(MONEY Magazine) – Bet you don't know this: while U.S. stocks have raced ahead 17.5% so far this year, more than a dozen foreign markets--including Brazil, Hong Kong, Ireland and Taiwan--have fared even better. What's more, many investment pros expect international equities to beat U.S. shares handily in 1997. "The coming year looks like one of the best for foreign stocks since the early 1990s," says Douglas Johnson, senior international investment strategist at Merrill Lynch in New York City.

Experts point to three reasons why foreign stocks will shine next year: Corporate profits are revving up overseas, interest rates are heading down, and stocks in many foreign firms are trading at bargain prices. The result, says Henry Frantzen, global chief investment officer at Federated Investors in New York City: "Emerging markets equities could return 30% next year, while Europe could gain 20% or so." By contrast, Money chief investment strategist Michael Sivy predicts U.S. shares will plummet 15% before eventually recovering for a meager 7% return for the year.

Moreover, since foreign markets tend to move in different cycles than the U.S. market over periods of five years or longer, international equities can provide a potent defense against downturns in U.S. stocks. A portfolio invested 70% in domestic shares and 30% in foreign stocks, for example, offers comparable returns to an all-American portfolio with about 10% less risk. "Buying foreign shares now gives you some of the world's best companies at extremely cheap prices," says Earl Osborn, a principal at San Francisco investment advisory firm Bingham Osborn & Scarborough, "and you reduce the overall volatility of your portfolio."

Given the ebullient outlook for foreign markets, many advisers urge long-term investors angling for growth to boost their international stake to 20% to 35% of their stockholdings. To uncover the best buys among the world's 44 or so foreign markets, we interviewed more than two dozen international investing experts. We begin by laying out the prospects for five regions around the globe and then focusing on a dozen international stock funds that invest in the countries expected to lead the pack in 1997.

For an overview of the world's markets, MONEY turned to leading international strategist Leila Heckman, managing director of brokerage firm Smith Barney's Global Asset Allocation group. Heckman's forecast for Money last year proved to be right on the mark. Her top pick a year ago, Latin America, posted solid gains led by Brazil, up 28% (to Nov. 1); Japan, which Heckman panned, lost 10.8%.

Heckman's 1997 outlook for five major foreign regions appears in the map on pages 98 and 99. To calculate these grades, she and her team of three analysts applied a proprietary forecasting model to 44 countries divided into these five regional groupings: Europe, Japan, Asia excluding Japan, Latin America and Eastern Europe/Middle East/Africa. Heckman based her rankings on five criteria, each of which received separate scores. She then combined the five scores to determine the regions' overall grades of A (best) to F (worst).

The five factors: stock market valuation (responsible for 50% of the final grade), taking into account price/earnings ratios based on current and projected corporate profits, and price-to-book ratios (a measure of the market value of the region's stocks compared with the net worth of its companies); economic growth (10%), including estimates for projected growth in both gross domestic product (GDP) and export volume; risk (10%), which reflects, among other things, the value of a country's currency relative to that of its leading trading partners; interest rates (10%), both short and long term; and earnings revision momentum (20%), which rewards countries where companies have had the highest percentage of earnings estimates revised upward over the past one and six months.

So where do Heckman and her analysts see the best opportunities in 1997? The emerging markets--especially Eastern Europe and Latin America--along with developed Europe. Here is a profile of each region:

Heckman's top-scoring markets, those in Eastern Europe/Middle East/Africa, make up just 3% of the world's stock market wealth (not counting the U.S.) but are nonetheless packed with a bounty of cheap stocks that have superior growth potential. For example, while the regions' forecast earnings growth of 17% and export growth of 7.7% are above the global average, their average P/E ratio of 14 (based on the most recent 12 months' earnings) is 26% below the global average. Heckman especially favors Turkey and Israel, where forecast P/E ratios are respectively 62% and 31% below the world average of 13.

A 13% run-up in stock prices in Latin America this year has made bargain hunting difficult, but you can still scoop up undervalued shares, especially in Brazil and Mexico. For example, in Mexico--which has climbed out of the recession that had kept share prices frozen since 1994--the price-to-book ratio of 1.7 is 19% below the world average and the forecast 1997 P/E ratio of 9 is 31% below the global average.

GDP in Europe is projected to increase just 2.5% next year, but the region's markets figure to enjoy solid gains, thanks to falling interest rates and fatter corporate profits as many countries slog their way out of recessions. Heckman prefers some of the smaller markets, such as Belgium, Finland and Ireland. In Ireland the economy is projected to grow at a 4.9% pace next year, or more than two percentage points faster than Europe overall.

The outlook for Asia excluding Japan is decidedly mixed. Despite jitters over China's takeover in July, Hong Kong's estimated P/E of 12 (8% below the world average) and high export growth of 9.2% (33% above) should lead to strong stock gains, as should India's combination of forecast 6.3% GDP growth and below- average P/E ratio of 9. Malaysia and Taiwan, however, are the two priciest world markets that Heckman follows--with forecast P/E ratios 38% or more above the global norm. Cautions Heckman: "In Asia, investors have to pick and choose with extreme care."

As for Japan, Heckman is encouraged by the country's low interest rates--10-year bonds yield just 2.5%--and 18% projected corporate profit growth. But even though Japan's market remains 46% below its December 1989 peak, Heckman believes that Japanese stock prices are still high, given their forecast P/E of 37, which is nearly triple the world average. Thus she rates Japan a "D" and figures stocks there won't take off for another six months or longer.

To profit from this overview, we recommend that you invest in a diversified group of funds that own shares in one or more of our higher-rated regions, as do the dozen below that were recommended by the experts we interviewed. Six of these funds are diversified--three emphasize European stocks, one focuses on Asian equities and two invest in emerging markets securities. In the final section of the story, we highlight six regional funds that specialize in Europe, Latin America and Asia. (For performance data on the funds, see the table on page 105.)

DIVERSIFIED FUNDS

Diversified international funds, which typically buy stocks in 20 or more countries to reduce volatility, make an excellent core holding for 50% or more of your international stake. One diversified fund closely aligned with Smith Barney's 1997 forecast is $1.2 billion Oakmark International, with a hefty 52% of assets in Europe, 31% in emerging markets (including 14% in Latin America) and just 2% in Japan. Managers David Herro, 36, and Michael Welsh, 33, are long-term investors who like firms that use their excess cash productively--say, to fund profit-generating expansion or to buy back their own stock. One such company is $1.3 billion (estimated 1996 sales) EVC International, a maker of hard plastics that has already bought back nearly 5% of its shares and may purchase another 5% over the next two years. The fund holds a concentrated portfolio of just 55 issues--vs. the 171 average for its peers--in 23 countries. Herro explains: "We don't want to dilute our best ideas."

For a fund that follows the more traditional approach of keeping its holdings in line with those of major foreign stock indexes, Jackson, Miss. financial adviser Tim Medley recommends $5 billion Vanguard International Growth. Managed since 1981 by Richard Foulkes, 51, the fund holds more than 180 stocks in 23 countries with 50% of its assets in Europe, 17% in emerging markets and 28% in Japan. Foulkes seeks overlooked growth companies trading below the value of their future earnings. One example: $20 billion ING, a sleepy Netherlands insurer that Foulkes bought five years ago. The stock has since risen more than 200% yet still trades at a modest P/E of 12.

Investors looking to cash in on small foreign companies selling at discounts to their underlying asset value or earnings potential should consider $1.1 billion Tweedy Browne Global Value. The 239-stock fund spreads its holdings over 21 countries (including the U.S., which accounts for 15% of assets) and avoids volatile emerging markets; 52% of its assets are in firms with stock market capitalizations of $1 billion or less. Since small-company stock prices in some European countries have yet to rebound from recession levels, co-manager John Spears says he's finding "the kind of small-company stock bargains we haven't seen in the U.S. in 20 years." One example: Italy's $200 million Franco Tosi, a water distributor that's selling at a 67% discount to its book value.

If you prefer a diversified fund that tilts its mix toward Asian shares, adviser Osborn recommends $3.4 billion Warburg Pincus International Equity. Lead manager Richard King, 52, has 22% of assets in smaller Pacific Rim markets such as South Korea and Taiwan and another 29% in Japan. King and his team of four managers look for companies that can capitalize on major economic trends. One such company, says King, is $10 billion DDI Corp., a large player in Japan's rapidly growing (120% annually) cellular-phone industry.

Once you've chosen a core of diversified funds, you may want to expand into emerging markets portfolios, making them 20% to 50% of your foreign holdings. This strategy is especially appropriate for 1997, since most experts pick these developing regions to post the highest returns. Emerging markets funds can take double-digit pratfalls, however, so plan on staying aboard at least five years. Further, be sure to learn how heavily your other international funds are invested in emerging markets so that you don't wind up with too big a stake in these volatile stocks. Oakmark International, for example, recently kept 31% of its assets in developing nations, while Tweedy Browne Global Value had less than 2%.

Tricia Rothschild, international editor of Morningstar Mutual Funds, recommends $3.2 billion Templeton Developing Markets Trust, managed by 59-year-old Mark Mobius, a 30-year veteran of the global investing scene. Mobius seeks out emerging market stocks that are cheap relative to their peers or their historical trading prices. He has spread his fund's assets among some 491 securities in 32 countries, ranging from Argentina to Zimbabwe. Just under 40% of the fund's assets are in Asia (including a 17% stake in Hong Kong), while another 29% chunk is invested in Latin America, where Mobius likes firms like $11.6 billion Telebras, Brazil's near-monopoly phone company.

Closed-end fund investors now have a rare opportunity to buy Mobius' $290 million Templeton Emerging Markets at a bargain price. (Unlike open-end funds, closed-ends trade like stocks on major exchanges, where investor demand determines their share price. As a result, they can sell at a discount or a premium to net asset value--NAV--the per-share value of securities in their portfolios.) Templeton Emerging Markets, which is managed in a similar style to its open-end sibling above, recently traded at just 1% above its NAV, vs. a premium of as much as 37.8% in January 1996. In addition to profiting from gains in the fund's underlying assets, investors have a shot at extra returns if the fund's market price again soars to a blimpish premium.

REGIONAL FUNDS

Aggressive investors may want to shoot for even higher returns by investing, say, 5% to 10% of their foreign stash in one or more of the six regional funds below.

--Europe. Morningstar's Tricia Rothschild recommends $122 million Invesco European Small Company, which invests in small, fast-growing firms. Managers Andy Crossley, 33, and Claire Griffiths, 30, monitor a database of more than 2,600 stocks in 13 countries, searching for ones with market values of less than $1 billion that, for example, have above-average growth potential yet sell at below-average P/E ratios. Recently, 32% of assets were invested in Great Britain. This relatively new fund, launched in February 1995, is off to a blazing start--up 25.9% for the year to Nov. 4. But small stocks can be flighty--the fund dropped 4.7% last July. If you find such a single-month drop scary, you ought to pass on this one.

Emerging Europe is an area that many pros expect to deliver huge gains over the next five years or so. Sheldon Jacobs, editor of the monthly newsletter No-Load Fund Investor ($129 a year; 800-252-2042), recommends $56 million Vontobel Eastern European Equity, which has the biggest chunk (38%) of its assets in Poland and lesser amounts spread around such countries as Hungary (31%), Russia (14%) and the Czech Republic (6%). The fund, launched in February 1996, is up 39.2% to Nov. 4.

--Latin America. To invest in Latin America, George Foot, a partner at Newgate Management Associates, a New York City investment adviser, recommends $143 million closed-end fund Latin America Equity. Manager Emilio Bassini, 46, spreads his assets among 110 stocks in 10 countries, led by Brazil (29% of assets), where GDP growth is expected to double in 1997 to 5%. Latin American Equity recently traded at 17% less than asset value, far below than its usual 4.3% discount.

Open-end fund investors can choose $630 million Scudder Latin America, one of the few Latin America funds that's been around long enough to establish a three-year record. Rather than making bets on specific countries, lead manager Ed Games, 59, looks for companies that invest their excess cash wisely or are market leaders, such as $2.6 billion Companhia Cervejaria Brahma, Brazil's leading beermaker. Lately, he's been finding the best buys for his 75-stock portfolio in Brazil (47% of assets) and Mexico (26%).

--Asia. To get a healthy helping of blue-chip stocks in the so-called Asian Tiger countries--including Indonesia, Singapore and South Korea--investors can select top-performing $1.6 billion Colonial Newport Tiger. Managers Jack Mussey, 55, and Tim Tuttle, 55, are focused on large companies in the seven markets that have the strongest GDP growth, most predictable earnings and lowest P/E ratios. Hong Kong now accounts for 47% of the fund's assets. Says Tuttle: "Hong Kong is a dynamic economy with a market that's trading at roughly a 25% discount to its Asian peers because of investors' fears about China's takeover in July." Tuttle doubts China will clamp down on Hong Kong's freewheeling capitalism, since Hong Kong's thriving market is China's best source for much needed foreign investment.

Finally, Orleans, Mass. investment adviser John P. Dessauer recommends $14 million Guinness Flight Asia Small Cap, which seeks to cash in on fast-growing small companies. Manager Nerissa Lee, 48, has invested 41% of her fund's assets in Hong Kong, where economic growth is forecast at 4% to 5% for 1997, and put a small side bet (4%) on China, a country that's rebounding from recession and is expected to expand at a 10%-plus pace next year. "China and Hong Kong will be the world's fastest-growing economies," says Dessauer. "And Guinness Flight Asia Small Cap has a big stake in the small, rapidly growing companies that should benefit most."

Reporter associate: Paul Lim