Take Your Money But Don’t Run From This Emerging Market

This year, investing has been all about the red, white and blue. Troubles in Europe and China have sent international and emerging market stocks to multi-year lows. That is, with the exception of one market…

Investors that once flocked to Chinese stocks have seen the market drop 3.3% since January, well below the 10% gain in the S&P 500 during the same period. Other favorites have not fared well either since most emerging markets are dependent on China as a resource buyer. Benchmark indices for Russia are down almost 2%, while Brazil is down more than 10% since January.

Lately, companies with revenues exclusively from the United States have been some of the only good bets. In fact, two strong domestic plays I highlighted in June have outperformed the S&P 500 since that time. Life Time Fitness (NYSE: LTM) is up almost 14% since June and Limited Brands (NYSE: LTD) is up over 17%.

But the one emerging market where investors have been able to book big gains is Mexico. Our neighbor to the south has seen stocks surge on strong manufacturing growth and optimism leading up to the presidential elections in July.

My position in the iShares MSCI Mexico Investable Market Index (NYSE: EWW) was up 13% before I sold it last week, beating the S&P 500 and most other regional funds.

So why would I sell out of such a strong market, especially when I think the long-term potential for the country is huge? Because knowing when to take your money and run is just as important as knowing when to buy.

Two fundamental factors go into all my investment decisions: sentiment and value.

Sentiment can turn in an instant
Investors jumped into the market during the past six months as presidential candidates promised reforms and a partial privatization of the oil sector. Shares of EWW are up 15% year-to-date, and they surged more than 14% in the month leading up to the elections. However, they are up only 3% since the elections on July 1, which is comparable to the S&P 500 and other regional markets.

Clearly, some of the fervor that investors had for the election year promises has already worn off. And sentiment could fall during the remainder of the year as people realize the administration does not have the votes necessary to push their promises through.

Valuation: The only way to buy low and sell high
EWW shares are getting pricey at 15 times trailing earnings compared with 13 times for the S&P 500 and just 10 times earnings for larger emerging market funds. Might the fund’s companies keep growing earnings, making the P/E ratio eventually justifiable? Yes, but as a value investor, I cannot justify paying a premium for something that may or may not happen. Baidu (Nasdaq: BIDU) may be the Chinese Google, but I can’t rationalize paying 32 times its earnings when I can get Google (Nasdaq: GOOG) for half that valuation.

Industrial output fell unexpectedly in May, largely from weakness in manufacturing associated with moderation in growth in the United States. Mexico’s consumer inflation rate jumped to almost 4.5% recently, its highest since December 2010, and Moody’s estimates that 28% of the workforce is employed in the underground economy. Markets like these make it hard to estimate future corporate earnings growth, so you really have to watch the price-earnings multiple and take your profits when it gets too high.

Risks to Consider: The long-term investment story for Mexico is still extremely positive and investors run the risk of missing the upside if they stay out of the market too long. Just a modest reform to the oil sector could make it a phenomenal growth story. While prices have been pushed up fairly high and economic fundamentals are weakening, the rest of the world is not so rosy either. Wait for a modest pullback in the market to reallocate long-term funds.

Action to Take –>
A rebound in U.S. economic data and the run-up to the Mexican presidential election helped the country outperform most other markets so far this year. The rest of the year could see a pullback as political realities sink in and weakening growth in the United States slows exports. Take gains and look for the pullback in prices to get back into the market toward the end of the year.