Emerging-markets stocks are dirt-cheap. That makes this a terrific time to invest in them. There's no telling which way they'll head in the short term. But economies of developing nations remain the world's fastest growers, and that means that over the long haul, emerging-markets stocks should deliver compelling returns.
Consider the anticipated growth rates of the developing and developed world. Next year, emerging economies will grow by an average of 5.7%, Moody's Investors Service estimates. By contrast, Moody's expects the 20 largest developed countries to grow just 2% in 2013.
Emerging nations face a slew of problems over the near term. But I think share prices already reflect the negatives -- and then some.
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The biggest headwind: the slowdown in the developed world. Western Europe is mired in recession, and Japan shows no signs of emerging from its two-decade-long funk. The U.S. economy is growing, but slowly.
All this raises doubts about the sustainability of the emerging-markets growth story -- which, after all, has been primarily about low-wage developing nations exporting goods and services to the developed world. It's hard to boost exports when importers aren't buying.
Nor is that the only challenge emerging nations face. China is undergoing a rocky transition from an export economy to an economy more focused on domestic consumers. Other emerging nations are struggling with the same transition, as well as myriad other problems. India, for instance, is an economic and political mess.
But the positives more than outweigh the negatives. Here are five reasons to invest -- along with a few caveats:
1. Emerging markets are on sale. The MSCI Emerging Markets Stock index trades at a mere 10.5 times analysts' earnings estimates for the coming 12 months. That's bargain-basement territory. By contrast, Standard & Poor's 500-stock index, which mainly includes large U.S. companies, trades at 13.4 times estimated earnings for the next 12 months (all figures are as of September 10). The long-term average price-earnings ratio for the S&P 500 is about 15.5, suggesting that U.S. stocks are cheap, too.
2. Emerging markets have already had their bear market. From April 29, 2011, through October 3, 2011, the MSCI Emerging Markets index plunged 27.9%, more than the 20% decline that usually defines a bear market (the S&P 500 dropped 18.6% over that period). What's more, the rebound off the bottom has been anemic. From the trough last October 3 through September 10, the Emerging Markets index returned just 17.2%, while the S&P 500 gained 32.8%.
3. The demographics are great. You've surely read the stories about aging U.S. baby-boomers. There aren't enough young people entering the workforce to support the boomers comfortably in retirement. The situation is worse in Europe, and Japan is in the most trouble of all. Meanwhile, emerging nations have billions of young people in the workforce or on their way to entering the workforce.
4. The domestic growth story. The emergence of the middle class is a huge story in most developing nations. Citizens in those nations have unmet needs in health care, housing, financial services and technology -- and, for the first time, the wherewithal to satisfy them.
The problem: The price-earnings ratios of the good companies in these sectors are nowhere near as low as the P/E ratio of the broad emerging-markets index. Most of these stocks command P/Es in the high teens or above, says Rusty Johnson, co-manager of Harding Loevner Emerging Markets Fund (symbol HLEMX), one of the best developing-markets funds. Johnson is buying the best companies -- as long as their anticipated growth rates support their high P/Es. He's particularly bullish on bank stocks.
5. Shares of export companies have cut-rate prices. Energy stocks and many other exporters have been beaten down because of slackening demand for their products throughout the world. Many exporters have seen their growth rates slow. But that doesn't mean you should avoid these stocks. Why? Because many are quite cheap. When the developed world does start to grow again, these stocks will surge ahead.
All that said, don't overdo your emerging-markets investments. They're simply too volatile. I don't think anyone should have more than about 20% of his or her stock money in emerging markets. But I think most investors should have at least 10% in them.
How to invest? Vanguard MSCI Emerging Markets ETF (VWO), an exchange-traded fund, is a solid choice, with an expense ratio of just 0.20%. The Harding-Loevner fund is also a fine pick. So is the exchange-traded WisdomTree Emerging Markets Equity Income (DEM), which sticks to dividend-paying stocks and charges 0.63% a year.
Steven T. Goldberg is an investment adviser in the Washington, D.C. area.
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