As we close the books on 2013, one clear theme has emerged. Investors have flocked to developed economies and shunned emerging markets. The S&P 500 Index is on track for a nearly 30% gain this year, but many emerging markets have tumbled by double digits.
That kind of massive performance gap only emerges every decade or so, and for farsighted investors willing to look past near-term headwinds, emerging markets now represent tremendous relative value.
You don't need to tell that to the executives at major U.S. companies. They already know that emerging markets have generated -- and will continue to generate -- robust growth rates, thanks in large part to ever-rising middle classes. While developed economies are growing at a 2% pace, emerging-market economies are growing at a 4% to 5% pace. Asian emerging markets are rising an even more impressive 6%, according the International Monetary Fund (IMF).
The key takeaway: Even if you're wary of investing in volatile emerging markets directly, you can focus on the U.S. companies that are positioned to derive a rising level of sales and profits in these countries.
Thankfully, the strategists at Citigroup have already done the heavy lifting. In a recent report, Citi's Tobias Levkovich took a look at companies that already derive more than 20% of their revenue from emerging markets. These companies have invested millions of dollars to establish market dominance in these economies, and their first-mover advantage will reap rewards well into the future.
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Which Industries Aren't Keeping Pace?
Levkovich has grouped these companies together in a portfolio he calls EMX, and not surprisingly, emerging-market exposure hasn't helped these stocks in 2013. The EMX basket has underperformed the S&P 500 by roughly 5 percentage points. Investors may be focusing on the fact that economic headwinds in 2013 are dampening the near-term financial performance for these companies.
The EMX portfolio holds a basket of 51 stocks, though I am most interested in the stocks that have notably underperformed the S&P 500 this year. Here are the EMX stocks that are up less than 10% in 2013.
You'll note that a number of these companies are in the energy services or exploration industries. The past year has been marked by regional challenges (in Libya and elsewhere) along with more restrained capital spending by major oil companies.
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Looking at other industries, it's interesting to note the relatively weak gains for Baxter International (NYSE: BAX), a global leader in intravenous supplies, dialysis equipment and plasma-based drugs. Over the past eight years, Baxter's sales and operating profits have never fallen. And that has fueled a 20% average annual increase in the company's dividend, which now yields roughly 3%.
So why is this stock lagging behind the broader market? The company's rock-solid hemophilia drug franchise is coming under pressure from Biogen Idec (Nasdaq: BIIB), which is expected to take some market share in 2014. Still, despite that challenge, Baxter's total sales are expected to grow more than 10% in 2014. Merrill Lynch, which has an $82 price target (which represents 20% upside), thinks "the core markets Baxter's bioscience business competes in have attractive fundamentals that should sustain mid-single-digit growth over the long term." The impressive emerging-markets exposure is part of that forecast.
The Mining Slump
Many emerging-market economies have felt the pressure of falling commodity prices. The copper-heavy markets of Peru and Chile, for example, are off more than 20% this year. And companies that sell mining equipment have felt the pain as well. Shares of industrial tire maker Titan International (NYSE: TWI) have trailed the S&P by more than 40 percentage points, while Caterpillar (NYSE: CAT) and Joy Global (NYSE: JOY) have also badly underperformed the benchmark index.
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I discussed the near-term challenges and long-term potential for mining equipment maker Joy Global in a recent column. Although shares have rebounded roughly 10% since then, they are still extremely cheap in the context of longer-term profits.
To be sure, the fiscal year that began last month will be a tough one: The company sees sales falling more than 20% (to around $3.6 to $3.8 billion) and EPS dropping to the $3 to $3.50 range . But it's important to remember that Joy Global earned more than $7 a share in fiscal 2012 and will likely earn again at that rate when commodity production rebounds. The good news: Mining equipment wears out, and as miners hold off on discretionary spending in the year ahead, that will simply boost demand down the road as a pent-up replacement cycle kicks in.
Risks to Consider: With such hefty exposure to emerging markets, these stocks would likely continue to underperform the S&P 500 if the global economic slowdown deepens.
Action to Take --> Whenever you are looking at emerging markets, you must take the long view. Not only are the stocks exposed to these markets more volatile, but history shows that they offer the best opportunities when near-term economic expectations are low. That's surely the case right now, despite the fact that such economies still hold the most robust long-term growth potential.