Foreign indirect investment

How to invest in emerging markets without leaving your home exchange

The foreign investment sphere keeps getting more complicated. What’s a discerning investor to do?

Experts say the debate over whether to invest directly in a country’s local companies or pick established, blue-chip firms that do business in foreign markets comes down to the decision between risk versus reward. What matters is how much comfort and understanding a client has about the target they’re investing in.

Emerging economies are always going to look more attractive because, by definition, they’re in the fastest stage of growth— yet transparency and risk abatement are never as high as in established economies, notes Hilliard Mac-Beth, portfolio manager at Richardson GMP.

“The growth rate of economies is going to be higher in places like China and Indonesia where consumers are just starting a lifestyle of consumption similar to that in North America or Europe,” he says. “Yet there’s a riskier environment of a boom-bust cycle in emerging countries.” This magnifies any hiccups in growth.

While it’s reasonable for clients to want to put money into countries that are growing rapidly, MacBeth takes pause when clients say things like, “Let’s pick China.” Investors need to know they’re buying a company’s stock, not a country’s. “The profits are made by the company,” MacBeth says, suggesting research still matters for individual stocks.

Investors can choose one of three ways to put money into firms abroad, each with increasing risk: buying into an established firm that does sizable business in emerging economies(such as Heinz), picking foreign firms that trade on recognized international exchanges (such as India’s Tata Motors, which trades on the NYSE) or delving into a foreign firm trading solely on its home exchange (such as Brazillian food multinational JBS S.A., which trades on Brazil’s Bovespa exchange).

Assessing the risks

The last option suggests the greatest opportunity, but it also presents the greatest uncertainty.

Accounting and disclosure standards in foreign markets are seldom as high as in Canada, and local foreign companies seldom face the same analyst scrutiny as those at home. The Sino-Forest fiasco is a case in point. The Hong Kong-based firm, traded on the TSX, was called out by analysts alleging the company orchestrated a massive fraud through fictitious revenue claims and inflated timber holdings over many years. Sino-Forest denied all charges but investors weren’t convinced, sending the stock plunging.

Foreign companies might voluntarily choose to abide by international standards, but they won’t be held accountable if they’re not on an international exchange.

Ryan Murphy, director and investment advisory specialist at UBS Private Wealth Management, suggests investors with strong knowledge of a particular foreign firm or economy make the best localized foreign spelunkers. (In all cases, investors should focus on businesses they understand and have the time to research.)

“If you’re a new entrant to Canada, you might have good knowledge of a [foreign] company,” he suggests. “Maybe you know the local economy well. Maybe you’ve sat on [a company’s] board or invested in it before. In that case, if you’re comfortable with its management and direction, investing can make sense. But you still need an appetite for risk to withstand the volatility of some markets.”

Currency fluctuations can have a profound effect on foreign stocks, so investors need to diversify their currency holdings to naturally hedge their portfolios. Firms that do business primarily in a local currency (like Tata Motors) can see their fortunes rise and fall dramatically over currency issues, something that conservative investors will find jarring. Even established names with strong foreign growth like Nestlé, hog-tied by the soaring Swiss franc in the first quarter of 2011, can find themselves in currency turbulence.

Yet since many western brands do enormous portions of their business in emerging economies (Coca-Cola earns roughly 75% of its revenue abroad), investing with an established name can be a way to invest abroad by proxy.

Overseas, yet close to home

Richardson GMP portfolio manager Mark Jasayko suggests the S&P 500 index as a starting point for picks that provide foreign exposure without the headaches of more localized buys.

“The S&P 500 itself is almost a defacto international index as half of its revenues are coming from overseas,” he says. “If you’re interested in a place like India, you should look for a company that gets a large percentage of its revenue from there.”

Buying established names also offers familiarity. “One of the big advantages of such an approach is clients will recognize the names of these companies. There’s a good amount of comfort already there that can help the client stay with the strategy, despite ups and downs,”MacBeth says.

No matter how a client chooses to invest abroad, emerging markets are by design a niche buy. Murphy suggests a maximum of 5% to 10% of a portfolio in emerging markets for balancedapproach investors. Any sensible venture into emerging markets by investors should be done with near term risk-acceptance and understanding, and a goal towards future growth.

“It’s more of a long-term allocation with vehicle diversification,” Murphy says.

BEWARE GOVERNMENT INVOLVEMENT

Emerging markets can differ greatly in the level of government involvement within their economies, and the three most popular emerging economies (China, India and Brazil) are no exception.

On one side of the spectrum, the Chinese government is not above implementing far-reaching subsidies, preferential loans and debt-forgiveness in various industries, as evidenced by the rapid growth of China’s largely state-owned steel industry on the back of massive government intervention over the past 15 years.

Foreign companies rarely operate in China these days without some kind of joint-venture setup and state-owned firms are kept on a tight leash. Also, China saw housing prices triple in the country from 2005-2009 so the government moved quickly to withdraw liquidity from the banking system, a strong-arm move anathema to many freemarket economies.

India, on the other hand, is less couched in state-control, though the Indian banking system is still highly nationalized. Economic reforms since the early 1990s have seen a consistent reduction in state-owned businesses and a drop in desire by the government to step in directly to change the course of specific industries.

Brazil has the most laissez-faire economy of the three, not only stemming from the government’s commitment to free-market principles, but also because their priorities lie elsewhere, such as with their ongoing currency war with the U.S.

“Brazil is a little more free-wheeling. The Brazilian government is riding favourable macroeconomic trends for now and is not nearly as interested in managing its economic industries. There’s less government interest to get involved directly,” says Mark Jasayko, portfolio manager at Richardson GMP.

Raf Brusilow is a freelance journalist and writer based in Toronto.