The Case for Emerging Markets

The old saw had it than when the U.S. sneezed, emerging markets caught cold. But it was supposed to be different this time because emerging markets had grown up.

But when U.S. stocks nose-dived early this year, emerging markets sold off right along with them. Standard & Poor's 500-stock index fell 9.5% in the first three months of 2008, and the MSCI Emerging Markets index tumbled 10.5%. Stock markets in China and India fared much worse. It seemed just like old times.

But things really are different this time. In marked contrast to the 1997-98 debt crisis, when emerging-markets stocks plunged more than 35%, nations that used to be collectively known as the Third World today are flush with cash -- and most are exporting far more than they're importing. It's the U.S. that's the troublesome debtor nation.

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While emerging markets' stocks still appear tied to U.S. stocks, particularly during sharp declines, the economies of developing nations are, to some degree, decoupling from the U.S. economy.

Three pillars support emerging markets growth. First is the expansion of their own consumer classes -- people who are eager to buy goods produced at home, as well as abroad. Second is the continuing need for emerging markets to build up their infrastructures. Third is exports from emerging markets to the U.S. and other developed nations. Only this third pillar is endangered by the slowing economies in the U.S. and other parts of the developed world.

In many respects, emerging economies are faring much better than the economies of developed nations. "Real wage growth is 20% in Russia," says Todd Henry, a portfolio specialist with T. Rowe Price Emerging Markets Stock (symbol PRMSX), citing just one example. "We still see the potential for emerging markets to outperform developed markets."

Consider these numbers. Emerging markets account for 15% of global market capitalization, but 25% of global gross domestic product and a whopping 50% of global GDP growth. Earnings per share of publicly traded companies in emerging markets surged 21% last year -- about double that in developed nations.

What's more, valuations in emerging markets seem reasonable, particularly in view of projected growth rates. The MSCI Emerging Markets index trades at a price-earnings ratio of less than 13 based on average estimates for corporate earnings over the next 12 months. That compares with a projected P/E ratio of 14 for the S&P 500.

The good old days are gone. But be realistic. Don't expect a rerun of the past five years in emerging markets.

Over that period, the MSCI Emerging Markets index returned an annualized 33% in dollar terms -- a stunning performance. Unfortunately, the easy money has been made. "You used to be able to get twice the growth at half the price," Henry says. No longer.

Emerging markets are encountering headwinds -- chiefly inflation. Skyrocketing global food prices are causing enormous pain in emerging markets. In Latin America, for instance, consumers spend almost one in every three dollars on food and beverages.

Soaring prices for energy and other industrial materials have cut both ways for emerging markets -- depending upon the country and the region. Russia and the Middle East, as well as much of Latin America, have benefited mightily from soaring commodity prices. Most of Asia, meanwhile, has been handicapped by the same phenomenon.

What should investors do? I think almost everyone should have some money in emerging-markets stocks. Yes, these countries lack the transparency, political stability and commitment to free markets of the U.S., but most continue to improve over time.

For a middle-aged investor saving for retirement, I'd recommend placing roughly 10% of stock money in emerging markets. But consider the percentage of emerging markets stocks in your broad-based foreign and global funds before buying another fund. For instance, no-load Vanguard FTSE All-World ex-US Index (VFWIX) has 20% of its assets in emerging markets. American Funds EuroPacific Growth (AEPGX), a load fund, has 17%.

Among emerging markets funds, the T. Rowe Price entry is my favorite. It has returned an annualized 17% over the past ten years and 35% annualized over the past five. That's an average of more than four percentage points per year ahead of the MSCI Emerging Markets index over both periods. Like all T. Rowe funds, the fund looks for growing companies selling at reasonable prices. The fund is run by four veteran co-managers and 17 analysts scattered around the globe.

The fund currently has about 42% of its assets in Asia and 22% in Latin America. The Latin American money is almost entirely in Brazil and Mexico. It also has 12% invested in the Middle East and Africa -- a big beneficiary of high-flying oil prices.

Emerging markets will continue to be volatile. The economies are still works in progress. Some may collapse. Political instability is always a concern. But over the long haul, a holding in a solid, widely diversified emerging markets fund like the Price fund ought to pay off -- in spades.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.