Affiliates offer way into emerging markets

(Published in the Financial Times on 26 Feb 2012)

Some domestic US fund managers argue that investors need not bother with emerging markets: they can obtain exposure to emerging market growth through developed market companies with substantial overseas sales. Since active managers in the emerging world underperform, the argument continues, why not buy a portfolio of multinationals?

The answer is: because they would miss great returns from emerging markets companies that outperform.

Over time, stock markets should track economic performance. Although this has held true in developed markets, it is much less evident in the emerging world.

Over the past two decades, real GDP growth of emerging Asia has been around 4 percentage points higher than that of the US. However, since the end of 1987 — the inception of the index — the MSCI Emerging Asia index has substantially lagged the MSCI US index.

Similar patterns can be seen at a country level. From 1992 to 2010 China's economy expanded by seven times in real terms but the MSCI China index went nowhere. While the average Chinese listed company may have created value for employees, suppliers, bankers, and local and national governments, it destroyed value for shareholders.

Paradoxically, the strong growth of emerging economies may cause the relatively poor performance of their companies. Many corporations, transfixed by the growth opportunities, invest new capacity, often outside their core area of expertise. A focus on top line growth rather than profitability tended to result in destruction of shareholder value.

It is therefore right to be wary of the average emerging markets company — but not all of them. Those disciplined about expansion tended to be better performers over the long term. But discipline requires a strong corporate culture that can take decades to build, unless there is a parent company with a strong culture.

In a recent research paper* supported by Aberdeen, Martijn Cremers, associate professor of finance at Yale School of Management, analysed the performance of listed emerging markets affiliates of multinationals. Unilever, for example, has listed affiliates in India, Indonesia and Pakistan in which it owns stakes of 37 per cent, 85 per cent and 75 per cent respectively. There were 92 such companies across the emerging world, 24 of them in Asia, 46 in EMEA and 22 in Latin America.

Prof Cremers found the share price performance of listed affiliates was vastly better than that of both emerging and developed markets broadly, as well as their own local markets.

Over the 13 years from June 1998 to June 2011, a period chosen for its balance between sample size and history length, an equally weighted index of the 92 listed affiliates returned 2,229 per cent. This compared with total returns of parents, local markets and parents' markets of 407 per cent, 1,157 per cent and 147 per cent respectively. 

The pattern of outperformance was consistent across regions too. Affiliates in Latin America, Emea and Asia outperformed their local indices by 41, 134 and 50 percentage points respectively. Adjusted for volatility the affiliates' performance was even better, as many of them demonstrated defensive qualities during the 2008-09 financial crisis.

Prof Cremers says strong performance is attributable neither to changes in affiliates' valuation (price-to-book ratio) nor to them being in better performing industries. Instead he suggests two explanations.

First, the affiliates had adopted their parents' business culture and corporate governance practices, and with them a focus on shareholder returns. Second, financial support from the parents served the affiliates well in good times but particularly during the difficult times.

While there will be homegrown success stories, they are hard to identify other than with hindsight, and picking losers hurts. Listed multinational affiliates, on the other hand, may offer more reliable pickings. A strong corporate culture is hard to build so the competitive advantage companies in this select group enjoy may be a sustainable one.