SSgA's George Hoguet maintains emerging markets are still cheap.

After beating the U.S. equity market for much of the last five years, emerging markets still appear inexpensive relative to their growth prospects, says George Hoguet, head of the active emerging markets team at State Street Global Advisors (SSgA).

According to State Street estimates, stocks of emerging market countries sell at an average of 11 times forward earnings. With a continued global economic recovery, increasing demand for exports and rising commodity prices, these companies have the potential to deliver 20% earnings growth over the next twelve months, Hoguet contends. And while current prices are richer than they were at the beginning of last year, they still appear inexpensive compared to most of the world's more developed markets.

"Emerging market valuations are considerably less demanding than those in established markets in the U.S. and Europe, yet many of the companies and economies have higher rates of growth," he notes. While he maintains a favorable outlook for emerging market stocks over the next three to five years, he cautions investors not expect them to outperform by as wide a margin as they have over the last five years, when the MSCI Emerging Markets Index trounced the Standard & Poor's 500 Index by roughly ten percentage points a year.

Recent and historic performance suggests that any continued growth will likely be marked by the fits and starts characteristic of this volatile sector. At the beginning of last year, both established and emerging markets stalled as concerns mounted over the war in Iraq, the uncertainty of an economic recovery in the U.S. and unrest in the Middle East. As the year progressed, investors shed their doubts in the face of a growing U.S. economy, low interest rates and strong domestic demand in countries such as India, Russia and China. By the end of 2003, the MSCI Emerging Markets Index had risen 56.7%, compared to an increase of 33.1% for the MSCI World Index, a benchmark for developed markets.

The ebullient mood continued into the first quarter of 2004, when emerging markets rose another 10%. But the gain vanished in April as concerns mounted over rising interest rates, rising oil prices, terrorist threats and the continued instability from the war in Iraq.

Emerging markets couple hypersensitivity to the world's triumphs and tragedies with their own specific political and economic risks. Today many market watchers are keeping an eye on China, where economic reforms aimed at curtailing inflation threaten to bring economic growth to a screeching halt. And rising interest rates remain high on the list of possible market busters. "The market is anticipating that the Fed will tighten rates at a modest pace, which might push the Fed funds rate to 4% or 4.5% over the next 18 months. Anything much beyond that level would be particularly harmful to countries with high debt levels, such as Turkey or Brazil," Hoguet cautions.

Despite their risks, he believes emerging markets have a lot to offer investors who want to diversify their portfolios beyond familiar borders. In addition to having the potential for higher returns, he says, they open a new set of investment opportunities. Emerging market countries now account for about 5% of the world's stock market capitalization, and many of the companies that trade on their exchanges have become household names. Improving corporate governance and transparency, as well as continuing inflows from investors, continue to support these markets.

And while their sensitivity to world market patterns has increased in recent years, emerging markets remain a solid diversification tool. Emerging markets were largely decoupled from the rest of the world in the early 1990s, with a correlation to established markets of about 0.3%. A number of factors, including greater investor participation and the growing integration of world markets, has increased that figure to about 0.65%-a correlation that, Hoguet points out, is still lower than many other alternatives, such as small-cap or mid-cap U.S. stocks. For diversification purposes, he recommends a 5% allocation to the asset class.

Hoguet says the fund "makes a large number of small bets" to add an element of risk control to this inherently risky sector. Because of its parameters, the tracking error, or the level of deviation one can expect from the benchmark return, is usually no more than 4.5% to 5%.

The firm's top-down research process starts at the country level, then drills down to individual security selection. If a country's weighting in the MSCI benchmark is over 10%, its weighting in the portfolio can vary by as much as seven percentage points. If a country's weighting in the benchmark falls below 10%, its fund weighting can deviate by a maximum of five percentage points. For example, if a country has a 5% weighting in the MSCI benchmark, its weighting in the fund can range from 0% to 10%.

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