EM’s hidden treasures

Dave Adams asks what emerging market smaller companies can bring to a portfolio

Looking back, it seems bizarre how recently investing in emerging markets was regarded as a somewhat left-field and radical course of action. Today, most institutional investors seek at least some exposure to companies working in these rapidly developing economies. “If you look back about six years ago there
was some exposure to emerging markets, but it was fairly small: perhaps just held within peoples’ global equity portfolios,” recalls Debbie Clarke, head of equity boutiques at Mercer. “Today we’d be recommending maybe 20 per cent of the equity portfolio be in emerging markets.”

The first article in this supplement makes the case for considering a GDP-weighted strategy along-side consideration of market capitalisation for pension funds seeking to benefit from the growth of the middle class in these markets (see pages 26-27). This article will seek to expand on the advantages and challenges of doing so by investing in smaller companies.

“When you look at emerging markets, it’s a two pillar story,” says Scott Leiberton, managing director, equities, at Principal. “One is tapping into global multinational themes; the other is tapping into consumption growth.”
Leiberton believes that only by giving the full emerging markets universe all the attention it requires can investors gain exposure to both pillars.

Dave Adams asks what emerging market smaller companies can bring to a portfolio

The figures associated with middle class consumption in the larger emerging markets are indeed startling. Extensive research at the McKinsey Global Institute in 2007, which tracked the development of India’s economy from the 1960s onward, concluded that if India continues its current high growth, incomes will almost triple by 2025 and the country will become the world’s fifth largest consumer market. This research predicted that even levels of rural consumption would reach compound growth rates of 5.1 per cent over that period, with urban consumption compound annual growth hitting 9.4 per cent.

China’s middle income consumers will triple in number over the next decade, according to analysis by Boston Consulting Group published in November 2010, with another 270m consumers joining the group of consumers whose annual household incomes exceed 60,000 yuan ($9,000). The total number of consumers in China who could be considered part of an affluent middle class will rise from 148m today to 415m in 2025.

“It’s China and India driving this, but it’s not just those countries,” says Fraser Hedgley, emerging market product specialist at Nomura Asset Management. “What pension schemes have to do is to look at asset allocations and figure out how to manage exposures to those consumers. People need to take a fresh look.”
Ewan Thompson, emerging markets fund manager at Neptune Asset Management, also believes this can only be achieved by taking a more fine-grained approach. “We’ve seen a shift from people just looking at the whole big picture to a more detailed view,” he says. “We meet a lot of people who say ‘Can’t I just buy Unilever to get my exposure to those markets?’

“We would say absolutely buy Unilever or whoever – we’ve long been keen on buying multinationals – but there are often trends that these companies don’t have any access to.”

To explain what he means, Thompson points to examples of western companies trying to break into emerging markets and finding that the best way to do so is through acquisition of an existing player in that market, as illustrated by, for example, Pepsi’s purchase of a majority stake in Russian dairy and fruit product manufacturer Wimm-Bill-Dann in December 2010. “That shows you that the international companies don’t always have the ability to access growth if they don’t have all the local knowledge they need,” he says.

Other large companies have come unstuck in emerging markets because fundamental differences in business cultures, or problems associated with that country’s infrastructure have derailed tried-and- tested methods that succeeded elsewhere.

“People say surely big companies can just replicate what they do in developed markets, but sometimes these companies are too sophisticated, in a way,” Thompson explains. “They think that if they apply a rational, super-organised approach like they use in the US or Europe that they can just harvest the profit, but when you’re operating across multiple timezones, using infrastructure that’s a bit creakier than you’re used to, you tend to find that the local players tend to dominate. Luxury brands do OK, but with more basic things it's the local guys who know what they’re doing.”

That points investors towards a strategy encompassing more small caps. “As an emerging markets manager we tend to take an all-cap approach,” says Principal’s Scott Leiberton. “You have to look past some of the larger emerging markets companies to get that, so you might be looking at an Indonesian cement company, or a Brazilian food company.”

But dealing with small caps can be challenging. “You need a reasonable amount of [liquidity] to trade, but here we're talking about something that is in an emerging market and it’s small cap, so some shares will be more closely held,” warns Headley.

“It’s still perfectly possible to find thousands of investable companies, but the liquidity is spread over a very large number of names. So you need to be able to look at a large range of companies. And the data for emerging markets small cap companies is not as prolific as for large cap.”

“It could be difficult getting access to corporate governance information, making sure you’re investing on the same terms as other investors,” adds Clarke. “You just need to understand what you're getting into.” But, counters Leiberton, “small caps doesn’t necessarily mean the very small”.

“Emerging markets do include a lot of tiny, illiquid securities that institutional investors should avoid and certainly emerging markets include country by country sovereignty risks and other risks,” he says. “But that’s one other reason why they offer a return premium, because there are those risks. And it's also a reason why they require specialist expertise.”

Thompson agrees that a sufficient depth of local knowledge is crucial. It’s helpful if managers understand the idiosyncrasies of different markets. It’s also essential to keep abreast with developments such as the emergence of brand loyalty, he continues, citing the Chinese sportswear market, where companies that looked very similar only four or five years ago have now diverged significantly in terms of business models used and thus may now offer quite different investment prospects.

This growing complexity is one of the most compelling reasons to dedicate more resources to understanding and managing exposure to emerging markets, says Leiberton. “Over the past decade a lot of things have been transformed,” he notes.

“[Emerging markets] have matured quite a bit, their debt situation has, in some cases, completely reversed, you’ve had better stability with credit markets. Most of these markets have enjoyed currency appreciation.

“You’ve had much less headline risk coming out of emerging markets. That’s one of the things that underpins the continued favourable outlook. In the 90s many emerging markets had high GDP growth, but that didn’t translate into earning growth and return on equities. Now it has.”

One more important advantage of working with an emerging markets specialist, he suggests, is that by doing so investors should get some exposure to emerging market risks associated with both international and local markets.

“This year the global export theme has outperformed the more domestic side, as opposed to what happened in 2010, when performance was driven by smaller countries rather than the BRIC countries,” he points out.

“Markets that performed best in 2010 were places like Indonesia and the Philippines and countries in Latin America, smaller markets that had more of a local market consumption flavour. This year it’s more the countries like Korea and Mexico, countries more geared to recovery in the West. Local markets have performed less well because of inflationary worries and currency devaluations.
“So one of the things that makes the case for exposure to both global and local is that they don’t always move in tandem. A skilled specialist should be able to help you tilt between the two.”

There’s no doubt that doing business in many emerging markets is getting easier. But now, of course, it will be harder to repeat the most spectacular success stories of the past decade. Investors will need a skilled guide to find the best opportunities. As Thompson concludes: “These economies are growing fast, but not so fast that everyone can make money without trying.”

Dave Adams is a freelance journalist

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