Navigating the Challenge of Beating the Stock Market in Emerging Countries

Investing in the stock markets of emerging countries presents a unique set of challenges. While it may seem appealing due to potential high returns, the road to success is fraught with obstacles compared to investing in more developed markets. Let's explore why beating the market in emerging countries is harder and how this can be addressed.

Why Beating the Market is Harder in Emerging Countries

One primary reason is the varying levels of government control and intervention. In the United States, the government has the capability and will to support key indices like the SP 500 during downturns. For example, during the market crash in December 2018, the U.S. government took swift action, leading to a market rebound throughout 2019 before the pandemic broke out. However, in emerging countries, governments often lack the resources or willingness to provide similar support. The market fluctuates based on external factors without immediate government intervention.

Another factor is the high volatility of emerging markets. Unlike advanced markets, which see steady growth followed by short but intense bear markets, emerging markets tend to witness rapid growth over a few months, followed by prolonged periods of slow and painful downturns. This makes it challenging to find consistent investment opportunities that yield positive returns.

What's Still Easier: Frontier Markets

Despite the challenges, investment in emerging countries is not entirely without benefits. Frontier markets, such as countries on the verge of becoming emerging markets or those with smaller and mid-cap sectors, present unique opportunities for savvy investors. Here's why:

Greater Opportunities for Undervaluation

In developed markets and most MSCI Emerging Markets indices, institutional investors dominate. Approximately 70-80% of the market is held by banks, hedge funds, and other institutional investors. This means that unless there is a severe market panic, it's hard to find undervalued opportunities. Conversely, in frontier markets, there are fewer institutional investors, making it possible to find more undervalued stocks. This can be critically important in markets where information is often less transparent.

No Advantage from Boots on the Ground

Another limitation in larger, developed markets is that having boots on the ground doesn't necessarily provide a competitive edge. For instance, visiting a company's offices, like those of Microsoft, might offer no significant advantage over remote analysts. Similarly, knowing a top executive wouldn't necessarily give you an inside advantage, as the information is often publicly available. However, in frontiers markets with fewer institutional players, on-the-ground knowledge can be more valuable. It can help identify opportunities that larger firms might miss due to their size and focus.

Risk Management in Frontier Markets

While frontier markets can offer unique opportunities, they also come with significant risks. It's important to allocate a small portion of your portfolio to these markets. A sensible allocation, perhaps 10%, can help balance the high potential for returns against the elevated risk.

This principle is similar to how some professional gamblers focus on smaller football leagues or private investments like private equity. The markets are less crowded, and there is a mismatch in pricing, making these opportunities more attractive to those with a well-calibrated risk profile.

Conclusion

While investing in emerging markets can be challenging, especially in more mature markets, the frontier markets offer a different landscape. With greater flexibility, fewer institutional players, and a higher potential for undervalued opportunities, these markets can provide unique investment opportunities. However, investors must be aware of the higher risks and manage their portfolios accordingly.

For those interested in exploring these markets further, here are some recommended reads:

The Uses and Misuses of Stock Market Valuation Ratios Understanding the Importance of Emerging Markets in Your Portfolio Strategies for Effective Portfolio Diversification