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Late last month, a member asked me what I thought about Gordon Pape’s TFSA portfolio. In my answer, I mentioned several points of disagreement I had with Mr. Pape’s approach. One of them concerned the decision to invest in emerging market companies. Emerging markets refer to those countries that have growing, but not yet high standards of living. Prominent examples include China, India, Russia and Brazil.
Mr. Pape’s portfolio appears to contain a significant amount of emerging market stocks through the presence of two ETFs - EEM, and FM. MoneyGeek’s portfolios, on the other hand, have never contained any emerging market stocks. Rather, MoneyGeek’s portfolios invest exclusively in developed market companies such as North American and European stocks.
In this article, I would like to explain my reason for leaving out emerging market stocks.
According to conventional wisdom taught in business schools, emerging market stocks are expected to generate higher returns than developed market stocks. There are two main reasons why.
One, they expect companies in emerging markets to grow their profits faster. Emerging market economies tend to grow much faster than developed market economies. As the economy grows, the total profit earned by emerging market companies should grow at the same rate.
Two, investing in emerging markets entails higher risk. Modern finance theory states that risk is proportional to expected returns, so we should expect emerging market stocks to yield higher returns.
While these arguments sound good in theory, they’ve been disappointing in practice. Since 1988, when a company called MSCI started keeping track of emerging markets, stocks in the those markets returned an average of about 7.6% per year until July 2016. In comparison, U.S. stocks returned about 10% per year during the same time period.
So why is there a disconnect between theory and actual results? There are several reasons why the conventional wisdom surrounding emerging market stocks is wrong.
First, let me deal with the argument that higher risk investments tend to generate higher returns. The basis of this argument rests on modern finance theory, which assumes that investors act rationally. However, as I have written in the past, there are many reasons to doubt that this is the case. Further, as I showed in a more recent article, lower risk stocks have, historically, outperformed higher risk stocks.
The more compelling argument for emerging market stocks is the one related to the higher growth rate of their economies. However, this argument falls flat on close examination as well.
Now, it’s true that total profits earned by all companies track the growth rate of economies. Therefore, if the same emerging market companies earned all of the corporate profits in their countries, the average profits earned by those companies should go up rapidly. The problem is that as the economies grow, not all the profits go to the same companies.
One reason for this is that as the citizens of emerging markets become wealthier, their tastes begin to change. For instance, when a country is poor, its citizens spend a greater portion of their income on necessities like food. As the country grows richer, its citizens tend to spend more of their income on non-necessities like cars and jewelry. An agricultural company operating in such a country probably won’t see their profits double, even if the country’s economy doubles.
Of course, an established company could try to expand their operations into new growth areas and benefit from the growing economy. However, this is easier said than done because companies tend to be only good at a limited set of industries. For example, a mining company will probably find it incredibly tough to start up a car manufacturer.
Rather, the growth areas of an emerging market economy tends to be dominated by new companies and foreign firms. For example, in China, one of the dominant companies in its technology sector is Alibaba, a company that only came into existence in 1999. Another growth area in China is the luxury goods sector, and much of the profits from this sector are going to foreign companies because of consumer preferences.
If you had invested your money into emerging market stocks in 1988, you would not have invested either in new companies like Alibaba, nor in foreign companies like BMW. Rather, you would have invested much of your money into the likes of mining stocks. Therefore, the stocks that you invested in in 1988 would not have profited much from growth industries such as internet services and luxury goods.
What was true of 1988 is also probably true today. As emerging market economies grow, their consumer spending patterns will probably continue to change, and new profits may flow to either new companies or foreign companies. If this is the case, the companies that constitute an ETF like EEM today will not fully benefit from the economic growth of their home countries.
Rather than investing in emerging markets stocks, I believe that a smarter way to benefit from emerging market economies is to invest in well run international companies based in the developed world.
Such companies will benefit from emerging market growth because they often sell products that domestic emerging market companies can’t match. For example, it would be nearly impossible for an emerging market company to produce computer chips that can compete with Intel’s.
Because no domestic company can match such products, emerging markets will have no choice but to allow such international companies to sell products in their country, and the profits earned by those companies will go up. Of course, investing in international companies like Intel will carry less geopolitical risk too.
The above is the reason why all types of MoneyGeek’s portfolios contain substantial exposure to well managed international companies. As such, I don’t believe that it’s necessary to include emerging market stocks as Gordon Pape has chosen to do.
