Question: When is an emerging market stock not really an emerging market stock?
Answer: When the company sells virtually all of its products in the West.
In the decades that followed World War II, Japan pioneered the "Asian Model" of economic development, which can be boiled down to two bullet points:
Manufacture as cheaply as possible by keeping your currency weak
Ship it all to the United States and Europe
This was a wildly successful strategy—so long as the Westerners were buying. Following Japan, it is what allowed Taiwan and South Korea to enjoy European levels of development and China to quickly jump from being one of the poorest countries in the world to be the number two economy after the United States.
But with consumer demand in the West tepid at best (see Figure 1), this model is looking questionable. China managed to post an 8.7% annual growth rate in 2009, and a blistering 10.9% in the second quarter of 2010.
This would normally be considered phenomenal. But 92% of the 2009 number was capital spending, a fair amount of which was spurred by government stimulus programs. If you take out capital spending investment, China's economy barely budged at all.
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China is a unique case. Not all emerging economies are as heavily driven by infrastructure and construction spending. But the problem is that most emerging market investment options for retail investors are weighted specifically to these sectors that I see as being the most at risk: financials, construction, and manufactured exports.
Enter the Emerging Market Consumer
While I question the sustainability of the "Asian Model" of economic development, I am not at all bearish on emerging markets in general.
The rise of the Emerging Market Consumer is real, if Figure 2 is any indication. In Figure 2 we can see that Indian and Brazilian consumers barely missed a beat during the crisis. Consumer spending continues to soar higher.
So, how do we as passive portfolio investors profit from these trends?
In the Sizemore Investment Letter, we have thus far chosen to invest mostly indirectly, buying Western firms like Philip Morris International (NYSE: PM) and Telefónica (NYSE: TEF) that have a strong presence in emerging markets. Our only direct investment thus far has been in Turkcell (NYSE: TKC), the leading mobile communications company in Turkey.
The standard answer for most investors, however, has been to buy an emerging market mutual fund or ETF like the popular iShares MSCI Emerging Market Index Fund (NYSE: EEM).
The problem is that this ETF is perhaps the most poorly named ETF in history. It's not a play on emerging markets at all. It is primary an indirect play on the American consumer, as most of its constituent parts are export-oriented companies, materials companies, and banks.
Take a look at Figure 3, which lists EEM's largest holdings. Samsung (SSNLF.PK) and Taiwan Semiconductor (TSM) top the list, followed by a string of banks and oil companies. This is hardly a play on the emerging market consumer. What's more, consider the country concentrations in Figure 4.
China and Brazil have the largest concentration, which is fine. But following Brazil, South Korea and Taiwan make up a combined 24% of the fund. Nothing against these countries, of course, but it's hard to really consider them "emerging markets" today. If Greece and Portugal are considered "developed countries," then why are South Korea and Taiwan not? (MSCI considers certain factors such as the convertibility of the local currency as criteria. Still, my point stands.)
Up until very recently, Israel also had a fair-sized allocation in the fund. It's hard to see what Israel—which is second only to Silicon Valley in tech startups—was doing in an index full of South American and Pacific Rim developing countries.
It should be obvious that when you buy EEM, you're not really buying an emerging market fund. You're buying a volatile emerged market fund with high exposure to global factors—i.e. the American consumer, international banking, and commodities prices (see Figure 5)—and virtually no exposure to the real source of long-term growth, the Emerging Market Consumer. Less than a fourth of EEM's holdings are in consumer oriented sectors, such as consumer goods and services, utilities, and telecom.
Of course, you could always assemble your own portfolio of emerging market consumer stocks and American companies with growth prospects abroad—stocks like SIL recommendations Philip Morris International, Turkcell, and Telefónica. But some investors prefer a "one-stop shop" for the Emerging Market Consumer. I finally have a good one to recommend.
Introducing the Dow Jones Emerging Markets Consumer Titans Index Fund
Emerging Global Shares has stepped up and filled a gap that sorely needed to be filled. The company has launched a series of emerging market sector funds—including, among others, basic materials, metals and mining, financials, health care, industrials, technology, telecom, and utilities.
For now, some of these sectors do not fit my portfolio strategy; my focus is capitalizing on the growth of the Emerging Market Consumer. Emerging market metals and mining, for example, is not likely to ever have a place in the portfolios I manage.
The new EG Shares DJ Emerging Markets Consumer Titans Index Fund (NYSE: ECON) begins trading on Tuesday September 14 and is exactly the fund I've been waiting for. Let's take a look at what's under the hood.
In Figure 6, we see a very different mix of companies than in EEM's Figure 3. The largest holding is Brazilian mega-brewer AmBev, which is a perfect match for the SIL on multiple counts. Not only is it an excellent play on the rise of South America's middle class, it is also a "sin stock" that I consider attractive. (See "Why Good Investors Like Bad Stocks".)
We also see a much different country allocation, as you can see in Figure 7.
Brazil and Mexico are the largest concentrations. Conspicuously absent are South Korea, Taiwan, and Israel—countries that, whatever their investment merits, have no place in an emerging markets portfolio. Also, China is a comparatively small allocation. Given my ambivalent view of China and its apparent real estate and infrastructure bubbles, that is fine by me. Any investor wanting to complement ECON with more direct exposure to China's consumers can add a small allocation to The Global X China Consumer ETF (NYSE:CHIQ), which I covered in a previous article.
All of this sounds great on paper. It is a story that makes a lot of sense as an investment theme. But how does it actually perform?
ECON is a new ETF and has no history. But the index on which the ETF is based goes back to December 30, 2005, making it possible for us to make comparisons. Figure 8 compares ECON to EEM and the S&P 500.
Over this time period, several observations can be made. All three indexes rose during the global bull market, fell during the crisis, and rose again during the recovery. Correlations were particularly tight during the meltdown and subsequent "melt-up." EEM led the back before the meltdown, which should be expected during a prolonged global boom. ECON has performed the best since the March 2009 bottom, however, and now comfortably sits near new all-time highs.
During a global boom, I might expect EEM to perform better than ECON, as it is driven more by global factors and is comprised of more cyclical companies. But in a period of "decoupling" in which growth is comparatively slow in the West, I would expect ECON to outperform.
Remember, our goal here is not necessarily to generate the highest return in any given period (though this would clearly be welcome). This is not a "high beta" trade. Our goal is to get targeted exposure to a powerful demographic macro trend—the rise of the Emerging Market Consumer.
In this age of globalization, virtually all markets are correlated to some extent. It's nearly impossible to find growth without accepting some amount of global beta risk. That said, ECON keeps its beta risk to a tolerable minimum. Let's prove this statistically.
In Figure 9, I built a matrix that compares the correlations between the daily returns of the three indexes from Figure 8.
For those who might be a little rusty on their statistics, the correlation coefficient is the degree to which two assets move together. A value of 1 is perfect correlation, meaning that the two assets move in lock step. A value of -1 is perfect negative correlation, meaning that two assets move opposite of one another (for example, and long and short position in the same security would have a correlation of -1).
Figure 9 confirms everything I wrote earlier in the article. The correlation between the S&P 500 and EEM is .895—not quite perfect correlation, but awfully close. This tells us statistically what we already knew—that EEM is not really an emerging market play at all, but rather a higher-volatility play on the U.S. consumer. Interestingly, the correlation between the Emerging Market Consumer Index and the S&P 500 is only .669.
The numbers get even more interesting when we divide the data into sub-periods. It is common knowledge among traders that "all correlations converge to 1" during a financial crisis. This certainly held true during the meltdown that followed the collapse of Lehman Brothers in 2008. All assets save U.S. Treasury bonds and the U.S. dollar fell in unison during that unfortunate period, and it was scary to live through.
Figure 10 isolates the crisis months, defined here as July 2008 through March 2009. Correlations didn't quite converge to 1, but they came pretty close. The correlation between the S&P 500 and EEM rose to 0.916, and the correlation between the Emerging Market Consumer Index and the S&P 500 jumped to 0.732. During this nightmarish series of months, there was really nowhere to hide.
This raises an important point: given the extreme nature of the 2008 meltdown—the biggest of its kind since the 1907 panic—are the tight correlations of that period distorting the "normal" correlations that we would see under more benign circumstances? Let's take a look.
Figure 11 is a correlation matrix that excludes the volatile July 2008 to March 2009 time period. Just as I suspected, correlations in Figure 11 are lower across the board than those in the original Figure 9.
The correlation between the S&P 500 and EEM is still unacceptably high at 0.862, but the correlation between ECON and the S&P 500 is significantly lower at 0.605.
By this point, I've probably overloaded you with statistical jargon. Don't worry, we're done with it for now.
In case you glazed over after the first mention of the word "correlation," these are the relevant points to take away:
EEM is an ineffective way to get exposure to emerging markets; it's really a play on the American consumer—which we distinctly want to avoid.
ECON provides a better alternative—direct exposure to the emerging market consumer.
The rise of the emerging market consumer is the demographic growth theme for the decades ahead.
Action to take: Buy shares of ECON for the portion of your portfolio allocated to emerging markets. Make this a core portfolio holding.
Disclosure: PM, TKC, TEF, and ECON are recommendations of the Sizemore Investment Letter