Investors grab for growth in emerging markets

After being written off as an asset class just a few short months ago, emerging-markets equities are back.

And what a turnaround it's been.

The Morgan Stanley Capital International Emerging Markets Index fell a whopping 53.2% last year, its worst year ever. But from March 10, the day after the broad U.S. markets closed at their lows, through last Tuesday, when emerging markets began to correct, the index had gained 63.94%, according to Morningstar Inc. of Chicago.

That compares with a total return of 40.42% for the Standard & Poor's 500 stock index since early March.

The sizzling run in developing-country stocks is, for better or worse, attracting investors — although some warn that equating a fast-growing economy with market growth is a fallacy and that the enticing returns are likely to entrap “performance-chasing rubes.”

Morningstar estimates that a net $1.6 billion flowed into emerging-markets funds year-to-date through April.

Last year, investors yanked an estimated $13.7 billion more from emerging-markets funds than they put in.

“Part of [the run-up] is because [emerging markets] fell so far” during the downturn, said William Rocco, a senior analyst at Morningstar. “Areas that did the worst from 2007 through [March] 2009 have done the best since.”

“Look at how much [emerging markets] have gone down,” said Jeremy Siegel, professor of finance at The Wharton School of the University of Pennsylvania in Philadelphia.

“The Shanghai Composite Index, from top [in late 2007] to bottom [early this year], fell 72%,” he said.

“I'm pretty positive about emerging markets now,” except for Russia, Mr. Siegel added.

The low valuations for hard-hit emerging-markets equities, the apparent beginning of economic recovery in the United States and more investor appetite for risk are all helping to drive emerging markets upward, Mr. Rocco said.

“The general understanding is that those [emerging] countries are better financed than the last time we had a big contagion in the 1990s,” said Barry Mendelson, managing partner at Capital Market Consultants LLC, a Milwaukee-based provider of managed-account platforms and money manager due diligence.

This time around, missteps by developed countries caused the financial crisis, and developing markets now seem poised to run with the help of some good news from the developed world.

“The people doing the buying [of emerging-markets stocks] think the worst is over, that the stimulus plans will do some good and that a U.S. recovery is good for the world,” Mr. Rocco said.

What's more, many observers expect to see slower-than-average economic growth in developed nations as those countries work to cut debt levels. That's put the focus on emerging markets as prime areas for growth.

“It's still clear that the real growth will be in the developing world, particularly in Asia,” where both consumers and governments have stronger balance sheets than the developed world, Mr. Rocco said.

NEGATIVE CORRELATION

But there's a problem in relying on fast-growing economies to produce stock market gains: Economic growth doesn't always correlate with equity market performance.

“There is a negative correlation between [economic] growth and security returns” that is still not widely understood, said William Bernstein, a market historian and founder of Efficient Frontier Advisors LLC in Eastford, Conn., which manages $116 million.

“In the very long run, there is [a negative correlation],” added Mr. Siegel, who has researched the phenomenon. In the short run, markets in fast-growing economies can do better than slower-growing markets, he said. “But what happens is that they ultimately become overvalued,” Mr. Siegel said.

There is “ample evidence” that unexpected changes in economic growth affect stock prices, according to a 2005 research paper written by Jay Ritter, a professor of finance at the University of Florida in Gainesville.

But those new expectations are quickly incorporated into prices.

“Investors have a tendency to apply a high price-to-earnings ratio to a country [that is] expected to have high long-run growth,” Mr. Ritter wrote in an e-mail.

If the P/E of a country is too high, though, investors are likely to reap low returns even if the country grows rapidly, he wrote.

Investors who simply buy and hold in a market such as China, for example, are taking a big risk, Mr. Siegel said.

The idea of staking a claim in a promising market “sounds good,” said Mr. Siegel, who finished his thought by audibly knocking on wood.

He and Mr. Ritter said that aggregate economic growth doesn't translate into earnings growth for individual companies, because corporations must issue more shares and borrow money to finance their growth — essentially diluting any gain from a growing economy.

“GDP growth doesn't always translate to higher earnings growth,” said Todd Henry, a specialist in emerging-markets-equity portfolios at T. Rowe Price Group Inc. in Baltimore, “but prior to the crash, earnings growth was better in emerging markets.”

“INTENSE BURSTS’

Meanwhile, observers urge caution in chasing returns from the developing world.

Emerging markets, when they become undervalued, produce “in-tense bursts of positive returns,” Mr. Bernstein said. But those enticing returns more often than not simply entrap “performance-chasing rubes,” he said.

“We think that on a valuation basis, emerging markets are pretty fairly valued,” said Brian Kazanchy, chairman of the investment committee at RegentAtlantic Capital LLC in Morristown, N.J., which manages about $1.5 billion.

The P/E of emerging markets, based on current prices and the past 10 years' worth of earnings, is about 17, he said. “Ten is really cheap, and 20 is expensive, so they're getting toward the expensive side.”

RegentAtlantic, which normally allocates about 12% of client equity exposure to emerging markets, overweighted the sector last November but recently has been trimming back, Mr. Kazanchy said.

E-mail Dan Jamieson at [email protected].