A Whole New World of Tempting Plays

Investors have spent four years ignoring emerging markets. Pioneer Investments' Mark Madden thinks the time is ripe to take another look

By Amey Stone

Most mutual-fund investors have given up on emerging-markets funds -- and with good reason. The category had some great years in the late '80s and early '90s, but when currency devaluations rippled through developing economies in 1997 and 1998, the gains evaporated. A 1999 recovery proved all too brief: Once economic conditions in Europe and the U.S. slowed in 2000 and 2001, most of these funds again lost money. For the past five years, investors would have lost an average of 5% a year in a typical emerging-markets fund while coping with bone-jarring volatility.

Yet for investors with an appetite for risk, there are some good reasons to take another look at the sector, says Mark Madden, managing director of Pioneer Investments' Global Emerging Markets division. The lead portfolio manager of Pioneer Emerging Markets (PBEFX ) -- up 12% in the last three months -- is convinced that the sector is about to embark on a prolonged rally that will see it dramatically outperform U.S. markets. Madden has been managing the fund, which has $200 million in assets, since its inception in 1994.

You'll still get a lot of volatility, he warns, but he expects it to be "upside volatility," meaning that the price swings will result in higher returns, rather than the kind of "downside volatility" that has been driving down U.S. technology stocks over the past two years. "Emerging markets are under-owned," he says. "The '97-'98 crisis caused most investors to flee, and that money never really came back."


  Madden is pounding the table because he believes that current global economic conditions are a good combination for fueling growth in emerging markets. With the U.S. economy beginning what looks to be a modest recovery, he expects gross domestic product to grow only 1% to 2% a year, starting in 2003. That will keep the pressure on U.S. companies to cut costs. As a result, he believes many will outsource more services and buy more goods from parts of the world where overheads are lower. That should benefit developing nations and companies that do a lot of exporting. "You'll get a double-barreled positive effect in the next up cycle," says Madden.

Also, emerging markets are free of many of the pitfalls that plague U.S. investors today. For one thing, stocks are cheap. The price-earnings (p-e) ratio of the benchmark MSCI Emerging Markets Free Index is only 14.6 while U.S. stocks have an average p-e of 33, according to Madden. More significantly, he says, the price-to-cash-flow ratio of emerging markets is 7.9 vs. 16 for U.S. stocks. Madden says his team pays more attention to cash flow, since such data are a lot more difficult to manipulate than earnings numbers.

Unlike what has happened in the U.S., where investors have been blindsided by the downfall of Enron and fears of accounting abuses, emerging markets are rife with slipshod corporate reporting, even outright fraud. That means analysts are accustomed to doing lots of independent research to verify the story a company puts forth. "In emerging markets, we know that accounting can be an issue and so pay a lot of attention to it," says Madden. In the U.S., he says, "Professional investors got pretty sloppy."


  Pioneer Emerging Markets has had above-average returns for its group -- particularly lately. Fund-research outfit Morningstar ranks it in the top third of funds in its category for one-month (up 3.5%), year-to-date (up 5.7%), and five-year (down 4.5%) periods. Morningstar analyst William Samuel Rocco says Madden is more adventurous than some of the other funds in the group, so returns are more volatile. When Madden's analysis is right, the fund soars. When he's wrong, his mistakes can sting. "While it has been more volatile than most of its rivals, it remains one of the best options in its wild group," Rocco wrote in an October, 2001, report on the fund.

Madden first analyzes macroeconomic and political conditions to decide which countries to emphasize in the fund. Today, he has made Asia, Central Europe, and the Middle East his biggest bets. He's maintaining only minimal exposure to Latin America, in part because he believes Argentina's problems may worsen. His fund has long been light on Argentina, where he says the economy has been a "slow-moving train wreck." The largest country weightings in the fund are 14% in South Korea, 12% in Taiwan, 10% in Hong Kong/China, 10% in India, and 7% in South Africa.

After deciding which regions to emphasize, Madden and his team pick stocks by looking for names that are cheap and where there is the prospect of a catalyst in the next 6 months to 12 months that could see other investors jump in. For example, he thinks the currently low-priced stocks of some companies in Indonesia will benefit from the economic and military aid that the country is likely to receive to help it deal with the threat of terrorism from Islamic fundamentalists. While he usually buys the foreign shares since they tend to be cheaper, some stocks he likes that trade on U.S. markets include inexpensive telecom plays Korea Telecom (KTC ) and Indonesia's PT Telekomunikasi (TLK ). He also likes Brazil's Aracruz Celulose (ARA ) a low-cost paper producer, which is trading at only 11 times projected 2003 earnings.


  In an effort to protect investors from blow-ups in any one company, industry, or country, the fund stays broadly diversified and invests across about 30 countries, in 20 sectors, with around 150 stocks. "Even if you really love a stock, you need to really contain yourself," says Madden, who has a six-member team of analysts reporting to him from Asia, Latin America, Europe, and the Middle East.

Emerging-markets investing is still a risky proposition, and turnover in Madden's fund is high. But investors who have been confronted of late with more volatility than they bargained for in U.S. blue chips might find that a small stake in an emerging-markets fund is a try. If he's right, exposure to the sector could give their portfolios a nice boost. And even if emerging markets don't improve, given the past five years' performance, investors won't be able to say that they didn't know what they were getting into.

Stone covers the markets for BusinessWeek Online. Follow the Mutual Fund Maven column, only on BusinessWeek Online

Edited by Patricia O'Connell

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