Part One

On the Selection and Classification of Developing Markets

Part One frames the various general concepts and perceptions of developing markets as they are commercialized by index, service, and asset management providers. From a terminology to group economies into similar stages of development for analytical purposes, the various names, categories, and grouping of developing nations have taken on a life of their own in the investment community. This has created boundaries that are not necessarily useful.

At the outset we demonstrate that from being a minor player on the global stage only a few decades ago, emerging markets as a group and distinct from developed markets (traditionally the United States, European Union, and Japan), have come to the forefront of growth and economic success. They now dominate world economic growth with their commercial activity, economic output, and population. At the margin, for any one additional unit of world gross domestic product (GDP), developing markets account for double the value of growth of developed markets.

This reversal from only two decades earlier is fostering immense and exciting opportunities for businesses and investors. Thus, investors no longer can afford to ignore developments and opportunities in developing and emerging markets as a group or in select individual emerging markets.

The informal nature of developing markets is often considered the key impediment—there is hardly any reliability in bandit economies, markets dominated by connected entrepreneurs and opportunistic bureaucrats. Investors most value good information. A survey of institutional investors on key issues likely to deter investment in developing markets shows that lack of information or lack of reliability of information is one of the major reasons not to invest in certain markets. The information gap is often more important than liquidity concerns and more important than political risk concerns.1

Yet these bandit economies may be about to bloom. Macroeconomic analyses may not help. An experienced private equity investor outlines a very pragmatic assessment of economies as to their potential and future opportunity. Without resorting to economic data or third-party analyses, indicators of booming economies and growth are identified. They are hands-on and only depend on the powers of observation.

In addition to the touch and feel approach, institutional investors need some benchmarks to allocate investments in developing economies. The question on all minds is how to develop the tools or use existing tools to select which market to focus on or, even more broadly, how to select the likely high-performance markets of the future.

We look into prevailing classification approaches to developing markets. Principally, these markets or country economies are segregated based on some varying criteria, largely dominated by stock market requirements, into two main categories: emerging markets, considered investible by the investment community at large, and the less investible frontier markets heretofore reserved for contrarians, private investors, and long-term, often public financiers.

We review approaches to classifying developing markets and conclude that combining vastly different economies with fundamentally different structures into one basket or category simply because the stock market fulfills to some degree size, regulatory, and transaction criteria is not well-suited to guide investors. For all investment, the single most important aspect is the individual company or security to be invested in and the overall conditions for industries, sectors, or companies to prosper. Macroeconomic aggregates of the country as a whole and stock market standards are not the sole compass for investors as most service providers postulate.

The prevailing classification of economies into emerging markets excludes a number of well-performing economies with attractive public or private securities or opportunities for investment; however, the prevailing classification benefits a number of economies that have little else to offer than a stock market that meets the criteria with very limited worthwhile securities. This leads to an artificial market and price for these few securities. Moreover, the much hyped BRIC (Brazil, Russia, India, and China) economies are dominating by their sheer size, but some of them less so on their merits. In fact, they are hardly comparable and constitute an artificial group, ranging from the global manufacturing leader to a major economy with some of the weakest public governance structures.

Therefore, in the context of investing in developing markets, frontier economies and heretofore excluded economies must be considered more deeply and in a similar category as a matter of principle. We review some of the approaches and indexes dedicated to frontier markets. Frontier markets represent the next wave of emerging markets and should not be excluded solely because their stock market is too small, illiquid, or restricted. Small stock markets may have some very good stocks and companies about to be listed or seeking private equity. There are multiple ways to participate in these markets and the investment community offers a large number of vehicles that allow participation in frontier markets. Going further into unclassified economies, several such markets have stock exchanges and several markets have investible instruments even if the market or economy as a whole does not meet other standards.

By strictly segregating developing markets into a first class (emerging), a second class (frontier), and a third class (unclassified), investors assume some sort of quality rating attributable to these markets when in reality only access to and tradability of public equities is truly assessed. Sovereign ratings of these markets are often relatively strong—even when accounting for the inherent limitations of the ratings process—and even more so when considering the possible ratings or assessments of individual securities.

Since current approaches are not entirely satisfactory, we suggest looking at developing markets from different angles, namely less from stock market attributes and more toward enabling economic framework conditions and economic structures. It is not the stock market on which companies trade that matters ultimately but rather the fundamental modus operandi of an economy, in particular the relative importance of the informal economy.

In considering the nature of developing economies, we argue first and foremost that the texture in which the economy operates, that is their level of organization and relative structure, matters most. We call this governance or the formal economy. Organized economies have a small informal sector. Economies that lack institutional or administrative frameworks tend to have more important informal structures.

Markets with predominantly informal economic structures (lack of rule of law, institutions, transparency), also referred to as bandit economies, should not be considered universally investible even if the stock market has attained certain benchmarks and qualifications. Caution is equally appropriate when considering listed companies operating in informal markets. As part of the system, companies operating in informal markets tend to adopt a more informal approach to business. The market listing and associated trading conditions are not the drivers of the opportunity or risk.

Smaller companies operating in smaller markets with a dominance of a formal economic structure (prevalence of rule of law, institutions, transparency), tend to outperform in the long term comparable companies in informal or bandit economies. This holds true even if the latter economies have a better developed stock market.

Many current approaches of analytical service providers may value some bandit economies higher than those economies developing more slowly or from a smaller base albeit along an orderly path. We conclude that current service providers do not adequately cover the universe of investible economies or markets.

Leading academics provide a solid analysis of indexing and passive investment requirements from an Asian investor perspective. They underline the widespread usage of equity indexes and concerns about the concentration of investment that defeats the very essence of diversification into developing markets. Given the importance that investors attach to indexes with a market development focus, a point argued in the issues section, the emphasis on huge BRIC (Brazil, Russia, India and China) and fairly advanced markets (Next 11 or CIVETS) at the expense of interesting but less developed markets supports the concern that capital flows are guided by indexes rather than fundamental investment considerations since most in the investment industry rely on or use extensively external analytics. A more dynamic approach of analytical service and index providers would stand to reason.

This leads us to discuss alternative definitions of investible developing markets based on the critical factors for investors: rule of law, proper treatment of shareholders, and absence of government interference/shadow economy. The world’s Heritage Freedom Index covers many of these hallmarks and based on their latest ranking, we define a subset of attractive developing economies.

We also review global competitiveness of economies, their economic global governance ranking, and ease of doing business. Many popular economies and investment destinations, indeed the BRICs, do not fare that well.

We also consider the strength of economies outside macroeconomic and structural aggregates. As a substitute for support service industry and overall capital market attractiveness, we look at a financial center index for the relative strength in financial services and at a manufacturing competitiveness index for the equivalent in the real economy.

A summary indicator seems to be private equity flow. Growing and significant private equity flows provide a lead indicator for future market potential. Private equity is less constrained by capital market development, in fact they substitute the lack of growth funding. At the same time, private equity investors enhance governance and company prospects through active management participation. Thereby, they enhance the stock of companies and provide the first stage of liquidity for company shares when they exit or trade. Comparing relative private equity flows and relative market capitalization suggests that high private equity flows in economies with relatively low stock market capitalization is a lead indicator for upcoming stock market growth.

Those developing markets with the highest private equity when eliminating certain anomalies such as extraction industries or energy-related investments already demonstrate many of the core elements of an attractive market.

The World Bank and its affiliates have been investing in private equity in developing economies for several decades, initially in infrastructure but increasingly in core industries to support the development of a country. Their International Finance Corporation (IFC) makes a case for private equity investment that is not only compelling but based on what is probably the longest systematic experience of any developing market investor of significance.

Some of the advantages and myths of private investing are dispelled on the base of the IFC private equity data base. Private equity investments in developing markets are not inherently riskier and provide very attractive returns. It is simply a matter of time and effort until formalized stock markets catch up.

Enabling economic framework conditions outside the stock market and the propensity to further improve these conditions foster attractive companies and make all the difference for the developing market investor. Economic endowment and activity have a mutually reinforcing effect on stock markets. Stock markets require improving governance structures, and with improving governance structures, stock markets tend to grow, all else being equal.

In applying this principle, we find that a number of hereto highly valued developing markets should not be at the forefront of principal attraction except for the sheer relative size of the stock market. On the contrary, the most attractive markets based on the criteria of solid governance structures—always given similar growth rate and development potential—are a different selection. They seem most relevant in fostering solid long-term investment performance.

We provide a metric of the emerging markets along a scale of governance that is outside traditional aspects as well as their stock market size in recognition that small but highly attractive economies may not have the absorption capacity required for larger investments. Thus investors with long-term capital appreciation aspirations but not guided primarily by the overall stock market size can consider some of the likely winners of the future. At the same time, investors mainly guided by the potential for capital absorption, crudely measured by stock market capitalization, can select other markets.

The resulting groups of economies looks somewhat different than traditional classification providers suggest. The key difference lies in addressing the opportunity of developing markets along two axes: size (stock market) and quality (underlying structures). In this way, both small and big investors can participate in the opportunity, select their targets, and assess the systemic risks before selecting the security itself. Looking at any one aspect alone either increases principal risk (quality) or liquidity risk (market attributes). Only together do they form the necessary base for investment for any investment type, size, or objective.

Some attractive markets are only accessible through private equity, but many are accessible through public equity. All of them are or can be made investible through listed securities, be they ETFs, country funds, dedicated investment companies, tradable indexes, or other instruments. It would be up to the investment community to provide appropriate vehicles that give investors better choices. It is not the access vehicle that matters when unlocking opportunities in developing markets but the choice of the specific investment-country combination.

Further down the road, even these metrics of GDP growth in combination with a more formalized economy may take second stage to the economic sustainability of an economy. The recent work of the United Nations University International Human Dimensions Programme on Global Environmental Change (UNU-IHDP) and the United Nations Environment Programme (UNEP) has started to look at the wealth creation of an economy covering all its factors: human; productive; and natural. The resulting measure indicates the sustainability of an economy in terms of growth and resource replenishment.

Ultimately, the long-term investor may choose economies with strong sustainability (purely from a commercial perspective and ignoring any ethical aspects) over economies that are depleting resources. This would quite fundamentally change today’s perspective from being fixated on GDP growth (for example, one that only irreversibly pillages natural resources), as a necessary condition and a decent formal economy as a sufficient condition (as we argue) to a world where sustainability of all resources is the necessary condition. After all, GDP is nothing but the income calculation of an economy and its outlook is driven by sustainability. Growth and economic success is the consequence of decent economic framework conditions but only in sustainable economies. This would provide a great base measure of investment attractiveness but we are still a good step away from assessing these sustainability metrics.

NOTE

1. EMPEA Special Report, Asian LP Sentiment Toward Private Equity (2012).