Friday, January 6, 2012

GMO: Capturing Domestic Demand in Emerging Markets: Neither Small Caps nor Multinationals Are a Good Proxy - By Arjun Divecha

As a complement to his article published in the FT on Jan. 4, Arjun Divecha fleshes out more fully his argument that buying emerging small cap stocks or large multinationals is not the best way to tap into domestic demand in emerging markets.



We believe one of the most compelling investment opportunities over the next few years is likely to be in companies that serve domestic demand within emerging markets. Our case rests on two underlying and interconnected forces – one economic and the other demographic. As poor countries get richer, they save as much as they can. Savings rates usually rise until countries reach a range of $3,000 to $10,000 per capita GDP. Once in that range, savings rates begin to decline and consumption becomes a larger part of GDP growth as society starts to provide a social safety net. At this level of wealth, per capita consumption of all goods and services rises in a highly non-linear fashion. For example, while Chinese per capita GDP quadrupled from $1,000 to $4,000 during the past decade, auto sales rose from one million vehicles per year to over 17 million. Markets rarely anticipate this kind of non-linear growth.

Fifty percent of all emerging markets (by market capitalization) are now in this sweet spot of shifting from savings to consumption.

Further strengthening the economic case is a shift in demographics: a record number of people are coming into their earning years in emerging markets at the same time that baby boomers are starting to retire in the developed world. As a result, we believe that the world is in the midst of a massive shift in demand from the developed world to emerging markets.

As this domestic demand play gains momentum, we hear increasingly that the best way to capture this theme is to buy small cap emerging stocks. We believe, however, that this is a mistake and that focusing on companies that specifically serve domestic demand is a more effective way to exploit the opportunity. Besides, why buy a proxy when you can buy the real thing?