The Most Undervalued Emerging Market In The World

Forget the old adage “When the U.S. sneezes, the world catches a cold.”

Friday’s solid employment report shows the U.S. economy – the world’s largest by a considerable margin– to be faring reasonably well.

The new adage: “When China sneezes, the world catches a cold.”

China’s economy, which recently overtook Japan’s as the world’s second largest, has been slowing throughout the first half of 2013. That slowdown is wreaking havoc on many emerging economies.

The sharp pullback in places like Brazil, Australia, Turkey and elsewhere should be seen as opening for investors that have been awaiting better valuations in these markets. Indeed, theforward earnings multiple for many of these countries’ stock markets has been drifting ever lower, creating a valuation gap with U.S. stock markets that, in some instances, approaches 40%.

Still, investors need to know that these markets can surely fall lower, so it’s crucial to take the long view with investments in Latin America, Asia, Eastern Europe and Africa. If the Chinese economy weakens further, its huge role in global trade means that some emerging-market economies might actually slip into a recession in coming quarters.

It may be too soon to draw such a dire conclusion, and some these markets may have already hit bottom. However, the International Monetary Fund (IMF) this week pared back its growth forecast for this year to 3.1%, down from the 3.3% it projected in April. This underscores the need to monitor the global economy closely if you plan to wade into these markets.

A Lone Bright Spot?
Yet throughout the downturn in emerging markets, one country appears poised to feel only a minor impact from a slowing China. It’s home to 250 million people (the fourth-largest population in the world), has been posting robust growth rates thanks to a rapidly expanding middle class, and now has sufficient domestic consumption to insulate itself from the global trading headwinds that are emerging.

That country: Indonesia, which has been moving up in global rankings and now has the 17th-largest economy in the world, just ahead of Turkey and right behind South Korea, according to the IMF.

This economy is growing at such a robust pace that one can cite a variety of impressive statistics. For example, auto sales rose 17.8% in the first quarter of this year from the same period last year. Here’s another: Foreign direct investment surged 27% in the first quarter to around $7 billion. That’s the fastest growth rate of any of the world’s 50 largest economies. Notably, much of that recent foreign direct investment is targeted at the Indonesian consumer — not at the traditional mining industries that were once the backbone of the economy.

Indonesia’s economy has grown in excess of 6% for each of the past three years, according to the IMF. Can that growth rate last? Probably not. The troubles in China will likely shave a percentage point or two off of Indonesia’s growth rate. The IMF’s latest forecast suggests 6.3% GDP growth this year and 6.4% growth in 2014. Look for that forecast to move closer to 5% as the year progresses.

Indonesia’s biggest headwind isn’t China — it’s corruption and red tape. The country is “growing by 6% but should be growing by 10%,” a U.S. Chamber of Commerce official recently told The New York Times.

The good news: The Indonesian government is aggressively revamping the process for new business applications, and anti-corruption efforts, which were launched five years ago, are starting to finally take root in the form of heavy fines and jail time for bribery. (As the Huffington Post notes, however, more work still needs to be done.)

Time To Invest?
Indonesian stocks have surged more than 300% since the end of the 2008 economic crisis, and investors waiting for an entry point have been frustrated as the Indonesia market moved ever higher. In recent weeks, that opening may have arrived.

There are three exchange-traded funds (ETFs) that focus on Indonesia, all of which have been sucked into the emerging-markets downdraft of the past few weeks:

• iShares MSCI Indonesia Investable Market Index (NYSE: EIDO). This fund has $475 million in assets and a 0.61% expense ratio.

• Market Vectors Indonesia Index ETF (NYSE: IDX), which has $325 million in assets and a 0.59% expense ratio.

• Market Vectors Indonesia Small Cap ETF (NYSE: IDXJ), which has just $7 million in assets and a 0.61% expense ratio.

Risks to Consider: Emerging markets remain quite volatile, and though they appear to have found a floor in recent sessions, they could easily stumble further before an eventual rebound.

Action to Take –> Investors who were wise enough to invest in Japan in the 1960s, South Korea in the 1980s or China in the past decade scored huge gains for one basic reason. Those economies put the foundation in place to build a thriving middle class, which established a self-sustaining pattern of rising domestic consumption. Indonesia appears to be working off of the same playbook. It’s unclear where Indonesian stocks will trade three or six months from now, but long-term investors could reap significant gains.

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