Emerging-Market Optimism: Are Things Different This Time?

By TOM PETRUNO

July 6, 1997 12 AM PT

Just about five years ago, it was very popular for financial columns like this one to suggest that foreign stocks belonged in every American investor’s portfolio.

“You’ve got to diversify overseas,” people were sternly advised. “The opportunities abroad are just too exciting to pass up.”

Well, let’s check the score of this game:

* Average annualized return for general U.S. stock funds, five years ended June 30: 17.5%.

* Average annualized return for international stock funds, same period: 12.5%.

* Average annualized return for emerging-market stock funds, same period: 11.7%.

The last number is particularly galling. What happened to the concept of higher risk equals higher return? Emerging-market investors took the risk over the last five years--but they weren’t rewarded with higher returns.

All of the above is important context for what’s happening this year. For the first time since 1993, there is real excitement among American investors over foreign stocks. Many overseas markets were red-hot in the first half of the year, racking up returns that topped even the stunning 19.5% advance in the blue-chip U.S. Standard & Poor’s 500 index.

And when foreign markets in general are hot, emerging markets usually are blazing. So it is this year. The Turkish stock market, for example, was up 90% in the first half, measured in the native currency. The Hungarian market rocketed 64%, Peru was up 51% and

the Indian market gained 38%. (Even if you couldn’t name a single stock that trades in those markets, wouldn’t it have been fun to brag at the office about how much money you made in Istanbul?)

There were some less dramatic returns, to be sure. But overall, for the roughly 65 emerging-market stock mutual funds available to U.S. investors, the average first-half return was 21%, fund tracker Lipper Analytical Services said.

That handily beat the 13% gain of the average general U.S. stock fund in the half.

The resurgence of emerging markets is stirring memories of 1993, the last great year for these markets. And not surprisingly, emerging-market analysts believe that momentum--and fundamentals--are on their side now.

“We see a tremendous amount of value in emerging markets,” says Vincent McBride, an analyst for the Warburg Pincus Emerging Markets fund in New York.

But given the disappointing results of the last five years--even including the huge gains of 1993--why think the next five years will be different? Indeed, some global stock pickers worry that the current emerging-market surge is just a short-term speculative burst, a prelude to another bust.

For the bulls, the case for emerging markets today relies on two basic premises. One is the attractive-by-default argument, which holds that the U.S. market is expensive and overextended, while many emerging markets are cheap and are early in their rallies.

On the face of it, that seems like a decent argument. The price-to-earnings ratio (P/E) of the average U.S. blue-chip stock now is a lofty 22, based on the last four quarters’ earnings. Among other major markets, Germany’s average P/E is 25, France’s is 24 and Canada’s is 23, according to Morgan Stanley Capital International.

In contrast, the average stock P/E is 15 in Brazil, India and Poland; 17 in Mexico; and just 11 in Turkey, Morgan Stanley figures.

Yet P/Es alone don’t tell you all you need to know about a market’s prospects. Higher-quality companies should merit higher P/Es--and America leads the world in high-quality companies. Moreover, a low P/E won’t guarantee protection from a downturn. Since 1994, each time the U.S. market has been slammed it has taken most foreign markets down with it.

The second basic premise for optimism about emerging-market returns over the next few years is a far sounder one: that these markets, and the underlying economies, have been and are in transition, and that the fundamentals are improving dramatically in terms of the countries’ ability to succeed in the global marketplace.

But the two major emerging-market regions--Latin America and Asia--are in different phases of this transition:

* Latin America has been the big winner this year, with the Brazilian market up 92%, Mexico up 38% and Argentina up 29%, after strong gains last year as well.

In effect, Latin America faced a major test in 1995 and ‘96, and passed it: After Mexico’s devastating currency devaluation in December 1994--a shock that was greatly responsible for emerging markets’ generally lousy performance in 1995, as global investors shied away from those stocks--the question was whether Mexico’s problems would trigger devaluation and economic ruin across Latin America.

Instead, major governments stuck to their programs of reform aimed at slashing inflation, privatizing inefficient state enterprises and opening their economies.

Most important, “they went through their transitions without social upheaval,” says Jean-Marie Eveillard, manager of the SoGen International fund in New York.

Mexico required a large U.S. loan (since repaid) to get through the worst of its economic suffering. But currency devaluation--the price Mexico paid for a surging trade deficit and misguided investments--has had one positive effect: It made Mexican products cheaper overseas, thus bolstering exports and sparking economic recovery.

Many emerging-market fund managers remain ebullient about Mexico and other Latin American markets, even after this year’s gains. Josephine Jimenez, co-manager of the Montgomery Emerging Markets fund in San Francisco, expects 25% to 30% profit growth from many of her Latin companies this year amid robust economic growth. Given the markets’ P/E ratios, she sees no reason to exit those stocks.

As for today’s Mexican elections--expected to bolster the opposition political parties--the outcome has already been cheered by the stock market, which hit a new high on Friday. “I think it’s a good sign for progress on [Mexico’s] road to democracy,” Jimenez says.

* Asia’s transition, by contrast, is in a much earlier stage. After riding high in the 1980s and early 1990s on the back of export growth, particularly electronics, the region now is challenged by the stronger dollar (which makes Asian exports more expensive, since many of the countries tie their currencies to the dollar); overbuilding funded by what had been easy money; and country-specific problems, such as labor unrest in South Korea.

Thailand has become the symbol of emerging-Asia’s troubles: The country last week was forced to devalue its currency, a la Mexico 1994, as speculators drove it lower, reacting to the Thai economy’s deepening trade deficit and unfolding real estate bust. Some fear Malaysia could follow.

But is the glass half full or half empty? Thai stocks, down 50% over the last year, rallied 25% last week, as some investors sensed that the government has finally bitten the bullet. Also, the battered Korean market has zoomed since March; even as corporate bankruptcies rise, the nation’s trade picture has been improving.

Morgan Stanley analyst Robert Pelosky argues that Latin America has benefited immensely from the private- and public-sector restructurings forced on it by global economic realities since 1993. Now, he says, “it seems that Asian policymakers, executives and investors may be starting to come to grips with the need to do the same.”

How soon that might lead to a resurgence among emerging-Asia’s once star economies isn’t clear. But some fund managers aren’t waiting to buy in. Warburg Pincus’ McBride, for example, argues that Korean stocks already “are ridiculously cheap on any valuation basis.”

Likewise, with Indian stocks at a relatively low average P/E and interest rates there falling, “from a stock picker’s point of view we see a great market,” McBride says.

The key point is, the investment opportunities abroad are only multiplying with the increasingly open global economy. That means opportunity for failure as well as success. But if one ingredient of successful investing is buying when things are relatively cheap, there is more potential to do that in many emerging markets today than in the developed world.

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Emerging Markets’ Long Drought

Emerging-market stock mutual funds are beating U.S. stock funds this year after three years of dismal returns that followed the 1993 bull market surge overseas. Average returns by category, annually and in first-half 1997:

1992

Emerging-market funds: 0.3%

General U.S. funds: 8.9%

1993

Emerging-market funds: 72.2%

General U.S. funds: 12.5%

1994

Emerging-market funds: -9.6%

General U.S. funds: -1.7%

1995

Emerging-market funds: -3.7%

General U.S. funds: 31.1%

1996

Emerging-market funds: 12.5%

General U.S. funds: 19.5%

1997

Emerging-market funds: 21%

General U.S. funds: 13%

Sources: Emerging-market fund returns from 1992 to 1996 are from Morningstar; 1997 figure and general U.S. fund returns are from Lipper Analytical Services.

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A Fund Sampler

There are three simple ways to invest in emerging-market stocks: buy shares of major emerging-market companies that trade in U.S. markets; buy shares of closed-end country funds, which are 17023885841635000424 *

Bernstein Emerg. Mkts. Value; [(212)-756-4097] (NL)* +2.5% +7.1% +11.5%

Total returns

1995: +2.5%

1996: +7.1%

1997**: +11.5%

Fidelity Emerg. Mkts.; [(800)-544-8888] -3.2% +10.0% -2.3% Total returns

1995: -3.2%

1996: +10.0%

1997**: -2.3%

Lazard Emerg. Mkts.; [(800)-228-0203] (NL) -5.9% +23.6% +21.1% Total returns

1995: -5.9%

1996: +23.6%