The easy way to invest in emerging markets
There has always been something intellectually upsetting about investing in emerging markets. The theory is simple: if you invest in developing countries with a young and rapidly growing population, cheap labor, improving infrastructure, and reasonably clean government, then stock returns should be higher than those. more mature and slower growing economies. This is the thread that I have both spun and believed in during three decades of involvement in emerging markets in fund management, brokerage and corporate finance.
Many times, however, you are not buying the story of local growth, but rather the companies selling to multinationals in advanced countries, taking advantage of cheap local labor, a lack of rules. employment and low taxes. A good example is the iPhone. Less than 10% of the components are actually designed and made in America. Most of the manufacturing takes place abroad, mainly in Asia. The same goes for semiconductor components, vital for a wide range of devices, from cars to washing machines. The value goes less to the emerging economy and more to the multinational. For example, Apple’s gross profit margin has been between 30-40% over the past 15 years, while the margins of local component suppliers are only a fraction of Apple’s. Companies will always try to find the cheapest suppliers to stay competitive. This has been going on ever since East Anglia experienced an industrial revolution 3,500 years ago, exporting flint for spears and axes to Europe.
Another problem for developing economies was that foreign firms often crowded out local firms because of their ability to raise capital and absorb start-up costs. This is why Africa has only a rudimentary automotive sector producing a handful of models, while key components such as the engine are imported or manufactured under license. Until recently, Asia (excluding Japan) had failed to create significant players in services such as advertising or to develop global beverage brands. In broadcasting and publishing, too, there were few winners.
Where does the value go
The result was that until recently most emerging market indices were dominated by local banks, real estate companies and utilities, where the government tended to impose controls against foreign competition. As local banking regulation and supervision was generally weak and capital flows erratic, emerging markets have become as notorious for their ups and downs as they are for their growth stories.
Even in sectors where emerging markets have the edge, such as raw materials or apparel manufacturing (the starting point for Singapore and Hong Kong’s success stories), added value is often lost for the trader or company. foreign buyer. Swedish company Hennes & Mauritz, for example – better known as H&M – is a worldwide success in selling clothing (and if you had invested 30 years ago, you would have made 200 times your initial investment) . It does not have factories, but designs and sources its clothing from more than 800 local production sites around the world, many in developing countries. The gross profit margin over the four years to 2020 was 50%. The suppliers will have been negotiated as low as possible; moreover, with so many sources, H&M can switch suppliers in the blink of an eye. With Sweden only having 11 million inhabitants, this is the remarkable story of a company turning its comparative disadvantage into success. But its shareholders were the winners, not emerging market investors.
In the area of natural resources, too, a disproportionate number of winners have been foreign companies rather than local ones. Indonesia groans with copper and gold, but its largest mine is owned and operated by Arizona-based Freeport-McMoRan. The world’s largest deposits of copper are in Chile. Anglo-Australian BHP Billiton owns the largest copper mine in Chile and the world, the Escondida project, as part of a joint venture with British company Rio Tinto and a Japanese consortium.
A lower index
The main benchmark for developing economies is the MSCI Emerging Markets Index, which reflects the performance of large and mid-cap companies in 27 countries. These markets are defined as “economies or countries where certain sectors are expanding rapidly and engaging aggressively with global markets”. Seems woolly enough? It is. The index is dominated by three countries: China (nearly 40%), then Taiwan and South Korea (27% combined). Some countries, such as Singapore and Hong Kong, are absent because they have achieved developed market status, and the index does not cover “frontier markets” (the poorest economies), which have their own index. China as an emerging market is an anomaly because it is the world’s second-largest economy. Its dominance over the benchmark led many funds to use indices with a lower weight in China, but as a result Taiwan and South Korea got even bigger. Either way, the index still doesn’t make sense given that Taiwan has a per capita income significantly higher than that of the UK and South Korea, roughly equal to the average of the ‘EU.
The definition of emerging markets is therefore now outdated and the term has become a pretext to market “exciting” products and earn high fees. Emerging market funds tend to charge 50% more than others. As an investment category, it’s not going to go away anytime soon, but the examples of companies making hay in these countries indicate an often more efficient and cheaper way to invest.
Where should investors look
Look at where a business makes its money, not where it is listed. Many companies listed in emerging markets make their profits by selling overseas, so they are linked to the slow growth of mature economies – the opposite of what investors think they are buying. Because the main reason for investing in developing countries is to capture their strong national economic growth. So it makes much more sense to invest in companies (wherever they are domiciled) that derive a large portion of their sales and profits from emerging markets.
There are many in the UK and other major markets, which have the added benefit of better corporate governance and less corruption. In addition, the returns are often better. Some of the best companies in emerging markets are actually “home”. There are some interesting growth stories in the small segment of the UK market …
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