Image Credit: T.W. Ingersoll, stereograph, “Dancing the maypole dance,” ca. 1900, Strong National Museum of Play via Google Arts & Culture
I’ve got a long history with emerging markets. In 1979-80, I lived in the Middle East; in 1985, I traveled roughly 3,500 miles through eight West African countries over four months; in 1992, I spent a day at the Zimbabwe Stock Exchange.
And, my records show, on Valentine’s Day 1990, I bought 100 shares of Templeton Emerging Markets Fund, a closed-end portfolio that in those antediluvian days was the only practical way for an individual investor in the U.S. to put money to work in emerging markets.
Earlier that winter, I’d been in the Bahamas for the wedding of a friend and went out to Lyford Cay to interview John Templeton, the great global investor. He’d told me about the bargains that abounded in Asia and Latin America and, to a lesser extent, in Africa.
A few weeks later, back in New York, I attended an event at which Templeton pitched his new fund to an auditorium full of wealthy investors. Chatting with them over dessert after Templeton had finished his presentation, I was startled to find that most had no interest in the fund. Hearing about stocks trading at single-digit price/earnings ratios didn’t excite them, but the threat of unstable governments and collapsing economies did frighten them.
To me, that was the clincher: Emerging-market stocks were cheap, and American investors wanted nothing to do with them. So I bought. With my own experience telling me that these markets were neglected and cheap, and knowing that almost no one else shared my enthusiasm, I invested what then was a ton of money for a young reporter. The 100 shares of Templeton Emerging Markets Fund cost me $1,472.50 ($14.375 per share, plus a $35 — or nearly 2.5% — commission).
A few years later, when the yields on emerging-market bonds widened out past 15%, I’d also bought Scudder Emerging Markets Income Fund.*
So I was an extremely early enthusiast for investing in emerging markets. But few areas of investing are so rife with myths and misunderstandings. Foremost among them is the perennial claim that emerging-market stocks should have higher returns because emerging-market economies are faster-growing than the U.S. After writing my column for The Wall Street Journal this weekend about the way many emerging-market companies seem to be manipulating their reported earnings, I realized that the expectation of rapid earnings growth is probably rooted in the same old erroneous belief that stocks in fast-growing countries ought to have higher returns. No matter how many times this story gets debunked, it still comes back. People are still saying it in 2019 — even though it isn’t true. I first debunked it in 2007, in this old column I just fished out of my archives:
Markets Where Fools Rush in
Money Magazine, August 2007
Whenever a popular investing argument starts to sound like a no-brainer, I know that lots of people will soon be losing lots of money.
Anyone with ears has been hearing lately how “it’s obvious” that emerging markets stocks are sure to keep outperforming those in the industrialized world. To which I say, look out below.
Don’t get me wrong. Investing in emerging markets is the right thing to do in the long run. But the investing gods punish people who do the right thing for the wrong reason.
Jump into emerging markets now in pursuit of hot returns and you’re sure to get hurt. Here’s why.
Who gets the growth?
These days everybody from Goldman Sachs strategists to your dry cleaner seems to believe something like this: Because the economies of places like Brazil, China and India are expanding two to three times faster than in the U.S. or Europe, these emerging markets are bound to have higher stock returns.
But the obvious “truth” is wrong. The U.S. economy — the original “emerging market” — grew faster in the 19th century than in the 20th, and yet stock returns were no higher.
Over the past 20 years, Asia has grown faster than Latin America but Latin American stocks have done better.
And London Business School’s Elroy Dimson, the world’s leading expert on long-term market performance, has found that on average the highest stock returns come from the countries with the lowest rates of economic growth. In the long run, stocks in the slowest-growing nations earn an average annual return of 12%, or twice that of stocks in the fastest-growing economies.
Japan was the world’s fastest-growing nation over the past century, but it produced the lousiest returns of any big stock market. The same upside-down relationship applies to countries such as Italy (high growth, low returns) and Australia (low growth, high returns).
What accounts for results that seem to fly in the face of basic logic?
First of all, when countries grow fast, the economic pie does expand, but it gets cut into thinner and thinner slices as more companies offer stock in initial public offerings.
In 2003, for instance, there was a single IPO in Russia taking in just $14 million. In the first five months of 2007 there have been 13 Russian IPOs raking in $16 billion.
Last year more than 130 Chinese companies issued roughly $60 billion in new shares. That’s at least 20% more than the total value of IPO stock that was issued here in the U.S.
Future profits in China and Russia now have to be divided among many more investors. That leaves less for you.
Second, it doesn’t matter how glorious the future turns out to be if you paid too much for your piece of it. Emerging markets stocks sell for an average of more than 16 times their net profits, while U.S. stocks trade at around 17 times earnings.
That gap is seldom so narrow, and when it is, emerging markets usually end up getting hammered. That’s because they should be cheaper.
The U.S. government, whatever its faults, doesn’t confiscate industries or create inflation so severe that you need a wheelbarrow full of money to pay for a loaf of bread. Russian president Vladimir Putin isn’t shy about jailing critical CEOs and busting up their companies. The next stock he seizes may be one your fund owns.
I’m not saying you should bail out. As an enduring part of your portfolio, emerging markets are a great way to hedge against the hazard of keeping all your money at home; when the U.S. zigs, emerging markets tend to zag. If you invest patiently over time, you have little to worry about.
But there’s a big difference between owning and buying. Owning an emerging markets fund permanently makes all the sense in the world. Buying one today – plunging in for the first time – does not.
Emerging markets will go on sale soon enough; the time to buy is when the headlines turn bleak and your friends stop bragging about how much money they’ve made in China.
When that day happens, buy a cheap index fund like Vanguard Emerging Markets Stock, iShares MSCI Emerging Markets or Vanguard Emerging Markets ETF.
Until then, if you want to jump into the developing world, book a vacation to Rio.
* I no longer own either fund. I don’t know exactly when I sold, but I remember it was sometime in the late 1990s, when Americans suddenly couldn’t get enough of emerging markets. I do own a permanent position in emerging-market stocks through the total international-stock index fund that constitutes about 40% of my overall stock allocation.
For further reading:
Benjamin Graham, The Intelligent Investor
Jason Zweig, The Devil’s Financial Dictionary
Jason Zweig, Your Money and Your Brain
Jason Zweig, The Little Book of Safe Money
Articles and other research:
Jay R. Ritter, “Economic Growth and Equity Returns” (Pacific-Basin Finance Journal, 2005)