There’s an old Saturday Night Live sketch in which Will Ferrell plays a German intellectual talking to a baby. After facing frustration that the baby does not appreciate his insights, the intellectual demands, “Grow up now!”

Emerging market investors seem to have the same problem. They know that emerging economies will one day be developed middle-class consumer giants. They boast booming populations of potential young consumers who will buy phones, open bank accounts, buy fast food, date online and get home loans. But investors often don’t want to wait through developing countries’ gawky growth phases. They want the baby to grow up now.

Still, there were few better places to be in 2017 than in emerging market stocks, which easily outpaced developed market names. After years in the doldrums, the MSCI Emerging Markets Index shot up 37% for the year, finally rewarding patient investors, while the S&P 500 had a return of less than 21% and developed world markets returned 23%. The reasons for the outperformance were fairly straightforward, say portfolio managers.

“In the end, it comes down to earnings,” says Deborah Vélez Medenica, portfolio manager of the Alger Emerging Markets Strategy. “I think there was perhaps a recognition that overall aggregate earnings in emerging markets was probably better than that of the developed world and there was probably acceleration in those earnings.”

Katie Koch, the global head of client portfolio management and business strategy for Goldman Sachs Asset Management, says 2017 was an outstanding year for EM stocks because you got two times the earnings growth at a 25% to 30% discount to what you could get in the U.S. and many developed markets.

A lot of managers had been optimistic about 2018 for the same reasons (at least they had been until a recent market selloff began). But the asset class had also been the beneficiary of a lot of good cyclical macroeconomic trends: The dollar had finally started to deflate. China initiated reforms, opening up its capital markets to more foreign ownership and reining in its material-making capacity to allow the price of commodities to strengthen.

There’s also a richer set of public company names in EM than there used to be. While the maturing U.S. economy today has half the number of publicly listed companies it did 20 years ago, Koch says, many of the EM countries GSAM invests in have seen a 50% increase in public listings, she says.

The composition of the markets has changed, too. Ten years ago, the combined weight of energy and materials, (i.e., commodities) in the MSCI index was close to 40%. Today it’s about 14%. “Consumer, health care and technology have all taken share,” Koch says. Indeed, information technology, which was only 13.2% of the index in 2007, was 27.6% at the beginning of 2018. Some argue that the MSCI index is starting to look more like the S&P 500, top heavy with tech companies like Tencent, Alibaba, Samsung and Baidu. But more names makes for a richer universe of diverse and idiosyncratic opportunities. “We own an online Indian dating company,” says Koch. “We own a Polish discount food retailer. We own a Brazilian e-commerce company. These are the types of businesses that we think are going to thrive.”

Warning Signs

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