Published: September 28, 2010

If you had a crystal ball in the 1960s, you probably would have seen that Japan would turn out to be a great investment. The country's economy was growing nicely, family birth rates were high enough to ensure a young workforce, its education system was excellent, its currency was cheap and it was generally regarded as ranking high in terms of lack of corruption. The Japanese stock market did great for two decades, rising +178% in the 1970s and an eye-popping +587% in the 1980s.

Of course, some of those metrics (such as a cheap currency and high birth rates) stopped being a positive factor years ago, and my help explain why Japan's Nikkei Index fell -51% in the 1990s and another -49% in this last decade. (It plunged from 38916 at the end of 1989 to a recent 9600. Yikes).

Such a rare confluence of positive factors such as Japan had in the 1970s and 1980s rarely exists. These days, countries with strong education systems are often found in the developed world, where population growth rates have cooled. In other places, stock markets may look like relative bargains, but corruption concerns should keep you far away.

So your preference in international markets is largely a factor of what you consider to be important. For example, many investors will only put their money in countries that have a history of clean and transparent business climates. And for good reason. The Heritage Foundation has historically found a tight correlation with strong market returns and low national corruption. The organization produces an annual "Freedom Index" that highlights the best places to do business. Here's the latest snapshot:

I cross-referenced these high-ranking countries with their respective birth rates. The greatest enemy of long-term growth is a shrinking population that yields fewer younger workers supporting a rising tide of retiring workers. Of these least corrupt countries, only New Zealand, Ireland, the United States and Chile are having enough children to avoid the retiree crunch (immigration policies notwithstanding).

Before we move on, there is an important secondary corollary to this table. New Zealand, Ireland, Canada and Chile are all adjacent to strong economic regions or trading partners, and their growth can be sustained through exports even if their domestic markets are small. For example, Australia is blessed with massive natural resources and high growth rates -- just the right environment for neighboring New Zealand, which has a comparatively weaker currency and could increasingly become an export powerhouse to Australia.

Get schooled
To establish sustainable long-term growth rates, countries need to develop well-educated middle classes, and not just Harvard-educated elites. The fact that Korea ranks high in math and science is a big factor in explaining that country's solid economic growth during the past decade. In the developed world, Canada and New Zealand score quite high in terms of education standards. And as noted, they are fortunate to have larger trading partners right at their door.

Chasing momentum
The global economic crisis of 2008 and 2009 has led to a slowdown in economic growth. But some countries were able to see their economies expand at a rapid pace in 2009. The table below highlights the world's fastest-growing economies, and it's no surprise that they are mostly located in Asia and Latin America, where rising middle classes are fueling a virtuous cycle of further spending gains.

Historically speaking, fast-growing economies can maintain their momentum for quite some time, especially when key trading partners are growing in tandem. It's no coincidence that Argentina, Brazil, Chile and Colombia all made this list. All of these countries feed off of each other and (with the arguable exception of Argentina) are also benefiting from far sounder fiscal policies that encourage growth and inhibit inflation.

Now, let's see how those economic growth rates have translated into stock market returns this year for those same countries:

Several of these countries were discussed in my analysis of the CIVETs, thought by some to be the new hot investment area after the BRICs (Brazil, Russia, India and China).

As I noted in the article, countries like Colombia are quite appealing, but after a strong run they are no bargain. If one were to disregard relative valuations, then places like Chile, Indonesia and Colombia would look far more appealing.

The Big Mac Index
Of course, a country's competitiveness is tied to its currency, as Chinese government bureaucrats would likely note. Japan was blessed with a cheap currency 20 to 40 years ago. More recently, its currency has strengthened, which partially explains why the Nikkei has shed -70% of its value in the last 20 years.

Every year, The Economist takes a look at the price of a Big Mac to gauge the relative strength of a country's currency. Looking at those same countries in the last table (below), you'll note that a Big Mac can be had for a low price in Russia, Poland and China. It's an inexact gauge, as the cost of Big Macs is also a function of taxes, local sourcing and other variables. But it's no coincidence that a Big Mac is relatively expensive in places like Colombia and Israel. The cost of doing business in those countries is fairly high, and they must compete in the global economy on the basis of an educated workforce and/or an abundance of natural resources.

Action to Take --> In many respects, it pays to focus on the "proximity plays," or those countries that sit adjacent to larger economies, yet possess their own set of considerable skills. So New Zealand is a solid play on Australia. Hong Kong stands to benefit from ever-rising prospects in China. Chile sits a stone's throw away from Brazil. Canada has a big neighbor just to the south.

Just as important, these countries grade out very well in terms of corruption and educational attainment. You can invest in those countries through exchange-traded funds such as iShares New Zealand (NYSE: ENZL), iShares Hong Kong (NYSE: EWH), iShares Chile (NYSE: ECH) or iShares Canada (NYSE: EWC).

-- David Sterman
Staff Writer
StreetAuthority

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