Why invest in emerging markets? The reasons are well understood by now. Rising living standards are driving demand for goods and services, leading to compelling investment opportunities across countries and sectors.
How can we invest in emerging markets? That is the tougher question. We have seen significant changes in the investment landscape since we started managing the world’s first emerging market equity fund almost 30 years ago, and we believe it is time for a rethink in a number of areas.
Look beyond mega caps for growth
Mega caps in developing markets are often held up as emblems of the economies’ striking growth. However, it is the smaller companies that have historically delivered superior returns (Figure 1). Investors who seek smaller companies most exposed to rising living standards are likely to uncover better opportunities.
Figure 1: The largest companies have trailed in producing returns
Annualised returns of MSCI EM IMI by market capitalisation in quartiles
Data from 31 December 2003 to 30 June 2014. Based on MSCI Emerging Markets Investable Market Index using index weighted returns. Returns in USD, rebalanced monthly. Source: FactSet, MSCI, Capital Group.
Dividends matter more than they seem
Investors typically associate emerging market growth with capital appreciation, but dividends also make up an important part of total returns. Importantly, companies that consistently pay dividends at above-median yields have generated the best risk-adjusted returns within the emerging market equity universe (Figure 2). Steady dividend-payers often have strong and competitive business models that can generate sustainable earnings and cash flows over time.
Figure 2: Consistent dividend payers have had higher returns with lower volatility
Focus on economic exposure
Investors tend to assume that companies based in emerging markets benefit the most from demand growth in the developing world. However, that is not always the case. In sectors like healthcare and branded consumer products, a large part of the growth is often captured by companies based in developed markets. Investors should focus on where companies earn their revenues, and not where they are based. Taking a domicile-neutral approach widens the opportunity set for investors significantly.
Achieve multiple objectives with fixed income
Fixed income is not just for reducing risk, especially in the developing world. The emerging market debt universe has grown swiftly in breadth and depth. Some subsets help to manage portfolio volatility, but others offer meaningful returns that are equity-like. At times, bonds are the only way to gain access to an investment opportunity, and this applies in parts of Latin America where equity markets are less developed. With emerging market debt, investors are able to pursue various objectives, from risk reduction to return generation.
There are ways to manage volatility
Emerging markets are often associated with volatility, and emerging market stocks have experienced several periods of sharp decline over the last two decades. However, investing across the entire universe of emerging market securities, including bonds and currencies, can create diversification. When we consider the meaningful returns that some emerging market bonds can deliver, combining them with equities potentially leads to equity-like returns with lower volatility.
Reconsider your investment strategy
With these observations in mind, how can one invest in emerging markets?
Investors targeting capital appreciation should seek companies that have the most attractive exposures to rising living standards, whether they are based in emerging markets or developed markets. Investors should also look beyond mega caps to consider smaller companies that are better positioned to capture growth.
Investors searching for income should recognise the yield opportunities that exist in emerging economies, whether in equity or fixed income.
For investors who emphasise capital preservation, having the flexibility to invest across the full spectrum of emerging market securities can help generate a smoother pattern of returns.
Investing in the developing world requires a new mindset, and we encourage investors to start exploring the new ways of doing so.
