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Investors seeking to invest in growth economies via emerging markets ETFs such as iShares Emerging Markets (NYSEARCA:EEM) might be surprised when looking at what they are investing in. According to iShares, EEM seeks to give exposure to the emerging markets by tracking the constituent stocks underlying the MSCI Emerging Markets index. So far so good.

According to MSCI, the Emerging Markets index covers a range of stocks in 21 emerging markets, spread between Asia, EMEA, and Latin America. However, this does include significant weightings to several countries which are already quite far along the path of economic development, and do not offer outperforming future growth rates, and has no exposure to numerous markets approaching the highest economic growth phases. To compound this, because the index is market cap weighted, within those markets, the participation is skewed towards larger companies, which have generally already experienced their peak growth phase. I would argue that for this reason, investors looking to capture the growth phases of economic takeoff and a drive to maturity need to look beyond the broader EEM index.

To expand, a look at the country composition of the EEM and their respective GDP/Capita as recorded by the IMF shows the following:

Source: IMF, iShares.

Standing out here are S. Korea and Taiwan, where the current level of GDP per capita show relatively little lag behind the US, but between them constitute over a quarter of the index. A check of the iShares site shows the top 10 holdings of the ETF include Samsung Electronics, Taiwan Semiconductor, and Hyundai Motors, Korean and Taiwanese stocks in high tech industries with strong correlation to US equivalent stocks that probably take a position in US investors holdings, such as Ford, Apple etc.

So what growth prospects do these more developed economies hold?

The table below shows a compilation of recent GDP growth economic research estimates, and projections for developed and developing Asian economies.

(click to enlarge)

Source : IMF, Research Estimates.

This shows a clear divergence of growth rates between the emerging markets and the more developed markets. EEM weightings of the higher growth markets that are not in the top 10 table above are - Indonesia 2.7%, Thailand 2.2%, Philippines, 0.94%, and no allocation to Vietnam. Interestingly, the index also includes 0.56% weighting to Hong Kong - where GDP per capita in 2011 was 5% higher than in US.

So EEM, designed to follow the MSCI emerging markets index, does have some surprising correlation with US stocks, includes significant weightings of low-growth countries, and is restricted to a sample of only 21 countries in total.

Getting the right ingredients

For investors to seek investment in high-growth markets, EEM can do part of the job, but broader coverage and a higher weighting to true growth markets requires the inclusion of other positions, which can most easily be done on a country-by-country basis.

In order to target specific markets, I have found simple economic development theory to be useful. One key authority here is WW Rostow, an economist who outlined 5 stages of economic growth:

(click to enlarge)

Source: Bized.co.uk

The more developed countries included in the MSCI Emerging Markets index are geographically in the right area, but are in stage 4 or 5 of economic development, and thus can expect to enjoy lower growth rates than the countries about to enter take-off.

Growth rates are high in the transitional stage, but as the main drivers tend to be in urbanization and development of physical infrastructure, major opportunities for investment are captured by overseas capital, or government-related industries, as we have seen in China and Russia during this phase.

As economies move into the takeoff phase, there is a heavy reliance on foreign direct investment flows, which move in to exploit labor efficiencies, and the investment landscape is high risk, as corporate governance and regulatory control for local firms are not fully mature. A major concern for investors from overseas is the political and social risk level, which is high during the takeoff stage.

The ideal stage of economic development into a high growth market for the individual investor is in the early stages of take-off. Such a country is characterized by political and social stability, consistent governance and legal environment, strong domestic demand, and a diverse range of industries represented in the corporate landscape, including manufacturing, distribution and service sectors. The demographic profile is important here, as countries with a high proportion of the population in the economically productive and higher consumption 20-45 age range offer both labor productivity and the promise of strong domestic demand.

To compile a portfolio targeted to capturing growth at the optimal stage of economic development, I have developed a model for asset allocation that scores growth countries on a range of growth and risk indicators.

Taking the US as a benchmark, the rating provides a weighted score to the following factors:

GDP growth over the next 5 years - IMF estimates.

Country investment risk - sourced from AM Best.

Demographics - the proportion of population in the economically active 20-45 age group.

Country debt - the debt/GDP ratio relative to the US. (It is interesting to note that even Egypt, the most indebted country on the list, has a significantly lower national debt than US).

The total column indicates the appetite for a specific country, with allocation at over 90% overweighting to EEM, 85-90% marketweight, and 85% or lower underweight. Taiwan scores 91%, but I have overridden this to allocate a marketweight position due to country-specific factors. Taiwan is in a politically sensitive relationship with China, has less attractive demographics, and is dominated by the semiconductor industry.

(click to enlarge)

A targeted EM investment strategy

To develop a high growth strategy following this allocation model, I construct a portfolio using EEM as the core. 50% of my emerging markets allocation will be to EEM. The other 50% will be targeted at specific country opportunities to develop a blended allocation. Exposure via country ETFs is the base strategy, but complemented with positions in individual local or global companies active in the industry segments most likely to benefit from the country's current stage of development. ETFs targeted to the markets indicated as underweight in the EEM include IDX (Indonesia) EWZ (Brazil) RSX (Russia) EZA (S Africa) THD (Thailand) ECH (Chile) and EPU (Peru). The model indicates an overweight position to Hong Kong, but as HK is a mature market representing a China play, I will not seek broad exposure to HK on an index basis, but select specific HK-listed stocks rather than an allocation to the higher risk China onshore market.

Where possible, I will also seek positions in high scoring countries where EEM has no exposure.

The bottom line

Rather than choosing to simply buy an ETF that follows the MSCI index, the astute investor seeking growth in emerging markets can use a strategy of targeting markets with the right mix of growth and stability, the right stage of development, relatively lower country and currency risk, and diversity of sector - constructing a balanced emerging markets portfolio with these characteristics.

This requires a higher knowledge of emerging markets and their opportunities. In future articles, I will be looking into some of these markets in more detail.

Disclaimer: I am a private investor, not an investment advisor, and share my analysis for the purpose of information only. Readers should not rely on this analysis, but undertake their own research and take advice before making any investments.

Source: Looking For Growth Economies: Getting The Right Ingredients