Limiting the risk of investing in emerging markets

Many developed-market companies find emerging markets attractive because of their strong economic growth, favourable demographics, rising middle class, increasing domestic consumption and growing adoption of technology. The International Monetary Fund forecasts that emerging-market economies, which currently account for 75% of global gross domestic product (GDP) will grow by 4.9% in 2018 compared with 2.5% for developed-market economies; by 2020, emerging markets will be growing more than twice as fast as developed markets, at 5.1% vs 1.7%, respectively.

Indeed, developed-market companies are experiencing slower growth in their home markets and see the potential “for double-digit growth rates over multiple years” in emerging markets, says Matthew Strauss, vice president and portfolio manager with CI Investments Inc. in Toronto. In addition, the population of emerging markets is almost 90% of the world’s population, providing an immense market for expansion.

The amount of emerging-market exposure investors could get by investing in equities of developed-market companies depends on the proportion of the companies’ profits that are derived from emerging markets and by how much such profits contribute to their growth.

Developed-market companies included in the MSCI world index derived 21% of their revenue, on average, from emerging markets, according to a 2014 MSCI Inc. report entitled Economic Exposure in Global Investing. North American companies on the index — such as Exxon Mobil Corp., Amazon.com Inc., Apple Inc., Microsoft Corp., Facebook Inc., JP Morgan Chase & Co., and Johnson & Johnson — derived 16% of their revenue, on average, from emerging markets. And European companies — such as Nestle SA, Novartis International AG, Roche Holdings AG, HSBC Holdings PLC and Royal Dutch Shell PLC — earned 27% of their revenue from emerging markets.

Many companies — such as Netherlands-based Airbus Group NV, U.S.-based Colgate Palmolive Co., Germany-based Henkel AG, U.S.-based Mondelez International Inc., Switzerland-based Nestle and Netherlands-based Unilever NV — have a much higher revenue exposure to emerging markets than the average, in the range of 40%-60%.

“Some multinational corporations are more successful than others,” says Christine Tan, associate vice president and portfolio manager with Sun Life Global Investments (Canada) Inc. in Toronto. This is especially the case for Unilever and Colgate Palmolive, consumer goods companies that have decades of experience in emerging markets and are leaders in their respective space in markets such as India and Latin America.

The MSCI report notes that although “some companies may have high international revenue exposures, their revenue might be concentrated in a handful of countries.” For example, U.S.-based consumer discretionary company Yum! Brands Inc. had 77% revenue exposure to international markets in 2014, but 53% of its revenue was derived from China alone, exposing Yum! to the peculiarities of a single market. But many multinationals have exposure to a range of different countries and are consequently not subject to country specific risks.

From a client’s standpoint, investing in these companies just for the sake of getting exposure to emerging markets, may result in missing out on opportunities that direct plays in emerging markets offer. But while developed-market companies might be less volatile, “investors will miss out on the extra tailwind” they can get from investing directly in emerging-market equities, says Arup Datta, senior vice president and head of Mackenzie Investments global quantitative equity team in Boston.

Although emerging-market equities can be volatile, their long-term growth generally is higher than developed-market equities, says Tan, making these stocks a better direct investment.

In addition, some developed-market multinationals have had a successful track record in growing their revenue and profitability in emerging markets, others have found it more challenging, reducing their growth potential.

In some ways, that’s because local companies are beginning to compete head-on with multinationals, Tan says, forcing them to add local content or to partner with domestic companies to gain market share.

For example, companies such as McDonald’s Corp., Starbucks Corp. and Yum!-owned KFC have had to either partner with local companies or change their menu options to adapt to local conditions or to compete with domestic companies, she says.

Thus, it’s no longer smooth sailing for multinationals as emerging markets mature, especially in regions such as Asia, “where there is little opportunity for growth left,” Tan contends.

Clients must recognize that multinationals’ spending in emerging markets actually can result in losses and, therefore, might not be good investments in lieu of emerging-market exposure, Strauss says. Conversely, successful emerging-market companies may reinvest their profits in those regions to support their expansion.

Strauss cautions that investing in developed-market multinationals to get emerging-market exposure in a world that was moving toward globalization was less a risk than in the current environment, in which trade protectionism is more prevalent. Consequently, it might be better to invest in emerging-market companies based locally to get exposure to emerging markets.

At the other end of the spectrum, the risks and inefficiencies inherent in emerging markets will remain, making developed-market multinationals safer bets, with less volatility, says Datta. But it all comes down to the unique risk profile of clients, who must find a balance between investing directly in emerging-market equities and investing in developed-market multinationals to gain indirect exposure to emerging markets.