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Last week in this space I wrote about three top stocks in three top markets, implying that I expect the massive emerging markets bull market that's characterized the last decade of investing, though with a few hiccups along the way, to continue in 2011. While I stand by that view, I'd be lying if I said I didn't read a few things this week that made me start to feel uneasy about my view.
Were these more allegations of fraud against Chinese reverse mergers, predictions of painful inflation for China, Brazil, India, and Indonesia in 2011, or observations that stocks in China, Mexico, and other key emerging markets are trading at lofty valuations? Although every one of those realities illustrates some of the risks associated with investing abroad and is worthy of concern, they are not what have me uneasy.
Rather, what has me uneasy is the near universal celebration of emerging markets in the investment community and widespread view that they will do well again this year. If, as Warren Buffett says, it's just as important to be fearful when others are greedy as it is to be greedy when others are fearful, then emerging markets are spinning a pretty scary story right now.
It was a dark and stormy night
Just how good are investors feeling about emerging markets? Not only was Janus Overseas manager Brent Lynn named Morningstar's fund manager of the year after loading up on volatile emerging market stocks in 2010, but assets under management at the largest emerging markets ETF, iShares MSCI Emerging Markets Index (NYSE: EEM ) , are up a whopping 13% since September -- from $41 billion to almost $47 billion. That's a lot of asset growth for such a large fund in one quarter, and it's indicative of the fact that U.S. investors are getting very comfortable investing abroad.
Further, five of Morgan Stanley's 10 best global investing ideas for 2011 rely on continued rapid growth in emerging markets to pay off and represent almost every conceivable way to play emerging markets. They are emerging market equities, emerging market currencies, "global gorillas" (their name for large multinationals that have a significant emerging market presence), resource-rich countries, and commodities.
Finally, and perhaps most incredibly, emerging market debt continues to strengthen against U.S. debt, with the current spread at just 280 basis points. Is 2.8% really enough to compensate an investor for taking the risks associated with investing abroad?
The long view
Although there are myriad reasons to be excited about the potential for long-term growth in emerging markets, they are no short-term sure things. Among the risk factors to consider are:
- The standards of corporate governance in these places often leave a little to be desired.
- They tend not to be diversified economies, which means, for example, that a decline in copper prices would reverberate across the entire Chilean economy.
- Capital historically has flowed out at the first sign of trouble just as fast as it has recently flowed in, creating an environment ripe for crisis.
In other words, if emerging market economies turn south, chances are they turn south hard, meaning that if you choose to invest in companies in these places, you need to do so with the right timeline and temperament. What is the right timeline and temperament? Long, as in a decade or more, and willing to tolerate large potential (and potentially temporary but potentially permanent) losses.
And if you're among the many investors plowing into emerging markets of late, here are a few more dos and don'ts to keep in mind:
Because individual company risk is heightened in emerging markets, with so many tied to commodities, it's important to invest across companies and countries. At Motley Fool Global Gains we advise investors to identify promising global themes, and then buy a variety of promising companies with exposure to that theme.
DON'T: Buy an ETF
Although ETFs seem like the most convenient way to diversify, they are the wrong way to invest in emerging markets. The iShares MSCI Emerging Markets Index, for example, is focused on the wrong sectors, overexposed to troubled global banks, and has a market-cap weighted approach that has dramatically underperformed a broader, equal-weighted emerging markets index. Incredibly, that ETF has 24% of its assets allocated to financial stocks, just 14% allocated to emerging consumers, and only 1% to health care.
DO: Invest regularly over time
Emerging markets will be volatile. That volatile will kill you if you try to trade in and out of related stocks, but will be your friend if you dollar-cost average in to promising emerging market names over time. You'll end up buying shares from time to time for a real bargain.
DON'T: Use options
I may catch some heat for this because options strategies in emerging markets often pay off big, but when it comes to options, you have to be right with both your idea and your timing. Given the potential for volatility in emerging markets stocks, getting that timing right can be extraordinarily difficult.
DO: Buy a few "global gorillas"
Global giants are one of the best ways to get a piece of emerging markets profits without taking on added company risk, and they currently look like one of the cheapest part of the emerging markets universe. Wal-Mart (NYSE: WMT ) continues to be my time pick in this regard, but don't sleep on Coca-Cola (NYSE: KO ) or Procter & Gamble (NYSE: PG ) .
DON'T: Buy only "global gorillas"
Although multinationals are an important part of any emerging markets portfolio, they shouldn't be the only part. That's because the biggest gains in emerging markets will come from smaller, local names, who know their markets and have the most concentrated growth potential. At Global Gains, for example, our two biggest winners over the past year are Melco Crown Entertainment (Nasdaq: MPEL ) , a casino operator in Macau, and BBVA Provida (NYSE: PVD ) , a Chilean asset manager, up 80% and 55%, respectively. What these companies have in common is that they're small and almost entirely focused on their one market. Companies like these will be more volatile than multinationals, but that's why investors should pair them together.
The global view
This year is shaping up to be another exciting one for emerging markets and emerging market investors. But before you start forecasting riches, make sure you're aware of the risks and have portfolio strategies in place to deal with them.