Focus On: Emerging Markets

December 1, 2006

(Published 12/01/06) There are two ways to invest in emerging market funds. One is to choose a small allocation and stick with it through booms and busts. As these fluctuations will sometimes occur opposite the other investments, investors may experience a lower overall risk. With a buy and hold strategy, investors should rebalance after big market moves to maintain their small – say, 5% to 10% – emerging market allocation.

The other way is to invest a bit more than this permanent allocation, but only after significant weakness in emerging markets and widespread fear of crisis by investors occurs (i.e., when prices are dirt cheap). Such an active strategy would require lightening up after a big run-up in emerging markets (such as we did in our portfolios in recent years). This means a 20% allocation after an emerging market slide, lowered to perhaps 5% after significant gains.

We’re following the second plan – invest when down, and lighten (even to 0%) when up. However, there is nothing wrong with the first method for investors who don't have the time or the expertise to be active investors.

Sadly, too many investors follow plan 9 (from outer space) – they load up on emerging markets funds after a big 3-5 year run, only to get slammed by the eventual hit these markets will take. Then they sell low. We know this happens because funds in this category often have tax loss carry forwards on the books – ghosts of bad investments by investors.

We can tell we're probably near a market peak when all the past losses on the books of old emerging market funds are gone. Today, the Vanguard Emerging Market Index fund (VEIEX) – one of the largest (started in 1994) and a favorite here – has almost no capital gains on the books, even after a 5-year average ANNUALIZED return of 23%. That's one of the best performing funds in recent years, and as a group, shareholders haven’t made a dime. That should give you an idea of how badly fund investors time their buying and selling of emerging market funds. (Not to brag, but our other fund favorites in this category have beaten even this top–performing, low-fee emerging market index fund, and the bulk of all emerging market funds since we added them as favorites).

Investor activity is a good way to gauge optimism – tracking what they’re buying and what they’re selling. This is our primary gauge of investment opportunity. Another is fund company launch dates. Check the inception date of most emerging market funds and you’ll see they were launched in the early 1990s – around the time of big run-ups in emerging markets, and right before a big slide.

Another useful indicator is relative valuations across investment categories.

If junk bonds (high yield bonds) are in favor with investors, prices generally run high relative to other bonds. This means a low quality corporate bond might pay just 2% more than an ultra safe U.S. government bond. In times of investor fear of default, junk bonds can pay 4% or more than U.S. government bonds. We had larger allocations to junk bond funds in our model portfolios in the “Enron” days a few years back when these fear premiums were more pronounced.

Emerging market stocks currently trade at a discount of roughly10-15% to the valuations of “emerged” stocks like you find in the U.S. In other words, a beverage company in Brazil may trade at 15 times earnings, while Coca-Cola (KO) trades at 17 times earnings.

Clearly, Coke is a safer investment. The company is based in the U.S. and has global operations. As far as any single stock goes, Coke is relatively low-risk. The chances of currency fluctuations, accounting shenanigans, or political risks destroying your investment in Coke are small.

The Governor of Georgia isn’t going to nationalize Coke. Their core product is safer than most products from the risk of competitors guzzling their market share, and most people that drink Coke can afford to – regardless of where the economy goes. Investors can relax…and enjoy Coke. They’ll even collect dividends along the way. Unlike bank CDs, the dividends will even likely go up over time.

By comparison, a company located in an emerging market is chock full of extra risks. How much cheaper investors expect to get emerging market stocks as a whole is a good indication of how enthusiastic they are about investing in emerging markets in general. Scared investors would expect a big discount. You want to invest where investors are scared to go without major incentives in the form of cheaper stocks.

Just a few years ago, before most emerging market stocks went up 2x, 3x, even 4x or more, emerging market stocks were trading at big discounts to U.S. stocks – 50% or more typically, or 10x earnings compared to 20x earnings in the U.S. Not anymore. Returns have been exceptional because there has been valuation expansion (now stocks trade at higher multiples of earnings) AND earnings have grown faster than safer stocks. This is the double whammy that leads to huge investor returns – it’s exactly what drove tech stocks in the late 1990s.

Rather than considering the risks in emerging markets, investors today are more focused on great opportunities. Unlike in the U.S., economic growth in many emerging markets seems boundless. The worldwide commodity boom has been particularly lucrative for many emerging markets that rely heavily on commodity exports.

But there is always a good reason why an investment can continue to go up. The investment went up largely due to these reasons in the first place. In fact, those reasons seem more sound the better the past performance – the ultimate legitimizer of investor theories (…these numbers don’t lie…).

This current optimism is why future returns will be sub-par going forward. Current optimism is not quite as wild as it was in the last emerging market craze – the early 1990s. Back then, emerging market stocks were actually trading at HIGHER valuations than U.S. stocks. From those levels investors in U.S. stocks did very well, and investors in emerging markets fared poorly. Some emerging market funds are only now getting back to those boom 1993 levels. The difference was about as extreme as it has been in the last five years, as the Dow struggled to get back to year 2000 levels and emerging markets posted double digit gains year after year.

It’s possible that the action in emerging markets will continue a little longer. We’ve already shortchanged the emerging market move and bailed out a little too early. Maybe we’ll return to early 1990s valuations and U.S. stocks will be cheaper than emerging markets. However, we don’t play the hope-for-valuation-expansion-to-save-us game.

Category Rating: (Least Attractive) - should underperform the market and 80% of stock fund categories over the next 1 to 3 years

Previous Rating (12/31/05): (Weak) – should underperform the market and 60% of stock fund categories

Expected 12-month return: -8% (lowered from -7% in our last favorite fund report)

1. SSgA Emerging Markets (SSEMX) 9/02 209.90% 145.86% -2.93% 45.08%
2. Excelsior Emerg Mkts (UMEMX) 9/02 217.43% 153.39% -5.09% 37.90%
3. Vanguard Emerging Markt Indx (VEIEX) 9/01 224.45% 194.02% -3.20% 37.89%
4. Bernstein Emerging Markets (SNEMX) 9/02 270.69% 206.65% -3.26% 36.36%