How to Pick Emerging-Market Stocks

Investors looking to add an edge to their portfolio could look no further than emerging-market stocks.

Even though emerging markets have been characterized as economies that are second or third tier in the past, interest in these types of assets has steadily shifted.

Emerging-market equities offer a multitude of possibilities for growth and exposure in an innovative direction, and that’s where the future is headed:

What Are Emerging Markets?

Emerging markets account for a large portion of the world’s economic output, which can present buying opportunities for investors looking to widen the scope of their investments.

During global financial disruptions, developing countries are more severely impacted since they have more vulnerabilities. For instance, as a result of the pandemic, the global economy has been experiencing a recession with emerging markets seeing negative growth rates, according to the International Monetary Fund, headquartered in Washington.

In response, the central banks of these countries are supporting the economies through sweeping fiscal policies.

Despite this setback, investors shouldn’t shy away from emerging-market economies because of their impressive long-term growth potential in secular trends, referring to structural changes in a sector or industry.

Emerging markets have augmented their growth in recent years and still have a lot more room for economic maturity compared with developed economies. Consequently, emerging markets are said to deliver more returns in the future compared with developed markets.

Risks of Emerging-Market Stocks

There are a variety of risks facing investors in emerging-market equities, but experts say this risk comes with the territory of investing in this market.

Currency-fluctuation risk due to exchange rate changes is a source of caution in international investing. Investors expose their asset valuations in emerging markets when currencies depreciate compared with the dollar.

Investors should have a sharp eye to catch potential problems in the accounting and regulatory space, but the reality is they are no worse in emerging markets than in the rest of the world. Still, some countries can be reluctant to disclose company information, says Eric Leve, chief investment officer at Bailard in San Mateo, California.

“China wants to lead with an iron hand in politics but open its markets up to global investors. U.S. regulators, however, require companies listed on U.S. exchanges to open their books like other countries’ companies will,” Leve says.

These risks are important for investors to consider. However, while these factors can be influential drivers of volatility in the short term, over the long run, it may be less of a concern.

Many investors consider emerging markets to be fraught with risk because of the pandemic, currency fluctuations, high deficits and distrust due to different regulatory standards. Yet, Keith Fitz-Gerald, chief investment strategist at the Fitz-Gerald Group in Seattle, sees them very differently.

“The average investor could triple their exposure yet still not have enough since many emerging markets have already emerged. This offers unprecedented opportunity and profit potential for savvy investors wanting to look beyond United States-centric markets and investment funds,” Fitz-Gerald says.

Fitz-Gerald says emerging markets and developing economies now account for nearly 60% of the world’s gross domestic product while developed economies account for 40%, with the expectation of continual decline. “Innovation isn’t limited to the United States and Europe,” he adds.

Investors should also consider the diversification that emerging-market stocks offer. Fitz-Gerald says many investors are surprised to learn that emerging markets run on different economic cycles from advanced economies, which means this diversification’s working in their favor “is more important than ever,” he says.

Tips for Picking Emerging-Market Stocks

Emerging-market exchange-traded funds are built around indexes by providers, the two major ones being listed on the FTSE Emerging Index as well as MSCI Emerging Markets.

Each index tracks very different groups of countries and chooses how it weighs different companies and economies. The issue with index providers is that they’re making their own choices on how to account for certain markets where some of the best stocks don’t get included in the indices.

The year-to-date total return for the FTSE Emerging Index is down 16.3%, and three-year total return is 1.9%, as of May 29. That’s while the total return for the S&P 500 is down 3% year to date, with the three-year return at 10.69%.

“You might not have enough of good companies in your portfolio,” Leve says of emerging-market index investing. “You will have the very biggest stocks, which are not always the winners in emerging markets; small- and mid-cap are the ones with the real opportunities, and those are not allocated much in the portfolio.”

Therefore, Leve recommends focusing on individual emerging-market stocks, especially for investors who are willing to do the research.

For an emerging-market stock picker, a company centered on the outcome for shareholders is one you want to own, Leve says.

But apart from the company’s commitment to dividends, strong balance sheets and future earnings, investors need to think more broadly to identify an innovator in their field.

“If you’re looking for outsized returns, leave it to people who have a research edge in emerging markets,” says Jared Leonard, an investment specialist at International Equity at Hartford Funds in Wayne, Pennsylvania.

“Institutional investment strategies with local ‘boots on the ground’ analysts or sophisticated systematic strategies incorporating rigorous data validation can be a more effective means of picking emerging-market stocks that may outperform their peers,” he adds.

Historically, emerging markets have a low allocation in an investor’s overall portfolio. But with global competitors outweighing U.S. performance in areas such as their innovative technology use and development, investors can access these pockets of opportunity on a global scale.

Investors allocate about 2% to 5% of overall equity exposure in emerging markets, says Brian Bandsma, portfolio manager at Vontobel Quality Growth in New York City.

There are now more ways to gather qualitative and quantitative information in our data-driven environment, which should put investors at ease about transparency concerns.

“Emerging markets have changed dramatically within the last 20 years, where more information about companies is more readily available,” Bandsma says.

Misunderstandings About Emerging-Market Stocks

A stigma that has latched onto emerging-market companies is the misconception of lackluster quality of businesses.

Investors need to know emerging-market equities are up to developed-market standards, says Badsma, “There are several emerging markets that act like developed markets,” he says.

Since they’ve been interacting with U.S. market guidelines, their company reporting standards are up to par.

“A majority of companies in emerging-market economies that want U.S. exposure tend to meet the scrutiny of U.S. guidelines,” Leve says, and this has improved dramatically over time as they’ve increasingly grown in line with U.S. market standards.