Emerging markets will arguably be the growth engine of the future. Many factors favour that view; after all these nations seem to exhibit the right components of sustainable economic prosperity such as double digit growth rates, exploding populations and in some cases vast natural resources. Many fund managers at a recent Reuters financial conference considered emerging markets as a top investment region for next year, citing double digit returns. Emerging markets continue to lure investors in mature economies, reaping a notable 40% increase in foreign direct Investment over the last decade. Portfolio investments are expected to top US$186 billion this year, triple the $62 billion annual average of five years ago. Even after accounting for a noticeable drop in the last two years due to the 2008 financial crisis, the flow of funds is still monumental.
Nonetheless, looking at the picture from another angle, it seems like investors are being carried away to a new “Eldorado.” Although there is no doubt about the growth story and the impressive run over the last few years, there is some excess euphoria. Emerging market stocks have been bid up and analysts are wary that some stocks have reached bubble territory. For value investors in particular, there is an increasing challenge to gauge the intrinsic value of these securities as the tremendous inflow of capital has inflated asset prices to unsustainable levels, risking a repeat of the emerging market crisis of the mid-1990s. But it is important to underline that it is not yet time to pull the alarm; rather it is better to analyze emerging markets from a lateral perspective in order to capture the best they have to offer.
Astute long term investors are aware that global markets are now more interconnected than ever before. Moreover, developed and developing economies cannot co-exist without each other. One consequence of this interconnectivity is that an increasing number of corporations are deriving their revenues from the faster growing emerging markets. It is estimated that currently 25% of sales within the U.S.’s S&P 500 come from emerging markets and that number is expected to grow. More importantly, large multinationals such as Caterpillar and Coca Cola have as much as 50% of their revenue exposed to emerging markets. Household names such as KFC, McDonald’s and Starbucks have seen their emerging markets sales explode in the last few years.
From an investment standpoint these developed market stocks benefit from global growth and are cheaper on a price to earnings metric, especially with the recent market pullback. They also tend to have lower volatility and are more liquid than those in emerging markets. For example, the total market cap of consumer companies in emerging markets is around $500 billion. This compares to the $4.7 trillion market cap for consumer corporations based in the developed world. Therefore a great way of playing emerging markets is to get the best of both worlds by investing in companies with strong franchises in developed markets that are also expanding into emerging markets.