You Can't Afford Not To

This is the first in a series of articles regarding the outlook for emerging-market investments in 2006 and beyond.

Did you ever wonder where the term "emerging markets" came from? The World Bank's International Finance Corporation coined it in the early 1980s to describe the roughly 130 countries around the globe that were in the process of industrializing and that sported lower gross domestic product per capita than more developed economies did.

Since that time, these markets have offered investors, to borrow from Charles Dickens, the best of times and the worst of times. After a spectacular run during which the Morgan Stanley Capital International (MSCI) Emerging Markets Index nearly doubled between early 1992 and late 1994, emerging-market equities ran into a series of financial storms that included the Mexican peso devaluation in 1994, the Asian financial crisis in 1997-1998, and the Russian debt default in 1998. As a result, these once high-flying markets went into a nosedive and fell roughly 43% between December 1994 and October 2001 . all while the S&P 500 was racking up gains totaling 130%.

Ouch.

Of course, emerging markets, like their more developed cousins, are cyclical creatures, and the past couple of years have once again brought pretty good results to long-term investors in these markets. Since bottoming out around March 1, 2003, the AMEX Mexico Index has risen 166% through last Friday, while the Hang Seng Index is up 88%, and India's BSE Sensex Index has gained 260%. Even Russia's RTS Index has advanced close to 173% since mid-July 2004.

So, where does that leave the individual investor? Have emerging markets had their run? Are they now likely to repeat the underperformance of the mid- to late 1990s, or do they still have some gas left in their tanks?

In my Foolish opinion, the prospects for emerging-market equities have never looked brighter, and investors should have at least some exposure to this asset class. In fact, my belief is so strong that -- more conservative investors might want to cover their eyes -- emerging-market stocks make up close to 75% of my personal portfolio.

Simply put, I believe that emerging markets in general stand to benefit from both favorable demographic trends and rapid GDP growth that will fuel the emergence of a consumer-oriented middle class in most developing countries.

Let's take a quick look at these three points to help assure you that I haven't completely lost my mind.

Demographics
In 1995, according to the World Bank, the world's population was approximately 5.7 billion, with 84% of the total, or 4.8 billion people, living in developing countries. By 2030, an additional 2.5 billion people will be added to Earth's population, with 90% of that growth coming in developing countries, whose share of the world population will expand to 88% of the total.

To look at it another way, the population of the world's developed economies -- today's main contributors to global economic growth -- is expected to stagnate or decline over the next couple of decades. According to the World Population Reference Bureau, Western Europe's population is expected to decline 2% by 2050, Japan's population is expected to fall from 127 million to a mere 100 million over the same period, and while the U.S. population is expected to grow 42% by 2050 to 420 million, that still represents just a drop in the bucket.

Hmm . let's see. That means developed nations and markets will include a mere 984 million potential customers, versus the roughly 7.3 billion inhabitants of emerging-market economies.

I think the numbers speak for themselves.

GDP growth and the emerging middle class
According to the International Finance Corporation, GDP growth in emerging-market countries continues to be roughly double that of developed economies and is expected to come in between 5.5% and 5.9% in 2006. Furthermore, the IFC notes that much potential remains untapped because economic activity in the "informal" market -- i.e., unreported, unregulated, and untaxed business -- ranges from 40% to 80% across developing nations.

While estimates vary widely in terms of the actual size and growth rate of the middle class in emerging-market nations, there's no doubt that these newly enriched consumers will be key drivers of growth going forward. Take India, for example. As India's economy powers ahead, the ranks of the country's 300 million middle-class consumers will continue to grow, as will demand for all manner of goods ranging from cars to new homes. Annual sales of passenger cars are expected to nearly double to 2 million by 2010 in India, and there is currently a nationwide housing shortage there -- by more than 22 million units -- according to the National Real Estate Development Council.

On a similar note, a recent McKinsey report estimates that the ranks of the lower middle class in China will reach some 290 million by 2011 and that China will boast a middle-class population of 520 million by 2025, with consumer purchasing power in excess of $2.5 trillion.

Simply put, by 2025, the number of middle-class consumers in India and China alone is likely to be equal to the entire population of the developed world.

How's that for a potential eye-opener? Do you think companies aren't champing at the bit to get a piece of this potentially vast market? Don't you think that you, as an investor, should as well?

Don't get me wrong, I know that this asset class is risky in the best of times, and I have heard all the arguments -- many of them valid -- about the dangers inherent to investing in emerging markets. Yes, there is corruption . but what would you call Tyco (NYSE: TYC  ) , Enron, WorldCom, and their ilk? Yes, there are the risks of political instability . but what market is really stable in an era of international terrorism? Yes, there are currency translation risks . but how's the dollar doing these days?

You get the picture.

There is also a way to mitigate at least part of this perceived risk: Invest in individual companies that hold a dominant share of their home markets, have strong growth prospects, and are attractively valued -- essentially, blue-chip companies by any other name. The long-term (and I emphasize long-term) rewards of investing in such companies can be substantial, as the stellar performance over the past few years of many quality emerging-market plays illustrates, from Chinese oil giant PetroChina (NYSE: PTR  ) to Latin American cell-phone operator America Movil (NYSE: AMX  ) ; from Indian banking behemoth HDFC Bank (NYSE: HDB  ) to Mexican cement manufacturer Cemex (NYSE: CX  ) .

People often talk about the risks involved with investing in emerging markets. My question is this: Given the trends I've outlined here, can you really afford not to have at least some exposure to emerging market equities?

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Fool contributor Will Frankenhoff is enjoying his time writing for the Fool more than he enjoys reading The Financial Times, rooting for the New York Giants, or pondering the vagaries of life -- pretty unsuccessfully up to this point. He welcomes your feedback and does not own shares in any of the companies mentioned above. Tyco is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.


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