Developing markets have performed poorly in recent years, but if you pick the right countries, you can make money. Plus: How to play frontier markets. Thinkstock By Carolyn Bigda, Contributing Writer October 30, 2015 Investing in emerging-markets stocks lately may feel like dealing with a teenager. One day, everything is doom and gloom, and the stocks are in free fall. The next, the world doesn’t seem so bad and the stocks rebound.See Also: Why You Should Buy Emerging Markets Stocks Now Right now, things are looking up. In October, China’s government reported that the country’s economy expanded 6.9% year-over-year during the third quarter. It was the lowest growth rate since 2009—and even then, considered by economists to be overinflated—but it still officially beat the consensus forecast of 6.8%. The Federal Reserve’s decision not to raise its short-term benchmark rate in September was also a positive. A rate hike would have strengthened the dollar further, making it harder for developing nations to repay debt denominated in the greenback. As a result, since bottoming on August 24, the MSCI Emerging Markets index, a benchmark of stocks from 23 developing countries, has climbed 13.1%. (All returns are as of October 27.) But as when dealing with a teenager, patience is in order. Even with the rebound, the MSCI Emerging Markets index has lost 7.6% year-to-date and 2.0% annualized over the past five years. Meanwhile, Standard and Poor’s 500-stock index has returned 2.0% and 14.2% annualized for the same periods. Advertisement One reason for hanging on: Stocks in developing markets are now exceptionally cheap. According to the Leuthold Group, a Minneapolis investment research firm, emerging-markets stocks trade at 11 times the average of the past five years of earnings. The comparable price-earnings ratio of the MSCI USA index, which measures stocks of large and midsize domestic companies, is 21. Bargain prices won’t make emerging-markets stocks any less exasperating. “Valuations can stay low for a long time,” says Jun Zhu, a portfolio manager at Leuthold. But they do mean that if you’ve got a strong stomach and invest now, the payoff over the long term may be substantial. In fact, Research Affiliates, a money-management firm based in Newport Beach, Calif., forecasts that over the next 10 years, U.S. stocks will return just 1.1% annualized, after inflation. Emerging-markets stocks, on the other hand, could deliver 7.9% annualized, after inflation, over the same period. You shouldn’t invest in just any emerging market. Focus on the countries or regions that will be better able to stanch the bleeding. The drop in oil prices is boosting profits in nations that are heavy energy importers, for example. Stalled growth has encouraged some governments to execute much-needed reforms. And so-called frontier markets—countries in the early stages of economic development—are beginning to hit their stride and deliver ever-faster economic expansion. To that end, we’ve identified three developing markets where stocks are reasonably priced and the corporate-earnings picture is improving. And we name the best funds for cashing in on the coming turnarounds. India. Economic growth in the world’s second-most populous nation stalled beginning in 2011 as the country dealt with rising inflation and political discord. But last year, Narendra Modi was elected prime minister on promises of introducing a host of economic reforms, and investors cheered. The MSCI India index, a benchmark of 71 Indian stocks, returned 23.4% in 2014. So far this year, the index has given up 1.6%, a relatively stellar performance for developing markets. Advertisement Still, Modi has to continue pushing through reforms for India to prosper—a not-so-easy task in the world’s largest democracy. But the government has made some progress. Modi, for example, eliminated expensive government subsidies on diesel fuel and relaxed restrictions on direct foreign investment in the country’s insurance, railways and defense sectors. In August 2014, he also launched a nationwide program to open 75 million new bank accounts for the country’s poor (more than 188 million accounts have been opened to date). At the same time, India, a major energy importer, is benefiting from low oil prices. The country’s current account deficit has fallen from a high of 6.7% of its economy in 2012 to 1.2% during the second quarter of 2015. (Current account balances measure the movement of goods, services and investments into and out of a country.) So although earnings of companies in the MSCI India index expanded by just 3.2% last year, analysts expect profits to jump 10% in 2015 and 20% in 2016. That may be one reason the MSCI India index trades at a relatively high 17 times estimated year-ahead earnings. A solid choice for participating in the country’s reforms is Matthews India Fund (symbol MINDX). The no-load fund returned a whopping 63.7% in 2014 and 6.2% so far this year. Its returns were among the top half of India stock funds in four out of the five past calendar years (including so far in 2015). Lead manager Sunil Asnani, who has worked on the fund since 2010, invests in fast-growing companies of all sizes. The minimum investment is $2,500, and the fund charges 1.12% per year, which is reasonable for a fund that focuses on a single emerging market. Philippines. Economic growth in this Southeast Asian archipelago nation has slowed this year, thanks to delays in infrastructure projects and tepid global demand. During the second quarter, for example, the economy expanded by 5.6%, down from 6.7% in the same period a year ago. But the government has begun to loosen its purse strings, spending 15.7% more during the third quarter than it did the previous year. As a result, the International Monetary Fund estimates, the Philippine economy will expand by 6% in 2015. That’s below earlier estimates of 6.7%, but it’s still enviable compared with many other emerging countries. Advertisement The nation is benefiting from a robust outsourcing sector (jobs that foreign companies send overseas). Revenues for the industry were $19 billion in 2014, and the IT & Business Process Association of the Philippines has set a target of $25 billion for 2016. That, plus remittances sent home by Filipinos working overseas, helped boost consumer spending by 5.4% last year. Spending in 2015 is expected to rise 6.0%, according to FocusEconomics, which tracks economists’ forecasts for 127 countries. “It’s a very young economy, making a lot of right infrastructure investments,” says Nick Niziolek, a senior comanager of the Calamos Evolving World Growth Fund (CNWGX) “And the outsourcing market provides a nice tailwind.” Stock values reflect this rosy outlook. The MSCI Philippines index trades at 18 times estimated earnings for the next 12 months. But, says Niziolek, “you pay for what you get.” So far this year, the MSCI Philippines index has retreated just 0.4%. The easiest way to get exposure to the country is to invest in iShares MSCI Philippines ETF (EPHE). Launched in 2011, the exchange-traded fund currently holds shares in 46 Philippines-based companies and so far this year has lost 3.6%. Annual expenses are 0.62%. Taiwan. China’s growth rate may be slowing, but its middle class continues to expand rapidly. So for a less nail-biting way to invest in rising consumer demand, consider Taiwan. In 2014, exports accounted for 70% of the island nation’s economy, with China being its largest trading partner. Japan, Europe and the U.S. were also big importers of Taiwanese goods. China’s meltdown, slow global growth and the depreciation in Asian currencies have been a major drag for Taiwan lately. During the first half of 2015, Taiwan’s exports dropped 7.1% from the same period a year earlier. But improving economies in the U.S. and Europe will help prop up Taiwanese stocks, says James Syme, comanager of the JOHCM Emerging Market Opportunities Fund (JOEIX). And although China’s expansion is decelerating, the country is still growing more rapidly than developed markets, says Leuthold’s Zhu. “The companies doing business in China will capture that growth,” she says. Meanwhile, Taiwanese stocks are attractively priced, trading at 12 times estimated earnings over the next 12 months. Advertisement A low-cost way to invest in Taiwan is through iShares MSCI Taiwan ETF (EWT), which tracks an index of stocks of large and midsize companies. Tech firms, many of which provide components for smartphones and other electronics, make up more than half of the underlying index. Those companies are starting to benefit from the arrival of the iPhone 6s. The ETF, which charges 0.62% annually, has stumbled 5.9% so far this year Alternatively, consider the closed-end Taiwan Fund (TWN, $15.52). Closed-end funds typically issue a fixed number of shares, then trade just like stocks and the more-popular ETFs. Unlike ETFs, closed-end funds often trade at a premium to or discount from the value of their underlying holdings. As of October 27, Taiwan Fund sold for a 12.0% discount to its net asset value per share. Year-to-date, Taiwan Fund has lost 1.9% on the value of its assets and 5.1% on the basis of its share price. Annual expenses are 1.80% Frontier markets. Hyper-growth may be a thing of the past for the emerging-market giants, but frontier markets are picking up the baton. These countries are still in the early stages of development. For example, the African Economic Outlook, which forecasts economic trends in Africa, projects that Kenya’s economy will expand by 6.5% in 2015, up from a 5.3% increase in 2014. Bangladesh’s economy is projected to strengthen 6.0% in 2015 and 6.3% in 2016, according to the Asian Development Bank. In Vietnam, 6.5% growth is predicted for this year and 6.6% next year. Like their emerging-markets peers, frontier stocks have stumbled lately, thanks in part to the strong dollar (which lowers returns held in foreign currencies when they are translated into the greenback). So far this year, the MSCI Frontier Emerging Markets index has surrendered 12.3%. But frontier markets, which are less integrated into the global economy than larger emerging countries, do not always move in lockstep with developing-markets stocks. For example, the Frontier index returned 26.3% in 2013 and 7.2% last year, beating the MSCI Emerging Markets index by 28.6 and 9.0 percentage points, respectively. This year, the Frontier index has trailed emerging markets by 3.3 percentage points. You might welcome that kind of diversification in your portfolio, but keep in mind the risks: Because of the small size of frontier markets, stocks in these countries don’t trade hands readily. So consider investing a small portion of your overseas stock money in an actively managed fund with investments in a wide range of frontier markets. Harding Loevner Frontier Emerging Markets Portfolio (HLMOX), launched in 2008, invests in at least 12 countries. Pradipta Chakrabortty, the fund’s lead manager, says he is finding some companies in Asia and Africa, such as Bangladesh, Kenya and Vietnam, that are generating profit growth of 15% to 20% annually. Year to date, the fund has dropped 14.1%. In 2013, Harding Loevner Frontier returned 16.5%, and in 2014, 5.8%. The fund’s annual expense ratio is a stiff 2.22%. See Also: Have Emerging Markets Hit Bottom Yet?