From growth to profitability
Arjun Divecha likes to talk personal hygiene. In particular he likes to tell a story about HengAn International, China's leading producer of sanitary towels and diapers. Disposable goods like these do not enjoy much demand where per capita GDP is less than $1,000 (€757.3), and it is difficult to grow demand where per capita GDP exceeds $5,000; but as an economy breaks through that $1,000 mark, growth in consumption of disposables goes through the roof. "In 2000, China's GDP per capita was at precisely $1,000, right in the sweet spot, and HengAn had a 50% market share," Divecha recalls. "What could be better?"
As it happened, Divecha's teams were not crazy about HengAn's management in 2000 and chose not to invest at that time. It turned out to be the right decision, even though HengAn probably got its strategy exactly right for the next decade. Demand for its products soared and it retained its market share by doubling sales twice over. Profits, however, barely moved. As investment flooded in, hundreds of other sanitary-towel producers were capitalised, depressing HengAn's margins.
"It may not have paid for them to focus on profitability in 2000," notes Divecha. "But now they can capitalise on brand recognition as the consumer starts to shop in department stores and branded outlets, having protected their market share for the past eight years. Their strategy for 2000-07 was probably the right one for the long term, but it was not good for shareholders. The moral of the story: You can have all the growth in the world, it doesn't mean that you'll make any money."
That is a sobering thought for all those over-weighting emerging markets because they have been told that those economies will be driving the growth of the future. The HengAn experience is well documented at the macro level. Eight years ago Elroy Dimson, Paul Marsh and Mike Staunton showed, in ‘Triumph of the Optimists', that long-term total return on developed market equity is only 40% correlated with GDP growth, and even negatively correlated with per capita GDP growth. If GDP is an aggregate of total imports, exports, consumption and investment spending, it is clear that economies that are growing very fast must be doing so by overweighting the investment spending part (was that another airport that just popped up in China?). And just as over-investment in sanitary-towel factories depressed margins for HengAn, so general over-investment depresses profitability across the board.
"High economic growth is good for the Chinese, but not necessarily good for investors into China," says Divecha. "Likewise, economies that under-invest might be bad for the average citizen, but it's better for the shareholders of the companies that work there. That's basic capitalism."
Now, basic stock valuation suggests that price is equal to expected dividends divided by equity risk premium minus the growth rate of the dividends. By that measure, emerging market valuations relative to those of developed markets depend upon how their relative risk and profitability stacks up. "Historically, emerging markets have traded at a discount because they were riskier and not enough economic growth accrued to shareholders," says Divecha. "Has something fundamentally changed so that you can now say that emerging markets should trade at the same P/E ratios as developed markets?"
The risk side of the equation is now well-worn in investment circles. After running up unsustainable debts and current account deficits through the 1960s-90s, most developing economies used the various crises around the turn of the century to repair balance sheets and reform fiscal policy, and intra-emerging market trade began to displace the exposure of their manufacturers to the OECD's increasingly indebted consumers. Economic risk has converged dramatically, and the response of emerging market credit spreads to successive economic shocks over the past 15 years suggests that markets are buying into that convergence.
Future demographics of many developing economies look much healthier, too, with dependency ratios coming down and disposable income going up, while the developed world endures the opposite trends.
What about profitability? For Divecha, progress here outstrips even the convergence of risk, with the average emerging market company closing in on developed-market levels of profitability for years before the crises of 2007-08, and even overtaking them since. Increasingly, western-educated management has eroded the old mentality that managers, not shareholders, own the company; criminal activity has waned as managers realised that they can get much richer by growing P/E ratios from 10 to 30 times than by stealing a portion of sales earnings; and globalisation of finance has ensured greater transparency and engagement with foreign investors. And these bottom-up improvements are equalled by top-down macroeconomic policy improvements.
"In a lot of these countries there was pretty strong industrial policy on the Japanese model - Korea is a classic example - which involved domestic banks making loans to manufacturers who would export their goods, regardless of whether or not they made any money," Divecha says. "Thanks to the 1990s crises this national service idea has pretty much disappeared outside of Russian energy companies and some Chinese companies - where a huge percentage of MSCI China is minority-owned by government and looks and acts like utilities. These companies won't go bust but they won't make super profits because government will simply tax them away."
At the same time, he points to the fact that almost all emerging economies - with the prominent exception of China, now back on track to ‘normalisation' - are responding to their crises by moving from fixed to some kind of floating exchange rates. "My theory is that the cost of your currency is a signal for your cost of capital," says Divecha. "When your currency is too cheap it attracts too much foreign capital and you get over-investment, and vice versa."
None of this is a guarantee of plain sailing into a world of emerging market super-profitability, of course. Profitability results from the optimal level of investment in economic growth, and the key driver of economic growth in emerging markets is the change in consumption and savings patterns associated with its demographics. "It may be that the West's demographics prevent it from growing in the way that it has over the past 30-40 years, while there's no reason why India can't grow at 6-7% a year for the next 20-30 years, looking at its demographics," Divecha says.
But while Brazil, Turkey and Indonesia are examples of economies with good and improving demographics, and India and the Philippines are examples with bad but improving demographics, it has to be said that Russia and China are in the good but dramatically deteriorating camp. And even if the demographics are ‘good', how are jobs to be created to prevent unemployed youngsters rioting in the streets? That can be done from the bottom up, by educating a new generation of entrepreneurs, or from the top down, by throwing investment capital at uncompetitive industries (which is perhaps why India is better positioned to manage its ‘good' demographics than the Middle East).
Given Divecha's argument that profitability is most depressed by state over-investment, it is perhaps a healthy sign that recent interventions have been directed at keeping a lid on investment flows - from China's credit restrictions and emergency exchange rate policy to India's monetary tightening, and Brazil's 2% tax on foreign capital inflows. "One reason why we haven't seen a massive bust in emerging markets this time around is that they didn't have their own Greenspans," notes Divecha. "South Africa has suffered because it hasn't put these kinds of restriction in place. And these are responses to extraordinary circumstances in an asynchronous world, not long-term policies to keep foreign capital out."
For the first time, the potential for growth in emerging economies is aligned with the potential for investors to reap profits, as the allocation of their capital becomes more efficient. It is not a universal equation, but Divecha is in no doubt about the implications it should have on Europeans' allocations to emerging markets.