Emerging Markets Command Premium

Editor's note: This is the second of four stories reviewing the quarter in mutual funds. To read the first story, click here.

It's no surprise to anyone with even a passing interest in international investing that foreign stocks have been doing much better than their U.S. counterparts, and emerging markets in particular have been on fire.

The iShares MSCI EAFE (EFA Quote) index fund of developed-market stocks is up about 12% year to date, while the iShares MSCI Emerging Markets (EEM Quote) index fund is up around 30%.

What you might not realize is that emerging markets are now trading at a valuation premium to stocks in developed markets.

Specifically, stocks in EEM are trading at 15.6 times estimated 2007 earnings per share, compared with 14.6 times for stocks in EFA.

This violates conventional wisdom that emerging markets should trade at a discount to their developed-market counterparts, and surely must be a sign of irrational exuberance and a bubble on the verge of collapse, right?

Maybe not.

Now, it is not lightly that we tread in "this time it's different" territory, but some things have changed that warrant consideration. Namely, globalization has made access to capital easier for firms in emerging markets while at the same time expanding markets for the goods and services these firms produce.

Evidence of emerging-market firms' easier access to capital these days is apparent in the composition of EEM itself: Over half the value of the fund is in fact comprised of American Depositary Receipts -- U.S. listings of foreign stocks.