Why Emerging Markets Are Worth a Look

Europe’s economy is flat, and much uncertainty surrounds the sustainability of the recovery in the U.S. Japan, as usual, is moribund.

Given that grim picture, where should you invest? One place is in emerging markets. Look at China, for instance. Its government seems to be successfully engineering a soft landing -- slowing inflation without choking off rapid economic growth. Millions of subsistence farmers are waiting to move to factory jobs in China’s burgeoning cities.

India’s economy is also booming, as is Brazil’s. Indeed, some of the more-established emerging markets, such as China and India, are starting to gain competition, particularly in manufacturing labor costs, from less-developed emerging markets, such as those in Southeast Asia (Thailand and Vietnam, for example). The demographics of emerging markets stand in marked contrast to those of the developed world. Young people, many of them just entering the workforce, play a much larger role in emerging nations than they do in the developed world. Populations in almost all of the world’s developed economies are aging -- meaning they have fewer people of working age and more people relying on those workers to pay the taxes needed to fund social-welfare programs (including our own Social Security and Medicare programs). Thanks to immigration, the U.S. is in much better shape than Western Europe and Japan, but demographics are nevertheless a huge negative here, too.

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Of course, no investment is worth anything unless it’s reasonably priced. And that’s the surprise: Emerging markets are selling at attractive levels. The MSCI Emerging Markets stock index trades at 11 times estimated earnings for the coming 12 months. That’s cheap -- even if those earnings estimates prove to be a bit over-optimistic. By comparison, the Standard & Poor’s 500-stock index trades at 13 times the next 12 months’ earnings (the average P/E of the S&P 500 over the long term has been 15.5). The emerging-markets index yields 2.3% and trades at 1.9 times book value (assets minus liabilities), both favorable ratios.

Emerging markets have had a rocky year so far -- just as developed markets have. But thanks to a recent rally in stock markets around the globe, the emerging-markets index was up 6.6% year-to-date through September 13. Over the past ten years, emerging-markets stocks returned an annualized 12.3%, while the S&P 500 lost 1.1% a year and the MSCI EAFE index, which tracks developed foreign markets, returned a paltry 2.2% annualized.

Don’t even think about investing in emerging markets without understanding all the risks. Most important, investors often beat up on emerging markets when the developed world falls into a funk, as it plainly is today. That showed clearly in the returns for 2008. The S&P 500 plunged 37.0% in that horrific year, but the emerging-markets index tumbled 53.2%.

The emerging-markets index is 62% more volatile than the S&P 500. That’s a good predictor of how emerging-markets stocks will fare relative to U.S. stocks in the next bear market.

Most emerging nations, especially China, rely heavily on exports to the developed world. If demand in the developed world falls off the table, China’s economy will almost inevitably stumble.

Corporate governance is a huge issue, too. You can’t expect the same quality of corporate accounting in emerging nations that you get in the developed world. Many companies are run partly by the government, or by and for wealthy families who care little about shareholders.

The cream of emerging-markets funds

But the positives far outweigh the negatives. Most Asian emerging nations and some Latin American countries are in far better shape economically and fiscally than most of the major countries in the developed world. They’re running trade surpluses, not deficits, and most are running budget surpluses as well. That means that the next time a recession strikes, it will be a lot easier for those countries to stimulate their economies with deficit spending.

Recognizing that exports will take them only so far, many Asian nations are also encouraging more domestic consumption of goods and services. “We’re seeing domestic consumption play a much bigger role in Asia,” says Richard Gao, co-manager of Matthews Pacific Tiger (symbol MAPTX). “We’re focusing much more on domestic companies.” Many multinational companies now treat China and other Asian countries as their most important growth opportunity, Gao says.

What to buy? Vanguard Emerging Markets Stock ETF (VWO), an exchange-traded index fund that tracks the MSCI index, is one of the best options. Expenses are just 0.27% annually. T. Rowe Price Emerging Markets Stock (PRMSX) lost 60.5% in 2008, but new manager Gonzalo Pangaro has put the fund back on track (the fund is a member of the Kiplinger 25). If you want an Asia-only fund, Matthews Pacific Tiger is the best of the bunch.

Remember, too, that many major western companies earn significant and growing revenues from these fast-growing economies. Nestlé SA (NSRGY.PK), which trades in the U.S. through an American depositary receipt, PepsiCo (PEP) and Yum Brands (YUM) are just three of the major beneficiaries of this trend.

Indeed, when the developed nations finally emerge from their prolonged economic slump, they’ll have emerging markets to thank for the revival.

Steven T. Goldberg (bio) is an investment adviser.