Personal Finance: Developing countries offer potential for better returns

Personal Finance: Developing countries offer potential for better returns

September 14th, 2011 by By Travis Flenniken in Business Diary

Finding growth among industrialized nations, such as the U.S. and Western Europe, is very challenging for investors these days. According to the Federal Reserve, U.S. Gross Domestic Product growth is expected to be about 2.8 percent in 2011. The European Central Bank expects GDP growth in that region to be 1.4 percent in 2011 and between 0.4 percent and 2.2 percent in 2012.

Investors may want to consider investing in emerging markets to capture more opportunities for growth. Amid the turmoil of the European sovereign debt crises and the high unemployment in the U.S., companies operating in emerging markets may present opportunities for investors to find growth at a reasonable price.

The emerging market category comprises roughly 40 nations undergoing rapid industrial growth and infrastructure development relative to developed nations. The "BRIC" nations -- Brazil, Russia, India and China -- are the largest and more recognized countries that fall into this category. This group also includes Taiwan, South Korea, South Africa, Mexico, Israel and a host of others.

While the emerging markets are not completely immune to the global slowdown, their growth rates are still relatively strong. The Brazilian government recently cut their 2011 GDP growth expectations from 4 percent to 3.7 percent. China's GDP cooled from 11.9 percent growth in 2010 to an expected 9.7 percent growth. India's growth is expected to be between 7.5 and 8 percent.

According to an April 2011 study by McKinsey & Co., China, India, Brazil, Mexico, Russia, Turkey and Indonesia combined are expected to contribute about 45 percent of global GDP growth in the coming decade.

In terms of relative value, emerging markets appear to be attractively priced. Buying companies with high rates of growth usually means investors must pay a price per share that is several multiples above the company's earnings per share, as calculated by the price-to-earnings (PE) ratio. By incorporating a PE-to-growth (PEG) ratio, investors can determine if the premium paid for a stock is justified by its expected growth.

For example, if a company is trading a $24 per share and had net income per share of $2, the PE ratio would be 12 and investors who buy the stock are willing to pay 12 times the company's earnings. If the rate of earnings growth for the stock is 6 percent, the PEG ratio is 2 (12/6). However, if the growth rate was twice as high, 12 percent, the PEG ratio would be 1 (12/12). So a lower PEG ratio means the stock is cheap relative to its rate of earnings growth.

Companies in emerging markets are trading at a PE of 10, with an earnings growth rate of 20 percent, as measured by the MSCI Emerging Market Index, giving the index a PEG ratio of 0.5. Earnings of U.S. companies, as measured by the S&P 500 Index, are expected to grow 6 percent and trade with a PE of about 11.7. This gives the S&P 500 a PEG of about 1.8, indicating that the emerging market index is cheaper than the S&P relative to each one's expected rate of growth.

While nations within the emerging market category have improved their infrastructure and transparency, risks still remain. Emerging market stocks tend to be more volatile than U.S. stocks. Inflation has been a concern for fast-growing economies, such as Brazil's; however, its appears to be under control, as evidenced by the Brazilian central bank's actions to cut interest rates 50 basis points in September.

The volatile nature of stocks in the emerging market category may make it difficult for many to stomach an investment; however, the prospects for growth are hard to ignore.

Travis Flenniken, CFA, is vice president of investments with DeMoss Capital -