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In Emerging Markets, Proof of Progress Is Key

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Emerging markets are on every investor’s lips, and why not? Their 10-year cumulative record through 2010 is up 350%, about twice that of any other sector. It compares with a puny 15% for the S&P 500. Many emerging market countries learned their lesson in the late-1990s “Asian Tiger” boomlet and crash, and placed their balance sheets in much better order than the United States and Europe with obvious benefits for their economies and markets.

A key reason for this performance, and perhaps the most influential factor for many emerging markets in the future, is China. Few people realize that China became a relatively backward nation with its weak response to the Industrial Revolution. Before that, it was a leading nation and in the Middle Ages actually contributed as much as one-third of world GDP. Given its rapid growth rate of 8%–10% per year and its population size, it is now projected as the latest threat to America’s economic dominance in the post-World War II era.

China’s Influence
China appears to be handling its future in good fashion with: a) a diverse entrepreneurial system; b) an emphasis on infrastructure building and a priority on producing more sophisticated equipment, particularly in energy related areas; c) a Chinese “Tiger Mom”-like emphasis on improving education; and finally d) a lower priority on the consumer. In contrast to their avowed concern for their people, China’s percentage of GDP going to consumer expenditures is an extremely low 35%–40% in contrast to our own 70%. This weak consumer allocation leaves much more money for capital expenditures, which intensifies growth.

In emerging markets, I like to see evidence of economic progress like competitive industries, a growing middle class and a strong broad-based educational system. China, at least in Shanghai, leads the world in educational equality (we are well down from the top, even in verbal skills). Many Asian countries are at or near the top. Brazil and Colombia are at the bottom. I give a lower appraisal for countries that are just benefiting from a commodity and equity inflow boom since they are not masters of their own fate and may not be building growth for the future.

From a current investment standpoint, China is struggling with a conflict between its desire to keep its currency down to maintain competitiveness for its exports and a serious inflationary rise in real estate, food and other products that official figures may understate. Its attempts to control inflation have been unsuccessful to date. Applying the brakes in a harder fashion could tilt the country into a significant slowdown in economic growth. Interestingly, continuation of weak government restrictive policies could further stimulate inflation and have the same effect on export competitiveness as an upward movement in its currency over a period of a few years.

Any slowdown in its growth could result in significant weakness in China’s stock market. A possible decline in the partly China-derived commodity boom could ensue. At its extreme, it could trigger a movement out of the emerging market countries. The Asian country that is best positioned to handle this potential situation is India. It is much more insular than China and has a freer economic framework.

We believe all advisors should establish a core holding in developing markets. As value-oriented investors, we instituted our positions in late 2008 near the bottom. As markets have risen, we have in some instances trimmed a little and kept the rest. We remain somewhat concerned about the popularity of this sector which, in contrast to domestic mutual funds, has seen inflows in every year but one over the past six.

For advisors, participation in emerging markets involves keeping holdings that are less well-known, subject to governmental influence and that often have a lower quality of earnings. It is still worth it given their growth potential. I prefer investing through mutual funds whose managers have expertise and choice in controlling individual holdings and country allocations.

On balance, despite the favorable long-term prospects of China, India, South Korea, etc., we are not currently adding to our positions. We are waiting for what we hope will be a more opportune time, perhaps one built on greater negativism in what can be volatile markets.