The Bulls Are Abroad

By Daniel Kadlec

A few years ago, it was fashionable to shun foreign investments, not just because U.S. stocks were the toast of the world but, some reasoned, because you get international diversification by owning global companies such as General Electric and Gillette or the mutual funds that hold them. That logic always sounded a bit twisted to me. When the air gets let out of a market, few stocks are spared, no matter where they derive their profits. Gillette and GE, for example, have been cut in half from their highs.

Now, as U.S. stocks slump for a third consecutive year, investors are rediscovering the benefits of true international exposure. Mutual funds that invest in foreign stocks are seeing net inflows, and much of the action is in emerging markets, a sector that boasts economies with heady growth rates of 4% to 8% and companies that are relatively disconnected from conditions in the U.S. In a period of weakness for the U.S., the best foreign funds will be those that own shares of local companies that don't do a lot of business in the States. These funds, like Pioneer Emerging Markets and Dreyfus Emerging Markets, tend to have a small-company focus.

This year through June, investors have pumped $1.3 billion into emerging-market funds, after taking out $110 million in 2001, reports fund-research firm Lipper. South Korea, Pakistan, Russia and Thailand are up more than 20% this year. Many emerging markets were solid winners last year too. Typical stocks in Russia and South Korea trade at just eight times next year's projected earnings. That's less than half the developed world's P/E ratio. A broad mix of emerging-market stocks--most easily available through mutual funds--is up 3% for the year, a downright gaudy figure next to the S&P 500's decline of 21%. Any long-term portfolio should have 3% to 5% of assets in emerging markets. I would go even higher now (6% to 8%), given the malaise hanging over the developed world.

Almost everyone agrees the most promising markets are Russia and other countries in Asia. Both have beefed up corporate governance and taken steps to bolster their domestic economies. Russia benefits from low labor costs and vast natural resources. Brad Aham, emerging-market portfolio manager at State Street Global Advisors, owns Russia's two big oil stocks, Lukoil and Yukos, which should benefit as the West looks for oil outside the Middle East. But all Russian industries will benefit as "post-9/11, Russia more clearly aligns with the West," says Aham. The ING Russia fund is a stalwart in this space--up 33% a year for the past three years.

South Korea and Taiwan are generally thought to be the most promising markets in Asia. Through tax incentives, South Korea has been promoting credit cards, luxury goods and travel--creating a free-spending middle class to boost domestic demand. "Korean companies have streamlined and have very little debt," notes Steven Schoenfeld, head of international equities at Barclay's Global Investors. Some of the best values are in Taiwan. Aquico Wen, portfolio manager at Citigroup Asset Management, especially likes the nation's fast-growing electronics industry, which includes world-class outsourcers like Taiwan Semiconductor and United Microelectronics. Two good Asian funds are Eaton Vance Asia Small Company and Matthews Asia Growth and Income.

Prospects in Eastern Europe, Africa and Latin America are mixed. Many fund managers like resource-rich South Africa. But Argentina's debt problems are dragging down South America, as are polls that show an antibusiness candidate leading his rivals in Brazil's presidential campaign. The Brazilian market seems to be discounting its troubles. So it may surge on good news. With that in mind, the wisest strategy may be exposure to all emerging markets through diversified funds such as Oppenheimer Developing Markets and Eaton Vance Emerging Markets.