From emerging markets come emerging champions

Institutional Investor, January 2013

They are the new Cokes and Microsofts, this century’s Fords and Exxons, born from the world’s most populous and high-growth regions and now competing on the world stage. From emerging markets come emerging global champions.

It’s no surprise that markets like China, India, Brazil and Indonesia, with their prolonged high GDP growth rates, low-cost labour bases and burgeoning consumer demand, should have created some of the world’s most vibrant companies. The domestic stories in these nations are mind-boggling: China has routinely been adding about 10 million mobile phone subscribers per month for years, while Coal India has an employee headcount the size of a western city. Naturally, the progress of billion-strong populations towards middle class wealth and spending habits has created powerful national champions. Most of the biggest banks in the world by market capitalisation are Chinese, despite being almost entirely domestic enterprises.

But the more recent trend has been for companies from these countries to grow into global rather than domestic leaders. Powered by cash flow and balance sheet from their home economies, they have been able to compete with global leaders that have dominated their fields for a century or more. And moreover, it’s happening across more and more sectors.

We tend to associate emerging market leadership with technology, and have consistently done so in the post-war era: when Taiwan was considered an emerging market, it built a fledgling industry around semiconductors and chips that is the lifeblood of the economy today. One could say similar things about Korea. Today, China is the source of emerging technology leadership, from straight tech plays like Huawei Technologies to home computing leader Lenovo and even internet companies like tencent. But tech is far from the only story. India clearly leads the field in business consulting and IT through global names like Infosys and Wipro, while also using domestic heft to finance the acquisition of technology and brands in other industries, such as Dr Reddy’s in pharmaceuticals, and the all-reaching Tata group in pretty much everything else. Brazil, Thailand and Indonesia have nurtured leaders in resources and basic materials – Brazil’s Petrobras and Vale, for example, or Thailand’s PTT, and Indonesia’s Adaro. Most major emerging countries, and most sectors, have a candidate: from Russia’s Sberbank to South Africa’s MTN, Mexico’s Femsa and America Movil to China’s Sinopec and India’s Bharti Airtel.

Different companies have taken different routes to global significance, some through research and development, some through acquisition and others through sheer domestic strength.

Huawei, for example, is interesting not just because it is the second largest provider of telecoms equipment in a market traditionally dominated by North American and European companies (Ericsson is the only one ahead of it), but also because of what it has become along the way. “It is not only a company which is a big vendor, but a significant IP company,” says Nicolas Baratte, regional head of technology research at CLSA in Hong Kong. Huawei started out in 2G networks, before moving to 3G and 4G, and along the way has shifted from being a follower to a leader. “4G is basically 3G plus faster data transmission, and because Huawei is a network company, it knows lots about network transmission.” This intellectual ability is now probably more important than its ability to produce and sell equipment. “If you look at their financial statements, they’re an IP company. They manufacture almost nothing themselves.”

In the same country and the same broad sector, Lenovo looks different again. This is more a case of attrition in a traditionally western-dominated business. “The only companies growing in the computer market are Lenovo and Asustek [from Taiwan],” says Baratte. “Westerns like HP keep losing market share and we should expect that to continue.”

Lenovo is best known in corporate finance for its audacious takeover of IBM’s personal computer business in 2005. While we tend to look back on this as a pivotal moment, symbolising the shifting of power from west to east, in truth it was something of a gamble. Baratte recalls what was “at the time, a huge bet. This was not a simple or straightforward story for Lenovo.” For several years financial results were poor. “It amplified the idea that merging with a western company is not that simple,” says Baratte. “There are cultural issues, differences in labour costs, and it can be very problematic. It’s not a question of funding, because many Chinese companies are sitting on a lot of cash, but there is a complication in integrating a western entity.”

Yet for Indian companies, acquiring in the west hasn’t seemed so problematic, and here we see a different model for global growth. In terms of expansion by acquisition, there’s really nothing to compare with the Tata group, whose purchases over the years have included Tetley Tea, Corus Group, PT Kalim Prima Coal (Bumi Resources), General Chemical Industrial, Jaguar Cars and Land Rover. These have, in the main, been established brands and marques and have largely gone quite smoothly. Another illustrative example of Indian expansion overseas is the pharma group Dr Reddy’s Laboratories, which has bought smaller businesses rich in patents or intellectual capability, such as BMS Resources in the UK, Trigenesis Therapeutics in the US and Betapharm Arzneimittel in Germany. The model here has been to acquire ability, technology, or a particular marketing specialism.

“Indian companies have tended to make a large number of small acquisitions in the US and Europe where they are acquiring skillsets in specific industries,” says Baratte. “My feeling is that Indian firms are less worried than Chinese companies about acquiring in a developed country. Probably the cultural gap is smaller for Indian firms: the communication and language gap is certainly smaller.”

Some other Indian companies have had no need of acquisition. Infosys became a global champion just by building and building out of Bangalore. What’s interesting here is how western companies have responded. “If you look at Infosys, they are dominant in the product segments, but they don’t compete entirely with Accenture or CapGemini because the western companies have consulting activity,” says Baratte. “The Indians are the most cost efficient and time efficient companies to develop and implement software, but are still lagging behind in those consulting services. This is the way western companies have developed: because Indian firms have gained so much market share, they have to do something different.”

In Brazil, the resources and chemicals sector generate the most obvious candidates (many Brazilian banks are powerful but not really considered global players), although in recent times the most obvious Brazilian champion, Petrobras, has divided opinion. Gustavo Gattass, head of research at BTG Pactual, says Petrobras began international expansion in the late 90s and “if anything they’ve been backtracking ever since, cutting back on what they were planning to do abroad.” Instead, he sees better candidates in the chemical industry, particularly Braskem and Ultrapar. “These guys don’t exactly have global aspirations as of yet, but they do have what I would call an Americas aspiration as opposed to just a Brazil mindset.” Braskem, for example, has bought assets outside of Brazil, “with the ultimate objective of not being a Brazil-centric company, and gaining access to lower-cost feedstock, sometimes moving into projects that were in the past projects of the majors themselves. Like Petrobras, it’s a case of: I already own the market, so where do I go next?” In a different continent, one might see an equivalent story in Malaysia’s CIMB: a bank that has done most of what it can hope to domestically and has set out not with global ambitions but a clear regional plan, in this case southeast Asia.

Many leading emerging companies are notable for their commitment to research and development. Petrobras is an interesting instance here, since it has a legal obligation to spend a certain percentage of revenues on R&D because of concession laws in Brazil. “When you take into account that revenues are linked to the oil price, what you have is a massive amount of spend in R&D that is bigger than the multinational players out there in the world,” says Gattass. “It is so large that sometimes we think Petrobras doesn’t even know how to use it.” Both the chemical industry companies he names also commit significantly to R&D. “Ultrapar pretty much is R&D,” he says. “It goes hand in hand with its clients and they figure out together what they need and how to make it happen.”

Back in China, one sees similar trends. Baratte points to research in the semiconductor design segment, previously the preserve of Taiwanese groups like Mediatek. “We should expect that in the next five years we are going to see large semiconductor manufacturing and design beginning to be dominated by the Chinese.”

Then there are resources champions, whose strength rests partly on their good fortune of being on top of extraordinary coal or oilfields, and partly upon what they then do with them. Vale in Brazil, for example, is as close an emerging markets equivalent to BHP Billiton or Rio Tinto as one could hope to find: involved in mineral exploration in 24 countries, diversified across iron ore, nickel, coal, fertilizers, copper, manganese and PGM, and with related businesses from steelmaking to logistics and energy. Chinese powerhouses from CNOOC (exploration) to more downstream businesses (Petrochina, Sinopec) are becoming similarly diversified by geography, if not by product set.

Some resource companies have such a bounty at home that they can be considered global players without crossing their national borders. Consider Indonesia, which McKinsey believes by 2030 could be the world’s seventh largest economy, bigger than Germany and the UK, by which time it will have added 90 million people to its consuming class. Antam is largely a domestic company, but its diversification across exploration, excavation, processing and marketing, in nickel ore, ferronickel, gold, silver, bauxite and coal, makes it a sought-after stock internationally.  Adaro, to give another example, is only the second largest coal producer in Indonesia, but is a global player because it is one of the lowest-cost producers in the world. Then there is Coal India – the world’s largest coal company, yet entirely domestic and based around only one fuel – while Thailand’s PTT group has come to dominate its national stock exchange, with its integrated suite of businesses from exploration all the way to petrochemicals.

All of these companies are powered overseas by the tailwind of their home economies. In Asia and Latin America, growing wealth, increased consumer demand, a demographic sweet spot in the workforce, and a far easier availability of bank liquidity than in the west, all create an outstanding environment for growth for new companies. Perhaps the next stage is greater experience and worldliness among the management classes from these countries. In Gattass’s  view, what Brazilian companies lack is efficiency; global experience could bring them that. “If I could hope for one thing,” he says. “I would love to export every Brazilian so he could live for three months outside this country so he notices what ‘normal’ is for other people.”

BOX: The alternative view

It has long been an article of faith that emerging markets are providing the growth, and so emerging companies are the ones with the best prospects. But one view has it that the traditional arrangement is being turned upon its head.

“Asia became very competitive and very efficient at selling stuff to the west,” says John Woods, chief economist for Asia at Citi Private Bank. “Based on that model, it has grown and developed for the last 50 years. But that model, since 2008, has basically broken, and what we’re seeing is actually a deterioration in productivity and efficiency metrics in Asia. We are seeing weakening ROA and weakening ROE; emerging markets are now less efficient than the US.”

Woods says there are two reasons for this. One is that Asia tends to benefit from easy money, whether through local stimulus or QE measures. “Money floods into this part of the world and I think has possibly prevented corporates from exercising the sort of cost efficiencies and productivity gains they used to be known for.” Additionally, there has been a considerable increase in unit labor costs across Asia, with wage growth particularly high in China. In the US, by contrast, there have been improvements in productivity and profitability because employers have been able to keep a lid on labor costs. “So ironically, you have an EM/DM reversal going on, where this focus on promoting domestic consumption in Asia is leading to higher living standards, higher wage costs and reduced profitability, while in the US companies have become fantastically more efficient, assisted by cheaper inputs like oil and gas.”

While there is nothing inherently wrong with this – it is essential, Woods says, for Asia “to normalize its growth model rather than being completely fixated on selling things abroad” – one side effect is that the potential for growth in emerging markets is declining. In this environment, it’s possible that developed world companies with large emerging market exposure will increase market share. This also helps to explain the dreadful performance of emerging market equities compared to the US in recent years, because emerging market corporate profitability and EPS growth has been weak while the reverse has been true in the US. “And, in the end, all money chases profit growth.”

This view is starting to appear in portfolio recommendations for private wealth clients. “It’s on a case by case basis, but whereas we would never reasonably have considered western companies in an Asia-centric portfolio in the past, now we do. A lot of consumer companies from the west are now part of our equity baskets, because they are benefiting from the Asian growth story. We are leveraging Asian growth not just through local companies, but increasingly through international companies.”