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Institutional investing in emerging markets, such as China, is now as low as it was in the aftermath of the 2008 market crisis.KIM KYUNG-HOON/Reuters

One of the things contrarian investors frequently do is try to gauge what the investment crowd is feeling – both good and bad – about certain assets, securities or markets.

Notice I said "feeling" rather than "thinking"– it's emotion that's key. Once contrarians discern where the crowd's emotions are – what the crowd hates or loves and hence where they are pulling or putting their investment dollars – it becomes easy to identify opportunities.

So, how do you know what the crowd is feeling? One way is to follow the latest inflows and outflows of assets from investment funds. When inflows and outflows become extreme, or for prolonged periods, that's often a sign that the crowd's feelings are getting the better of rational investment analysis.

When outflows become large and for a prolonged period, it's generally a time to buy before the asset comes back into favour. When inflows become large for a prolonged period, it's also generally a time to sell assets before the market rolls over. This is the way contrarian investors increase their odds of success significantly, and reduce their risk substantially.

Over the years, I've used this simple strategy repeatedly with all types of assets, and I've had significant success with it.

Recently, we've noticed this kind of opportunity in emerging markets. Allow me to make the contrarian case for this unloved asset class that's been suffering from a massive underperformance over the last four years.

In the fourth quarter of 2014, there was a remarkably large inflow to U.S. equity funds – particularly large-cap stocks. Conversely, there has been a substantial outflow from emerging market funds. After almost four years of disappointing performance, it's easy to see why many investors have thrown in the towel.

Over the past two years, investors have pulled a total of $52-billion from emerging market equity funds – while allocating $512-billion to other markets, according to Bloomberg and EPFR Corp. This type of inflow/outflow analysis alone would be enough to interest any contrarian. But the case to invest has become a lot stronger when considering the behaviour of large institutional investors.

Data from the Institute of International Finance show that the level of institutional investment in emerging markets has gone down steadily since 2010. It's now about as low as it was in the aftermath of the 2008 market crisis.

You'd expect this amount of selling to have a sizeable effect on emerging market valuations. In fact, the current price-to-earnings ratio of the MSCI Emerging Markets Index is about 12. Compared to the index's long-term average of 14.6, that's pretty attractive. And it's downright cheap compared to the U.S. stock market ratio of about 18.

These are strong contrarian signals. But our chart shows another one that might be even stronger.

The key takeaway is that over the past 25 years, there has only been one instance in which emerging markets were down three years in a row – 1999 to 2001. And as the chart makes clear, the upward "turn" was quick and sharp. As contrarian signals go, this is a strong one.

Now, some might say just because emerging markets have been down for awhile, that doesn't necessarily mean they will recover this year, or right away. Emerging markets may be cheap, but they may become cheaper.

There's no way to time these movements perfectly. Rather, the contrarian looks at the "balance of probabilities" and seeks asymmetric opportunities. Is the potential upside considerably more than the potential downside?

Based on this information, I would say emerging markets offer a "yes" to that question, particularly for mid- to long-term investors with a three-to-five-year outlook. After three, almost four, disappointing years, the more likely possibility is that the next move will be up over the next three or more years.

Today's emerging equity valuations seem to be ignoring many of the positives such as lower debt to GDP figures and lower valuations that continue to be driving the emerging market economies.

And the balance of probabilities suggests we're closer to the end of a downturn than a beginning. When astute, value-conscious investors come across such unpopular opportunities, they tend to buy and wait patiently for catalysts to emerge. Once they do, the upside potential can be significant.

Thane Stenner is founder of StennerZohny Investment Partners+ within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors). (www.stennerinzohny.com) The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.

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