High growth stocks at a fraction of the cost

Glenn Freeman

Livewire Markets

It’s been 35 years since Capital Group first ventured into emerging market investing. Over this time, many changes have unfolded. The world has shrunk in the face of major technological shifts. Countries have risen and fallen. Wars have been won and lost. And more recently, of course, a major pandemic has forever changed our lives.

In a recent chat with Matt Reynolds, an investment director of the world’s oldest and largest active asset management company, he reflected on some of the biggest shifts, particularly over the last decade.

Detailing how Capital Group weighs emerging market investment opportunities, Reynolds explains why he believes the odds are stacked in favour of emerging market investors. Reasons include the broader range of opportunities and particularly the cheaper valuations relative to developed markets.

In the following wire, Reynolds discusses:

  • The themes he’s most bullish on
  • The key aspects to weigh when addressing investing in emerging markets
  • The challenges emerging markets face that developed markets don't
  • The companies (from Argentina, Brazil and China) providing opportunities.

What are some of the greatest changes you have observed in the last 35 years in those markets?

Access to reliable financial information has improved dramatically since the early days. And for many companies, there has been an increased acknowledgement of the need for better governance.

Over the last 10 years, it’s been really interesting to see the changing opportunity set for investors. A decade ago, around one-quarter of the EM index was in extractive industries – energy, metals and mining. 

But today, these industries are less than 10% of the index. They have been largely replaced by many companies involved in e-commerce, gaming, healthcare, digital payments.

And over this timeframe, the earnings growth that has been available from emerging markets has been roughly aligned with developed markets. There has been very little earnings per share differential between the two. But now, we’re seeing more of a gap develop, with emerging markets EPS growth pulling ahead of developed markets, and by several percentage points. That’s very interesting from an investors’ point of view.

Which countries are you most bullish on over the next couple of years?

We tend to focus on opportunities at a company level within all of the markets. It doesn’t matter too much where the company is listed, what really matters is where its revenue comes from and how that’s expected to grow over time. 

We don’t try to forecast how individual country markets will go, preferring to spend our time worrying about individual companies. And some of those do well – cash digitisation beneficiaries are going very well, particularly e-commerce companies. And a lot of these companies are listed in the US rather than being based in EMs themselves. That’s why it’s problematic to look at it from the perspective of individual countries.

There are three broad aspects of EMs:

  1. They account for around 60% of the world’s GDP, but only 12% of global equity market availability, so there’s a real imbalance there.
  2. They are trading at around a 28% discount to developed markets, which is below the historic five and 10-year averages. And they’re offering a higher earnings growth rate versus developed markets.
  3. Emerging market stock markets are quite under-developed relative to the size of their economies. On average, only around one-fifth of EM stock markets are reflected relative to their nominal GDP. Whereas in developed markets, that’s about 100%. That highlights the size of the opportunity set in the listed stock market. So that’s why we think looking across the full spectrum of emerging markets and at the individual companies is a far better way to think about investing here.

How do you assess the opportunities you see, which might be based in a developed market but have exposure to emerging economies?

Well, what we don’t do is try and filter anything out, we are looking at all the listed opportunities that are available. That’s obviously a lot of work, and we’ve got big analyst teams that do that.

For our strategies, we have certain eligibility criteria for companies, including a minimum level of revenue and where this comes from.

What are some of the biggest themes that influence your EM portfolio construction at the moment?

We’re really interested to see the acceleration in the adoption of many of the same consumer trends that we’re seeing in developed markets.

A few examples include:

  • Digital payments – the pandemic has escalated the structural trend away from cash to electronic payments. In China, for example, e-commerce sales comprise more than 25% of total retail purchases, which is a very high number.
  • Biotech and pharmaceutical – many of these companies have very promising innovation departments working on new compounds and molecules. There’s the opportunity to invest in companies in that sector that are winning big contracts in drug testing, for example.
  • Insurance companies – after SARS in early 2000, many insurance companies saw a big increase in demand. This pandemic could see a similar increase in demand
  • Travel sector – we see big pent-up demand, with potential growth in short-haul and domestic travel initially, while international will be further off.

We’ve also been paying a lot of attention to the macro environment as well. Through COVID, it’s been interesting in emerging markets that have been less able to roll out significant fiscal and monetary stimulus than developed markets. 

So, while they were harder hit on the way down, they have a lower debt burden to deal with as they emerge from the pandemic. And what some have done is focus on reforms, such as Indonesia, where it has passed laws to cut taxes and regulation and ease some of the labour rules. 
That’s a different backdrop to what you see in developed markets.

There are some other strong non-COVID related dynamics we’ve seen in EMs, including:

  • Rising income levels, which are up 10% per annum.
  • The expanding middle class – 88% of the next billion entrants to the middle class are expected to come from Asia.
  • The demographic profile of emerging markets – the dependency ratio (the number of very old or very young people) is far lower in EM than DM.
  • Structural improvements in productivity should continue in EM, which can be very beneficial.

What are some of the big challenges EMs are facing that DMs aren’t?

There are several that are common across both, such as COVID and particularly the Delta strain and how this will affect populations. So, the provision of better medical care and vaccine deployment in EMs is a key issue and something investors need to be aware of.

Inflation also seems to have accelerated in many EMs. Again, this is similar to what we’ve seen in many developed markets such as the US, but we’ve started to see a couple of EMs increase interest rates in response. In many EMs, inflation rates were already much higher than in DMs, which could pressure the post-COVID recovery.

There are also trade tensions, most notably between China and the US, which is an ongoing issue. And at the same time, there’s the slowing of China’s economy, which is something we need to remain aware of.

Given the macro backdrop, is now the time for investors to be scaling back rather than increasing their exposure to EMs?

The way investors think about EMs has changed over the last several years, and we’re now seeing a much more considered, deliberate, and patient allocation than previously. They’re now looking much more broadly than just the index, looking for active exposures.

This whole risk of investing in EMs needs to be seen through a broader lens than simply what the index gives you. And there’s a lot of other potential out there.

With two broad schools of thought around what happens in global markets now – a fairly smooth reopening as vaccinated countries reopen more quickly as stimulus continues; or a mutant variant of COVID decimates markets, particularly those in emerging economies. What’s your view on this?

When we look at the current levels of activity, it’s clear that economies are taking steps to reopen, coupled with vaccination programs that are being rolled out at varying degrees. I’m in the former of the two scenarios you mentioned, but the level of volatility may end up being higher. We can see the other side of the valley and the path there – in terms of increased vaccination rates, antiviral drugs, the deployment of rapid testing kits – they’re all steps on our journey that can help make dealing with the virus a little more effective along the way. 

But that journey can be a bit rocky and there will be times your foot lands on the wrong spot. It’s encouraging to see the speed of response from pharmaceutical companies and the medical profession more broadly to changes in the virus. It gives us hope, but it’s clearly not going to be a smooth journey. But this is why focusing on your portfolio on a stock-by-stock basis is probably the best way to deal with that volatility.

What are some specific stocks you're most excited about in getting exposure to some of the themes you’ve mentioned?

Among some companies that touch on the growth in online purchasing are stocks like MercadoLibre, an Argentinean company listed in the US.

Zai Lab Technologies – A China-domiciled biotech company that holds several big contracts in testing and research.

And in emerging markets payments, we like Brazilian company PagSeguro, which is benefiting from some of those e-commerce growth trends that we see.

Matt Reynolds
Investment Director
Capital Group

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Glenn Freeman
Content Editor
Livewire Markets

Glenn Freeman is a content editor at Livewire Markets. He has almost 20 years’ experience in financial services writing and editing. Glenn’s journalistic experience also spans energy and automotive, in both Australia and abroad – including the...

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