Why investing is safer overseas

By Jim Jubak

Over the past five years, China's stock market returned 31% annually, Chile's 24%, Russia's 31% and Poland's 24%.

Of course, even if you had some money in any or all of those emerging markets, you probably now think you didn't have enough. Especially considering that the U.S. stock market, as measured by the S&P 500 Index ($INX), returned just 7.1% annually for that period.

Don't fret about that, orthodox financial planners advise. Portfolio Construction 101 says you should build your portfolio around a core of U.S. stocks, because, well, the rest of the world is too risky. It's OK to add a dollop of stocks from mature economies such as Europe and Japan to diversify, because that cuts risk further. But only then, and only if you're really daring, should you buy a few stocks -- and only a few -- in those high-risk, high-reward emerging markets, such as Russia, Chile, Poland or China.

To which I say: Wake up and smell the new world order. The U.S. financial markets are relatively riskier now than they were five years ago, and (many) emerging country financial markets are relatively less risky. If you haven't updated your view of what's called country risk in the last five years, you're costing yourself money.

Big money.

And the money that you're leaving on the table isn't buying you and your portfolio as much safety as you think.

Country risk and the individual business

What's country risk? Read the prospectus for a company doing business in an emerging market, and it comes at you from all angles.

Take Central European Distribution (CEDC, news, msgs), the largest vodka distributor in Poland and a stock I put in my Future 50 portfolio in 2006. "Substantially all of the Company's operating cash flows and assets are denominated in Polish Zloty," it says in its 2006 annual report. So Central European Distribution is exposed to currency risk -- "every 1% movement in this exchange rate would result in an approximately $3.9 million change in the valuation" of the company's secured notes, which are denominated in euros. All the company's financing for its working capital is at floating rates, so a surge in interest rates could send the company deeply into the red.

All that working capital comes from three banks in Poland, a financial crisis at these banks would force Central European Distribution to scramble for replacement loans. And, most critically, the company's working capital and its credit lines are all in zloty. A currency crisis in Poland could freeze those credit lines, leaving a company that lives and dies with its ability to spend money to gather inventory for sale essentially dead in the water.

What we learned in the Asian crisis

Think it's impossible that a currency crisis could bring a business to a halt? Well, the Asian currency crisis of 1997-1998 threatened to bring national economies across Asia to a halt. The crisis finally ended when the International Monetary Fund arranged financial packages of $17 billion for Thailand, $40 billion for Indonesia and $57 billion for South Korea, three of the countries hardest hit by the crisis. Currencies in those countries fell by 38%, 81% and 50%, respectively, from July 1997 through January 1998. Local stock markets plunged by 26%, 40% and 30%.

It's a crisis like this -- only 10 years ago, mind you -- that forms the foundation of advice to shun the financial markets of the emerging world. And if a crisis like this loomed on the horizon, I'd be giving you exactly the same advice.

But what's most interesting to me about the Asian financial crisis of 1997-1998 is how much has changed since then in much of the developing world. For example, in exchange for its $57 billion credit line, the International Monetary fund imposed a checklist of financial and fiscal reforms on South Korea. The country had to reduce its current account deficit to no more than 1% of gross domestic product, or GDP. It had to cap annual inflation at 5%. It had to build its international reserves to more than two months of imports. It had to require its banks to meet recently toughened standards for capitalization. And finally, it had to pass legislation to turn the Bank of Korea into an independent central bank.

Continued: Reforms in the developing world

 1 | 2 | 3 | next >