2 Funds To Capture Emerging Market Growth

Just a decade ago, you could throw a dart at the field of emerging market stocks for double-digit gains. Strong economic growth in the Brazil, Russia, India and China, which are considered the four dominant emerging markets, was augmented by a commodity boom, which helped resource exporters throughout the world.

Even after the United States housing bubble burst, emerging markets rebounded more quickly than developed markets. The iShares MSCI Emerging Markets (NYSE: EEM) outperformed both the S&P 500 and the Vanguard FTSE Europe ETF (NYSE: VGK) by more than 32% over the two years to March 2011.

#-ad_banner-#‚ÄčBut that’s about when the music stopped. Slowing growth in China and economic stagnation in Europe has weighed on commodity prices and the recent selloff in crude oil has been the final straw for many emerging markets.

Those that failed to use the good times to diversify their economy have seen the worst of the drop. Shares of the iShares MSCI Brazil Capped ETF (NYSE: EWZ) have plunged more than 20% over the last year on lower oil revenues and a higher government deficit. The iShares MSCI Chile Capped ETF (NYSE: ECH) has fallen a relatively benign 7% over the same period.

Despite weakness over the last several years, is there a longer-term picture to the emerging markets story? Can investors still book solid returns as the developing markets play catch-up to the rest of the world?

The answer to both is yes, but only if you are willing to step off the beaten path of funds that focus squarely on the BRIC nations, a common acronym for the four countries mentioned above.

Could The Emerging Market Theme Return?
Nearly a decade ago, The Economist summarized the then-prevailing view for investors: “Emerging economies are booming. In 2007, they are expected to grow nearly four times as fast as developed ones.”

The article featured a graphic depicting the recent strong gains and then-current valuations for leading emerging markets. Brazilian shares, for example, had risen nearly 900% over the prior five years. Despite strong gains, only four of the 15 markets highlighted were more expensive than the U.S. market on a forward basis.

While economic growth in Brazil has slowed from 6.1% in 2007 to expectations for just 0.3% this year, other economies have continued to outperform. The economies of Colombia and Poland slowed from growth of 6.9% and 7.2% in to 2007, but are still expected to book 3.8% and 3.2% growth this year, respectively. Even these muted expectations would be more than three times the 1.1% growth expected in the eurozone for 2015.

Growth has indeed slowed, but it is investor enthusiasm that has really caused the weakness in emerging market funds over the last few years. Strong growth in the United States and economic uncertainty abroad has led to a rush back to the perceived safety of U.S. stocks.

While the S&P 500 is trading well above its average historical price-to-earnings ratio, or P/E, the EEM trades for 13 times trailing earnings, a clear discount to its historical average of 15.5 times earnings.

Over the long term, emerging market growth should outperform that of the developed world, thanks in large part to technological progress. A 2013 report by the World Bank estimates that the middle-class in Latin America increased by 50% over the previous decade and now comprises 200 million people, or 30% of the population. That’s the second largest proportion among developing regions after Eastern Europe.

A near-term catalyst for growth could be stronger exports on the recent surge in the dollar. Weaker currencies relative to the dollar and Yuan make exported goods cheaper to sell in the United States and China. Emerging markets could also get a boost if monetary policies in Europe lead to stronger economic growth, something that is already looking likely.

Not All Funds Created Equal
While the broad emerging market funds may do well if investors return to the general theme, stronger returns may be found targeting higher growth regions.

In January, I warned investors about the challenges facing the BRIC countries and suggested a pairs trade, buying the Market Vectors Russia ETF (NYSE: RSX), while shorting the iShares MSCI Brazil Capped (NYSE: EWZ).Since my recommendation, the Russian fund rebounded 27% and Brazil dropped 1%, which brings the trade’s total return to 28%.

Singular exposure to Russia may no longer be a safe bet, even against the fact that Russian stocks still appear relatively cheap. The economy is expected to shrink 2.9% this year and frosty relations with Western governments show no sign of thawing. The iShares MSCI Emerging Markets Eastern Europe (NYSE: ESR), which holds 32% of assets in shares of companies from Poland, Hungary and the Czech Republic offers a more diversified approach to the region.

A weight of 67% in shares of Russian stocks means the fund is still heavily exposed to Russia, but 23% of assets are in a liquid U.S. Treasury fund and ready to be deployed when regional economics improve. The fund trades for an extremely cheap seven times earnings and pays a 3.4% dividend yield.

Economic weakness in Russia will weigh on the shares, but my target of $23.30 per share (representing 16% upside) is based on 2.5% blended earnings growth and a P/E ratio of 8.

Despite weak expectations for Brazil, I like the Latin American region over the long-term. Even in a period of weak commodity prices; Mexico, Chile, Colombia and Peru are expected to book GDP growth of between 2.8% and 4% this year.

Brazil still accounts for 49% of the iShares Latin America 40 (NYSE: ILF), but the rest of the assets offer the opportunity to profit from growth across Mexico (33%), Chile (11%), Peru (4.5%) and Colombia (2.2%). Holding shares of the fund means you get the diversification and near-term growth from the 50% of assets in regional markets, while still being able to profit from an eventual rebound in Brazil. Using 2015 growth forecasts and weightings in the fund, the region will grow by 1.8% this year and jump 3% higher next year.

Regional growth under 2% is not something I would normally get excited about, but stronger growth is expected next year, and that could bring investor sentiment back quickly. The fund trades for a relatively inexpensive 13 times trailing earnings of companies in the portfolio and pays a 2.5% dividend yield. My one-year target for the fund is $37.25 (a projected 14% gain), based on a 6% earnings growth in the region and a P/E ratio of 14 times.  

Risks To Consider: Economic growth in China will still correlate highly with gains in emerging markets. While the Chinese government has taken steps recently to jumpstart faster growth, slowing economic activity could present a headwind to some countries.

Action To Take –> Select emerging markets present the opportunity for strong returns, thanks to a combination of low valuations and long-term economic growth prospects. Diversify your exposure with two funds across two regions to benefit from long-term upside.

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