As the United States, Japan, and Western Europe struggle to get their fiscal house in order, international equity investors who have been able to identify dynamic growth and value companies in emerging markets in all kinds of economic conditions have had plenty to write home about.

In fact, between 1988 and 2012, a period marked by several major financial crises, emerging markets generated greater long-term returns than a diversified portfolio of developed market stocks (see Chart 1). For a while, BRICS grabbed most of the attention, as if they were some monolithic growth engine, which of course they weren't. Now that BRICS have cooled off, Turkey, Philippines, Poland, and even former Latin America trouble spots such as Mexico and Colombia have stepped into the limelight (see Table 1).

No matter what acronym you use to describe them, emerging markets have been one of the great equity investment opportunities of the last several decades, and what’s striking is the number of countries that overcame significant structural issues to become top performers. Of course, volatility has fluctuated greatly, but the frontier continues to expand.

Up and Down the BRICS Road
With an average of 19.9 years in the financial industry, Lord Abbett's 12-person international equity team has developed extensive knowledge of emerging markets in northern and Southeast Asia, Latin America, Central and Eastern Europe, the Middle East, and Africa.

In assessing the prospects of various emerging markets, the emphasis has been on the company as well as country, as one would expect of a time-tested research approach that spans the globe for optimal risk-adjusted returns across all sectors, especially when the performance and business climate of BRICS varied widely.

Brazil, for example, was by far the weakest among BRICS last year, hampered by declining exports, lower commodity prices, higher inflation, and government policies that impeded growth, all of which held its major stock index to a measly 0.8% gain in 2012. South Africa was racked by poverty, 25.5% unemployment (through the third quarter) and violent strikes, as exports plunged, inflation picked up, and three credit rating agencies downgraded South Africa's rating. Yet the stock market showed a healthy 19% gain in dollar terms³ (see sidebar, "Alpha Beta Soup," below). Russia, on the other hand, despite a long history of corporate governance issues and dependence on vast natural resources and the eurozone, seemed so undervalued that Lord Abbett's international team invested in a major gas producer, as well as a railcar transportation company tied to that country's huge energy and materials sector. And in India, after considerable political instability and a significant slowdown in growth of gross domestic product (GDP), the hard-hit financial sector created an opportunity to invest in a large, well-managed bank with considerable upside potential.

Of course, the international team have been quite selective about China. Although the world's most populous nation is renowned for its long history of double-digit growth, the Hang Seng China Enterprise Index⁴ is down more than 18% over the five-year period ended December 31, 2012, with property, financial, and manufacturing companies particularly hard hit.⁵

In recent months, however, Lord Abbett's international core equity strategy has been adding to its positions in China, particularly in the property sector, where housing demand continues to be robust, prices appear to have bottomed, and stock valuations appear attractive. Lord Abbett's international small cap core strategy also has been adding to its China position by buying shares in a Chinese truck manufacturer, a department store company, and two different property companies that appeared poised for recovery. (For the full country breakdown of each portfolio, please see the "Portfolio" tab on lordabbett.com.)

Why invest in a Chinese property company when some experts claim the market is overbuilt? Some of those fears are exaggerated. In fact, property prices in certain markets have stabilized and margins of certain companies in the sector have started to improve. One company we decided to buy was selling at 40–50% discounts to net asset value (i.e., the value of the company's assets minus the value of its liabilities) and had good top-line and bottom-line growth and relatively cheap multiples of 7–8 times earnings versus 2011, and the upside potential appeared attractive.

Among emerging markets in Asia, the biggest gainers were Thailand, an amalgam of six spectacularly diverse regions, and the Philippines, an archipelago of 7,107 islands—both nations' growth driven by expanding economies and a rising and increasingly prosperous middle class that is likely to drive consumption in 2013.

One common denominator in those countries is the greater availability of credit, especially in the Philippines, where property prices are still below where they were during the 1997 Asian financial crisis. Now that banks have delevered, deposits have rebounded, and interest rates are low, those institutions can lend at attractive terms—all of which has benefited investments in property companies and banks.

Keep in mind that the emerging market story is about the democratization of credit. Like the explosive growth of the United States in the 1950s, it's about helping young workers with sufficient jobs and income to buy their first motor scooter, first car, or first house. They do that by getting credit and saving enough to afford other installment purchases.

Powerful Dynamics
"Emerging market economies did so well in the past decade, that for the first time they spent more time in expansions and had smaller downturns than advanced economies," the International Monetary Fund said in a recent report.⁶ "In the 1970s and 1980s, emerging market and developing economies spent more than a third of their time in downturns. In the 2000s, however, they spent more than 80% of their time in expansion. In contrast, the advanced economies have spent less time in expansion over the decades, and in the 2000s, they were in downturns more than a fifth of the time," the report continued.

Given such dynamics, emerging-market growth should be a major story for the next several decades as rapidly rising incomes and better technology, machinery, and skills help young and growing populations consume more goods and services. According to an October 2012 report by HSBC Global Research, nearly three billion people—more than 40% of today's population—will join the middle class by 2050, almost all of them in emerging markets. If so, emerging market consumption could comprise almost two-thirds of global consumption by that time, compared with about one-third today, said HSBC.⁷

"Countries such as the Philippines, India, Pakistan, Egypt, and Saudi Arabia all have populations today with a median age of 25 or under," HSBC added. "These young people, with growing incomes, are getting ready to shop, in stark contrast to aging populations in [developed] countries such as Italy, Germany, and Japan."⁸

Of course, the outlook for emerging markets may be clouded by energy, environmental, political, and currency factors, but the proliferation of consumers there could go a long way toward addressing global cyclical and structural challenges. As HSBC concluded, "The world became far too dependent on the U.S. consumer in the 1990s and early 2000s and ended up paying a heavy price because of the imbalances that dependence brought with it. Luckily, major new sources of demand are emerging in the East and South."

While some emerging markets have demographic challenges of their own—Brazil, China, and Mexico also have rapidly aging populations—emerging markets may be better positioned than developed economies to weather the shocks if the global recovery stalls, said Kate Moore, global equity strategist of Bank of America/Merrill Lynch Global Research. For one thing, government debt in developing countries averages about 33% of GDP versus 78% of GDP in the developed world, Moore said. In the event of another global recession, emerging markets would be in a better position than heavily indebted developed countries to cut interest rates and increase stimulus programs, she added.9

Of course, emerging market performance may fluctuate widely. As Ruchir Sharma, author of Breakout Nations: In Pursuit of the Next Economic Miracles, put it recently, only Malaysia, Singapore, South Korea, Taiwan, Thailand, and Hong Kong have been able to grow at an annual rate of 5% or more for four decades. So even before BRICS stumbled, the chances of Brazil experiencing a full decade of growth above 5%, or Russia, its second in a row, were slim.¹⁰ "Although the world can expect more breakout nations to emerge from the bottom income tier, at the top and the middle, the new global economic order will probably look more like the old one than most observers predict," Sharma concluded. "The rest may continue to rise, but they likely will rise more slowly and unevenly than many experts are anticipating. And precious few will ever reach the income levels of the developed world."¹¹

The bottom line is that while emerging markets have generated greater long-term returns than a diversified portfolio of developed market stocks, they also have become riskier, according to a recent study by Ernst & Young.¹² This is all the more reason to rely on active managers with extensive experience in navigating volatility as investment opportunities and competitive advantages cycle around the world.

Edward Allinson is a Portfolio Manager of the international small cap core equity strategy and also contributes as a Research Analyst to the international core and international dividend equity strategies. Mr. Allinson joined Lord Abbett in 2005. He received a BA and MBA from the University of Pennsylvania. He also is the holder of a Chartered Financial Analyst designation, and has been in the investment business since 1985.