Looking to explore the realm of the emerging market consumer? Beware the hidden risks.
With slowing growth in the developed world and success stories in their home markets, investors have naturally looked to emerging economies to identify the next Apple, Wal-Mart or McDonald’s. These investors are hoping to benefit from rising disposable income—and, consequently, the increase in consumption of premium beer, branded clothing and countless other goods. This strategy may prove to be a powerful and exciting trend that, with careful selection and diligence, could be rewarding for investors.
But now, a word of caution: the reality is that investors cannot invest in GDP; they have to invest in real businesses—either through equities or fixed income—and it is the price they pay for those businesses that determines investment returns. Strong growth translates into strong returns for investors only when the current valuation does not fully reflect that growth potential. When seeking to capitalize on consumption trends in emerging markets, it’s worth remembering the following lessons.
1. Rapidly growing economies do not necessarily lead to higher equity returns
Conventional wisdom asserts that economic growth drives stock markets. History has shown, however, that there is no correlation between real per capita GDP growth and the stock returns that investors can expect.
Even if economic forecasts prove to be correct—which is a big if—the relationship between a country’s economic growth and its stock market is tenuous at best. For example: if, in 1991, investors knew for certain that real industrial production in Asia would grow eight-fold in U.S. dollar terms over the ensuing 13 years, they might have been tempted to place all of their money in Asian stocks. But the situation did not play out as expected. Real equity returns in Asia ex-Japan stocks only doubled over the period.
To understand this issue, consider what happens when a business invests in a new plant and machinery to increase production. These investments appear as increases in GDP, according to government statistics—so the greater the level of investment by businesses, the faster GDP grows. Unfortunately, when capital investment in productive capacity occurs across an industry, it will lower the return on capital invested for all companies operating in that sector. This can drive profits lower and result in poor returns for equity investors.
Within high-growth areas, it’s not always obvious to see how the profit pool derived from revenue growth will accrue to businesses competing to serve emerging market consumers. A good example is the beer industry in Nigeria. Consumer goods companies have been keen to capitalize on the Nigerian consumer story and have invested heavily to meet expected demand. While this is good for the local economy and for Nigerian consumers, it can be bad news for investors, as greater competition can reduce profitability across the sector. Guinness Nigeria, a highly rated brewer, has seen its return on capital fall from 40% in 2010 to 22% currently—still a very high number but nonetheless a disappointment for investors, who may have expected the return on capital to stay at 40% or even to grow from there.
The effect of competition is also evident in the Chinese Internet sector. Rising Internet penetration and growth in services, such as online gaming, was a predictable trend. However, in this highly competitive space, picking the winners is challenging. Looking at how the competitive landscape in the Chinese online gaming sector has changed over time, some of the early leaders have since disappeared, as was the case with the Internet boom in the late 1990s.
2. There are cyclical highs and lows within long-term trends
Even within long-term structural trends, there are periods of high and low growth that affect businesses. How does this occur? Capital flows into listed assets (i.e., equity and fixed income securities that are traded on public exchanges) are attracted to emerging markets because consumption is growing. This causes currencies to strengthen, and inflation and interest rates to decrease, spurring credit—which, in turn, fuels consumption. Fiscal and current account deficits widen, and fixed direct investment in machinery, plants, etc., falls.
Everything runs smoothly until an external factor—such as an increase in rates by the U.S. Federal Reserve or fears about a slowdown in China—causes things to unwind. Capital flows can head quickly for the door at the same time as the currency starts to weaken. If sales at consumer-related companies suddenly decrease, putting pressure on margins, this creates a double whammy for equity valuations. This has played out across many emerging markets, particularly the “Fragile Five”—the newly coined term for Brazil, Indonesia, India, Turkey and South Africa. For investors who focus on the underlying business fundamentals and take a long-term approach, these cycles can create opportunities to buy companies for less than they are worth, when shorter-term investors capitulate.
3. Demographics can be a double-edged sword
Part of the attraction to many emerging markets is their young and growing populations—the so-called “youth bulge.” As young people leave school, become employed and have more money to spend, disposable income and consumption naturally rise. But this doesn’t come without risk—particularly if the educational infrastructure is substandard and jobs are hard to find.
South Africa, for example, has one of the largest youth bulges in the world, with more than 28% of its population between the ages of 15 and 24 (versus 11% for an aging society such as Japan). But half of South Africans between ages 15 and 35 are unemployed—which may turn out to be more of a socio-economic risk factor than a consumer opportunity.
Faster economic growth and favourable demographic tailwinds are appealing trends, but they do not guarantee higher equity returns. Competition is alive and well, and determining the “winners” is not always obvious.
The best way to achieve high absolute returns is to pay the right price for businesses that benefit from the emerging consumer. By focusing on the fundamentals and taking a long-term perspective, disciplined investors can take advantage of short-term swings in sentiment to buy businesses for attractive valuations—and, in so doing, increase their long-term return prospects.
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Duncan Artus is a portfolio manager with Allan Gray, South Africa, and Craig Bodenstab is head of the Investment Counsellor Group at Orbis.
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