>CAPTURING DOMESTIC DEMAND IN EMERGING MARKETS: Neither Small Caps Nor Multinationals Are a Good Proxy

We believe one of the most compelling investment opportunities over the next few years is likely to be in companies that serve domestic demand within 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 to $10,000 per capita GDP. 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, auto sales rose from one million vehicles per year to over 17 million. Markets rarely anticipate this kind of non-linear growth.


Fifty percent of all emerging markets (by market capitalization) 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 that baby boomers are starting to retire in the developed world. As a result, we believe that the world is in the midst 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 specifi cally 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. Favoring small cap stocks rests on the presumption that large cap emerging market stocks represent export 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 fi rst 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 the large cap universe.


If one divides all emerging market companies into those that are domestically-oriented (Financials, Consumer Discretionary, Consumer Staples, Health Care, 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.


The sector weights of the Emerging Broad and Emerging Small Cap universes are shown in Exhibit 1. In fact, globally sensitive sectors represent 45% of the small cap universe vs. 47% for the broad universe as of September, 2011.


If one were to construct a universe of domestic companies (handpicked on a company-by-company basis based on who their ultimate customers are rather than market capitalization), one would see that it is nothing like the small cap universe. Exhibit 2 shows sector weights of this true domestic demand universe alongside those of the small cap universe. We
can see that the domestic demand universe has a far lower exposure to globally-sensitive sectors than does the small cap universe. In fact, even the companies represented within globally-sensitive sectors of the domestic demand universe are those that specifi cally serve domestic demand (e.g., technology companies whose business is primarily within emerging
markets) rather than those that export to developed countries. An example of such a company is Kingdee International, which provides Chinese language ERP software and services and competes with the likes of SAP for small- and medium size businesses in China.

One might raise an eyebrow when noting that fi nancials are such a large part of this domestic demand universe. This concern, however, is somewhat misplaced. Most emerging market fi nancials are an extremely good play on demand growth because they provide the credit that is essential to the rapid growth of these economies. Second, most emerging market financials sectors are underleveraged and have extremely strong balance sheets. The average Tier 1 capital ratio for banks in emerging markets is north of 15% versus 8-10% for developed banks. The one exception is Chinese fi nancials: there are serious concerns about their health in any housing/ infrastructure downturn. Any actively managed strategy would most likely take this into account.


One other problem with using small caps as a proxy for domestic demand is that they tend to have low profi tability and higher volatility of earnings, given the high proportion of materials and industrial companies. Exhibit 3 shows the average return on equity (smoothed over 36 months) for small caps and the domestic demand universe. Clearly, small caps have been less profi table historically than true domestic demand companies.


Last, but not least, not all domestic demand is served by companies domiciled within 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 or will within a few years.


While very few multinationals currently meet this test of being driven largely by emerging demand, they will inevitably become a larger part of this theme. While some commentators make the argument that investing in multinationals alone is the best way to access domestic demand in emerging markets, we believe that domicile is irrelevant. What matters is whom they serve. 

The winning companies could be domiciled in either developed or emerging markets. The primary advantage that domestic companies have over multinationals is home fi eld advantage in the form of having well-established local brands, supply chains, products adapted to local conditions, and barriers to entry in the form of government xenophobia and anti-competitive rules. The biggest advantages that multinationals have over domestic companies are global brands, management expertise, and access to cheaper capital and supply chains. In the early stages of penetration to a market, the locals have economies of scale in their favor, which switches to an advantage for multinationals as their market share grows and they are able to source globally.


To conclude, 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.


In short, if you want to buy domestic demand, buy the real thing, not a poor proxy.


RISH TRADER