The Smarter Play in Emerging Markets

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 (NAS: 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 (NYS: 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 (NYS: 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.

Instead, prosperity in emerging-market economies would increasingly rely on elevating citizens of those countries to middle-class status, igniting a self-perpetuating economic machine that wouldn't rely as much on exports or resource wealth. Investing to take advantage of that trend made more sense.

Over the past year, that's exactly what we've seen happen. Investors in the Vanguard ETF have suffered big losses of almost 20%, while the EGShares Emerging Markets Consumer ETF, which focuses on consumer stocks, has almost managed to break even. That's impressive given the lousy performance of emerging stock markets overall during that period.

Some of the best performershave come from pedestrian sectors of the economy. Beverage companies Ambev (NYS: ABV) and FEMSA (NYS: FMX) have profited from having more consumers with enough disposable income to buy more of their products, and that's turned into some impressive profits for the company and for shareholders. Meanwhile, companies like New Oriental Education are squarely aimed at helping average emerging-market people improve their skills and make themselves more marketable in a global economy, giving them an edge that could pay off not just personally but also for their home economies as well.

Can the good times last?
The recent declines in traditional emerging-market stocks in sectors like natural resources and exports will put the consumer success story to the test in the next few years. For now, though, things look bright for these countries and the companies that serve them. Investors would do well to take notice.

Some companies right here in the U.S. are poised to benefit from a strong emerging-market middle class. Find out all about them in our latest special report: "3 American Companies Set to Dominate the World." This report is completely free, so don't miss out!

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter@DanCaplinger.

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Fool contributor Dan Caplinger owes a lot to emerging markets. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of New Oriental Education and FEMSA. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy protects you worldwide.

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