Fund Managers Spy Emerging-Market Bargains

NEW YORK ( TheStreet) -- Investors have grown wary of emerging markets.

During the past year, diversified emerging-market funds lost 17.9%, while the S&P 500 gained 1.9%, according to Morningstar.

Part of the problem may be that growth is slowing in some big emerging countries, such as Brazil and China. In addition, investors worry that the crisis in Europe could hurt exports from Asia and Latin America.

But some fund managers argue that the fears are overdone. The bulls say that the earnings outlook for most emerging markets remains favorable, and that the securities look cheap.

Allan Conway, portfolio manager of Schroder Emerging Market Equity ( SEMNX), says that emerging-market stocks trade with a forward price-to-earnings ratio of 9, much less than the P/E of the S&P 500. He estimates that emerging-market earnings should grow 10% this year.

"That's not a bad outlook, especially in a year when you will have a recession in Europe and anemic growth in the U.S.," he says.

Though exporters could suffer from slowing sales to Europe, domestic companies are likely to generate surprisingly strong sales, says Arjun Divecha, portfolio manager of GMO Emerging Countries III ( GMCEX). In a white paper, he predicts that emerging-market consumers will go on a shopping spree in the next several years.

Divecha bases his case on past experience in emerging markets. He says that whenever countries have started to modernize, consumers initially reacted to growing incomes by saving as much as possible.

Families accumulated cash to cover medical emergencies and support elderly relatives. But once per capita GDP reached $3,000 to $10,000, countries began increasing medical services and pensions. In response, consumers raced to buy things that they never had before.

The shift to consumption has been especially dramatic in China. During the past decade, per capita GDP rose from $1,000 to $4,000. In response, auto sales rose from 1 million vehicles a year to more than 17 million.

Divecha says that half of all emerging markets are now in the sweet spot, shifting from saving to consuming.

Domestic sales will also get a boost from demographic changes in countries such as India and Mexico. A record number of young people are entering their earning years. To profit, Divecha suggests investing in such domestic sectors as financials, consumer staples and health care.

Even if Divecha's optimistic forecast proves correct, the emerging markets will remain volatile. The problem is that investors from the developed world are fickle.

When the global outlook improves, investors pour into small emerging markets, pushing up prices. Then, at the first sign of trouble, the outsiders dump their shares and head for home.

This occurred during the financial crisis. Throughout the downturn, the balance sheets of emerging markets remained in fine shape, but investors dumped the stocks. During the turmoil of 2008, emerging-market funds lost 54.4%, compared to a decline of 37.0% for the S&P 500. In 2009, investors regained their confidence, and emerging-market funds soared 73.8%.

To limit risk in emerging markets, consider a cautious fund that can benefit from growing consumer sales.

A solid choice is Virtus Emerging Markets Opportunities ( HEMZX). The fund focuses on dominant domestic businesses that can maintain high returns on equity for years.

The portfolio has 48% of assets in consumer stocks. Holdings include Wal-Mart de Mexico (WMMVF) and Baidu ( BIDU), a Chinese Internet company.

The steady approach has enabled the fund to excel in downturns. "When the market collapsed in 2008, our portfolio still had high single-digit earnings growth," says portfolio manager Peter Newell.

Another relatively cautious way to play the emerging markets is with bond funds.

Unlike the developed world, countries in Latin America and Asia have controlled their debt. That has enabled the bonds to thrive. During the past 10 years, emerging-market bond funds returned 12.8% annually, compared to 5.4% for the Barclays Capital Aggregate benchmark.

A steady choice is MFS Emerging Markets Debt ( MEDAX). The fund stays broadly diversified and avoids outsize bets on shaky issues. During the past 10 years, MFS has returned 12.3% annually, outdoing 73% of its peers.

Portfolio manager Matt Ryan argues that the outlook for emerging-market bonds remains strong. "A lot of these countries are running very tight fiscal accounts, and they are not issuing a lot of new debt," he says.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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

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