How to Play Emerging Markets?

NEW YORK ( TheStreet) -- From Indonesia and Thailand to Chile, emerging markets have had a strong run so far in 2010. With the U.S. and U.K. bracing for another period of slower growth, emerging markets could well continue to outperform.

In the global recession, these economies have proven resilient compared with developed economies, growing at rates significantly higher than the U.S. and U.K. China's GDP is projected to grow slightly less than 10% in 2010, while India is likely to record a growth rate of over 8%.

While emerging markets are subject to higher volatility because they lack depth and liquidity, they may actually be less risky over the long term given their better economic conditions, according to James Dailey, portfolio manager of Team Asset Strategy Fund ( TEAMX).

"It is a question of time horizon. When the next crisis emerges, do we think emerging markets will be decoupled from developed markets? Probably not," said Dailey. "But emerging markets are in the middle of a stair step, whereas the developed markets are just oscillating. We are going up and down and going nowhere, kind of like a roller coaster ride. The emerging markets are like an escalator. There are some steps and some ups and downs but overall the trend is up."


Chad Deakins, portfolio manager of the $235 million RidgeWorth International Equity Fund ( STITX), thinks emerging markets will also benefit from the weak currency outlook in developed economies.

"We think the currency return to U.S.-based investors is going to be a big part of the total return from emerging markets for those investors," said Deakins. "The developed world will print money which will lower the value of those currencies relative to some of the emerging markets which have lower debt to GDP ratios, and don't need stimulus to have stronger GDP growth and better earnings growth."

Meanwhile the U.S. is also stepping up pressure on China to let its currency appreciate, as developed economies' exports are hurting from the "artificially low" value of the Yuan. Asian countries are also likely to encourage a rise in their currencies, as they battle raging inflation in food prices, according to Dailey.

( To listen to Dailey's views on why China will let its currency appreciate click on the audio button below.)

Here is a look at what countries and themes within emerging markets are expected to do well in the near future.

Which Emerging Market Will Outperform?

Indonesia has been among the highest performing markets in 2010, delivering a return of 40% in dollar terms. Philippines, Thailand, Malaysia and India have been other strong markets in the Asian region. In Latin America, Chile has topped returns, delivering 34% in 2010 on the back of strong demand for copper.

Valuations are at fair levels for most of these markets, and on parity with developed markets, when historically they have traded at a discount. Analysts say the valuations are, however, still not too expensive considering the relative strengths of these economies and their earnings potential.

James Dailey of Team Asset Strategy is most bullish on Latin America, especially on Brazil and Peru. "They have been running their countries with the lessons learned from the eighties and nineties and they have been very responsible stewards of their relative prosperity in recent years," he said.

( To learn more on what drives Latin America, click on the audio clip below for an excerpt from Dailey's interview with TheStreet.)

Australia may not be an emerging market but it stands to gain from the boom in China, says Deakins, whose fund has an 8% exposure to Down Under. "The Chinese economy has been one of export but is now turning into one of consumption. They are doing a lot of construction, buying lots of material and they need lots of food. These are two things that Australia has lots of ... they have land and lots of iron ore," he said.

While China looks poised to make a soft landing, the portfolio managers say better opportunities lie outside of China, according to Christian Wagner of Longview Capital Management. Wagner tends to focus on markets that have relative strengths vis-a-vis their regional indices. His top picks are India, Chile and Mexico.

Deakins, however, warns that investors should avoid focusing on countries alone, as they often have concentrated exposures. "The one big problem is a lot of emerging markets have very narrow markets. A lot of telecom, a lot of materials ... not really diversified domestic exposures. You've got to pick the stocks, not just pick the countries," he said.

Which emerging market do you think will outperform in the next year? Vote in our poll.

Which emerging market will outperform?

Brazil
China
Chile
India
Indonesia
Mexico
Russia
South Korea
Thailand

Top Sectors in Emerging Markets

Investors who seek more focused exposure to themes in emerging markets can consider investing in select sector ETFs, says Wagner.

Wagner likes consumer cyclicals within emerging markets. He also thinks Emerging Global's Emerging Markets Metals and Mining Titans ( EMT) would be an interesting way to gain exposure to metals and mining. For broad market exposures, he thinks PowerShares DWA EM Tech Leaders ( PIE) is one of the better ETF offerings, as it weights emerging markets on the basis of relative strength rather than by market cap or earnings.

RidgeWorth International Equity seeks a balance of domestic themes and cyclical in its emerging market exposure. It has an exposure to emerging market utility companies as well as cyclical sectors like metals and mining and automotives.

Commodities might also be a good way to play the growth story in emerging markets. Agricultural commodities have been soaring on supply shortages of grains. Forest fires in Russia have disrupted the wheat market. Base metals, cotton and crude oil are other commodities that emerging market experts are bullish on. In fact, Dailey says he prefers commodities to stocks from a risk-reward perspective.

"We feel there are added risks to playing the equities in various emerging markets whether they be currency, political geopolitical, tax and legal regimes," he said. "We feel we can get access to the same emerging market themes- demographics, economic growth- more efficiently and with better risk reward exposure in many of the commodity areas we are active in," he said.

An August report from Keefe, Bruyette and Woods also identified Asian financials as a sector for cautious investors looking for defensive plays. While Indian and Indonesian banks were growth oriented, they suffered from poor yields and valuations. A number of large-cap Chinese banks continue to be good defensive plays, despite recent capital raisings, because of their high dividend yields.

Near-Term Headline Risks

If you do decide to invest in emerging markets be prepared for wild shocks to your portfolio, warn experts, as further stress in Europe or fears of a double-dip continue to loom.

"There is lot of risk investing in emerging markets. There has been lot of equity issuance. Valuations are fair, but things tend to get overdone. he said. "And emerging markets always carry with them the political risk," he added, pointing to markets like Indonesia and Philippines which have outperformed this year but have had political instability.

Wagner believes one of the largest threats to emerging market performance in the near term could be unexpected strength in the dollar, as that would prompt a reversal of funds from emerging markets back to the U.S.

Markets such as India are tackling high inflation, which has already prompted five rate hikes by the Indian central banks in the past year. Deakins still believes food inflation could be a big risk. "One of the places we are seeing danger of inflation is in food costs ... a big component of the incomes of people in emerging markets. When we have high inflation for these staples, you are going to crowd out discretionary consumption which will hurt different segments of the market," he said.

Still with fair valuations, investors with a long-term horizon may be rewarded for their risk. "Globally with fixed income markets and interest rates where they are at ... fair values in economies and countries with appreciating currencies and fundamentals and demographics are far more attractive than buying 1% treasury bonds," said Dailey.

--Written by Shanthi Venkataraman in New York

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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