Emerging Markets Are Still a Bargain

China's economic juggernaut is clearly losing steam, beset by soaring energy and labor costs, horrible pollution, and, most important, weakening demand from Europe. Localized real estate and investment bubbles, meanwhile, threaten to erupt into bigger problems.

Against that gloomy backdrop, the MSCI China index has climbed 9.4% so far this year. The broader MSCI Emerging Markets index has done even better, jumping 14.4% year-to-date (all returns in this article are through March 26 unless otherwise noted). That comes on the heels of an awful year for emerging-markets stocks, which lost 18.2% in 2011. Still, over the past ten years, the emerging-markets index has returned an impressive 14.6% annualized.

It's impossible to know which way emerging-markets stocks will lurch from month to month or year to year. What's worse, they're the most volatile segment of the world's stock markets. But they're simply too promising for long-term investors to ignore. Economies in emerging nations are growing much faster than those in developed lands, and there's little to suggest that this trend will reverse in the coming years.

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But invest with your eyes open. Rapid economic growth of the kind most analysts expect in emerging markets hardly guarantees stock market gains. As counterintuitive as it sounds, growth in gross domestic product is often unrelated to shareholder returns.

Consider China. It's rife with corruption. Corporate executives often view shareholders as victims to be fleeced. The Chinese government -- with an agenda often at odds with that of investors -- is the biggest owner of many companies. Regulation is far more lax than in developed countries. Financial reports are inadequate, at best.

But look at the pluses. Most important: Emerging-markets stocks are cheap. As measured by the MSCI index, emerging-markets stocks trade at 11 times analysts' estimated earnings for the coming 12 months. By contrast, Standard & Poor's 500-stock index trades at about 13 times estimates, and the S&P's average price-earnings ratio over the long term is about 15.5.

In terms of price to book value (assets minus liabilities), the MSCI Emerging Markets index trades at a reasonable level -- 1.6 times book. The index trades at less than one times sales, which is dirt-cheap. Finally, the index's return on equity (a measure of profitability) is 21, just a shade less than the S&P 500's return of 23.

Emerging markets, for the most part, are in better fiscal shape than the U.S. and other developed countries. Low labor costs and favorable demographic trends also argue strongly in favor of emerging markets. Populations are aging in the U.S., Japan and Western Europe; that's not so in developing nations.

What to Buy?

I despair of finding good, actively managed, no-load emerging-markets stock funds. My favorite is an index fund, Vanguard Emerging Markets Index (symbol VEIEX), with an expense ratio of just 0.33%. Better still, buy the ETF version of this fund (VWO), which charges just 0.20% annually.

I suspect that brokerages in emerging markets do substantially more cheating than those in developed countries. And the costs of trading are generally far higher in emerging markets, even if you assume brokers are honest. Those two factors make it more expensive for actively managed emerging-markets funds to buy and sell stocks. That gives index funds, which rarely trade, a big advantage.

One actively managed fund, Matthews Asia Dividend (MAPIX), does impress me. As is the case in the U.S., paying out dividends is a superb sign that corporate executives care about shareholder interests. The Matthews fund invests solely in dividend-paying stocks. About half its assets are in emerging Asia; most of the rest are in developed Asia, including Japan. Returns, particularly in lousy markets, have been impressive.

WisdomTree Emerging Markets Equity Income ETF (DEM) is another intriguing fund. It holds 285 of the highest-dividend-yielding emerging-markets stocks. The stocks are weighted according to their dividend payouts. The fund's volatility is lower than that of the MSCI index, and, indeed, it lost less than the index both in the 2007-09 bear market and during the 2011 downturn (from May 2 to November 25 the fund lost 21.9%, compared with a loss of 25.4% for the EAFE index). WisdomTree's fat dividends -- the fund sports a current yield of 6.5% -- helped cushion the blow of last year's decline.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.