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By Gregg S. Fisher, CFA

Over the past 20 years, from January 1992 to December 2012, China's GDP per capita grew about 17 times and India's GDP per capita grew about 4 or 5 times. These are astronomical increases.

Now, think about what this might mean for the public markets if, all of a sudden, people in these countries have more money to spend. What would it look like if they went from living on $2 a day to living on $4 a day? It might be hard for you to imagine living on $2 a day or $4 a day - it probably cost you at least $2 just to get to work today.

I remember that it was very hard to get people to think about investing in international markets in the early 1990s. It became much easier as these markets started to do well. By 2006-2007, most investors wanted to buy two things: a condo in Miami and emerging markets. There was nothing else that anybody wanted to be in.

Right around that time, we started seeing covers of Time magazine with such headlines as "China: Dawn of a New Dynasty" or "India Inc." We all thought emerging markets were going to be the "next new thing" that would take over everything we knew. But in fact, if you invested right around the time of those covers, emerging markets were down roughly 60% from their earlier growth levels.

But it didn't stay that way. In the last year or two, I have found that people are a little reluctant to invest in international markets again, given that non-US markets have done much worse than the US market in the last couple of years.

The Value of Added Diversification

Imagine that you go back 20 years. You have a dollar to invest and you don't know in advance what will do better: emerging markets or the US stock market.

If you put 100% in the US market, you will earn a little more than 8% a year. If you put all your money in emerging markets, you will earn a little more than 8% a year. These results are close enough to be the same. But what if you put these two things together?

If you put 50% in the US market and 50% in emerging markets and rebalance every couple of months, you will earn closer to 9%.

I would imagine that most investors in the United States wouldn't put 50% of their portfolio in emerging markets. Emerging markets are riskier than the US market. We don't want to over-complicate this scenario with the exact percentage you should have. But the point is that when you diversify, you can earn a better return than you can by investing in only one of these things.

But what if you go back the same 20 years and are more reasonable about this investment decision? Instead of 50% in the US market and 50% in emerging markets, you put 50% in the US market, 25% in developed non-US companies (such as the EAFE Index), and the remaining 25% in emerging markets. This is a more realistic scenario.

In this case, you end up with a return of about 8.26%, compared with the US-only portfolio return of 8.21%. Because they're so close, we'll call 8.21 and 8.26 the same. The question to ask yourself is, if I knew 20 years in advance that I could have a portfolio with 50 countries and 55,000 companies and I'd end up with the same rate of return as a portfolio with only one country and 500 companies, which would I choose?

Most investors would choose the diversified approach. This is an example of a way to reduce your risk but end up with a similar rate of return through global diversification. These are probably things we all know intuitively, but it's good to be reminded and look at them again.

Prevailing Sentiment Is Less Overwhelmingly Positive Now

When investing in emerging markets looked great and rosy - remember the "India Inc." cover story - the price for that greatness was generally reflected. The perception of those economies was that they were safe, there was not a lot of risk, they were going to continue to grow, and we all wanted to be a part of that growth.

Market prices went up after that story, but as the global financial crisis kicked in, we saw them come down by 60%.

Here we are today, and suddenly, the sun is shining on China and India, other emerging markets, and all the risks that investing in those markets can present.

Those risks were there before. It's just that now we are more aware of them. We're focused on them. In October 2011, the cover of Time magazine featured "The China Bubble" ... "We're counting on China's growth to save the world. Unless its economy blows up first."

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Right after the article, even though it was negative about China and India, China's economy still expanded by more than $900 billion.

Risk Is Getting Priced in, and Rewards Could Be Attractive

It's popular and attention grabbing to argue that things are cheap or undervalued. I don't like using such words as "undervalued" because they imply that the market got the price wrong.

Low prices simply mean that there's risk in the emerging economies, the risk is getting priced, and the market price is low. In other words, we all know there's risk out there, and the prices have come down because of that risk. If risk and return are related, it's possible that the risk could be rewarded.

India's GDP is approximately $2 trillion, which is about 8% of emerging markets' total GDP. China's GDP is about $8.5 trillion, or 37% of total GDP of emerging markets. The basket of countries that we refer to as "emerging markets" produces $23 trillion in GDP.

You'd be smart to ask, "What does that look like compared with the United States?" The US GDP is about $16 trillion.

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Now, what about the value of the companies in these countries? The sizes of the boxes reverse. The US market capitalization is greater than the market caps of India, China and the other emerging markets. US GDP is smaller than the total GDP of emerging markets, but the US market cap is greater.

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The way I like to think of it is that the United States has less revenue but a greater net worth. The market and the participants that invest all over the world are willing to pay a higher price for US revenues than they are willing to pay for the revenues of these other countries. You can think about valuing a country the same way you think about valuing a company.

Most of us are familiar with the concept of a price-to-earnings ratio. What is important about the price-to-earnings ratio, in my opinion, is the price. There's a ton of information contained in the price.

Fundamentally, what is the price of a stock? It is the collective opinion of lots of people all over the world, doing all kinds of analysis, thinking about what things should be worth, and eventually giving the stock a price.

Ultimately, the price of a stock is the collective opinion of everyone. That's the price. For our purposes, we can relate the price to the market cap of a country. If we take every stock in the country and go through that exercise, the market cap of a country is like the collective opinion of everyone who's buying and selling securities. The market cap is the average of all those opinions.

Now, we have to determine earnings. We can pull earnings from companies' financial statements, but where do we get those numbers for countries? In my mind, GDP is about as close to earnings as we'll get. We can think of market cap to GDP as the price-to-earnings ratio. Then, we can apply this approach to these countries.

What you see when you do that is that the market is pricing US earnings at a significantly greater multiple than the earnings in India and China.

Why do you think that would be? Why would rational people put a lower price on the earnings, revenues or production in India and China than on the same things in the United States?

Risk.

Investors around the world are bright people. They say, "It's riskier over there, therefore, drop the price so that I am sufficiently rewarded for taking on that risk. The way I get rewarded for taking on risk is through my expected return. The lower the price that I pay for a security or a country, the higher my expected return. The markets do a pretty good job, on average, pricing this risk."

There are some issues with using market cap to GDP in financial analysis. It's not meant to be a complete assessment of each country, just an illustration. Remember that it takes a while to adjust GDP because it comes from government agencies, and so the release of GDP data can be delayed weeks or months.

If the fundamentals in China, India and other emerging economies are not tremendously different today from what they were in 2006 and 2007 and if the story remains relatively the same but the market price is significantly lower, what process are investors using to determine that they liked the emerging markets in 2006 and 2007 and they don't like them now?

Is it just because the price went down? Is it because the US market did a lot better than emerging markets? There's something going on as to why all these investors are taking their money out of emerging-market stocks and buying US stocks. Is it a mathematical exercise, such as efficient markets, or is there something else going on?

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From a diversification point of view, we can see that the best periods are in different time spans, and the best period for China was better than the best period for the United States. The worst 12-month period was 6% for China, ending in 1999, and -8% for the United States, in December 2008, just a few short years ago during the financial crisis.

Investment professionals sometimes measure risk by using standard deviation, the statistical measure. If we were measuring risk that way here, we'd conclude that the United States is probably riskier.

I don't think the United States is riskier, but we must be careful in how we measure risk. When we're looking back at empirical data, studying it, and thinking about statistics, empirical measures are not good enough. We also need a sound economic framework for what we're looking at. It has to make sense.

I'm not sure it would make sense that someone would argue that China is less risky than the United States, but if all we're looking at is volatility of returns or something like that, we might come to that conclusion.

How Do You Invest in China and India?

We've touched briefly on public equity markets, but another way to invest is through the commodity markets. You could invest in the companies in these countries, but you could also think about investing in the things their people consume.

Obviously, the commodity markets have been an important part of the story for emerging markets. The graph below shows that there is significant risk from rising food costs. News about food costs has been all over the media lately, particularly in India.

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We can see that in China and India, the average person spends about 30% to 35% of his or her income on food, compared with the United States, where that figure is closer to 5%. Rising food prices in China and India have a much bigger impact on inflation than do rising food prices in the United States. Rising food prices are thus a big risk in such countries as China and India.

If you wanted to own something that would do well if food prices rise, what do you think you would buy? Food? Agriculture? You might not think food prices would rise, but if you wanted to have something in your portfolio that you think would do well if food prices rise, you might think about food.

Other themes complement food, such as water. Making food requires a lot of water. Think about the countries that have a lot of water per capita. They can make the food and export it.

We also see China and India spending a lot more money on energy. If we consider electric power consumption per capita, China has just surpassed the amount of electrical usage per capita in the rest of the world.

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Clearly, inflation is a big threat to these economies. We've seen a significant amount of inflation in the last 20 years. There has been more inflation in India than in China and certainly more in both than in the United States. For example, in India, what $1 bought in 1992 now costs roughly $4. In China, $1 in 1992 bought what now costs around $2.

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The United States hasn't had much inflation compared with China and India, where inflation is a big issue. Commodities would be a way to embrace that risk in your portfolio.

Another way to invest in China and India is through real estate. What ends up happening is a mass flux of urbanization in these countries. More people are living in the cities.

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When you move from the farm to the city, you need a place to live. You might even want a Starbucks nearby. You probably want a bowling alley. You might want a restaurant. A lot of spending is going on - in construction, development and housing. We're seeing a ton of construction going on. Some people are saying that there is a real estate bubble, especially in China.

There's a lot to say about all this. If, in fact, these trends continue, if people go from $2 to $4 a day, if we continue to see these countries grow, then there will probably be some increased need for housing and other forms of infrastructure.

In China, for example, approximately $2 trillion is expected to be spent on infrastructure in the next couple of years. On average, that's about $300 billion a year. That's more than what is projected to be spent in the United States. China is spending a lot of money on infrastructure.

Both Countries Diversify, But Are They the Same Thing?

People often talk about China and India as if they were the same, but they are very different. To see that, take a look at a breakdown of their exports. China exports a lot of manufacturing, more so than India. In contrast, India does a better job exporting services.

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China is a net exporter, but India is a net importer. Both countries import a lot of energy and food. China is a net exporter that exports a lot.

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Compared with other emerging economies, China is exporting a lot. That's been an important trend for China and, I think, is an important one to pay attention to.

The cost of capital is also trending down in these countries. If you're a business and you want to borrow money, the interest rates that you can borrow at are lower than they might have been in the past.

China and India are becoming less dependent on the developed world. It used to be that to attract capital, they'd have to raise their interest rates and then, maybe, we'd invest. Now, there's a lot more going on internally in these countries.

China and India are less dependent on the United States and other developed countries, which is giving them a good environment for keeping their interest rates down. I think that's helping their businesses in the private sector. Growth can definitely reduce dependence.

The following are just anecdotal examples. If you wanted to buy a car a few years ago, you might have bought a GM. For a computer, you would have considered a Dell, and for gas, Exxon Mobil.

Today, you think about Tata as a company you can buy cars from, Lenovo as the company for computers, and so on. There are risks associated with investing in these countries. The extreme good years and the extreme bad years are more significant and more pronounced than in the United States. You have to think carefully about how to put them in your portfolio.

Growth isn't a zero-sum game. Good news for China and India doesn't equal bad news for other countries. It means we can sell to them too. There are other things going on.

For example, in 2012, the number two market in the world for Rolls-Royce was China. Rolls-Royce sold a lot of cars there. That's an interesting sign. What are the opportunities in that for other countries around the world?

China and India represent more than 14% of the world's GDP. Together, emerging markets represent about one-third of the world's GDP. The United States represents 20% of worldwide GDP. The emerging markets represent 33%; the United States, 20%. So, I leave you with a question:

How much exposure in your portfolio do you currently have, or should you have, to these countries that represent one-third of the world's GDP?

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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Source: Why Should You Invest In Emerging Markets?