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?
- Has it under-performed during the past year?
If the answer for both those questions is "yes," that market is much more likely to get my vote.
But with every rule, there are exceptions, as we shall 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 with 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 getting left behind - and jump in.
That's why these markets tend to overshoot on the upside.
And it's emotions that cause these markets to overshoot to the downside, too, following a crash, making the best emerging-markets bargains very good, indeed.
So let's take a look at markets around the globe right now to find the very best one to invest in.
The High-Rent District
Since the beginning of 2010, the best four performers among the emerging markets have been Thailand, Peru, Chile and Indonesia. This last country is 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 a startlingly lofty price/earnings (P/E) ratio of 44.9, according to The Financial Times. 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 the newcomers to the government remain 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.
India and China: A Tale of Two Outlooks
There are other markets that are simply overvalued, even though they have not advanced to become even more overvalued in 2010.
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% in 2010, 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.
India's P/E ratio of 25 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 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 & Technology 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 & Surveillance Technology Inc. (NYSE:CSR), whose shares are trading at an alluring 5.68 times earnings.
But 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 "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 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 2011 is one that could easily be overlooked as belonging to the "junk" end of the market.
I'm talking about Chile.
This is a well-run country with good property rights. The Chilean government's handling of crises, both the major crisis of February's earthquake and the minor one of the trapped miners, has been exemplary. New President Sebastian Piñera promises faster growth, and the country is well-positioned for high commodities prices.
In a world in which China and India's 2.5 billion people are increasingly fully engaged in the world economy, natural resources look to me a better bet for development than cheap labor, so Chile is currently my favorite emerging market.
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 a major earthquake, and its excellent new government has 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.
Action to Take: Invest in Chile, with the expectation that it will be an emerging markets top performer in 2011.
The most straightforward way to travel is the exchange-traded fund route, via the iShares MSCI Chile Fund (NYSEARCA:ECH).
In terms of individual stocks, I like Vina Concha y Toro SA (NYSE: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.
(Editor's Note: The stuff in one remote Chilean sand pit could create six times more revenue than oil. And one tiny company owns the lion's share of it. Governments in China, the U.S., Japan and even Russia are spending billions to refine it. And since we're due to hit "peak oil" in 2011, it could even spark a war. Own this stuff and it's likely you'll double your money… four times. This must-see presentation has all the details. Just go here.)