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Published by Fidelity Interactive Content Services

Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.

4 funds if you're looking for bargains

Emerging market stocks have gotten punished lately, but it may be time to take another look. Here are four funds worth considering.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 07/26/2012
  • Emerging Markets
  • Investing Strategies
  • Investing in Mutual Funds
  • Emerging Markets
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Investors scouring the globe for bargains may be tempted by Europe's beaten-down blue-chip stocks but there may be an even more contrarian play on the global stage these days: emerging markets.

With economic growth slowing worldwide, investors have fled developing markets since slower growth often translates to lower corporate earnings.

The MSCI EAFE Emerging Markets Index has tumbled 17.6% in the last 12 months and the BRIC nations—Brazil, Russia, India and China—have seen their stock markets sink even more. Overall, emerging markets recently traded at about 11 times trailing earnings—a 20% discount to the U.S. The drop means many big-name companies in the index trade for well under 10 times earnings, while the average dividend yield has risen to 3.1%.

Granted, the misery index for emerging markets looks high. Lower stock valuations reflect investor worries about a sharp slowdown in China's economic growth, weaker earnings for commodity producers in Brazil and Russia, and a recession in Europe—a key export market for finished goods produced by companies in developing countries.

At the same time, emerging market stocks may not be quite as cheap as they appear. That's because profits for the big financial, energy and materials companies in the BRICs, which account for a large share of the MSCI emerging markets index, may have reached a peak. If earnings estimates fall, their P/E ratios would likely jump, rendering them less compelling.

But none of these issues are new, and the "fear factor" around declining earnings may already be factored into the stock prices. It's also important to keep the latest emerging market downturn in perspective.

The long view

Looking back, these markets have doubled their share of global economic output since the early-1990s to around 33% today, and they still account for the majority of global growth. Incomes are rising as millions of people move into the middle class, raising demand for everything from financial services to dental care. And fiscal balance sheets are generally strong for households and governments—in contrast to debt-burdened western countries where austerity measures are sapping growth.

While there are bound to be some cyclical slowdowns, emerging markets are in the early stages of a 30- to 40-year "virtuous growth cycle," says Ashish Swarup, manager of the Fidelity Emerging Markets Discovery Fund (FEDDX), which launched last year. Investors who focus on high-quality companies with good corporate governance and steady growth in earnings per share are likely to see higher returns over the long run, he adds.

How to invest? One option is to use an exchange traded fund such as the iShares MSCI Emerging Markets Index Fund (EEM). ETFs like this track the MSCI Emerging Markets index; annual expenses are below 1%, and they offer broad exposure to the big names in the BRICs. The downside is that ETFs like this one are a blunt instrument. They provide exposure to the biggest companies in the BRICs, but those companies may not have the strongest growth at this point in the earnings cycle.

"You can find multinational growth companies in the U.S. and Europe with better prospects," says Howard Schwab, lead manager of the Driehaus Emerging Markets Growth Fund (DREGX).

Indeed, investors may want to use an actively managed fund to avoid overpaying for big BRIC stocks and also to tap into stronger growth elsewhere in emerging markets. Though expenses are higher, active funds have more flexibility to invest in secondary and "frontier" markets, along with "domestic consumption" stocks that are less cyclically sensitive and may provide better growth.

Looking for 'local champions'

One actively managed fund to consider: Harding Loevner Emerging Markets Advisor Fund (HLEMX). The fund has returned 9.14% a year, on average, over the past three years and its 13.93% annual return over the last 10 years puts it ahead of 72% of funds in its category, according to Morningstar. Co-manager Simon Hallett and his team look for "high quality, long-duration growth" companies trading at reasonable prices. Many of the big names in the BRICs now look "a bit ho-hum," he says, so the team has been emphasizing what they call "local market champions."

A recent addition, for example, is OdontoPrev, the largest dental benefits company in Brazil. Dental insurance is growing rapidly in Brazil (which has 228,000 dentists, more than in the U.S.) and the company has been snapping up competitors and growing its membership 29% a year, according to the firm. Elsewhere, Hallett and his team have added holdings in Nigeria and Qatar, where valuations for a Nigerian bank and Qatari industrial conglomerate look attractive, he says.

Another fund looking beyond the BRICs is Driehaus Emerging Markets Growth (DREGX). The fund returned an annualized 10.71% over the last three years, outperforming 92% of its peers, according to Morningstar. While it holds some big names—such as Samsung Electronics and China Mobile (CHL)—manager Schwab supplements those holdings with companies in secondary markets that have faster sales and cash flow growth.

One theme he likes now is telecom companies benefiting from surging demand for smart phones and data services across Asia. The fund holds Malaysia's Axiata, for example, a pan-Asian service provider with 200 million mobile subscribers. The company has made significant capital investments to build out its network, he says. That spending cycle has peaked, making the company more profitable.

Schwab also sees opportunity in Indonesian stocks such as cement company Semen Gresik. Though Indonesia's economy is slowing, foreign capital is still flowing into the country for infrastructure projects and retail development. That should benefit Semen. The company is the largest domestic producer with a 44% market share and is operating near capacity. "It's a different way of playing the domestic infrastructure and consumption themes," says Schwab.

Don't forget China

Of course, China can't be ignored in any emerging market fund. Despite a sharp slowdown, China's economy is still growing at a 7.6% clip, more than three times the pace of Europe and the U.S. China's central bank has cut interest rates twice in recent months to prevent a further slowdown in growth. Falling inflation may allow for further rate cuts later this year. And with China's market down 23% in the last year, some contrarian managers see pockets of opportunity in Chinese stocks.

"There are areas of hurt, but we think the problems are temporary," says John Goetz, a subadvisor on the Northern Multi-Manager Emerging Markets Equity Fund (NMMEX), which is up an annualized 9.15% over the last three years, beating 83% of peers, according to Morningstar. Goetz is one of five subadvisors on the fund and manages its "deep-value" sleeve, looking for undervalued companies based on his team's estimates of a company's "normal" earnings power.

One area he likes now is Chinese electric utilities that are starting to pass through price increases to customers. These companies are likely to benefit from lower coal costs if China's economy weakens further, yet they may benefit from higher electricity usage rates if the economy strengthens—winning in either scenario, he says.

Goetz also sees strong potential in a China-based shoe manufacturer, Stella International, the largest non-athletic footwear maker in the world with an estimated 10.5% share of the global market. The stock sold off sharply on fears of a global consumer slowdown. Yet it has good opportunities to win business from competitors in a highly fragmented global marketplace, says Goetz, and trades around nine times estimates of "normal" earnings on "conservative assumptions" about its future growth and operating margins.

Regardless of how investors approach emerging markets, it's important to be patient and take a balanced approach. These markets are volatile, and remain highly sensitive to foreign capital flows: Money floods in during good times, bidding up asset prices, and can flee just as quickly at the first sign of trouble.

One way to smooth out returns is by adding an emerging markets bond fund. Though these funds aren't immune to global economic and market forces, they tend to be less volatile than emerging market stock funds and offer income streams that can provide a cushion in a downturn. Investors can also choose an option with minimal currency risk, such as a fund that mainly holds government debt denominated in U.S. dollars rather than government or corporate debt issued in local currencies.

One such choice: the Fidelity New Markets Income Fund (FNMIX). The fund primarily holds bonds denominated in U.S. dollars—which reduces currency risk—and manager John Carlson has lowered exposure to corporate debt to just 6.8% over the last 18 months, putting more than 85% of the portfolio in sovereign and government agency debt. The fund's 4.34% yield is slightly lower than funds holding more bonds issued in local currencies. Still, his approach has paid off with a three-year annualized return of 14.98%, beating 78% of funds in the category, according to Morningstar.

With sovereign debt issued in U.S. dollars, investors can get exposure to growth trends in developing countries without the currency or company-specific risks in the corporate market, according to Carlson. Credit quality has improved to the point where two-thirds of the 57 countries in the emerging market universe are now rated investment-grade. And these bonds have rallied as governments have strengthened their finances, established independent central banks and built up hard currency reserves—making them more stable and desirable to global investors.

At the same time, Carlson has ventured off the beaten path to find values. He bought bonds issued by the governments of Croatia and Hungary when they were under pressure as Europe's debt crisis flared. The bonds have since rebounded.

A top holding now is Venezuelan government debt. The country's uncertain political situation has driven down prices yet Venezuela has continued servicing its debt and has the ability to pay creditors across a range of oil prices (which provide most of Venezuela's hard currency revenues), says Carlson. Moreover, the bonds yield 12-13% so "you're getting compensated for the risk."

Carlson's fund could underperform if corporate and local market debt stages a big rally, and investors shouldn't expect the double-digit returns to last—especially if there's another global economic shock. Nonetheless, the fund is likely to hold up better than stocks in a slowdown while providing an income stream. "We're in a deflationary global period," he says. "In this environment we're looking for insured cash flows. You can get paid while you wait in emerging market debt."

Emerging market funds for the long run

Fund: Harding Loevner Emerging Markets Advisor Fund (HLEMX)
Expense ratio: 1.49%
3-year annualized return: 9.14%
Profile: The fund looks for high quality, long duration growth companies trading at reasonable valuations. Though it holds some big index names like Samsung Electronics and Vale (VALE), it is underweight the BRICs and has well over half the portfolio in secondary and frontier markets. "We try to take advantage of volatility to go in the opposite direction," says co-manager Simon Hallett.

Fund: Driehaus Emerging Markets Growth Fund (DREGX)
Expense ratio: 1.68%
3-year annualized return: 10.71%
Profile: The fund has a high-growth profile with a below-average market cap and above-average P/E ratio. Manager Howard Schwab is emphasizing Southeast Asian markets such as the Philippines and Indonesia, and likes companies with strong domestic demand, such as Want Want China Holdings, a snack food company based in China with 30% annual revenue growth.

Fund: Northern Multi-Manager Emerging Markets Equity Fund (NMMEX)
Expense ratio: 1.52%
3-year annualized return: 9.15%
Profile: Run in a "style agnostic" manner, this fund is managed by five subadvisors who use strategies ranging from quantitative to deep value. The resulting portfolio is broadly diversified across regions, style and market cap with a slight overweight to frontier markets.

Fund: Fidelity New Markets Income Fund (FNMIX)
Expense ratio: 0.87%
3-year annualized return: 14.98%
Profile: The fund holds bonds predominately based in U.S. dollars—reducing currency risk—and, more than 85% of the portfolio is in government agency and sovereign debt. This reduces credit risk, though the fund's 4.34% yield is a bit lower than funds that hold more corporate and local-market bonds. Performance has been strong, and manager John Carlson isn't afraid to venture into secondary markets where he sees opportunity, such as Eastern Europe and Venezuela.

Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services. 

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© 2008-2013 Fidelity Interactive Content Services LLC. All rights reserved.
Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.
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