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

This is not to say that non-U.S. listings are somehow cut off from capital; they are not. But a U.S. listing not only facilitates access to large pools of capital but also entails conforming to U.S. standards of accounting and disclosure.

As a result, the argument that the opacity of emerging markets is deserving of a valuation discount becomes less pertinent.

So if the majority of stocks in EEM are actually U.S. listings of multinationals that happen to be headquartered in emerging-market countries, shouldn't they be valued just like any other U.S. stock -- on the basis of profit expectations?

We think so, and it is here that we find some evidence to support the notion that globalization and the expanded opportunities it entails is translating into faster earnings growth for firms in emerging markets.

Annual earnings growth for firms in EEM is expected to surpass that of firms in EFA both this year and next, with next year's expected earnings growth in emerging markets roughly double that of developed-economy stocks.

Furthermore, although analysts' estimates of long-term earnings growth must be taken with a grain of salt, there is some basis for the difference between forecasts for the two funds.

Aggregate consensus expectations for long-term earnings growth for firms in EEM is 14.9% compared with 10.2% for firms in EFA. In reality we'd guess that both figures are too optimistic, but long-term earnings growth is likely to be better for emerging-markets firms.

We're quite sure that emerging-market stocks will remain volatile and aren't suitable for everyone. But don't let the pundits scare you out of emerging markets entirely just because they now garner a small premium -- there's a decent case to be made that it's deserved.

Emerging-Markets Premium
P/E ratio on 2007 Est. EPS
Source: ETF Research Center

Easy Access to Capital
Over half of EEM's constituents are ADRs
Source: ETF Research Center

Faster Growth
Annual EPS Growth, 2007 Est. and 2008 Est.
Source: ETF Research Center

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Michael Krause is president and founder of AltaVista Independent Research. AltaVista provides fundamentally driven analysis of exchange-traded funds to help investors select ETFs based on investment merit, much the same way they would evaluate a single stock. The firm offers both print and online ETF research to subscribers, but does not manage clients' money. Mr. Krause is also a frequent contributor to broadcast and print media.

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