Active investments in emerging markets offer long-term growth
Best returns will be found in the financial-services sector and in companies that increase their market share at the expense of weaker players
Investment opportunities are created when economies modernise, increase in size and see a step-change in financial sophistication.
Just look at China and India. Both were poorly managed by their respective governments until the early 1980s and 1990s and it is no coincidence that a loosening of regulation and an opening up of domestic markets to capital investment and competitive forces coincided with a significant increase in growth rates in these countries.
Shanghai’s stock exchange, for example, was re-established in late 1990 after a 41-year closure. From having no listed companies 30 years ago, the market capitalisation of Chinese stocks today exceeds $10-trillion. India’s market capitalisation has increased from $280bn in 2003 to $2.5-trillion in 2018, a nine-fold increase in 15 years.
The table, drawn from the World Federation of Exchanges database, shows how the market capitalisation (in US dollars) has changed for the listed universe of several countries over the past 14 years for which data is available for all the selected countries.
The figures highlight that the investment universe in emerging markets has expanded rapidly and therefore should be given serious consideration by investors. As markets develop, and as liquidity and trading continuously improve — as they have done over the past two decades — we would expect the weight of emerging markets within global indices to increase significantly.
About 80% of the world’s population live in the developing world, with close to half this populace from China and India alone. As a general principle, developing countries started on the path to industrialisation decades after their developed peers and remain far poorer overall. For this reason, their contribution to global economic output, at between 40% and 50% — depending on whether market or purchasing power parity (PPP) exchange rates are used — is substantially below their population share.
Financial markets in developing regions also developed much later than those in the developed world, rendering their current share of global market capitalisation at only about 25%. Within the broader MSCI All Country World Index (ACWI), emerging markets have a 12% weight and frontier markets have no representation at all.
Given that emerging markets are between 40% and 50% of global output and are growing 1.5 to two times faster than the developed world (in aggregate), investors in ACWI (or any other global index) are structurally underweight emerging markets and are generally missing out on the long-term opportunities they offer.
It is, however, important to highlight that emerging markets are not one homogenous asset class where equity values in the various countries move in tandem. The returns in the various individual emerging markets can and do diverge materially, as their drivers are very different.
For example, China’s market has grown alongside rapid industrialisation. Its market is comprised of oil, property, banking, industrials, consumer and internet stocks, and no one individual industry or sector dominates. The currency (renminbi) is also heavily managed, reducing the impact of currency on returns for dollar-based investors. Brazil, on the other hand, has a higher equity weighting towards oil, iron ore, agricultural commodities and regulated utilities and its currency, like our rand, is volatile and heavily influenced by commodity prices.
The broader emerging-market classification includes countries that are growing fast but are relatively poor in absolute terms, such as India, and those that are relatively wealthy and growing at rates similar to those of developed markets, such as South Korea and Taiwan. The investment opportunities between these countries therefore differ materially, since industry structures are quite divergent.
Some of the best returns available in emerging markets will be available where companies increase their market share at the expense of weaker players, growing revenue at a rate substantially above nominal GDP growth. In the process, these companies will be able to raise margins as their scale relative to competitors increases and barriers to entry for new entrants rise.
Substantial opportunities also exist in the financial-services sector due to fairly low credit penetration. In most emerging markets, access to financial services is far from universal, and penetration of products such as bank accounts, credit cards and mortgages are a fraction of developed countries.
Some examples will naturally answer the question most asked by investors with respect to their potential emerging markets exposure: should the investment be passive or active? Coronation has been an active manager in at least one emerging market (SA) for more than a quarter of a century and we believe it is the most suited option to investors looking for long-term value uplift in returns.
While the index quality has improved over the past decade, we still don’t believe it represents access to the most compelling businesses and investments in emerging markets.
A good example is found in Indian banks. About 70% of the market is still run by the state-owned banks, whose operations have underperformed their private-sector peers since their monopoly ended as part of the economic reform process. The combination of high growth, robust credit processes and long-term thinking from management will yield higher returns for investors in select private-sector banks over the long term.
An index-tracking investor would have a larger allocation to public-sector banks and would also have significant exposure to overvalued consumer stocks in the fast-moving consumer goods sector sector within India.
In our view, emerging markets offer a compelling long-term opportunity for investors. The most important consideration, however, is time horizon. As countries and economies are still decades behind their developed-market peers on most metrics, the duration of the investment opportunity is also long dated. A focus on the long term (five years or longer) rather than shorter term will, in our view, deliver compelling returns for investors even if shorter-term volatility may be higher than in developed markets.
• Suleman is emerging markets portfolio manager for Coronation Fund Managers.