A Hitchhiker’s Guide to emerging markets

by Terry Smith | Aug 01, 2014
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In my last column for FT Money* I tried to get to the bottom of why so many investors have had such a bad experience pursuing the superior economic growth in emerging markets. This begs a further question: is there a better way to invest in the developing world?

Growth is often achieved only at the expense of returns on capital and so does not create any value for shareholders. This problem is sometimes ignored by investors hungry for growth, particularly so in emerging markets where superior growth rates are such a significant part of the rationale for investment.

When a company makes an inadequate return on capital – which I will define as one below its cost of capital – it destroys value. Far from growing and employing more of their capital, shareholders should want such a business to shrink its operations and return any cash liberated as a result.

So where can you find companies with consistently high returns on capital and which are capable of profitable growth?

One of the clearest trends after the second world war has been the rise of the middle class or consumers. In emerging markets there are various definitions of what constitutes this class, but one of the commonly accepted cut-off points is around $10 per day in disposable income. Below this level, individuals cannot afford to be consumers. Their life is one of subsistence.

As their income grows, they start to want convenience, even if it is initially only in the form of instant noodles – the reason for their increasing prosperity is often that they have a job in a factory or call-centre for the first time and cannot spend as much of their time sourcing and preparing food. In short, they become consumers.

Out of a world population of 2.5bn in 1950, probably only some 300m were consumers by this definition. By 2010 this had become 2.4bn out of a total population of 6.8bn. Extrapolation is a dangerous forecasting technique but by 2025 it is estimated (by Groningen University, the Brookings Institute and McKinsey) that out of an estimated world population of 7.9bn, 4.2bn will be consumers. More importantly, it is expected that the growth rate in consumption in emerging markets will be more than three times that in the developed world.

The ranks of the middle-class consumer are expected to be swelled by 1bn between 2010 and 2020. On the chart shown, it is sobering to note that the UK, and indeed the whole of Europe, is included in the small box in the top right hand corner labelled “all other”.
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It reminds me of the moment when Arthur Dent, protagonist of Douglas Adams’ The Hitchhiker’s Guide to the Galaxy, discovers that the entry for Earth in the Guide consists in its entirety of the word “harmless”. His friend Ford Prefect, a contributor to the Guide, tells him that the next edition will contain an updated entry on Earth that Ford has been researching. It will read: “mostly harmless”.

What Arthur Dent is forced to come to terms with is that his home planet is not particularly significant in cosmic terms. Similarly, as investors, we would do well to realise that our home market, the one with which we are most familiar, is not that important.

This is certainly so in terms of growth in consumer spending. A strategy that relied solely on such growth in the developed world would at best be forgoing better opportunities elsewhere – which is exactly why so many multinationals in consumer sectors are focused on growing their business in emerging markets.

Ally this to the consistent high returns on capital that many consumer companies are able to sustain and you have an investment strategy with the potential for superior returns. Consumer staples companies generate those returns as their combination of brands, pricing power, distribution and control of their supply chain helps fend off competition.

A strategy of investing in consumer staples companies with the bulk of their operations in developing markets has substantially outperformed the other emerging markets investment strategies that I reviewed in my previous article, over the past five to 10 years. Of course, the past is an imperfect guide to the future but it would be unwise to ignore the rapid and predictable growth in consumption of everyday necessities and luxuries when considering investment in emerging markets.

* Why buy Brics when you can have Mugs?, FT Money, April 12 2014.

Terry Smith is chief executive of Fundsmith
Click here to view the article on FT.com