Enter the global dimension
There is no rule that says emerging market securities are the only - or even the best - source of emerging market exposure. Martin Steward looks at access points closer to home
We all know that we want exposure to emerging markets. But what exactly does that mean? Buying a Chinese widget manufacturer - even if those widgets are sold to Europeans? What about a British mining company selling copper to that manufacturer? Or a German cement maker selling to the Chinese government? Or should we really be focused on Danish brewers selling beer to Kenyans, or Spanish banks selling mortgages to Brazilians? And doesn’t a European manufacturer selling to Europeans but outsourcing costs to India offer a kind of emerging market exposure, too?
“We live in a globalised world,” observes Thomas Beevers, pan-European equities manager at Newton Investment Management. “There are plenty of globally-competitive companies in Europe. The country of incorporation or listing is less important.”
Recent Morgan Stanley research suggests that European companies now source 23% of their revenues from emerging markets - almost doubling in a decade. By contrast, sales to North America represent 16% and falling, while sales within developed Europe have also fallen. Go to stock markets like Finland’s, Austria’s, Sweden’s or Spain’s (while underweighting Belgium’s Ireland’s and the Netherlands) and you concentrate that effect - they all get more than 30% of revenues from emerging markets.
But there are revenues and there are revenues. That British mining company selling to the Chinese manufacturer selling to the European consumer offers European economic exposure, ultimately. The consumer is not the be-all-and- end-all. Firms like Cairn Energy and Vedanta are clearly selling into the emerging market infrastructure boom as well as to Chinese exporters. And as L&G Investment Management equity strategist Georgina Taylor points out, if they sell to a low-cost Chinese manufacturer they are likely to benefit from that manufacturer’s growing market share against the US manufacturer that patronises their less globalised competitors - so even that is a distinct emerging markets exposure of sorts.
But if by emerging market exposure we mean exposure to emerging market growth, there is no doubt that the consumer is - or will be - the purest form of that growth. “That’s why we prefer to target consumer staples, generally, and beverages and tobacco in particular,” says Charles Dautresme, a strategist with AXA Investment Managers, who reveals that his sales force in Hong Kong is designing “a Europe fund with emerging market exposure”.
However, while there are consumer businesses like SABMiller and British American Tobacco that are successful in emerging markets, very few source more than half their revenues there. Morgan Stanley’s ranking of the top 50 European companies by emerging market revenues put seven energy and mining companies in its top 10 (the other three were banks). Swedish cosmetics firm Oriflame came in at number 11, but most of its exposure is to emerging Europe rather than the action-packed markets of Latin America and Asia.
Regionally things look better. IT and materials dominate European companies selling into Asia. Morgan Stanley’s China-specific top 50 contains no less than 43 industrial, materials and consumer discretionary stocks (with the latter being mostly auto and luxury goods makers). So there is little day-to-day consumer exposure, and it is difficult to tell how much of the final demand for the industrial and materials companies is really Chinese. But the top 50 sellers into Latin America sees cyclical exposures like materials and consumer discretionary balanced much more by staples, utilities, telecoms and healthcare (see figure 1).
Portugal Telecom and Endesa both make the top 10. This is no doubt why a concentrated, cap-weighted basket of the Latin America top 15 exhibits lower volatility than all the other sources of revenue - even lower than an equally-weighted basket of the global emerging market top 50 (see figure 2).
So it is possible to get that exposure in Europe. Is it desirable? Comparing the valuations of developed market stocks selling into emerging markets with their local equivalents, the story seems clear. Dautresme put a basket of 74 European names together for his colleagues in Hong Kong and found that its trailing P/E of 15 times compares well with the MSCI Europe index (19 times), let alone MSCI Emerging Markets (21 times). In the consumer sector this is magnified: Indonesia’s Indofoods trades at 47 times, making Danone (42% of revenues from emerging markets) look like a snip at 15 times. The steady stream of IPOs is changing things, but emerging stock markets remain tilted away from consumers and towards materials, energy and banks. “That means many consumer-facing companies in emerging markets attract a scarcity premium,” says Richard Turnill, head of global equity at BlackRock.
Furthermore, many argue that global companies (with their long track records and high corporate governance standards in shareholder-friendly cultures with robust legal frameworks and international accounting standards) are better positioned to tap into this growing consumer base. “Part of joining the aspiring middle class is wanting to buy branded goods, after all,” says Turnill. The consumer discretionary names that have made it in China are the likes of BMW, Audi, Peugeot, Swatch, Bulgari and Burberry. This is high-end stuff right now, “but as the Chinese consumer moves above the $6,000 per annum mark, brand aspiration may start to go through food products as well,” suggests Dautresme.
The beverages sector, especially SABMiller, has shown the way. Ann Gilpin, a senior stock analyst and consumer sector specialist at Morningstar, relates how the Brown-Forman Corporation’s advertising for Jack Daniels in China emphasises themes of modernity and sophistication - a million miles away from the posters we see in European metro stations, showing pensive old blokes sitting about on rickety chairs. “Being rural is not something one aspires to in China,” she observes. She also singles out Avon as a very different unexpected play on emerging market demand - its direct-selling model seems outmoded in its home market but in Brazil, where not everyone has access to department stores or online shopping, it is “huge”. Sweden’s Oriflame is an interesting European equivalent.
Moreover, the marketing, distribution and infrastructure needed to tap into these consumers can be capital intensive, while margins can be relatively small. “Nigeria is right at the top of the key markets for Guinness already,” says Gilpin. “Part of that is the brand, but it’s also about Diageo’s huge war chest dominating the smaller players. They take the cash they’re generating from the huge, but non-growing US market and invest it in emerging markets.”
This interesting angle takes what might be perceived as a weakness - only a fraction of these revenues come from emerging markets - and turns it into a positive. European consumers may not be gorging on credit cards anymore, but their consumption is at least entrenched and stable.
Taking the long view is important. China is the glittering prize, and while Morgan Stanley estimates that European companies’ Asian revenues are rising faster than those from other emerging markets, as we have seen, Latin America’s consumers are easier to crack than China’s. Consumption represents less than 30% of China’s economy and extensions of the social safety net that might change the savings mentality are a long-term project. The artificially depressed yuan is great for the exporter but inflationary for Mr and Mrs Li. “When I ask people living in China whether keeping growth at 8.5% is more important to the authorities than diversifying that growth, they tell me that all they care about is the 8.5%,” says Taylor at L&G. “That suggests they’re not focused on moving away from exports.”
Cracking the Chinese consumer will be a struggle culturally, too. One of the reasons Brazil has been ‘emerging’ for much longer than China is that US and European corporates have been working fairly happily there for decades (while they have “only recently become comfortable about protecting intellectual property rights within the Asia growth context”, observes Aviva Investors’ CIO Niall Paul), and their brands translate readily into that context. “Countries as huge as China will develop their own brands and national champions,” warns Aviva Investors’ head of European equities John Botham, “it won’t be just about Nestlé and Diageo.”
That’s debatable - Western corporate marketing’s power over a new middle class shouldn’t be underestimated - but it does appear that China’s authorities will put up resistance. Avon had to open shops because direct selling was prohibited until 2005. SABMiller has done well there through a joint venture, but Coca Cola’s acquisition of Huiyuan Juice was blocked by the ministry of commerce and Danone got a bloody nose from its JV with Wahaha, ending in 2009 after years of acrimonious accusations of fraud.
“The Chinese have shown that they will make global companies fight to enter their consumer staples market,” says Dautresme. “It’s more likely that we’ll see Chinese companies trying to buy European companies.” Of course, buying the under-valued European acquisition target is potentially yet another type of emerging market exposure - not that France would ever allow a takeover of Danone.
All of this begins to delineate the two stories of emerging market exposure: already-happening beta and forward-looking alpha themes. “For instant gratification the companies selling into the infrastructure boom are seeing earnings coming through right now,” says Taylor. “Gaining consumer market share will be a slow burn.”
Morgan Stanley identified one in five European companies with major expansion plans in China. Some will be SABMillers, some Cokes. Even sources of current revenues are difficult to pin down with publicly available information (much of the Morgan Stanley research quoted here is analysts’ best guesses), so extrapolating earnings out over years is a true stockpicker’s game. As Beevers at Newton suggests, that can be about recognising the role that private healthcare will play in the lifestyles of new middle classes, and then identifying that Novo Nordisk, for example, already has a growing insulin-production franchise in Asia. It can be about recognising that, while “emerging markets sounds like an attractive theme”, as Pioneer Investment’s head of European equity Andrew Arbuthnott reminds us, “we also have to look for business models where the trade off between valuations and future growth stand up”.
It can even be about assessing the relative quality of a European firm’s domestic revenues, which will provide the free cashflow to fund emerging market expansion.
“Just buying emerging market exposure is unlikely to work as well as it has in the past, simply because that story is now so widely accepted,” says BlackRock’s Turnill. “The stocks to own are the ones that can surprise by taking market share with a winning strategy.” That is a simple but important observation: stockpicking alpha is about stockpicking. “There are an awful lot of companies in emerging markets whose business models simply can’t be duplicated by other, developed-market companies,” he reminds us.
The same applies vice versa, as we have seen. Which takes us back to our starting point: the best emerging market exposure is not about emerging market companies or developed market companies, but about the best truly global companies.