Emerging markets, changing world
Julian Mayo, co-CIO at emerging markets specialist Charlemagne Capital, has a memory from the early 1990s that serves as a corrective to the idea of ‘de-coupling’.
Based in Tokyo, he had just returned from a marketing tour of Scandinavia, which was on the precipice of its banking crisis. Then he visited an Asian crockery manufacturer that sold quite a lot of its stock in Sweden.
“They told me Sweden was the future for them and they were doubling their capacity,” Mayo recalls. “We didn’t invest, the firm failed. That’s the danger of basing your business model on growth that’s simply not going to happen.”
Today, of course, almost the entire Western world has been brought low by its failing banks, and what Mayo calls the “fantasy economy” of the last 20 years. There are emerging market companies that sell into the West that can deal with this – Mayo picks out Kia Motors and Turkish white goods manufacturer Arçelik – but he warns that business models assuming pre-crisis growth rates are “completely deluded”.
But what about the great engine of emerging market growth – China? Mayo is clear. The commodities supercycle is over. China will have to rebalance its economy away from exports and capex. But some perspective is called for: even if growth goes from 10% to 5%, that growth will be off a much bigger base than it was a decade ago.
“I suspect that the fashion for knocking China has a lot to do with genuine fear that Western dominance in the world is under threat,” he says.
That may explain some of the underperformance of emerging market equities over recent times. Mayo also notes that it is the developed markets’ authorities that have been most aggressively creating the money that inflates asset prices. He concedes that 2012’s single-digit earnings growth from emerging markets has disappointed investors, but points out that much of that came from Russia, and Chinese SOEs.
“Those areas are not really representative of the real opportunity within emerging markets,” he reasons.
All of this leaves emerging market equities trading at about 10-times 2013 earnings. “Moreover, that value opportunity is supported much more than in the past by a genuine income stream,” Mayo adds.
Today, the MSCI Frontier+Emerging Index dividend yield is 2.75%, within touching distance of the MSCI World’s 2.79%. Asset managers have launched emerging market dividend funds and Charlemagne’s, up-and-running since 2010, was among the first. It boasts a dividend yield of around 5%, and reduces the volatility of emerging markets to around 10%.
“In the mid-1980s when Asia was at its most hubristic the discussions company management would have with you would all be about growth – putting flags on maps and, dare I say it, ‘living the dream’, hobnobbing with senior politicians,” says Mayo. “There was no concept of value creation. You ended up with companies in Malaysia, which had double-digit GDP growth, delivering single-digit EPS growth.”
The hubris evaporated in 1997. There followed 10 years of de-leveraging – but also growing ROE, which tells a compelling story of capital discipline in action. The way investors approach emerging market equities should also be changing, Mayo argues.
“The big test will come if and when there is a big slowdown and companies are forced to do ‘national service’,” he says. “Governance issues are more common among some of the commodity players, where you have much more significant government involvement – the Chinese oil companies, the Brazilian commodity companies, and the many implicit or explicit examples in Russia. We’ve seen that to some extent in the Rosneft TNK-BP deal. But in other markets you get companies with very good capital discipline.”
The better-managed companies tend to be the ‘traditional’ exporters like Samsung or TSMC, or those that play on the domestic economy, he argues, and Charlemagne’s dividend strategy is tilted towards domestic demand.
However, with the conventional retail plays somewhat expensive, Mayo points to other ways to build this exposure. The portfolio’s top holding is Fibra UNO, a Mexican REIT that taps into the themes of housing, mortgages and real estate. Its second-biggest holding is
Poland’s PZU, which plays the theme of insurance.
“There are compulsory non-life products that you need to buy as you graduate from bicycle to motorbike to car, each time with an uplift in premiums,” says Mayo. “Property and health insurance is growing. As people grow wealthier life insurance becomes a bit of a blank canvas for growth in many markets.”
Charlemagne also likes telecoms for the growth potential from smart phone data usage – the Dividend fund has four in its top-10 holdings. Utilities represents another domestic-focused sector overweight, despite Mayo’s misgivings about political risk. India’s epic power cut in 2012 was “a big shock” that led to the announcement of reforms that have made provision of power to households interesting, he says.
“Governments recognise that they have to make these businesses attractive if they want to see the capex they need,” he explains. “But you need to be flexible enough to respond to the shifting political sands. We saw that in Brazil recently, where the regulatory goalposts [on electric power concessions] were moved.”
Even companies majority-owned by “charismatic individuals” are preferable to those at risk of government meddling – Mayo picks out Thailand’s Major Cineplex and its founder, Vicha Poolveraluck, which has good growth prospects outside Bangkok and pays a generous dividend.
But does all of this suggest a lack of true ‘quality’ companies in emerging markets, comparable to the household names of developed markets? Mayo says not. He points to Hengan in China, using its local scale, but also its quality sanitary products, to out-compete Proctor & Gamble; and also the Brazilian retailer Lojas Renner.
“One of my colleagues visited six or seven retailers there recently and returned even more convinced that the company we own is the right one,” he recalls. “The gap between what has worked and what hasn’t worked is just enormous. In Russia, compare what Magnit has achieved against competitors like X5 Retail. It’s about doing the simple things really well.”
Is there cutting-edge technological IP upon which to build franchises? Perhaps not so much – but Mayo does not see this as a big problem.
“Samsung has never been at the leading-edge of technology – with TVs they took their lead from Sony, with phones they took their lead from Apple and with semiconductors they looked to the US,” he notes. “Hyundai wouldn’t be where it is now without the Japanese carmakers and Arçelik is not a particularly innovative company. That’s fine if you get your efficiencies, scale and marketing right.”
The bigger picture is more important. This is about better dividends and governance, but also the fact that the West now labours under higher debt, lower growth and growing political risk.
“There is an ascendant anti-business culture in the West,” Mayo reflects. “That’s not to say that populism isn’t unquestionably on the increase in Brazil, for example, or even Singapore – but ultimately, populism taps into discontent. Discontent in emerging economies is addressable by redistributing a growing income stream, but if the income stream is no longer growing it is much more difficult to keep a lid on populism.”