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.]

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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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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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