For many investors, having a presence in emerging market stocks means investing in either an exchange-traded fund that follows a particular index or an actively managed mutual fund that takes its cue from one. But those funds are dominated by mega-exporters that rely heavily on sales to the U.S. and Europe, so they may not be the best way to take advantage of growth on these up-and-coming countries’ home turf.

The idea of investing in emerging market companies with so much skin in the Western world seems almost counterintuitive to Lewis Kaufman, who runs the $110 million Thornburg Developing World Fund. “We prefer to focus on developing market companies with strong domestic demand because they are in a better position to take advantage of growth in consumer income, spending and consumption in emerging market countries,” says the 37-year-old manager.



Like other funds in the Santa Fe, N.M.-based Thornburg family, this one likes to color outside the style box. While the MSCI Emerging Markets Index has a 25% stake in export-driven companies in South Korea and Taiwan, the Thornburg fund has only 1.5% of its assets in those companies. And instead of sticking to one company size, it holds small-, mid- and large-cap stocks. The first two categories account for three-quarters of its assets.

Kaufman will also devote more money than most funds to lesser-known markets, such as the Philippines and Indonesia, if he believes they are on a particularly strong growth path. And unlike many emerging market fund managers, he will invest in more familiar developed market names, such as Mead Johnson Nutrition and Colgate-Palmolive, if they have a leading product footprint in emerging markets.

So far, the unorthodox mix has proved successful. From its inception on December 16, 2009, through the third quarter of 2012, the fund posted a 10.4% annualized return, significantly better than the 3.6% return for the MSCI Emerging Markets Index. Over the same period, it ranked in the top 3% of Morningstar’s diversified emerging markets category.

Despite its untraditional ways and emphasis on companies most Americans haven’t heard of, safety nets are also important here. “This fund was still on the drawing board back in 2008, when the MSCI Emerging Markets Index lost nearly half its value, and a lot of actively managed mutual funds did even worse,” Kaufman says. “From the start, our focus has been on how to not have that happen again.”

To that end, he seeks out the stocks of companies with strong balance sheets and ample free cash flow that won’t have to rely on the stock or bond markets for funding during periods of economic distress. He treads cautiously in some countries, such as Brazil, where large current account deficits foreshadow the significant devaluation of the local currency against the dollar. Although he won’t necessarily avoid companies in those areas, they must “pass a higher hurdle rate” than those based in countries with a stronger financial profile. On the other hand, he will often have above-benchmark weightings in locations that have current account surpluses, such as the Philippines and Peru, where currencies are more likely to hold their value or appreciate against the dollar.

Although the portfolio is fairly concentrated among 50 or so stocks, about half the number of the average equity mutual fund, Kaufman doesn’t bet the ranch on one or two stocks: The fund’s top 10 holdings each account for only 2.3% to 3.2% of assets. To avoid getting enwrapped in one investment genre, he divides the portfolio into a basic value category (financially sound companies with well-established businesses), a consistent earner category (companies with steady earnings growth, cash flow or dividend growth) and emerging franchises (companies in the process of establishing a leading position in a product, service or market).

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At 9.2% of assets, the fund’s stake in the Philippines, well above the benchmark weighting, reflects Kaufman’s view that the area is in the early stages of a growth spurt. Coming out of the 2008 financial crisis, the country did not attract as much money as some emerging markets, and the companies there are not recognizable names to most Westerners. But low interest rates, a successful battle against government corruption and improved macroeconomic and currency stability have increased business confidence, encouraging both foreign and domestic capital to return to the region.
 
“It’s also a Catholic country with a high birth rate and a population of 92 million, many of whom speak English,” he says. “Since there are not a lot of jobs domestically, these people are going out of the country to work and sending money back home.” Much of that cash has been flowing into the coffers of retailers such as Puregold Price Club, the second-largest modern retailer in the country. Patterned after off-price warehouses such as Costco, the company targets middle-income consumers and derives more than 70% of its profits from food. Another Filipino holding, Security Bank, is seeing double-digit loan growth as borrowing catches on in that country.

The fund also has over three times the MSCI benchmark weighting in Indonesia, the world’s fourth-most-populous country. Over the last decade, the country, which boasts a well-capitalized banking system and solid government finances, has experienced strong economic growth and a rising consumer class. Still, Kaufman has reduced the fund’s position in the country by a few percentage points over the last year and moved the money into the Philippines, which he considers an earlier-stage growth story. The fund maintains about 10% of assets in Indonesia through stocks such as Mayora, a leading manufacturer of candy, cookies, coffee and breakfast cereals. While the company has a significant export business, it generates most of its revenue domestically.

In China, a slowdown in GDP growth in recent years has sparked concern among investors and depressed the country’s stock prices. But Kaufman believes Chinese stocks, which account for 13% of the fund, offer “the best value in emerging markets.” Economic growth will likely continue to be slower than it was a few years ago, he says. But the population is still spending. People are increasingly using credit. And their wages are rising. These forces will provide a tailwind for the economy, he thinks.

One of the fund’s holdings, Mead Johnson Nutrition, the American spin-off of Bristol-Myers that produces baby formula and other infant-care products, has benefited from the trend in rising consumption. Seventy percent of the company’s baby formula business comes from emerging markets, including China.

Other fund holdings in the region include Biostime, a premium brand for pediatric nutrition and infant-care products, and HengAn International Group, which makes diapers, women’s sanitary products and tissues. With annual earnings growth of 20% and a selling price of 20 times estimated 2013 earnings, the latter stock is “an attractive value proposition,” says Kaufman.

He’s less enthusiastic about Brazil (because of the current account deficit problem). Still, he has an allocation of about 12% to Brazilian companies such as retailer Cia. Hering, a large apparel retailer. Despite economic weakness in its home country and disappointing operating results, the stock has done well over the last year. That strength is due in part to the company’s limited credit dependence. The company also benefits from self-financed growth, and it could enjoy a rebound in consumer spending.

Peru accounts for 3.1% of the fund’s assets. With its current account surplus, the country offers a good Latin American complement to Brazil. While Peru has suffered from periods of political instability, its mining industry has supported growth, and lower interest rates are helping to stimulate the use of credit. One of the fund’s holdings is commercial banker Credicorp. With its extensive branch network and its lack of competition, this company is well positioned to capitalize on lending growth in the region.

Two Internet businesses in the fund are dominant players in Russia and China, where Internet penetration is still lower than it is in developed markets. Internet search provider Yandex, the leading search engine in Russia, has significantly higher market share there than Google, its closest competitor in the region. Yandex has the potential to grow earnings as disposable income increases, infrastructure improves and the advertising market expands.

Even with a relatively low level of Internet penetration, China already boasts the world’s largest online population. Many of those users are familiar with Tencent, a leading Chinese Internet provider with more than 500 million active users and services that include instant messaging, social networking and online gaming. The use of the company’s service should increase as Internet penetration in the country grows.

Southern Copper rounds out U.S. holdings, which account for 8.4% of assets. Headquartered in Arizona, this producer of high-quality copper derives most of its revenue from mines in Peru and Mexico. Relatively inexpensive labor, along with high-quality reserves, has helped make it one of the lowest-cost producers in the world.