Patience Pays in Emerging Equities
Equity investors are increasingly focused on short-term results. In an impatient marketplace, investors can discover powerful sources of returns in emerging-market (EM) companies that deliver extended growth over several years.
In recent decades, investing horizons have shortened considerably. The average holding period for NYSE stocks has halved since the 1970s, to less than two years. Turnover is even higher in emerging markets, with the average holding period across five key Asian markets shrinking to less than a year (Display).
Why are investors so restless? First, technology now enables access to financial data in seconds, and has spurred a boom in algorithmic trading, which accounts for over half of US trading volume today. Second, hedge funds—with short investment horizons—have mushroomed to nearly US$3 trillion in assets under management since the mid-1990s; the sell side has responded to this shift by focusing research more on the 12-month outlooks of stocks.
As other market participants shorten their horizons, we see opportunities for long-term investors. This is especially true in emerging markets, where market data is less readily available and consumer trends can take years to play out.
FAVORABLE ENVIRONMENT IN EMERGING COUNTRIES
In developed markets, relatively modest macroeconomic growth has challenged companies to produce durable growth. Yet EM companies are operating in a much more favorable economic environment. Today, emerging countries account for over 50% of global GDP, compared with 33% in 2000. And rapid growth is driving higher disposable income and consumption. That’s why the world’s 20 fastest-growing consumer-staples companies are all EM businesses, with nearly half in India or Indonesia (Display). Domestic brands are often better than multinationals at understanding and addressing local needs. For example, in China, Asian-brand facial moisturizers have outgrown global competitors such as L’Oréal, and generated superior returns for their shareholders.
LOOKING BEYOND YEAR FOUR
How can investors find EM companies with durable growth prospects? Our approach is to start with a discounted cash flow (DCF) analysis, which estimates the intrinsic value of a business by calculating the net present value (NPV) of its future cash flows. The mathematics of compound interest that underpin the DCF model magnify the impact of long-term growth. So if the growth rate in the first three years rises or falls by 1 percent, the NPV barely moves (it only changes by 3%). Yet if we look at the same growth rate in years four through 10, the NPV changes by 12%¬–13%, as represented by the green bars (Display). In other words, an investor stands to make much more money by predicting growth beyond year four rather than by forecasting next quarter’s results.
Time acts as a fulcrum, magnifying the impact of sustained growth. But to profit from sustained growth, investors can’t simply buy and hold a stock for several years. Extensive research must be dedicated to studying the long-term prospects of a business, instead of simply trying to predict the next quarter’s results.
Finding durable growth isn’t easy. There’s limited information available on how a company might fare in five or 10 years. Long-term market forecasts have inherent biases and are often wrong. In 2007, former Fed chairman Alan Greenspan warned that the world might need double-digit interest rates to control near-term inflation. Rates have been near zero for most of the time since.
MARKET PENETRATION GUIDES TO GROWTH
Market penetration rates are a good guide to sustainable growth. For example, online retail accounts for just 16% of China’s US$4 trillion consumer market, and penetration continues to tick up. Even in mature sectors like semiconductors, the fabless model (where the design and manufacture of chips are done separately) accounts for less than 20% of global semiconductor revenues, and has increased by roughly 1 percent each year since 2002. When investors focus too closely on daily news flow, they often overlook structural shifts like these, which can affect a company’s operating environment.
Identifying secular growth markets is only half the battle. It’s just as important to understand a company’s competitive advantage and its industry structure. Consolidating markets often provide a company with more pricing power and help increase profitability for industry leaders.
Companies with a highly defensible competitive moat are well placed to deliver sustainable growth. In India, the “financial inclusion” of millions of people into the banking system is creating a huge growth opportunity for publicly listed lenders. We believe that well-managed banks with strong brands, large distribution networks and an innovative digital offering will have an advantage in a vast country like India and will continue to gain market share in years to come, especially as many of their competitors are state run and inefficient.
Growth investors always strive to identify companies that can produce growth for longer than expected. Today, we think it’s more important than ever to find businesses with sustainable growth prospects that are being overlooked in favor of the fastest-growing companies. With a patient and persistent perspective on the future, investors can cut through the short-term noise to discover reliable sources of superior long-term returns.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.