Global stocks best way to tap domestic EM growth

We believe that one of the most compelling investment opportunities over the next few years is likely to be in companies that serve domestic demand in emerging markets.

Our case rests on two underlying and interconnected forces – one economic and the other demographic. As poor countries get richer, they save as much as they can. Savings rates usually rise until countries reach a range of $3,000-$10,000 of gross domestic product per capita. Once in that range, savings rates begin to decline and consumption becomes a larger part of GDP growth as society starts to provide a social safety net. At this level of wealth, per capita consumption of all goods and services rises in a highly non-linear fashion. For example, while Chinese per capita GDP quadrupled from $1,000 to $4,000 during the past decade, car sales rose from 1m vehicles per year to more than 17m. Markets rarely anticipate this kind of non-linear growth.

Half of all emerging markets (by market capitalisation) are now in this sweet spot of shifting from savings to consumption. Further strengthening the economic case is a shift in demographics: a record number of people are coming into their earning years in emerging markets at the same time as baby boomers are starting to retire in the developed world. As a result, we believe that the world is in the middle of a massive shift in demand from the developed world to emerging markets.

As this domestic demand play gains momentum, we hear increasingly that the best way to capture this theme is to buy small-cap emerging stocks. We believe, however, that this is a mistake and that focusing on companies that specifically serve domestic demand is a more effective way to exploit the opportunity. Besides, why buy a proxy when you can buy the real thing?

First, let’s look at the core of this argument. Favouring small-cap stocks rests on the presumption that large-cap emerging market stocks represent export-oriented and globally oriented businesses. As a result, removing these large-cap names from the investable universe would leave a collection of companies that are focused primarily on domestic demand. The first part of this contention is true, the second is not. Large-caps are geared highly to global demand. However, the small-cap universe alone does not represent a pure play on domestic demand and, in fact, is as exposed to globally sensitive sectors as large caps.

If one divides all emerging market companies into those that are domestically oriented (financials, consumer discretionary, consumer staples, healthcare, telecoms and utilities) and those that are globally sensitive (energy, materials, technology and most industrials), globally sensitive sectors are almost as highly represented in aggregate in the small-cap universe as they are in the broad emerging markets universe. Globally sensitive sectors represent 45 per cent of the small-cap universe compared with 47 per cent for the broad emerging universe, as of September.

If one were to construct a universe of domestic companies (handpicked on a company-by-company basis according to who their ultimate customers are rather than market capitalisation), one would see that it is nothing like the small-cap universe. It has very different sector composition, with a much smaller emphasis on globally sensitive sectors (not surprisingly) and a larger emphasis on consumer-oriented and financial companies.

Another issue with using small caps as a proxy is that they tend to have low profitability and higher volatility of earnings, given the high proportion of materials and industrial companies. The current return on equity for small caps is 15 per cent versus 18 per cent for the broader universe. The final kicker is that current valuations for small caps are high. Historically, small caps have traded at a 7 per cent discount to the broad universe but are currently trading at a 4 per cent premium, which is almost as expensive as they have ever been.

Last but not least, not all domestic demand is served by companies that are domiciled in emerging markets. Global multinationals also serve this rising demand and, in some cases, are dominant players. A complete domestic demand universe should include multinationals that receive a substantial part of their earnings/revenues from emerging markets. While very few multinationals currently meet the test of being driven largely by emerging demand, they will become a larger part of this theme. While some commentators argue that investing in multinationals alone is the best way to access domestic demand, we believe that domicile is irrelevant. What matters is whom they serve.

The best way to access demand from the burgeoning middle class in the emerging markets is to invest in companies globally that directly serve that demand, rather than using emerging market small caps or global multinationals as a proxy.

Arjun Divecha is portfolio manager of the GMO Emerging Markets Fund and the GMO Emerging Domestic Opportunities Fund