Some risks of investing in emerging markets include political risks through unstable governments, economic risks through unregulated markets, inflation or deflation and labour issues, and currency risks. These risks greatly vary across markets as some sections have higher risks than others.
At the same time, much like advanced economies, emerging markets are moving towards developing more sustainable regulations and business practices which can help greatly reduce risk and provide the potential of solid returns for investors.
To help discover the gems of emerging markets, investors can use elements of bottom-up, fundamental analysis in assessing companies that could provide solid returns while mitigating risk. These elements include:
Finding a good corporate citizen
Companies who act as good corporate citizens are generally more sustainable investments.
Finding good corporate citizens includes looking for the companies that have business practices which positively influence the environment they exist in, as these are the companies that will thrive over the longer term.
As an example, we have identified a company based in India which, we believe, is a good corporate citizen through its buying and distribution of its consumer goods. This Indian company produces coconut oil. It sources one in every 10 of its coconuts from local smallholder farmers in India and then distributes the product to 58,000 rural villages (annual report 2016-17). The company helps fund local farmers and provides training programs on improving yields sustainably across their farms. Supporting farmers and local communities through its business model therefore makes this company a good corporate citizen and, in our opinion, ultimately, a good long-term investment.
It is companies like this that, we believe, help improve local conditions that investors in emerging markets should look out for, as these companies are helping lead the way to a more sustainable environment for emerging markets.
Long-term returns through business models with sustainable cash flows
Following on from this, businesses that are sustainable in their nature should generate sustainable cash flows and, in turn, generate sustainable returns for investors.
The Indian coconut oil company is a company that has been able to generate sustainable cash flows and profits and, in the process, has been able to nudge out multinational competition. The company sits in a large addressable market and has therefore been able to deliver sustainable and attractive growth. The company has produced annualised returns of around 24 per cent for the last 10 years (Bloomberg L.P. 2021) and it has done this through redeploying 60 per cent of its profits into expansion.
Not only is the company currently making profits, but it is reinvesting that profit to create more projects that will deliver future cash flows for the business. These future cash flows help drive valuations for investors.
A rapidly growing market
The growth of emerging markets companies is reflected in the market’s overall economic numbers. Emerging markets’ growth is now outpacing that of advanced economies, with advanced economies’ GDP expected to grow by 5.1 per cent for 2021 compared to 6.7 per cent for emerging markets (IMF, April 2021).
This growth in emerging markets is driven by expansion in various sectors, much like the well-placed Indian coconut oil company being a part of the growing coconut oil sector. However, finding these growing sectors is one thing; picking the right company to invest in within a particular sector is another.
The telecommunications sector in India is another growing sector with India consuming the most mobile data per capita of any country in the world (BloombergQuint 16 June 2020). Several years ago, Stewart Investors had identified the emergence of this trend and decided to invest in an Indian telecoms company. Yet, the company slumped to losses after a major competitor drove Indian data prices to become the cheapest in the world. The company didn’t have a business model that was resilient and sustainable enough to generate attractive shareholder returns. This was reflected in its share price – the share price halved and since 2018, has fallen by more than 80 per cent.
As investors, the lesson was that using bottom-up, fundamental analysis to pick companies that will perform better than others is key, as the Indian telecoms company lacked the necessary resilience and pricing power to generate solid returns from the underlying tailwinds of volume growth. This was an important reiteration of the need to focus on quality – the downside risk in equities is 100 per cent.
An industry that is similarly benefiting from strong and sustainable tailwinds of growth is IT services for digital transformation. Companies globally have started investing heavily into improving their own digital capabilities and interactions with customers and one of our holdings stands to benefit from these investments by both aiding these companies and improving their efficiency in design and execution. The company has involved designing digital patient engagement tools for healthcare providers, instant payment solution blueprints for financial institutions, and they remain well placed to continue benefiting from these tailwinds of growth. Bottom up; the company has built this strong business model through decades of investing in developing strong trust-based relationships with key clients, growing and nurturing their talented pool of engineers, and focusing on resilient free cash flow generation. Under the stewardship of their founder, they remain focused on executing well over the next decade too.
Finding sustainable investments within emerging markets can help mitigate risk and clear the noise. Assessing a company’s fundamentals through bottom-up research should provide good tools for investment. Companies who are good corporate citizens, with sustainable cash flows and tailwinds of growth behind them should place investors well in finding their emerging markets gems.
Jack Nelson is a portfolio manager at Stewart Investors Sustainable Funds Group.
