Taiwan Is Not Greece, and Other Reasons to View Emerging Markets Individually

China. India. Brazil. Insert Emerging Market country here. It didn't matter which one! Everyone wanted a piece of these fast-growing darlings during the 2000s. But after the last few years of underperformance, sentiment has flipped and people have become quitedour toward Emerging Markets (EM) as a whole-save for some who are starting to consider EM countries individually-pointing out strengths and weaknesses of the 23 EM countries.^[i] A rational mindset, in our view, and one that can help investors better understand where future opportunities exist.

In the 1990s and early 2000s, EM nations acted as more of a bloc. They were at similar stages of economic evolution, with many bearing the fruits of catch-up growth and emerging middle classes. Country-specific returns varied, but correlations were pretty high. That's how we got snappy acronyms like BRIC-Brazil, Russia, India and China (and now with an S for South Africa). To many observers back in 2001 (when the term was coined) they appeared poised to take the world by storm. In the 2002-2007 bull market, most Emerging Markets went on a tear, beating developed markets widely. This reinforced the notion EM's superior economic growth would generate big relative returns.

But the last three years have pretty much debunked this. EM overall underperformed, with the MSCI Emerging Markets index falling -18% in 2011 and -2.6% in 2013, and countries diverged quite a bit.^[ii](Exhibit 1) Fast growth didn't necessarily mean high returns, and sentiment turned on the category overall. They were largely seen as one big lump of countries subject to the Fed's whims, rather than 20 or so diverse countries with diverse economic drivers and political situations. Most still see them this way-despite 10 months of shifting Fed policy that hasn't wrought havoc on EM economies.

But it seems to us this notion is quite overdone. These are still nations with overall fast economic growth. There are still big opportunities there. But you have to be choosier and look at countries one-by-one, assessing relative strengths and weaknesses. The vast minority of investors approach EMs this way, but more should. Tech dynamo Taiwan, for example, is not Greece. Some countries have modernized faster than others. If it weren't for some lingering capital controls, MSCI would have classified Korea and Taiwan as developed markets years ago (the IMF has already recognized them as such). Both are modernized, rich (high per-capita GDP), diversified, high-tech and have burgeoning service sectors. Korea today isn't much different from Japan (at least, if you ignore Japan's whole uncompetitive 19^th century mercantilistic political quagmire lost-decades thing).

Who exactly MSCI labels as emerging evolves, too. In the 1990s and early 2000s, most countries in the MSCI EM were on the way up toward developed status-truly emerging, as it were-and Greece, Portugal and Israel graduated.^[iii] But by mid-decade, there was significant attrition as Venezuela, Jordan, Pakistan and Argentina were downgraded to Frontier Markets-they submerged rather than emerged. Morocco cracked EM in 2002 but was back down to Frontier by 2013. New countries joined along the way, too, with Qatar and the UAE added this year. These countries, it likely goes without saying, are far less developed than Korea, Taiwan, Brazil, Indonesia, Malaysia and other EM stalwarts.

Even longtime EM countries are at different stages of development. For instance, Taiwan, which joined EM in 1996, used to be the "it" low-cost manufacturer, but now semiconductors, LCD screens and other high-tech gadgets are its bread and butter. China, which joined at the same time, had picked up the low-cost baton, but with labor costs rising, that activity is shifting to other places, like Mexico-in EM from day one-and some Frontier Markets like Vietnam. Brazil and Chile have both been in the MSCI EM since day one. Brazil is an industrial and energy powerhouse, while Chile's economy isn't nearly as large and diverse. And those BRICs didn't quite turn out as many assumed. Brazil's economy is in recession by one popular definition. Russia is on the verge-and was heading the wrong way even before sanctions started biting. India is still growing, but not at those eyecatching rates of old. Only China is still regularly clocking enviable growth rates.

Exhibit 1: Emerging Markets Countries' Characteristics-Diverging

Source: FactSet, Bloomberg, as of 07/09/2014. Policy rate is the interbank rate for each respective country. MSCI IMI is the MSCI Investible Market Index, a gauge designed to cover 99% of market capitalization.

Political factors are wildly divergent, too-the 23 current EM nations have varying degrees of private property rights, free markets, state-run industry, independent monetary policy and overall political stability. Brazil and Russia have meddled with Energy (and other) firms for years, using them as political tools. China has long done the same with pretty much its entire economy. State-run firms in a lot of these nations are publicly traded, but the government has a big stake and redirects or taxes the heck out of earnings. Mexico used to be on this list but has opened long-entrenched monopolies to competition over the past year and a half. China has some of the world's weakest property rights. And stability and political structure are all over the map. China is a one-party communist state where the party elite select the new government on a planned schedule. Korea is about as free and democratic as they get. Greece, an EU member, claims to be the world's oldest democracy.^[iv] India, Mexico and Brazil are also pretty well-functioning democracies. Indonesia, South Africa and Taiwan are young democracies. Russia, Hungary and Turkey seem to be turning away from democracy. Thailand seems to have a coup every other week and is presently under martial law, months after a military junta deposed the democratically elected government.

To invest successfully in EM, investors should do the same things they would do for the developed world: Look at each individual country to see how fundamentals compare to sentiment. Assess expectations versus the likely reality. Look at where opportunities and risks are overlooked and where they are widely discussed. It is not as easy as selecting the country with the fastest growth. If it were, China wouldn't be one of the worst-performing EMs over the past 20 years. Nor is it as easy as assuming political instability leads to less than favorable returns-after all, Thai stocks have done fine over the past eight years. In our view, the savvy investor will approach EM with a more nuanced analysis than a categorical buy or sell.

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