This article was taken from the Spring 2024 issue of The 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications
There is no doubt that we live in a multi-faceted world. Some nations are economically well-off, others less so. Some have strong manufacturing sectors, others rely on services for economic output, and many more depend on commodities for growth. Clearly, countries can be grouped into various economic categories. Yet, for investors, the simplest method is to classify them as either one of the Developed Markets (DM) or Emerging Markets (EM). The former receives the majority of investor attention as it comprises of stable, high-income, free-market economies, whereas the latter consists of developing countries with growing but largely cyclical and less well-established businesses. Consequently, volatility and currency risks are amplified when investing in emerging markets which is a deterrent for more cautious investors. Despite this, there are many attractive growth and income opportunities which often go undetected.
To better paint the picture, it is important to consider that last year the emerging market housed 4.3 billion people, accounted for half of global GDP, and was responsible for two thirds of global growth over the past decade. Much of this can be attributed to China, which recorded growth levels reliably above 6% throughout the 21st century so far. However, low consumer confidence, an aftermath of strict COVID-19 lockdowns, an ageing population, and a property crisis have all adversely affected China equities, which on average fell by 13% last year. Even though market gloom and poor sentiment have hit the country, many quality companies remain. Luzhou Laojiao, for example, is a specialist in the production and distribution of Baijiu, a native liquor. Its annual sales have grown by 20% on average over the past five years, with a net income margin exceeding 40% and a dividend yield of 2.5% to date. Therefore, if the macroeconomic barometer starts moving the other way, there could be a lot of upsides to capitalise on.
Across the Himalayas, sentiment is more favourable in the second-largest EM economy, India. The NIFTY 50, a market cap weighted benchmark index of the country’s 50 largest firms, delivered returns of 93% over a five-year period, out-performing even the S&P 500 by 15%. Demographic tailwinds of a growing middle class and a young, educated workforce, as well as a competitive advantage in the outsourcing industry, are likely to continue propelling growth in the coming years. Although an attractive market in its own right, the growth-tilt in India results in expensive company valuations and limited investment income opportunities, as business profits are predominantly channelled into pipeline projects rather than dividend payouts.
Certain investors may be content with this, especially if their focus is solely on capital appreciation. Nonetheless, the importance of dividends should not be overlooked as they can be indicative of a company’s governance quality. This view is shared by the Guinness Emerging Markets Equity Income team, which only invests in EM companies with high returns on capital and a reliably growing dividend. The rationale is that firms with a focus on shareholder value, financial prudence and sustainable growth are the ones willing and able to incrementally increase dividend payouts. Take a look at Bank Rakyat Indonesia, one of Indonesia’s leading financial service providers. It is a dominant player in the country’s microfinance market, with over 30 million customers, and annual dividend growth of 23% over the past five years.
When seeking to invest in emerging markets, investment funds could be the more appropriate vehicle to use, as opposed to investing in companies directly. By pooling money, funds can invest in a broader range of sectors and companies, diversifying risk, and hopefully stabilising returns. In conjunction with an experienced management team, this should help mitigate the heightened EM volatility risk. In terms of options, these are somewhat restricted, with only ten emerging market equity income funds to choose from. The largest one being the JP Morgan Emerging Markets Income Fund, with a distribution yield of between 3% - 4%. Investors are clearly still warming up to the notion of investing in EM equities for income.
Conversely, the selection of emerging market bond funds is far more extensive. Incidentally, EM hard currency bonds (those denominated in US Dollars) have outperformed their global and Sterling corporate bond peers over both a 10-year and three-year basis, delivering total returns of 56% since 2014, compared to 52% and 27%, respectively. This is due to the higher yields on offer in emerging markets, to compensate investors for the perceived risks.
Emerging market securities can be daunting for some given unfamiliarity with the markets and perceived risks. While operating as a catch-all term, emerging markets encompass several of the world’s largest economies, with strong growth drivers and maturing financial markets that could lead them to become a more common feature of income-focused portfolios going forward.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.