A widespread selloff in emerging markets is currently in progress.  This is partly the result of portfolio realignment by veteran fund managers who believe that economic growth there is slowing, while growth in developed markets–weak as it is–is beginning to accelerate.  They’re reacting to what they perceive, rightly or wrongly, to be a change in momentum.

It’s also partly the result of novice investors, many of them retail, working out the risks in what they bought when they rolled the dice on an emerging markets fund a couple of years ago.

why emerging markets?

Conceptually, foreigners invest in emerging markets for two reasons:

–the possibility of very rapid economic growth in these countries, and

–the chance  that foreigners’ knowledge of how growth has occurred elsewhere to make superior stock selections.

The first point probably gets you to try an emerging markets index fund.  The second sends you looking for a seasoned emerging markets portfolio manager who can beat the index.  I’ve done both.

they’re different, though

But emerging markets aren’t just like, say, the US, only the people speak a different language.  There can be major differences in countries’ economic health, as well as in the types of stocks available for purchase.

Tomorrow, I’ll write about stock markets.  Today, I’m going to write about countries.  (NOTE that in all of this I’ve taken off my hat as a human being and put on my hat as a portfolio manager.  I’m not writing about what’s right or wrong;  I’m writing about what a foreigner has to think about to protect his investments.)

Three topics for today:

1. political stability

This is not something investors typically think about in developed markets.  We take it for granted that shareholders’ rights will be preserved, and that the legal conditions for companies doing business won’t change arbitrarily.

These are reasonable assumptions in large, mature economies.  But not necessarily elsewhere.

–Egypt, for example, has had two changes in government over the past year or so.  Protests forced a dictator to step down.  His successor was removed by the army.

–Thailand’s system of administration change through bloodless military coups blessed by the king has recently broken down into violent confrontation between the army and advocates for a different system.

–During the Asian Crisis of the late 1990s, as one of a number of measures to protect politically connected insiders, Malaysia arbitrarily refused for about a year to allow foreigners to repatriate funds from stock sales.

On a deeper level, in some countries the political debate is still open as to whether, and to what extent, capitalism should be allowed. In others, the question is whether the same proections afforded to local investors should be extended to foreigners.  In most cases, the answer to the latter question is “No!!,” at least until a crisis requiring foreign capital happens.

Political issues aren’t necessarily deal-breakers, but they are risk factors.

2.  macroeconomic stability

–India is a current case in point.

The economy is heavily dependent on monsoon rains.

The government is running a large current account deficit.  It’s being made worse by the fact that many people there either can’t afford or don’t trust banks, so they save by buying gold–which must be imported.  In addition, Delhi heavily subsidizes the price of petroleum products–again an import–meaning people use a lot more than they would if they had to pay world market prices.  The difference between what India buys from the rest of the world and what it can pay for through its own exports has become large enough to reach a tipping point where investors fear the country won’t have enough foreign currency to meet its obligations.

India is also a place where the capitalism/socialism debate is still not settled.  As a result of that and of the presence of very powerful industrial groups, the central government is dysfunctional.

–What about the rolling currency crisis in smaller Asian countries during the late 1990s.

–Greece.

Debt crises aren’t only a factor in the developing world.  Look at the US financial crisis or the EU.  But the latter two have the financial wherewithal to fix their problems.  That’s not always true in emerging markets.  And, unless you’re paying close attention, the difficulties there can fly under the radar for a long time.

3.  accounting methods

Personally, I’m not an advocate of having a single world accounting standard for financial reporting.  My point isn’t that the books in emerging markets are constructed using different systems than US GAAP or the IFRS of the EU.

I’m also not talking about occasional frauds, like Enron in the US or Polly Peck in the UK.

The issue is that in some emerging markets, there is either not enough information disclosed, or that the disclosure has little to do with reality.

This doesn’t mean you can’t get solid information about a company.  It just takes a lot more legwork + time and experience observing how a given company operates.  Think of all those bogus Chinese companies that have listed in the US over the past few years.  There’s a reason they didn’t list in Shanghai or Hong Kong, which are their natural markets.  Why not list in Asia?  It’s because investors there knew who the companies and the reputations of their backers were and would have refused to buy the shares.

Tomorrow, emerging stock markets.