I HAVE frequently been asked why we bother to invest directly in countries where governance is often an issue, there is political risk, and disclosure can be less than adequate. Surely it would be easier to buy a large multinational with an expansion strategy into emerging markets?
There are a few caveats associated with that approach. The first is that these well-known top companies often trade at fairly high ratings (probably well deserved, but nonetheless not appealing to us relative to what we can find elsewhere) due to their market dominance and the value of their brands.
For example, Coca-Cola and Proctor & Gamble trade on PEs of 18 and Colgate on 17. These companies have many moving parts one needs to assess to understand the impact of different markets and currencies (especially with the dollar being stronger of late, which dampens export earnings for products manufactured in the US).
At the same time, we are still able to find well-run, lesser-known companies with much lower valuations in emerging markets.
We think investors are often compensated for the risks of buying directly into an emerging market company which is largely reliant on domestic growth.
While emerging markets frequently show the fastest growth for many multinationals, the largest part of their revenue may still come from slower-growing regions, eg Europe and the US, so the slower growth prospects in these regions cannot simply be dismissed in the face of an emerging market strategy. Two-thirds of Proctor & Gamble's revenue, for instance, still comes from developed markets.
The other issue to consider is that multinationals often find it harder to break into an emerging market, even if they are open-minded as to whether their model can be applied there or not. A case in point is the tobacco industry in China. Out of a population of about 1.3 billion, well over 300 million smoke - about one in four people. Of the 300 million people living in the US, a sixth smoke.
A matter of loyalty
Put another way, there are more smokers in China than people living in the whole of the US. Cigarette sales in China were nearly $70bn in 2009, almost three times the annual global sales of Philip Morris.
The Chinese like to smoke - in fact "it is loyal to smoke", were the words of an industry contact. The young girls think it looks cool and that it keeps them thin. The men do it to fit in socially. While smoking is declining in many other countries, it is still growing in China and the emerging world.
When questioned about health implications, one industry CEO was fairly dismissive, stating that "we're not so sure about all the health stuff. After all, the Japanese smoke a lot and they live forever, and they don't die of lung cancer. Look at the Americans - so they smoke less now, but they eat more and they have lots of health problems because of that!"
Of course, he is not a smoker, but he is the exception as smoking and drinking the local brew, Maotai, are almost a requirement for social acceptance and for opening doors fo business. He points out the the longevity of many chain-smoking Asians. He also points out that the Japanese - a smoking race - get stomach cancer instead, which he puts down to "all that sushi". Who says company meetings are not entertaining! The facts are sobering, though, with smoking-related diseases on the rise and reportedly the most common cause of death in China.
Equally fascinating is that local Chinese brands, despite multinationals' efforts, still dominate the Chinese market. Foreign brands reportedly have a market share in China of below 10%. We were told, proudly, that no Australian company has ever made money in this industry in China. The big brands have been more successful in other emerging countries, for instance Philip Morris in Indonesia.
Health equals two veg and a smoke
Perhaps the fact that income from the tobacco industry forms the single largest category of Chinese government revenue, almost 10%, provides some subtle and not-so-subtle incentives to the sector and its distribution chain to support local industry. At a recent company meeting, Emic and I were told that when the credit crunch caused a slowdown in China in 2008, government departments were told to buy more cigarettes with their entertainment budget as part of the effort to stimulate revenue.
Chinese cigarette companies' competition is not the multinationals, but contraband. When asked what their competitive edge was, a packaging company specialising in cigarette boxes stated unequivocally that "our design team stays ahead of the counterfeiters". The conversation was reminiscent of talking to an IT company that has to keep innovating while the Chinese imitate their products.
What may also be surprising to foreigners is that in a country teeming with cheap labour, the tobacco industry has been modernised and many plants are totally mechanised. The Chinese are serious about becoming world class manufacturers. The industry has also been consolidated to fewer, more dominant players.
Governance and disclosure may remain an issue when investing directly in emerging markets, but assuming that a multinational is just going to clean up may provide an even bigger hurdle to investment returns. In true contradictory fashion, the Chinese are also large consumers of fresh vegetables along with cigarettes.
It is in these companies that we have preferred to invest in for some time now. After all, it is harder to manufacture a counterfeit vegetable. More about this next time.
- Fin24.com
*SIM Global, a division of Sanlam Investments, researches listed international companies.