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Investing in Emerging Markets – July 2016Investors depart for developed markets
The rise of emerging markets has transformed the global economy and the way investors allocate capital over the past 25 years.
Emerging markets have become increasingly synchronised, reflecting their enhanced integration into global trade and capital flows – with China at the epicentre of this shift.
As measured by purchasing power parity (PPP), China has risen from less than 3 per cent of global economic output in the early 1980s, to around 16 per cent in 2014.
Many of these countries are forecast to grow significantly over the decades to come. According to the International Monetary Fund and PwC, developing economies are set to incrementally increase their share of global GDP on a PPP basis.
Investors have allocated significant capital into these economies in search of investment returns and yieldCapital has flowed into emerging markets during the past two decades, as institutional and retail investors flocked to the growth story and increasing relevance of these economies within a global context.
Nonetheless, there are ominous signs that the spectacular rise of the developing world is starting to unravel, with emerging markets suffering a net outflow of capital in 2015 for the first time since the 1980s.
Part of this is down to the US Federal Reserve raising interest rates, the significant moves in the US dollar over the past 18 months and the effects of quantitative easing on risk assets.
So where does this leave emerging markets, in terms of an allocation within portfolios?
The most important point is not where a stock is listed, but the breakdown of where it generates its revenue from. Secondly, there is not necessarily a discernible link between economic growth and investment returns.
That said, as can be seen from the capital flows into emerging market equities and debt since the turn of the millennium, investors have allocated significant capital into these economies in search of investment returns and yield.
It is unsurprising that the end of quantitative easing in the US and subsequent strength of the US dollar along with the US Fed raising interest rates has led to the flight of capital out of emerging markets.
| Expert view: Emerging vs developed companies |
William Ball, senior equity analyst at Sanlam Private Wealth, compares two food companies that both have exposure to emerging markets, with one listed in the US and one in the Philippines: “Yum! Brands is a company we hold that is listed in the US, yet derives more than 70 per cent of its revenue from its Chinese business. It is one of the world’s largest restaurant companies with over 41,000 restaurants in more than 125 countries. Its restaurant brands – KFC, Pizza Hut and Taco Bell – are the global leaders of the chicken, pizza and Mexican-style food categories. “A comparable direct emerging market company would be Jollibee Food, which is listed in the Philippines. The company is the owner of a multinational chain of American-style, fast-food restaurants, having expanded into international locations in Brunei, Hong Kong, China, Kuwait, Qatar, Saudi Arabia, Singapore, Vietnam, the United Arab Emirates and the US. The company has achieved attractive double-digit revenue growth, high returns on capital and produced an average return on equity of close to 20 per cent since 2010. “This begs the question: why do we not own Jollibee Food? This ultimately comes down to valuation, with Jollibee Food trading on a free cash flow yield of just 1.7 per cent compared with Yum! Brands, which is trading on a yield of 3.9 per cent.” |
This perhaps confirms the premise that investing in emerging markets is inherently more risky than the developed world and under this scenario it is not surprising to see many retail and institutional investors reduce their direct exposure to emerging markets.
Allocations to emerging market risk assets are at multi-year lows and, no doubt, many investors prefer to gain exposure through developed market companies. Over the long term, this dynamic will likely change as emerging economies and their capital markets develop.
William Ball is senior equity analyst at Sanlam Private Wealth
