Success story to continue
The BRIC (Brazil, Russia, India, China) story is a long-term theme focused on investing in the equity beneficiaries of globalisation. Goldman, Sachs & Co, which first coined the term ‘BRICs' in 2001, projected that by 2050 the BRICs could become four of the seven largest economies - with China leading the way. Trade liberalisation, combined with favourable demographics, has contributed to this trend.
In recent years, the BRIC theme has gained a lot of attention, with a number of investment managers launching BRIC investment products and a significant amount of money flowing into these markets as a result. According to Emerging Portfolio Fund Research, BRIC-related funds have garnered $12.4bn (e9.98bn) on a net basis this year alone1. This trend has been supported by the strong performance of the asset class: between January 2004 and August 2006, the MSCI BRIC Index returned 113% compared to 38% from the MSCI World Index2.
Are these high equity returns sustainable, or are they largely the result of fund flows into these markets? Will companies in the BRIC economies find profitable growth opportunities going forward? Are valuations still attractive given the expectations that are priced into the stocks?
If the answer to these questions is yes, there is potential to make money in BRICs in the years ahead. Over the medium term, we believe that the answer lies in the fundamentals of companies in these markets rather than in the flow of capital, even if in the short-term fund flows and sentiment can dominate as we saw during May and June. It is also worth remembering that opportunities to exploit the growth of the BRICs are not restricted to companies domiciled in Brazil, Russia, India and China. There is an array of companies around the world that are benefiting directly from the growth in the four BRIC markets. These companies range from luxury goods manufacturers to oil services businesses and shipping companies, all of which are seeing their profits increase on the back of demand from the BRIC economies.
We see two key themes driving the BRIC growth story. The first is the pivotal and increasingly more important role the BRIC economies play in global supply and demand dynamics. India and China, the BRIC engines of growth, are driving unprecedented demand for the commodity and energy exports supplied by Russia and Brazil. For example, India imports two-thirds of its energy and this may rise to more than 80% in five years.3 Russia, on the other hand, has huge reserves of oil, natural gas and coal reserves and is rich in minerals including uranium, palladium, copper, iron, tin and nickel. Brazil's natural resources include gold, iron ore, manganese, nickel, platinum, uranium, sugar and timber.
his trend has been reflected in the rise in intra-BRIC trade in recent years. As the trade relationships between the BRIC economies deepen, they become mutually supportive of each other's growth. As China and India demand more resources, high commodity prices are also helping to re-ignite the domestic economies in Brazil and Russia.
The second key theme driving the BRIC growth story is one of growing domestic demand, as rising income per capita within the BRIC countries enables consumers to buy increasing numbers of cars, houses, durable goods and financial products. Goldman Sachs & Co estimates that the number of people with annual income over $3,000 per capita in the BRICs - a key threshold for entry into the middle class - could double in the next three years and reach 800m by 2015.
Rising per capita income can have a profound impact and India has already seen some of this change. According to data from the Reserve Bank of India, in 1990 agriculture accounted for around 31% of GDP, while services accounted for 47%. By 2004/05, however, agriculture's share of GDP had fallen to 21%, while that of services had risen to 58%. For Indian corporates, these shifts can create important opportunities for profitable growth domestically. More importantly, perhaps, the shift towards a service-based economy reflects India's growing role within the world economy as a home for globally competitive services companies.
Further, by 2025, there could be over 200m people in the BRICs with incomes of over $15,000. This is a large high-income pool, significantly larger than the total populations of developed countries, which is likely to drive significant growth in the consumption of goods and services. Past performance is not a guide to future growth, but it is an important fact that over the last five years, these four economies contributed 28%3 to total world GDP growth, despite only currently accounting for 4% of global equity market capitalisation. This suggests that there is potential for substantial equity market growth going forward.
Headline multiples suggest that the BRIC markets, particularly Brazil and Russia, remain attractively valued. According to UBS, the BRIC markets trade at around 11x 2007 PE, whilst the world market is currently trading on approximately 134.. Profitability also looks robust, with UBS estimating a return on equity for the BRIC markets of around 19%4.
However, below the headlines, the valuations range widely by country, from India on approximately 17x 2007 PE to Brazil on around 8x PE. Sector weights explain part of this difference, with resource plays looking relatively cheap at current commodity prices, but India's valuation reflects a significant re-rating over the last couple of years. Such wide valuation ranges suggest that careful stock selection is crucial when investing in these markets as certain stocks already reflect expectations for strong, sustained growth in their prices.
One consistent comment we hear relates to the apparently close links between the BRIC markets and commodity prices. There is little question that the BRIC markets have significant exposure to commodities, as energy represents more than 35% of the MSCI BRIC Index, but there are a few points worth making here.
he first is that to some extent the recent increase in global commodity prices has been the result of strong demand from the likes of India and China. Goldman Sachs & Co projects that by 2040 the GDPs of the BRIC economies could potentially exceed the GDP of the current G6 (US, Japan, Germany, France, UK and Italy). They also estimate that China and India, with their large populations and low levels of industrialisation, are contributing a rising share of world manufacturing, driving demand for energy and commodities. If you believe in the sustainability of this demand for raw materials, you would expect commodity prices to remain higher over the medium to long term than they have been in the past.
The second point relates to valuation. We do not believe that oil stocks, for instance, are extrapolating an oil price of $70 per barrel into the future. We think that analysts are typically now using a long-term oil price of around $45 per barrel when valuing oil companies, which is higher than that used in the past but significantly below current oil prices. Thus the expectation that commodity prices will decline from current levels is already factored into valuations.
Lastly, with very low (even negative) correlations to traditional asset classes, commodities offer an attractive diversification benefit to investment portfolios. Investors considering an allocation to BRICs, however, should be aware of the associated exposure to commodities and factor it into their total portfolio allocation.
We continue to find attractive investment opportunities both within the BRIC markets and in companies that benefit from the BRIC theme. Inevitably, this combination of growth, valuation and profitability comes with risks - be they corporate, economic, political or regulatory - suggesting that a small allocation to BRICs within an overall equity portfolio may be optimal.
Nonetheless, provided investors focus on identifying the strongest stock stories within this dynamic environment, we believe that there may be a significant opportunity to make money in these markets in future years.
1 Source: Emerging Portfolio Fund Research, as at 17 August 2006.
2 Source: Bloomberg. Returns in dollars.
3 Source: Goldman, Sachs & Co.
4 Source: UBS estimates for 2007, as at August 2006.
Richard Flax, CFA, emerging markets equity analyst and portfolio manager, BRICs Portfolio at Goldman Sachs AM