All That Glitters Is Not Gold

All That Glitters Is Not Gold

Digging for genuine growth in emerging market equities

Emerging markets investing is entering a new stage. The case for having exposure to emerging markets in an investment portfolio has increasingly become a consensus view. However, after two years of strong returns, emerging markets (EM) stocks lurched sideways for the first half of 2011 (as measured by the MSCI Emerging Markets Index).1

James Upton
Convention Speaker
Monday, October 10
“All That Glitters Is Not Gold”

In this new environment, many investors may be looking closer to understand the underlying source for future growth and for future investment returns. Many large cap stocks in the energy and materials sectors dominated EM returns over the past ten years. But we see the chief driver behind that—mainly China’s extraordinary fixed asset investment and nearly double-digit economic growth—cooling down in coming years as the country matures. Weaker growth in the developed countries also puts a damper on demand for such commodities. We see more compelling drivers for EM equities coming from consumer-oriented plays. One key factor will be the demographic changes and productivity gains expected for the next few years; these shifts mean consumption will likely represent an even larger part of economic growth in the emerging markets.

Today, consumers in the higher income EM countries increasingly own a mobile phone or two. Mobile phone subscriber penetration levels are as high as 156 percent in Russia and 129 percent in the Czech Republic,2 where gross domestic product (GDP) per capita is now US$10,000 and US$18,000, respectively.3 There is, however, material opportunity for voice growth in lower income countries, including, for example, Bangladesh and Nigeria, where subscriber penetration is only around 50 percent4 and GDP per capita just US$600 and US$1,400, respectively.5

We also find compelling earnings opportunities in those integrated telecommunications companies that are climbing up the value chain by providing ever newer services and transmitting massive amounts of data in creative ways. A citizen of Kenya, who may not even own a bank account, is increasingly likely to bank via mobile phone—or pay utility bills on it, rather than wait in line at the post office to do so.

In addition, valuation spreads on EM equities are below long-term averages and have come off significantly since the global financial crisis of 2008.6 When spreads are high, value tends to work as a strategy for the next few years. This is because the cheapest stocks are significantly cheaper than the average market stock valuation. By contrast, when valuation spreads compress, the case for growth investing becomes more compelling. This is because the difference in intra-stock valuation is very low. Spreads now are suggesting future growth stock outperformance as economic cycles within EM countries diverge and the market starts distinguishing between the winners and losers.

In less mature emerging market economies like Indonesia and the Philippines, where economic growth rates are higher than in mature, quasi-developed markets such as Taiwan, investors can find growth opportunities in telecommunications as well as banking and consumer discretionary sectors such as automobiles. This is due to relatively low penetration levels in some of these sectors, thus providing the greatest potential for catch-up.

Another key insight into the economic changes taking place is that commonplace features of life in developed countries— such as the use of credit cards and mortgages—are still at incipient levels in many EM countries.

Egypt is a country where only 10 percent of the population has a bank account.7 With GDP per capita at only US$2,800 in Egypt,8 spending on food amounts to nearly 40 percent of income,9 but we have observed that consumption choices can shift dramatically when income rises from such a low base. Market reforms and access to credit, if and when they occur, will help bring about such changes in Egypt and other low-income countries.

Consumer staples may sometimes be viewed as defensive investments, but in many cases individual companies are becoming market leaders or are getting involved in active cross-border mergers and acquisition (M&A) activity.

One of the biggest foodstuffs companies in Latin America, for example, was once a relatively small local seller of chickens. What was a $400 million market cap company in December 1997 is today a $16.4 billion market cap conglomerate providing chicken, beef and processed foods.10 Its rapidly increasing market share now extends beyond Brazil to include the rest of Latin America and the Middle East, capitalizing on the growing demand for protein and processed food in countries where consumers are experiencing rising per capita income.

Long-term consumption changes are underway in the emerging markets, and we advocate investors consider well-managed companies that can benefit from improving consumption patterns where they exist. In our view, some of the companies capable of delivering healthy earnings include select consumer staples and discretionary, telecommunications, certain industrials and prudently managed banks.


1 Past performance is no guarantee of future results.
2, 4 Bank of America – Merrill Lynch Survey, Global Research Estimate. Data as of December 31, 2010.
3, 5, 8 IMF 2010 Estimates. Data as of May 24, 2011.
6 Empirical Research Partners Analysis. Data as of June 2011.
7, 9 Emerging Consumer Survey, Credit Suisse Research Institute. Data as of January 2011.
10 Bloomberg. Data as of May 11, 2011.


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Jim Upton Meet the Author
James Upton is chief operating officer of the Morgan Stanley Investment Management Emerging Markets Equity team based in New York City.