Missed the Rally in Emerging Markets? Pullback May Offer a Second Chance

Emerging stock markets are often the best performers in a global rally, and they are out front again this time around, just about doubling since early March.

It's easy to see why they do so well: They are highly sensitive to economic conditions, which makes them big beneficiaries of a recovery from recession, and they are natural destinations for investors who suddenly crave risk again. Their continuing rise out of economic, political and technological backwardness makes them feel-good stories too.

It's no surprise that portfolio managers who specialize in emerging markets would like their chances in a climate like this (they tend to like them all the time, actually). But one manager who has been producing superior returns is warning of a correction.

Josephine Jimenez, chief investment officer for Victoria 1522 Investments in San Francisco, expects stock markets in the developing world to fall by 10 to 15 percent mainly because, in her view, the rally has left them overvalued.

As the year began emerging markets collectively traded at just six times the amount of their earnings from the previous four quarters, a common method of valuing companies. Lately their price-earnings multiple has risen to 16.

Jimenez has been raising cash in her Victoria 1522 Fund (named after the ship that Ferdinand Magellan sailed around the world and the year he made it back to Spain) by selling some of her holdings in China, which began a correction in early August. She is also wary of such diverse industries as telecommunications, especially in India, and South African mining.

Jimenez selects her stocks in part by sifting through arcane bits of information and using occasionally offbeat logic to envision their impact on economies, industries and companies.

The formula works. Her fund had returned 65.9 percent this year through Wednesday, better than nine-tenths of emerging-market funds in the database of the independent research firm Morningstar. The MSCI Emerging Markets Index was up 61.1 percent over the same period.

A factoid that Jimenez is focusing on these days is the $360 billion in capital gains that investors within emerging economies have realized this year by selling their winning stocks. Her belief that they will use a lot of that cash for conspicuous consumption, American style, is leading her into big-ticket items like cars.

One favorite investment is Tata Motors. The Indian company makes a $2,500 vehicle called the Nano that is enjoying tremendous sales growth at home and is expected to be rolled out in Europe and Latin America.

The capital gains windfall also could prove a boon for banks in developing economies as some sellers choose to salt their winnings away rather than spend them, Jimenez said. She offered no names, though, and said she was still in the exploratory stage.

Another stock she likes is Cosan, a Brazilian company that is the world's largest publicly traded sugar producer. This is a play on higher sugar prices and also on the greening of Brazil. In an effort to protect its environment, the country is limiting the amount of acreage available for planting sugar, which could further lift prices, Jimenez noted.

Many of the stocks she likes are based in Brazil, where the long-term economic outlook is solid and the stock market still trades at a cheapish 12 times earnings. A couple of others there that she mentioned are the paper producer Votorantim Celulose e Papel and the oil major Petroleo Brasileiro, known far and wide as Petrobras. Both of these, along with Cosan and Tata, trade on the New York Stocks Exchange, so would-be buyers will not have to go far to pick up shares.

The pullback in emerging markets that Jimenez anticipates is fairly modest given the huge rally that has preceded it, but betting on such a Correction Lite may be the most sensible play from a contrarian perspective.

Many investors no doubt are chasing the run-up, trying to make up for lost time. Others, knowing how volatile emerging stock markets are, are probably awaiting a spectacular collapse before stepping in.

Markets have a way of doing the thing that catches the greatest possible number of people leaning the wrong way. A correction just big enough to scare some investors into selling stocks before the next leg up and small enough to keep prospective buyers on the sidelines could be that thing.