Why All Emerging Markets Are Not Created Equal

The concept of emerging markets has achieved a sense of uniformity in recent times, but investors make a fundamental mistake in lumping those markets together. You've no doubt heard the cliche that it's not a stock market, but a market of stocks? Well, the universe of emerging markets is as diverse as the many stocks on the New York Stock Exchange.

How to tell the bad from the good
Check out this table, courtesy of Bridgewater Associates:

Short-Term Debt of Emerging Economies

In billions. Source: Bridgewater Daily Observations, 9/19/08.

That table says a lot. (Interested readers can see all of the data in the PDF on Bridgewater's website.)

The short-term borrowings and debt-service payments exceed the total value of foreign reserves in the case of Turkey, Hungary, Israel, Slovakia, Lebanon, Jordan, Romania, Bulgaria, Uruguay, South Africa, Ukraine, and the Czech Republic. Of the 12 culprits with such extended finances, seven are in Eastern Europe. The 13th such ranking in our table -- Croatia -- is almost as bad, with a 99% ratio of short-term debt and debt-service payments to foreign reserves. For comparison, BRIC favorites Brazil and China have much more reasonable ratios of 54% and 16%, respectively.

Eastern Europe holds a lot of potential, but the region is plagued with high current account deficits that have been financed by the willingness of foreign capital to invest in those emerging economies -- in most cases in the overheated commercial and residential real estate markets. Right now, this capital is rapidly fleeing the area. That's causing floating currencies in the region to depreciate rapidly and putting big strains on currencies that are fixed -- that is, they don't float against the major currency to which they are pegged. Real estate prices are falling as well, and that's causing trouble for banking systems in the same way that it's wreaking havoc in the United States.

Avoid Eastern Europe
I vacationed in Bulgaria in 2007, and it seemed that everywhere I turned were advertisements for "the new best investment" -- which were new condos on the beach. What's more, in the corner of one billboard ad was the suggestion that you can receive "20% annual capital return." I knew this was trouble, but the locals did not want to believe it. A friend in the real estate business tells me now that a 25%-35% decline in the price of such speculative properties is expected in 2009.

In my opinion, the picture everywhere in Eastern Europe is pretty much the same, given the similar overextended nature of their finances. (Refer to the table for a reminder.) The flight of capital and faltering real estate markets are likely to produce an effect similar to the Asian Crisis of 1997-1998 -- which is why I'd recommend staying away from investments in the region. Yes, Asia was a great buy after the crisis was over, but in my opinion, with Eastern Europe, we are, at most, one-third of the way into the drama.

It's true that most Eastern Europe investments are down quite a bit ... but I'm still not biting. I'd avoid the closed-end funds: Central European Equity Fund (NYSE:CEE), Morgan Stanley Eastern European Fund, and Templeton Russia Fund (NYSE:TRF). Also stay away from the Market Vectors Russia (NYSE:RSX) exchange-traded fund. The Russian ruble is seeing a lot of pressure because of the huge outflow of capital from the country, and a more severe devaluation cannot be ruled out.

Since Russia is the largest nation in the biggest Eastern European market, it is most heavily weighted in all of the closed-end funds. And since Gazprom is the biggest stock in the Russian stock market, it is a major part of all fund portfolios I've mentioned here. Gazprom is probably the safest stock to own in Eastern Europe, because of its dominant position in the European natural gas market. The shares are trading around $13, even though the company owns 17% of all gas reserves in the world, enough to give the company a market cap of $79 billion. Just six months ago, you had to pay nearly five times more for the same gas reserves.

The emerging-market favorite
The winners are in Asia, where the cleansing that took place after the Asian Crisis has left most of the countries in the region in better fiscal shape to cope with the current global recession. India is a big favorite because it is a domestic demand-driven economy -- that is, it does not rely on exports to grow. For investors wanting to focus on a macro bet on India's comeback, two closed-end funds are worth a look: Morgan Stanley Dean Witter India Fund (NYSE:IIF) or The India Fund (NYSE:IFN). Both funds trade within 1% of net asset value, which means they lack the premium/discount issue that most closed-end funds have.

The top two holdings in the Morgan Stanley fund are Infosys Technologies (NASDAQ:INFY) and HDFC Bank (NYSE:HDB), which would make fine investments on their own. Infosys is the biggest IT outsourcing company in India, and HDFC Bank is one its biggest banks.

When it comes to emerging markets, do your homework the same way you do with stocks. They are not created equal.

More on emerging markets:

• Why I'm Buying Emerging Markets
• One Heckuva Cheap Stock
• News Flash: Emerging Markets Aren't Safe Havens