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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 impedimentāthere 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 strongāeven when accounting for the inherent limitations of the ratings processāand 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 ...
