5 Funds to Catch a Rally in Emerging Markets

The emerging-markets “anthem” is as familiar as “We Are the Champions” at sports events: Developing nations, such as China, India and Brazil, are growing faster than the rest of the world, and they stand to deliver outsize stock gains as they industrialize and their middle classes grow. But in recent years, the song has been off-key. Over the past five years, the MSCI Emerging Markets index was essentially flat, compared with a 1.1% annualized gain for Standard & Poor’s 500-stock index. In the past year, emerging-markets stocks earned 24.6% and the S&P 500 returned 33.0% (all returns are through October 4).

In part, the bum performance is collateral damage from economic woes elsewhere. Over the past couple of years, many asset classes around the globe have been whipsawed by a phenomenon known as risk-on, risk-off trading. When investors learn of positive developments about, say, the European debt crisis, they scoop up risky investments, such as emerging-markets stocks, in a fit of optimism. When headlines bear bad news, investors sell their risky holdings. “The recent precipitous declines have been driven predominantly by European and other worldwide economic fears,” says Howard Schwab, co-manager of Driehaus Emerging Markets Growth Fund.

That’s understandable, given that Europe accounts for almost 20% of Chinese and Indian exports. But it’s also partly because of a self-fulfilling prophecy: Even though many emerging nations have stronger balance sheets and better growth prospects than the developed world, investors think of the stocks as riskier than developed-market stocks, so they treat them as riskier. So the stocks fall disproportionately on bad news and rise disproportionately on good news.

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But many emerging nations also face serious problems. China’s economy, which grew at a double-digit percentage pace as recently as last year, is slowing and may expand only 7% to 8% in 2012 and 2013. Any attempt to stimulate the country’s economy needs to avoid adding air to China’s precarious real estate bubble. And it’s possible that less-heady growth will be the new normal for China as it refocuses its economy away from a dependence on exports and government investments and toward greater domestic consumption. All of this is happening as the country goes through a once-per-decade change in its political leadership. The Shanghai Composite index of Chinese stocks dropped 11.6% over the past year.

Meanwhile, the economies of big commodity exporters, such as Russia and Brazil, are bound up in China’s fate because Chinese demand has been the key driver of commodity prices over the past decade. Although India is less dependent on China, its economy is also slowing. And India is plagued by persistent inflation, trade and budget deficits, and a business environment riddled with corruption and burdened by government red tape.

The Wealth Effect

Still, in the long run the core reasons for owning a stake in these markets remain unchanged. Emerging markets have huge populations—China and India together account for half of the world’s population. And as their economies industrialize, large numbers of people are moving from rural areas to cities—opening up opportunities for them to get a better education and higher-paying jobs. That leads to increased consumption. “Despite the fact that emerging-markets stocks have done relatively poorly, the fundamental picture continues to be strong,” says James Donald, co-manager of Lazard Developing Markets Equity Fund.

Emerging-markets stocks appear to be cheap. The MSCI Emerging Markets index trades at less than 10 times estimated earnings for the coming 12 months, compared with 13 for the S&P 500. Furthermore, many developed nations and their citizens are still at the beginning of a long process of belt-tightening and debt-reduction, and that makes emerging-markets shares look all the more appealing. “The contrast between the long-term-growth outlook for developed and emerging markets couldn’t be starker,” says Lewis Kaufman, manager of Thornburg Developing World Fund.

Some emerging-markets stocks have continued to thrive. Shares of com­panies that sell goods and services around the world, and those that primarily serve domestic demand, have diverged. Exporters, such as China Shipping Container Lines and state-owned Russian oil producer Gazprom, which depend on a strong global economy, have suffered. But firms that largely serve demand within their own borders—such as Philippine grocer Puregold Price Club and Turkish supermarket discounter Bim Birlesik Magazalar—have performed well and are poised to deliver further growth.

If you don’t already have a stake in developing markets, start by putting 25% of the money you have dedicated to foreign stocks into an emerging-markets fund. (Before doing so, check to see how much your diversified foreign stock funds have in these markets and adjust accordingly.)

Our top pick among broadly div­ersified funds is T. Rowe Price Emerging Markets Stock (symbol PRMSX), a member of the Kiplinger 25. Manager Gonzalo Pangaro looks for growing companies selling at reasonable prices. He believes that earnings of economically sensitive industries, such as commodity and materials producers, will disappoint for several years as profit margins retreat from recent highs.

Shares of companies that serve domestic consumption are in some cases much more expensive than those of firms that rely on exports, Pangaro says. But he doesn’t mind paying a higher price for a firm with strong growth prospects, such as Turkey’s Bim Birlesik or Brazilian department store Lojas Renner. “Companies that are generating earnings growth of 20% per year can quickly grow into their valuations,” says Pangaro. Over the past three years, Price Emerging Markets returned 6.6% annualized, matching the MSCI Emerging Markets index’s annualized gain.

Managers at Driehaus Emerging Markets Growth (DREGX) also prefer to focus on consumer-driven businesses. Schwab and co-manager Chad Cleaver seek companies of any size with above-average earnings growth and a catalyst that is likely to drive stock-price gains. One of their themes has been to shun businesses that are subject to government meddling. For example, Cleaver says, the case for Brazilian mining giant Vale has been hampered by government-levied royalties. And state-owned energy companies in Brazil, China and India have at times found themselves unable to pass higher costs on to consumers because their governments want to keep a lid on prices.

Recently, the fund also had 14% of its assets stashed in so-called frontier markets—nations such as Cambodia and Nigeria that don’t yet qualify for emerging status. For example, Nigeria’s Zenith Bank, a Driehaus holding, has a strong balance sheet and highly profitable lending operations, says Cleaver. The fund returned 9.2% annualized over the past three years, beating the MSCI Emerging Markets index by an average of 2.7 percentage points per year.

For a steadier, income-centric approach, consider Matthews Asia Dividend (MAPIX). The fund, also a member of the Kiplinger 25, seeks growing companies that also pay handsome dividends. The fund invests all over Asia, including in developed markets; Japan recently accounted for 24% of its assets. But many of its Japanese holdings, such as Pigeon Corp., which makes maternity, baby- and child-care products, earn a big portion of profits from emerging Asia. “With all of the food-safety scares in China, being a Japanese company has sway,” says Jesper Madsen, lead manager of the fund.

Madsen says he and colleague Yu Zhang have anchored the portfolio with relatively steady stocks. Consumer staples companies account for the largest portion of the portfolio, at 21%. (For comparison, the fund’s benchmark, the MSCI All Country Asia Pacific index, allocates 7% to consumer staples.) But Madsen and Zhang are also taking small positions in stocks of economically sensitive businesses that they believe have been overly punished. The fund returned 11.7% annualized over the past three years, with slightly less volatility than the S&P 500. It recently yielded 3.1%.

For a zippier approach, consider Lazard Developing Markets Equity (LDMOX), an aggressive fund that seeks companies that are cheap relative to their projected earnings growth. Its managers have loaded up on economically sensitive firms in the industrial, energy and financial-services sectors. Co-manager James Donald says the fund typically races ahead when markets are on a tear. That was the case in 2009, when it gained a stunning 108.2%, compared with 73.8% for the average emerging-markets fund. But the fund will often fall farther than its peers when markets take a dive—witness its 26.3% decline in 2011, compared with the average emerging-markets fund’s 19.9% drop. Because of that, Donald says, the fund isn’t suitable as a core emerging-markets holding. But it can be a nice complement to one of the more conservative funds.

If keeping costs down is a priority, consider Vanguard Emerging Markets (VWO), an exchange-traded fund that tracks the MSCI index and charges just 0.20% in annual expenses. You’ll have a larger position in some of the big natural-resources firms and other economically sensitive industries than you would with some other options, and that could make for a bumpier ride. But if your aim is to hold on for the long haul, the fund is a fine choice.

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