The Case for Buying the Scariest Stocks Now

Conventional wisdom and common sense would tell you to steer clear of emerging-market stocks, especially now with China in the throes of what seems like yet another market slide.

Not only is the developing world at the epicenter of the global slowdown, but shares of companies based in developing countries like Russia and Brazil have been stuck in a bear market since 2011.

And most money managers think the biggest risk in the market today is a meltdown in China, which could have a domino effect on other developing countries that have long supplied China with the raw materials needed to fuel that country's once-rapid growth.

Sounds like disaster. But while it may be hard to see signs of hope here — let alone a catalyst for a turnaround — contrarian radars are on high alert. As Warren Buffett likes to say, you have to be greedy when others are fearful. And there's no area of the market that spooks investors more today than emerging-market equities.

Chris Brightman, chief investment officer at Research Affiliates, says this reminds him of 1997 and 1998, when the developing markets were reviled in the wake of the Asian currency crisis and investors thought the U.S. was the place to be.

"What we learned was that there was in fact no better time to invest in emerging markets," says Brightman. From 1999 through 2003 the MSCI Emerging Markets index gained 66%, vs. a 3% slide for the S&P 500.

Research Affiliates believes emerging markets will similarly outperform in inflation-adjusted terms over the next decade. The money manager projects emerging-market shares will generate nearly 8% annual real returns over the next decade, based on factors such as forecasted earnings growth, yields, and valuations. That's seven points better a year than U.S. stocks are expected to do over the same period.

The firm isn't alone in thinking that to see any growth in your portfolio over the next decade, you have to be willing to own emerging-market shares.

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GMO, another respected contrarian firm — which correctly forecast the 2000 tech wreck — expects emerging markets to beat U.S. blue-chip shares by about six percentage points a year over the next seven years.

What do these money managers know that the rest of the market doesn't appreciate? For starters, that valuations really matter. The long-term argument for investing in stocks in rapidly developing economies — aside from the potential for faster overall growth — starts with price.

After a seven-year bull run in the U.S., marking the third-longest rally in history, valuations for the S&P 500 index are well above norms. That's likely to be a big headwind for domestic equities in the years to come. "Higher prices today mean lower long-term returns," says Rick Ferri, founder of Portfolio Solutions. Yet there are no such impediments facing emerging-market equities. In fact, it's just the opposite.

Historically, emerging-market shares have traded at around a 15% discount to U.S. stocks, based on five years of averaged, or "normalized," earnings. Today developing-market stocks are trading at closer to a 50% discount, with a price/earnings ratio of less than 11.

There's also an important transformation afoot.

For years, investing in these stocks meant choosing among companies largely tied to infrastructure—say, a mining firm, a construction company, or even a bank financing the build-out. "Now we're seeing the next stage of evolution where there is demand for consumer goods and services that a growing middle class wants," says Chuck Knudsen, a member of the team managing T. Rowe Price Emerging Markets Stock Fund.

But remember that this is a long-term investment, not a short-term bet that emerging-market stocks will bounce back this year. The key is to understand the risks, manage them along with your own expectations, and find smart ways to gain exposure to these stocks in a way that will let you sleep well at night—so you'll hang on. Here's what to keep in mind.

Steel yourself for a bumpy ride

If you're seeking higher returns, you have to expect higher risk. The argument for adding to your emerging-market exposure now, as opposed to waiting for these stocks to recover, is simple. For starters, it's impossible to tell when the rebound will take place, as was the case in late 1998 when emerging-market stocks began to rally while many economies were still in recession and oil prices were weak. Plus buying now is the only way to capture these historically low prices.

Admittedly, there are risks, like a potential bear market on Wall Street. Emerging-market shares typically lose more than U.S. equities when a bear strikes. This time, though, developing-market stocks have already been hit, so their decline might be no worse than U.S. stocks.

Even if a bear isn't lurking, whatever prospective reward these stocks will deliver will come with plenty of rockiness. Research Affiliates estimates that over the next 10 years the volatility of these shares will be about 60% higher than that of large U.S. stocks.

Also, don't expect an immediate rebound. Doug Ramsey, chief investment officer at the Leuthold Group, notes that in the late stages of bull markets — like today — stocks that already have momentum typically lead the late charge. So don't count on out-of-favor emerging markets to go from unloved to sought-after soon.

Keep your emerging-markets stake small

You may need only to rebalance to take advantage of this opportunity. Research has shown that investors don't need to keep more than 30% of their overall stock portfolio in foreign shares to capture the full effects of diversification. But given the volatility and risk involved, Ferri of Portfolio Solutions recommends holding no more than 30% of that foreign-equity stake in emerging-market shares.

This means that if you're shooting for a portfolio that's 70% U.S. stocks and 30% foreign, you should have 10 percentage points or so in emerging-market shares.

Yet if you started with that exposure three years ago — and didn't rebalance among your stocks — your emerging-market allocation would have sunk to around 5%. To replenish that stake or simply to boost your exposure, shift assets from overpriced U.S. shares to underpriced developing-market stocks.

Avoid the commodity trap

Bet on consumer-oriented economies, not on those reliant on natural resources. Sluggish economic growth around the globe reduces demand for commodities, especially for crude oil, whose prices have dipped to an 11-year low in part due to China's slowdown. That's not good news for resource-rich developing nations.

This is why fund managers and market strategists say you should avoid the absolutely cheapest emerging-market stocks that are heavily tied to extracting natural resources. "Just because stocks in Brazil, South Africa, and Russia are inexpensive doesn't mean they are bargains," notes Jeffrey Kleintop, chief global investment strategist for Charles Schwab.

Not only are corporate earnings falling in those regions — since so many companies are tied to the energy sector — but these economies are plagued by rising inflation brought about by weakening currencies. Value-minded investors are better off focusing on emerging markets with more diverse economies and stronger currencies, Kleintop says. This group includes more consumer-driven economies, such as Mexico, South Korea, India, and Taiwan.

The good news is that these four markets make up about 40% of the MSCI Emerging Markets index, which many funds directly or indirectly track.

Seek out funds that can adjust to this shifting landscape

This asset class may be one of the few in which active managers have an advantage over index funds. Before you add any direct investment in an emerging-market fund or ETF, check to see if your diversified international fund is already doing the job for you. While the typical blue-chip foreign-stock fund holds 5% to 10% of its assets in the developing world, some funds are more adventurous.

The managers of Dodge & Cox International (DODFX), for instance, keep more than 20% of their portfolio in emerging-market stocks. And more than 17% of the Vanguard International Growth Fund (VWIGX) is held in shares of companies based in the developing world. Vanguard International Growth is a member of our Money 50 list of recommended mutual and exchange-traded funds (see "Great Funds for the Long Run" on page 104).

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If you're looking for a fund focused solely on emerging-market shares, go for an actively managed one. Active managers have the freedom to downplay sectors that are most affected by the commodity slump and sluggish economic growth. In recent years this flexibility has worked to their advantage.

According to S&P Dow Jones Indices, nearly 30% of actively run emerging-market funds beat their benchmark over the past five years. That's not exactly a needle in the haystack compared with the 11% success rate for actively run funds focused on U.S. large stocks.

Among the better performers over the past five years has been the T. Rowe Price Emerging Markets Stock Fund (PRMSX), which is in our Money 50 list. Manager Gonzalo Pangaro invests less than 9% of the fund's assets in energy, basic materials, and industrial stocks.

By comparison, the index-tracking iShares MSCI Emerging Markets Fund recently held 21% of its assets in those sectors. Another active fund that underweights energy and natural resources is Fidelity Emerging Markets (FEMKX), which has beaten at least 70% of its peers over the past one, three, and five years.

Whichever fund you choose, patience is a must. "So much has gone wrong, maybe it's time to think about what could go right," says T. Rowe Price's Knudsen. "We wouldn't need a lot to go right to see a turnaround."