Emerging Markets Still Show Promise

Don't get used to those juicy emerging market returns. But that doesn't mean you should get out of funds in that space.

The incredible performance of emerging-market stocks is well known by now: The iShares MSCI Emerging Markets IndexEEM has returned a spectacular average of 25.5% annually over the past three years thanks to the economic ascendancy of countries like Brazil, Russia, India and China.

David Lazenby, portfolio manager of the $560 million Legg Mason Emerging MarketsLMEMX fund believes the outsized gains may be over, but there are still solid returns to be had in so-called less-developed countries, primarily due to improved fundamentals.

Lazenby's fund has crushed its benchmarks, returning an average of 32% per year over the past three years and 40% over the last five.

The fund manager chatted with TheStreet.com about his favorite emerging market stocks, and whether the rally can keep going even as the U.S. economy slows.

Is the wild bull run in emerging markets over, or close to it?

We don't expect continued 40% annual returns. However, we do believe the combination of better sovereign fundamentals, better earnings growth, less balance sheet leverage and valuations roughly in line with developed market equities justify expectations for relative outperformance.

What is the impact of a slowing U.S. economy on emerging market stocks?

Some emerging-market economies are more tied to the U.S. than others. Certainly export-driven economies in Asia, such as South Korea and Taiwan, are heavily influenced by U.S. growth. Other markets, like Brazil, are less linked to U.S. growth and more linked to strength of commodity demand -- which is more dependent on infrastructure development in the emerging world.

How is inflation affecting emerging-market economies, especially China?

Price inflation is increasingly moving beyond hard commodities and into food and elsewhere. Raw-material inflation could have an impact on margins; however, increasing disposable incomes and associated potential for product pricing power offset that in many market segments. Inflation concerns may provide support for many emerging markets currencies that have been artificially cheap due to government intervention since allowing currency strength would dampen inflation.

How would you rank your favorite emerging markets and on what basis?

Currently, we are most overweight Russia, Mexico, Egypt and Turkey. Turkey, after recent underperformance, is the cheapest of the emerging markets and continues to promise very significant growth. Mexico may have already fully discounted its acknowledged linkages with the U.S. economy. Egypt and Russia have positive domestic liquidity environments linked to high oil prices and somewhat lower correlation with global markets. They are both also among the cheapest, with Russia second only to Turkey.

What are your top China stocks?

We like Angang Steel due to strong steel prices and its relatively attractive valuation. We also like ICBC, which is the strongest domestic bank in China, with solid loan growth and still improving non-performing loans

What about Brazil?

Our favorite Brazilian stock is UnibancoUBB, which is closing the return-on-equity gap to the domestic leaders ItauITU and BradescoBBD but trading at cheaper valuations.

We also like Suzano, which just completed a plant expansion ahead of plan and below budget. It also trades at a discounted valuation versus its peers.

Which country -- and its stocks -- could surprise investors in 2008?

Perhaps Mexico, because that market was relatively early in discounting U.S. recession risk given the high linkages between the two economies, even though Mexican consumer and financial names, including housing are not meaningfully leveraged to US-related issues and have their own positive domestic drivers. Our key overweight positions there include América MóvilAMX and HomexHXM.