The Bright Side of the Emerging-Markets Correction

As emerging-markets stocks have tumbled over the past month, I just can't help smiling. The reason for my sadistic happiness: I'm finally beginning to see a few good values among our favorite emerging-markets stocks, when only a few weeks ago there were very slim pickings.

It Has Been Quite a Party
Emerging-markets stocks have enjoyed a prolonged party over the past few years. Our data show that through June 16, the average emerging-markets stock fund had produced a total return of more than 30% annually over the last three years, a little more than 20% per annum higher than the S&P 500 over the same time frame.

Emerging-markets stocks were not rising without cause; indeed, developing economies are enjoying almost unprecedented strength right now. According to The Economist magazine, emerging markets accounted for more of the world's total output than developed economies in 2005. This hadn't happened since before the 20th century. Further, of the 32 largest emerging-market economies tracked by The Economist, not one experienced a recession in either 2004 or 2005. Before that, every single year during the past three decades saw at least one of these countries in recession, if not worse, and we're now solidly into a third consecutive year of unfettered growth in 2006.

Recently, while at the peak of this revelry, our stocks team at Morningstar looked like the ultimate party-poopers, encouraging investors to stick to the sidelines until prices came down. As recently as May 15, we thought the median stock in our emerging-markets coverage universe was 24% overvalued, based on our fair value estimates. On that date, there were 51 1-star stocks (stocks we'd consider selling) in emerging markets, compared to just one lonely 5-star stock that we'd consider buying.

All Parties Have to End Sometime
Things sure can change quickly!

Over the past month, many emerging markets have experienced precipitous declines in stock prices. The selling has been widespread, with some markets declining by 30% or more in the matter of just a few weeks. Our data show that the average emerging-markets stock fund has declined by about 13.1% over the last month! This significant and sudden correction has helped the valuations in our coverage universe look a little more reasonable.

As of the close June 16, the median emerging-markets stock in our coverage universe was about 9% overvalued--15 percentage points better than one month earlier--with 33 1-star names and four stocks with a 5-star rating. While this shows that we think emerging-markets stocks remain overvalued, they're beginning to look a little better. Who knows what another month may bring!

A Sampling of Some Quality Emerging-Markets Stocks
We're not exactly swamped yet with a flood of deeply undervalued emerging-markets names. However, over the past few weeks we've found a few very intriguing opportunities among some of our highest-quality emerging-markets companies.

Among these are the three Mexican firms highlighted below. Mexico's stock market declined by about 13% over the one month period ending June 16, and these fine companies went along for the ride, even though our fundamental outlook for the firms is unchanged. With the Mexican presidential election coming up soon (elections often spur volatility in developing countries' stock markets), there may be some more turbulence to come.

All three companies boast narrow economic moats and hold average risk, in our view. Each one reached 5 stars during the recent downturn, and is either at or near a 5-star Morningstar Rating today. Also, two of the three stocks highlighted below--Cemex and Fomento Economico Mexicano--are members of the International Stalwarts, a watch list of our favorite non-U.S. stocks with moats. (The list appears in each issue of Morningstar StockInvestor.)

 Cemex (CX) is the third-largest cement company in the world. While it still receives a large portion of its returns from Mexico, it has successfully expanded throughout the world. It now has large revenue streams in the U.S., Europe, and Asia, which protect it from an economic slump in any one country. Its Mexican base provides it with a low cost structure, and its experience in cement trading enables it to take advantage of supply and demand imbalances between countries.

 Fomento Economico Mexicano (FMX), better known as Femsa, is the dominant player in the Mexican beverage market, controlling about 43% of the duopolistic beer market, and 35% of the total soft-drink market, thanks to its ownership stake in  Coke Femsa (KOF). It also owns the quickly expanding Oxxo chain of convenience stores, which provides a guaranteed route to market for the company's beverages and allows Femsa to keep competitors' products off the shelves.

 Telefonos de Mexico , or Telmex, is the dominant player in Mexico's local and long-distance telephone market. It boasts a market position that would make even  Microsoft (MSFT) blush, with about 96% market share of landline telephones in Mexico. While we expect the company's revenue growth to run less than inflation over the next several years, it's very profitable and spews cash. Its returns on capital far exceed its cost of capital, and free cash flows have averaged almost 24% of sales over the past 10 years.

One caveat for those contemplating investing in emerging markets: We at Morningstar believe that investing in firms with economic moats and buying only when there's a sufficient margin of safety help to protect the capital of emerging-markets investors, but we caution investors that only those with healthy appetites for volatility need apply. Just as many stocks can run up far beyond what we think they're worth, it's possible for undervalued stocks to become ridiculously undervalued before the market regains its senses, so both patience and an iron gut are essential virtues in emerging-markets investing, in our opinion.