The economic model that has sustained Asia's emerging markets for 35 years is under pressure. The threat and initiation of trade wars combined with underwhelming performance of the region's equity markets have driven the point home. But that doesn't mean equity investors should abandon the asset class.
In fact, the opportunities that exist are as compelling as ever, perhaps even more so, said Damian Bird, portfolio manager of BMO Global Asset Management's specialized emerging markets strategies at LGM Investments. But the paradigm has shifted. The focus for yield-hungry investors has now changed from export-oriented companies to those selling goods for internal consumption.
For close to four decades, most emerging market economies in Asia followed a simple script: a cheap local currency in U.S. dollar terms, abundant land assets and inexpensive supply of productive labor forces. This allowed these countries to grow into export powerhouses. As a result, it's no surprise that the largest companies to emerge were tied to the export businesses, according to Bird, who has spent most of his career focusing on emerging markets.
“If you look at Asia's biggest listed companies by market cap, you're going to see a lot of the big exporting companies in there,” he said.
For Bird, the stock market's initial reaction to Donald Trump's election victory was puzzling. “I thought that was a little bit strange, for the risk-on rally to resonate through emerging markets as well, given the model of Asia equities in particular,” he said. There simply didn't seem to be much concern from investors. This despite the fact that “candidate Trump was very clear” about his ideas for tariffs and trade wars, with China in particular. Over the last six months, as the repercussions of his policies have begun to feed through into Asia and into emerging markets, investors' views have started to change, and for good reason.
“If you are a business that has built your operations on making products to ultimately get sold to the rest of the world ― and of course the biggest consumer out there is the U.S. ― then all of a sudden, there are challenges to your business model,” said Bird.
While the export-driven model is unlikely to disappear outright, especially overnight, the market ― including institutional investors ― is right to be concerned.
“It really is a headwind for these companies right now,” said Bird. “If you're an emerging market investor, and you're looking across your universe and looking at some of the big companies out there, you absolutely have to see some relevant points of risk.”
Where does this leave investors? For Bird and BMO, the most interesting opportunities are not in businesses that sell their products in the U.S. While many of these will of course continue to thrive, especially as old trade agreements are amended and new ones are hatched, BMO's focus has always been elsewhere: the companies targeting the 6 billion consumers who live in emerging markets.
“These are the consumers who are seeing the exponential growth in their disposable income,” Bird said. “They are moving from the countries to the cities in millions and millions per year” and seeing the rapid spillover benefit of using technologies that increase the ease of doing business.
These trends are much more difficult to stop with trade barriers or tariffs. “The weight of numbers in terms of number of people and the spending power coming from just the incremental marginal growth in terms of social income” create a powerful force when multiplied together. “This is not a change in strategy for us as a result of the changing macro environment,” Bird said. “This is very much how we've always believed is the right way to invest, which is to focus on the domestic opportunities in emerging markets.”
One investment that exemplifies BMO's approach is a leading toothpaste company in India. The company has a 55% market share domestically. According to estimates, about 400 to 600 million of India's 1.3 billion population currently brush their teeth.
“Our hypothesis is that if you roll forward a number of years, whether it be five or 10 years, you're going to see a lot more people in India brushing their teeth,” Bird said. The numbers can become dizzying when one factors in the multiple levels of growth taking place at different times in different parts of the economy. While some people may initially just be weekly brushers, others are going from once a week to twice a week, while others still increase their brushing schedule in incremental parts, before “finally, you get to some point where people [are] brushing their teeth daily.” These numbers then double when people start to brush their teeth twice daily. “You then have the whole price matter within the toothpaste category, from the very basic toothpaste to the whitening toothpaste, to the cavity-protection toothpaste,” to the natural elements, where maybe local ingredients are added, he explained.
Taking a Long-term View
For investors to take advantage of growth like this, their focus must shift to a more long-term horizon.
“To invest in over or under next quarter's earnings” is certainly possible, “but we would argue that if you're going to invest in that style, you can try that with any asset in any part of the world,” according to Bird. For BMO, the idea is to identify businesses that are going to benefit from emerging markets' long-term trend of rising domestic consumption ― and that requires a multiyear view.
“We define ourselves as quality investors,” Bird said. “The biggest beneficiaries are going to be the best businesses in emerging markets. We identify those, own them for a number of years and watch them compound capital.” For this reason the team at BMO focuses on companies with sustainable business models, defined as having robust and durable growth plans, deep moats and strong balance sheets. “Leveraged balance sheets have risk,” so the firm prefers to own businesses with less debt.
An alignment of interest with minority shareholders is also key. This is particularly true in a part of the world where many businesses are family-owned and managers may not always be focused on generating returns for all shareholders. There is an element of trust that is also vital to BMO's portfolio managers.
Visiting the companies is a vital step. “You can't run an emerging markets portfolio from your desk,” said Bird. By his estimation, the team at BMO met about 1,000 companies last year and expect to visit a similar number this year.
“We like to invest in businesses where we know who the owners are, where we know who the management teams are ― and we've sat in front of them across the table ― [so] that we can fully trust that they are looking after our interests as well as their own, in the sense that we are aligned as co-investors,” said Bird. ■