Tuesday, January 10, 2012

Grantham, Mayo, Van Otterloo: "Capturing Domestic Demand in Emerging Markets...

...Neither Small Caps Nor Multinationals Are a Good Proxy"

From GMO:
We believe one of the most compelling investment opportunities over the next few years is likely to be in companies that serve domestic demand within emerging markets. Our case rests on two underlying and interconnected forces – one economic and the other demographic. As poor countries get richer, they save as much as they can. Savings rates usually rise until countries reach a range of $3,000 to $10,000 per capita GDP. Once in that range, savings rates begin to decline and consumption becomes a larger part of GDP growth as society starts to provide a social safety net. At this level of wealth, per capita consumption of all goods and services rises in a highly non-linear fashion.

For example, while Chinese per capita GDP quadrupled from $1,000 to $4,000 during the past decade, auto sales rose from one million vehicles per year to over 17 million. Markets rarely anticipate this kind of non-linear growth. Fifty percent of all emerging markets (by market capitalization) are now in this sweet spot of shifting from savings to consumption.

Further strengthening the economic case is a shift in demographics: a record number of people are coming into their earning years in emerging markets at the same time that baby boomers are starting to retire in the developed world. As a result, we believe that the world is in the midst of a massive shift in demand from the developed world to emerging markets. As this domestic demand play gains momentum, we hear increasingly that the best way to capture this theme is to buy small cap emerging stocks. We believe, however, that this is a mistake and that focusing on companies that specifi cally serve domestic demand is a more effective way to exploit the opportunity. Besides, why buy a proxy when you can buy the real thing?

First, let’s look at the core of this argument. Favoring small cap stocks rests on the presumption that large cap emerging market stocks represent export and globally-oriented businesses. As a result, removing these large cap names from the investable universe would leave a collection of companies that are focused primarily on domestic demand. The fi rst part of this contention is true, the second is not. Large caps are geared highly to global demand. However, the small cap universe alone does not represent a pure play on domestic demand and, in fact, is as exposed to globally-sensitive sectors as the large cap universe. If one divides all emerging market companies into those that are domestically-oriented (Financials, Consumer Discretionary, Consumer Staples, Health Care, Telecoms, and Utilities) and those that are globally-sensitive (Energy, Materials, Technology, and most Industrials), globally-sensitive sectors are almost as highly represented in aggregate in the small cap universe as they are in the broad emerging markets universe. The sector weights of the Emerging Broad and Emerging Small Cap universes are shown in Exhibit 1. In fact, globallysensitive sectors represent 45% of the small cap universe vs. 47% for the broad universe as of September, 2011.

If one were to construct a universe of domestic companies (handpicked on a company-by-company basis based on who their ultimate customers are rather than market capitalization), one would see that it is nothing like the small cap universe. Exhibit 2 shows sector weights of this true domestic demand universe alongside those of the small cap universe. We can see that the domestic demand universe has a far lower exposure to globally-sensitive sectors than does the small cap universe. In fact, even the companies represented within globally-sensitive sectors of the domestic demand universe are those that specifi cally serve domestic demand (e.g., technology companies whose business is primarily within emerging markets) rather than those that export to developed countries. An example of such a company is Kingdee International, which provides Chinese language ERP software and services and competes with the likes of SAP for small- and mediumsize businesses in China.

One might raise an eyebrow when noting that financials are such a large part of this domestic demand universe. This concern, however, is somewhat misplaced. Most emerging market financials are an extremely good play on demand growth because they provide the credit that is essential to the rapid growth of these economies. Second, most emerging market financials sectors are underleveraged and have extremely strong balance sheets....MORE (3page PDF)