Many financial advisors have come to view emerging markets as a more rollicking version of the Nasdaq, and their feast or famine performance in recent years has done little to shake that reputation. In 1999, for example, the IFC Investable Composite, a bellwether emerging-market benchmark, rose 67.14 %. The following year, it lost nearly one-third of its value.

Since the early 1990s, the downs have far outweighed the ups. Despite some short-term rallies, the benchmark has seen negative returns in five of the last eight years, and has a five-year average annual total return of -5.05 %.

But last year, when emerging-market stocks rallied 28.5% in the fourth quarter, the fog finally looked like it was lifting. The market had been so downtrodden until then that the spike, the strongest quarterly performance since 1993, only brought the IFC into slightly positive territory for the year. The jumpstart continued into 2002, with emerging markets up 6% through the end of February.

The question now is whether emerging-market stocks and the funds that invest in them will fizzle or fly in the coming months. In either case, the recent rally has given Arjun Divecha, manager of the Grantham, Mayo, Vanotterloo's GMO Emerging Markets Fund, a new familiarity with the financial press. "In the last few years, I've hardly had any calls from journalists," he says. "In the last few days, I've gotten five or six. People are always interested in what's doing well now."

Skeptics have long argued that widespread press coverage for a fund is a good sign that the easy money has already been made, but Divecha thinks that dirt-cheap valuations will continue to give his fund an edge over those investing in U.S. securities. "Eighteen months ago, emerging-market stocks were trading at just 10 times earnings. Today, they are priced at 12 times earnings, which is less than half the valuation of the S&P 500. There's still plenty of room to grow."

Stocks in the GMO Emerging Markets Fund are even cheaper. The portfolio is priced at a penurious nine times earnings, reflecting a focus on small, largely neglected companies in emerging markets. The median market capitalization of the portfolio is $1.4 billion, well below the $3.4 billion of the median market cap for the benchmark.

"Smaller emerging-market stocks have not been this attractive since I began managing the fund in 1993," he says. "And smaller does not mean junkier. The return on equity of the small companies in the portfolio is actually higher than that of the benchmark."

The small-company focus worked against the fund late last year, when its 20.8% return lagged the fourth-quarter performance of its benchmark by 7.7%. Divecha attributes at least some of the gap to the fund's underweight position in Korea and Taiwan's technology giants, which led the rally. But with a total return of 9.78% in 2001, GMO Emerging Markets Fund still managed to finish first out of 180 emerging-markets funds tracked by Morningstar, and it has ranked in the top decile of all emerging-markets funds for the past one, three and five years.

Divecha's firm believes that emerging markets will outperform most other asset classes in the coming years. Its prognosticators predict an average annual return of 9.4 % for the group over the next seven years, compared with -1% for U.S. large-company stocks, 2.2% for U.S. small-company stocks and 5.2% for small-company stocks trading in established international markets.

Weighing against such optimism is a post-September 11 world in which political instability-which has sent emerging-market funds reeling many times in the past-seems almost routine. Even before that day, the world bore witness to market-shaking debacles such as the Asian currency crisis, Russia's massive debt defaults, the devaluation of Brazil's currency and, most recently, the Argentine debt crisis.

Divecha acknowledges that while some emerging-market country economies are on shaky ground, many are stronger than they were just a few years ago. "Most emerging markets have gone through a crisis and are in recovery mode," he says. "There is strong domestic growth and low reliance on exports that makes them less dependent on the state of the economy in developed markets."

Besides, he argues, maintaining a position in emerging markets is a sensible asset-allocation strategy because they do not correlate as closely with the United States as developed markets in other parts of the world. "A lot has been said in the last few years about how emerging markets have not fulfilled their promise of providing diversification and were simply a high-beta version of the Nasdaq," he says. "But correlations in daily price movements are irrelevant. The true test of diversification is how much money you make or lose in relative terms over a number of years." Many of the firm's clients, he says, have between 15% and 20% of their international equity holdings in emerging-market countries.

And over the last three years in particular, emerging-market investments have been an effective tool for pulling up sagging portfolio returns. During the period, the IFC Investable Composite had a total return of 16.1%, while the S&P 500 Index, Nasdaq and the MSCI EAFE Index all fell into negative territory.

When it comes to emerging markets, the real estate market mantra "location, location, location" applies solidly. In U.S. markets, some stocks or sectors can do well when others do poorly. Not so in emerging markets, says Divecha, where stocks tend to move in sync with the country's overall market.

"Individual stock selection in emerging markets adds much less value than it does in the U.S.," he says. "In 1997, if you picked the 10 best stocks in Malaysia, they might have dropped 70% instead of 90% for the overall market. There's not much comfort in that."

He believes that 80% of the added value of active management comes from country selection, while only 20% comes from stock selection. Country selection is critical because, unlike developed nations that depend heavily on the health of their respective economies to support each other, the more insular emerging-market countries can be completely out of step in their economic cycles. The portfolio is broadly diversified with some 300 names, reflecting the relative importance of country rather than individual stock representation.

Divecha looks for countries whose markets are just beginning to turn up or are on the verge of doing so. "Countries that have done well recently will continue to do well," he says. "And those that have done badly in the last three to five years tend to do well over the next one to two years."

Right now, the fund's largest overweight position is in the TIP (Thailand, Indonesia and the Philippines) markets. All of these markets are in a recovery phase, he says, with the worst of their economic turmoil behind them. One TIP holding, Land and House, is one of only four or five real estate developers in Thailand that remain standing after the Asian economic crisis in the late 1990s. At $1 a share, it sells at 14 times trailing 12-month earnings-a bit more expensive than the portfolio's typical value stocks, but a price Divecha is willing to pay for the company's strong growth prospects.

Russia also looks attractive because of a stabilizing political system, continued major financial and economic reforms, increasing attention to shareholder rights and cheap valuations. Rising oil prices, which have doubled from $10 a barrel to $20 a barrel in the last two years, have been a driving force behind the country's improved fortunes. The one thorn in Russia's rosier outlook, he says, would be a drop in oil prices to less than $15 a barrel. For the time being, though, companies like portfolio holding Yukos Oil are enjoying rising stock prices and earnings. The stock is selling at five times its year-ago level, but still trades at just four times trailing 12-month earnings.

One country that Divecha finds less attractive is Mexico, whose market is overvalued and whose economy depends too heavily on exports. Hefty valuations of stocks in China and Israel also make investments in those countries look unappealing.