Emerging markets (EMs) are on a tear, outperforming developed markets for the first time in six quarters, climbing 5.2%. Almost $11 billion poured into developing-nation exchange-traded funds listed in the U.S. this quarter, the most since 2012, according to data compiled by Bloomberg.

Why are EMs’ stocks booming? Market analysts point to many reasons, but most of them are irrelevant. One such reason analysts is that EMs offer better investments than now available in the U.S. The U.S. stock market, they say, is grossly overvalued, has anemic growth and is living in a toxic bubble from income sapping, artificially-low rates as a result of Fed stimulus.     

All that may be true, but what the analysts fail to see is that the same forces that are artificially inflating asset markets at home are also inflating assets in various countries overseas. In fact, many economists have said that central bank stimulus in the U.S., Japan, and China is driving investors to buy assets overseas that may be overvalued or too volatile. So if developed markets are the frying pan, EMs are the fire.

In its annual report, released last week, The Bank of International Settlements, which serves central banks, said low interest rates and low volatility encouraged investors “to take positions in the riskier part of the investment spectrum.” It noted that in developed countries lots of low-rated debt was issued and lapped up by investors, as stock markets reached new highs.

Also, the report said, some assets rose so high they lost touch with fundamentals, while at the same time volatility “in many asset classes approached historic lows.” If Lewis Carroll wrote the Bank of International Settlements report, he’d have titled it, Through the Looking-Glass. 

EM Requires Value Investing

As readers following Global Investment Strategist know, investing in EMs requires a laser-like focus on the countries themselves. Is growth real and sustainable? Or is the economy being artificially propped up by hot money flows from investors and central bank stimulus?

These short-term influences can evaporate at a central banker’s or market’s whim, leaving investors with heavy losses. Remember Fed Chairman Ben Bernanke’s comments last May that he was going to ease stimulus in the U.S? That caused a rush for the EMs exits and a huge sell off by investors expecting higher rates in the U.S. (which never materialized).  

Instead of analyzing which EMs have solid growth, some managers of EMs funds figure it’s best to throw too wide a net, and so fail to capture where the real growth trends are happening. Their water-down portfolios underperform.

For example, the iShares MSCI Emerging Markets Latin America (Nasdaq: EEML) has been criticized for being too commodity heavy and too exposed to South America, and has not always reflected the true economic activity in Latin America as a whole. We have long argued the indices have weak representation from Mexico and Central American countries.      

In addition, the problem with the shotgun approach in EMs is that while it does provide a form of protection, the growth drivers from country to country can be vastly different, and thus the performance. Further, investors being told that emerging markets are attractive because developed equities markets are cheap should not forget that no investment in the world is a bargain if there are little to no real long-term growth opportunities. 

And as some equity investors have chased growth without really understanding the differences between countries and the risks, so too have bond investors been guilty of blindly chasing income.   

For example, EM investors have been snapping up bonds from frontier markets such as Kenya, which in late June made a $2 billion offering. What was the attraction?  The 10-year portion of Kenya’s two-part bond yielded more than 6 percent, compared with 2.6 percent on US treasuries, 1.35 percent on German Bunds and a miniscule 0.6 percent on Japanese government bonds.

But Kenyan is in an unstable region where terror attacks from Somali extremists can occur, as happened earlier this year, hurting its sizeable tourism industry. And the World Bank has reduced its growth projections for Kenya this year because the economy is being hurt by and severe drought that has hit the bread basket areas of the Rift Valley.

Considering these risks, Kenya isn’t such a bargain compared with developed economies.

America the EM Growth Driver

A great debate has run for many years over whether emerging markets could ever truly “decouple” from the United States. Decoupling here means that the world’s emerging markets no longer need to depend on U.S. demand to drive economic growth.

On one side of the debate analysts say that some emerging markets, such as China, India and Brazil, have become sizable markets on their own and no longer rely on the U.S.  But analysts on the other side argue that it’s not clear economic decoupling has truly happened. They point out that many U.S. firms that have operations in EM markets have been contributing to the improvement in consumer purchasing power that is attracting investors.

For example, one of Panama’s top five exports is antibiotics (28%), according to the MIT Observatory of Economic Complexity.  Did the Panamanians become adept at pharmacology and start an indigenous industry? No, the world’s top pharmaceuticals companies have built operations there, from Johnson & Johnson (NYE: JNJ) to Merck & Co (NYSE: MRK). Many pharmaceuticals companies have located in Panama as a hub to sell into high-growth Latin American markets and to take advantage of lower labor costs and a highly skilled workforce.

Almost every well-performing EM country has had some significant investment from, and large trade ties with, the developed world.  

In fact, in March the Mexican central bank governor Agustin Carstens said that emerging market decoupling is “more a mirage than reality. The main risk to emerging markets is to be confronted with sudden massive capital reversals, which so far have not happened.”

Such reversals, or withdrawals of capital by developed countries, may be spurred by developing nations’ own vulnerabilities, such as poor economic management and current-account imbalances, Carstens said. They could also be sparked by a minefield of conditions, such as abrupt changes in monetary policy in advanced nations, an interruption in the European Union’s economic recovery, financial-market contagion or rebalancing in investor portfolios, he added. 

Emerging markets with strong ties to developed markets will improve as those developed markets improve.

The Reality of Productivity Growth

At the heart of what drives growth in economies is productivity, and EM investors should be aware that productivity is faltering in both some rich and emerging nations as a result of central bank stimulus that distorts economies, and of investors chasing growth and yield without regard to the fundamentals.

Declining growth rates are a result of a long history of falling productivity growth in advanced economies, which is no longer more than offset by huge rises in the efficiency of emerging economies, according to a Financial Times analysis. Countries’ economic fortunes can boom and bust, but it is only by improving the efficiency by which labor and capital are turned into goods and services that living standards are sustainably increased, the FT observed.

A Conference Board report on global productivity estimated that productivity stalled last year in China and declined in India, suggesting even the largest emerging economies are now struggling to make advances in efficiency. The Conference Board showed that in 2013 total factor productivity, its broadest definition, declined for the first time in decades, indicating that the world made no improvements in the way it used and allocated labor and capital resources last year.

We think that fall in productivity is a direct result of the global downturn. The downturn has produced unprecedented number of unemployed workers, caused investment to be limited by the world’s corporations, and reduced consumer demand to historical lows.

Given this, EM investors should look to countries and companies that are overcoming these limitations through innovation, strong economic fundamentals, and above all, increasing productivity.   

Will History Repeat?

In his 2012 book, “Breakout Nations,” Ruchir Sharma, Head of Emerging Markets Equities and Global Macro at Morgan Stanley Investment Management, said that “in 2009 and 2010 hundreds of billions of dollars went into emerging markets funds,” and investors made little distinction among “Poland and Peru, India and Indonesia.”

The result, he said, was that the prices of stocks in all the mainstream emerging markets moved in lockstep.  “In the first half 2011 the difference between the best performing and worst performing major stock markets in the emerging markets was just 10 percent, an all-time low and a dangerous indicator of herd behavior.”

This was exactly the same mistake, he observed, that the world made in the run-up to the Asian crises of 1997-1998, when all the emerging market “tiger” economies were seen, one way or the other, as the next Japan.   

And given that all but three of 296 emerging-market sovereign dollar bonds tracked by Bloomberg gained in the first half, the broadest rally in at least three years, the data show, it’s clear that the some EM investors are making the same mistakes all over again.

Sharma predicted that “over the next few years the new normal in emerging markets will be much like the old normal, dating back to the 1950s and 1960s, when growth was averaging around 5 percent.  In sum, EM investors will have to exercise discipline, avoiding herd mentality, focusing on the fundamentals of each individual country, as well as the business case of the companies, as these will be the keys to avoiding a repeat of history, and open the door to long term income EM opportunities.  

Banking on EM

Consumer purchasing power growth is an essential ingredient to determine the best investments. One firm that is a strong play on this in various regions in Latin America such as Colombia, Chile, Brazil and Mexico is Itaú (NYSE: ITUB) a Brazilian bank with headquarters in San Paulo.

The bank is the result of the merger of Banco Itaú and Unibacno, which occurred in 2008 to form the largest financial conglomerate in the Southern Hemisphere and the 10th largest bank in the world by market value. The bank reported first-quarter 2014 recurring earnings of R$4.5 billion ($1.90 billion), up 29% year over year. Including non-recurring items, net income came in at R$4.4 billion ($1.86 billion), up 25.7% year over year.

Itaú currently is the second biggest Brazilian bank by assets, after Banco do Brasil. Despite recent economic headwinds, Itaú is now planning to expand into high growth countries in Latin America.

Itaú has shunned many high-risk loans in Brazil at the expense of growth, but its conservatism has paid off in positive earnings. Last summer Itaú revised its expansion expectations to no more than 11 percent in its credit portfolios in 2013, down from 14 percent projected previously. The bank has shown itself to be very shrewd in managing the risks in its home market, which has had a slowdown in growth in the last year, which gives support to its potential success as it expands in other parts of Latin America.    

The bank has been pursuing diversification by expanding throughout the region. In a conference call with reporters last year, Rogerio Calderon, the bank’s comptroller, said Itaú was interested in expanding both its retail and its investment banking operations in the sprawling region, including Argentina, Chile, Paraguay and Uruguay.

In the case of Peru and Mexico, Calderon said Itaú was interested in expanding through both its retail and its investment divisions. He said expansion into investment banking in Peru and Mexico could follow the existing model created by Itaú’s investment bank, Itaú BBA, in Colombia.

The bank is also growing through acquisitions. In June 2013, it agreed to buy Citibank’s retail banking operations in Uruguay. Itaú also took over Citigroup’s Credicard unit, an R$8 billion asset business that includes the Credicard brand and credit cards as well as 96 consumer finance outlets. The bank also bought 51 percent of the credit card operations of Cencosud in Chile and Argentina.

Itau is a Buy up to 17.