Size matters. Profitability matters. To identify superstar companies in emerging markets, however, we believe ‘economic moats’ is an important concept. This is also identifying the key factors driving that competitive advantage and how dependent the business is on superior management.
For us, a superstar company can consistently generate superior returns on its invested capital and has many opportunities to reinvest capital over time, thus continuing to grow its economic value. However, regardless of size or industry, we believe the biggest determinant is the presence of an ‘economic moat’: a sustainable competitive advantage that protects the economics of the business.
A superstar company might have a structural advantage that enables it to be the lowest cost producer and beat competitors on price.
Another superstar moat is a unique brand (or franchise) that resonates with customers, giving these companies true pricing power.
In the age of technology growth, the network effect is another moat that can be difficult to challenge. This is evident in many of the platform companies, social media companies as well as the e-commerce companies we are seeing globally.
Management quality matters
In emerging markets, due to the large number of state controlled entities and state-owned enterprises (SOEs) incumbent to these regions, management quality plays a significant role. For that reason, we believe that for emerging markets, aside from an ‘economic moat’, the presence of sensible management acting as responsible agents of shareholder capital is an added characteristic.
Of course, the factors that shape an ‘economic moat’ can evolve over time. Unless companies adapt, they may fall from the top. At around 60% in emerging markets, the churn rate for superstar companies is higher than in developed markets where it is 40%1.
Secular themes can benefit EM superstars
Secular themes or trends are relevant when assessing whether superstar companies can sustain their ‘economic moat’. Any analysis of that sustainability must be forward-looking and hence secular trends and changes should be considered.
A growing middle class, and with it rising household income and wealth, is one of the hallmark secular trends in many emerging markets. This should create compelling opportunities to grow market share and revenues. These countries account for well over half of the world’s population and, by 2025, consumption of USD 30 trillion annually.
Demographics can be another sustainable feature. Of Africa’s population, for example, more than 50% is younger than 25. This is driving a mobile-first revolution, not just in communications generally, but also mobile banking and social media, as people entering the digital world skip buying desktops and move to smart phones and apps directly. At the same time, illiteracy drives demand for voice-based apps and search. Tech-savvy players stand to benefit.
Trends such as rapid urbanisation, economic growth and a rising middle class are creating an appetite for higher-end goods and services including, for example, luxury items, but also quality lodging and holidays.
Local and foreign interest
Clearly, such trends would allow incumbents, e.g. the typical state-owned telecoms giants, to benefit from their position of strength, but equally, local start-ups can jump on the bandwagon. Furthermore, established multinationals with the cash piles to finance growth abroad and the ability to adapt to local needs can seize on the opportunity.
Conversely, EM companies have used popular local brands to expand into developed markets, while others have transformed low-cost manufacturing and local engineering prowess into, first, a regional position of strength and then a growing global market share. Examples include Brazilian regional jets, Mexican cement, Chinese telecoms equipment and Indian pharmaceuticals and IT outsourcing.
So does ‘superstar’ fit particularly well with a growth-focused investment style?
As said, superstar companies are able to reinvest superior returns in new opportunities. Given this definition, these companies tend to fall into the growth bracket, which appeals to many investors.
However, the ability to value these companies and invest in them at a compelling price is critical for long-term returns. Often, EM valuations reflect a discount relative to those in developed markets caused by macroeconomic, political or even geopolitical concerns. Assessing the risks and concerns as well as the ‘economic moat’, both in terms of its building blocks and its sustainability, typically involves local knowledge. Determining the relevance of a trend or theme requires global industry insights. Investor considering EM superstars would do well to ensure access to both.