Biggest gains lie behind back door
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Investors hoping to benefit from emerging countries should look beyond obvious plays to the banks funding infrastructure investment and shipping companies transporting raw materials.
Conventional wisdom tells us that the biggest fortunes in the 19th century California gold-rush were not made by prospectors, but by those engaged in the more mundane activity of selling picks and shovels to the gold-diggers.
True or not, the point made by the story is a good one, and especially pertinent to investors looking to profit from the shift of economic power from the developed to the emerging world. The best returns might be found by looking beyond the obvious - what might be called "back-door" investing. The biggest winners from e-commerce have not necessarily been the companies with dotcom after their name, but the logistics businesses shipping online purchases from A to B.
Emerging economies are responsible for nearly three-quarters of global GDP growth and, while they continue to represent a relatively small share of the capitalisation of the world's equity markets, it is growing fast. From well under 10% of world markets in 1995, emerging markets account for 17% of the global total. Investors will need to tilt their portfolios towards the emerging world if they are to capture its expected growth, twice that of the developed world since 1990, according to the International Monetary Fund.
As recently as 1992, according to BNP Paribas, emerging economies shipped a quarter of their exports to America and next to nothing to China. Today they send more to China than America. Similarly, within the past three years, the proportion of exports from China to other emerging markets overtook that going to G7 countries. Meanwhile, exports from the eurozone have shifted decisively away from America, traditionally the region's biggest trading partner, to its emerging neighbours in the east. Four areas are beneficiaries of this unstoppable trend: infrastructure, agriculture, energy and consumer spending. In each of these, there is a way to play the theme and a range of less intuitive ones, which might offer better returns.
It is estimated that spending on infrastructure will treble in the 10 years from 2008. The obvious way of investing in that spending is via local equipment manufacturers or construction companies. But back-door investors could do well to explore less obvious plays: the banks funding the investment, the shipping companies transporting the raw materials and the miners digging the natural resources out of the ground. It is no coincidence that the Baltic Dry index, which measures the cost of chartering freight ships, rose more than five-fold between 2005 and 2008.
Shows the percentage of emerging economy exports to America and China, from 1992 to 2007.
Sources: EIU, EXANE, BNPP, IMFSome investors are choosing to play emerging market growth by investing in companies in developed markets that are positioned at a different point in the supply chain. This is to insulate themselves from perceived risks in emerging markets, although the widening spread between developed high yield bonds and the sovereign debt of emerging countries suggests it is time to re-assess this prejudice.
Upstream suppliers to emerging markets can be a better way to play the developing country growth story, although these days they are just as likely to be found in an emerging market as a developed one. An investor looking for exposure to the rapid growth of the Chinese construction industry a year ago could have invested in Angang Steel, a Chinese manufacturer, and ridden a share price rollercoaster back to where they started a year ago. Or they could have invested in Australian-quoted Mount Gibson Iron, which is exposed to the same macro trends but has seen its share price treble over the same period.
In the same way, playing the changing eating habits of Asia's developing markets does not have to mean speculating on soft commodity prices. As food prices soar, the seeds, fertilisers, pesticides and farm equipment that will make the world's farmland more productive are sounder investments. So too are the supermarkets where consumers will increasingly buy their more varied diet.
Asia's share of global soyabean consumption rose between 1990 and 2005 from 33% to 59%, and of meat from 21% to 33%. But some of the biggest beneficiaries of this trend are found on the periphery of the region or even on the other side of the world. Australia and Brazil account for 49% of world beef exports between them, while America and Canada have 40% of the world's wheat exports. A quarter of Tesco's sales are generated outside Britain.
A third way to tap into emerging market growth is through multi-nationals. Telefonica, a Spanish telecommunications company, generates 35% of its revenues in Latin American countries, such as Brazil, Mexico and Venezuela. More than half of Vodafone's revenue growth is expected to come from emerging markets and it is one of the top three mobile players in India.
Even when investing closer to the growth area concerned, there can be advantages in adopting a back-door approach. This is especially the case when investing in frontier markets that offer great growth potential but do not yet have the market depth or breadth international investors require.
Vietnam offers one of Asia's most potentially dynamic economies. But investors are playing safe by investing in the overseas companies that have doubled direct investment into the country in five years, rather than in its still relatively small stockmarket. Similarly, funds looking to tap into the potential growth in Africa are tending to approach the continent through its economic and political powerhouse, South Africa. Tackling Africa in this way gives them access to the continent's great growth potential but underpinned by South Africa's economic diversity, its relatively stable politics and one of the world's top 20 stock exchanges.
The message is that investors should consider how they might increase their exposure to the engine room of tomorrow's economic growth. How they end up doing so might surprise them.
