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Phil D'Iorio / August 26, 2021

The Allure of Emerging Markets

Our global research team has a positive view on emerging markets. Emerging markets make up more than 80% of the world’s population and they generate approximately 60% of the world’s Gross Domestic Product. Emerging markets are appealing to many investors because of their attributes, which include large populations, young demographics, and a rapidly expanding middle class.

Among the various emerging market regions, our team prefers Asia given the opportunities across several countries throughout the continent. China is especially interesting given its large population and the long-term factors that will fuel the growth of its economy. These factors include the rise of the urban middle class, increasing domestic consumption, and the growth of the services economy.

Investing in China has been popular for a long time and there are different ways for an investor to get exposure to China. Some investors prefer to get local exposure by investing in domestically listed companies in China and Hong Kong. This can be accomplished by investing directly in the region or by investing in an American Depositary Receipt (ADR), which are listed on various stock exchanges in the United States. The rationale for investing directly is to get pure play exposure. Other investors prefer to get their exposure by investing in developed market companies that happen to have strong footprints in China. We have consistently leaned towards the latter strategy given that we have a higher comfort level in the accounting and the rule of law for companies headquartered in the developed world.

It has been a difficult period for investors who prefer pure play exposure. Goldman Sachs recently identified a basket of China American Depositary Receipts that has declined by 55% since the middle of February. One of the key reasons for the large decline is related to Chinese regulators who have targeted certain industries, with technology at the forefront. Last November, Chinese regulators blocked the initial public offering of Ant Group. Ant is a sister company of Alibaba, the e-commerce colossus whose founders include billionaire Jack Ma. Since reaching an all-time high last November, shares of Alibaba have fallen by approximately 50%. Internet giant Tencent has seen its shares fall by approximately 40% over the same period on the back of this regulatory fallout. Another example of regulatory interference can be seen with a company called Didi, which is China’s answer to Uber and Lyft. On June 30th, Didi completed an initial public offering that valued the company at $67 billion, only to have Chinese regulators respond fiercely. Didi was ordered to remove its apps from mobile stores and the company is now being subjected to a cybersecurity review. Didi’s shares have fallen by approximately 50% since July.

The regulatory risks in China extend beyond the Technology industry as seen by recent developments in the education sector. In the month of July, China announced sweeping new rules for private tutoring. These new rules created a significant business impact for private education firms as Beijing stepped up regulatory oversight of the industry. Shares of New Oriental Education & Technology Group and TAL Education Group have each fallen by approximately 90% since the new rules were announced last month.

As previously mentioned, we prefer to get our exposure to China through developed market companies that happen to have strong footprints in China. Examples include Estée Lauder and Nike. A brief description of each company follows.

Estée Lauder has a market leading position in the global prestige beauty industry. Prestige beauty is a large and fast-growing industry in China and it includes skincare, make-up, fragrances, and hair care. According to the NPD Group (a leading global information company), China’s prestige beauty e-commerce sales reached $5.4 billion through the first half of 2021. This represents a 47% increase over the same period last year. Estée Lauder first established a presence in Hong Kong in 1961. Today the company employs more than 17,000 people in the Asia Pacific region and it operates more than 400 freestanding stores and thousands of points of sale. For fiscal year 2021, the Asia Pacific region accounted for approximately $5.5 billion in revenue for Estée Lauder or about 34% of the company’s total revenue. Although the company generates a substantial portion of its sales from Asia, it is headquartered in the United States.

Nike has a market leading position in the global athletic footwear and apparel industry. Nike has an exciting opportunity in China given that the government recently announced an ambitious plan to make sports into a $773 billion industry by 2025, a 70% increase from 2019. This announcement falls on the back of China’s success at the Tokyo Olympics where it won a total of 88 medals including 38 gold medals. Nike has operated in China for more than 35 years and the company employs more than 8,000 people directly in its Shanghai headquarters and Taicang Distribution Center. In fiscal year 2021, the Greater China business accounted for more than $8 billion of Nike’s revenue or approximately 19% of Nike’s total sales. Nike’s Greater China business grew by 24% during fiscal year 2021. Although the company generates a substantial portion of its sales from China, it is headquartered in the United States.

In addition to Estée Lauder and Nike, we own several other companies that generate a significant portion of their revenue from China and other emerging markets. These companies include Moët Hennessy Louis Vuitton (luxury), Diageo (alcoholic beverages), and Essilor-Luxottica (eyewear). Like Estée Lauder and Nike, these companies are headquartered in developed countries. In addition to these companies, we also have some investments in companies that are headquartered directly in emerging markets. We have intentionally stayed away from industries where we see substantial regulatory risk and we believe that our exposures are manageable in the context of our global portfolios. When taken it aggregate, the majority of our emerging markets exposure is held through companies headquartered in developed world countries. However, this doesn’t mean we are completely insulated from the risks that exist in emerging markets. Earlier this year Nike went through a period of volatility on the back of a boycott of international brands. The issue was related to Nike’s avoidance of the Xinjiang cotton region and the controversy around forced labour in the region. More recently, we have seen some volatility in Moët Hennessy Louis Vuitton on the back of the backlash against luxury companies and conspicuous consumption in China. While we don’t enjoy it when our companies go through periods of volatility, we believe that the volatility is manageable in the context of our overall portfolio. More importantly, we remain optimistic about the long-term prospects for the companies held across our portfolios.

In conclusion, we prefer to get the majority of our emerging markets exposure by investing in companies that are incorporated in the developed world that happen to have strong footprints in the emerging markets. By embracing this strategy, we believe that we can accomplish three things. We will have more certainty about the sustainability of our investment, we can lower the volatility of our portfolios, and ultimately generate smoother returns for our clients over the long term.

Have a good weekend,

Phil

Sources:
Future Returns: Finding Value in Asian Emerging Markets
https://www.barrons.com/articles/future-returns-finding-value-in-asian-emerging-markets-01629831214
Emerging Markets – Powerhouse of global growth
http://www.ashmoregroup.com/sites/default/files/article-docs/MC_10%20May18_2.pdf
China’s new private tutoring rules put billions of dollars at stake
https://www.reuters.com/world/china/chinas-tal-education-expects-hit-new-private-tutoring-rules-2021-07-25/
China Prestige Beauty E-commerce Sales Increased 47% to $5.4 Billion in the First Half of 2021, Reports The NPD Group
https://www.npd.com/news/press-releases/2021/china-prestige-beauty-e-commerce-sales-increased-47-to-5-4-billion-in-the-first-half-of-2021-reports-the-npd-group/
China Sees Sports as Growth Driver After Its Olympics Success – Bloomberg News
https://www.bloomberg.com/news/articles/2021-08-06/china-sees-sports-as-growth-driver-after-its-olympics-success
Hedge Fund Trend Monitor: Goldman Sachs

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