A Case for Emerging Small Cap

Transcription

1 Introduction A Case for Emerging Small Cap The staggering growth of emerging market economies has led to a new dynamic in global consumerism. Increasing wealth and modernization across these markets is creating a new global middle class, which will likely become tomorrow s most important consumer base. Favorable long-term demographics, low productpenetration levels, and greater purchasing power all point to current and future growth in domestic demand. While emerging market equities are able to capture much of this economic expansion, traditional indices have a bias toward the natural resources sector and global exporters. In order to access this new middle class, investors must look beyond the more popular emerging market indices or global multinational corporations and consider smaller, more domestic-driven companies. Emerging markets small cap equity provides another option for investors looking to capitalize on the promising trends derived from a new consumer population. By Carolyn M. Kedersha, CFA, CPA Managing Director Senior Portfolio Manager November 2009 Any statements of opinion constitute only current opinions of The Boston Company Asset Management, LLC (TBCAM), which are subject to change and which TBCAM does not undertake to update. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. For Professional Investors Only

2 Demographics support long term secular growth Large industrialized markets do not fully reflect the long-term potential of global demand. Emerging markets are at the forefront of worldwide growth, with over 80% of the world s population advancing towards income parity with the developed world. This unprecedented phenomenon provides fertile ground to tap current and future consumer demand. (Please see Exhibits 1, 2 and 3.) Exhibit 1 Percentage of Global Population (2008) 18% 82% Less Developed More Developed Source: US Census Bureau. Exhibit 2 Composition of Global Population (%) Poor Middle Class Rich Source: World Bank 2

3 Exhibit 3 Population Distribution by Age 100% 90% 5% 6% 5% 6% 8% 6% 8% 13% 17% 80% 70% Percent of Population 60% 50% 40% 64% 65% 66% 67% 65% 67% 72% 67% 67% 30% 20% 31% 29% 29% 27% 27% 27% 10% 0% 20% 20% 15% India Mexico S outh Africa Turkey World Brazil China US EU Source: CIA World Factbook Several emerging economies have been investing in capital at a higher rate than many industrialized nations. While the investment rate (the rate of gross capital formation as a percent of GDP) of developed OECD member nations has remained somewhat stagnant for the past decade, those of China, India, and other developing economies have been trending upward and many have already exceeded the rates of the OECD members. This high rate of capital investment has begun to expedite modernization, from increased electricity generation to greater telephone access. These countries are likely to see a commensurate rise in key elements of a developed economy: a solid middle class and consumer-driven expansion. (Please see Exhibits 4 and 5.) Exhibit 4 Electricty Generation 2500 Terawatt hours (TWh) Brazil C hina India Indonesia Electricity generation growth is particularly high in China and India, with both countries expected to out-produce some of the largest developed economies by (India is expected to out-produce Japan, and China to out-produce the US.) Source: OECD Factbook 2009 The Boston Company Asset Management, LLC 3

4 Exhibit 5 China: Lifestyle Indicators Consumer expenditure on food (US$ million) 300, , , , ,607 Internet users ('000) 111, , , , ,253 New registrations of passenger cars ('000) 3,971 5,176 5,451 5,699 Consumer electronics (RMB million) 188, , , ,159 Dog and cat food (RMB million) 1,797 2,007 2,223 2,452 2,687 Cosmetics and toiletries (RMB million) 75,323 82,762 90,125 97, ,097 Soft drinks (RMB million) 160, , , , ,352 Source: World Income Distribution, Who Buys What, World Consumer Spending, World Consumer Lifestyles Databook. In fact, many companies around the world are already generating a sizeable proportion of organic revenue growth from emerging markets. From auto companies to agricultural exporters, the world sees emerging markets as essential to future growth and success. The demographics of these regions point to long-term consumption growth. Over the 15 years between 1990 and 2005, the poverty rates of developing countries (by developing country standards) dropped by 18.4%. (For an individual country and region breakdown, please see Exhibit 6.) At some point, emerging markets will be on par with the world s consumption powerhouses. China s middle class rose from 65.5 million in 2005 to 80 million in 2007, and Euromonitor estimates that number could rise to as much as 700 million by In addition, economic reform has created a surprisingly upwardly mobile middle class in India, a country with better age support than China. By 2025, India will surpass Germany as the world s fifth largest consumer market with a middle class surpassing half a billion people, ten times higher than today s figure. At the same time, average household income is also expected to triple. Exhibit 6 Percentage of Population Poor by Developing Country Standards Source: World Bank India East Asia and Pacific China

5 In Latin America, Brazil has recovered from a sluggish period of high inflation and falling household income to show remarkably stable economic growth accompanied by the emergence of a strong middle class. A populist president has provided support for low earners, and Brazil s consumer market should rise exponentially over the next decade on an absolute basis, far outpacing its neighbors. These trends will likely continue well into the future. World Bank forecasts suggest that the global middle and upper classes will have doubled in population between 2000 and Access to Emerging Markets through Multinationals Falls Short Since the demographics and economic trends suggest promising future growth in emerging markets, how can investors capitalize on this opportunity? Mainstream and conventional wisdom would propose a higher investment in multinational corporations; however, this is not a direct route to the benefits of a rising global middle class. Although multinational corporations have an extensive worldwide presence, their penetration in emerging markets does not fully capture the consumption trends in these countries. For example, Procter & Gamble, one of the world s largest consumer staples companies, derived only 30% of their fiscal 2008 sales from developing markets. Local companies are often more sensitive to culture, consumer tastes, and shopping behavior. They often compete admirably with more well known global competitors. The formation of a new middle class within these markets will boost demand for food, clothing, education, and other basic goods and services. We believe the most effective way to participate in this burgeoning opportunity is through a diversified portfolio, which includes a portion of emerging markets small cap equity. Emerging Markets Small Cap versus Traditional Emerging Markets The MSCI Emerging Markets Small Cap Index serves as a complement to the MSCI Emerging Markets Index in several ways. First of all, MSCI EMSC provides additional exposure to the Asia/Pacific region, which coincides with positive demographic and higher GDP growth trends in areas such as India and China. EMSC is also geared toward consumption growth through its heavier concentration in demand-driven sectors such as consumer discretionary, consumer staples, and industrials. (Please see Exhibits 7, 8 and 9.) The Boston Company Asset Management, LLC 5

6 Exhibit 7 Select Sector Exposure August 31, Consumer Discretionary Source: FactSet Consumer Staples Energy Financials Industrials Telecommunication Services MSCI EM MSCI EMSC Exhibit 8 Consumer Exposure: Consumer Discretionary + Consumer Stables + Industrials August 31, Consumer Exposure (%) Source: FactSet Taiwan China Korea India Brazil South Africa Total* Top Consumer Sector Related Countries *Total reflects all countries in the index MSCI EM MSCI EMSC

7 Exhibit 9 Regional Exposure, August 31, Region Exposure (%) Latin America Asia/Pacific Eastern Europe Middle East/Africa MSCI EM MSCI EMSC China (15.6%), India (11.2%) and Brazil (8.3%), along with Taiwan (18.9%), constitute 54% of the EMSC benchmark. Korea 14.1% and Russia a surprising 0.9% due to its economy s strong focus on energy and other natural resources. Source: FactSet Unlike in the MSCI EM Index, there is noticeably less exposure in MSCI EMSC to the commodities complex and export-driven companies. In fact, of the top thirty stocks in the MSCI EM Index by weight, there are no companies within the Consumer Discretionary or Consumer Staples sectors. At the same time, over one-third of the top 30 companies in the MSCI EMSC Index are composed of Consumer Discretionary or Consumer Staples stocks. (Please see Exhibit 10 for a comparison of the top 20 stocks in each index.) Furthermore, the opportunity set in the MSCI EMSC universe, which is composed of over 1,700 securities, is far greater than MSCI EM, which consists of less than half of the former, with 744 securities. In addition, many large cap emerging market bellwethers that populate the MSCI EM Index are more efficiently priced than smaller cap issues. Thus, the potential to deliver alpha through stock selection is somewhat greater in emerging markets small cap. The Boston Company Asset Management, LLC 7

8 Exhibit 10 MSCI Emerging Markets - Top 20 Stocks by Weight September 30, 2009 Security Name Sector Country Weight Petrobras Petroleo Brasileiro Energy Brazil 3.9 Samsung Electronics Information Technology Korea 2.6 Cia Vale do Rio Doce Materials Brazil 2.6 China Mobile Telecommunication Services Hong Kong 2.0 Gazprom Energy Russia 1.9 Taiwan Semiconductor Manufacturing Information Technology Taiwan 1.7 Teva Pharmaceutical Industries Health Care Israel 1.5 Itau Unibanco Banco Multiplo Financials Brazil 1.4 America Movil Telecommunication Services Mexico 1.4 China Construction Bank Financials China 1.2 Industrial & Commercial Bank of China Financials China 1.2 China Life Insurance Financials China 1.1 Hon Hai Precision Industry Information Technology Taiwan 1.1 Banco Bradesco Financials Brazil 1.0 Reliance Industries Materials India 1.0 Bank of China Financials China 1.0 POSCO Materials Korea 0.9 Lukoil Holdings Energy Russia 0.9 CNOOC Energy Hong Kong 0.8 PetroChina Energy China MSCI Emerging Markets Small Cap - Top 20 Stocks by Weight September 30, 2009 Security Name Sector Country Weight Lojas Renner Consumer Discretionary Brazil 0.5 Gafisa Consumer Discretionary Brazil 0.4 BR Malls Participacoes Financials Brazil 0.4 PDG Realty Consumer Discretionary Brazil 0.4 Spar Group Consumer Staples South Africa 0.4 Barloworld Industrials South Africa 0.4 Diagnosticos da America Health Care Brazil 0.3 Empresas ICA Industrials Mexico 0.3 Tongaat-Hulett Consumer Staples South Africa 0.3 LLX Logistica Industrials Brazil 0.3 Poly (Hong Kong) Investments Industrials Hong Kong 0.3 Corporacion Geo Consumer Discretionary Mexico 0.3 Sun International Consumer Discretionary South Africa 0.3 Duratex Industrials Brazil 0.3 Central European Media Consumer Discretionary Bermuda 0.3 Nampak Materials South Africa 0.3 Seoul Semiconductor Information Technology Korea 0.3 Adcock Ingram Health Care South Africa 0.3 Punj Lloyd Industrials India 0.3 Multiplan Empreendimentos Financials Brazil Source: FactSet 8

9 Diversification Benefits Correlation analysis suggests that an investor who seeks to diversify US large cap exposure would benefit from investing in the emerging markets small cap asset class. Over the past few years, US Large Cap returns and US Small Cap returns have become more correlated. Conversely, the correlation between the excess returns of the MSCI EMSC Index and Russell 1000, as well as the MSCI EMSC Index and Russell 2000, have considerably weakened. As a result, the diversification benefits of emerging markets small cap may exceed those of US small cap in portfolios with a sizeable domestic allocation. (Please see Exhibit 11.) Exhibit 11 Correlation of Excess Returns (against S&P/Citigroup Global BMI Index) US Large Cap & US Small Cap US Small Cap & EM Small Cap US Large Cap & EM Small Cap Dec-97 Jul-98 Feb-99 Sep-99 Apr-00 Nov-00 Jun-01 Jan-02 Aug-02 Mar-03 Oct-03 May-04 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08 Jan-09 Aug-09 Source: Zephyr Clearly geographic and currency exposure has a major influence on performance correlation. However, sector variation could also be causing this shift in asset class correlation. The following table (Exhibit 12) illustrates the difference between the Russell 1000 sector allocation when compared to both the Russell 2000 and MSCI EMSC. There is a much greater difference in the MSCI EMSC sector construction when measured against the Russell The Boston Company Asset Management, LLC 9

10 Exhibit 12 Absolute Variation of Sector Weights, September 30, 2009 Source: FactSet Russell 1000 vs. Russell 2000 Russell 1000 vs. MSCI EMSC MSCI EM vs. MSCI EMSC Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunication Services Utilities Total Variation Conclusion With a burgeoning middle class, pent up consumer demand, and young population, emerging markets appear unmatched in their prospective return on investment. In our view, smaller local companies provide more focused exposure to structural developments in the emerging market consumer. However, the market segment is inefficient and prone to periods of volatility that require an active, stock-selection-based investment strategy. We believe this approach will navigate the everchanging investment landscape and capture the promise of emerging markets greater role as a global consumer. 10

11 Author Biography Carolyn M. Kedersha, CFA, CPA Managing Director Carolyn serves as a Senior Portfolio Manager on The Boston Company s Non-US Value Equity Team where she conducts research on Latin American and emerging markets small cap companies. Prior to joining The Boston Company, Carolyn worked for Kelso Management (an affiliate of Fidelity International). Previously, she was a consultant to the Center for International Financial Analysis and Research and spent several years as an Auditor with Price Waterhouse & Co. Carolyn received a BA in Accounting from George Washington University and an MBA with a concentration in Finance from Rutgers University. She holds the Chartered Financial Analyst designation and is a Certified Public Accountant. The Boston Company Asset Management, LLC 11

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