EM Capital Dynamics Offer Income Opportunities

The new fiscal stimulus and investment focus that was unleashed during the COVID pandemic continues to ripple through global economies with the potential to reshape underlying dynamics and create corporate outperformers that experience accelerated growth. That includes the emerging markets, where a number of companies across these markets offer institutional investors attractive — and long-term — income opportunities.

All the spending, both overseas and in the U.S., “has had consequences for emerging markets in a variety of ways. The first is whether you’ve become a friend or foe,” said Matt Williams, senior investment director of global emerging markets at abrdn. “Many emerging markets have been economic ‘friends.’ Separate from China, there are a lot of emerging market countries that are running very orthodox policies with interest rates that do their job of setting the right price of money, which drives purposeful investment decisions and profitable growth.” The prudent approach will encourage capital flows to countries where policymakers have used traditional strategies to develop their economies and avoid debt-led growth, he said.

While the biggest “friend or foe” question is China, it remains an open one. A dramatic economic downturn in the world’s second-largest economy “is in no one’s interest,” Williams pointed out.

The second consequence of the stimulus in emerging markets has been “to provide the labor, technology and natural resources” that are supporting the green energy transition — including in the West — such as the development of new technologies for electric vehicles, said Williams.

Capex boom
This is a timely moment for investors to diversify into and find income in emerging markets that are seeing capital inflows as a reward for their orthodox policy approach and solid growth trends, according to Williams. In contrast, the U.S. Federal Reserve is nearing the end of its rate-hiking phase amid uncertainty around a recession and growing debt levels.

“As policy makers attempt to buffer the impending growth slowdown, there could be more debt growth in the U.S. and more inflation,” Williams said, “that we believe could lead to more investment, more capital transferring to emerging markets. Emerging markets have a lot more domestic dependency than they had before, so the importance of the U.S. in driving economic growth has been dampened somewhat.”

Several income-paying companies in the emerging markets are making use of a broad-based economic transition that has a level of capital expenditure these markets have not experienced in decades, probably since China was first being integrated into the global economy, Williams pointed out. “The opportunity and the catalysts are evident and quite a number of countries are able to participate,” he said. “It has the prospect of driving earnings growth over a multiyear period.”
“There will be a reappraisal of the asset class, but it’s going to take a number of years for investors to fully see the light.”

Logistics grid
Williams pointed to logistics as an example of an underlying driver of investment opportunities in the emerging markets because of the labor, technology and natural resources needed to support the energy transition in the developed world.

“You need to have a logistics network. And to do that, governments have to invest in myriad technologies,” he said. “The logistics operation is like your train, and you need to invest in a railway network first to put that industry on top of those tracks,” he explained. “There are a number of really critical technology companies that are providing those bits of railway equipment, so to speak, from emerging markets countries that are very important to this economic transition that’s going on in the West.” For example, several companies in Indonesia offer low-cost production of critical natural resources, such as copper or nickel, that are essential for the green energy transition.

Follow the cash flow
Institutional investors seeking equity returns tend to focus “too much” on a stock’s rating potential, accounting profits and investor sentiment rather than “cash flow health in a business, and the ability to invest for growth which is essential to grow the dividend,” Williams said.

For abrdn, it starts with identifying the right companies. “We are bottom-up stock pickers,” he said. “The way we build the portfolio is first with an insight led by our interactions with companies.” Following that, he noted, the equity team conducts careful analysis with a focus on company earnings and cash flows that drive dividends.

“If you follow the cash flow through the financial statements, you’re going to get a much richer interpretation of the health of a business, and you can make more informed investment decisions. It leads you to more transparent companies, better governance practices and a shareholder return mindset,” he said.

Williams and his team identify investment opportunities by slotting companies in one of four corporate lifecycle quadrants.

• The first quadrant is when a company is new, establishing its brand and customer base but not generating much cash flow.
• The second quadrant is when a company is established, growing above market rates and generating high levels of cash flow.
• The third quadrant is when a company is fully mature and growing steadily, albeit more slowly than in the second phase.
• The fourth quadrant is when a company’s growth has slowed, and it is paying out an unsustainable level of dividends without investing capital back into the business.

Sweet spot
Abrdn’s sweet spot is companies in the second and third quadrants. “We focus on high dividend-related companies that are backed by high cash flow streams, and then we focus on high-growth companies that are backed by growing income streams,” Williams said. “The combination of the two gives us a really wonderful dynamic.”

While the analysis can lead to a multiyear investment in a company, vigilance is critical. “There are so many dynamics — competition, new pricing, new regulation — that you just have to always be vigilant and not take anything for granted,” he said.

Finding the right companies to invest in, however, is one part of the investment equation. The other part is the portfolio. Once a company has been identified as meeting the teams’ earnings, cash flow and dividend criteria, it has to meet the client’s investment portfolio’s overall risk-return considerations.

“We think a lot about risk, and we try to make sure that we’re prioritizing our clients’ active risk in our stock-specific insights, and then we want to orient that budget toward where we’ve got the highest conviction,” Williams explained. “The portfolio has a couple of functions. One is to drive returns and the other is to provide diversification to achieve a cleaner exposure to the stock drivers that we identify and away from factor- or macro-related shocks.”

Favored markets
Speaking of conviction, abrdn favors opportunities in Indonesia and Mexico. Both countries — India too — are on solid financial ground and have not had to inject large fiscal stimulus into their economies to stabilize them. As a result, their currencies have been “quite robust,” he said. Indonesia and Mexico also benefit from low levels of debt, among other structural tailwinds.

“Indonesia has some of the lowest-cost green metals, such as nickel. It is going to be a relevant part of providing resources to economies in this green transition,” Williams said. “Mexico is going to be an important beneficiary of the friend- [and near-] shoring trends, and it is going to take market share, as an exporter to the U.S., away from China. That means China has a difficult transition ahead.”

Overall, in the portfolio, “we have a relatively low exposure in India because of high valuations,” though the economy has a bright outlook, Williams said. China faces a difficult economic transition, he noted, though investors can find selective opportunities in China, particularly around consumer brands.

Those who don’t see the light on the dynamic capital flows into the emerging markets, Williams said, could miss the compelling reality of the attractive emerging markets universe for income investors. ■

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