Time to Buy the Sinking BRICs

Stock markets in Brazil, Russia, India and China have tumbled of late on signs of slowing economic growth.

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That is presenting an opportunity for investors to buy what others are fleeing. The BRIC markets now look cheap based on their corporate profits and dividends. And despite slowing growth, their long-term prospects remain bright.

The key is to choose the best way to buy in. BRIC mutual funds pose problems, as do other stock funds that track small baskets of emerging markets with names like "Next 11" and "Civets." Investors should look instead to broader emerging-markets funds that can buy wherever the bargains appear.

The BRICs got their name from a 2001 paper by Goldman Sachs (GS) economist Jim O'Neill, now head of the firm's asset-management division, who cited those countries' potential for rapid economic growth. As predicted, their economies have expanded much faster than developed markets like the U.S.

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The returns, however, have been less pleasing. Over the past year, the MSCI BRIC index has lost 19.7%, including dividends worse than the 13.6% loss for the broader MSCI EM emerging-markets index. The MSCI USA index has returned 4.3%.

BRIC funds have been around for longer than a year, of course. The actively managed Goldman Sachs BRIC fund launched in mid-2006, and the passive iShares MSCI BRIC (BKF), an exchange-traded fund, in late 2007. But big returns haven't materialized. Over the past five years, the BRICs have lost an average of 2%, including dividends, versus 0.4% for the U.S.

Now some investors are losing patience. BRIC funds saw large inflows in 2009 and 2010, but they have suffered outflows in 43 of the past 52 weeks, according to EPFR Global, a data firm.

Why have the BRICs performed worse than other emerging markets of late? One possible reason: Those are the ones investors piled into, so they're the ones investors are now selling, says Matthew Freund, who oversees $50 billion in stock and bond mutual funds for USAA.

Therein lays one problem with the BRIC approach to emerging-markets investing. Countries whose economies are growing quickly don't necessarily produce handsome stock returns. A London Business School study that looked at data for 83 countries over 110 years through 2009 found "no evidence that investing in growth economies produced superior returns."

If that sounds counterintuitive, consider that countries that compare well in terms of economic growth already might have attracted plenty of stock buyers, pushing valuations higher. Valuations are a key predictor of future stock returns; inexpensive stocks do better, all else held equal.

If the BRICs remain poised for decades of economic development, their recent stock-market slide should make them more appealing for long-term investors. They trade at an average of 8.9 times the past year's earnings with a dividend yield of 3.6%, versus 13.8 times earnings and a 2.3% yield for the U.S., according to MSCI.

Be warned: While BRIC economies still are growing faster than those in the U.S. and Europe, the growth is slowing. Half of the MSCI BRIC stock exposure comes from energy and financials, but crude prices are sliding, and bank profits can be volatile.

A better approach than buying into a BRIC fund is to find one that shops in many emerging markets for companies that look cheap based on measures like cash flow, dividends and yields on local government bonds, says Bernard Horn, founder of Polaris Capital Management in Boston, which oversees $2 billion. Such funds can scoop up BRIC bargains as they arise, without being confined there.

Lazard Emerging Markets Equity has returned an average of 15.5% a year over the past decade, ranking among the top 10% of peers, according to Morningstar (MORN) . It recently had less exposure than the MSCI benchmark to China but more to Brazil. There is no upfront sales charge and yearly expenses are 1.42% of assets.

Oppenheimer Developing Markets has less exposure than its benchmark to financials and energy and more to consumer companies, especially those that make staple items. Its top four country weightings are India, China, Mexico and Brazil. Like many emerging-markets funds, it's costly, with a maximum upfront sales charge of 5.75%. But it has returned an average of 17.3% a year over the past decade, ranking it at the top of the pack.

—Jack Hough is a columnist at SmartMoney.com. Email: jack.hough@dowjones.com