Why to Buy Emerging Markets Now

Kiplinger

Thank goodness for emerging nations such as China, India and Brazil. By continuing to grow briskly, they kept the recession of 2007-09 and its immediate aftermath from turning into a global calamity. Now, however, emerging economies are slipping. In India, for example, inflation is higher than in any other large country, yields on ten-year government bonds have jumped to nearly 10%, the rupee has lost two-fifths of its value, and growth in gross domestic product has dropped from about 9% to half that. China's growth rate is down by one-fourth, and Brazilian economists estimate that their nation's GDP will increase by a puny 2.9% in 2013.

See Also: SPECIAL REPORT: Foreign Stocks and Emerging Markets

Investors who rushed into emerging markets for protection from the economic storms at home are now heading out again. During the summer, individual investors pulled $18 billion out of emerging-markets bond funds as interest rates rose and prices plummeted, and little guys and institutions alike are fleeing stocks.

To borrow an old joke, emerging markets have become submerging markets. So far in 2013, even as U.S., European and Japanese stocks have climbed sharply, iShares MSCI Emerging Markets (symbol EEM), an exchange-traded fund linked to a popular index for developing-market stocks, has lost 8.0%. Over the past three years, iShares S&P India Nifty 50 (INDY) lost 8.9% annualized. If you had put $10,000 into iShares MSCI Brazil Capped (EWZ) three years ago, your stake would be worth about $7,000 today; if you had put the same amount into Vanguard 500 Index (VFINX), which tracks shares of large U.S. firms, you would have $16,500 (all returns are as of September 6).

As a contrarian--that is, someone who seeks out-of-favor investments--all of this misery piques my interest. The best time to buy is when most investors are scared to death. Of course, you need to have con­fidence--in this case, that submerging markets will reemerge. I do.

Emerging markets are highly volatile. Sharp ups and downs are in their DNA. Data compiled by Morningstar shows that emerging-markets stocks are about 50% riskier than U.S. stocks. Nothing goes straight up, but when stocks from developing nations come down, they usually fall hard.

Volatility is the price you pay for higher returns. If an investment produces the same return year after year (as, say, a Treasury note does), then the return is typically modest. Low risk, low return. But if you endure the sickening declines inherent in a high-risk investment, you tend to get a higher average return in the long run. There's no guarantee for the future, but over the past decade, the Brazil ETF returned an annualized 16.7%, and Vanguard 500 Index returned an average of 7.0% per year. Buy at a time like this, when emerging markets are suffering, and you have a better chance of winning in the end.

Threats to prosperity. Emerging markets could, of course, be settling in for many years of decline. China's centralized control of the banking system, India's protectionism and Brazil's populism are certainly threats to economic growth. So is the new debt that both governments and businesses in such countries have issued in recent years, as lenders have stampeded to offer them cash. China's private-sector debt, for example, rose from 129% of the size of the economy in 2008 to 214% this June.

In my view, however, all of these economies--and the governments that steward them--are moving, in fits and starts, in the right direction, as are governments in Mexico, Indonesia, Malaysia, Chile and many other developing markets. In addition, businesses based in these countries are managed much better than they once were.

Also, emerging nations have advantages over developed countries. Most have plenty of young workers to support retirees, lack costly welfare systems that are difficult to reform and, despite recent increases in borrowing, carry low levels of government debt--partly because after the defaults of the 1990s, lenders were reluctant for a time to extend credit. The ratio of total government debt to GDP in Brazil and India is 65% and 68%, respectively. In both China and Indonesia the figure is 23%. The debt-to-GDP ratio in the U.S. is 102%.

Finally, emerging markets have a lot of people. China, India, Indonesia and Brazil are four of the world's five largest countries (the U.S. ranks third) and together account for roughly half the global population. Brazil's per-capita GDP is only about one-fourth that of the U.S.; China's is less than one-fifth. They have a long way to go.

So now, when developing markets are flat on their backs, is the time for contrarian investors to look closely at them. The easiest way to invest is to buy an ETF, such as iShares MSCI Emerging Markets, which charges 0.69% per year. (That expense ratio is high compared with the typical domestic ETF but lower than most actively managed emerging-markets funds.) Stocks from Asia account for 64% of the portfolio; Latin America, 16%; Eastern Europe, 8%; and Africa and the Middle East, the rest.

Among mutual funds, I like Vanguard Emerging Markets Stock Index (VEIEX), which tracks the FTSE Emerging index, and Harding Loevner Emerging Markets (HLEMX), an actively managed fund that has done a bit better over the long run. (The Harding Loevner fund is a member of the Kiplinger 25.) I slightly prefer the Vanguard fund because its annual expense ratio of 0.33% is less than one-fourth that of the Harding offering. The broad exposure to the global economy of the large-company stocks in such funds tends to dampen volatility, and they do own loads of stocks in real emerging markets, such as China, India and Brazil.

If you can absorb more risk, focus, in these dark days, on India. One of my favorite ETFs is EGShares India Consumer (INCO), linked to the Indxx India Consumer index. It holds firms that sell to the huge domestic market, including Zee Entertainment, a film- and TV-production firm; and United Breweries, India's largest beer purveyor.

Another way to get the most out of emerging markets is to invest in the stocks of small companies, which tend to have more of a local focus. Consider SPDR S&P Emerging Markets Small Cap (EWX), an ETF with an expense ratio of 0.65% and holdings such as China Everbright International, a developer of environmental projects, and Kroton Educacional, the third-largest for-profit education firm in Brazil.

Market Vectors Brazil Small-Cap (BRF) is an ETF whose top holding is another chain of post-secondary private schools, Brazil's Anhanguera Educacional Participacoes. It also owns Qualicorp, which offers insurance to unions and trade associations, and Marfrig Alimentos, a meat processor that is expanding to China.

I would stay away from individual stocks of small companies and emerging-markets bonds. Bonds, too, have been clobbered in 2013, but although risks are lower than for stocks, they are still too high for the potential rewards.

You can't time emerging markets any better than you can time domestic ones, but there's no doubt that it's better to buy when investors are heading for the exits. And that's just what they're doing.

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