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So you think you know how to play the emerging markets story? While investing in the Canadian commodities sectors has been touted as a lower risk way of accessing the high-growth emerging markets, there may be another approach.

While investing in companies or funds that operate within emerging markets is the most obvious way to get in on the action, stopping to look at the way emerging markets affect global trade from a macro perspective reveals other possibilities.

A new strategy focuses suggests the end winner of emerging markets’ growth may not be the emerging markets themselves, but companies and markets that are profiting from the emerging market consumer. That points to Europe, thanks to its proliferation of globally-known brands.

“If investors didn’t want to go directly to emerging markets, then certainly I think it’s something that is going to help a lot of European consumer stocks,” says Phil Langham, senior portfolio manager and head of global emerging markets for RBC Global Asset Management.

With millions of residents reaching the middle class in the past decade, consumerism is booming in powerful economies like China and India. From luxury cars to French yogurt, the new middle-class just can’t get enough stuff; something we in the west know a little something about.

“After there is an emerging number of middle class, there is a huge rush of people who want to say, ‘I made it before you did,’ ” says Dr. Luke Chan, associate vice-president, office of international affairs at McMaster University’s Degroote School of Business. “How you show this is having a really nice Gucci handbag, or Louis Vuitton or expensive ties or shirts or jewelry.”

Emerging consumerism
As developing markets have more and more success on the global stage, the benefits trickle down to residents of those countries in the form of better jobs and income.

“The s-curve suggests that when you get to US$4,000 a year in terms of your salary, then you tend to start to buy consumer goods,” says Dominic Wallington, chief investment officer, RBC Asset Management UK Ltd.

Many Chinese workers have been hitting this $4,000 tipping point in the last few years. In 2007, the national average salary was 24,932 yuan (roughly US$3,550). In 2008, that average rose by 17% to 29,229 yuan (approximately US$4,280).

This shift may have come just in time, with many experts saying that without the emerging market consumer, the global financial crises could have been much worse.

“In terms of the sustainability of the global economic recovery, we believe that it’s really going to come from the emerging markets consumer, or the developing market consumer, rather than the U.S. consumer,” says Serge Pépin, director, BMO Retail Investments. “We’ve always tended to rely on the U.S. consumer and I think that’s shifting.”

While they may have emerged at a time of global financial uncertainty, the developing economy consumer acts very much like their western counterparts.

“The culture is very forward and very progressive looking and therefore replacement cycles are very short — they want new things on a constant basis,” says Wallington.

“Anecdotally, I just came back from Hong Kong; I managed to walk through a couple of shopping malls and it was remarkable. Even as a European fund manager, I was amazed at the amount of brands that were European; in fact, almost exclusively European.”

This consumer favoritism towards all things European has less to do with buyer preference than it does with which companies are investing the most capital in advertising, says Dr. Chan.

“The whole issue is not Europe [vs. North America] the issue is how much money you can put into marketing,” says Dr. Chan.

“This trend [of buying foreign consumer goods] is going to continue until the domestic product has caught up to the point where people are going to say ‘this is as good as an imported product,’ ” he says.

Europe’s foothold
European consumer goods may be the most popular among consumers in developing economies right now simply because they have greater exposure than Canadian brands.

“I would say that at the moment, European funds do tend to have a higher allocation to emerging markets than in Canada,” says Wallington. “In Canada, certainly the impression that I get is that emerging markets are relatively unpenetrated; although, having said that, the Canadian stock market, until very recently, has shown a very strong correlation with emerging markets.”

“The proxies that I’m aware of from an index perspective — proxies of indexes made up of companies with substantial exposure to emerging markets — have tended to outperform the major European markets,” he says. “Clearly, a substantial number of European fund managers are aware of that and are trying to tap into the kind of superior performance that this type of index is providing.”

Though an increase of investment in advertising in developing economies could boost Canadian exports to those nations, Europe — and to a lesser extent, America — is still far ahead in terms of the number of luxury brands to promote.

“I think we have a number of companies here in Canada that can benefit from that, but if you look at the U.S. and Europe in terms of consumer goods companies, I definitely think they may be in a better position because we don’t have those same companies here,” says Pépin. “We are sort of a raw materials type of economy.”

Direct vs. indirect investing
It is an accepted truth that investing in emerging markets has the potential to yield a high return. However, this lure of fortune is not without its downside.

“There is no such thing as a high return without high risk,” says Dr. Chan. “When you look at whether you want to pick a specific item or company, rather than picking the market as a whole, they are two different issues altogether. All of the emerging markets were subject to a lot of volatility and fluctuations.”

According to Dr. Chan, one of the main benefits of investing indirectly in the emerging market consumer is that it avoids a lot of the confusion often encountered when dealing with foreign investments.

“At least you understand what it means when you read the income statement,” he says. “And you know how diversified they are. So that’s an easier way for you to make a decision for you to participate in those emerging markets.”

However, this strategy is not viewed as a direct alternative to investing in the emerging market itself. Though the risk might be lower, so too might the reward.

“If you want exposure to emerging markets, you would still need direct exposure to emerging markets as opposed to trying to play it through a company that has exposure to emerging markets,” says Pépin. “You would yes have some diversification, but you would not receive the full benefits [from full exposure].”

Langham says that on the back of the global financial crisis, emerging markets are looking much less volatile.

“The risks have substantially reduced in emerging markets,” he says. “And at the moment, if you look at the overall economies of emerging markets, in many ways they’re much healthier than most developed markets.”

Risky or not, the lure of emerging markets is too tempting for many investors to ignore.

“Valuations are attractive in emerging markets,” says Langham. “We’re trading on 2011 P/E of 10.7 times, compared to a long-term average of 13 times. Companies have been improving; return on equity has been better than the developed world for most of the last decade.”

(05/04/10)

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