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.

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