Emerging-Market Funds Unbowed by Crisis

NEW YORK ( TheStreet) -- With investors fretting about the European debt crisis, foreign mutual funds have sunk.

Japan funds dropped 6.8% during the past month, and European funds declined 4.5%, according to Morningstar. Among the most resilient were diversified emerging markets funds, which dropped 3.7%.

The outperformance by emerging markets was noteworthy. In the past, stocks in Latin America and Asia sometimes collapsed at the first sign of trouble in the developed world. As investors lost their appetite for risk, they would stampede out of the emerging markets.

But now the picture has changed. At a time when the U.S. and other developed economies are plagued with debt burdens, many governments in the emerging markets are on sound footing. The public debt of Chile is equal to 9% of the country's gross domestic product. The figure is 192% for Japan and 115% for Italy.

"The emerging markets now seem less risky than they did a few years ago," says Howard Schwab, manager of Driehaus Emerging Markets Growth ( DREGX). "I would much rather hold sovereign bonds from Indonesia or Brazil instead of bonds from the Japanese or Europeans."

Because of the debt burdens, growth in the developed markets is likely to remain sluggish for years. But the outlook for emerging markets is considerably brighter. With hundreds of millions of people leaving impoverished villages and taking urban jobs, economies in Asia and Latin America are reporting strong growth, says Schwab.

"In the United States, a consumer-products company might increase earnings at a single-digit annual rate," he says. "In the emerging markets, you can find straightforward consumer businesses that will increase earnings 40% a year for the next five years."

Despite their superior growth, emerging-market stocks are cheap compared with their counterparts in the developed world, says Steve Cao, a manager of Invesco Developing Markets ( GTDDX). Based on earnings estimates for the next 12 months, the price-to-earnings ratio for emerging markets is 10.5, says Cao. That is below the historical average of 12. Developed markets currently sell for a multiple of 12, Cao says. Besides offering strong growth potential, emerging-market stocks also pay a dividend yield of 3%, compared with 2% for the S&P 500.

Make no mistake, emerging-market funds still come with plenty of risk. So it makes sense to select a fund that delivers relatively steady results. To find candidates, I screened for funds that excelled in downturns and delivered strong long-term returns.

A top choice is Oppenheimer Developing Markets ( ODMAX), which has returned 14.7% annually during the past 10 years, outdoing 98% of its competitors. Manager Justin Leverenz shines in downturns. The fund lost only 1.3% in the past month, beating 96% of competitors.

Leverenz looks for solid businesses that have massive advantages over their competitors. He aims to buy such stellar companies when they are temporarily out of favor. Once the fund buys, it often holds for five years or longer.

A big holding is Infosys Technologies ( INFY), an Indian outsourcer that serves many U.S. companies. As the U.S. credit crisis began to unfold in 2007, shares of the Indian company sank as investors worried that demand for outsourcing services would fall. Leverenz bought the outsourcing stock and scored big gains as fears of a global downturn subsided.

Oppenheimer also owns Megastudy ( 072870.KQ), a Korean company that provides private tutoring for students seeking to pass entrance exams. While thousands of tutoring services exist in Korea, Megastudy has emerged as a dominant provider, capturing 15% of the market.

"This company earns extremely high returns on capital, and it should report higher growth than the market expects," says Leverenz.

A fund that outperformed in the past month is Evergreen Emerging Markets Growth ( EMGAX), which has returned 11.7% annually in the past 10 years. Manager Jerry Zhang seeks quality companies that seem likely to present only limited downside risk. A big holding is China Mobile ( CHL), a leading telecom. Zhang says the company can grow at an annual rate of 10% to 15%, but the shares only command a price-to-earnings ratio of 11.

To own a growth fund, consider Driehaus Emerging Markets Growth ( DREGX), which has risen 11.8% a year over the past decade. Manager Howard Schwab looks for stocks that are poised to report improving growth. He favors stocks that are already outperforming competitors. If earnings plateau, he considers selling.

"We tend to have faster growers than the average emerging markets fund," he says.

A holding is Pacific Rubiales ( PRE.TO), which produces oil in Colombia. The company acquired acreage cheaply and is increasing its production, says Schwab.

The fund also owns Hypermarcas ( HYPMY.PK), a Brazilian company that produces over-the-counter and generic drugs. The company has been acquiring competitors and improving their operations, says Schwab.

"This is one of the strongest pharmaceutical companies in the emerging markets," he says.

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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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