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Market Update

How to Participate in the Emerging-Markets Rally

Taking measured risks is a must for investors in this divergent asset class.

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Emerging-markets are on pace for a banner year. Whether further growth expectations are aligned to reality remains an open question.

The MSCI Emerging Market Index is up more than 14% so far this year as of this writing. Why the interest? Poor growth prospects in developed economies have compelled money managers to look elsewhere for better returns. The International Monetary Fund has cut its projections for global growth at 3.1% for this year and 3.4% for 2017--with much of the world's expansion driven by emerging-markets.

In fact, emerging-markets have been on a recovery trajectory since commodity prices plummeted in 2015 as China, the world's largest consumer of commodities, switched its economic growth approach away from a reliance on investment and industry and toward consumption and services. Those emerging economies reliant on commodity exports for their financial stability--including Russia, Brazil and Africa's major economies--suffered the most. More than a year later, investing in these markets seems like an opportunity.

Yet, "the emerging-market rally of 2016 is not really based on fundamentals," says Patricia Oey, a senior fund analyst at Morningstar. "Investors are looking for returns in markets that have underperformed for the past few years."

Given the recent interest in these markets, let's take a look at the risks of investing and share some investment ideas from Morningstar's analysts.

Emerging-Markets Risks
Emerging-markets investing is not for the fainthearted. Before investing in this part of the market, it is essential to understand its geopolitical risks. 

For example, Turkey is the third largest weight in percentage terms among Europe, Middle East, and Africa in the MSCI Emerging Market Index. The country dragged the index lower late last month after Moody's rating agency downgraded the country's debt to junk status. The downgrade was a result of political deterioration after a faction of Turkey's military tried to overthrow the government in mid-July triggering money withdrawals. This caused Turkish stocks to fall, bond yields to rise, and the lira currency to depreciate.

Another major risk of emerging-markets investing is foreign exchange rate fluctuations. Investing in foreign stocks (and bonds) will likely produce returns in the local currency of the country; but as the local currency's value fluctuates relative to the U.S. dollar, the returns will, too. To wit, if the value of a Brazilian stock increases by 4%, but the real depreciates by 8%, the investor would have realized a net loss in total returns once converted to U.S. dollars.

Economics is another major risk. As some emerging economies depend on commodities for their economic stability, many of those have seen a deceleration of growth or even contraction since commodity prices plummeted last year. In sub-Saharan Africa, for example, the largest economies continue to drag down the region's growth due to lower commodity revenues. Nigeria's economy is forecast to shrink 1.8% in 2016, and South Africa's will barely expand, according to the IMF. China and India however, continue to grow. China is expected to expand 6.6% this year, down from 6.9% last year, while India is projected to grow 7.4% in 2016 and 2017.

But outliers may exist--take Brazil, for example. For the past two years the country has been entangled in a corruption scandal and gone through a crippling recession and a presidential impeachment--all major risks that should've kept investors at bay. And yet, Brazil has seen its stock market and currency soar: The Ibovespa stock market is up 42% so far this year as of this writing and the Brazilian real has appreciated 23% against the U.S. dollar during the same time period.

Morningstar senior fund analyst Gregg Wolper says the rebound in Brazil's market and currency is the main reason the Latin America stock category stands as the top performer of all 15 international equity categories for the year to date as of this writing, with a gain of more than 38%. Brazilian holdings make up more than half of the portfolios of nearly all pan-Latin America funds, says Wolper.

Stock Ideas
If the allure of higher growth in emerging-markets is attractive to you despite the risks, there are a handful of stocks in Morningstar's coverage area that are attractive today based on their valuations. All of these stocks are trading in 4- or 5-star range as of this writing, which means they're selling below Morningstar's estimates of their intrinsic worth.

Four-star Mobile TeleSystems PJSC (MBT) is the largest wireless telephone operator in Russia and a large provider of fixed-line broadband and pay-TV services in the country. "Despite the weak Russian economy, the telecom market is holding up quite well, and MTS continues to grow faster than the market," notes Morningstar analyst Allan Nichols in his latest analyst report. Morningstar assigns the company a narrow economic moat; Nichols notes that its scale generates a cost advantage versus its competitors. "For investors wanting exposure to Russia, MTS remains our preferred option."

Chile's  Empresa Nacional de Electricidad (EOCC) also rates 4 stars as of this writing. "We think growth, solid free cash flow, and low-cost generation make Endesa Chile worth consideration for investors seeking infrastructure exposure in emerging-markets despite setbacks from low hydrological conditions," writes Morningstar analyst Andrew Bischof in his latest analyst report. The narrow-moat utility recently spun off its legacy operations in Aregntina, Peru, and Colombia; as such, all of the company's current profits come from Chile. "Its low-cost generation advantage and high barriers to entry should help safeguard future cash flows," adds Bischof.

 Embraer SA (ERJ), a Brazilian manufacturer of commercial aircraft, is also in 4-star territory. The company earns a narrow moat due to its strong competitive position, particularly in regional aircraft. "We see value due to the company's strong competitive position," says analyst Chris Higgins in his latest report, "but investors in the ADRs will have to stomach significant currency risk."

 Teva Pharmaceutical Industries (TEVA), headquartered in Israel, is the world's largest generic pharmaceutical manufacturer. "We give Teva a narrow economic moat thanks to its large scale and vertically integrated generic drug manufacturing business, combined with intellectual property protection and a modest pipeline in the specialty drug segment," writes analyst Michael Waterhouse in his latest analysis. Currently rated 5 stars, Teva should be able to maintain its earnings thanks to the acquisition of Allergan's generics unit, ongoing benefits from its cost-savings plan, and its drug pipeline, he adds. 

Fund Picks
If you'd rather get emerging-markets exposure via a managed product, look to Morningstar's list of medalists for ideas. Here are a few choices to consider:

 American Funds New World (NEWFX), the sole Gold-rated fund in the diversified emerging-markets category, is up 8.7% year-to-date as of this writing, compared to a 14% gain by the MSCI EM Index. The fund's relatively conservative portfolio tends to underperform in rallies but produces favorable returns in a market decline. "This fund often looks best when emerging-markets are at their worst," notes fund analyst Alec Lucas. The fund is now available to no-load investors via Schwab's and Fidelity's NTF platforms.

 Oppenheimer Developing Markets (ODMAX), Silver medalist, is up 12.7% since January. It focuses on firms that will benefit from trends such as a growing middle class, new technology and consumer products, Oey says. As commodity-oriented countries such as Brazil, Russia, and South Africa bounce back, returns should rise in tandem.

Invesco Developing Markets (GTDYX), a Silver medalist, has gained nearly 25% this year after suffering a sharp drop in 2015 due to its large stake in Brazil. With Brazil's market roaring back, the fund has returned to positive territory with a bang. "This fund is not appropriate for investors who want more typical exposure to emerging-markets, or a fund that's usually fully invested; the managers will let cash rise when they can't find appealing companies at reasonable prices," says Wolper. "But it offers a distinct, and proven, take on the field."

If you're seeking a passive strategy to emerging-markets,  iShares Core MSCI Emerging Markets (IEMG) offers broad exposure to large-, mid-, and small-cap companies across 23 emerging-markets, including Taiwan and South Korea. "Its rock-bottom fee (0.16% expense ratio) and inclusion of small-cap companies set it apart from its peers in the diversified emerging-markets Morningstar Category," says fund analyst Matthew Diamond.

 Vanguard FTSE Emerging Markets ETF (VWO) (0.15% expense ratio) recently transitioned to a new FTSE index that will begin including China A-shares. It is also available in a mutual fund format as the Bronze-rated  Vanguard Emerging Markets Stock Index (VEMAX). "Vanguard Emerging Markets Stock Index's low costs overcome concerns about country weightings," writes Oey in her latest analyst report.

Manuela Badawy is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Manuela Badawy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.