The Best Way to Get Big Returns from Emerging Markets

Lots of investors got the emerging markets call wrong in 2011. At this point a year ago, pundits were urging them to buy both stocks and bonds in countries like Brazil or Indonesia (not to mention China) as a hedge against still-sluggish economic growth and corporate profits in the developed world. The pundits nailed the diagnosis: Developed markets certainly were “sluggish” last year, as they battled to shake off Europe’s sovereign debt crisis. But those gurus bungled the prescription: As correlation levels among markets and asset classes zoomed higher, emerging market securities failed to serve as a panacea.

Now that the calendar has turned, that call is looking a lot better. By February, countries like India, Argentina and Russia were posting double-digit returns, and correlation levels were falling. Is it time now to make the leap into emerging markets?

So-called risk assets are certainly on a tear, so the momentum seems to be positive, and governments in a number of developing nations are either easing liquidity, as in China, or taking the first steps in that direction, so the pace of economic growth seems likely to argue in favor of being an emerging markets bull.

One of the big problems when it comes to investing in emerging markets has been that while the economies are growing, sometimes at double-digit rates, it has been hard to figure out which stocks will benefit. In some cases, equity markets are underdeveloped or illiquid, or the range of stocks available doesn’t give an investor the ability to capture a large part of that growth. Emerging market government bonds can certainly be more lucrative and offer higher yields than their peers in the developed markets, from U.S. Treasury securities to the German Bunds.

Still, new research backed by Aberdeen Asset Management suggests that there is a way around all of this. Aberdeen asked Martijn Cremers, an associate professor of finance at Yale University, to take a gander at the performance of publicly traded affiliates of big multinational companies based in the emerging markets. There are a total of 92 of these companies around, based in countries ranging from Malaysia to Turkey and Poland to South Africa. The stakes their parent companies own in them varies widely: Unilever owns 75.3 percent of its Pakistani affiliate and 85 percent of its Indonesian subordinate, but only 36.8 percent of the Indian company. The parent companies include such household names as Nestle (NSRGY), Goodyear (GT) and Coca-Cola (KO).

Cremers found that investing in these companies would have yielded a better return than investing in the parent companies, the developed markets as a group, or the emerging markets as a group. For instance, over the 13-year period studied, the Unilever affiliates mentioned above returned 2,229 percent; investing in the parent companies would have generated a return of 407 percent. Buying the developed markets that are home to the parent companies returned a mere 147 percent and owning the developing markets that are home to the three affiliates generated gains of 1,157 percent.

The icing on the top of that piece of cake? Cremers discovered that at the height of the financial crisis, the shares of emerging markets-based offspring of European, Japanese and North American corporations continued to outperform their parents. The theory is that these affiliates benefit from the combination of local growth rates and the parent company’s culture of business discipline and emphasis on shareholder returns. The returns can’t be explained by industry exposure or other factors.

Before you log in to your brokerage account and start ordering stock in the likes of Walmart de Mexico, Goodyear Lastikleri Turk or Lafarge Malayan Cement, you might want to bear a few caveats in mind.

1. The past doesn’t determine the future. When it comes to investing, this caveat can’t be repeated often enough. This was obviously a fabulous investment strategy to adopt back in 1999 (and stick to, through 2011), but that doesn’t mean that the markets aren’t changing in ways that will ensure it doesn’t work going forward.
2. Publicity is a big spoiler. How many hedge fund traders have begun taking a look at this as a way to generate profits for their clients, and how long will it be until arbitrage between the various securities drives up the price of the affiliates’ stocks in recognition of the advantage of owning those securities?
3. Aberdeen, with more than $6 billion under management from U.S. investors alone, is the world’s largest manager of closed-end mutual funds focusing on the emerging markets. It has a vested interest in generating enthusiasm for emerging markets on the part of current and potential clients.

None of these cautionary notes mean that this isn’t the right solution to the perplexing question of what to do about emerging markets; buying these stocks will offer exposure to what is still likely to be above-average economic growth while at the same time reducing the volatility of a portfolio. It’s one of those clever and very intuitive investment theses that is likely to be interesting to those who have been told to get their emerging markets exposure by owning the multinational parent company that generates a hefty chunk of its own earnings from sales in those regions. This approach is really just a fresh twist on that, and in the still-uncertain market environment, it’s worth examining closely.