Emerging market stocks often get overlooked. Indeed, the U.S. stock market has long been one of the world's best sources for investment growth, and there's little reason to believe that will change going forward.
But it's important for investors to know that it's not the only place to stash your dollars if you want them to blossom.
Emerging markets (EMs) are a one-two punch, offering both the ability to spread out risk geographically, as well as the potential for explosive returns. But they carry plenty of risks all their own – sometimes too many, and too much, for more cautious investors. So it's best to know what you're getting into before you take the plunge into international waters.
Today, we'll discuss emerging markets, including what they are, why they have a place in certain portfolios, and what you should consider as you're seeking out the best emerging market stocks.
What are emerging markets?
Generally speaking, the world's countries are divvied up into three categories based on how mature their economies are. From most mature to least, they are:
- Developed markets
- Emerging markets
- Frontier markets
Curiously, there is no single official definition for what constitutes an emerging market. Indeed, in many cases, developed markets are defined by specific criteria, and EMs are simply defined as not being a developed market.
But emerging markets tend to feature several similar traits.
Most noteworthy is greater economic growth than their developed peers. Indeed, more quickly expanding gross domestic product (GDP) is the primary allure. This is largely because these nations are in much earlier stages of industrialization than developed countries such as the U.S., the U.K. and Japan – and thus they have much more room for rapid improvement in unemployment, disposable income and other critical economic metrics.
High value can often come into play, too. These companies usually aren't as well-covered by the media or analyst community as developed market stocks – and as a result, can become significantly overpriced.
"We believe emerging markets equities are becoming ever more attractive as it remains one of the most mispriced asset classes globally, with valuation discounts relative to developed markets and U.S. equities hovering near 30% and 40%, respectively," Lazard Asset Management says in its 2024 emerging market outlook. "While many parts of EM equity remain markedly under-owned despite their low cost, we expect earnings growth to be higher in EM in 2024 compared to the developed world, driven to great extent by emerging Asia and information technology companies."
And, of course, emerging markets represent another way that investors can add diversification to their portfolios: geographically. Rather than putting all of their eggs in a U.S. basket, they can buy emerging market stocks to hedge against slow periods for American markets while still accessing high-growth opportunities.
These roses frequently boast thorns, however. The risks are many and varied, including (but hardly limited to) unstable governments and political unrest, unregulated markets, volatile currencies and poor monetary policies.
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Noteworthy emerging markets
While there are literally dozens of emerging markets, investors have long been enamored with a group called the BRICS: Brazil, Russia, India, China and South Africa.
These five countries' collective GDP actually began to surpass the G7 (Canada, France, Germany, Italy, Japan, the U.K. and the U.S.) in 2020. And that lead has only widened since, with the BRICS representing 32% of global GDP vs the G7's 30%.
The BRICS became more than the BRICS this year, however. As of January 1, the economic bloc had expanded to include Egypt, Ethiopia, Iran, Saudi Arabia and the United Arab Emirates (UAE).
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How to find the best emerging market stocks
Trying to pluck a few names out of the emerging market hat, which carries many thousands of stocks worldwide, is no small task.
It goes without saying that you'll want to start by evaluating these stocks much like you would any other U.S. name: valuation, growth potential, balance sheet health, cash flow generation and so on. But there are a few other considerations as you seek out the best emerging market stocks.
Do they trade as an ADR on major U.S. exchanges? Unless your portfolio is run through a broker with access to foreign bourses, you'll largely be limited to emerging market stocks that trade as American depositary receipts (ADRs). These are certificates issued by a U.S. bank that represents stock of a foreign country – but they trade just like regular ol' U.S. stocks. Importantly, ADRs must adhere to the requirements of whatever exchange they list on, so if they list with the New York Stock Exchange or Nasdaq, that communicates a higher level of accounting and transparency than might be required in their home markets.
The country they're based in: U.S. stocks can be pushed and pulled by the state of the U.S. economy, and the same relationship exists between emerging market companies and the nations in which they're domiciled. So when seeking out the best stocks to buy, you'll want to know the growth prospects and risks not just of the individual equity itself, but its home nation as well.
Individual stocks vs ETFs. Researching individual equities is difficult enough when you're dealing with U.S. stocks – and emerging market stocks add an additional layer or two of complexity. Also, given the relatively higher risk of investing in companies from emerging markets, you might be best off scattering that risk across hundreds or thousands of stocks via emerging market ETFs (exchange-traded funds).
If you want access to stocks from a number of emerging markets, you could consider broad-based EM ETFs such as the SPDR Portfolio Emerging Markets ETF (SPEM), Vanguard FTSE Emerging Markets ETF (VWO) or iShares Core MSCI Emerging Markets ETF (IEMG). However, there's also a wealth of single-country EM funds, including the iShares MSCI China ETF (MCHI), WisdomTree India Earnings Fund (EPI) and Franklin FTSE Brazil ETF (FLBR).
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