Getting ahead of the trend in emerging markets
Emerging markets had a stellar year in 2020, but was this a COVID-19 recovery boost or are long term fundamentals at play?
One of the sectors - luxury goods - is benefitting from the rising wealth in China, while everywhere else in emerging markets is riding the wave of technology and innovation - especially when it comes to digital payments.
Reynolds explores an interesting trend for technology companies to evolve along with their markets to cover the full ecosystem for the consumer.
For example, Reynolds looks at Reliance Technology, an Indian-based company that started as a mobile network, before expanding into payment systems and then following a natural pathway to e-commerce networks.
What is interesting to us, as investors, is that while we can see the broad trend being created in the developed markets, sometimes a little earlier, we can identify the same types of trends being developed in the emerging markets. So we can be early investors into these trends," said Reynolds.
While technology might be the darling of the portfolio, Reynolds puts forward a solid case for a surprise contender to boom in emerging markets. The services and maintenance industry for aerospace will seek to benefit from the tail-end of recovery.
Aerospace ... is very similar to the electric vehicle industry in terms of lots of component suppliers. And interestingly also very similar to the semiconductor manufacturing industry, which has a whole ecosystem of suppliers supporting the manufacturer of chips and chip sets," he said.
Why invest in emerging markets?
So there are two aspects to investing in emerging markets. We find that firstly, sometimes the growth rates can be much stronger. So prospective growth can be higher, particularly for products and services where it hasn't been extensively rolled out into the local population. And that's obviously a positive for the company that can execute well.
We also find that we can invest in companies that have a lower valuation than what we see in developed markets. So companies that may not have been as well discovered by the markets, for example, or whose prospects have not been as well understood by general market participants. And so that combination of being a little bit more "growthy" as well as being better value, can be very powerful in terms of being an initial investment in emerging markets.
Is the growth rate of emerging markets sustainable or just a short-term recovery boost?
Many of the trends we saw in COVID through emerging markets and indeed across the rest of the world as well, got a very strong boost in areas such as the use of digital payments and card payments. The increased use of internet-delivered TV, for example. They all saw very strong tailwinds of growth that, we think, continues in the medium to longer term.
Clearly, there was a pull forward in some of that demand as a result of COVID, but as long-term investors, we continue to be confident those trends are well-established. And we think some short-term investors may actually be surprised at how sticky some of that demand has been.
Do you think emerging markets will benefit from pent-up demand for luxury goods?
Luxury goods demand in our estimates continues to be very strong. And there's an element of pent-up demand to the demand for luxury goods at the moment we see worldwide. But we are particularly seeing that within China. In fact, Chinese-based consumers of luxury goods, we think will grow far more rapidly in size than we see in other parts of the world and they will become an increasingly large portion of total luxury good demand in the world.
The interesting thing from our point of view is as investors in luxury goods companies is that many of them are European-based. And so when we look at the opportunities to invest in Chinese growth and the growth in the Chinese consumer, we see those opportunities often listed in Europe but really benefiting from Chinese onshore growth.
The pandemic and the recovery from the pandemic has been a particularly powerful tailwind in terms of those Chinese consumers wanting their top-shelf products, their new and sparkly luxury goods products to really reward themselves after a very difficult time.
The large luxury goods brands should benefit from this type of growth going forward and there are others as well. What we find is that the luxury goods market has lots of companies that are very specifically positioned in particular product sets.
So the way the companies can evolve over time will really depend on where those products demanded. But LVMH is an example of a broad-based company that has exposure to lots of parts of the Chinese consumer.
Do you think demand in China has reached its peak?
Well, demand in China at the moment is very strong. It's being supported by a credit impulse, and that is consistent with what we've seen around the world, in terms of the reactions to the virus and the deployment of fiscal and monetary policies around the world.
To say that there's a limit in demand, I think probably undersells the potential for China to continue to grow. The potential is certainly there, and it will certainly depend on individual products and services offered by different companies - depending on what sectors they are in.
So for example, if you look very long term, the growth in electric vehicles in China could be very substantial as it could be in many other developed markets as well, but in China it could be particularly substantial.
Technology stocks have been very strong in emerging markets as they have been in developed markets as well. And many of the emerging markets are developing their own national champions in technology in some of the sub-sectors like payments technology, technology that helps small to medium enterprises approach online sales, and general e-commerce selling as well. We've been invested in a number of those companies through this period, and they've seen a very strong tailwind of growth.
What are some examples of how technology is spurring growth?
When we think about technology growth in emerging markets, what we have found is that there are a number of franchises being developed that are really turning into their national champions over time.
These companies are involved in say, deploying initially, say, their own mobile networks, and then expanding those mobile networks into payment systems and eventually into e-commerce networks. A company like Reliance Industries (NSE: Reliance) in India is a very good example of this evolution.
What is interesting to us, as investors, is that while we can see the broad trend being created in the developed markets, sometimes a little earlier, we can identify the same types of trends being developed in the emerging markets. So we can be early investors into these trends, and into the effect of these national champions, as they seek to grow their footprints and their exposure to different parts of the market.
As long-term investors, we are patient, and we can see how those trends develop over time.
So in short, yes, we see technology continuing to be very strong in emerging markets. But one, mustn't also forget that emerging markets have a number of very large natural resource companies. And those natural resource companies could actually do quite well as well in a strong global growth environment.
Which natural resource companies excite you?
Some of the net large iron ore producers in emerging markets are doing well and continue to benefit from a high iron ore price, for example, at the moment. And some of the copper companies continue to do well as well.
What risks do investors face in emerging markets?
Geopolitical risks in particular come to mind in emerging markets. It seems to come with the territory. Lots of different countries have their own geopolitical risks from time to time. And we can monitor those on a country by country basis.
But I think the overall risk at the moment from an emerging market's point of view is really the China-US relationship and how that might evolve under the new Biden administration and so that's something we monitor carefully. China is obviously a very substantial part of emerging markets. But the impact on global growth could be felt in other countries as well, going forward.
Will this risk dissipate under a Biden administration?
Well, it's a little unclear exactly how the relationship will unfold and we're watching events with interest. Clearly, there are different approaches being adopted by the new administration from the previous one. But that's not unusual, we see changes in approach whenever the US administration changes. So I think it's worthwhile as investors to monitor the rhetoric that is deployed and see what comes out from those negotiations between the countries.
Are there any other risks we should be aware of?
In emerging markets, we do think about a lot of this country's specific risks. So there are individual fiscal policies, for example, in emerging markets that we need to take into consideration as investors. We also need to look at the income growth and the levels of unemployment in each of the markets to get a gauge for how robust the growth and how broad-based that growth is over time.
But many of the companies we've invested in, we feel have a very strong tailwind of growth as they seek to address new and growing addressable markets. So if we take, for example, the replacement of cash with cards, that has a very strong trend beneath it, that really does power, these companies beyond just the geopolitical environment and the growth in the country itself.
So if we think about some of the risks in emerging markets, one of the risks that goes across all emerging markets is the role of the US dollar and how strong it is or how weak it is at a particular point in time in its trajectory.
So for an investment in emerging markets, we do monitor the US dollar and its impact on emerging markets equities, because that can have quite a significant impact on returns for investors in the region.
What long-term trends are you predicting for the region?
I think it's fair to say that some of the changes we've seen from COVID-19 have a very long tail nature to them - and they can be quite positive. So if we think about, for example, the resumption of business travel, we think business travel resumes in time, but it looks very different to what it was in the past. It becomes very targeted in its nature.
People love to collaborate and brainstorm and get together to solve problems and travel to do so. But we think that the use of business travel will become much more focused in terms of specific occasions rather than the broad-based business travel we might've seen in the past.
We also see a significant trend towards using more networking and online working really benefiting some of the smaller cities versus the largest cities around the world. And we're starting to see evidence of that in various local property markets where regional cities and smaller cities are seeing strong demand from migration from larger cities. And this is being underpinned and helped by the use of internet for remote working, for example.
I must add we are bottom-up investors. So we're looking for individual companies and how they can perform relative to our modelling and our expectations over the coming five to 10 years.
So when we're looking at the economic stats of any particular country, it's really from the perspective of, "Is the surrounding environment that that company exists in supportive or unsupportive? Will it face headwinds that are unexpected over those next five to 10 years?" for example. And we monitor those stats like many investors do to gauge any impact on our investment going forward.
But our focus is really on the individual companies. We'd seek to understand the company's position within its industry, how large its addressable market is, for example. Whether it can maintain its margins and its risks in terms of competition going forward. And so the monitoring of the economic stats is really secondary to that primary focus on individual companies.
What sector, in particular, do you think is set to boom?
One of the more interesting markets at the moment is the travel-related industries. And by that, I mean the whole ecosystem around travel, being the hotel and accommodation market, the airlines themselves, and also the aerospace companies that supply the planes that we all used to travel on. We think that there's a huge amount of pent-up demand, particularly for leisure travel and that it will clearly benefit parts of that ecosystem, including the hotels and the airlines. But one of the sectors that has been particularly hard hit during the COVID period has been the aerospace industry where we've seen lots of deliveries of planes stalled, and we've seen commensurate foreign stock prices.
Aerospace is an interesting industry from our perspective because it is clearly very hard for companies to get into aerospace and so there's a natural position in aerospace for those companies to perform well in what had been a very strongly secularly growing market.
If we look forward over the medium to longer-term, it's clear that we will continue to need planes to fly on, and the companies that can actually manufacture those planes are quite limited.
So when we go about our assessment and reviewing opportunities, looking forward, one of the areas that may benefit from a resurgence in leisure travel and to some degree business travel, it could be the aerospace sector and supporting component suppliers.
The aerospace industry is very similar to the electric vehicle industry in terms of lots of component suppliers. And interestingly also very similar to the semiconductor manufacturing industry, which has a whole ecosystem of suppliers supporting the manufacturer of chips and chip sets.
And very often as investors, we can investigate and analyse the component suppliers or the second and third-order into semiconductor manufacturing, electric vehicle manufacturing, aerospace manufacturing, to gain insights in terms of the level of growth that we can expect. But also we can uncover really interesting investments in those areas themselves.
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