November 2, 2005

Don't Get Caught Up in the Hype Over Emerging-Market Investments

It's a developing story -- and it may not have a happy ending.

The International Monetary Fund forecasts that emerging-market economies will grow 6% in 2006, while the developed world plods along at less than 3%. But will this sizzling economic growth translate into dazzling stock-market performance?

The recent answer has been an emphatic yes. According to Morningstar Inc., the investment-research firm, emerging-market stock funds soared an average 56% in 2003 and 24% in 2004.

Despite a rough October, these funds are up an additional 16% this year. Yet I have just 5% of my stock portfolio in emerging markets -- and I don't think it's wise to allocate too much more than that.

 People power. True, there are a truckload of reasons to be optimistic about emerging markets, starting with demographics.

In the years ahead, the U.S., Europe and Japan will all struggle with an aging population. That will mean tough decisions, including how to contain retiree health-care costs, whether seniors will need to postpone retirement and what to do with unaffordable government pension plans.

The developing world, meanwhile, doesn't have these concerns, thanks to its relatively young population. Indeed, we are likely to see a huge global wealth transfer over the next few decades. The folks in the developing world will sell us goods and services and, in return, we will sell them our stocks, bonds, real estate, entire businesses and other assets.

Not only does the developing world seem likely to grow rapidly for years to come, but emerging-market stocks also remain relatively cheap. If you look at valuation yardsticks like price/earnings and price/book value, these markets appear to be trading at a 25% to 30% discount to U.S. stocks, according to data from Morgan Stanley Capital International.

 Growing pains. Sound appealing? Of course, the developing world's growth may not come through as expected. Also, there are legal and political risks. Corporate disclosure isn't as great and property rights aren't as secure as they are in the U.S.

Here, however, is possibly the most surprising drawback: There's no guarantee that the developing world's rapid economic growth will fuel sparkling stock-market returns.

For proof, consider a working paper by academics Elroy Dimson, Paul Marsh and Mike Staunton. They looked at the performance of 17 national markets over the past 105 years.

Their jaw-dropping conclusion: High-growth economies don't post the highest stock-market returns. In fact, if anything, low-growth economies seem to have the performance edge.

How can that be? In fast-growing economies, the truly rapid growth may be occurring among private, entrepreneurial businesses, not publicly traded companies.

At the same time, these publicly traded companies might regularly sell more shares, so they have the capital to finance further business expansion. Even as this new investment capital spurs economic growth, it may not do much for existing shareholders, who have seen their ownership stake diluted.

"We aren't presenting a case for avoiding these markets," says Mr. Dimson, a finance professor at London Business School. "We aren't forecasting that they will have inferior returns. But those who think high-growth economies will produce superior returns have history against them."

 Finding value. The story gets even more intriguing if you look at short-term returns. Suppose that, each year, you had invested in national stock markets based on their country's economic growth over the prior five years.

According to Messrs. Dimson, Marsh and Staunton, if you had regularly stashed your money in the 20% of countries that had recorded the highest five-year economic-growth rates, you would have earned the lowest stock-market returns. Conversely, if you had bought the 20% of countries with the lowest five-year growth rates, you would have had the best results.

This parallels what's often found within each national stock market. Frequently, the best returns go to mundane "value" companies, while rapidly expanding "growth" companies often generate dismal results.

"Growth stocks may grow faster," says Jeremy Siegel, author of "The Future for Investors" and a finance professor at the University of Pennsylvania's Wharton School. "But are you paying too much for that growth? That's critical for countries as well as individual stocks."

Prof. Siegel cites China. "It's been absolutely astonishing," he says. "Since 1992, China has had the fastest economic growth and the worst stock-market returns."

Where does this leave investors? As part of a diversified portfolio, you should own an emerging-market stock fund. Indeed, while these funds have highly erratic performance, they could help calm down the gyrations in your portfolio's overall value. The reason: Your emerging-market fund may post gains when the rest of your portfolio is suffering.

That said, don't go overboard on these markets. Emerging markets currently account for around 5% of world stock-market value. That seems like a reasonable allocation.

You might put 25% or 30% of your stock portfolio in foreign markets, with maybe 5% of your total stock allocation earmarked for emerging markets -- though really aggressive investors could go as high as 7% or 8%.

Which emerging-market fund should you buy? I would look for a no-load fund with low annual expenses and decent performance. You can find a list of such funds in the accompanying table.

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