Ready for the Latest Challenge?

I told you months ago to shift your portfolio to emerging markets in the spring. Here, I’ve found some good stocks to consider. The trouble is, individual investors can’t always buy the best ones.

Hope you like challenges.

For months I’ve argued that the United States would have the best-performing stock market in the world for the first half of 2011. But I've added that investors shouldn’t get too comfortable with their portfolio allocations, because the second half of 2011 looked much rockier for the US and other developed stock markets.

Sometime in the spring, I said, investors would want to start shifting the weighting in their portfolios to add more exposure to emerging stock markets.

And in my April 8 column, about how global risk is shifting, I wrote that I thought the time had arrived to start making that re-allocation in investors’ portfolios.

I call this Challenge No. 1. It’s not easy to go through an existing portfolio, cull the stocks that you want to sell to create cash for new investments, and then pick new stocks that you’d like to overweight.

Remember Challenge No. 2?
The global economy has not stood still while investors enjoyed profits from the US stock market and got ready to shift portfolios toward emerging markets.

Way back in January, I wrote in a column called “How to Invest in a Zigzag Economy” that the US economy was in the early-recovery stage of the economic cycle. Developing economies were further along—maybe making a transition from the early recovery to the late recovery.

Now, three months later, I think the US economy and the global economy have both moved further along in the economic cycle. And that should change the kinds of stocks you cull from your US portfolio, as well as the kinds of stocks you add to your weightings of emerging-market stocks.

Adding to your positions in emerging markets right now doesn’t mean going back to the commodity-heavy picks of earlier in the global cycle. If you’re going to overweight Brazil, for example, that doesn’t mean just loading up on iron miner Vale (VALE) and oil producer Petrobras (PBR).

Let me try to explain what meeting Challenges No. 1 and No. 2 means right now.

Back in January, I laid out Sam Stovall’s scheme for the stages of the economic cycle. (I think his 1996 book Sector Investing is still the best resource on the subject.)

Stovall divides the economic cycle into four stages:

• Early recession. You should remember this stage vividly. Consumer sentiment ranges from fear to terror, industrial production plunges, interest rates peak and then start to fall, and unemployment begins to rise rapidly. Sectors that have done well—relatively, at least—during this stage include services (near the beginning), utilities, and (near the end of the stage) cyclicals and transports.
• Full recession. Gross domestic product tumbles, interest rates keep falling, and unemployment rises. Sectors that do best during this stage, historically, have been cyclicals and transports (at the beginning of the stage), technology, and (near the end) industrials.
• Early recovery. Consumer sentiment improves, industrial production turns up, interest rates hit bottom, and unemployment peaks and starts to move lower. Sectors that do best are usually industrials (near the beginning of the stage), basic materials, and (near the end) energy.
• Late recovery. Interest rates rise as the central bank tries to control inflation, consumer sentiment heads down, and industrial production is flat. Sectors that have done well in this stage include energy and (near the end of the stage) consumer staples and services.

In January, I argued that the US economy was in the early-recovery stage, so your US portfolio should overweight industrials, basic materials, and (gradually) energy stocks. Emerging markets were further along toward the late-recovery stage. Central banks in those countries had already started to raise interest rates, for example.

Now that the European Central Bank has raised interest rates, and the Federal Reserve looks likely to do so at the end of 2011 or in early 2012, I’d argue that developed economies are on the road to late recovery.

NEXT: A Closer Look at Emerging Markets

A Closer Look at Emerging Markets
It’s always dangerous to apply an economic model developed for the economies of the developed world to the emerging economies of Brazil, China, or India. Growth rates are higher in those developing economies, for one thing, and that means that even in a late-recovery stage, industrial production is likely to be growing.

But correcting for some of those differences as well as we can, I think it is accurate to say that in a late-recovery stage, industrials and basic material sectors in developing economies have recovered off the bottom and seen their biggest surge in growth.

For example, in March, passenger vehicle sales in China increased just 6.5% from March 2010. I say “just” because auto sales grew by 63% in March 2010 over the prior year. Annual auto sales are now forecast to grow by 10% to 15% in China in 2011. That’s certainly solid growth, but it’s not the 32% annual growth the market saw in 2010.

You can see the same pattern in material stocks. Copper, for example, is in a price decline that’s expected to last until the middle of 2011, before commencing a recovery that will take prices up 17% by the end of the year from the end of 2010. Copper demand is projected to grow by about 6% this year.

There's nothing wrong with any of those numbers, but that’s not the jump in demand or price that you get in a commodity that’s coming off the bottom. In 2009, copper prices climbed about 120%, for example.

In the late-recovery stage, I think investors are looking at solid gains from material stocks in emerging markets, but not of the dimensions for 2009 and 2010.

As the global economy moves toward the late-recovery stage, I think that even in emerging stock markets, investors should add domestic growth companies to their holdings of material and industrial stocks.

Now for Challenge No. 3
And that creates another challenge—No. 3, if you’re counting.

It’s relatively easy for US-based investors to buy the commodity producers and industrial companies of the emerging economies. Many are listed in New York, either directly or through ADRs (American Depositary Receipts.) A US investor has no trouble buying shares of such Brazilian companies as Vale, steel producer Gerdau (GGB) or sugar-cane and ethanol processor Cosan (CZZ) that way.

But try to find a way to invest in Brazil’s or India’s or Indonesia’s domestic growth companies and the job gets much, much harder.

So, for example, I like Brazilian cosmetics company Natura Cosmeticos as an investment in the growing size and income of Brazil’s middle class. But while I can buy shares in São Paulo, they don’t trade in New York.

It’s the same with Lojas Renner, a Brazilian maker and retailer of women’s, men’s, and children’s fashions. Plenty of volume in São Paulo. Doesn’t trade in New York.

And exchange-traded funds don’t offer an easy solution for investors looking for domestic emerging-market stocks. Because most ETFs are market cap-weighted, their portfolios are dominated by commodity producers, telecommunications companies and banks.

Natura Cosmeticos is the 25th-largest position in the iShares MSCI Brazil Index ETF (EWZ). Even the Market Vectors Brazil Small-Cap ETF (BRF) doesn’t give an investor wide exposure to Brazil’s domestic growth companies.

NEXT: So What Is a US Investor To Do?

So What Is a US Investor To Do?
You should find multinationals investing heavily in Brazil’s domestic market. Unfortunately, the best bet of this sort—French cosmetics giant L’Oreal (LRLCY)—trades most of its volume in Paris. But it does trade in New York.

You can also buy the shares of domestic banks that track the Brazilian economy, such as Itau UniBanco (ITUB) or Banco Bradesco (BBD). Unfortunately, I think you’re a little early on these, since a slowing economy is creating worries about rising bad loans at some of Brazil’s more aggressive lenders.

There are a few Brazilian domestic growth companies listed in New York, such as brewer AmBev (ABV) and airline Gol Linhas Aereas Inteligentes (GOL), but you’re hardly looking at a big selection for building diversified exposure to Brazil’s domestic economy.

So why am I concentrating on Brazil, if its domestic economy is such a tough nut to crack?

• First, because it illustrates the problems that investors face in building domestic growth portfolios in a group of emerging markets that includes India, Indonesia, and Turkey.
• Second, because Brazil is the emerging market that I’d put at the top of my most timely list for emerging markets right now. It’s slightly ahead of Indonesia and Turkey, and about three months ahead of China.
• And third, because Brazil is a good example of the trade-offs that face investors who want to put more money to work in emerging markets.

It’s far easier to invest in China’s domestic economy—Internet portal Baidu (BIDU) and hotel chain Home Inns & Hotels Management (HMIN) both leap to mind as domestic Chinese companies that trade in New York. Brazil doesn’t have counterparts to them.

So do you put more money into China than Brazil, even though the timing isn’t as good, simply because you can?

Or do you overweight less-than-ideal Brazilian companies such as Gerdau (which should get a big bump from Brazil’s drive to build out infrastructure for the 2014 World Cup and 2016 Olympics) and Gol (because oil prices do have to go down eventually)?

Or do you use multinationals such as L’Oreal or Nestle (NSRGY) to give you a bit more emerging-market exposure with the baggage of their developed-economy business?

It's not easy. It's challenging, in fact. This problem, by the way, is one reason I started my mutual fund, Jubak Global Equity (JUBAX). As an institutional investor, I can trade in many of the domestic stock markets in emerging economies.

There is no ideal solution for individual investors. My best advice is for you to mix a little of this solution and a little of that. Eventually, more of these domestic growth companies will trade in New York. Until then, we and our portfolios have to muddle through.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Baidu, Cosan, Gerdau, Gol, Home Inns & Hotels Management, Itau UniBanco, L’Oreal, Lojas Renner, Natura Cosmeticos, and Vale as of the end of January. For a full list of the stocks in the fund as of the end of January, see the fund’s portfolio here.

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