Are Emerging Markets The Next Great Trade?

I love it when perception differs from reality... that's when you can really make money in the stock market.

Take emerging markets for instance.

If you read the news regularly, you'd think emerging markets were the last place you'd want to put your money. Almost every day there's a headline decrying how the economies in these developing nations are on the verge of collapse. In 2010 it was Greece... in 2012 Egypt... last year it was Syria... and today it's Ukraine.

The problem with following all this bad news is that sometimes it leads us to miss out on the good things... like how stocks in India and South Africa recently touched new 12-month highs or how Irish companies rebounded 45.6% in 2013.

Unfortunately, most investors didn't see a dime in profits from these incredible rallies. They succumbed to the headlines, avoided emerging markets and instead settled for the good, but lower returns offered by U.S. stocks over the same period.

The good news is that the opportunity to earn explosive profits from emerging markets is far from over. While India and South Africa might be doing better, the rest of the world's emerging markets have been absolutely crushed lately, and conditions are ripe for incredible returns...

My colleague, Michael Vodicka, who writes our premium newsletter High-Yield International , recently talked about this exact opportunity in an update to his subscribers. Here's what Michael had to say:

[Emerging market] pessimism was on display early in the year when many analysts were warning investors about weakness in emerging markets, leading to large capital outflows from the group. That's when I told readers of High-Yield International that I was

One of the keys to making money in emerging markets is realizing that they rely on momentum and sentiment as much as they do fundamentals. Emerging-market stocks can sometimes fall further than you might have imagined possible... and they can soar to unexpected heights. Lately, pessimism has been rampant. But as Mike referenced, with the iShares MSCI Emerging Markets ETF (NYSE: EEM ) bouncing up off recent lows, we think sentiment is beginning to change.

We've seen this pattern play out over the last six weeks. According to a research report by Jeffries, $6.5 billion worth of investor capital has flowed into emerging-market funds (equity and bond) since March. This stands in stark contrast to what we saw in 2013, when emerging-market funds saw net capital outflows in excess of $24 billion.

Why are people returning to emerging markets? The answer is simple... they're one of the last places in the investment universe that remain attractive given today's conditions.

Think about it. After the market's historic 30% rally in 2013, U.S. stocks are now trading at ridiculously high valuations. The price-to-earnings ratio for the S&P 500 currently sits at 20 -- significantly higher than its long term average of 15.5. To make matters worse, growth stocks in the U.S. have started to slow down. The Russell 2000 index -- an index that tracks some of the fastest growing small caps in the United States -- has retreated over 10% in the last few months.

With U.S. stocks trading at sky high valuations and momentum plays cooling off, investors are starting look to emerging markets as the next undervalued growth story. That's one reason emerging-market stocks have been rallying lately. Since the beginning of February, the iShares MSCI Emerging Markets ETF (NYSE: EEM ) has surged 12% -- more than double the S&P 500's return over the same period.

While the jury is still out as to whether the rally indicates a long-term shift in emerging-market momentum, one thing is clear: emerging markets are one of the last places you can find cheap stocks today.

As it stands, the iShares MSCI Emerging Markets ETF trades at a price-to-earnings ratio of 8. Some emerging market stocks are even cheaper. For example, the MICEX (Russia's version of the S&P 500) trades at a price-to-earnings ratio of 6.47.

If sentiment towards emerging markets really is starting to take a turn for the better, then these record low valuations should provide plenty of upside for investors going forward. But even if it doesn't, and emerging-market stocks continue to remain out of favor, those low valuations should limit the downside risk for investors who buy emerging-market stocks today.

The question, of course, is which emerging-market stocks to buy...

One of the principle fears investors have when investing in emerging markets is political risk. Typically, these countries are still trying to figure things out... getting their legs underneath them and figuring out their priorities. And we think state-owned behemoths (like Brazilian oil-giant Petrobras, China Mobile and Russia's Gazprom, to name a few), are one of the biggest risks investors take when investing in emerging markets. These companies are typically bloated, inefficient operators that more often than not serve the interest of government bureaucrats than that of investors.

That's why we think investing in small-to-midsized companies in emerging markets is far preferable. And while that may sound like a risky proposition, as we'll explain in a moment, there's an easy, safe way for investors to get exposure to the best small-to-mid-cap companies in emerging markets all in one simple investment.

The thing is smaller companies in emerging markets are more focused on local growth trends. They're not concerned with having to meet oil production quotas, for example, so that it can meet budgetary shortfalls caused by the state. Their main concern is meeting the demand of consumers -- things that directly contribute to an emerging economy's growth. And because of their relatively smaller size, they have plenty of room to run when conditions are good.

There's one exchange-traded fund ( ETF ) we've found that we believe will benefit from the incredible growth opportunities available from smaller companies in emerging markets -- the WisdomTree Emerging Markets SmallCap Dividend (NYSE: DGS ) ETF.

This fund invests primarily in small-cap companies in emerging markets, and rewards shareholders in the form of cash dividends. DGS employs a more active approach in its search for small-cap companies than other funds. On a yearly basis, it screens for firms that have paid out at least $5 million in cash dividends in the past 12 months as well meeting certain market-cap and liquidity requirements. It also caps individual holdings at 5%, and sectors and countries are capped at 25%, which makes sure we aren't over allocated to one country or sector.

As with all investments, there is risk associated when investing in emerging markets. But the composition of this fund is one of the best ways we've found to invest in the long-term potential of emerging markets. We also like the fact that it currently yields 3.45%.

For those looking to get in on the emerging-markets trend, DGS provides an excellent way to allocate a small portion of your portfolio toward these developing countries

P.S. -- If you haven't thought about adding international exposure to your portfolio, you are missing out on the world's best and highest-yielding stocks. In fact, according to our research, 79% of the world's highest-yielding stocks are found overseas. That's why we've created a special presentation that tells you everything you need to know about some of the safest, highest-yielding stocks the world has to offer. To get more information on these stocks, follow this link now.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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