Secrets for Picking Winning Stocks Now

There are years in which emerging-market stock funds plunge and years in which they soar. And then there are years like 2013 when, overall, they slipped slightly despite stellar gains by funds focused on developed nations, especially the US.

That’s because it was unclear how badly the formerly robust economic growth in the developing countries was slowing and how much the prospect of rising interest rates would divert investments away from emerging markets. Fears over economic setbacks and political unrest continued in early 2014 as emerging-market stock prices lost more ground.

So what lies ahead? Mutual fund managers say that it has become especially important to choose the right kinds of emerging-market companies—the strongest of the remaining stock bargains—as the pool of attractive picks shrinks.

Bottom Line/Personal turned to one of the most successful emerging-market stock fund managers to find out where the best of these opportunities are and what will determine whether the outlook will brighten.

Lewis Kaufman, manager of the Thornburg Developing World Fund, which ranks in the top 1% of its category over the past three years and gained 15.6% in 2013, says that he still is finding plenty of great stocks, but that it is vital to adopt new strategies if you want to profit from emerging markets in the coming years…

EMERGING MARKETS GROW UP

For years, the Federal Reserve’s ultra-low interest rate policies pushed major investors overseas in search of higher returns. But in 2013, the Fed said that it would start to phase out, or “taper,” its massive bond-buying program as the economy improves, causing interest rates to start jumping. Billions of dollars were redirected from emerging markets back into US dollar-based investments, a massive reversal that hurt emerging-market stocks and weakened currencies across the developing world.

At the same time, investors are nervous that economic growth has slackened as emerging markets undergo a difficult but vital transition. Many countries, including China, have developed to the point where they want to create more balanced and stable economies that are less exposed to the fluctuations of commodity-related industries and exports to developed nations. As wages improve and more people migrate to big cities, these countries are increasingly focused on the domestic spending power of their own fast-­growing middle classes.

Over the next few years, emerging-market stocks likely will continue to bounce up and down in price as investors grapple with these issues. However, I don’t expect the kind of stock market collapses, bank failures and soaring inflation that have occurred in the past. Developing countries are far better positioned today to withstand economic shocks because they have well-capitalized banks and governments that carry relatively low levels of debt.

HOW TO INVEST

You don’t have to abandon emerging-market stocks. Even with diminished growth prospects, developing economies still should grow two or three times faster than economies in the US, Europe and Japan over the next decade.

A recent forecast by GMO, the global investment management firm, predicts that emerging-market stocks will show 7% annualized returns after inflation, on average, through the year 2020, compared with -2% for US large-cap stocks and 2% for international large-caps. Stocks may offer even stronger returns in secondary emerging-market countries such as Colombia, Mexico and the Philippines, which have achieved successful economic reforms and greater political stability than they have in the past.

Strategies that the Thornburg Developing World Fund is using to navigate this tricky investment landscape…

Focus on local consumer markets. More than half of the fund’s portfolio is in consumer-oriented companies that generate plenty of free cash in industries such as health care, food retailing, gambling, media and hotels. They will set the tone for the next decade, just as export and commodity-oriented stocks were the big winners over the past decade.

Attractive examples now…

Alsea, S.A.B. De C.V. (ALSEA.MX). The Mexican restaurant operator is the largest in Latin America, with more than 1,400 outlets including Burger King and Domino’s Pizza. ­Alsea’s revenue for 2013 is estimated at $1.18 billion, up 10% from 2012. The company is diversifying to include more higher-margin casual eateries and coffee shops such as California Pizza Kitchen, Cheesecake Factory and ­Starbucks in Argentina, Chile, Colombia and Peru. Recent share price: $42.20.

Galaxy Entertainment Group (GXYEY) operates two casino-hotel complexes that attract billions of dollars in annual revenue in Macau, a special administrative region of ­China similar to Hong Kong. The casinos benefit from increased wealth throughout Southeast Asia. The fund also owns shares in several casino-hotel companies in developing nations including Cambodia and the Philippines. But Macau is the world’s largest gambling market, four times larger than Las Vegas, and it is dominated by Galaxy and just a handful of other companies. Galaxy’s revenues rose by 16% in the third quarter of 2013 and are expected to rise 20% annually for the next several years. Recent share price: $98.31.

Look for developed-market firms that d raw most of their revenue from emerging markets. The fund keeps about 10% of its portfolio in companies whose long-term performance is correlated with emerging markets but that can achieve high returns without high volatility.

Attractive example now…

Compagnie Financière Richemont SA (CFRUY)is a Switzerland-based global luxury-goods company whose 20 brands include watch and jewelry makers such as Cartier, Piaget, Van Cleef & Arpels and Vacheron Constantin. The company gets half its total revenue from Asia, including high-end watch sales in mainland China, Hong Kong, Macau and Taiwan. A Vacheron Constantin watch can cost more than $100,000. Sales of luxury goods slowed last year after news that the Chinese government was clamping down on corporate gift-­giving. But investor fears were overblown. Richemont’s brands will remain highly desirable to the burgeoning class of wealthy and elite consumers throughout the Asia-Pacific region. Recent share price: $9.25.

Invest in Internet companies that are emulating the US online giants. There’s a voracious demand in ­emerging
markets for everything Internet, ranging from search engines and instant messaging to blogging and social networking. But competitors such as Google and Facebook have made limited headway in many developing countries because of punitive government regulations as well as language and cultural barriers.

Foreign Internet companies are among the fund’s favorite investments because they can grow their earnings by 30% or more annually for many years…they dominate their markets…and they have little or no debt to weigh them down while generating enormous cash flow.

Attractive examples now…

Tencent Holdings Ltd. ADR
(TCEHY) is China’s leading Internet firm, providing instant messaging, social networking, mobile gaming and blogging for more than 800 million users. Recent share price: $63.36.

Yandex N.V. (YNDX) often is called the Google of Russia. It has more than a 60% share of Russia’s search engine market. It makes money from Web-advertising revenue and is expanding into e-commerce. Yandex has a new partnership with Apple in which Yandex could become the default search engine on Apple’s Web-browsing software Safari. While many Russian companies suffer from corruption and questionable balance sheets, Yandex actually is based in the Netherlands and trades on the Nasdaq exchange, which requires companies to abide by stricter US accounting standards. Recent share price: $44.22.