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The Smarter Play in Emerging Markets

Dan Caplinger
June 27, 2012

Throughout the past decade, investors have turned to emerging-market stocks in a last-gasp effort to take advantage of strong economic growth. Those who did so managed to avoid the full extent of the Lost Decade for U.S. stocks.

Recently, though, many popular emerging-market investments have started to lose their luster. Yet even as those formerly hot stock markets cool off, you can still find pockets of strength in areas that could well continue to thrive even if overall growth continues to decelerate.

Looking outward vs. looking inward
For much of their histories, investing in emerging markets was all about what those countries could provide for the developed world. In China, for instance, cheap labor allowed companies to manufacture goods far less expensively, and so the nation's export-oriented economy represented the lion's share of its overall growth. Similarly, India notoriously thrived by providing outsourcing opportunities for U.S. and other higher-cost labor markets, allowing Infosys (Nasdaq: INFY  ) and a host of other specialists to profit from differentials in labor costs.

The other thing that emerging market economies gave the developed world was a rich array of natural resources. Russian oil, natural gas, and precious metals have been a big driver not only of commodity prices worldwide but also for the resources Europe in particular needs in order to function efficiently. Similarly, Brazil provided energy and mineral wealth not only to the developed world but also to China and other emerging economies, as Vale's (NYSE: VALE  ) status among the world's big miners attests.

Initial investment in emerging markets largely followed these priorities. So when you invest in the Vanguard MSCI Emerging Markets ETF (NYSE: VWO  ) , you end up with a host of companies that are primarily aimed either at natural resources or at exports.

But that's not the only way to invest in emerging markets. And especially over the past year, it hasn't been the best way either.

Looking at the consumer
Early on, some of my fellow Fool analysts realized that looking at exports and natural resources was the wrong way to take advantage of the second growth phase in emerging markets. Inevitably, economic pressures would start to even out labor-cost disparities, reducing the advantage gained from outsourcing and export manufacturing. Meanwhile, natural resources would go through normal cyclical movements that would prevent them from achieving unlimited growth.