How to avoid the traps of emerging market investment

Emerging markets have staged a strong recovery since the financial crash. But strong economic growth doesn't necessarily mean good returns, says Tom Bulford. Here, he explains why you should be careful when investing in emerging markets.

When it comes to a clash between the objectivity of academics and the vested interests of the City, I know who I believe.

I've been poring overthe last two editions of theCredit Suisse Global Investment Returns Yearbook, the work of Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School. It's as authoritative as usual, and duly debunks one of the many marketing myths directed at unwary investors.

Today, I'd like to pass on a warning that I take from this. And I'll show you a better place to invest, in my opinion.

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Don't get sucked in by this City marketing spin

Since the financial crisis, emerging markets have staged a strong recovery. Of course, this has had the City sales teams out in their droves. The marketing spin could hardly be simpler: if you invest your money in countries with fast-growing economies you will do better than if you invest it in slow growth economies.

What could be easier? Just plant your money in Brazil, China, India or one of the other tiger economies and wait for the profits to roll in. Well hold on there not so fast!

Unfortunately it does not work. It's just not as simple as that. Dimson, Marsh and Staunton have done some serious number crunching and here is their conclusion: "$100 invested at end-1975 in emerging markets became $2,215 by end-2009, an annualised return of 9.5%. An equivalent investment in developed markets gave a terminal value of $3,307, an annualised return of 10.6%."

There a couple of general points to make here. First, that returns from all stock markets around 10% per year have been very decent. That's much better than bonds or cash.

Second, note that the difference between 9.5% per year and 10.6% per year compounded over 30 years roughly the length of time you might save for your pension makes a huge difference.

But I hope you know that already. The issue today is this: how come the whizzy growth of emerging economies does not generate equally whizzy returns for investors?

Credit Suisse provides a few of the answers: "...dictatorships, corruption, civil strife, wars, disastrous economic policies, hyperinflation and communism". Gulp!

Let's find out more about these markets.

What makes a market an emerging one?

Perhaps that list of pitfalls is enough to put you off emerging markets. But Credit Suisse goes on to provide some really interesting history. Based on the same criterion that defines emerging markets today, namely low GDP per capita, it has determined which countries would have been considered 'emerging' and which 'developed' back in 1900.

Interestingly, "only seven of the 38 countries with equity markets in 1900 changed their status in the next 110 years". Five markets managed to clamber up from 'emerging' to 'developed' Finland, Japan, Hong Kong, Portugal and Greece while Argentina and Chile went in the opposite direction. Of the remaining 31 countries, 17 that would have been deemed developed in 1900 remain so; while the 14 that were emerging then are still emerging now.

Moving from 'emerging' to 'developed' is clearly harder than it might seem, and things can easily go the wrong way. As Credit Suisse points out, Argentina, which in 1900 had a GDP per capita similar to that of France, is now categorised as a 'frontier market'. Meanwhile, Hungary, Czechoslovakia, Poland and Russia all seemed poised to join the developed-economies club at the start of the 20th century but failed to do so.

The rise and fall of national fortunes is not the only factor that can trap the unwary investor. The link between economic growth and stock market returns is tenuous. There are four important points to consider here.

Four reasons why the case for emerging markets is oversold

First of all, GDP growth is often little more than the automatic consequence of a rising population.

Second, the companies that have their shares traded on the stock market are not necessarily representative of the emerging economy. Many big companies are private or owned by the state.

Next, the return that these businesses make on invested capital is not necessarily high. Indeed, some have argued that the ease with which emerging market companies have been able to raise money from slavering foreign investors has made them complacent and able to survive even while generating a low return on capital.

Finally, there is the matter of investor behaviour. Investors typically miss the best periods of return by plunging into emerging markets after a period of strong growth when fund management marketing cries are at their shrillest and before the inevitable downswing.

And even if fast GDP growth matters for stock market returns it should, in theory, be already discounted in share prices. In fact, Credit Suisse concludes not that high GDP growth is a precursor of good stock market returns, but that the latter predicts the former.

Undoubtedly, emerging markets, which now account for just 12% of global portfolios, will go on to take a larger share. But the best that Credit Suisse can come up with is that their greater volatility should be a trade-off for higher returns in future.

But having floated this theory it concludes that "the case for emerging markets is often oversold".

Too right. That's not to say that you won't be able to make money in certain stocks that have exposure to emerging markets. Of course there are exceptions. But you need to pick carefully and not get caught up generalisations put about by fund managers.

Here's a far better idea for you

OK, so that's my warning for you today. But where is a good place to invest right now? Well, one of the best penny share ideas I've seen lately is about gold. That's one story that's not going away anytime soon. But how best to play it?

There's a tiny gold company I've found that could be a superb money maker for you. It's high risk, as you'd expect from penny shares. But I just think it has what it takes to capture the imagination of investors and it's not on most people's radars yet. Now should be a good time to get in

Plus it's got one of the few what I would call undeniable emerging market stories feeding into it. With this powerful force behind it, this one little stock could soon start a 'gold rush' of its own and, if it's successful, I reckon it could double your money at least over the next year.

The report I've been putting together on this stock is just about ready. There are just a few things I need to finalise. That's what I'm off to do now.

This article was first published in Tom Bulford's twice-weekly small-cap investment email The Penny Sleuth .

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Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund. Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.