Emerging markets represent 13 per cent of the value of the world’s stock markets today and a third of global economic output. That compares with just 1 per cent of market capitalisation and 18 per cent of global GDP 30 years ago. The developing world is no longer a niche interest for adventurous investors – it is too important to ignore.

Unfortunately, the relatively recent development of many emerging stock markets (not much more than 20 years in Russia, China, India and Eastern Europe) means long-running data has been hard to find. Many of the rules of thumb about investment strategies are, as a consequence, really a reflection of what has worked and not worked in developed markets like the US and Britain.

That might explain why investors have latched, intuitively but randomly, onto factors like GDP growth and country size when deciding how to invest in emerging markets. Perhaps we should not be surprised that the links between these and subsequent investment returns have not been helpful.

Good news

Good news then that three professors from the London Business School – Elroy Dimson, Paul Marsh and Mike Staunton – have just completed a useful analysis of emerging-market returns over the past 100 years or so, with a particular focus on which trading strategies have worked best. Their report, for Credit Suisse, goes some way to answering the question: how should I invest in emerging markets?

The most useful conclusion from the analysis is that value is an important driver of emerging-market returns. The “LBS Three” identified this using a rotation strategy that ranked up to 59 emerging markets by dividend yield and then recorded and analysed their subsequent performance.

The countries were re-ranked each year between 1976 and 2013 and the following year’s returns grouped in five equally sized buckets. The performance of the countries with the highest fifth of dividend yields could then be compared with those with the lowest yields and with those of the three groups in between.

Correlation not perfect

The correlation is not perfect but the scale of the outperformance by high-yielding markets is impressive. Low-yield countries had an annualised return of 10 per cent while the highest yielders returned 31 per cent a year.

Two other factors that appear to have a strong influence on future stock-market returns are the strength or weakness of a country’s currency and its recent (five-year) GDP growth. Currency weakness is good for equity returns, which is logical when you consider the extra competitiveness a falling currency can give an export-dependent country.

Less intuitive is the fact that countries which have experienced low GDP growth have tended to outperform those which have grown quickly. Again the difference between the best and worst fifths is significant – the lowest-growth group of countries had an annualised return of 28 per cent a year between 1976 and 2013 while the highest-growth quintile grew by 14 per cent.

Undermining commentary

This undermines much of the commentary on emerging-market investing in recent years, which has focused on the high growth of the developing world versus the west. The shift in the economic balance from west to east has been trumpeted as a reason for investing in emerging markets, but a focus on growth has been unhelpful.

The most likely explanation of these trends is that economic growth and foreign exchange are just proxies for the value demonstrated by the dividend yield. Countries with weak currencies and low growth tend to be distressed or higher risk. That means that investors demand a bigger reward for investing in them.

In other words, they are cheap and so better placed to outperform. By contrast, those countries where everything seems to be going swimmingly are popular with investors, expensive and so likely to underperform.

Two factors

Two factors that appear to have little bearing on future returns are the size of a country or the recent performance of its stock market. Small countries don’t do better than larger ones and momentum doesn’t seem to work either.

In the long run (since 1900), emerging markets have underperformed the developed world, although there have been long periods like the 1960s, 1970s and the period from 2000 to 2010 when they have done much better. Much of the underperformance is, however, due to wipe-outs in Russia, China and Japan as a result of revolution and war. In more peaceful times, investors are modestly rewarded for taking emerging market risk but to benefit fully investors need to take a contrarian approach and to avoid jumping on bandwagons.

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