Emerging Markets: Tread Carefully

You'll find plenty of promise, but you'd better know when to buy--and when to bolt

Only a year ago, emerging markets were taking a beating. Asia seemed nowhere near struggling out of its fiscal crisis, and the Asian flu had infected Latin America. The coup de grace came in August, when Russia defaulted on a portion of its debt. At the first anniversary of the crisis, the world looks quite different. As a group, emerging markets have far outpaced many U.S. indexes lately, rising nearly 70% since last August. Some pundits say even more gains lie ahead. But these markets are not for the faint of heart. Although several Asian economies are on the mend and Latin America boasts cheap valuations, history has proved emerging economies' stock markets to be wildly erratic. Says Standard & Poor's Corp. senior analyst David C. Masters: "The nature of emerging markets is that they are highly volatile."

Indeed, unless you have the discipline to plunge in when markets are in crisis and bail out when they're back in favor, you're unlikely to make money in the long run. "Emerging markets force you to be a contrarian investor," says Joe Rooney, London-based global investment strategist at Lehman Brothers Inc. Being an active trader, of course, flies in the face of the advice of many emerging-market fund managers, who insist that investors need to ride out downturns and exercise patience. But a look at how emerging-market bourses have performed over the long term--and how investors have fared in emerging-market mutual funds--suggests that Rooney's opportunistic approach, rather than the conventional buy-and-hold, may be the wisest strategy.

For example, say you jumped aboard Templeton Developing Markets A, a respected pioneer among emerging-market funds, at the end of 1998. Through Aug. 30, you'd be up a tidy 25.34% in 1999, beating the Standard & Poor's 500-stock index by nearly 17 percentage points. But if you were a long-term investor in the fund, you'd be wondering why you'd ever bothered buying in. Its average annual return over the past three years has been a meager 0.05%, vs. 28.65% for the S&P. Over five years, its average annual return has been only 0.93%, 24 percentage points less than the U.S. index. If you adjust the fund's returns to highlight the extra risk in emerging markets' extreme volatility, the comparison grows even worse.

BIG DROP. You need to be a sharp-eyed trader in emerging markets partly because corporate fundamentals can be less important than local economic and political conditions. But even pros have gotten badly burned. Conservative investors have gotten the message that emerging markets are tough going. The amount of money flowing to such markets from pension funds and other institutional investors fell to $1.6 billion in 1998 from $3 billion in 1997, and to just $0.6 billion through this summer, according to Eager Manager Advisory Services, a firm in Louisville, Ky., that tracks institutional money flows.

More than ever, therefore, investors must be choosy. Although emerging markets in the past often moved as a group, they now increasingly chart their own courses. Widely varying economic programs and political agendas are dictating sharply different market performances. For example, even as some Latin American markets struggle with recession and political uncertainty, many Asian markets are rocketing higher. "International investors need to be more discriminating," says W. Travis Selmier II, a portfolio manager with USAA Investment Management Co., a San Antonio-based money-management firm serving U.S. military personnel.

Access to the emerging markets has gotten easier in the past several years. Many large companies list American depositary receipts on U.S. markets, and so-called global depositary receipts often trade on major European exchanges. For less widely traded stocks, investors need to contact specialist firms or brokers who can obtain shares for them in local markets. Of course, this may force you to put up with hassles, including currency conversion and corporate disclosure documents in local languages. An easier way is to buy shares in mutual funds that focus on emerging-market stocks. Matthews Korea Fund, for instance, is up 87.5% so far this year, mirroring the broad recovery in Asian markets.

For the coming year, at least, Asia continues to look like a smart bet, even though markets are not moving in sync. While South Korean stocks have soared on hopes that the government has finally stopped propping up the inefficient chaebol, political instability has clouded Indonesia's markets.

Sheila H. Coco, who manages institutional global equity accounts at Fiduciary Trust Co. in New York, thinks Asia, including China, should grow by 4% over the next year or so, with corporate earnings rising 15%. While high valuations in many Asian markets indicate "a lot of good news has already been factored in," Coco says, there still are companies that can "surprise you on the upside." She cites Development Bank of Singapore, which recently delivered higher-than-expected earnings for the first half.

CHINA PLAY. Even in upbeat markets, it pays to be picky. Worried that valuations of many Hong Kong stocks may be outstripping the tepid economy, some analysts urge investors to stick with companies tied to growth in mainland China. One example is Guangdong Kelon Electrical Holding Co., a refrigerator maker that boasts the top market share in China and is trading at just slightly more than its book value. "It's a play on middle-class consumption," says Angus J. Tulloch, an Edinburgh-based portfolio manager with the $4.8 billion mutual-fund partnership Babson-Stewart Ivory International.

Winning in the more volatile markets means keeping a close eye on local conditions. For example, some Indian stocks may seem like bargains--even after the market has soared this year. But India's worsening military tensions with Pakistan and its high fiscal deficits are prompting some pros to steer clear. By contrast, stocks in South Korea seem likely to keep surging despite saber-rattling by the North. Few analysts believe that Korea's problems with its neighbor will really threaten the reviving country.

Still, with growth just now accelerating, Korea's economic rebirth has a ways to go. Industrial production is rebounding at a 25% annual rate. But economist Robert M. McKee of London investment consultancy Independent Strategy argues the economy is still moving out of the deep trough of just over a year ago. As the economy builds momentum, companies that feed rising domestic demand or Western export markets--such as H&CB bank, Samsung Electronics, Pohang Iron & Steel, Korea Telecom, and Daeduck Electronics--are high on many money-manager lists.

LATIN BARGAINS. Even treacherous times can spell opportunities in some emerging markets. Much of Latin America, for instance, is mired in recession. The weakening of the U.S. dollar against the yen and euro is bad for Latin economies tied to the greenback. And widening spreads over U.S. Treasury bonds for emerging-market debt reflect increasing political uncertainty about the region. Ecuador recently announced it would postpone payment on its Brady bonds for 30 days. And in Venezuela, ultra-left-wing President Hugo Chavez is winning over voters to the idea that the country should defy the International Monetary Fund's recommendations for fiscal austerity.

But such factors are combining to make many Latin American stocks bargains. "Some of the values on these stocks are incredible," says Felicia Morrow, a portfolio manager with Emerging Markets Investors Corp. of Arlington, Va. Among her picks: Grupo Financiero Banorte, a well-run retail bank that is trading below book value because of general anxiety over Mexican bank management. She's also bullish on Masisa, a Chilean particle-board maker whose business is thriving but whose stock is trading at just 12 times expected 2000 earnings.

Now that the prices of many commodities are rising, some Latin American countries that depend on oil, gas, and various minerals should see their markets improve. Rising copper prices may help Chile overcome some of its toughest economic times in decades, for instance. So some money managers, betting on a recovery there, are high on bank stocks such as Banco Edwards and Banco Santiago, and retail plays, such as Distribucion y Servicio, a chain that is expected to thrive as consumption improves.

MATERIALS GAIN. Still, commodity prices aren't the only thing influencing stocks. While the South African market may be weighed down by the slide in gold prices, other factors are more important in tracking local stock performances. Furniture-maker Profurn Ltd., for one, is high on USAA money manager Selmier's list because it is aiming at lower- and middle-income consumers in growing parts of eastern and southern Africa. And Bernard R. Horn Jr., who runs global value fund Polaris Capital Management Inc., is thrilled at the cheapness of paper maker SAPY Ltd. and copper miner Palabor--both plays on what he considers to be an undervalued basic-materials sector.

During the cold war, the fortunes of Eastern and Central European countries depended on Russia, where political uncertainty is on the rise again amid a widening money-laundering scandal. But now, the region's economic ties are with Western Europe, where economies are recovering. That bodes well for the new euro bloc's fast-growing satellites. Elektrim, a Polish telecom company run by American Barbara Lundberg, is likely to gain as cellular-phone use grows in Poland--where fewer than 10% of the population have cell phones, compared with 30% in France. Another intriguing Polish play is the Orbis Hotels group, which holds the premier urban sites and dominates the hospitality market. And in Hungary, Babson-Stewart money manager Stuart W. Paul likes regional pharmaceutical supplier Gedeon Richter Ltd., the leading purveyor of generic drugs to the former East bloc.

For investors with a strong stomach for risk, improving peace prospects in the Middle East may mean lucrative opportunities. Israeli outfits such as ECI Telecom, a dynamo catering to the country's fast-growing communications sector, is exciting many money managers. And in Egypt, Paul is intrigued with Al-Ahram Beverages, a nonalcoholic beer and wine supplier that wants to cater to the entire Muslim world and is trading at only around 10 times next year's expected earnings. Beware of being seduced by such exotic little bargains, though. Emerging markets are full of companies with the potential to offer investors outsize rewards. But before you invest, remember that they also carry outsize risks.

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