Emerging markets theory

As a category of equity investment, emerging markets may be considered to have begun in 1986 under the sponsorship of the International Finance Corporation (IFC), an arm of the World Bank. David Gill, then head of its Capital Markets Division, convinced the IFC to invest in equities in some of the strongest countries the World Bank was financing with debt, initiating private involvement in what had largely been a public domain. The Emerging Market Fund, which Gill started, gave its investment mandate to Capital Group in Los Angeles, a firm that now manages $75 billion in these markets. David Fisher has successfully managed this group since the early days.

But no one epitomizes the emerging market manager better than Mark Mobius of the Templeton Emerging Markets Group. Mobius meets the requirement for physical stamina of an emerging market investment guru. Now in his sixties, he is in top physical shape to maintain the pace of fifteen-hour days, seven days a week. From a childhood in the United States, he has been based in Hong Kong since the 1960s and travels on a German passport. His scope is global with more emphasis on the fast-growing economies, like Asia, that especially challenge an investor when reminded that volatility is two-way.

Mobius is a hard-headed investor in markets that do not usually inspire confidence. His tough valuation bottom-up discipline demands that investments sell at no more than five times earnings five years hence. And the cheaper the better for him. He is a fundamental investor who visits companies and studies the businesses, while fretting little over the country's macro issues (see Value Investing, Economic Forecasting and Politics and Investing). Since his techniques are common to the well-schooled analyst, he has to find different markets and different industries from other analysts. He is often out of step, buying investments that look like they may continue to decline. It is discipline the old-fashioned kind.

Mobius is a frequent commentator on emerging market investing and has written a well-received book, Mobius on Emerging Markets, which summarizes his keys to success:

Hard work and discipline: the more time and effort put into researching investments, the more knowledge will be gained and wiser decisions will be made.

Common sense: the clarity and simplification required to integrate successfully all the complex information with which investors are faced.

Creativity: looking at investments from a multi-faceted approach, considering all the variables that could negatively or positively affect an investment. Creative thinking is also required to look forward to the future and forecast the outcome of current business plans.

Independence: when making investments, it is most unlikely that committee decisions can be superior to a well thought-out individual decision.

Risk-taking: investment decisions always require decisions based on insufficient information. There is never enough time to learn all there is to know about an investment and even if there were, equity investments are like living organisms undergoing continuous change. There always comes the time when a decision must be taken and a risk acquired.

Flexibility: it is important for investors to be flexible and not permanently adopt a particular type of asset or selection method. The best approach is to migrate from the popular to the unpopular securities, sectors or methods.

Understanding Emerging Markets

"Emerging markets may be a euphemism but it is also a declaration of hope and faith," Mark Mobius has said. "Although some of the stock markets of developing nations may sometimes seem `submerged,' they are generally emerging into bigger and better things."

Such a definition of emerging markets expresses the typically optimistic view of people specializing in this branch of equity investment. Certainly, this relatively new focus of investor enthusiasm is always exciting with something happening all the time, somewhere in the world, with the opportunity for huge profits. Investment returns in some emerging markets have the potential to exceed those in the developed world.

But equally, for the dedicated emerging market investor, there are considerable challenges: the frequent frustrations of a lack of common standards and a lack of information, grueling travel schedules, language problems and cultural suspicions. And, of course, as the Asian crisis and subsequent global economic events have confirmed, stock markets and currencies in the developing and formerly communist worlds can be highly volatile, reacting strongly to international investor sentiment and economic and political changes.

Investments in emerging markets can result in spectacular returns, positive or negative. But picking potential winners, at the level of either country or company, is very difficult. There are frequently problems in comparing the relative merits of companies across markets: financial reporting and accounting standards vary, and indicators such as price-to-earnings ratios are often unreliable for international comparisons. Countries employ a variety of accounting conventions in their treatment of corporate profits.

It is clear that emerging markets carry considerable risks, including illiquidity, lack of transparency and sharp swings in prices. Individual investors seeking a stake in these markets should be either thinking long-term or prepared to take substantial risks. They should also consider carefully what proportion of their portfolios they can reasonably afford to commit to such markets.

Where Forecasting Goes Next?

Forecasting is a key task in financial institutions because of the profound effects economic developments can have on potential profits. And while leading economic indicators might provide a hint as to what the economic future holds, they do not anticipate what the additional effects of powerful economic agents like government policy and the financial markets themselves might be. To try to get ahead of the competition, companies will aim to model more accurately, and with more consideration of possible discontinuities in the markets.

One way to make forecasts more useful though not necessarily better might be to follow the principle of truth-in-labeling used on food packages and elsewhere. We could describe the kind of forecast we are making more accurately. For example, if we are using backtesting, we should say that that is exactly what we are doing and which of two varieties.

One form of backtesting is momentum: the forecast is derived from a view that the past momentum will continue in roughly the same direction often straight line as it has in the past. The other form is regression to the mean: we think things will not go back or up or down, but return to average conditions. This is like a series of coin flips that goes ninety-nine times in one direction, and we think the next event is related to the preceding one.

Alternatively, we can say that our forecast comes from our own insight or novelty, and label it that way so it is known as essentially out of our head and our own creativity or lack of creativity, which will be known in time. Sometimes different techniques like high-frequency forecasting come from this. Or it can come from news and our response to new news. This is not necessarily insider information but news that is not necessarily generally recognized by others a form of forecasting derived from information.

Finally, the most common form of forecasting is waffle: we do benchmark investing or stick to the middle because we do not know what else to do. That is perfectly all right, but we should label it as such. Let us say that is what we are doing, so people can understand what they are getting when they listen to us. Most of the time, a waffle is the right thing to do, but at all times, we can make our forecasts better by correctly labeling them.