Yesterday I wrote about emerging countries.  Today, it’s their stock markets.

There are two important factors to consider, in my opinion, before taking the plunge in any given emerging market.

1.  The engines of an emerging country’s economic growth may not be available on its stock market   …and if they are, foreigners may not be able to buy them.  There are a number of reasons for this:

–generally speaking, every country, emerging or developed, has limits on foreign ownership of key industries, usually media, telecommunications and transport

–also, in general, there’s no reason to think, as many do, that there’s a close correspondence between the structure of a country’s economy and the structure of its stock market.  There usually isn’t.

But, for emerging economies in particular:

–a country, understandably, won’t want to allow foreigners to gain control of its economic crown jewels for what would be seen a decade down the road as a pittance.  So foreigners may be relegated to non-voting shares or limited in the percentage of any company that they, as a group, may own.  Depending on the rules, “foreign” shares may have far different performance from “local” ones.  That can be either very good or very bad, again depending on the rules.

–local investors, many times an ultra-wealthy elite, may regard stocks as a particularly risky kind of bond.  If so, they may be only willing to buy shares in mature companies with limited growth prospects but large free cash flow generation–and therefore rising dividends.  This difference in risk preferences may slant the local market away from the kinds of stocks foreigners find most rewarding.

I’m not saying don’t buy emerging markets stocks.  My view is quite the opposite.  But you have to look before you leap.

2.  Many emerging markets have very little local trading support.  Brokers are dependent for their commissions on the kindness of foreigners.

In a country where average annual income may be, say, $5,000 a year, the ordinary citizen is lucky to have a bank account.  He has no interest in the stock market.  His employer probably doesn’t offer a pension plan or retiree health care, either.  So, in addition to the absence of retail support for the market, there are probably no large pools of local institutional money interested in stocks, either.

Therefore, under most circumstances, there’s no local guy eager to take the other side of the trade when foreigners want to transact.  So when foreign money wants to enter, stock prices skyrocket.  When it wants to leave, the bottom falls out of the market.  (By the way, a stock market like Germany’s was like this in the 1980s.)

Again, I’m not saying don’t invest.  Quite the contrary.  But expect a lot of volatility.  On the brighter side, there’s significant money to be made by timing the swings in foreign sentiment correctly.