Three 'Backdoor' Ways to Play Emerging Markets in 2011

Includes: DEO, ECON, EEM, TEF, UL
by: Charles Lewis Sizemore, CFA

Most experienced globetrotters have come across a copy of Rick Steves’ Europe Through the Back Door in one of their travels. Appealing to budget-conscious students and backpackers, Steves’ book gives tips on how to avoid many of the expensive pitfalls of foreign travel and offers cheaper “backdoor” ways to enjoy Europe’s treasures.

Today, I want to do precisely the opposite. I want to recommend that readers use Europe itself as a backdoor way to get access to the riches of emerging markets. The explosive growth of emerging titans like China, India, Brazil, and Turkey is real. Living standards are quickly rising, and tens of millions of eager consumers join the ranks of the global middle class every year.

The problem is that it is not always easy to get access to the pocketbooks of these consumers.

Quite frankly, most investment options are terrible. Consider the case of the popular iShares MSCI Emerging Markets ETF (NYSE: EEM). This ETF has an average daily trading volume of 60 million shares, making it one of the most widely traded ETFs on the market. Unfortunately, it’s also one of the most poorly named ETFs on the market.

EEM is not really an emerging market ETF at all. It is primarily an indirect play on the United States and Europe and on global factors, as most of its constituent parts are export-oriented companies, materials companies, and banks. Furthermore, nearly a fourth of the fund is allocated to South Korea and Taiwan—two countries that are already emerged, but not emerging. Investors wanting direct exposure can instead buy shares of the EG Shares Emerging Market Consumer ETF (NYSE: ECON), which invests in emerging market companies that cater to those domestic consumers I mentioned above.

But today, some of the best bargains I see are actually indirect backdoor plays.

You see, the lingering sovereign debt crisis has curbed investor enthusiasm for European stocks in general. But with crisis comes opportunity, and today I am going to recommend three dirt-cheap European blue chips that are well placed to benefit from the continued rise of the emerging market consumer.

I’ll start with British premium spirits company Diageo PLC (NYSE: DEO). Chances are good that you’ve never heard of Diageo, but I guarantee you’ve heard of the company’s brands. Diageo has the number one premium scotch whiskey in the world by sales in Johnnie Walker, and the number one premium vodka in Smirnoff. In Tanqueray gin, Bailey’s Irish Cream, Jose Cuervo tequila and Guiness Irish stout beer, Diageo enjoys category leadership. Other brands of note include Captain Morgan rum, J&B scotch whiskey, Crown Royal Canadian whiskey, and the high-end Ketel One vodka.

Diageo has excellent exposure to emerging markets, where premium spirits are still a growth industry. In the United States, Europe, Japan, and Canada, the drinks business is highly profitable, but it is also a mature industry. Consumer tastes are always changing to some extent, and consumers are likely to continue moving upscale. But the real growth story is in emerging markets, where rising incomes have made premium spirits affordable to millions of new middle-and-upper-class consumers. Diageo gets a full third of its revenues from emerging markets.

The past three years of economic turmoil have taken their toll on the American and European desire to celebrate, and sales have been mostly flat in developed markets. In emerging markets, however, the party continues. Despite the Islamic prohibitions against alcohol consumption, sales in the Middle East and North Africa have grown at a nice 16.3% clip in 2010, followed closely by Latin America at 15.4%. Russia and Africa also posted decent increases at 11.2% and 10.4%, respectively.

Diageo trades at a modest 13 times forward earning and sports a 4% dividend yield. Not bad for a company with Diageo’s growth prospects in the developing world. Next on the list is Anglo-Dutch consumer products company Unilever PLC (NYSE: UL). Unilever is essentially a European version of the American consumer conglomerate (and Warren Buffett favorite) Procter & Gamble (NYSE:PG). American readers will be most familiar with its condiment brands—including Hellmann's, Wish-Bone and Ragu—and its market leading tea, Lipton. The company also offers popular personal care brands like Axe, Dove, Suave and Vaseline.

Unilever also happens to get half of its revenues from emerging market countries. In 2011, this number will likely move well above the 50% mark, as growth in these countries should far outpace that of austerity-burdened Europe. Like Diageo, Unilever is attractively priced at a forward P/E of 14 and a dividend yield of 3.8%.

Both companies are also proud members of the Mergent Dividend Achievers Index, meaning that they have a long history of rewarding their shareholders with annual dividend increases. Given the persistence of low bond yields, this would make these two all the more appealing.

I saved my favorite European stock for 2011 for last—Spanish telecom giant Telefónica (NYSE: TEF). Though the European sovereign debt crisis has been centered on Ireland of late, it is in Spain where we see the best values. By the Financial Times’ estimates, Spain is the only major market in Europe with a P/E lower than 10.

Part of this legitimate worry is that Spain is simply too big to bail out like Greece or Ireland, and that the country is at high risk of defaulting on its debts. While I don’t see Spain defaulting, if it were to happen, all Spanish stocks would at least temporarily plunge in value, even rock-solid multinationals like Telefónica. The question becomes, “at current prices, are we being compensated for this risk?” And to this I give an emphatic “yes.”

Telefonica is trading at a P/E ratio of 7. Yes, 7. This is one of the finest telecommunications companies in the world and it gets 40% of its revenues from the fast growing markets of Latin America—only 33% comes from Spain itself. It also yields a very impressive 6.2%.

If the European sovereign debt crisis takes another turn for the worse, any or all of these recommendations could take a short-term hit. But given the quality of the companies and the fear already reflected in current prices, the downside would appear to be limited while the upside could be years of market-beating returns.

Take advantage of Europe’s woes by snapping up shares of these three “backdoor” plays on the rise of the emerging market consumer.

Disclosure: I am long ECON, TEF, DEO, UL.