(MONEY Magazine) – When it comes to emerging markets, there's almost no end to the bad news. After a disastrous 2000, when they shed 30% of their value, stock markets in Latin America, Africa and Asia continued to tumble further this year, thanks to the global slowdown. Then came Sept. 11. In the wake of the terrorist attacks, the Morgan Stanley Capital International (MSCI) emerging markets index joined the S&P 500 in its nosedive. But while interest-rate cuts and the prospect of a federal stimulus package have helped U.S. stocks recover, emerging markets hover well below Sept. 10 levels. The MSCI emerging markets index has lost 19% for the year as of Oct. 25. More bad news seems likely. The Institute of International Finance in Washington, D.C. estimates that emerging economies will grow only 2.8% in 2001--just half of last year's rate.

The long sell-off, however, has left emerging markets even cheaper than usual: The average price/earnings ratio for emerging markets is 10.8, compared with 20.6 for the S&P 500. Of course, these markets have tempted investors with low prices before--only to crush their hopes. What's different now? The events of Sept. 11 seem set to drag the U.S. and Europe into recession, yet some emerging markets continue to thrive. China's economy is expanding at a robust 7% this year and is expected to maintain a similar rate even in 2002. And countries like India and South Korea should continue growing even in this tougher global environment because they've been pushing through economic and corporate reforms in recent years. "Generally, managements are becoming more transparent, and companies are getting better," says David Herro, co-manager of Oakmark International. It's also worth remembering that when these markets do rebound, they can produce spectacular returns. After the 1998 collapse, they soon soared to gain 66% in 1999. In fact, emerging markets have outperformed the S&P 500 from the start of 1999 through Oct. 25, 2001, losing 6.1% to the S&P's loss of 10.5%.

There's still plenty of risk--no more than 5% of your portfolio should be invested in this volatile sector--so it's important to invest carefully. Those who do best differentiate not only among countries but also among sectors within a country. Consider: While Asia's emerging markets are down 15% so far this year, Korea is up 9.5%. That's a solid performance--yet Matthews Korea Fund is up 31% this year because its managers reduced their exposure to Korean techs and telecoms.

For those willing to bet on another emerging markets revival, here are some guidelines, followed by some of the funds that know these markets best.

FORGET TIGERS, FIND ELEPHANTS

As the American economy cools, its appetite for foreign-made goods is falling off sharply. That's bad news for Asia's fast-growing "tigers" like Taiwan and Malaysia, which rely heavily on tech exports. Yet the drop in exports won't be such bad news for the world's "elephants"--densely populated countries whose enormous internal markets for the staples of life help insulate them from the global economy. Think India and Brazil. The latter has numerous problems, notably an electricity shortage and a crumbling currency, but Dreyfus Emerging Markets manager Kirk Henry says Brazil and its 174 million people are being excessively punished by investors worried about a meltdown in neighboring Argentina. Brazil's stock market has fallen 36% for the year, and its average price/earnings ratio is a paltry 7.4.

The world's second most populous country, India is modernizing its socialist economy and has been one of Asia's top performers of late, expanding its gross domestic product 6.2% annually from 1996 to 2000. Investors in India face profound challenges--entrenched bureaucracies and a constant state of tension with nuclear rival Pakistan--but here's the upside: With the Bombay exchange down 45% since early 2000, prices are cheap in a country that's set to grow 5% next year.

CATCH BUTTERFLIES EARLY

Nothing excites global investors as much as finding a "pupa," a once-backward country that's transforming itself into a butterfly. One breeding ground for new butterflies is Eastern Europe. Julius Baer International Equity co-manager Richard Pell predicts that interest rates should decline in countries like Hungary, Poland and the Czech Republic as they converge economically with their more prosperous Western neighbors. That's good news for all businesses in Eastern Europe--particularly the banks.

Another potential wing-flapper: South Korea. After the financial crisis of 1997-98, many investors wrote off Korea. Yet under its dissident-turned-president Kim Dae-jung, last year's Nobel Peace Prize winner, the country is fixing its banking sector and reforming its corporate practices. Matthews Korea co-manager Mark Headley points to a former clunker like Hyundai Motors, Korea's biggest car maker. Low prices and 10-year warranties have made Hyundai and its Kia subsidiary among the fastest growers in the American car market. Their combined market share here is now 4%.

CONSIDER THESE FUNDS

The best global funds give you a fair amount of emerging markets exposure--while shielding you from the full volatility of the sector. Here are two diversified favorites, followed by two pure plays for investors who can stomach more risk.

OAKMARK INTERNATIONAL. This MONEY 100 fund has about 17% of its assets in emerging markets, while spreading the rest across Western Europe and Japan. Herro and his co-manager buy ultraresilient stocks like Unibanco (UBB on the New York Stock Exchange), a $4.7 billion Brazilian bank that Herro says has survived "military coups, hyperinflation and currency devaluations" to keep churning out profits. At a recent $16, it's 43% below Herro's estimated value of $28. The fund's one-year return through Oct. 26 is -2.46%, and its three-year return is 12.81%. Expense ratio: 1.30%. Telephone: 800-625-6275.

JULIUS BAER INTERNATIONAL EQUITY. It's tough for individual investors to buy into Eastern Europe--a region with few ADRs and many restrictions on foreign investors--but one way is through this MONEY 100 fund, which has 10% of its assets in the region. Co-manager Pell is buying financials like Ceska Sporitelna, the Czech Republic's largest savings bank. The fund's one-year return: -17.26%; three-year: 14.12%. The expense ratio is 1.37%, and their phone is 800-435-4659.

DREYFUS EMERGING MARKETS. Manager Henry has taken big bets on all the right countries--South Korea (13% of his portfolio), India (12%) and Brazil (10%). Henry buys dirt-cheap stocks like Videsh Sanchar Nigam Limited (VSL, NYSE), a $1.3 billion telecom that offers overseas phone calls to India's 1 billion residents. Only 2% of Indian homes have phones, giving this debt-free company ample room to expand its revenue. One-year fund return: -4.54%; three-year: 12.51%. Expense ratio: 1.85%. Phone: 800-373-9387.

T. ROWE PRICE EMERGING MARKETS STOCK. Another MONEY 100 fund, it tends to hold on to its picks twice as long as its peers. Co-manager Chris Alderson likes Reliance Industries, an Indian textile and petrochemical conglomerate with $6 billion in sales. Long considered one of India's best-run companies, Reliance has boosted its earnings per share an annualized 12.5% over the past five years. One-year fund return: -23.65%; three-year: 6.49%. Expense ratio: 1.5%. Phone: 800-638-5660.

--ARAVIND ADIGA