Toothpaste and toilet paper aren't usually the things that growth stock dreams are made of, at least in this country. But in India and other emerging markets, such pedestrian items are among the building blocks of a growing middle class, according to Roger Edgley, who runs the Wasatch Emerging Markets Small Cap Fund with co-manager Laura Geritz.

Edgley says toothpaste is relatively new in India, and many people still don't have indoor plumbing. As more people update hygienic practices in the world's second most populous county, companies such as the small-cap subsidiaries of Colgate and Proctor & Gamble, which trade separately from their large U.S. parents on India's stock exchange, should benefit.

By now, it's a well-told story that strong economic growth in China, Brazil, India, Russia and other countries will create demand for a variety of products. The burgeoning sales of emerging market exchange-traded funds such as iShares MSCI Emerging Markets Index (EEM) or Vanguard Emerging Market (VWO), points to these markets as an increasingly popular complement to investments in developed nations. At over $90 billion in combined assets, the two offerings are now the third and fourth most popular ETFs on the market.

The downside of strong flows into the asset class, of course, is the potential for a market bubble. A recent Wasatch fund report acknowledges that with more people crowding into the market, stocks in some sectors and countries are "closer to fair value." Even Edgley believes this may be a good time for investors to edge in gradually rather than dive in all at once.

Yet he also sees attractive opportunities in the small-cap investment universe, and believes emerging market stocks have the potential to outpace their developed market counterparts by a substantial margin over the long term. "Over the next few years, difference in performance between the two could easily be 5% to 10% annualized," he says.

The fund's managers view inflation as a temporary risk rather than the structural weakness in government policy that it used to be. Stronger monetary leadership, inflation-targeting, the establishment of floating exchange rates and the prudent management of public finances have helped emerging market countries keep inflation under control and helped them avoid the collapsing banking and property bubbles seen in the U.S. and Great Britain. Countries such as Indonesia, with long histories of corruption and political unrest, have instituted higher standards of corporate governance.

Despite the run-up, the Wasatch managers believe that their portfolio's 164 stocks, which are expected to grow earnings at an average annual rate of 22% over the next three to five years, remain reasonable compared to other, slower-growing corners of the stock market. They cite several reasons to consider complementing an emerging market allocation with small caps:

Fluctuations in commodity prices or demand in established markets can have a big impact on the multinationals that most emerging market ETFs and mutual funds focus on, a universe concentrated largely in energy, materials and financial stocks. By contrast, smaller emerging market companies provide a more direct connection to growth in their home markets, where they derive most of their revenue, and have a commanding presence in their niche markets.

Like small companies in the U.S., emerging market small caps have higher earnings growth potential, leaner operations and the ability to respond more quickly to changing markets. Standard & Poor's projects 2011 earnings growth of 13.9% for developed international companies represented in the MSCI EAFE Index, well below expected earnings growth for the Wasatch fund's holdings.

Small caps could outperform. In 2010, the Wasatch emerging markets small-cap fund was up 42%, compared to 27% for the MSCI Emerging Market Small Cap Index and 19% for the MSCI Emerging Markets Index. Between its launch in October 2007 and the end of last year, the Wasatch fund had an annualized return of 8.3%, compared to 3.6% for the MSCI Emerging Markets Index. But there has also been a lot of volatility, including a drop of 57% in 2008 followed by a 117% rebound in 2009.

There are more small-cap stocks to choose from. The MSCI Emerging Markets Small Cap Index contains a universe of more than 1,800 companies, over twice the number in the MSCI Emerging Markets Index. Foreign small- and micro-cap companies represent 90% of public foreign companies.

Foreign micro caps and small caps have a lower correlation to U.S. stocks than foreign large caps.

Many of the stocks the Wasatch fund invests in are off the radar screens of most Wall Street analysts, so the fund's managers and analysts travel extensively to talk to companies' management to see what's going on firsthand. Assessing the inner workings of these businesses, many of which have high levels of family and insider ownership, isn't always easy.

"Sometimes the managers of our favorite high quality companies aren't motivated to see us because they already have enough capital," says Geritz. "But many of them are quite receptive." Many foreign companies also comply with international financial reporting standards, she adds.

Since it's one of the few actively managed small-cap emerging markets funds, Wasatch's managers take advantage of the broad discretion they have over country and sector allocations. For example, the fund has about 8.5% of its assets in China, less than half the weighting of the Vanguard Emerging Market ETF. Nearly one-quarter of the assets are invested in India, the second most populous country in the world. In the iShares Emerging Markets Index fund, that country accounts for only 6.5% of assets. About 60% of the Wasatch fund's assets are invested in Asia, 16% in the Middle East and Africa and 14% in Latin America.

To the managers, the difference in country allocations from popular large-cap-focused ETFs is more about the quality and growth potential of companies than a particular country's economic profile. "We want higher-quality companies that have the ability to grow solidly over the long-term, and the breadth and depth of the companies in India fits in with our style," says Geritz. "These aren't new businesses. A lot of them have been around for decades." Once the managers settle on a stock, they will usually hang on to it for several years, as evidenced by a 20% turnover rate.

They also consider each stock's potential against a backdrop of broad economic trends. "There is a point in a country's economic growth where consumer demand really begins to take off and per capita GDP explodes," says Edgley. "In China, that happened in 2001 and 2002. It's happening now in Indonesia. And in India, we expect that explosion in consumer demand to occur over the next three to five years."
Sector allocations also vary from those in popular large-cap emerging market indexes.

"GDP growth in emerging market countries ranges from about 4.5% to 9%," says Edgley. "But some sectors are growing at several times their country's overall growth rate." As an example, he cites Brazil's health-care industry, which is growing at two to three times the rate of the overall economy.

To capitalize on growing consumer demand in domestic markets, the fund has nearly one-quarter of its assets in consumer discretionary stocks, which is three times more than the allocation in the iShares ETF. Since emerging market consumers are only beginning to use credit, the potential upside for the sector is large, says Edgley. Other large sector weightings include financials at 21%, industrials at 15%, and materials at 12%.

Even in South Africa, where a government clampdown on lending in 2008 led to a deeper recession than other countries had, the groundwork for a bounce-back is being laid as financially sound consumer-oriented companies, such as fund holding Mr. Price Group, capitalize on a growing middle class. The company, which opened its first store in 1885, is the country's leading apparel retailer.

In India, top ten holding Bata India has been selling shoes since the early 1900s. Each of its 1,250 stores scattered throughout the country is about half the size of a convenience store, and its next biggest competitor has far fewer stores. "Bata India is elegantly simple, yet it's also in a position to grow and remain dominant in its niche," says Geritz. "Compare that to China, where I can name at least five companies that have 6,000 stores apiece."

In Brazil, a strong culture of consumerism is well in place. During her trips to the country, Geritz has noticed that people differentiate between high-end and low-end merchandise and aren't shy about using credit cards.

While most emerging market ETFs invest heavily in commodity-related companies for their Brazilian sleeve, Wasatch zeros in on consumer stocks such as Cia. Hering, a trendy retailer with an instantly recognizable fish logo. New Brazilian additions to the portfolio include Diagnosticos da America, the largest clinical diagnostics and imaging laboratory in Brazil, and apparel store chain Marisa Lojas.