Why Successful Investing All Comes Down to “Integrity”

Successful overseas investing all comes down to the “integrity” of each country’s business system.

You can get a good idea of this by looking at the Transparency International Corruption Perceptions Index, which is published every year.

On the 2011 Index, for example, Chile is rated No. 21 – one spot higher than the United States – whereas Russia is ranked an appalling No. 154 out of 178 countries ranked.

Most of the world’s emerging-market economies are located in Asia or Latin America. In general, most emerging markets rank lower than their European counterparts on the Transparency International CPI, which is why Chile’s high position is so remarkable.

Even more remarkable is the country that holds the No. 1 ranking – or, rather, that shares it with Denmark and New Zealand.

I’m talking about Singapore.

Singapore is rather too rich to be considered an emerging market these days. But according to the team of forecasters at The Economist, Singapore is enjoying emerging-market growth rates – currently projected to be 4.7% this year and 5.2% in 2012.

As if that’s not alluring enough, Singapore’s stock market hasn’t really run-up in kind. It is currently trading at only 13 times earnings.

Chris recommended the iShares MSCI Singapore Index Exchange-Traded Fund (NYSE:EWS) back at the end of January, after his investment scouting trip to Singapore. Since then EWS has risen 5%. If you haven’t already bought in, consider it an opportunity.

Another emerging market near the top of the Transparency International CPI is Hong Kong – ranked at No. 13 – which I am somewhat bearish on. Its rank has slipped, and it is being absorbed more and more into China.

Qatar at No. 19 and Uruguay at No. 24 are high. But both are too small to invest in easily.

Taiwan at No. 33 and South Korea at No. 39 are each too rich to be viewed as true “emerging” markets. But both countries are currently quite interesting: South Korea is up 8.3% this year, and is a little pricey at 16.6 times earnings, meaning that Taiwan, flat on the year and trading at about 15.3 times earnings, looks to be a better deal. (Consider the iShares MSCI Taiwan index ETF (NYSE:EWT).

Estonia, Slovenia and Poland are also in the Top 50. Out of that trio, Poland (No. 41) is the easiest to invest in, thanks to the Market Vectors Poland ETF (NYSE:PLND) – although the market is also a little pricey, up 13% this year.

The two biggies of China (No. 78) and India (No. 87) are in the middle of Transparency International CPI rankings, as are several other favorite investment spots. (If I haven’t mentioned your favorite investment destination, check out the survey on Transparency International’s Website.)

China stands as a great example of why investors seeking profits in the emerging markets need to pay more attention to the integrity of those markets. Consider, for instance, the recent trouble with some of China’s small-capitalization stocks. These have been hammered in the last quarter – the average stock is down around 20% – because of increasing investor concern over the quality of their financial figures.

The problem is not that large numbers of small-cap Chinese companies have been fiddling the books; in reality, we’re probably talking about, at most, four or five firms. But the differential between a Chinese small-cap with a second-tier (but U.S.) auditor and one with a Big Four auditor is currently the difference between a valuation of 3 times earnings and 8 times earnings.

Personally, I think investors in this case are putting altogether too much faith in the Big Four. After all, it was a top-tier name, Arthur Anderson, which audited Enron. Nevertheless, when the name of your investment’s auditor is far more important than its reported earnings track record, its solid balance sheet, its growth prospects, or its position in the world’s fastest-growing economy, then rational investment has become impossible.

The bottom line: Investors who bought attractive looking Chinese small-caps have found their shares falling out of bed on bearish “analysis” by dodgy short sellers. Presumably the honest companies will eventually recover… But who can tell when?

While money remains cheap (at close to zero cost, in inflation-adjusted terms), emerging markets will continue to do well, particularly those with good commodities endowments. But your own investing success there depends on the countries’ levels of integrity, so stick to the top half of the CPI list.