Emerging-Market Funds Enter Danger Zone

NEW YORK ( TheStreet) -- Emerging-market funds have been on fire. Van Eck Emerging Markets ( GBFAX) has returned 108% this year, and Dreyfus Emerging Asia ( DEAAX) is up 121%. Plenty of investors have been piling into emerging funds. But before you write a check, consider the fate of other high-flying funds. In nearly every case in the past, they have crashed soon after returning 100% in a year.

An episode of triple-digit returns occurred two years ago. With investors keen on the outlook for China, some Asian funds doubled. During the 12 months ending in October 2007, Dreyfus Greater China ( DPCAX) soared 148%, while Aberdeen China Opportunities ( GOPAX) jumped 145%. Then, with the credit crisis beginning to unfold, Asian stocks fell. For the year ending in October 2008, Dreyfus Greater China lost 72% of its value, and Aberdeen tumbled 64%.

Among the most dramatic market performances ever came in 1999 when 126 funds returned more than 100% for the year. Within months, nearly all the winners fell off a cliff.

Considering that history, should you stay away from red-hot emerging-markets funds altogether? Not necessarily. While emerging stocks could be rough for the next year, long-term investors have good reasons to begin gradually buying. By many measures, the outlook for emerging economies looks stronger than ever.

In the past, financial advisers viewed emerging-market stocks as shaky investments. Many countries in Latin America and Asia were plagued with heavy debt loads and sketchy financial regulation. In light of the extra risk, the price-to-earnings ratios of emerging shares were always lower than the multiple that investors paid for the S&P 500.

But the picture has changed in recent years. While U.S. banks and consumers borrowed heavily, countries in Latin America and Asia paid down their debts. Many governments tightened their financial rules, and it's currently hard to argue that U.S. regulators are vastly superior to those in the developing world.

As emerging markets became stronger, the stock multiples have improved. Based on earnings estimates for next year, emerging markets sell for a multiple of 13 times earnings, only a bit below the figure for the S&P 500. Now some managers believe that emerging markets are poised to overtake developed stocks. "Over the next few years, we will begin to see emerging-market stocks trade at a premium to the developed markets," says Simon Hallett, a portfolio manager for Harding Loevner.

To appreciate why Hallett is bullish, compare his two funds, Harding Loevner Emerging Markets ( HLEMX) and Harding Loevner International Equity ( HLMIX), which focuses on the developed markets of Japan and Europe. Both funds seek high-quality companies that can deliver sustained annual earnings growth of 10% or so, and both have outperformed most of their competitors during the past decade.

But the developed stocks in the international equity fund are more expensive. The fund's portfolio has a P/E ratio of 17 and average earnings growth of 11. In comparison, the emerging-market fund has a P/E of 13 and a growth rate of 13.

Hallet argues that emerging-market stocks are undervalued because investors don't yet appreciate that companies have improved dramatically. While some businesses in Latin America and Asia continue to be shaky operations, a growing number of companies now rank as world-class competitors with strong balance sheets and profits that compare favorably with competitors in the U.S. and Europe.

As an example, Hallet cites HDFC ( HDB), an Indian bank that has strong profit margins and high returns on equity compared with America institutions. The Indian bank has kept its business simple, giving mortgages and loans to individuals. "They are not involved in the weapons of financial destruction that have hurt American banks," Hallet says.

Another company Hallet owns is Petroleo Brasileiro ( PBR), a Brazilian oil giant. In recent years, many oil companies in the developed world have had trouble growing and developing new reserves. But the Brazilian company stands to double its production because of huge offshore finds.

To bet on growth in emerging markets, try BlackRock Global Emerging Markets ( MDDCX), which has returned 17% annually during the past five years, outperforming 83% of its competitors, according to Morningstar. Manager Daniel Tubbs says emerging markets can grow much faster than developed countries for years to come. While population growth is stagnating in Europe and Japan, the number of employed people is increasing throughout much of the emerging world. Millions of workers in Asia and Latin America are rushing to buy houses and cars for the first time in their lives.

To profit from growing economies, Tubbs is buying companies that serve eager consumers. A favorite holding is China Life Insurance ( LFC). "China Life has the largest market share in the country, and they have tens of thousands of people in their sales force going all over China," Tubbs says.

Another fund that seeks to profit from the growth of consumption is Aim Developing Markets ( GTDDX), which has returned 19% annually during the past five years, outdoing 90% of rivals. The fund favors high-quality companies that can grow for years. "We like dominant companies that don't necessarily depend on economic growth in the developed world," says Pavlos Alexandrakis, a portfolio manager.

A big holding is America Movil ( AMX), the largest mobile-phone operator in Mexico. While mobile-phone markets are becoming saturated in the U.S. and Europe, millions of potential customers still aren't served in Latin America. That leaves plenty of room for growth.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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