Why smart money is on emerging markets

FOR years, Russia and China have been better known for hiding their economies behind the red wall of Communism. Little was known about how they operated and neither country welcomed outside investment.

But in recent years, all that has changed. China in particular is moving forward apace with construction projects, gobbling up huge quantities of raw materials such as steel.

And Russia, with its massive reserves of oil and gas, has found itself in demand from oil giants such as BP and Royal Dutch Shell, which are continually looking for ways of replenishing their stocks.

These countries, together with - to a lesser extent - India, are the high-profile examples of emerging markets at work. But there are numerous other parts of the globe that are exciting experts and investors alike and are likely to keep the sector to the fore in coming years.

Kim Catechis, head of global emerging markets at Scottish Widows Investment Partnership (SWIP), says: "This last 12 months have been pretty good again. It's the sixth year of consecutive outperformance of the world's developed markets by the emerging markets."

Andrew Mathewson, investment manager at Martin Currie, agrees, saying: "It's been a very strong market. In 2006, returns in emerging markets are up on average 29 per cent.

"It's been a good few years in the sector across the board."

So what has been behind these strong performances? Ronnie Petrie, head of global emerging markets at Standard Life Investments, believes the need for countries to import huge amounts of goods has been a major factor.

"China, for example, needs more than its fair share of raw materials and commodities such as copper, iron ore and energy," he says.

There have also been improvements in market fundamentals - the kind of things that used to derail emerging markets equities in the past have improved, such as the balance sheets of the countries themselves.

Mathewson says China is becoming "the factory of the world", with growing wealth leading to increased consumption. And strong global growth means the exports China is producing are in great demand.

"The China phenomenon is something that is once in a generation," he says.

Catechis also enthuses about the Chinese economy. "We are finding insurance companies in China are very attractive," he says. "The market has under-penetrated the population in terms of financial services. And there are 30 million families in China today that have liquid assets of $100,000 (51,000) each."

Petrie adds that India has had another year of consumer boom, together with the investment sector picking up. "It was an economy that was pretty much closed to the outside world for many years," he says.

"It has been opening up and in the last couple of years that's really paid dividends. Economic growth has been strong and outsourcing from western countries has also been beneficial for the country."

So what does 2007 hold for emerging markets? Catechis thinks returns for sterling-based investors in emerging markets are going to be anywhere between 10 and 15 per cent.

"On one hand, you have companies that are fundamentally more profitable than their counterparts in the developed markets," he says. "At the same time, they are undervalued relative to those companies to the tune of between 30 and 40 per cent, depending on the sector and company."

Petrie is slightly concerned that investors' appetite for risk may reduce, but, in terms of the economies, he is still positive.

"Vietnam, which is just coming onto the investment horizon, is interesting," he says. "It's not very investable at the moment, but it could be a year where a lot of Vietnamese companies list and the stock market moves more into the mainstream."

Petrie still likes Russia. He says: "There will be more banks listing, which we think could be interesting. Penetration of products like mortgages is still very low in Russia but should be increasing rapidly."

Mathewson believes there will be some interest in Mexico and Brazil, with both on the verge of having mortgages becoming a mass market product.

"Until now that hasn't been the case because interest rates have been too high," he says. "That means there will be house builders erecting property for people who can get a mortgage. This is secular domestic growth that won't be affected by whether consumers in the US stop spending as much money as they have in the past."

Whether emerging markets continue to go from strength to strength depends a lot on global growth. But as long as US growth remains reasonable, there is such strength in emerging markets that they remain very well positioned.

There are many companies with strong earnings growth, with valuations still below developed markets, providing ample scope for strong performance for emerging markets.