The power of an economy is largely rooted in its capacity for production, which is based on the presence of land, labor and capital. Emerging markets and frontier markets — developing countries that are still too small to be considered emerging markets — have the majority of the world’s land and labor, but only share a fraction of the capital that could serve as the foundation for expansive growth. These markets continue to evolve from net exporters of raw goods to export and domestic consumption of finished products, a transition that is continually accelerating. While fundamentals, growth and transparency are increasing, developing market investment suffers from two main issues that have little to do with the markets themselves: investor emotion and susceptibility to “headline risk.”

Generally, headlines regarding emerging markets have not been favorable and usually only highlight the negative aspects of a particular region or country; as investors read these tales of terrorism, disease, crime and systemic corruption, it is impossible for their perception to be free of misgivings. In most cases, these circumstances have little effect on the domestic market, but evoke fear in the minds of investors. This emotional response is based on perceived risks and not on actual on-the-ground fundamentals. These markets, for the most part, are not anywhere near as scary as they seem.

UNDERSTANDING THE GROWTH DRIVERS

The growth of emerging and frontier markets can be attributed to two main factors: growing domestic middle classes and the rise of technology. These markets began their major growth spurts as efficient and affordable destinations for outsourcing, which ran parallel to the export of raw materials. As local wages began increasing because of the presence of international employers and improvement in labor laws, tax receipts and disposable income resulted in development and economic freedom. With greater purchasing power in these markets, the demand began to grow for those consumer goods and services, including Western-style food, enjoyed in the developed world. With imported goods still being relatively expensive, local production began to increase. The lower-middle class of emerging markets began to drive internal growth, production and consumption. The answer to why emerging markets have enjoyed such long-term growth is simple: People want to have nicer things and do more fun and meaningful things.

The rise of technology is the second-largest driver but more relevant to Asia. The Asian market has evolved from the simple production of components and software in contract manufacturing to producing finished products that have a universal consumer base. Using the MSCI Emerging Markets Index as an indicator, material and energy sectors, by weight, have fallen more than 50 percent, while the IT sector now makes up 40 percent of the index. Emerging market production has the advantage of being price competitive both in domestic and international markets.

HOW TO INVEST

Once investors have a basic grasp of the potential of emerging markets, the question becomes how and where to allocate capital. Far too many variables are involved when dealing with regions spanning the globe and covering a multitude of asset classes, sectors and currencies. The most important questions to ask first, however, are those of an introspective nature. The question of how to invest in emerging markets can only be answered via a process of reverse engineering the goals of the investor to narrow the plethora of opportunities:

• What type of returns are you seeking: asset growth or asset protection?
• What is your risk profile: risk averse or risk tolerant?
• What is your time horizon: short, medium or long?
• Do you prefer indirect exposure, such as through ETFs, or direct exposure through private equity funds?
• Is your strategy income, value, growth, diversification, etc.?

Once these questions have been answered, intelligent choices regarding emerging market allocation can be made. For the investor looking for low risk and high liquidity, perhaps the best strategy is emerging equity American depositary receipts, which give some security through being listed in U.S. markets, but with local exposure or, conversely, international firms listed in emerging markets, such as Nestle Nigeria PLC.

On the other end of the spectrum, highly volatile direct investments in resource plays can be found in timber from Myanmar or mining in Mongolia, and they can have potentially huge upside mirrored by an equally huge downside. Within this spectrum, almost infinite options exist to fit the needs of an investor’s portfolio.

Regardless of the asset class, sector or region, there is one indisputable piece of wisdom: Always have a local partner. Every emerging market has its own idiosyncrasies, despite potential similarities. Only someone on the ground or with significant experience can provide reliable advice about the situation. Although knowledge within a sector is transferable, once borders are crossed there often may be unforeseen challenges. While a cattle ranch in Argentina might bear a very good resemblance to one in Texas, the establishment and operation are worlds apart.

GLARING MARKET OPPORTUNITIES

Not for the weak of heart, emerging market venture capital has been and continues to be a huge opportunity. This is due to the combination of previously discussed growth drivers, increase of Internet and cellular penetration, and the lack of available credit and financing within these markets. The term “tropicalization” refers to taking an established and working business model, then transplanting it to a developing market. Because the validity of the business model has been proven, one might argue the transplanting simply needs to be deemed culturally appropriate. With the cost of capital so high, terms for investors are quite favorable.

2018 OUTLOOK

Emerging markets have a positive outlook heading into the new year, based on strong performance during 2017, when the MSCI Emerging Markets Index posted a gain of 34.2 percent versus 20.1 percent for the MSCI World Real Estate Index, which reflects large and mid-cap companies in 23 developed nations. Among the developing countries that will be interesting to watch this year:

Brazil: Coming off a hard recession and plague of corruption, high commodity prices will help get the Latin American giant back on the path to its former glory; while this will not be a quick process, there will be investment opportunities.

Argentina: One of the most loved and simultaneously hated markets, the France of Latin America is technically a frontier market, having been downgraded after its most recent default. The administration of Mauricio Macri is making huge strides to repair the nation’s reputation, however. In a country with such a wealth of natural resources, highly educated workforce, not to mention excellent wine and beef, it is hard not to want to invest, though a few burned bridges need to be rebuilt before investor faith is restored.

Vietnam: Having benefited from overflow of Chinese manufacturing, Vietnam is in a mini-boom period, with record numbers of applications for foreign business, foreign direct investment and M&A activity. Matched with increased economic liberalization plus privatization of traditionally state-owned enterprises, Vietnam’s solid growth cannot be ignored.

Again, the world is a big place and emerging markets occupy most of it; the key to intelligent allocation is to determine the end goal and narrow options to a shortlist of appropriate sectors and regions, then begin reviewing asset classes or vehicles to find the correct expertise. Logical or not, there is an innate fear of the unknown; the farther away from home one gets, so grows uncertainty. As the world gets “flatter,” as Pulitzer Prize–winning journalist and author Thomas Friedman says, we become ever more connected, and transparency and the rule of law improve. Uncertainty can be not only mitigated, it can be turned into a driver for profit and diversification.

Nate Suppaiah is managing director at Emerging Market Investor’s Association.