Be Wary of Emerging Markets: BRICS & N-11

What Are the BRICS and N-11 Countries?

The BRICS refer to Brazil, Russia, India, China and South Africa. These countries are at a similar stage of newly advanced economic development and have symbolized the shift in global economic power away from the developed G7 economies (US, UK, Canada, Japan, Germany, Italy, and France). In fact, it is estimated that the BRICS economies will overtake the G7 economies by 2030.

The N-11, or "Next Eleven," are the countries (along with the BRICS) that have a high potential of becoming the world's largest economies. These countries are: Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey, and Vietnam.

Jim O'Neill, the Chairman of Goldman Sachs Asset Management, coined these phrases and evaluated these countries based on their macroeconomic stability, political maturity, openness of trade and investment policies, and quality of education.

Investment Strategy: Following Growth Around the World

O'Neill's criteria in determining which countries are among the fast growing economically (the BRICS and N-11) are important to consider when deciding which investments to make, especially when analyzing individual companies. For example, a new company with an exciting new product may be attractive, but if its country's government does not have strong patent or copyright laws, it may be difficult for that company to make sustained profits; the weak laws of the government could end up slowing growth in certain industries.

In other words, there are many factors that may be outside a company's control that should be considered before investing in that company. Fundamental analysis -- the analysis of income statements, balance sheets, etc. -- is not enough.

Instead of simply diving deeply into the specifics of an individual company with fundamental analysis, O'Neill takes a different, wider approach, stepping back to also look at which countries he believes will have the most growth in the future. O’Neill maintains that finding the country with the right infrastructure, economic policies, and laws, such as strong patent and copyright laws that promote the potential for growth, could be just as important as finding a profitable company. A growing economy gives a company more opportunity to grow itself, which goes back to the saying, "a rising tide lifts all boats."

After evaluating these countries, a process similar to evaluating an individual company, and then deciding where the best potential lies, the next step is to determine which industries are high growth and likely to be successful in those countries. Finally, decide which companies within those industries have good growth potential, and why. In sum, finding a good investment begins with a snapshot of which countries will likely have growth in the future, then narrowing the search to specific industries and companies. I call this strategy "Following Growth Around The World."

In analyzing countries –and companies-- some questions to ask are: What laws or economic policies will affect it? Is it likely these laws or policies will change? Is there a growing population and what will its consumption most likely look like in the future? Is such population growth good or bad for the company/country? Who is in charge, and why, and where does he/she want to take the country/company?

Emerging Markets Hot or Not During Potential European Recession?

It is also important to remember that these emerging markets are just that, up and coming. They are not already as developed as, say, the U.S. or Germany, and their economies and markets may swing with more volatility than the economies of developed countries, especially in times of economic turmoil. In contrast, during good times, their economies may flourish and expand more quickly than a more economically developed country.

Currently, however, if you are not an investor with a high risk tolerance, I would recommend avoiding the N-11, as they have experienced over 20% decline during the past 6 months, according to Goldman Sachs' N-11 Equity Fund. Similarly, the BRIC 40 Index, which provides exposure to 40 leading companies in the BRIC countries, also has fallen over 20%. This is in comparison to the S&P 500, representing 500 large US companies, which has fallen only 4% over the past 6 months. Europe, while facing sovereign debt problems, has fallen almost 30% during the same time period according to Vanguard's European ETF, which is composed of over 450 stocks of companies in 16 different European countries.

Recommendation: Stay Out, Wait Until The Dust Clears, And Then Re-Evaluate

Overall, I suggest avoiding companies that have their core businesses in the BRICS or N-11. This is because, in general, emerging markets such as the BRICS and N-11 are more sensitive to market swings. During extreme crisis, market correlations tend to go to 1. However, while this correlation means all markets are brought down by a significant economic crisis, markets such as the BRICS or the N-11 whose economies are more underdeveloped, have greater volatility and a greater likelihood of being dragged down significantly.

With continued uncertainty about the economy after the 2008 crisis, in addition to the unknown economic reforms and restructuring that Europe will make after its sovereign debt crisis subsides, I recommend waiting out the storm by playing it safe in US large cap stocks. Although investors may think that each dive in the market presents a buying opportunity, I believe this is just speculation keeping the market afloat. I think an appropriate approach with this strategy would be to wait until the dust clears, identify which countries' economies survived the best, and then re-evaluate which countries have the greatest potential for growth.