What is the best way to invest in emerging markets?

Authors: Simon Henry and Dáire Dunne, equity portfolio managers at Wellington Management

The equity of emerging markets offers investors the possibility of considerable growth and a way to diversify their portfolio. However, finding the best opportunities can be a challenge.

As an asset class, they may lack transparency and be volatile, they tend to be less efficient and uniform than developed markets, and are more susceptible to geopolitical risks. In addition, the increase in tensions between the United States and China has further cooled enthusiasm for the "emerging" universe, especially in view of the, for many investors, disappointing recovery of the Asian country after the pandemic. However, interesting valuations and lower inflationary pressure compared to developed markets are some of the factors that, in our opinion, bode well for the emergence of good investment opportunities in emerging markets. In the following lines we will analyze how to do it.

Investing in the structural development of emerging economies can serve as an alternative strategy. This approach, more focused on the long-term growth potential of certain structural drivers that develop over several years and less on specific countries, sectors or regions, may possibly have a lower correlation with traditional economic cycles. These drivers are changing the world and can be supported by public policies, demographic changes or technological advances.

What opportunities does economic development offer?

Discovering structural trends depends on the ability to understand the direction of long-term changes. We are convinced that political interest is increasingly shifting towards an inclusive, innovative and sustainable economic model and that, in the future, development will have little to do with traditional ideas of progress. From our point of view, "1.0" growth had three basic characteristics: it was concentrated in a few big winners; environmental damage was considered a side effect whose cost was not calculated; and, as a result of globalization, it benefited from a reduction in costs as supply chains expanded and labor and capital became cheaper. On the other hand, we see the new generation of economic development as more inclusive as the base of beneficiaries has expanded. The emergence of environmental, social and governance (ESG) criteria and the effects of climate change will mean greater attention to sustainable growth. Finally, as the process of deglobalization progresses, the pressure to increase the efficiency of the industrial and service sectors will favor the emergence of innovative solutions to problems.

This more inclusive, innovative and sustainable perspective of the future allows investors to design a roadmap and is, in our opinion, especially relevant in the case of emerging markets. When investing in them, we anticipate that certain difficulties will persist, but adopting a structural vision will allow us to understand some events more clearly. Moreover, the very context of emerging markets can serve as a catalyst for the following reasons:

• The enormous prominence of "green" technology and science-based industries, such as the manufacture of high-end products, for the next decade. Emerging markets are a diverse asset class, so, despite China's slowdown, growth could intensify in many other countries, thereby boosting relative business results and market shares.

• Demographic change. 82% of the world's population lives in emerging markets, but they currently only represent 26% of global market capitalization. With a young population and a rising middle class, company revenues could be boosted by the "premiumization" of consumption and the increasing adoption of cutting-edge technology.

• The accelerated diversification of supply chains, as a result of deglobalization, to achieve greater self-sufficiency and less dependence on China. This trend is being capitalized on by countries with relatively low wages but with skilled labor or access to advanced technology, such as India, Indonesia, Thailand, Vietnam, and Mexico.

• Digitalization and infrastructure development. Emerging markets drag fewer inherited problems than developed markets when building infrastructure. This gives them an advantage when creating smart cities, 5G networks, and transport systems. The same can be applied to the design of electric vehicles and future consumption.

An example of economic development opportunity

The factors mentioned so far can provide unparalleled investment opportunities, but it should not be forgotten that the themes unfold their full potential over time and that diversification in shorter periods is fundamental. For this reason, it may be more convenient to focus on multiple themes than on one or two. The following examples serve to illustrate the different time horizons of action.

Most promising areas. One of the themes that we find particularly interesting in the context of the economic development of emerging markets is social emancipation. Its objective is to invest in the "facilitators" of social mobility and includes, among others, entities that grant consumer loans, education providers, and telecommunications companies. This structural opportunity is usually distributed in several sectors with exposure to more defensive companies, such as wireless telecommunications companies, which are fundamental in promoting digital inclusion initiatives. Likewise, the theme has benefited from the resurgence in Latin America of educational companies with solid business models and that, as in Brazil, have renewed political support.

Areas to closely follow. Environmental awareness and energy efficiency are two other structural themes where we see potential opportunities, even though they have recently been affected by macroeconomic factors. As a global leader in renewable energy investment, China is an excellent focus of opportunities related to these themes; and this even despite the slowdown of other growth factors, which highlights the importance of knowing what will be the drivers of sustained growth in the future. A good example of this is the electric vehicle market, which Chinese original equipment manufacturers are accessing in the midst of a transition to electrification, despite the fact that they have historically struggled to establish themselves both in China and internationally. But by continuously developing their capabilities and creating strong and broad supply chains, they have become the world's leading producers of electric vehicles. Therefore, we believe that the increase in this attractive and affordable offer of electric vehicles has a long way to go both nationally and internationally, benefiting Chinese original equipment manufacturers.

How to increase the chances of success

Although, as we have already seen, emerging markets offer great investment opportunities, their risk profile is also higher than that of developed markets. To mitigate this circumstance, we believe that investors should take into account other important considerations.

• Risk management is key. In our opinion, it should be done from institutional rigor, in order to take advantage of opportunities while ignoring market noise.

• Focusing on several themes, instead of just one, allows maximizing diversification and risk-adjusted return.

• Achieving inclusive, innovative and sustainable economic development has, in our opinion, a natural relationship with ESG criteria. In line with this opinion, we believe that, the better we understand them, the better founded our investment decisions will be. The emerging and uneven attention to ESG issues in the investment universe of emerging markets often results in an incorrect valuation of companies, thereby generating opportunities for active analysts in the field. From our point of view, the integration of ESG criteria can improve profitability and mitigate risk.

• Combining fundamental analysis with a thematic approach facilitates the identification of potential winners of each structural theme.

If we take into account how the market undervalues the effects of economic development on profit segments, the thematic approach can be used to obtain above-average returns. However, as with any investment theme, the application of this strategy requires exhaustive research and knowledge, not only to detect timely long-term trends, but also to follow a disciplined process in risk management. In short, this novel approach to emerging markets, oriented towards economic development from a thematic perspective, offers a differentiated way to access all its potential without the limitations imposed by "retrospective" benchmark indices.