By R.J. Hottovy, CFA
With much of the eurozone mired in a recession and the recovery in the United States progressing at an almost glacial pace, it's not surprising that investors are increasingly turning to emerging markets to augment portfolio returns. It's easy to understand the appeal--emerging markets tend to have young and growing populations, and they now find themselves with an increasing amount of disposable income. By 2020, the number of middle-class consumers in emerging markets may be larger than middle-class consumers in the U.S. and Europe combined.
However, investing directly in the stocks of emerging-market consumer companies may not be the most prudent strategy to capitalize on these growth opportunities, as infrastructure investments needed to remain competitive with multinational behemoths may prevent these firms from realizing positive economic returns for an extended period. Instead, Morningstar believes that investing in consumer companies with established economic moats--structural competitive advantages--is the most effective way to participate in the tremendous growth potential of emerging-market consumers, as these companies do not face the same infrastructure burdens as their emerging-market brethren, have easier access to capital, and are not reliant on a single emerging-market economy to generate excess economic returns. These companies are better positioned to compete for share in some of the highest-growth markets in the world.
Growth Potential of Emerging-Market Consumers Is Undeniable
Euromonitor forecasts that emerging markets will account for nearly three fourths of the world's urban population by 2015, and that the consuming class (representing consumers with more than $5,000 in disposable income) in these regions will add about 1 billion individuals in the next 10 years. A large proportion of the growth in the global consuming class will come from India and China, which are expected to add 200 million and 400 million individuals by 2020, respectively. However, over the next several years, we also expect an increasing contribution from Eastern Europe (Russia), Latin America (Brazil), Africa (primarily South Africa, but also Kenya and Nigeria), and several other Asian nations (South Korea, Indonesia, Vietnam, and Malaysia).
More important, there are several reasons to believe positive consumption trends among emerging-market middle-class consumers will continue to grow in the years to come. Many emerging-market economies are backed by robust natural resource markets (agricultural, hydrocarbons, minerals), and we believe global demand for these products will continue to drive robust export market growth. Infrastructure spending and rapid urbanization trends are also important growth drivers for emerging-market consumer spending, which should keep wage rate growth trends above those of developed markets for some time. Moreover, the median age in many of these regions (particularly some of the more emerging Asian countries) is around 30, suggesting a long lifetime of discretionary income potential for consumers. By the end of the decade, we believe it is highly likely that the consuming class in emerging markets will be larger than the combined consuming classes in the U.S. and Europe.
Direct Emerging-Market Equity Investments Have Become Safer, but Risks Remain
Over the past several decades, direct investments in emerging-market companies have generally been a dicey proposition, owing to fiscal mismanagement by governments, corporate corruption, rising inflation and monetary tightening by central banks, rapidly evolving marketplace structures (including the threat of nationalization in more extreme cases), and a constantly changing regulatory environment. On top of those concerns, there was a relatively small pool of emerging-market equities to select from--often state-owned financial, energy, and utility firms--which offered little in the way of liquidity or were subject to restrictive foreign investment laws.
Today, we see a much different picture for emerging-market investment alternatives. Government corruption is no longer the norm, corporate fraud has dwindled, and the regulatory environment is less volatile. We find ourselves with a much wider pool of viable publicly traded equities in emerging markets, which offer an easier way for individual investors to gain exposure to the growth potential these markets offer (without facing the large minimum investment requirements and extended lockup periods typically associated with private equity funds). In fact, Morningstar's coverage universe of approximately 2,000 equities now includes more than 500 companies domiciled in fast-growing global economies such as China, India, Australia, Brazil, and South Africa.
While we believe direct investment in emerging-market stocks has become less precarious in recent years and could have a spot in a well-diversified portfolio (depending on risk tolerance), there are still inherent risks. First and foremost is that emerging-market exports still depend largely on the fortunes of developed economies, which are facing widespread deleveraging by governments, corporations, and consumers; increasing saving rates; unemployment rates well above historical norms; and sluggish wage growth. Additionally, with so much dependence on natural resource commodity prices, emerging markets are often subject to violent economic shocks (which can also have a meaningful impact on the local currencies, which in turn impairs the competitiveness of local corporations).
Inflation appears to have stabilized in a number of emerging markets over the past several quarters, though input costs for many consumer-facing companies remain well above historical norms, thereby constraining margin expansion opportunities over the foreseeable future. Finally, we have concerns that the arrival of large, multinational companies in emerging markets (Wal-Mart's controlling stake in South African retailer Massmart, for instance) has the potential to change economics for all market participants. For this reason, we tend to favor investments in the stocks of large, multinational companies with durable competitive advantages.
Infrastructure, Financing Hurdles Could Prevent Immediate Economic Returns
Rapid urbanization has also led to the need for infrastructure upgrades across much of the emerging world. We estimate that emerging-market nations will collectively spend $1 trillion-$2 trillion annually over the next 20 years on infrastructure projects, with water, environmental safety, energy, and power generation investments consuming the bulk of these funds. For consumer-facing companies, there are also additional infrastructure needs such as underdeveloped commercial real estate alternatives, a lack of existing warehouse and distribution facilities, and inadequate transportation.
For much of the past decade, emerging-market governments have shouldered much of the responsibility for infrastructure development and repair projects. An accumulation of foreign exchange reserves will help to fund infrastructure investments over the near future, but ultimately, governments may be unable (or unwilling) to cover the cost of infrastructure projects over the next several decades because of the sheer amount of capital that will be required, resulting in a vast funding gap. To fill this hole, we believe governments will look to the private sector to play a more important role. We estimate that 10%-15% of total infrastructure spending in emerging markets presently comes from private investors, and we believe this percentage should climb much higher in the years to come.
It's clear that the shift from government-funded infrastructure projects to the private sector will present compelling investment opportunities, especially for companies that provide construction, engineering, raw materials, and financing. The opportunity is not as straightforward for consumer companies, as positive economic returns may take a longer time to realize. There is little doubt that a consumer product company or retailer could generate immediate top-line growth by establishing a presence in emerging markets and capitalizing on favorable demand trends, but without the existing infrastructure in place, doing business in these regions could prove to be extremely costly and possibly destroy shareholder value.
Additionally, the need for emerging-market infrastructure upgrades leaves many local consumer companies at a disadvantage. To stay competitive with large, multinational consumer companies, emerging-market-domiciled companies will probably shoulder much of the infrastructure investment burdens themselves, implying that positive economic returns may take several years (if not decades) to realize. While it's true that the larger consumer companies face many of the same infrastructure hurdles in establishing a presence in emerging markets, access to inexpensive capital gives them the upper hand over their local rivals, which often face higher interest rates because of the inflation-prevention policies of their respective central banks.
Companies With Established Economic Moats Are Better Positioned to Capitalize
What advice do we give to investors looking for exposure to emerging-market consumers? Invest in companies with durable competitive advantages. Generally speaking, we look for five sources of an economic moat when screening for companies that are best positioned to capitalize on the growth potential of emerging-market consumers: (1) structural supply chain and distribution advantages; (2) economies of scale; (3) sufficient resources to extend brand reach; (4) pricing power to withstand softness in volume growth; and (5) an understanding of emerging-market economies. Companies meeting these criteria are usually well positioned to compete with local industry players for market share while extracting excess economic returns because they can leverage their existing supply chain and distribution assets (to an extent), have easier access to cheaper capital, and can foster brand awareness and loyalty through expansive advertising budgets.
Additionally, multinational consumer companies are less reliant on a single economy, meaning they can withstand an economic shock from any particular market. Some of the companies meeting these qualities are obvious, such as Yum Brands (YUM), McDonald's (MCD), Coca-Cola (KO), Diageo (DEO), and SABMiller (OTCPK:SBMRY), though there are also less familiar names like VF Corporation (VFC) (the parent company of brands like Nautica, The North Face, Vans, and 7 For All Mankind) that fit the bill. Occasionally, we also find local players in emerging markets that have these characteristics--Hindustan Unilever in India or FEMSA (KOF) in Mexico, for instance--but are often highly dependent on another major consumer company domiciled in a developed market.
Despite some of our hesitations regarding investing directly in emerging-market companies, we acknowledge that acquisitions and other partnerships are likely to play a larger role as multinational companies look to establish an immediate presence in these regions. For example, we believe a number of India's major retailers, including Reliance Industries (which operates 1,200 units spanning several retail categories through its Reliance Retail subsidiary), Pantaloon Retail (1,000 units representing approximately $1.2 billion), and Trent (the retail segment of the Tata Group with 60 units) could also become partners for developed-market retailers as foreign direct investment regulations gradually ease, given their experience with chain retailing in the region and relatively healthy balance sheets.
Under these types of partnerships, local market participants would probably have greater access to capital, which in turn could be used for infrastructure investments or other growth initiatives. For this reason, we believe modest exposure to locally domiciled consumer companies has a place alongside multinational consumer companies in a well-balanced portfolio.
A version of this article appeared Aug. 10, 2012.