A triple test for investing in emerging markets

The Globe and Mail

Emerging markets are popular these days, but how safe are these far-flung investments?

The Egyptian and Tunisian revolts prove that you can’t assess the risk of emerging markets simply by looking at economic data. Even Israel’s famed intelligence service failed to predict the recent uprisings in its own backyard, just as the CIA did not foresee the collapse of East Germany in 1989.

Or rather, one person did foresee the latter. Vernon Walters, then-U.S. ambassador to West Germany, had just returned from East Germany where he talked to people on the street, and quickly cabled James Baker, then Secretary of State, to report that the communist state would erupt. Mr. Walters was scorned, but he was right – the Berlin Wall fell in a week.

This reveals an important truth: It helps to talk to sources on the ground, especially ones who aren’t official leaders. This holds true for both countries and companies.

In the case of countries, people on the street can provide invaluable information about the state of popular unrest. In the case of companies, low-level employees can be an important source of insight about customers and top management. Their opinions won’t tell you much about the next quarter’s results, but they can give you a feel about how the next three years will unfold for their employer.

Phil Fisher, the famed investor, used to make a point of talking to employees in his search for well-managed companies. A similar method can help global investors ferret out the risks involved in emerging markets, especially in countries run by dictators or authoritarian regimes.

Before investing in any emerging market, you should ask three questions of people who know the country well.

First, could you walk down the capital’s main street with a sign saying “The President is a so-and-so” – and not only do so safely, but also reasonably expect the police to protect you? In Russia you cannot. Just ask Hermitage Capital Management, the hedge fund that faced persecution by Russian authorities after uncovering alleged corruption by officials.

Second, can you sue a local partner in an emerging market – or, better still, the government – and have a reasonable chance of facing an honest judge and winning? Investors in Russia or Democratic Republic of the Congo can’t. In Brazil, on the other hand, despite abundant crime, one can still expect most courts to be reasonably just, and political dissent is tolerated.

Finally, can you (or the company you invest in) take profits out of the country in dollars? If you can’t, be very wary.

This triple test will limit your international scope, but not necessarily rule out foreign investments. At the very least, if you’re aware of the risks, you’ll put many emerging market “investments” into the category of “speculation” and limit them to no more than 10 per cent of your portfolio.

Which brings me to China, the biggest emerging country of all. It isn’t identical to Egypt, of course, but the two do share more similarities than you may think. Both are ancient civilizations once dominated by colonial powers. Both are now ruled by authoritarian regimes and are dominated by single parties. Both countries pass the third question in my test, but flunk the first and second.

There is more political risk in China than many investors realize. Just last year China justified its support of North Korea by saying that if North Korea collapsed, hundreds of thousands of refugees would stream over the border into China. But deeper interviews revealed that China viewed the North Korean regime’s survival as key to its own: “North Korea is our East Germany,” a senior Chinese security official told The Washington Post. “Do you remember what happened when East Germany collapsed? The Soviet Union fell.”

What if the North Korean regime faced a revolt like the ones in Tunisia and Egypt? What happens to China then – or to Chinese stocks and ETFs?

Investing in many emerging markets is like writing hurricane insurance. Yes, you can get fat premiums for a while, but when the hurricane finally hits, you can lose both profits and capital.

So next time someone pitches you on investing in a country that fails the triple test, think twice – or at least classify it as a speculation.

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