As the growth drivers shift and emerging countries become less vulnerable to macro sensitivities, individual companies will matter more than countries.
- Emerging markets have undergone a tremendous change and investors should rethink how they approach the asset class. Next generation growth drivers, such as rising domestic consumption, leapfrogging technologies, and expanding economic formalization not only play a crucial role in reshaping emerging market economies, but also in the available underlying investment opportunities and where to find them.
- As the growth drivers shift and emerging countries become less vulnerable to macro sensitivities, top-down country approaches should provide less opportunity and will be challenged going forward. Through our research, there is already evidence that the returns between the best and worst performing countries have narrowed considerably over the past five years. Casting a wide net and focusing on top-down driven country allocations may not be as rewarding going forward.
- In contrast, the dispersion between the best versus worst performing companies has not only increased, but where you find these successful companies has also changed. Strong performing companies are less concentrated in a particular region or country, and instead are scattered across a wide variety of countries and sectors. We believe managers who have a bottom-up, security selection approach are best suited to discriminate between productive and unproductive investments and can sufficiently deliver attractive excess returns to investors.
Over the past couple of decades, the transformation of emerging markets has been remarkable. Influenced by major geopolitical, economic, and demographic changes unique to each country, emerging markets as a whole are not homogenous, but instead encapsulate a broad range of countries, each with their own currencies, political systems, and financial policies. Given the high degree of economic diversity and range of developmental trajectories within each emerging country, many managers have approached this asset class with a top-down, country-level approach. The belief is that making successful country allocation decisions can be enough to overcome the deficiencies from the lack of strong securities selection.
At Thornburg, we believe emerging market opportunities are best assessed through a high conviction, fundamentally built portfolio that targets the strongest companies across the asset class, regardless of where they call home. As emerging countries continue to mature, we believe the case for a focused bottom-up investment approach is stronger than ever.
In this paper, we investigate key factors to consider when investing in this asset class.
- What are the next-generation emerging market growth drivers?
- How has the divergence of country-level performance changed and what are the implications for managers focusing on top-down alpha generation?
- Will a bottom-up, security selection focused approach be sufficient to deliver the excess returns investors are looking for?
New forces reshaping the EM landscape
The picture for the emerging market landscape has changed dramatically in recent years. While commodities extraction and dependence on net exports were key factors driving emerging market growth historically, new forces are surfacing and reshaping the emerging market growth story. This is most evident from the stark shift in sector prominence within the MSCI Emerging Market Index between 2009 and 2021. As seen in Figure 1, materials and energy companies made up almost a third of the index in 2009, but have experienced a significant decline over the past decade. Meanwhile, over the same time period, the consumer discretionary and technology sectors have increased their prominence, doubling their combined weight from 19% to 39% in the MSCI Emerging Market Index.
Figure 1: Developing country economies are rapidly modernizing
Source: MSCI Barra and FactSet
There are several forces coming together that are driving this tectonic change. First, over the past decade more than a billion people in developing countries have entered the middle class, and hundreds of millions more will join their ranks over the coming years. Overall healthier demographics and rising income levels of the growing middle class have created durable, persistent demand for goods and services that will further support the “new economy” growth model led by domestic consumption.
Spurred by these shifts, a rapid expansion of innovation is allowing emerging market economies to leapfrog outdated technologies, often to the leading-edge, bypassing many of the intermediary steps of technological development. As one example, a global proliferation of smart phones has enabled mobile banking solutions, easing the need for branch banking and significantly reducing customer acquisition costs. The resulting “FinTech revolution” is enabling increased financial inclusion for a previously unbanked class of emerging consumers. Whether in FinTech, or other areas like transportation, manufacturing, healthcare and clean energy, technological leapfrogging is substantially improving the quality of bottom-up investment opportunities across emerging markets.
While the landscape is improving, a rising tide has not lifted all boats. As an example, we also see a growing bifurcation of the investment universe, where there is still a prevalence of “old economy” companies (e.g., state-owned banks, utilities, commodities and cheap manufacturers) mixing in with these innovative leaders striving to meet the new economy needs. Thus, it is increasingly important for managers to take a more nuanced approach in order to select companies that can benefit from these “next generation of growth drivers”.
As growth drivers shift, top-down country calls may provide less opportunity
The shift from “old economy” towards the “next generation growth drivers” is well underway. We believe that the increase in domestic consumption, coupled with the leapfrogging of legacy technologies, are driving factors that have led emerging countries to become more economically diversified and more stable than before. As a result, emerging countries are less tied to macro factors like global trade and fixed asset investment, which have historically driven emerging market volatility and contributed to large dispersions of returns among countries. As a result, emerging markets are less volatile today than in the past, and the spread of country-level performance across individual emerging markets has decreased dramatically.
As illustrated in Figure 2 we looked at the annual performance of each country in both the developed and emerging market regions, organized the country performance by quartiles, and calculated the spread between the top quartile versus the bottom quartile performers. We found that since 2003, the performance spread between the best and worst performing countries in the MSCI Emerging Market Index has narrowed considerably. In the early 2000s, the average annual return spread between the best and worst performing countries was 77%, making top-down country allocation decisions a seemingly compelling endeavor with big payoffs. However, over the last five years, the performance edge obtained by allocating towards the expected best performing countries versus the worst has eroded significantly to only 43%. As a comparison, we also investigated the country-level performance for developed markets and have found that the return spread between the best versus worst developed countries has remained more relatively stable.
Figure 2: Looking only at countries, top versus bottom-quartile EM return spread is eroding
Small segment of EM companies has disproportionately driven returns
Based on the country-level performance trends we’re seeing; investors may be tempted to conclude the transformative shifts in the emerging market space have improved market efficiencies to the point that it is much harder to generate alpha. This is not the case. In our view, we believe the most attractive alpha opportunities are best uncovered on a company-by-company basis versus on a regional or country level. The transitional nature of emerging markets has meant that there is more opportunity for truly elite companies to provide excess returns for investors. Emerging market equity managers need to take extra care in differentiating between the “old economy” laggards versus the “new economy” growth opportunities, which only active investment managers are capable of.
The evidence is clear, the divergence between the company-level winners and losers in the emerging market space has grown substantially over the past decade, both in absolute terms and relative to developed markets. In Figure 3, we begin our exercise by analyzing the contribution to returns of all the holdings in both the MSCI Emerging Market Index, as well as the MSCI World Index. We organize the holdings into quartiles based on the most contributive to the least contributive to total index returns. The best performing emerging market companies in the first-quartile group have contributed to 221% of the index returns over the last decade, while the worst performing bottom-quartile companies have detracted from the index by 114%. Within developed markets, the deviation between the top and bottom performers has been much more modest.
Figure 3: Getting stock selection right is critical in emerging markets
Taking a deeper dive and comparing the top-quartile performers in both the MSCI Emerging Market Index and MSCI World Index, we see in Figure 4 that the average return premium for the top quartile performers in emerging markets has been greater than in the developed region. More specifically, over the past five years, from 2016 to 2020, the return differential between emerging vs. developing markets top performers has widened to 14% in favor of emerging companies, compared to only 8% from 2011 to 2015. We also see similar trends when observing how the bottom-quartile companies performed in both regions. As seen in Figure 5, bottom-quartile companies in the emerging market space underperformed more than the bottom-quartile companies in developed markets.
Figure 4: Return differential of emerging vs. developed best performers
The performance data quoted represents past performance; it does not guarantee future results.
Figure 5: Return differentials of emerging vs. developed worst performers
The performance data quoted represents past performance; it does not guarantee future results.
It is worthwhile to re-emphasize that the spreads between the best and worst companies have persistently been widening, while the spread at the country-level performance has been narrowing. This underscores the importance of getting stock selection right in the emerging markets space, and we believe that deep research on company fundamentals should serve as the bedrock of investment decisions, especially in this space. Furthermore, we suspect it will be much more difficult for a top-down manager to discriminate between the individual winners versus losers, because these best performing names have been scattered across a broad range of countries and sectors. As an example, the top 100 best performing emerging market companies over the past decade were found across 14 different emerging countries and all 11 GICS sectors. A strong, bottom-up fundamental process will be best positioned to uncover the prime opportunities.
In summary, there is abundant evidence that multiple forces are reshaping the emerging market landscape. These include next-generation growth drivers, such as rising income levels of the middle class, leapfrog technologies, and increased economic formalization, which will give birth to additional investment opportunities in this space. Furthermore, given the level of transformation we expect to transpire in this asset class, we believe emerging country-level performance patterns will also be greatly affected. Emerging country returns are becoming susceptible to macro-level sensitivities and there will be less volatility and dispersion of returns among countries. Based on our research, this trend has already played out over the past few years where the spreads between the best and worst companies have persistently been widening, while the performance spread among countries has been narrowing. We feel this trend will continue to challenge top-down macro and passive managers, reinforcing the need to focus on selecting the best companies, which is best executed through a fundamentally driven, bottom-up approach.