Disentangling Emerging Markets

I get quite cross when I hear people talking about 'emerging markets' or even 'BRICs' as a single great lump of investment. To me, investing in Russia is completely different from investing, in, say, Brazil or China. You can't lump them together - it's apples and oranges, chalk and cheese, or... beer and beer.

Beer and beer? Or should I say cask ale and lager? Because the City made a bad investment mistake based on the idea that all cask ale was the same. And I think it's about to make the same mistake by thinking that one emerging market is just like another.

Let's run the clock back to the late 90s and look at the market for brewing and pub companies as it was then. Whitbread and Bass were the big brewers, and they were producing adequate, but not exciting, cask ale. They were also making much more money out of selling lager, and promoted their lagers unsparingly on TV. Unsurprisingly, their cask ales didn't do well.

So the City got the idea that cask ale was a declining market. Only problem with that idea; cask ale was booming! Not at Whitbread and Bass, admittedly - but regional brewers like Wolverhampton & Dudley were doing well. So were Young's, Fullers, Jennings, Hardys & Hansons - just about anybody except Whitbread and Bass! Even so, because the City thought that real ale was a rubbish investment, you could pick these companies up at a 50% discount to their net assets.

If you were a lucky investor, you were acquainted with some of the better products of regional brewers, like Ridley's Old Bob (now alas killed off by Greene King, though its Witchfinder Porter is being revived as a seasonal beer this autumn) and Woodfordes Wherry. And so maybe you didn't buy the City view, and maybe you invested in one or two brewers - but not Bass or £WTB.

Fast forward to 2007 and see what happened. The two big brewers got out of brewing completely - they'd never been a hundred percent committed to real ale, and in the end they didn't even want to brew lager. Whitbread and Bass both sold their brewing operations to Interbrew, the Belgian conglomerate, and exited the market completely.

Meanwhile Wolves & Duds had run all the way from about 375p to eleven quid on the back of a hostile - and unsuccessful - bid, and renamed itself as Marston's Plc, and many of the smaller brewers had been acquired by larger regionals. Result - brilliant returns to shareholders. If you really like irony, you may be interested to know that Marston's Plc eventually took over the contract to brew draught Bass from Interbrew.

So 'beer' turned out not to be the same as 'beer'. Investors who did a bit more research to get behind the easy assumptions turned out the winners.

So, to return to my theme about emerging markets, how do we distinguish one emerging market from another? Let's look at what's available in the market right now.

There's one kind of emerging market, which I call the post-colonial market. Russia is a good example. What's good about Russia? Well, it's big, and it's got loads of natural resources - aluminium, oil, gas, precious metals, you name it, it's got it. In fact it's got so much gas that it can hold its neighbour Ukraine to ransom just by turning off the taps.

Unfortunately most of those natural resources are in unfriendly environments, like Siberia - a frozen waste most of the year which turns into a mosquito-ridden waste for the remaining few months of it. The cost of extraction is high, and when I took a look at Russian aluminium a few years ago the cost of production was actually higher than the market price. Commodities prices has rocketed since then, but it's probable that Russian plants still have a higher cost of production than more efficient producers - since most of the profits of high prices seem to have gone to buying Premier League football clubs, rather than investing in more up-to-date facilities.

'Post-colonial' emerging markets don't do well in the long run. Much of Africa runs this sort of economy, exporting oil or coffee - and failing to create new industries with the returns. These markets are tied to commodity prices, and if commodity prices fall, they'll do spectacularly badly.

Then there's, say, China. Far from being a natural resources producer, China is now a net importer of many commodities. For instance Chinese demand (or lack of it) is the usual quoted reason behind moves in the copper price. Instead, China has become a major exporting economy competing in labour intensive sectors such as textiles, electrical equipment, and industrial machinery.

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I like to think of this as a 'truly emerging' market. It's not just 'emerging' in terms of being a long way away and having an increasing GDP - it's also emerging in the sense of structurally changing its economy. It's emerging from an agricultural and commodity-driven economy into a capitalist manufacturing and services economy - something which, if you read your Christopher Hill, England did back in the 17th century.

India is another market that's emerging in this way. True, it still has a huge hinterland of rural poverty relying on the agrarian economy, but it has managed to build companies like Wipro that are competitive on a global scale. Visit the call-centres and IT companies of Bangalore, even, and you'll see a tin shack with two cows lying in the dust next to a gleaming Norwich Union office building - but despite fits and starts, despite incredible bureaucracy and uneven development, the economy is changing.

Then of course you can also divide emerging markets by size. So far, everyone's been looking at the 'BRIC' markets - Brazil, Russia, India and China. Obviously, the size of the opportunity in these markets is immense - the countries have large populations and already sizable GDP. However, risk-friendly investors might feel they have already been well discovered and are no longer 'emerging' but 'emerged', though not fully grown.

BRICs investors are being sold the idea that they're in 'the emerging markets that matter'. But size, as they say, is not everything. BRICs investors may be missing out on higher growth - for instance in Indonesia, a top tip from a number of fund managers including Threadneedle's Julian Thompson. (Besides, the whole concept of a BRIC is wrong - linking Russia's natural resources based economy, Brazil's agricultural and oil bias, and the rapidly industrialising China and India.  Spot the difference!)

Panama, hardly known in the UK, is one of Latin America's top growth markets. In 2006 its GDP growth outstripped even China's. Panama City is a finance hub, the canal is being doubled in capacity and will help grow the intermodal sector; the one major fly in the ointment is oversupply in the property sector. GDP growth in the first half of 2009 was nil, after 8.4% growth in 2008, but it now appears the economy has returned to very modest growth, and it's expected to grow by 3% for 2009 as a whole. That's another of those smaller markets that is less well known to investors, but perhaps worth a look for those wanting to increase the growth potential of their portfolios.

There are also a couple of markets I'd describe as 'emerging neighbours', that again don't belong in BRIC portfolios but are well worth considering for growth. Turkey, for instance, will benefit from EU demand for exports. It has a dynamic, well educated and young workforce, and its strategic situation between Europe and Asia is important - not least as a potential 'energy bridge' bringing Central Asian oil and gas into Europe. The recurring problem of inflation has not completely beaten, but it's no longer at triple-zero percentages; GDP growth has been high, at bnt 4 and 5.5% over the past five years; and the hope of being able to join the EU has set the government on a reform path that has opened up the economy. 

Mexico, too, looks interesting - it benefits from US investment and from the North American Free Trade Agreement. Of course it's geared to economic recovery in the US, but it should actually benefit far more than the US does from any recovery. After all, given the choice of employing more people in the US, or in Mexico, which is substantially cheaper,  most companies will choose the cheaper option. Yet Mexico has the highest per capita income in Latin America, according to the World Bank, with low inflation, a whole bunch of free trade agreements besides NAFTA, and some interesting stocks including a telco with a 7% yield.

Of course you could take the view that finding the term 'emerging markets' deceptive is a piece of pedantry on my part - it's a convenient term for the non-developed world. In my view, though, that's a bit like Columbus found 'India' a useful description for that little set of islands he found - a basic navigational mistake covered up later by calling them the West Indies.

More seriously, though, an increasing number of collective investments including ETFs and OEICs market themselves to investors using the 'emerging markets' label. Investors obviously think they're getting one clearly defined thing - and my worry is that if they don't do their research in depth on the funds, they're going to get another.

An investor who thinks they're getting into 'the next Taiwan' or 'the next Korea', looking for an economy based on mass production of industrial goods, is going to be pretty disappointed if they end up with a fund whose main holdings are oil, copper and palm oil producers.

Fortunately investors can pick and choose which emerging markets they want - at least to some extent. For instance Lyxor offers ETFs that focus on specific markets - there's an MSCI India ETF, a China Enterprise ETF, and an MSCI AC Asia-Pacific (ex-Japan). First State offers a set of investment funds including Indian Subcontinent, Greater China Growth, and Latin America. (It also offers interesting funds playing particular aspects of world markets, such as the First State Global Listed Infrastructure fund and Global Property, though these are not focused on emerging markets per se.)

Saying 'I want an emerging markets percentage in my portfolio' is not enough. It's like saying 'I want to buy some stocks' without any idea of whether you're a value investor, a growth investor, an income investor, or what sectors might be attractive. Investors need to decide on what kind of emerging markets they want to buy - and why.