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Emerging Markets Forecast: Which Ones to Hold, and Which Ones to Fold

[Editor's Note: In this latest installment of Money Morning's "Quarterly Report" forecast series, columnist Martin Hutchinson takes us on a whirlwind tour of the world's emerging markets. Check back in the days to come for reports on such topics as the U.S. stock market and China.]

Late last year, as part of Money Morning's "Outlook 2011" economic-forecast series, I suggested investing in emerging markets that were relatively cheaply priced, and whose economies seem poised to do well in 2011.

My favorite recommendation, Chile, gave a mediocre performance, down 3.2% on the year.

On the other hand, I recommended Russia at several different points last year. That's not a market that I normally favor. But I'd been suggesting that low Price/Earnings (P/E) ratios and a commodity or energy orientation in an economy would be the keys to finding successful emerging markets in 2011.

Currently, the Russian market is up 19.2% in dollar terms, the best performance of any market except Hungary (which also satisfied my "low P/E" criterion, as it is recovering from a very deep recession).

In this installment of the current Money Morning "Quarterly Report" series, let's take a tour of the world's emerging-market economies. We'll study their most recent performance, and we'll identify the best investment candidates for the months to come.

Two Emerging Markets Predictions

Given their relative performances – and the fact that I recommended them both – Russia and Chile are fine places to start.

Indeed, to get the ball rolling, I'll stick my neck out and make two predictions right off the bat:

  • First, let me say that I'm not at all sure the Russian outperformance will last.
  • At the same time, I am confident the Chilean underperformance is temporary.

How can I seem so certain? Simple … it all comes down to the "integrity" of each country's business system.

You can get a good idea of this by looking at the Transparency International Corruption Perceptions Index, which is published annually. On the 2011 Index, Chile is rated No. 21, one spot higher than the United States, whereas Russia is ranked an appalling No. 154 out of 178 countries ranked.

So you may want to rethink that exciting investment in Russia – though matters might change next year, if Dmitry Medvedev beats out Vladimir Putin for the presidency: Medvedev at least believes lower corruption would probably be a good thing.

Some Emerging Markets Prospects …

Most of the world's emerging-market economies are located in Asia or Latin America. In general, most emerging markets rank lower than their European counterparts on the Transparency International CPI, which is why Chile's high position is so remarkable.

Even more remarkable is the country that holds the No. 1 ranking – or, rather, that shares it with Denmark and New Zealand.

I'm talking about Singapore.

Singapore is rather too rich to be considered an emerging market these days. But according to the team of forecasters at The Economist, Singapore is enjoying emerging-market growth rates – currently projected to be 4.7% this year and 5.2% in 2012.

As if that's not alluring enough, Singapore's stock market hasn't really run-up in kind, and is currently trading at only 13-times earnings.

Consider it an opportunity: Take a look at the iShares MSCI Singapore Index Exchange-Traded Fund (NYSE: EWS).

Another emerging market near the top is Hong Kong – ranked at No. 13 – which I am somewhat bearish on, as its rank has slipped and it is being absorbed more and more into China.

Qatar at No. 19 and Uruguay at No. 24 are high, but both are too small to invest in easily.

Taiwan at No. 33 and South Korea at No. 39 are each too rich to be viewed as true "emerging" markets. But both countries are currently quite interesting: South Korea is up 8.3% this year, and is a little pricey at 16.5-times earnings, meaning that Taiwan, flat on the year and trading at about 14-times earnings, looks to be a better deal (consider the iShares MSCI Taiwan index ETF (NYSE: EWT)).

Estonia, Slovenia and Poland are also in the Top 50. Out of that trio, Poland (No. 41) is the easiest to invest in – thanks to the Market Vectors Poland ETF (NYSE: PLND) – although the market is also a little pricey, up 13% this year.

… And Some Emerging Markets Suspects

At the other end of the emerging markets scale are some countries that you should probably avoid, including Venezuela (No.164), Russia, The Philippines and Nigeria (tied at No. 134), Vietnam (No.116) or Argentina (No.105).

The two biggies of China (No. 78) and India (No. 87) are in the middle, as are several other favorite investment spots. (If I haven't mentioned your favorite investment destination, check out the survey on Transparency International's Website.)

China stands as a great example of why investors seeking profits in the emerging markets need to pay more attention to the integrity of those markets. Consider, for instance, the recent trouble with some of China's small-capitalization stocks. These have been hammered in the last quarter – the average stock is down around 20% – because of increasing investor concern over the quality of their financial figures.

The problem is not that large numbers of small-cap Chinese companies have been fiddling the books; in reality, we're probably talking about, at most, four or five firms. However, the differential between a Chinese small-cap with a second-tier (but U.S.) auditor and one with a Big Four auditor is currently the difference between a valuation of 3.0-times earnings and 8.0-times earnings.

Personally, I think investors in this case are putting altogether too much faith in the Big Four – after all, it was a top-tier name, Arthur Anderson, which audited Enron. Nevertheless, when the name of your investment's auditor is far more important than its reported earnings track record, its solid balance sheet, its growth prospects, or its position in the world's fastest-growing economy, then rational investment has become impossible.

The bottom line: Investors who bought attractive looking Chinese small-caps have found their shares falling out of bed on bearish "analysis" by dodgy short sellers. Presumably the honest companies will eventually recover … but who can tell when?

While money remains cheap (at close to zero cost, in inflation-adjusted terms), emerging markets will continue to do well, particularly those with good commodities endowments. But your own investing success there depends on the countries' levels of integrity, so stick to the top half of the CPI list.

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  1. Daniel Victor | April 22, 2011

    A big auditor is no guarantee of a decent rating.Take Xinyuan Real Estate – Auditor Ernst and Young,trading at a fraction of book value and a p/e of around 5.Also,China Integrated Energy – Auditor KPMG but P/E below 2. But then,China Media Express used to have KPMG as an auditor – and then,suddenly,they didn't !

  2. tof | April 22, 2011

    What about that other big one, ie Brazil ; on the transparancy ranking, business friendly and corruption they don't rank too well ; any thoughts on this one ?
    Thanks for feedback

  3. Vitor Hugo Piangers | April 22, 2011

    Martin Hutchinson
    It is incredible your sense of analysis in small emerging markets but is more incredible that you don't even mention Brazil in your findings. Do you know that Brazil is also an emerging market and has the fifth large GNP in the world? That has great opportunities in several Cos that are leading their industries in the world?
    I hope you review your studires and balance it with Brazil. One can not talk in emerging markets and not mention Brazil.
    Have a great day

  4. armando salinas | April 22, 2011

    very interesting,good analysis……
    is it a good time to invest in the US,will the crisis get worse because of the debt ect…?

  5. Dr. Roger Voelker | April 22, 2011

    Very good article and thanks for the information about Corruption Perceptions Index.
    I never knew it existed. From the book Fiscal Hangover by Keith Fitz-Gerald, whose book I read many years ago, and learned a lot from it, he mentioned three things to consider when investing in an area or country : 1) Stable Government 2) functioning economic infrastructure and 3) fair and functioning justice system. I may have paraphrased number 3, but the rest is rather accurate. His advice has helped me financially. I can even use it in the states by looking at the State Government and its policies.
    I also read your articles and look for your name too.

  6. Diane Atria | April 24, 2011

    I heard from a friend that has been receiving the Money Morning Newsletter for quite a while, that he thinks it has been so helpful to him and the decisions he needs to make in this market. Great learning tool. He said that I should order it. I want to see for myself how it helps in my decisions. I hope it is simple enough to understand. Since it is free I would like to try. I get bombarded w/ newsletters that I can't understand and are confusing. My friend highly recommends the Money Morning Newsletter.

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