Emerging Markets: Dipping A Toe In The Risk Pool

The safest way to invest: Focus on companies that serve rising middle classes in maturing economies

Lima, Ho Chi Minhcity, Casablanca, Zagreb: exotic locales whose stock markets delivered equally exotic returns in 2006. Before you consider plowing your kid's college fund into these sizzling bourses, though, bear in mind that the developing world's highfliers are often small, illiquid, and highly volatile. After a 175% run-up in 2005, Dubai plunged by 44% in 2006. And Vietnam may be up 136% this year. But between April and July, it fell by 35%. Its market capitalization, meanwhile, is all of $5 billion--or about the size of a U.S. mid-cap company.

While any emerging market could plummet in the coming year, for investors with a good stomach for risk and a focus on the long haul, maturing countries such as China and India offer better opportunities than ever. And it's getting easier to invest in them, thanks to a surge in developing country funds and overseas companies that also trade in New York or London. "Emerging markets hold strong potential not only for this year but over a few decades," says Carlos Asilis, a fund manager at New York-based VegaPlus Capital Partners.

Fans of developing markets point to substantial macroeconomic reforms. Burned by the economic crises of the 1990s, countries such as Thailand and Mexico have adopted floating exchange rates. Russia and Brazil, once deadbeat borrowers, now run trade surpluses and have built up sizable reserves.

Globalization too, has changed the way people look at emerging markets. In the past their fortunes were often tethered to the whims of U.S. consumers. Today, China has become an important growth engine whose insatiable demand for minerals and oil has fueled the bourses in Peru and Venezuela. What's more, developing world companies such as Russian mobile carrier VimpelCom (VIP ), Indian outsourcing shop Wipro, and Brazilian aircraft maker Embraer are all world-class. "The distinction between emerging and developed markets has blurred," says Mark Dow, a manager at New York hedge fund Pharo Management.

Many experts say the best way to capitalize on emerging economies is to focus on companies that serve their burgeoning middle classes. As salaries in developing countries rise, more consumers will want bank loans, cell phones, flat panel TVs, and more. Retail investors would do well to put as much as 10% of their portfolio into developing markets where "the demographics are very supportive of future growth," says Kurt A. Umbarger, an emerging markets specialist at T. Rowe Price (TROW ) in Baltimore. He is particularly keen on China and has been loading up on Ping An Insurance and Industrial and Commercial Bank of China.

To be sure, emerging markets can be a white-knuckle ride. But by focusing on star performers in bigger countries with sensible economic policies, patient investors may do very well indeed.

By Frederik Balfour

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