There has always been something intellectually topsy-turvy about investing in emerging markets. The theory is straightforward: if you invest in developing countries with young and rapidly growing populations, cheap labour, improving infrastructure and a reasonably clean government, then stockmarket returns should be greater than those from more mature, slower-growing economies. This was the yarn I both spun and believed during three decades of involvement in emerging markets in fund management, broking and corporate finance.
Quite often, however, you were not buying into the local growth story, but into companies selling to multinationals in advanced countries, taking advantage of cheap local labour, a lack of employment rules and low taxes. A good example is the iPhone. Less than 10% of the components are actually designed and made in America. Most of the manufacturing occurs offshore, mainly in Asia. The same applies to semiconductor components, vital for a broad range of appliances from cars to washing machines. The value accrues less to the emerging economy and more to the multinational. Hence Apple’s gross profit margin has been between 30% and 40% for the last 15 years, while the margins for the local suppliers of components are a fraction of Apple’s. Companies will always try to find the lowest-cost suppliers to remain competitive. It’s been going on ever since East Anglia enjoyed an industrial revolution 3,500 years ago, exporting flints for spear and axe-manufacturing in Europe.
Another problem for developing economies was that foreign companies would often crowd out local businesses due to their ability to raise capital and swallow start-up costs. That is why Africa has only a rudimentary car-manufacturing sector producing a mere handful of designs, while key components such as the engine are imported or made under licence. Until recently Asia (ex-Japan) had failed to create significant players in services such as advertising or to develop global drinks brands. In broadcasting and publishing, too, there have been few winners.
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Where the value goes
The result has been that until recently, most emerging-market indices were dominated by local banks, property companies and utilities, where government tended to impose controls against foreign competition. Because local banking regulation and oversight were typically weak and capital flows erratic, emerging markets became as well known for their booms and busts as for their growth stories.
Even in sectors where emerging markets have the edge, such as commodities or clothing manufacture (the starting point for the success stories of Singapore and Hong Kong), often the value-added is lost to the overseas operator or buyer. Swedish-based Hennes & Mauritz, for instance – better known as H&M – is a global success in selling clothes (and if you had invested 30 years ago you would have made 200 times your original investment). It owns no factories, but designs and then sources clothes from over 800 local production sites worldwide, many in developing countries. The gross profit margin in the four years to 2020 was a chunky 50%. The suppliers will have been negotiated down as much as possible; moreover, with so many sources H&M can change suppliers in the blink of an eye. Given Sweden has only 11 million people, it’s a remarkable story of a company turning its comparative disadvantage into success. But its shareholders have been the winners, not emerging-markets investors.
In natural resources too, a disproportionate number of the winners have been foreign companies rather than local ones. Indonesia groans with copper and gold, but its largest mine is owned and operated by Freeport-McMoRan, based in Arizona. The largest global copper deposits are in Chile. Anglo-Australian BHP Billiton owns Chile’s – and the world’s – biggest copper mine, the Escondida project, in a joint venture with UK-based Rio Tinto and a Japanese consortium.
An inferior index
The leading benchmark for developing economies is the MSCI Emerging Markets index, which reflects the performance of large and mid-cap companies in 27 nations. These markets are defined as “economies or countries where some sectors are rapidly expanding and engaging aggressively with global markets”. Sounds pretty woolly? It is. The index is dominated by three countries: China (comprising almost 40%), then Taiwan and South Korea (27% combined). Some countries, such as Singapore and Hong Kong, are absent because they have achieved developed-market status, and the index does not cover “frontier markets” (the poorest economies), which have their own index. China as an emerging market is an anomaly as it is the world’s second-largest economy. Its dominance of the benchmark has resulted in many funds using indices with a lower China weighting, but as a result Taiwan and South Korea become even larger. Either way the index still makes little sense given that Taiwan has income-per-head substantially larger than the UK and South Korea about the same as the EU average.
The definition of emerging markets, then, is now out-of-date and the term has become a pretext for marketing “exciting” products and earning high fees. Emerging-market funds tend to charge 50% more than others. As an investment category it’s not going away anytime soon, but the examples of companies making hay in these countries points to an often more successful and cheaper way to invest.
Where investors should look
Look at where a company makes its money, not where it is listed. Many firms listed in emerging markets make their profits selling overseas, so they are tied into the slow growth in mature economies – the opposite of what investors think they are buying. For the prime reason to invest in developing countries is to capture their high domestic economic growth. Therefore it is far more rational to invest in companies (wherever they are domiciled) that derive much of their sales and profits from emerging markets.
There are many in the UK and other major markets, which have the added benefit of better corporate governance and less corruption. Moreover, returns are often better. Some of the best emerging-market companies are actually “at home”. There are some interesting growth stories at the smaller end of the UK market.
I have owned Nichols (Aim: NICL) for 20 years even though its main product, non-alcoholic Vimto, is an acquired taste. If you’re in the Middle East, it is the drink of choice. If you want to play Emerging Europe’s thirst for knock-out alcohol, then Stock Spirits Group (LSE: STCK) is the share for you. In soft drinks, consider Coca-Cola Hellenic Bottling Company (LSE: CCH).
If you are taking a shower in Nigeria then you’ll probably be washing with a product from PZ Cussons (LSE: PZC), whose brands include Imperial Leather. Until recently Nigeria accounted for over half of Cussons’ revenue and profits. Also in Africa, mobile telephony is a fast-growing business. Airtel Africa (LSE: AAF) provides mobile services in 14 countries; Helios Towers (LSE: HTWS), as the name implies, creates the infrastructure for mobile signals. There are also MP Evans (Aim: MPE), a successful palm-oil producer in Indonesia and Ocean Wilsons Holdings (LSE: OCN), a tug and maritime operator in Brazil.
In natural resources London remains a leader and the sector is on a roll. Demand for copper is increasing with the switch to electric vehicles. One of the best and purest copper miners is Antofagasta (LSE: ANTO), which runs four mines in Chile. For silver look no further than Fresnillo (LSE: FRES), which operates seven mines in Mexico, also producing gold, lead and zinc. Other large miners in developing countries include Anglo American (LSE: AAL), Rio-Tinto (LSE: RIO) and BHP Billiton (LSE: BHP).
Burberry (LSE: BRBY) has come to represent affordable luxury and its future depends entirely on Asia-Pacific and emerging markets, where it has three quarters of its stores and franchises. Many of the largest companies also depend on the growth of their sales in emerging markets. BAT (LSE: BAT) may make semi-lethal products – cigarettes – but a large percentage of its 600 billion cigarettes per year are smoked in these countries. AstraZeneca (LSE: AZN) was making 35% of its sales to developing nations even before the pandemic. Unilever (LSE: ULVR) sells more to them than to the UK and US combined.
In other advanced countries too some of the largest companies increasingly profit from the less-wealthy nations – half of all Gucci’s sales (the brand is part of Kering, (Paris: KER) are made in these countries and it will shortly be the same for Nestlé (Zurich: NESN). I have a love affair with the US-listed farm machinery maker AGCO Corporation (NYSE: AGCO). Most of its sales are made outside America, with a significant market share and production facilities in Latin America, eastern Europe and China. Eastern Europe and Asia account for more than 50% of profits at Denmark’s Carlsberg (Copenhagen: CARLB).
The funds to buy now
Much of the time the best way to play emerging markets’ undoubted growth and potential is through such large-cap and smaller companies, which have successfully navigated the barriers, corruption and local cultures, rather than through emerging-market funds. For the last decade this has certainly been the case: the returns from emerging markets have been miserable and not commensurate with the higher risks. The MSCI Emerging Markets index ex-China has produced an annualised return of just 3.2% over the last decade; including China, 4.1%. Meanwhile, the developed world ACWI index has returned 9.6%.
I think companies in mature economies who recognise that their future relies on expanding into these countries will continue to benefit. So I will keep buying household names with such exposure as well as some of the smaller companies I have mentioned. But if you prefer funds, then two investment trusts stand out on their five and ten-year records respectively: Fundsmith Emerging Equities (LSE: FEET) and JP Morgan Emerging Markets (LSE: JMG). Both are on attractive 7.5% discounts to their net asset value.
Jonathan Compton was MD at Bedlam Asset Management and has spent 30 years in fund management, stockbroking and corporate finance.
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