BRIC (Brazil, Russia, India and China) markets

EVERY investor should think like a professional, says asset-allocation specialist Tim Farrelly: which means making emerging markets -- especially the BRIC (Brazil, Russia, India and China) markets -- a part of your portfolio.

But whether this means buying a specialist emerging-markets fund or a global fund depends on valuation.

"Global fund managers are well and truly on to this theme, they are increasing their weights to BRIC markets within global equities.

"Generally speaking it's a good idea to let your global managers decide on the emerging-markets allocation. Maybe, when emerging markets' P/Es look reasonable, it's time to look at a separate weighting."

Typically, says Farrelly, leaving the allocation to the global fund managers results in a lower exposure to BRIC than if you had made a separate allocation to BRIC.

But he says on valuation grounds, that protects the investor.

"To me, that's been entirely appropriate in a world where you had to pay 25 times to get into China, when at the same time you could pay 11 times to get into the UK."

While BRIC economic growth is a "hugely important" investment theme, Farrelly says investors should "never get carried away" enough to buy into a market that is becoming over-valued.

"The attraction of emerging markets is that you're buying high-risk, high-growth assets, both to give your portfolio good diversification and make a lot of money.

"But buying potentially high-growth assets at high prices is not such a good idea: if things go well, you'll make as much money as you would have investing elsewhere, but you've added a ton of risk.

"You have to make sure you're buying at attractive prices."

For example, in March this year, says Farrelly, emerging markets would certainly have given you diversification -- but it would have cost too much.

"Back then, they were so expensive compared to other assets, I wouldn't have wanted to touch them.

"Price/earnings (P/E) ratios in India and in China were about 28 and 25 respectively.

"Part of that thinking professionally as an investor is understanding when you're being asked to pay too much for something -- and you were then."

This is a different question to the strength of the investment theme, he says. "Back in the tech-boom days, in 1999-2000, most of what was said about technology was true -- it was going to transform the world -- but the problem was that the companies involved weren't worth 100 times earnings.

"People paid far too much. The BRIC theme sounds similar. The basic story is right -- we are going to see massive economic growth out of those countries, particularly India and China -- but the second question is, are we going to make money in these stocks? That's an entirely different question."

Because emerging markets are riskier than developed markets, Farrelly says investors should always look to buy them at a discount.

"Investors should have been asking 'can these companies grow their earnings fast enough to justify paying 28 times earnings?'

"Historically, when you pay 28 times for anything, you lose money. In March, you were paying a massive premium.

"Now, those markets have had a lot of that premium stripped out -- they are down to P/Es of 16-18 times."

Although India and China have "come off more than the Australian and US markets", says Farrelly, they are still more expensive than most other markets. "That's because people perceive the earnings growth prospects to be so strong. The real question is, are the growth prospects really there? "If you're satisfied that they are, then in July 2008, the BRIC markets look a whole lot better than they did in March 2008." Exactly the same thinking should be applied to other emerging markets, he says.

"Take the MENA (Middle East/North Africa) region. Apparently, that is the next hot area in emerging markets, and it may well be.

"Because I tend to focus on what are valuations and how fast can earnings grow, I'm looking at whether you can buy Middle East stocks at 10-11 times earnings. "If you can, good idea. There is an enormous amount of money sloshing around there in some of the MENA economies, and if you can buy at those prices, fantastic."

MENA as the next BRIC is problematic, says Macquarie-Globalis' Sosa. "The theme has picked up steam because the high oil price is obviously good for oil-producing nations, and most of the best-performed equity markets in the world over the last 12 months come from the oil-producing regions of the Gulf. (Oman, Qatar, Saudi Arabia, Kuwait and Egypt were all in the top ten world stock markets for the year to June 30, with Tunisia coming in at number 11.)

"The Gulf countries and their infrastructure spending is a story that I like a lot, I believe that these are moderate Arab countries that have tremendous potential to become financial centres and the like, but they simply don't have enough people to be the next BRIC," says Sosa. "The biggest issue is that the largest Gulf country, Saudi Arabia, is quite an unstable place.

"That doesn't diminish the fact that Dubai and Abu Dhabi and Qatar will become major financial and media centres for the Middle East.