The list of reasons for being optimistic one merging markets just got longer. Now that Brazil and Russia are emerging from recession, growth is returning, with current account deficits in markedly better shape now than in 2013, when the Fed’s ‘taper tantrum’ caused consternation over those emerging economies with large deficits or dollar-denominated debt. As importantly, corporate earnings growth is on a much faster upward trajectory compared to developed markets. And while the developed world continues to experience negative, or compressed real interest rates, those of the emerging market world are positive, to the tune of 2-3%, allowing greater flexibility for monetary policy.
Consequently, macroeconomic winds are set fair for the foreseeable future. But, we would argue that the real test of a company is how it performs in a recession. Warren Buffet famously summed up the use of his economic moat analysis with the following quote. ‘The key to investing, ’he commented, is in ‘… determining the competitive advantage of any given company and above all, the durability of that advantage.’ In essence, the width of a company’s moat is driven by the ability to build high barriers to entry to keep marauding competitors at bay. Strong brands, patents, technology and cost leadership are some of those barriers. The best companies use tough economic times to broaden their moats and emerge even stronger.
COMPANIES WITH BROAD MOATS
As investors, we are constantly on the hunt for those companies with a broad moat. Brazil’s biggest car rental company, Localiza, is one such example with large economies of scale and high barriers to entry. By squeezing out the competition, through not raising its prices, it has not only ridden out Brazil’s savage recession, but is well-placed to benefit from an uptick in demand due to its operational gearing.
While other banks were making losses during the latest recession, Sber bank of Russia emerged relatively unscathed. With few legacy issues to address, better underwriting standards, and a cleaner loan book than its peers, profitability at the bank is well ahead of the competition.
The memory chip industry is a classic example of one that has undergone vast structural change over the years – for the better. Once deemed brutally competitive, with 20 or so players all vying for market share, the industry is now dominated by three streamlined corporations, two of which, Samsung Electronics and SK Hynix, we particularly favour. More rational management of supply, relative to demand, means that in the trough of the memory cycle margins should improve. Over the duration of the cycle, margins should be smoother, resulting in greater stability of cash flows.
IMPROVING CORPORATE EARNINGS GROWTH
And yet despite the fact that emerging markets continue to outperform their developed market counterparts, investors remain underweight the asset class. Reasons for doing so vary. They may have concluded that, given the rise in stock markets, the emerging market ship has already sailed. They may be scared by the ghosts of emerging market crises past – the devaluation of the rouble, Argentina’s default and, more recently, the political scandals in Venezuela and South Africa hitting the headlines. Political risk is ever present in emerging economies and has always been so. Investors should note that the real political surprises of late have come from the West – notably the election of President Donald Trump – together with an overarching distrust of ruling elites that led to the UK’s vote for Brexit.
But what investors might like to remember is that it is returns on capital and corporate earnings growth that drive markets in the long term. In this respect, expectations for growth in emerging market profits far outweighs those for much of the Western world, helped by a return to healthier economic conditions across most emerging markets and more stable currencies.
Given the abundance of tailwinds in the emerging world, in this vast universe there are many opportunities to find great companies at good prices, we believe. Isn’t it time to look at the real investment possibilities this asset class can offer?