How to find value in turbulent world markets

February 27, 2014: 5:00 AM ET

Global markets -- particularly emerging ones -- have been looking increasingly uncertain of late. But turmoil can mean opportunity.

By Lauren Silva Laughlin; graphics by Nicolas Rapp

FORTUNE -- The Polar Vortex may not have been the most spine-chilling storm this frigid winter. For many investors, that moment came in late January, when indexes ranging from the S&P 500 (SPX) to the MSCI Emerging Markets dropped 5% in a matter of days before stabilizing. The consensus on the culprit: the Federal Reserve, which has been paring its massive -- and interest-rate-lowering -- purchase of U.S. bonds. When the Fed sneezes, investors seemed to conclude, global stock markets will catch a cold.

Now that the Fed finally seems committed to winding down its multiyear liquidity binge, how does the world look for investors? The graphic below offers a snapshot of stock market values by country over the past decade. (Click on it for a full-size version.) It's based on the PEG ratio: the price/earnings ratio of a stock divided by the company's expected profit growth. We applied it to each country's major stock index. The PEG ratio was the favorite metric of legendary money manager Peter Lynch, who delivered epic returns at Fidelity's Magellan Fund (FMAGX). It essentially reveals how much investors are paying for growth.

When it comes to PEG ratios, a low number -- typically 1 or less -- is ideal. After all, you want to pay as little as possible for a stock's predicted earnings increases. The blue below indicates relative bargains, while red denotes higher priced markets. Negative PEG ratios, which occur when analysts expect profit declines over the next three to five years, are marked in black.



Historically, this ratio has offered hints of the future. Greece, for example, turned sharply from blue to red just before that country's economy fell off a cliff at the beginning of 2010. It has often been in very dark (that is, contracting) territory ever since. In Russia in mid-2010, the PEG ratio turned a deep blue; sure enough, that market roared to a 25% return the year after that. Similarly, in mid-2009, Korea's chart turned from red to blue. Its market posted a 23% return, and then repeated the feat after the chart turned a deep blue. (Korea and China have consistently remained promising, in PEG terms. China is particularly interesting, given the handwringing in the past few years about its prospects.) Indeed, Asia as a whole seems to have fewer dangerous pockets than other continents.

Looking ahead, the chart above suggests a divergence of potential in Europe. Countries like Italy and Spain, which have endured economic turmoil, may be worth an investment, while sturdier France and Germany don't look so cheap. That's a sentiment that Mike Wilson, chief investment officer of Morgan Stanley Wealth Management, agrees with. "If you believe in global recovery, you have to be going to lower-quality countries," he says. "That is where the value is." (Wilson is more bearish closer to home: "The U.S. has by far been the leader since 2008. That means that there is less opportunity left.")

No one would claim the PEG ratio is a perfect yardstick. Think of it more as a telling starting point. Since it measures multiple factors at the same time, it doesn't always reveal why a country is rated a particular color. For example, in early 2009, when stocks were a screaming buy in the U.S., the chart shows almost no change from a year or two earlier. Why? Because not only did P/Es crash in late 2008, so did the economy, meaning the numerical relationship between the two didn't change dramatically. That said, you can detect a band across the graphic around 2009 that reflects the recession that gripped economies everywhere.

The chart above also helps illustrate another phenomenon pointed out by Wilson of Morgan Stanley: For the first time in decades, emerging-markets stocks no longer trade up and down as a monolithic group. "The market has started to recognize that many of these countries are on very different paths," he says. And some of the best values can be found in this category.


For that reason, investors may want to avoid an ETF that lumps together multiple countries. Wilson cites a difference of 45 percentage points in recent returns between equities in Taiwan and Turkey, two countries that fall under the heading "emerging markets," to show that those countries are not remotely equivalent in investing terms.

It's a misnomer even to call many of them "emerging" these days. As Wilson puts it, "It is kind of insulting to call China an emerging market when they are the second-largest economy in the world." Many nations in this category have managed their debts more prudently than countries with more established economies. But the view persists that the newer markets remain more vulnerable to rising interest rates (a prophecy that has been self-fulfilling in the short run).

It's easy to get bogged down in international investing. Every country has its own economic, political, and cultural dynamics. It's hard to understand all the idiosyncrasies from afar. That's why one of the deans of emerging-markets investing emphasizes the most basic of fundamentals, which he reduces to a single word: "profitability." For Mark Mobius, executive chairman of Templeton Emerging Markets Group, that includes return on equity, return on capital employed, and earnings growth.

He argues that it's crucial -- especially in a tumultuous environment -- to stick to your convictions. Be wary of "market sentiment which increases volatility," says Mobius. "The markets have become more volatile all over the world, so we need to be careful not to be carried away by the emotions of the moment."

Go east for value
Emerging markets are likely to remain volatile for a while. but stocks in these four countries could rebound strongly.

Given the nearly 10% slump in emerging-markets stocks since autumn, investors are right to be nervous. Indeed, there's every reason to believe that many of these markets will continue slipping in the short run. But some will perform, argues Mark Edwards, co-manager of T. Rowe Price's $6.5 billion Emerging Markets Stock Fund (PRMSX), who adds that it's a mistake to wait and try to call the bottom. Investors, he says, should "start small and start sooner." Here are the markets he is most enthusiastic about, along with a low-cost ETF for each.

The Philippines

Youth is a key part of the allure of the Philippines for Edwards. The country's estimated median age is 23, noticeably lower than the 40-plus medians common in European nations and Japan, and the population is burgeoning. (Indeed, labor is one of the country's biggest exports, and overseas workers remit cash to their families back home.) Together with new political stability this has helped create a vibrant consumer market. A bonus: Edwards says the country is embarking on long-term, economy-stimulating infrastructure programs. ETF option: iShares MSCI Philippines (EPHE).


"Opening financial markets" is Edwards's theme for China. Economic growth has occurred at breakneck speed and has relied heavily on infrastructure investment. The new government seems determined to rebalance the economy toward services and consumption to foster sustainable expansion. One area for reform: the financial sector. At the end of last year, regulators detailed soon-to-be-implemented plans that, among other things, will allow foreigners to invest in the Shanghai stock market without as many restrictions. ETF option: Guggenheim China All-Cap (YAO).


The bad news when it comes to Turkey is obvious: economic and political turmoil, spiking interest rates (one central-bank-controlled rate jumped from 7.75% to 12% in a single day), and a plunging currency. The country remains risky, and with a presidential election looming, the uncertainty is unlikely to abate anytime soon. The good news: Stocks are now selling at rock-bottom P/Es (an average 8), and Edwards says Turkish companies tend to be effectively run. As the country's currency and politics stabilize over time, stocks will eventually rebound. ETF option: iShares Turkey MSCI (TUR).


Edwards is a believer in India's potential, given its enormous, aspiring working-age population and well-managed companies. But growth has stalled of late, in part because of what he calls a dysfunctional government led by the Indian National Congress party. The pro-business Bharatiya Janata Party is favored in the national elections this spring; its victory could boost markets. ETF option: WisdomTree India Earnings (EPI).


This story is from the March 17, 2014 issue of Fortune.

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