The performance benchmark for stocks in developing countries, the MSCI Emerging Market Index, has grown at almost 21% annually over the past three years.
Yet fund managers should view the emerging market sector with a healthy dose of skepticism.
That's according to William B. Gamble, author of "Emerging Markets: Rules of the Game (Apress 2012)."
"It is a joke," Gamble said of the emerging markets. "The state controls the economic and accounting data that is released. Employees cook the books."
Gamble, president of Emerging Market Strategies, Newport, RI, is a self-employed international lawyer and consultant specializing in emerging markets. He travels regularly to emerging countries for his clients and writes weekly columns for financial papers in Dubai, Alrroya and Mumbai.
Emerging markets, Gamble believes, will not be a viable place to invest for the long term unless legal systems are revamped. In emerging markets, there often is little rule of law. Instead, relationships govern the raising of capital and the handling of disputes.
"You can't access the corporate records of state-owned companies in China or most other emerging markets," he warned. "In some countries, the legal systems need reforming. In some emerging markets, the state is growing and not shrinking. It has the potential to kill economic growth."
Contrary to what many say, China could be one of the worst places to invest, he said. All power and control is wielded by the Communist government, he contends. Don't believe the annual 8.9% economic growth quoted by China for 2011, he advised. "There are empty buildings all over China. The real estate craze has been going on for some time. Chinese cities have been seeing rapid absorption of vacant office space, however, international property sales consultant CB Richard Ellis, which keeps statistics, reports. In its latest market view, the company reported a vacancy rate of 9.9% in Beijing's central business district, 8.6% in Shanghai and 12.0% in Guangzhou.
You also can't rely on U.S. multinational profits in China, Gamble warns. The Communist government has been opening "Mall-Mart" stores across the street from Wal-Mart stores. Meanwhile the profitable state monopolies are run by a small number of government officials.
"Relationship-based systems are a type of prelaw system," he said. "Trade throughout Southeast Asia and, even very recently, most global trade had very little law at all. If we just limit ourselves to the BRIC (Brazil, Russia, India and China) countries, we will see a common thread of weak institutions."
Here's the rub: The free market isn't determining value in the emerging markets. So investments are just bets on the future, he said.
"Russia has not shaken off its Communist past and China, despite the [public relations], is still a Communist country," Gamble stressed. "The central governments in both countries have dominated both the economic and the political systems. The result is that any and all aspects of business and investment can be changed at any time."
The Russian stock market is the smallest of the BRICs.
It is heavily concentrated in a few state-owned companies. In Russia, about 45% of the market is dominated by five companies. They include Gazprom, the world's largest gas producer; Sberbank, the largest Russian bank; Rosneft, Lukoil and Norilsk. Gazprom, Sberbank, and Rosneft are all majority-owned by the state and make up more than 35% of the market.
"If you get the timing right, you can do very well in the Russian market," he said. "If you get it wrong, you can be wiped out."
The exception in emerging markets: India because of its legal and educational system.
"India is home to some first-rate, world-class companies that meet international standards, especially in the IT sector, he said. "Companies like Wipro and Infosys compare favorably with their competitors in the United States."
Direct investment in India has also been successful. Gamble said that Vodaphone Group Plc, a British-based mobile telecommunications company, is running a profitable operation in India.
Nevertheless, there are serious problems with India's form of capitalism.
Satyam, a technology outsourcing services firm like Wipro and Infosys, went belly-up after reporting it held $1 billion that did not exist.
Gamble calls Brazil a "cautionary tale." The country is rich in natural resources. But its economy is heavily tied to China. It is state-controlled like other emerging markets.
"And like South Korea, large family controlled groups dominate the BSE (Bovespa) index of 30 stocks that are tracked by the Brazil exchange traded fund," he contends.
Brazil has a poor working legal system like India, he said. This could be a real problem, especially if Brazil's economy keeps slowing. Brazil's credit has expanded 2.4 times the Gross Domestic Product, as compared with 2, 1.6 and 1.2 times for Russia, India, and China, respectively. The consumer debt service burden, which stood at 24% of disposable income in 2010, is now 28%.
The Brazilian stock exchange, however, is the best run and most liquid in the emerging markets, said Gamble. The Bovespa is the largest stock market in Latin America and the world's tenth largest.
Although the Bovespa has also made major improvements in corporate governance, insider trading is still a major problem, Gamble says.
Gamble recommends that fund managers who invest in emerging markets stick with information from respected independent research firms, not government data.
Although there may be economic hurdles to investing in emerging markets, Taizo Ishida, manager of the Matthews Asia Growth Fund, says managers must focus on companies. A company's financial statements, he says, must adhere to the standards of the International Accounting Standards Board. The companies he owns in China are high quality with transparent accounting information, he said.
For example, he favors consumer stocks like Tingyi Holding Corp., a noodle manufacturer, and Ctrip.com International Ltd., a high-end business travel company. Both firms are growing earnings at more than 20% annually.