Emerging Markets: A changed asset class – More quality, less risk?

There is a great deal of confusion today about what really constitutes the asset class known as ‘emerging markets’ (“EMs”), and with good reason. The official grouping from index providers such as MSCI contain a hotchpotch of countries across the globe with often very little in common. There is also confusion about the characteristics of the asset class: everyone assumes it is risky, but is it? Is it cyclical, is it correlated to commodities, is it leveraged, what are the company returns like?

We decided to take a closer look at the changes over the last decade or so. In the period since the global financial crisis EMs have had a disappointing time, in index terms at least. Although we are not avid index watchers, looking at their makeup is the best way to see what most investors in the asset class are exposed to. Even if we are not!

In late 2009, energy and materials accounted for 30% of the MSCI Emerging Markets Index, consumer orientated sectors were a mere 21%, and financials (some of which will be consumer facing) another 23%. By 2023, energy and materials had fallen to 15%, with consumer sectors rising dramatically to 34% and finance steady at 22%. At a country level, commodity producing countries accounted for 40% in 2009, today that number is 22%, and that includes 7% in the various Gulf markets which were not there in 2009. From this, it is safe to say that EMs are no longer a punt on commodities.

The contra to this is clearly that the vast majority of EM equities are now commodity users and importers. Also, the consumer weighting is much higher and most of these will be buyers of commodities. All this is good news in this increasingly deflationary world, at least in commodity price terms.

The other striking change since 2009 has been the rise, in index terms at least, of the two giants, China and India. China from 17% to 29%, India from 6% to 14%. The biggest losers have been Brazil (16% to 5%), South Africa (8% to 3%) and of course Russia (6% to 0%). So much for the “BRICS”; there are really only two left standing, although Brazil’s President Lula is trying to make himself heard once again. Korea and Taiwan, which we would regard as developed markets, have seen little change in their weightings, although this hides an increasing dominance of semiconductors stocks, and particularly their two respective champions.

History also suggests that it is vital to stick to countries which are well governed and avoid those which are not. Those that cannot control their vices, usually inflation, rampant corruption, or both, are doomed to remain peripheral players, even if their populations and demographics suggest otherwise. Turkey is a case in point. The potential is huge, a decade ago it was 2% of the benchmark and growing. Yet today it is 0.6%, and that is only after last year’s Ukraine driven bounce – it was a rare winner from the conflict. The country has also, sadly, just voted to continue its decline, if indeed the vote was a true reflection of the people’s wishes (for more on why we don’t invest in Turkey, see here). Russia, much of Africa and parts of Latin America remain locked in this same tragic cycle.

Whatever the current travails in China, its economy has at least been relatively stable and growing steadily in recent years, covid lockdowns aside, but the makeup of its stock market has been transformed. Financials & real estate accounted for 39% of the China Index a decade ago, energy & materials another 21%, but these numbers have collapsed to 20% and 6% respectively since. The flipside is consumer facing sectors now dominate at 59%, up from 28% in 2009, and this excludes any financials that might have a consumer bent. Part of this is the addition of completely new sectors represented by Alibaba, Tencent and the like, but part is also due to the underperformance of much of the state-owned enterprises which dominate those declining, cyclical sectors.

India’s growth has been much more uniform, as well as remaining more diverse. Financials remain the largest sector at 27%, followed by IT (software in their case), and then energy. The only sector to make significant progress in the last decade has been consumer discretionary (mostly autos) which has risen from 6% to 11%. This does not surprise us since India’s income per capita is still at such an early stage, but we have no doubt that when we revisit these matters in a decade’s time, it will be a different story.

Given the health of the balance sheets in our portfolio, and the fact that lending growth has been very subdued in most EMs in recent years, we were surprised to find that the average net debt to equity was relatively stable over the period, maintaining a range of between 20% and 30%. Similarly, return on equity has been range bound between 15-20%, and currently sits mid-range. One metric which has seen a marked improvement has been free cashflow yield, rising from 3% to over 6% today. This is something we see evidence of every day, particularly in China, with an increasing number of buybacks announced.

There are a few clear lessons from this data. First, never buy an ETF for exposure to EMs. You will likely end up with a portfolio of dying countries, sectors, and stocks. Rear view mirror investing in a rapidly changing asset class is not the way to riches. Secondly, EMs are no longer driven by commodities, and are now arguably inversely correlated to them. Good news as commodities and inflation subside. Thirdly, today’s major EM markets are considerably more resilient thanks to a better mix of industries: more domestic consumer driven, less commodity and export driven. Fourthly, whilst balance sheets and returns are stable, it appears cashflow is much stronger than it was in the past, which means the next phase of growth can be more easily financed in most markets.

For the Aubrey Global Emerging Markets Strategy this means that, in some ways, the EM universe has moved closer to our portfolio, with the growth of domestic orientated consumer sectors. However, our active share of over 90% suggests that we are still looking beyond the mainstream and finding something different. It also reinforces our view that success in EM investing requires investing in the right markets, the right sectors, and most importantly, buying profitable, well managed growth companies with strong cashflow.

By Rob Brewis, Investment Manager, Aubrey Capital Management. Rob and his team have been reviewing the constituents and quality of Emerging Markets versus a decade or so ago, and drawing some conclusions on how the asset class has changed over time. 

Rob, who joined Aubrey in 2014, is a Director and co-Fund Manager of the GEMs strategy.

An engineering graduate from the University of Cambridge, Rob began his career in 1988 at Thornton Management in London. Then he spent ten years in Hong Kong as an Asian fund manager with Credit Lyonnais International Asset Management. This company was later bought by Nicholas Applegate and then Colonial First State, where Rob ran the North Asian investment team as well as managing the Asian Special Situations Fund and a number of single country funds investing in India, Pakistan, Indonesia and Thailand.

He then went on to co-found emerging markets investment boutique BDT Invest LLP in London in 2000. Whilst at BDT, Rob co-managed a number of emerging market portfolios as well as the BDT Asian and Oriental Focus Funds.