The blurring of the line between emerging and developed markets
01 February 2013 - Suhail Suleman
At Coronation we believe that over the next 20 years the global economy will be increasingly driven by the emerging market consumer, much like the last decade was primarily driven by commodities (and almost destroyed by the banking sector). The continued increase in the size of the middle class in countries with large populations will be the primary cause of this development. By some measures almost 600 million people in emerging markets can be considered middle class today, which is larger than the combined middle class of the developed world, and the figure is set to double by the end of the decade. Consumption of everyday goods remains very low in emerging markets relative to wealthier nations, but history shows that once income levels reach a certain inflection point, additional increases in income typically lead to a steep rise in consumption for some time before levelling off. This represents tremendous opportunity for the manufacturers of cars, white goods, branded foods, soft drinks, beers and personal care products, to name a few.
Our investment process often leads us toward consumer-focused companies as they typically have most of the qualities we look for in businesses we like to invest in. These include high barriers to entry, strong branding, stable margins, low capital intensity, high cash generation and little risk of falling prey to technological obsolescence. With this in mind, we are often asked by prospective investors why our emerging markets equity funds contain well-known US and European listed companies that one would typically associate with global funds, particularly when there are so many world-class emerging market consumer businesses to choose from already. Our response is always that, for our clients, we look for the best emerging market related investment opportunities and, therefore, where the company is domiciled is no reason for exclusion.
The example of South Korea (Korea) is a good illustration of the choice we as investors face. From a virtual wasteland 60 years ago, following a horrific war with the communist North, the country today is by all measures no less developed than most of the countries making up the European Union. South Koreans have a high standard of living, great infrastructure and long life expectancy, while their domestic economy has little in common with other emerging markets like Indonesia, Mexico or Turkey. In spite of this, it remains one of the largest weights in the MSCI Emerging Markets Index and several of its well-known conglomerates feature in emerging market funds. Even the country’s famed exporters that have become global brands like Samsung, LG and Hyundai typically sell more to their domestic market and in the saturated developed markets of North America, Western Europe and Japan than they do to the developing world. Funds that hold these stocks are ultimately buying exposure to the developed world but without the regulatory oversight and corporate governance that they would face as developed market listed companies.
Korea is not the only example of a de facto developed market that is still regarded as emerging for investment purposes. The island of Taiwan (or Chinese Taipei) is also largely a developed country that remains classified as emerging for various technical reasons. Taiwan’s largest companies feature prominently in the Emerging Markets Index, with the Taiwan Semiconductor Company (TSMC) being the most well known of these. Like Samsung and Hyundai of Korea, TSMC largely sells its products to developed market customers and is only an indirect beneficiary of emerging market consumer spending.
To return to the question of holding global stocks in our funds, it seems strange to us that investors looking to benefit from the development potential of emerging markets are comfortable holding Korean and Taiwanese businesses that are all but developed in nature when there are more appropriate investments at hand. When we first launched our emerging markets funds five years ago there were only a handful of global stocks that derived a material proportion (which we defined as 40%) of their revenue and/or profits from outside developed countries. Since then, the list has grown exponentially thanks to two phenomena – the continued rapid growth in developing countries and the stagnation in the developed world following the global financial crisis. Today, there are more than 25 of what we consider to be amongst the best businesses in the world that meet our materiality threshold.
Yum! Brands (Yum), owner of KFC and other global fast food brands, is one of the best examples of a global business that is predominantly driven by its exposure to emerging markets. In 2007, 70% of Yum’s company-owned restaurants were located in developed markets. By the end of 2012, the proportion had fallen to 32%. Almost 60% of group profits are now generated in emerging markets, 45% in China alone. These proportions will continue to rise over time as 80% of incremental capital spend is being deployed outside the US, with the bulk of this in places like China, Southeast Asia, Latin America and Africa. Yum is, in our view, a far more appropriate means for investors to obtain emerging market exposure than TSMC.
Similar arguments can be made for holding several other global consumer businesses in emerging market funds. Coca-Cola Hellenic derives over 60% of its business from Eastern Europe, Russia and Nigeria. Heineken’s acquisition of Mexican bottler FEMSA and Southeast Asian brewer Asian Pacific Breweries takes its emerging markets earnings to a similar proportion. Unilever, an everyday household name, has been operating in emerging markets for over 100 years and even has large listed subsidiaries in India and Indonesia. These subsidiaries trade on forward multiples of around 30 times earnings. Despite the compelling growth opportunities in India and Indonesia that would warrant higher multiples, we believe that these valuations provide little room for upside and we would rather own the holding company that trades half this valuation, derives more than half its earnings from emerging markets and has a diverse range of country exposures compared to single country risk.
The difficulty in classifying businesses as developed or emerging extends beyond the examples above and frequently afflicts companies that are clearly domiciled in an emerging country but earn their revenue elsewhere. India has made a name for itself in the last decade by developing an information technology (IT) industry that services the rest of the world. Although the largest Indian IT players like Tata Consultancy Services and Infosys may be headquartered and have the bulk of their workforce in India, they provide services mostly to large global corporates and therefore derive the majority of their revenue and earnings in developed markets. Investors in such companies are primarily buying exposure to IT outsourcing trends in the developed world, as opposed to emerging market exposure.
It should be clear from the preceding discussion that drawing a line in the proverbial sand between emerging and developed markets is increasingly becoming an exercise in futility. Our perspective is that domicile is far less important than the source of the earnings. Companies with high exposure to emerging market consumers are likely to be able to deliver above average long-term earnings growth and we prefer those that convert their earnings into cash for reinvestment in expansion, or distribution to shareholders.
The overriding objective is to purchase these businesses at a substantial discount to what we believe they are worth. In today’s market environment many of the premier emerging market consumer companies that are very popular with investors are trading at, or above, our assessment of their intrinsic value. These include Walmart de México, British American Tobacco’s Indian affiliate ITC, Brazilian beer brewer Ambev and the aforementioned Unilever subsidiaries. The ability to rather invest in eligible global businesses with significant emerging market exposure like Yum! Brands, Heineken, Coca-Cola Hellenic and luxury goods distributors LVMH, Richemont and PPR broadens the investment universe to the benefit of our clients, while still managing to achieve the desired emerging market exposure. This is a far better outcome than being forced to hold overvalued assets or investing in poorer quality companies that may be cheap but lack the inherent qualities of good consumer businesses.
SUHAILSULEMAN joined Coronation’s Emerging Markets team in 2007 and has 11 years’ investment experience. He joined after 3.5 years with Futuregrowth Asset Management where he was a portfolio manager within the fixed interest team specialising in structured credit and developmental equity investment funds. Prior to this he was a research analyst at Oasis Asset Management covering equities and bonds.
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