The Best Ways to Profit from Emerging Markets

If Charles Dickens had written the economic forecast for 2011, he might have called it A Tale of Two Worlds. And though the title would have echoed the name of his most famous novel, Dickens would have turned its primary theme on its head. Today, citizens of developed countries are facing the worst of times, and those in many emerging nations are enjoying the best of times.

It's a revolutionary change that smart investors shouldn't ignore. Robert Smith, manager of T. Rowe Price International Stock Fund, sums up the role reversal this way: "Do you want to sell to a consumer in Brazil or China who has a job, no debt and is experiencing double-digit annual wage growth, or to a consumer in the U.S. or Western Europe who isn't working -- or whose wages aren't growing if they are employed -- and who is paying down debt?"

The answer is obvious, but it raises two other questions: After the terrific run emerging-markets stocks have enjoyed already, are they overpriced? And what's the best way to profit from them?

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No question, emerging markets have rocked. Over the past year through November 5, the MSCI Emerging Markets index gained 27.3%, compared with 11.6% for the MSCI EAFE index (which tracks stocks in developed foreign markets) and 17.3% for Standard & Poor's 500-stock index.

Although markets in some countries may be overheated, emerging markets as a whole aren't out of line. Alec Young, S&P's foreign-stock strategist, says emerging-markets stocks trade, on average, at less than 12 times estimated 2011 earnings. That's on par with overseas developed markets, and it's less than the price-earnings ratio of U.S. stocks, which trade at 13 times forecasted 2011 profits.

Safer Ways to Play

Investors are typically willing to accept high price-earnings ratios for fast-growing companies. One reason developing-markets stocks are cheaper than U.S. stocks is that they are more volatile. Moreover, emerging markets rely on developed markets for customers and financing, and that leaves them at the mercy of nations that are often shakier than they are. Talk about ironic. In fact, emerging countries may limit the flow of easy money from developed markets so that their economies don't suffer the same types of credit bubbles that hurt established nations.

That gets us back to the question of the best ways to profit from emerging markets. Price's Smith likes firms in developed nations that appeal to emerging-markets consumers. For example, his fund owns Richemont, a Swiss luxury-goods company that books 40% of its sales in emerging markets.

You can also make a less-dramatic case for foreign stocks that don't have emerging-markets ties. Charles de Vaulx, co-manager of IVA International Fund, says that many European stocks have lagged since markets bottomed in March 2009.

So how do you make sure you're well positioned to profit internationally? You may already be covered. Many international funds have significant exposure to emerging markets -- and so do nominally domestic funds.

If you don't have at least 30% of your stock holdings in foreign names -- with at least one-third of that in companies tied directly or indirectly to emerging markets -- you should bring your allocation up to that level. The best way to boost your holdings is to buy T. Rowe Price Emerging Markets Stock Fund (symbol PRMSX) or the low-cost, exchange-traded Vanguard Emerging Markets ETF (VWO).