By the Columbia Acorn Emerging Market Team
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Emerging markets have become a significant component of the global economy, with higher GDP growth rates compared to developed markets.
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The wide range of local conditions and growth drivers present in emerging markets makes them particularly interesting as a diversifier for investors already exposed to developed markets.
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We believe that, for true diversification, investors should consider small-mid cap emerging markets investments.
The rising importance of emerging markets is a defining factor of the modern global economy. As of 2013, the International Monetary Fund (IMF) estimated they represented 45% of the global economy. During this century, emerging market gross domestic product (GDP) growth rates have been higher than those in developed markets. The IMF projects that higher GDP growth in emerging markets will likely continue in 2014. Driven by South Asia and Africa, emerging markets’ population growth is also likely to outstrip that of developed countries for years to come.
It’s important to remember that higher GDP growth does not necessarily translate into better profit growth or total returns. Indeed, there have been cases in emerging markets where total returns were negative even amid high GDP growth, while other emerging markets with low GDP growth rates delivered relatively high total returns.
Even if we don’t know whether higher GDP growth translates into profit growth, it’s important to recognize that growth drivers in emerging markets are different. Emerging market growth drivers derive from local conditions, they can differ greatly from country to country, and some of the drivers are unique to single countries. We believe this makes emerging markets particularly interesting as a diversifier for investors already exposed to developed markets.
The problem with a large-cap approach to emerging markets
Investors have recognized the potential for some time, but the most common investment approach focuses on the largest companies domiciled in emerging market countries. The problem is that many of the largest companies are technology and commodity companies driven by global macro factors. These global factors are already well-represented in developed markets.
For example, the largest constituent of the MSCI Emerging Markets Index is Samsung, as of June 2013. While Samsung is based in Korea, the company is basically driven by developed market trends in mobile telephony and electronics. It is driven by the same factors that drive developed market stocks like Apple. Korean conditions are relatively unimportant as a growth driver for Samsung.
Many of the largest companies in emerging markets are also state-owned or recently privatized and/or rely on financing from state entities for their operations. For example, more than two-thirds of the top 100 Chinese companies listed in Hong Kong and in China by market cap are state-owned. Often these state-owned companies serve as an arm of government policy and may not be oriented toward shareholders’ best interests.
The case for small-mid cap investing
We believe smaller companies can be a better way to capture the growth and diversification potential originating from emerging markets’ local drivers. As emerging markets’ economies grow, their rising entrepreneurs create and eventually list new companies, greatly expanding the investment opportunity set.
These new but smaller companies can capture a more truly local dynamic, such as traffic on a Chinese toll road, paint consumption in India, Brazilian rental car usage or South African demand for property insurance. In many cases, they compete with less nimble, state-controlled enterprises or enjoy favorable pricing dynamics associated with high barriers to market entry.
Smaller companies also have more exposure to local currency cash flows, which can provide an additional element of diversification. This creates two big advantages: (1) These kinds of companies can better isolate the dynamism of local growth while having (2) less exposure to global factors that likely will correlate with investors’ developed market holdings. As such, they present a powerful opportunity for investors seeking portfolio diversification.
For an extended analysis, read the white paper: Emerging market investing: Looking for true diversification
See more Market Insights from Columbia Management.
The securities listed are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable.
Diversification does not assure a profit or protect against loss.
Investments in foreign securities involve certain risks not associated with investments in U.S. companies due to political, regulatory, economic, social and other conditions or events occurring in the country, as well as fluctuations in currency and the risks associated with less developed custody and settlement practices. Risks are particularly significant in emerging markets. Investments in small-capitalization companies involve greater risks and volatility than investments in larger, more established companies.