A breather--or a downturn?
Scalding emerging-markets stocks have cooled lately. They may not rebound for a while.

(FORTUNE Magazine) – Like frequent fliers, veteran emerging-market investors are accustomed to stomach-churning turbulence. Over the past couple of years, those who weathered the spikes and dives of stocks and mutual funds from developing countries have been rewarded handsomely for their resolve. Investors who held on last spring, for example, after the benchmark Morgan Stanley Capital International emerging-market index plunged 20%, saw a surge of nearly 50% over the next eight months. In all, the MSCI index rocketed 130% from late 2002 to its all time high on Feb. 28.

Those gains attracted hordes of investors. The Institute of International Finance estimates that $310.7 billion in private capital will be poured into emerging markets this year, up from $120.4 billion in 2002. But the results haven't been quite as rosy the past few months. Since its peak at the end of February, the MSCI index has sagged by 8%. That's hardly calamitous by the bumpy standards of this sector. Indeed, investors looking back to 2004 might be tempted to see a buying opportunity.

Not so fast. An immediate rebound is unlikely this time. In fact, there's a good chance the weakness will continue for several months. But despite the short-term stagnation--or even a descent--experts agree the long-term prognosis remains bright.

The cautious near-term outlook stems largely from the same fears that have waylaid U.S. stocks: concerns about oil prices, creeping inflation, and especially rising interest rates. On top of that, emerging- market investors face slowing worldwide growth, particularly in China. Companies in fledgling economies are expected to increase earnings 8% in 2005, compared with 12% for those in developed markets, wrote Smith Barney strategist Ajay Kapur in a recent report.

Those factors add up to a potential short-term slump in newer markets. "We believe that the recent setback is not over, and that it will likely be deeper than a brief pause," Kapur noted. His conclusion: "Taking profits in emerging markets, and lowering risk, seems a prudent thing to do."

Still, for patient investors with strong stomachs, opportunities remain--as long as you remember that you should never expose more than a small portion of your portfolio to this sector. "If you are a very long-term investor in emerging markets and you have the wherewithal to withstand, say, a 10% or 15% drop and the volatility associated with that, you may want to just hang on," says Liz Ann Sonders, chief investment strategist at Charles Schwab. That's because the fundamental outlook remains bright. Developing economies grew 6.6% in 2004, the highest rate in 30 years, according to the World Bank. While that is expected to slow, long-term growth will continue to outpace that of developed nations.

Moreover, newer markets--and the companies in them--are stronger than they used to be. The Asian financial crisis of 1997--98 prompted structural reforms that are now paying off. And improvements in corporate governance and financial management, though they have much further to go, have significantly boosted returns on equity. Emerging-market stocks, meanwhile, remain less expensive than those in developed markets, trading at less than 12 times operating earnings, compared with 17 for the S&P 500.

Diversified mutual funds are the safest way to sample the developing world. Morningstar analyst Bill Rocco recommends the Oppenheimer Developing Markets fund (ODMAX), which has returned an average of 12.4% over the past five years. The fund takes an iconoclastic value approach, combining large companies like Embraer, SK Telecom, and Teva, with small and micro-cap stocks. Alas, the fund charges a 5.75% load. A no-load alternative, the T. Rowe Price Emerging Markets Stock fund (PRMSX), has returned 8% a year over the past ten years and carries a modest 1.33% expense ratio. Co-manager Chris Alderson is bolstering blue chips like Samsung, Petrobras, and Grupo Televisa with a disproportionate weighting in Egypt, Turkey, and India. Like all such funds, these two can be turbulent. But they've shown they can ride the updraft.