Emerging Market Diversification
There's a significant trend in international investing that hasn't yet received much attention from the press: More and more managers are investing ever larger sums in markets that are less and less developed. Tens of millions of dollars a month--or week, even--are pouring into equity markets in countries such as Egypt, Morocco, Zimbabwe, Peru, Poland, and Russia. As a result, most of these countries' bourses are soaring, in some instances doubling or tripling over the past year.
Closed-end funds, thanks to their risk-tolerant structure, have long invested in such places. What's new, however, is that open-end funds are increasingly taking big bets on these markets as well. In late 1995, the average open-end Europe-stock fund had a 1% stake in Eastern European markets; by December of last year, that number had risen to nearly 8%. In the open-end emerging-markets group, funds are also becoming more aggressive in their pursuit of these markets. Scudder Emerging Markets Growth Fund, for example, currently has 13% of its assets stashed in Poland and 8% in Egypt.
All this raises a host of questions. Do the potential returns in these newly-hatched markets outweigh the risks? Are managers genuinely attracted to the values such out-of-the-way places offer, or are they simply chasing what's hot at the moment? Can these markets, with their rickety capital structures and illiquid shares, really absorb all that foreign money without provoking a crisis? How bad could things get if something did go seriously wrong (as happened in Southeast Asia in 1994 and Latin America in 1995)?
The Discreet Charm Of Bourgeois Liberalization Policies
The newly-emerging markets that are attracting so much attention are mainly found in two regions: the old Soviet bloc and the Arabic-speaking world. The former group consists of four largish markets--Russia, Hungary, Poland, and the Czech Republic--and a smattering of smaller markets such as Bulgaria, Croatia, and Slovenia. In the latter group, the two biggest newly-emerging countries are Egypt and Morocco; other youngsters in this region include Jordan, Mauritius, Oman, Lebanon, and Tunisia.
The equity markets in all these countries, large and small, have seen substantial foreign interest this year and last. What's the big attraction? Obviously, conditions vary from market to market, but nearly all of these countries share one important feature: They're embarking on ambitious programs, often designed by the IMF and World Bank, to liberalize their economies. This has entailed selling off bloated state-owned companies, relaxing restrictions on foreign investment, clarifying ill-defined property rights laws, and encouraging the development of an equity culture among the general populace.
This is just the sort of thing that money managers love to see. As it becomes clear that a country is committed to freeing up its economy, investors' expectations about the future begin changing. Changes in expectations are generally what drive equity prices, so money managers who can get into a market early in the process can reap tremendous rewards. Take Brazil and Mexico, two countries that have privatized huge amounts of state assets in recent years, as examples. From 1988 through 1993, the Mexican market rose 17-fold in dollar terms--that's equivalent to an annualized return of 61%. Brazil's bolsa, on the other hand, has risen 11-fold since 1991, compounding at a rate of nearly 50%.
Wilder Than A Mexican Bus Ride
Although the potential returns in these markets are enormous, it's important to keep in mind that newly-emerging markets carry risks not usually seen in their more-developed but still-emerging siblings. In Eastern Europe, for example, few firms are well-managed, corruption is pandemic, and accounting standards are a joke. All this makes companies very difficult to value. In a shareholder letter published last year, Barton Biggs of Morgan Stanley wrote of Unified Energy Systems (generally considered to be one of the most open and investor-friendly companies in Russia) that "we can't really deduce what earnings and book value are." And that's not the worst of it: Most stocks are highly illiquid (in Russia, only 10 have an average daily trading value greater than $1 million), manipulation of share prices is common, and settlement systems are unreliable.
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