So clear is the pundit’s case for emerging markets in terms of macroeconomic fundamentals at the moment – with stronger growth rates, a tighter grip on inflation, and even the ‘goldilocks scenario’ of a depreciating dollar – that we can understand if such a near-universal consensus long is beginning to be viewed with some skepticism by allocators.
Oversimplifying the ‘long EM’ narrative masks quite how different the medium-term prospects are across this already highly disparate collection of markets. Aggregate ‘index EM’ valuation and performance figures, which are inevitably dominated by China and other East Asian tech (such as TSMC and Samsung), are pretty useless in assessing what is going on under the surface.
This is particularly true during the current outbreak of AI hype, which has very much brought the Asian chipmakers, including two of the three largest businesses in EM, along for the ride. In valuation terms, meanwhile, there is no doubt that index EM remains superficially cheap, despite relatively strong fundamentals – but weighed down heavily by large cap China. Several other ‘deep value’ markets are understandably cheap – for example Egypt, South Africa and Turkey, which face substantial macroeconomic headwinds. Beyond the slightly more benign US Dollar scenario, there is no particular reason why a rising EM tide should lift all boats. In fact, some of the most open economies, dependent on Western or Chinese demand for their exports, are obvious victims of near-shoring and de-globalisation. And if we entertain even a fraction of the AI hype, countries like the Philippines, whose principal export is menial man-hours, are on the cusp of a substantial loss of comparative advantage.
EM Indices: Current Valuation Multiples
Given the current gloom around both the subdued nature of the Chinese recovery (more on this in this blog), as well as geopolitical worries, it can be easy to forget that this is still an enormous economy growing substantially faster than developed countries. The combination of still relatively strong growth rates, with a large existing base, ensures that China will still account for almost a quarter of incremental global GDP over the next five years.
We are likely preaching to the converted here, but it still baffles us how any investor could look at the chart below and feel they can safely ignore emerging economies. We would also remark, however, that this forward-looking chart bears little resemblance to the typical geographical mix of even an EM-oriented portfolio. In terms of incremental world GDP, South Korea and Taiwan, for example, are relatively immaterial, but represent substantially outsized portions of EM market cap. India, and to a lesser extent Indonesia and Vietnam, are near-irrelevant in terms of current global market cap but major players in terms of incremental GDP.
We understand, however, that both bottom-up and top-down realities dictate that mapping portfolios neatly according to the apparent scale of economic opportunity is neither a practical, nor necessarily desirable, outcome. Top-down circumstances dictate that investing in Turkey or Russia, for example, requires the underwriting of a degree of currency and political risk which dwarfs company-specific upside. From a bottom-up perspective, while the ASEAN region holds huge potential, stock markets have through our lifetime as a firm offered disappointingly slim pickings, with Vietnam still early on the journey to a truly market-based economy, and large firms in Indonesia and the Philippines often dominated by a small cadre of politically connected families.
We find the most opportunity, therefore, where growth at scale accompanies deep capital markets with a strong stock market culture. This is most obviously on offer in the ‘big three’ of China, India and Brazil, which we expect to represent the cornerstones of our portfolios for as long as Arisaig is investing. India, the largest exposure across all three of our strategies, is the archetype of the EM narrative: an urbanising, growing middle class beginning to spend rising disposable incomes on small upgrades to their quality of life at a vast aggregate scale.
Brazil is a little different, essentially at middle income status already, and without the demographic dividend of India. Nonetheless, even absent the mid-high single digit economic growth prospects of India, there is ample opportunity in the reshaping of domestic demand, for example towards the growing healthcare needs of an ageing population; and through the digital channel shift across B2C and B2B products and services. Totvs, the ERP provider, is a fine example of this. Software spend in Brazil as a % of GDP is barely a quarter of the OECD average[1]. Yet a government survey found that over the two years to 2022, local companies made a 7x return on their IT investments in terms of incremental profits[2]. In cases like this, even in a middle-income economy like Brazil, there is both a vast top-down opportunity coupled with strong bottom-up incentives and demand drivers.
Currency depreciation has been a major headwind in Brazil over the past decade amid the unwinding of the 2000s commodity boom. But there is little reason to believe this is permanent. In fact, given the strength of the country’s institutions (for example, the proud obstinacy of its independent Central Bank amid pressure to cut interest rates), the country’s status as a burgeoning agricultural superpower, and its inoffensive neutrality amid China-US tensions, the country looks enviably placed for the years ahead.
All this said, we do not view the top-down merits of the EM ‘big three’ as a cue to ignore opportunities elsewhere. It is our role to identify the most promising exceptions to the rule. Often these investments offer outsized returns possibilities because of their locations off the beaten track. But what will most directly drive returns for us is the ability of our select pool of predominantly Indian, Chinese and Brazilian companies to drive earnings at a double-digit rate over the long-term.
[1] TOTVS Investor Day Presentation: https://api.mziq.com/mzfilemanager/v2/d/d3be5d49-62e7-4def-a3e1-ab25ff09f153/b3a6a48b-bab3-b662-2ea8-6c747a792882?origin=1
[2] FGV EAESP, Pesquisa do Uso da TI -Tecnologia deInformaçãonas Empresas, 2023
