When to Buy Emerging Market Stocks

06/15/2010 9:25 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

You probably know the big reasons developing economies are growing. Here's how to tell when to favor emerging market stocks over their developed-world counterparts.

The big-picture reasons for putting more emerging market stocks in your portfolio are compelling enough.

But you don't need to buy into the macro argument. The micro, stock-by-stock reasons are just as compelling. Put a developed-economy stock up against a developing-economy peer, and much of the time, the developing-economy stock is cheaper. Much cheaper. If you think the way you make money in the stock market is to buy low and sell high, that's a very convincing argument for emerging market stocks.

Let's do a quick dash through the big picture for anyone who's coming in late.

The world's developing economies are growing faster than the world's developed economies. Much faster in some cases: China is likely to see 10% growth in its gross domestic product this year; India could come at 8% or above, and Brazil seems headed for better than 7%. Meanwhile, growth is projected at 1.2% for the European Union and somewhere between 2.5% and 3.5% for the US.
 
Banking systems in most of the emerging economies are in better shape than those in the developed world. The subprime mortgage disaster and the resulting meltdown of major banks and insurance companies did relatively little damage in China, Brazil, India, and the rest of the developing world.

Developing countries largely dodged the huge stimulus burdens and pre-crisis spending policies that have left governments in the developed economies carrying debt levels of 70%, 100%, 120% of gross domestic product or more. (You've got to be careful here how you do your accounting, though. You can make a case, and I have, that China is broke.)

Developing countries have, by and large, younger populations than developed countries. That's a big plus for long-term growth—and means that the burden of paying for retirement and health care for an ever-larger population of oldsters is further down the road for countries like India and Brazil.

Growth at a More Reasonable Price

Now the micro.

It's hard to figure out what a reasonable market multiple is for emerging economy stocks. The Shanghai Composite Index, for example, is trading around 20 times trailing 12-month earnings. That's way below the five-year high of almost 50 times trailing earnings, so it's definitely cheaper than it was. But is it cheap in absolute terms? Got me.

But put a developing economy stock head to head with a developed economy peer, and the micro picture is frequently very, very clear.

Let's compare a US bank, Wells Fargo (NYSE: WFC), the fourth-largest US bank by assets at the end of the first quarter of 2010, and a Brazilian bank, Itaú Unibanco (NYSE: ITUB), the largest bank by assets in Brazil.

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A share of Wells Fargo went for $28.13 at the close June 10. With 5.2 billion shares outstanding, the market cap was $147 billion.

Itaú's American depositary receipts, traded on the New York Stock Exchange, sold for $19.05 on June 10. With 4.5 billon shares outstanding, the market cap was $86.25 billion.

None of this really tells us anything about how cheap these two stocks are. For that we need to look at their price-to-earnings ratios and earnings growth rates, and particularly at the ratios between the P/E ratios and earnings growth. Those are called the PEG ratios.

Analysts project that Wells Fargo will earn $1.97 a share in 2010. At the June 10 closing price of $28.13, the stock traded at 14.28 times 2010 earnings per share. Analysts also project that earnings will grow by an average rate of 9.4% a year over the next five years. That means the stock traded June 10 at a PEG ratio of 1.52. (That's the forward P/E divided by the average annual growth rate.) The price multiple is 1.52 times the earnings growth rate.

Do the same analysis for Itaú Unibanco. Analysts project that the company will earn $1.60 a share in 2010. At the June 10 closing price of $19.05, the stock traded at 11.91 times 2010 earnings per share. Analysts project that earnings will grow by an average rate of 9.6% a year over the next five years. That means the stock traded June 10 at a PEG ratio of 1.24. The price multiple is just 1.24 times the earnings growth rate.

An investor is paying about 20% less for Itaú Unibanco's projected earnings growth over the next five years.

Of course, these calculations are only as good as the projections in them. But if anything, in my opinion these projections err in projecting too much growth for Wells Fargo and too little for Itaú Unibanco:

  • The Brazilian economy is growing roughly two to three times faster than the United States


  • Brazil's credit rating is rising and that of the US is likely falling


  • The Brazilian real is appreciating, and the US dollar is depreciating

All these are reasons to suspect that the annual average 9.6% earnings growth rate for Itaú Unibanco is underestimated.

My point, though, is that even without any adjustment to the Wall Street consensus, Itaú Unibanco is projected to deliver more earnings growth for your investing buck.

(An aside to investors trying to decide when to get into a market such as Brazil: Peter Lynch, the great mutual fund manager, long advocated buying growth stocks when their PEG ratios were 1 or less. At a price of $15.60, Itaú Unibanco shows a PEG ratio of 1. I'm not saying you should wait for that price. I'm just saying . . .)

Itaú Unibanco has been in Jim's Watch List since December 17. The shares dropped 11.7% between then and June 10.

Measuring Up

In some comparisons, the emerging market stocks are so much cheaper that, even using growth estimates you think are ridiculously low, you can buy a whole lot of upside for nothing—if it turns out that your growth estimates, and not Wall Street's, are accurate.

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Compare two steel companies, for example. Brazil's Gerdau (NYSE: GGB) closed at $13.60 a share June 10. Wall Street projected 2010 earnings per share at $1.66 for an expected price-to-earnings ratio of 8.12. Gerdau's average annual earnings growth, meanwhile, was projected at just 6% over the next five years. I think that's ridiculously low for a developing country that's projected to grow more than 7% in 2010, but no matter: Even with the low Wall Street earnings growth estimate, the PEG ratio comes to 1.36. (I added Gerdau to my watch list with my June 10 column, "Pull Your Portfolio Out of Its Rut.")
 
Nucor (NYSE: NUE), to my mind the best US steel company, closed at $42.43 a share June 10. Its 2010 earnings are projected at $1.62 a share for a forward price-to-earnings ratio of 26.19. Wall Street estimates average annual earnings growth of 15% over the next five years. That works out to a PEG ratio of 1.75.

You'll notice that I've been picking pretty good developed-economy companies to use in my comparisons. That's important. You want to find the developing market stocks that can beat the best the developed markets have. We're not trying to find mediocre emerging market stocks that can beat really crummy developed market stocks.

So don't be afraid. Go for it and put those emerging market stocks up against the best.

How does PetroChina (NYSE: PTR), for example, measure up against Exxon Mobil (NYSE: XOM)?

According to Wall Street projections, PetroChina will produce earnings per share of $12.80 in 2010. With the June 10 closing price at $111.76, that's a forward price-to-earnings ratio of 8.73. Wall Street says PetroChina will show earnings growth of 5.7% a year on average over the next five years. That would be a PEG ratio of 1.53.

Exxon Mobil is projected to grow 2010 earnings to $5.76 a share. Based on the June 10 price of $61.90, that's a forward price-to-earnings ratio of 10.75. Average annual earnings growth over the next five years is projected at 8.63%. That's a PEG ratio of 1.25.

Exxon Mobil comes out on top in this comparison. Buy that developed-economy oil company if you want the most earnings growth for your buck.

But the contest was closer than I thought it would be. And it tells you something when the best-managed, most-profitable oil company in the developed world doesn't run away without breaking a sweat from one of the developing world's best.

The message isn't some depressing decline of the developed world drama, however. It's just a reminder that as an investor today, you can't take anything for granted. At least not if your goal is to make a buck.

At the time of publication, Jim Jubak owned shares of the following company mentioned in this column: Nucor.

See the complete Jubak Picks Portfolio here

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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