Many of these economies do have great potential, but investors have to understand the risks and discriminate carefully between markets

The character Dorothy in the 1939 MGM classic movie, The Wizard of Oz, finds herself swept away by a tornado and dropped into a world filled with garish colours and diminutive people with the improbable ethnic label of munchkin. When she realises that she is in a new environment, she exclaims to her dog Toto, "I have a feeling we're not in Kansas anymore." At least she had accurate situational awareness. Often investors do not.
 
In an area era of globalisation and ever faster international transfers of capital, new stock markets have been created and function in more countries than ever before. The variety of potential investments and their often spectacular growth have lured investors to new markets in various countries. These new markets are often categorised by various names including tiger economies, emerging markets, BRIC markets and most recently frontier markets.
 
Although these categories are useful for marketing financial products, they are exceptionally misleading in terms of understanding how these markets work and the risks and rewards inherent in each one. But the first thing that investors must realise is that they are not on Wall Street anymore.
 
One of the first issues that investors must understand is that the number of active investors in emerging markets can be quite small despite the size of the market itself. For example, the Indian stock market by capitalisation is among the largest in the world, but the number of players is limited. A report by the Indian minister of state for finance quoted in Moneylife showed that on average during the period from April to June 2010, "50% of turnover comes from a shockingly low 451 investors, of which 156 were proprietary traders."
 
The problem is not unique to India. Thailand has a population of 67 million, but there are only 120,000 active accounts on their stock exchange. In Brazil only a tiny proportion of people own shares and even Brazilian pension funds' exposure to equity is just 16%. Fewer traders mean a higher probability of manipulation.
 
Another problem with these markets is the concentration or domination of the market by a few companies or by companies in a single sector. Often this sector is financial. The MSCI Frontier Market Index tracks 175 companies in 26 countries. But 30% of the index is in one country, Kuwait, and 53% of those companies are financials.
 
In Indonesia the Bakrie family's controlled companies cover the breadth of Indonesia's economy, including mining, oil and gas, palm oil, property, telecommunications and finance. All of these interconnected companies make up about a quarter of the trading on the Jakarta stock exchange.

This is especially troubling because the businesses and the family patriarch, Aburizal Bakrie, have a rather colourful history. The conglomerate was near collapse during the Asian crisis of 1997 to 1998 and then again in 2008. The company has deftly avoided determined attempts to collect on debts in courtrooms across the world. The family's coal mining companies are presently under investigation for the evasion of hundreds of millions of dollars in taxes.
 
The financial sector also makes up a large portion of the Nigerian stock market. As in many of these markets corruption is a problem. In June of 2009 the central bank governor after an emergency audit discovered that nine of Nigeria's 24 lenders with at least 40% of the country's deposits were near collapse.
 
The companies listed on these exchanges are also often quite different from companies listed on exchanges in more developed countries. They include not only family country companies as in Indonesia, but also companies controlled by the state. Most likely every company listed on the Shanghai and Shenzhen stock exchanges are majority owned by an entity of the Chinese government. It is impossible to tell exactly because the records are not available.
 
Governments controlled almost 30% of the region's total market capitalisation in the Gulf. Governments are always happy to raise capital by selling minority interests, but investors have to remember that governments make and enforce law. It is doubtful that they will do so against their own political interests.
 
Fickle foreign capital is another risk. The Asia crisis was in part precipitated by massive flight of foreign capital from the so-called Asian tiger economies. The Indian stock market is close to its all-time high. This year foreign investors have bought $15.8 billion into the market including $1.7 billion in the second week of September alone. The demand for the Petrobras IPO has been so great that it has pushed up the value of the real.
 
Many of these economies do have great potential, but investors have to understand the risks and discriminate carefully between markets. Just like Dorothy in the land of Oz, investors will discover that many of the economic and financial tools do not work when the rules change.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).