Why should you not invest in the emerging stock market? Because the legal framework there is not fair or open like the US or UK. Emerging stock markets tend to benefit the corrupt. These civil law countries with dual-stock structures tend to create a private benefit of control. Just because China is growing doesn’t mean you should invest in the Chinese stock market because Chinese stocks and its shareholders may never capture the value of the growth.
Bad reasons to invest in the emerging stock market
A common advice from those who advocate for a balanced, risk-adjusted portfolio is to increase your investment in the emerging stock market. People say,
- “Look how fast China is growing, you want to invest in the next economy, the next United States!”
- “You don’t want to bank on the United States continuing to be the leader of the world, diversity your stock across the world “
- “If you already live and work in the United States, you don’t want to put all of your eggs in one basket, invest somewhere else.”
In theory, investing in the emerging stock market should offer the advantages and opportunities of diversification described above. But reality presents severe limitations.
How the stock market works in the United States
The United States stock market follows the assumptions of the Modern Portfolio Theory. MPT is a hypothesis put forth by a guy called Harry Markowitz. It states that all investors will have the same expectations and make the same choices given a particular set of circumstances. We can assume the market is correctly priced and reflects the real value of the company.
In other words, if you buy 1% of the Apple stock out there, the following scenarios hold true:
- You can assume that you own 1% of Apple. If Apple’s shares rise, you can capture 1% of the that.
- Owning 51% of Apple shares then effectively you have control over Apple.
- When Apple goes bankrupt, you will get 1% of the value of its assets sold.
- In the U.S., owning stocks is the same as having ownership of the company.
- Everybody is buying stocks based on publically available information only.
- The CEO of Apple and the entire management team is working with the goal of “maximizing shareholder value.”
How the stock market works in the emerging market
Stock markets in Asia, Latin America, and parts of Europe do not behave like the US and UK stock markets. First, the legal systems are very different. You may own 1% of the stock in an emerging market, but that does not guarantee real ownership. You may think the company is working to maximize the stock value, but the owner may be maximizing his life first.
The Civil law and the private benefit of control within the emerging stock market
The United States and most of the former colonies of the United Kingdom have a common law legal framework. Common Law doesn’t exist in the majority parts of the world. Instead, most countries use a version of the civil law legal framework. The differences between common law and civil law can range from marriage to investment to murder cases. The civil law’s impact on the investment front is quite damaging:
- A civil law country faces rampant, undetectable, and sometimes legalized insider trading.
- A civil law country often permits practices of perverse incentives, where the management pursue private benefit of control.
The weak legal framework, combined with a high concentration of family-owned businesses, means that emerging markets are very susceptible to corruption.
The dual-stock structure within the emerging market
What bad things could happen from publicly traded companies belonging to families? Imagine a father starting a family business and ultimately bringing it public. He intends to pass his business to his incompetent son, and everybody on the board agrees because they are all family. The incompetent son is destroying the value of the company by flying his friends to various resorts in the name of networking and business development.
The situation gets worse because emerging markets tend to have dual-stock structures. It means the son may own 1% of the total stock but 50% of the voting stock (and hence, 50% of power). You can see how that could be a setup for failure: the son doesn’t even care if the company isn’t maximizing its potential because he only has a 1% ownership, and so of course, he is just going to use up all of his power to direct funds to maximize himself.
Which countries have the civil law? Unfortunately, a whole lot: from France to Spain, to Germany, to all of Latin America, Southeast Asia, and China and Korea.
Reasons to not invest in the emerging stock market
What does this all mean? It means just because China (or Brazil or Russia) is growing 10% per year, doesn’t mean it’s stock market will grow at the same rate to capture the win!
Here is a genuinely excellent post from Isaac Presley and a chart below showing that from 2010 to 2014, the Chinese GDP grew at an average rate of 8.5% annually (vs. only 2% in the U.S.). However, investors in the Chinese stock market earned just 1.7% annually over that same period, versus a 15.3% annual return for the U.S. stock market (of course, helped by a rebound from the worst recession of our times, but nevertheless!).
Somebody in China is sure making a lot of money. But one thing is clear – the shareholders are not capturing all the value. The situation in Latin America is worse than Asia. And Germany and France have family-owned businesses facing similar issues.
The U.S. stock market is diversified internationally
People forget that the U.S. stock market already captures the growth of the emerging economy. In fact, the vast majority of the U.S. Fortune 500 companies have incredibly high revenue streams outside of the U.S., and it is only growing. When China grows, people there buy more Coca-Cola soft drinks and Colgate’s toothpaste. These are American companies listed on the U.S. Stock Exchange. When you are investing in the U.S. stock market, you are diversifying. Today, 40% of the Fortune 500 companies’ revenues are from outside of the United States.