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When I review each of the world's emerging markets in order to decide which ones to buy in 2011, I start with two questions:

  • Is the market cheap?
  • And has it under-performed over the past year?

If the answer is "yes" for both those questions, that market is much more likely to get my vote. But with every rule, there are also exceptions. As we will see.

The Art of Emerging Markets Investing

When you're choosing which emerging markets to invest in, it's important to keep this one precept in mind: With markets - even more so than for individual stocks - buying what's fashionable and overpriced (in other words, what's "hot") can be hazardous to your wealth.

The reason for this is fairly obvious. Most investors who buy emerging-market stocks don't have a good handle on the political and economic risks of the country concerned. When the market in question starts to rise, they get excited - or even worried that they might be missing out - and jump in to avoid getting left behind. That's why these markets tend to overshoot on the upside. Emotions, too, cause these markets to overshoot to the downside following a crash, making the best emerging-markets bargains very good, indeed.

The High-Rent District

The best four performers among the emerging markets since the beginning of 2010 have been Thailand, Peru, Chile and Indonesia, the sole member of the so-called "CIVETS" (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa) economies, that we'll be looking at here. Of these four emerging-market economies, Peru now carries the startlingly lofty Price/Earnings (P/E) ratio of 44.9, according to The Financial Times.

Of these, Indonesia and Chile are also fully valued at more than 20 times earnings (a valuation that's much less forgivable for a market than for an individual stock). Only Thailand looks reasonably valued at about 14 times earnings.

However, I think market optimism this year has not taken full account of the political risk that Thailand faces. The current government ousted the country's legitimately elected government in 2008 - under some very dubious circumstances. And it remains very unpopular outside Bangkok. Since an election is due in 2011, the chances of something going badly wrong must be pretty high. And even if the current government maneuvers itself to re-election, the risk of unrest is high. The bottom line: In spite of the decent growth rate - and apparently reasonable valuation - I think Thailand is best left alone.

There are other markets that are simply overvalued, even though they have not advanced to become even more overvalued this year.

India and China: A Tale of Two Outlooks

India, for example, appears overvalued at 25-times earnings. The problem with India is that its government can't stop spending money. Even with economic growth of more than 8% this year, the budget deficit including both national and state budgets is around 10% of gross domestic product (GDP).

Add to that an inflation rate that's persistently in the double digits - and an ongoing balance-of-payments deficit - and you have a country that is severely in danger of experiencing a credit crunch. At 25-times earnings, India's P/E ratio takes account of the opportunities available in that market, but not the risks. Avoid India for now.

China, on the other hand, looks to have a reasonable rating, with a market up only 11% this year and a P/E ratio of about 15. Here there is a "two-tier" market. There are companies - not all of them in the state-owned (SOE) sector - with astronomical P/E ratios: One such example is New Oriental Education & Tech Group Inc. (NYSE: EDU), which carries a P/E of roughly 50. At the other end of the spectrum are some value-oriented, medium-sized companies, including China Security and Surveillance Technology Inc. (NYSE: CSR), whose shares are trading at an alluring 5.68 times earnings.

Before we all rush out and buy the gamier Chinese small-caps, here's a word of caution. Although these companies are being sponsored for U.S. listings by the likes of Goldman Sachs Group Inc. (NYSE: GS) and have been audited by major international auditors, there appears to be a huge amount of fraud in the Chinese small-cap sector, with fictitious earnings and even fictitious revenue being quite common.

Of course, given the valuations, there's an easy solution: You just buy a portfolio of these companies and keep your fingers crossed that not more than 25% to 30% of them are fraudulent. You should make enough on the winners to cover your losers.

Playing Russian (Stock Market) Roulette

Speaking of fraud, the best current value among the major emerging markets is Russia: It's up only 5.7% this year and is trading at only 9.3 times earnings. At that level, I have to admit that I can get tempted. The contradictions inherent in the Russian economy are much less damaging when oil prices are high. With the price of the "black gold" at more than $80 per barrel right now - and with the current short-term price trend for oil headed up rather than down - Russia appears to be worth a bit of a flutter.

Bear in mind, though, that a flutter is just what this would be - a bet or wager. The country has no real property rights to speak of and any Russian company is subject to expropriation if the owner annoys Vladimir Vladimirovich Putin. Still, low P/E ratios in a decently growing environment can't be ignored altogether. And the team of forecasters for The Economist has Russia growing 4.2% in 2010 and 4.0% in 2011 - not bad for a country whose population is static.

The Market Investors Can't Ignore

Our journey through the world's emerging markets has finally reached its destination - and a surprising one at that. That's because the one market that's poised to be the class of the field in the New Year is one that could easily be overlooked as belonging to the "junk" end of the market. I'm talking about Chile.

Yes, Chile's stock market is trading at a somewhat lofty P/E of 23 times earnings. And, yes, that country's stock market is up 41% this year. However, the country is just emerging from recession and from a major earthquake and its new and excellent government has the policies that appear likely to speed growth. Sometimes - not often - high valuations are justified. I believe that Chile's market may be one such example. And I also believe that Chile could be a leading performer in 2011 - just as it was in 2010.

Invest in Chile, with the expectation that it is well-positioned to be an emerging-markets top performer in the New Year. The most-straightforward way to travel is the exchange-traded fund route, via the iShares MSCI Chile Investable Market Index Fund (NYSE: ECH).

In terms of individual stocks, I like Vina Concha y Toro SA (NYSE ADR: VCO), a producer of very-high-quality wine. It's currently trading at about 21 times earnings, with a dividend of nearly 4.0%. That's a somewhat premium valuation, but I like the dividend and Vina Concha is unquestionably a premium company.

Disclosure: None

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Source: Chile: The One Emerging Market That Investors Can't Afford to Ignore in 2011