization for Economic Co-operation and Development countries, and the difference in some regions has been substantially greater.

For example, China, where the stock market capitalization available for investment by local citizens is roughly US$500 billion, has grown at over 7% a year for the past 15 years, marking one of the greatest economic transformations in history.

Emerging markets provide a broader investment opportunity set. For example, the world's leading semiconductor manufacturer--Samsung Electronics in Korea--is an emerging market company.

In addition, the world's leading Internet security company, Checkpoint Software, is an Israeli emerging market company, and one of the world's leading energy firms, Surgutneftegaz, is a Russian oil and gas producer that earned more than $3 billion last year.

DIVERSE MARKETS

Many emerging market companies have an advantage, such as cheap raw materials and low labour costs. Given the rapid diffusion of technology, more and more emerging companies are able to enhance their returns on equity and integrate into the world economy.

The wealth of the world takes many forms. China and India, two potential powerhouses of the 21st century, are home to nearly 40% of the world's population. Meanwhile, the telecommunications, media and technology (TMT) revolution continues unabated.

Within the next two years, there will be a billion people on the World Wide Web. The productivity increases seen in the U.S. in recent years are likely to spread to the emerging world. TMT stocks represent roughly 34% of emerging market indexes. The emergence of broadband technologies will have a profound impact on global commerce.

Like Canada, the emerging markets may suffer from periodic adverse external shocks. Emerging markets investing remains constrained by the myriad problems of corruption, poor corporate governance, lack of transparency and political instability--to name just a few.

But investors must always ask the question: Is it in the price? For example, in 1999 the Russian stock market, which still sells for a tempting three times forward earnings, was the world's best performing stock market--up nearly 248%. Indeed, price-to-cash-earnings reveal that by historic measures, the emerging markets remain very attractively priced (see "Priced to sell," page 52).

What is the market saying? Valuations reflect concern over macroeconomic stability, currency risk and the ability to translate economic growth into earnings power. At this level, a slight change in perception could lead to a significant re-rating of the stocks. For example, as of Dec. 31, 2000, the emerging markets were selling at a forward price-to-earnings ratio of 10.9, and price-to-cash-flow ratio of 8.2, while the corresponding figures for EAFE were 23.0 and 12.0.

An investor can pursue a tactical approach to investing in emerging markets. One problem with this, however, is that markets can rally sharply in a week or even a day. Upward country moves of 10% in a day are not all that unusual. Tactical investors may miss large moves and incur substantial transaction costs if they try to capture them. On average, transactions costs are about 130 basis points one way in emerging markets.

A longer-term approach to emerging markets is to adopt a strategic allocation. Under this approach, the investor assigns roughly a world market weighting of about 4% to the asset class.

Volatility of emerging markets should be viewed in a broad portfolio context, and active management of emerging market equities can take advantage of market and currency overshoots when they occur.

It is important to take a long-term view when investing in emerging markets. Financial bubbles occur in both developed and emerging markets. Is the world in 2010 likely to be a stable place? Possibly.

Is it a reasonable bet that global trade, which has grown more than twice as fast as world output over the past 15 years, will continue this trend? Probably. And is cross-border investment apt to increase, given that investors hold sub-optimal long-term portfolios? Yes. A modest allocation of an investor's wealth to the emerging markets is reasonable.

George Hoguet is principal and head of active emerging markets with State Street Global Advisors in Boston. george_hoguet@ssga.com.

It's a big world after all

The emerging markets, as reflected in the MSCI EMF index, comprised 830 companies and US$1.1 trillion in capitalization at the end of 2000.

Source: Factset, Dec. 31, 2000

History lesson

Canadian dollar returns from January 1989 to December 2000.

Source: Factset

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