Top stocks to invest in – Emerging markets and a weakness for stories

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The rise of behavioral finance has delivered useful tools for analysts and investment managers. A deeper understanding of how psychology affects investing — and the biases that may come into play — can help address these weaknesses.

But one of the oldest and most fundamental human weaknesses — the love of a good story — is often overlooked. Stories offer an appealing wrapper for a mixture of fact and fiction. Disentangling which is which is the challenge. This weakness may be at the root of the long-running emotional attachment to the emerging markets story.

Investors love stories. Narratives can help to make sense of facts and figures. Stories can convey meaning by juxtaposing often unrelated information, and they offer hope. But not all stories have happy endings. The latest chapter of the emerging markets growth story has come as a nasty surprise to many, and there may be worse to come.

Narratives have intrinsic appeal and are told by companies to their shareholders, by investors to clients, and even by politicians to voters. People want to believe. Growth always sounds good, and the concept of lifting poorer parts of the globe into better living standards seems like impact investing. Advocates of the BRICS and emerging markets talk more about belief and a brighter future than they do about hard numbers. Their faith is not so easily unsettled by mere facts.

Unfortunately, studies suggest there is not much of a link between market returns and economic growth — at least not any relationship of investment value. Psychology comes into play when the representative bias encourages the belief that a growing economy must mean rising stock markets. Yet, even the idea that revenue gains must translate into profit growth is questionable. Developing economies are turbulent environments, with some unique risks to businesses. And that is before political instability, currencies, and credit are taken into account.

Even though forecasts are fraught with uncertainty, investors can learn from history. The long-term economic record in China, Argentina, and India shows that development is not a straight-line exercise. Emerging economies can spend decades dropping down the rankings, often wiping out equity investors.

The record shows previous regional crises — in Asia and Latin America — but rarely a broad-based pattern hitting all emerging economies. The current crisis looks different: It has developed slowly, catching many investors unaware. No single economy is overheated, nor is there any clear external shock. A sharp fall might have jolted investors’ faith in emerging markets and thus created a fresh narrative about panic and rebound. Instead, economic growth has gradually deflated, along with a slowing of world trade and a fall in commodity prices.

Were it simply a bubble being pricked — an asset overvaluation — investors might have a better understanding of where the floor lay. Instead, it is a creeping crisis of anemic growth, with no clear solution. Should the BRICS defend currencies that may really be overvalued? And, does competitive devaluation offer any real solution to failures of productivity or infrastructure investment? Many of these developing nations have failed to create sustainable value-add — a problem highlighted but not caused by falling commodity prices.

The one continuing competitive strength that emerging markets had in common was the ability of their governments and corporations to borrow cheap US dollars. Indeed, this has arguably been the biggest single factor driving the dream. In recent years, there has been little limit to leverage and almost no cost. Now, the world is no longer awash with dollar liquidity, and those dollars look increasingly expensive to repay.

Disentangling narratives is difficult. The simple act of aligning arguments with varying degrees of credibility can create a whole that seems to make perfect sense. Emotional attachment to such a narrative can then make it difficult to interpret new facts. The potential for political risk to emerge from current economic problems is scarcely recognised in most sell-side research. Growth and diversification have been argued for so long that many investors now find it difficult to retain objectivity.

Economic history offers a useful lens with which to view narratives. Comparing what once seemed persuasive with the eventual outcome can be a useful reality check. The past can help give context for the excitement of the new.

Investors need a new narrative on emerging markets — preferably a nonfiction one. The economies have potential for future growth, but investors need to analyze the hard facts of what this means for stocks. More thought must be given to politics, deregulation, productivity, and realistic infrastructure investments.

Wishing for a rise in living standards around the world is laudable, but equity investors must combine this with objective analysis.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: © Campbell, 2014

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