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Why You Should Invest in This Hot Sector

Newsflash: Emerging markets have been one hot sector.           

One way to tell is that Chinese, Indian, and Brazilian stocks are all trading above their historical valuations. But if you decide to jump on the bandwagon now, without doing the proper research, you're going to get burned by a market that's already overheated and overextended.

A bad game of follow the leader
The good news is that international equity funds have paused a bit, as worries over the debt crisis in Europe has slowed investment abroad.

But even with the pullback, there's no doubt that emerging markets have been on fire. Vanguard's Emerging Market Sector ETF, which holds stocks such as Petrobras (NYSE: PBR  ) and Teva Pharmaceuticals (Nasdaq: TEVA  ) , surged ahead last year by a whopping 76%. That's not to say these two companies aren't still good investments -- both have pretty wide economic moats, and both are trading below 12 times forward earnings. That's pretty darn good for stocks that have seen such a recent run-up.

Part of the reason this sector has performed so well is the vast growth potential in countries like China, India, Brazil, and Russia. China alone has a population of about 1.3 billion -- that's an awful lot of would-be buyers of products, services, and other business opportunities.

But another reason why the sector has been so popular is a phenomenon called "social proof". This is basically the theory that, as a shortcut to detailed analysis, people will just do things they see other people doing. Sometimes it's pretty innocent; for example, if you see a lot of people eating at a new restaurant, chances are it could be a great new find, so no one would blame you if you wanted to try it. But when it comes to investing, social proof has some dangerous consequences.

Following a herd of people into a particular asset class was what helped turn the commodity boom into a bust, as investors poured into oil and gas service companies like National Oilwell Varco (NYSE: NOV  ) and El Paso (NYSE: EP  ) at their highs, only to see them drop by over 70% during the 2008 collapse. Now, a few years later, these companies look like much more attractive propositions, as both trade for about 10 times earnings and should benefit from a nascent recovery in oil and particularly natural gas.

Social proof is also what made people believe that home prices would continue to go up in places like California and Florida, even when all realms of logic pointed to a market that was drastically overvalued.

But when it comes to emerging markets like China, can you really just ignore what may be the buying opportunity of a lifetime, just because other investors may have gotten there first?

The answer is a resounding "no" -- you can't ignore this type of opportunity. But you have to proceed with caution, and that's why I've identified three major trends that you can profit from in 2010; trends that haven't yet been stampeded by the social herd.

3 profit plays for 2010
Although 17% of Chinese citizens live on less than $1 a day, there is a very strong and growing upper class. "In recent years, the huge gap between rich and poor has become an indisputable fact in China," Li Wei, a director at the Chinese Academy of Social Sciences, told China Daily last year. This presents two important facts. First, the rich are going to continue to spend more, as they've most likely been the beneficiaries of increases in the stock and housing market. But, second, China knows it needs to close this gap and increase consumer spending if it's to stave off inflation, so it will focus in the years ahead on bringing rural Chinese into the fold of economic equality. What company stands to benefit? (Nasdaq: CTRP  ) , the leading online consolidator of hotel and travel arrangements in China. As wealth spreads throughout the country and the government puts pressure on its domestic spending, more and more Chinese will travel and go on vacation -- placing in a perfect position to benefit from both demographic and public policy trends.

You've probably heard by now that there's a massive housing bubble brewing in China's big cities. It's true, the Chinese real estate market has seen extraordinary growth, and clearly the government has taken notice as its adopted measures to rein in lending and slow the flood of capital into the markets. However, public policy and the massive stimulus passed last year both point to the continual development of China's smaller, tier 2 cities. Those people have to live somewhere, and that's where Xinyuan Real Estate (NYSE: XIN  ) comes into play. This company concentrates specifically on tier 2 cities and builds huge, affordable, residential developments. Trading at a P/E of 7.5, this is a rare opportunity to grab such a great company at such a reasonable price.

The stunning growth in China has done much to help its people, but it's come at a price -- especially to the country's natural resources and its environment. Part of the $585 billion stimulus China enacted last year is going to green initiatives, with a focus on water distribution and wastewater treatment. Who else to benefit from these programs than Duoyuan Global Water (NYSE: DGW  ) , a company that manufactures and sells water treatment equipment? China has set aside more money than any other country in the world to the implementation of clean technologies, and Duoyuan should profit immensely.

Be prepared
Remember that social proof is only prevalent when people have limited information and therefore depend on the opinions of others to dictate their own actions.

That's why at Motley Fool Global Gains, we take annual trips to China, meeting with manufacturers and management, scouring rural cities to find the best companies out there. These trips bear thorough and pertinent information that can help us all make the most informed decisions.

In other words -- buy emerging market stocks, just not the ones everyone else is buying. To see what other stocks you should be buying, click here for a free, 30-day all access to Global Gains.

Fool contributor Jordan DiPietro has no position in the stocks mentioned above. National Oilwell Varco is a Motley Fool Stock Advisor recommendation. International is a Motley Fool Hidden Gems selection. Petroleo Brasileiro is a Motley Fool Income Investor pick. The Fool has a disclosure policy that's 14 days away from a trip to Peru.

Read/Post Comments (4) | Recommend This Article (31)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 24, 2010, at 7:16 PM, xetn wrote:

    "But, second, China knows it needs to close this gap and increase consumer spending if it's to stave off inflation, so it will focus in the years ahead on bringing rural Chinese into the fold of economic equality." What? Just how does increasing consumer spending reduce inflation?

  • Report this Comment On May 25, 2010, at 12:20 AM, IzzyLizzy wrote:

    China knows it must increase consumer spending to decrease inflation? Inflation is not a phenomenon. It is not an act of God or a natural disaster. It does not happen by accident. It is a monetary policy chosen by those that control the supply of money.

  • Report this Comment On May 25, 2010, at 12:42 PM, theinfamoushw wrote:

    You're seriously telling us Chinese real estate is a good investment? Looking for a fool to short a position to?

  • Report this Comment On May 28, 2010, at 5:53 PM, drborst wrote:

    Your articles on China are starting to feel like a herd.

    When is Global Gains going to tell me about someplace else?

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