Finding Opportunity In China’s Emerging Market

Finding Opportunity In China’s Emerging Market

OCEAN CITY — It’s no great secret that China and other emerging markets have been keeping much of the global economy on its feet in recent years. And despite recent headlines that warn of an economic “hard landing,” China’s gross domestic product is expected to expand by as much as 8% this year and next, according to BofA Merrill Lynch Global Research. “That’s three to four times the growth we expect from the United States or any other developed market,” says Kate Moore, senior global equity strategist for BofA Merrill Lynch Global Research.

How can investors take advantage of China’s economic potential? It may seem counterintuitive, but buying shares of developed-market consumer goods companies, especially those in Europe and the U.S., can be a particularly effective way to invest in emerging markets in general and China in particular. Consumers in those companies’ home markets may be curbing spending in anticipation of additional financial hardships, but consumers in China and other developing economies are doing otherwise. They have more disposable income than ever before, and they’re buying brand-name beverages, packaged goods and other high-status products. “Real [after inflation] consumption growth in emerging markets has averaged 7% per year since 2007, which is 10 times the pace of growth in the U.S. during the same period,” Moore says.

Companies in China and other emerging markets have their eye on serving their own consumers, and investors may be tempted to take a more direct route by buying Chinese companies. But the options are limited, and buying individual stocks with access to China can be difficult. U.S. citizens must trade Chinese stocks through American depositary receipts (ADRs), which are issued by U.S. banks and carry extra fees. Moreover, “not all the Chinese companies you’d want to own have U.S. listings,” Moore says.

In addition, you might not be able to buy as many shares as you’d like because many of the fastest-growing Chinese consumer staples and consumer discretionary stocks are small- and mid-cap companies. “The market cap of all emerging market consumer discretionary and consumer staples companies together is just $600 billion, which is less than the market caps of just the two largest U.S. tech companies,” Moore says. Those smaller companies in China and other emerging markets issue relatively few shares compared with large U.S. firms, and that translates into limited liquidity and lower trading volumes for the emerging market stocks.

Another problem with direct investments in emerging market companies is that strong demand for their shares has pushed up valuations, so that the stocks are now trading at a premium to the prices of their developed-market counterparts. Perhaps even more important, lack of transparency about how Chinese companies manage their balance sheets may give investors pause.

One way to gain exposure to multinationals that are tapping growth in China and other emerging markets is through investing in exchange-traded funds (ETFs) or mutual funds that focus on this idea. Many investors use ETFs to take advantage of local equity indexes around the world, but you could also use them to invest in a basket of large-cap companies that do heavy business in a particular region. Or you could seek out an actively managed mutual fund that specializes in multinational firms that are best poised to sell to the Chinese and other Asian consumer markets. Your financial advisor can help you research and choose the most appropriate vehicles based on your specific goals, risk tolerance, time horizon and liquidity needs.

Keep in mind, too, that what counts as slow in developing countries would seem rapid in the West. Growth in emerging market consumption is expected to decelerate to 6% this year before edging back up to 6.2% in 2013—a tick down from the peak for those markets, but still many times higher than growth in Japan, the U.S. or Europe, Moore notes.

Despite the many advantages of gaining access to emerging markets through multinationals based in developed countries, many investors shortchange themselves by taking a narrow view of such companies, especially those that are based in the U.K. or on the European continent.

“Europe is a market people are very reluctant to own because of concerns about the stability of the Eurozone and whether Europe will fall into a recession this year,” Moore says.

Investors forget that European companies are global brands and that sometimes 50% to 70% of their sales go to emerging markets, with only a very small percentage going to Europe.

“These are among the highest-quality companies in the world,” Moore adds. “They are cash-rich and well managed, and they are trading at attractive valuations relative to their growth because of the financial crisis in Europe. You may want to own these companies, both for their quality and to get direct and consistent access to the emerging market consumer. Serving those expanding markets will continue to be a powerful theme in a world short on economic growth.”

(The writer is a senior financial advisor and can be reached at 410-213-8521.)