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2015 Investor’s Guide: Don’t buy this, buy that—Foreign Markets

December 4, 2014, 12:00 PM UTC

Sometimes the smartest actions are the ones you don’t take. That old dictum seems relevant at a moment when the markets are a paradox: Each new high only makes many veteran investors more nervous that disaster looms. Between lofty valuations, slowdowns from Europe to China, conflict from Ukraine to Syria, the end of the Fed’s bond-buying binge, and more, there are many reasons for caution. That’s why this year we decided to recommend not only investments to make but also ones to avoid. Smart defense is always wise, and the good news is that even in these precarious times, there are still opportunities to be found.

Europe’s sluggishness in 2014 surprised even conservative investors, and ­uncertainty continues. Fears of a full-blown downturn and falling euro have scared pros away from European industrials and other firms with predominantly regional business.

Some contrarians are seeking out a group whose stock price they view as unfairly maligned: “Companies with global operations that just happen to be domiciled in Europe,” says Rob Taylor, co-manager of the $29 billion Oakmark International Fund. Katrina Dudley, who co-manages the Franklin Mutual European Fund, for example, favors BNP Paribas (BNPQY), which has a global retail-banking franchise—but has the double whammy of being French and having paid $9 billion after a guilty plea for violating restrictions on transactions with certain countries. It trades at less than 10.5 times forward earnings “despite being one of the few banks in Europe currently earning a double-digit return.” Adds Taylor, who is bullish on German carmakers such as Daimler (DDAIY) and BMW (BMWYY): “We’re not investing in a government, an economy, or a GDP. We’re investing in a business. Is Germany going to go into a recession again? Interesting question. But it really has nothing to do with whether a company is cheap.” Daimler’s largest markets include the U.S. and China, and it’s on track to set new sales records this year, Taylor says. A Europe ETF can be useful, but Dudley warns against funds that don’t hedge to offset the impact of the euro. The ­WisdomTree Europe Hedged Equity Fund includes just European dividend payers that get more than 50% of their revenue outside the eurozone. (It outperformed a comparable non-hedged fund by 7.0% to –2.9% over the past year.)

Between slowing growth and government anti-­corruption crusades (which are raising compliance costs), the Chinese market has become more perilous. “A lot of companies that were go-to businesses for investors are not the go-to businesses anymore,” says Lewis Kaufman, manager of the Thornburg Developing World Fund, who oversees $4 billion. Kaufman says, “It’s a much more constrained environment in terms of investing.”

One has been hot—and one just may be ready for a turnaround. “We think India and Mexico are doing the right thing from a macro standpoint,” says Marko Dimitrijević, founder of Everest Capital, which oversees $3 billion in hedge funds. He says reform agendas are likely to spark the two economies, and their currencies should hold their values against the U.S. dollar. In India, Dimitrijević praises Tata Motors (TTM), which bought the Jaguar and Land Rover brands in 2008 and executed a turnaround so successful that Jaguar’s profits last year exceeded its acquisition costs. Mexico’s economy, meanwhile, may be bottoming out, says Kaufman. It seems poised to rise as the country opens its oil industry to private and foreign companies for the first time in decades, he says. Plus, Mexico’s trade relationship should make it a prime beneficiary of U.S. economic growth. Dimitrijević owns shares of cement company Cemex (CX), which will prosper as Mexico launches more infrastructure projects like roads and airports. Cemex has also expanded into Texas and Florida, so it should benefit when new-home construction eventually picks up. Kaufman prefers his exposure in the form of U.S. companies like railroad Kansas City Southern (KSU), which will bring more cargo across the border in both directions as Mexico’s energy industry begins to bloom.

BUY5-emerging marketsSources for all graphics: Dealogic; Bloomberg; S&P Capital IQ; MSCI; Everest Capital

“Bonds are expensive,” says Brian Singer, portfolio man­ager of the $900 million William Blair Macro Allocation Fund. His fund is betting against Japanese and Euro­pean credit and is neutral on U.S. credit. Inker of GMO agrees. Japanese sovereign debt is yielding 0.5% while inflation is at 3%. “I can’t fathom any reason why anyone would want to own” Japanese bonds, he says. When it comes to long-duration U.S. bonds, Heather Loomis, West Coast director of fixed income at J.P. Morgan Private Bank, is negative, given that the largest buyer—the Federal Reserve—is going into hibernation. Marathon’s Bruce Richards says U.S. Treasury bonds are “the most overpriced asset in the world.” If rates rise 100 basis points, you will lose close to 20 points in your Treasury bonds, he says: “There are very few assets in the world that, in your base case, you could lose 20%.”

Investors are too concerned that emerging markets are overly indebted, argues Rob Arnott, CEO of Research Affiliates, a sub-adviser to Pimco for $61 billion in assets. The BRIC countries (Brazil, Russia, India, and China) have about 40% debt to GDP, vs. 125% for the G-5. Emerging markets are also growing faster and yielding average interest rates four points higher than the G-5 after inflation. Because Arnott is more worried about inflation in the U.S., he recommends locally issued debt, which is available through Pimco Emerging Local Bond Fund (not affiliated with Arnott). Gerardo Rodriguez, portfolio manager of the BlackRock Emerging Market Asset Allocation Fund, looks for countries that have momentum or “can develop their own capacity to have domestic-driven growth.” He points to Mexico and India and favors the BGF Emerging Markets Bond Fund. It invests in “hard currency” bonds, a better choice if you are concerned that local inflation is a threat.

With China decelerating, emerging markets as a whole have sputtered. They also have to contend with rising U.S. currency and interest rates, which mean more expensive imports and a higher cost of capital. “Overall there’s some value in select emerging markets, but it’s hard to look at the asset class with a broad brush as exciting at the moment,” says Kaufman of the Thornburg Developing World Fund. There are other reasons to opt out of the blanket approach: First, emerging markets used to rise and fall as a group, but that correlation has been diminishing since 2008, so grouping them together makes less sense than it used to. Second, nearly half of the benchmark MSCI Emerging Markets index is dominated by China, South Korea, and Taiwan, which are not expected to be major growth drivers.

More nascent “frontier” countries in Africa and Southeast Asia boast not only cheaper valuations than emerging markets, but also economies that are chugging along, and they offer better diversification: “For now, frontier markets are peripheral to the global economy, so they’re less risky,” says Laura Geritz, who manages $4.5 billion, including the Wasatch Emerging Markets Small Cap Fund and Wasatch Frontier Emerging Small Countries Fund. She says many of her frontier holdings actually rise when the U.S. market falls. She thinks the best opportunities now are in markets such as Nigeria, Zimbabwe, Sri Lanka, Vietnam, Bangladesh, and the Philippines, where she’s finding companies with skillful, often Western-educated management teams. “The companies that survive in Nigeria or Zimbabwe have to be really well run—it’s the only way to survive,” she says. The category’s benchmark, the MSCI Frontier Markets 100 index, however, is also disproportionately weighted to just a few countries. Instead, retail investors might buy a single-country fund, such as the iShares MSCI Philippines ETF. “If you’re looking for frontier-market-like growth with a more established market, we prefer the Philippines,” Kaufman says. “We just think it’s a safer way to play a very high-growth area.” In a different tack, he owns certain U.S.-based companies such as Colgate-Palmolive (CL), which generates half of its business in developing markets.

Read more from the Fortune 2015 Investor’s Guide “Don’t Buy This, Buy That” series:

Consumer Stocks
Stocks, Bonds and Funds
Energy and Mining
Real Estate and Industrial Stocks
Technology and Biotech Stocks

This story is from the December 22, 2014 issue of Fortune.