CONTRIBUTE ARTICLE By Alex Duffy, portfolio manager, Fidelity Emerging Markets fund
Emerging markets (EM) have been growing rapidly in recent years. In fact, they now represent nearly 60 percent of global growth and more than 50 percent of global GDP. Once dominated by agriculture and cheap manufacturing, EM countries are today home to some of the world’s fastest growing economies and most innovative companies.
A quick look at the labels in most people’s wardrobe or the appliances in their kitchen highlights that China now produces more than 25 percent of everything manufactured around the globe. But other developing economies are powering ahead too. South Africa is a leading producer of motor vehicles, as well as precious metals, iron and steel. Brazil is home to four of the world’s 100 largest banks, as well as Embraer, the world’s third largest aircraft manufacturers*. And India’s economy is booming to the point where merchandise exports and imports grew 11.02 percent and 21.04 percent respectively in the year to February 2018**.
As money flows in, these economies are beginning to account for a much higher percentage of global GDP. In fact, ‘The World in 2050’ a PWC report into the growth of the ‘E7’, (the seven largest emerging market economies) showed that in 1995 these nations had a combined GDP less than half that of the G7 (the seven largest advanced economies). However, by 2040, it’s estimated that emerging economies will have an output that is double the developed world. In other words, in the space of 45 years emerging markets will have gone from a peripheral position in the world economy to a central one. Despite this, they still account for just a fraction of most Australian investment portfolios.
A demographic shift
One of the reasons why many emerging markets are experiencing such solid growth, is because they are undergoing a profound demographic shift. While much of the developed world struggles to come to terms with the cost of supporting an aging population, developing economies typically don’t have this problem as much of their population is still young. For example, India has a median age of 27.9, compared to the EU median age of 42.6, which means there are still plenty of productive workers to keep the economy running and fewer retirement age workers to support***.
As more of these productive aged workers find meaningful work, they also tend to have more disposable income which means we’re seeing a new middle class rising out of emerging market economies. Between 2009 and 2030, China alone is expected to add 850 million people to its middle class, in the process taking it from 12 percent of its population to 73 percent of its population****.
With this increased affluence comes increased consumption – not just of consumer goods such as cars, technology and electrical goods, but of more sophisticated products and services. China’s healthcare industry for example grew four-fold between 2006 and 2016. China is now also the second largest global market for financial services – behind only the United States – with home loans, deposits, life insurance and investment advice all becoming more integral to the way the economy functions and people live their lives*****.
ESG: Focusing on the G
However, despite these positive trends, one common concern for investors in emerging markets is environmental, social and governance (ESG) factors and how they could impact returns. Good governance is the bedrock upon which everything else rests; it determines the actions of managements, employees and shareholders, guides a company’s approach to environmental and social issues, and drives financial returns. If you get the ‘G’ right, the ‘E’ and the ‘S’ usually follow as a robust corporate structure and decision-making process creates the optimal framework for ESG-aware policies.
It is crucial to understand a company’s ownership in the first instance – who are we investing alongside and what do they want the business to achieve? The answer to this will go a long way to determining how the company allocates its capital. When a government is a major shareholder, for example, investors should not be surprised if the company makes decisions that prioritise national interests over those of other shareholders.
It also helps to know exactly what management teams are paid to achieve, which is why clarity around targets and incentives is so important. Through fundamental research and analysis we can build a comprehensive picture of a company’s opportunity set for creating long-term value. However, this is purely theoretical unless management is motivated to put it into practice.
As asset managers, we like companies that allocate their excess capital at an accretive rate of return, creating intrinsic value for investors over time – in other words, firms investing in projects which return more than their cost of capital. When managements are incentivised to think about the sustainability of cash flows, and when the shareholder structure supports that behaviour, it tends to lead to sustainable outcomes for the business. This can manifest in low staff turnover, or better investment in research and development leading to more efficient, cleaner manufacturing processes. If a company cuts environmental corners to maximise short-term returns, for instance, at some point this will become a financial liability. In this way, ESG and financial success are one and the same.
Different governance systems in practice
Companies in emerging markets with robust governance structures can create huge amounts of value, while those with poor governance can destroy it. AVI, a South African food and beverage firm, and Petrobras, a Brazilian oil and gas company both suffered currency devaluations of more than 50 per cent in the decade following 2008’s financial crisis. But the companies, driven by their different governance systems, responded in very different ways to the pressures and had very different results.
AVI’s costs for raw materials such as coffee, tea and wheat are in US dollars, while its products are priced in South African rand, which meant the weakening currency dramatically increased its cost base. However, AVI’s management felt they could not raise prices to offset the higher costs when their customers’ spending power was also deteriorating. Instead, they recognised that conditions were not ripe for growth and stopped investing in the business.
For almost five years, AVI added no net new capacity, choosing to focus on sweating the asset base and increasing return on invested capital through cost cutting, price optimisation and branding. While invested capital stayed flat, absolute profits began to increase and return on capital employed (ROCE) jumped from just over 20 per cent to 30 per cent.
AVI’s decision making has helped preserve its ROCE and increased intrinsic value
Source: Company statements, Fidelity International, December 2018
On the other hand, Petrobras’ major shareholder was the Brazilian government, which recognised that by 2009 the economy was under pressure and it needed to create jobs. Petrobras ramped up capital expenditure by around US$50 billion a year, with little regard for the returns such projects were generating. Invested capital rose from just under BRL150 billion to more than BRL250 billion in under four years, while ROCE plummeted and absolute profits fell sharply.
Poor capital management at Petrobras has hurt ROCE
Source: Company statements, Fidelity International, December 2018
Because of its capital management decisions, AVI was able to triple its dividend between 2008 and 2018. Meanwhile Petrobras eventually had to scrap its dividend after over-investing in projects that did not generate any cash flow, ultimately undertaking a massive capital raise to support its stressed balance sheet.
Petrobras, at one point one of the largest companies in the world and included in almost every emerging market portfolio at its peak, saw its share price fall almost 80 per cent over ten years. In contrast AVI, a lesser-known mid-cap in South Africa’s well-penetrated consumer goods sector, delivered a 340 per cent share price return over the same period.
Diametric returns of AVI and Petrobras
Source: Refinitiv, April 2019
These case studies help illustrate why, to me, good governance is not just a bonus or even one-third of a broader ESG strategy, but the starting point and foundation of all fundamental research. A company’s governance framework drives its capital allocation decisions, which determine the sustainability of both returns and broader business practices. In turn, this creates long-term intrinsic value, and that is music to investors’ ears.
Originally published in Money Management July 4th 2019