Hunting for High Flyers in Emerging Markets

Harry Markowitz, a pioneer of modern portfolio theory, once described diversification as the only free lunch in finance. The result of Britain’s Brexit referendum may mean that Markowitz’s advice is more important than ever. No-one will really know the full economic impact of the referendum result for years to come. However, investors are likely to face a period of economic uncertainty as the UK government negotiates Britain’s exit from the European Union. This uncertainty could generate instability and volatility in UK equity markets. Investors may consider diversification across Asian and Indian markets in order to generate more stable, less volatile returns.

Asian markets would arguably be more sheltered from the consequences of Brexit than stocks in Europe. Moreover, Asian companies generally have greater exposure to economic growth in India, China and other developing nations like Turkey and South Korea. Jim Rogers, who co-founded Quantum Fund with financier George Soros, believes that while London was the place to be in the 19th century and the US in the 20th, the 21st century belongs to Asia. So let’s explore how investors can gain exposure to economic growth in Asia and perhaps reduce the volatility of their portfolio as the UK negotiates its withdrawal from the EU.

Why hunt for High Flyers?

Before analysing individual companies, let’s take a moment to understand why India and Asia provide bountiful hunting grounds for High Flying stocks, which are typically good quality companies that have strong share price momentum.

High quality companies are usually profitable firms with a strong balance sheet, wide profit margins, and a track record of consistently growing sales year after year. In coming decades, it is expected that Asian companies will grow their sales as a result of surging consumer demand. Indeed Terry Smith, CEO at Fundsmith Emerging Equities Trust, believes that the ‘biggest predictable development in emerging markets is the emergence of a consuming class’.

Some economists predict that the consuming class in the developing world will grow by approximately one billion people between 2010 and 2020. This trend would of course be advantageous for consumer stocks - retailers in particular. Smith notes that ‘in the Developing Economies we can find retailers in markets where the potential growth is so great that we do not need to worry about the ability to grow outside their national boundaries.’

Furthermore, many companies in the consumer goods sector, like Dabur India and Ulker Biskuvi Sanayi, own portfolios of well known, trusted brands. Companies with strong brand names can typically sustain high profit margins and strong returns on capital, as we explain below.

The second component of High Flying stocks is strong price momentum. Companies across Asia may enjoy strong price momentum as the region’s economic development gathers steam. Why would investors buy shares that have already gone up? Although it may sound counterintuitive, many academics broadly agree that stocks which are rising in price tend to keep on going up. This is known as the momentum effect (see here).

How can investors find High Flyers?

Stockopedia’s Quality-Momentum (QM) Rank is a useful tool that can help investors identify quality companies with strong price momentum. We’ve put together this webinar which shows how investors can use the StockRank Portal to hone in on high ranking companies that trade in specific regions or sectors. Let’s take a closer look at High Flyers on a region by region basis...

High Flyers in Turkey

The wake of an attempted military coup may not seem like the best time to invest in Turkey. Nevertheless, many economists are bullish about Turkey’s long-term prospects. Lord O’Neill -the Goldman Sachs economist who first coined the term BRIC- has named Turkey as one of the N-11 (Next-11) countries that have the potential to rank amongst the world’s largest economies during the 21st century. Indeed, he predicts that by 2050, ‘Turkey, along with China and Brazil, will have per capita incomes similar to those we see in the United States today’.

The Turkish confectioner, Ulker Biskuvi Sanayi, has one of the highest QM-Ranks in Europe (96). The firm owns the luxury chocolate brand Godiva. This helps to explain why Ulker is able to command strong operating margins (12.7%). Furthermore, in coming years Ulker plans to expand Godiva sales in emerging markets like China, Russia and the Middle East. The growth of a consuming class in Turkey and other emerging markets could therefore provide a strong tailwind for Ulker’s sales and profits. Ulker’s share price has appreciated by 30% over the last twelve months, despite ongoing turmoil in the Middle East.

Many investors will understanderbly be reluctant to invest in Turkey because of the political situation in the region. However, the Turkish stock exchange has survived periods of political instability in the past. The exchange was founded in 1866 and has survived military coups in 1960, 1971 and 1980. Moreover, contrarian investors like Warren Buffett and Sir John Templeton believe in buying at the point of maximum pessimism. Political instability may create opportunities for investors to buy high quality companies with strong fundamentals that are  nevertheless undervalued by the market.

We will continue our hunt for contrarian plays in later weeks, but first let us turn our attention to High Flyers in India.

High Flyers in India

When Warren Buffett bought shares in Gillette back in the 1980s, he explained that ‘you go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep’. Perhaps investors don’t need to worry that demand for razors will dry up, especially in countries like India, where projections suggest that the population could grow by 300 million over the next thirty years. In other words, India’s population could grow by the same number of people that currently live in the US (see here). One company that is well placed to take advantages of this trend is Gillette India. The company is a subsidiary of Procter & Gamble and, yes, it does produce shaving products. Gillette India is a High Flying stock with a QM-Rank of 99.

Consumer growth could also drive sales at companies like Dabur India. The firm owns famous brands like Babool toothpaste and Amla Hair Oil. These are products that consumers across India use on a day-to-day basis. In 2015, Dabur’s hair oil and toothpaste brands were ranked in the Top 100 Most Trusted Brands List by Brand Equity magazine. I’ve already mentioned that firms which own strong brands can generate high profit margins and returns on capital. Dabur’s operating margins have averaged around 15% since 2011, while the firm’s ROCE has exceeded 30% over the same period. India’s growth prospects help to explain why Dabur’s share price has risen by around 190% since over the last five years and 61% over the last two years. The company has an overall QM-Rank of 98.

Other Indian companies with high QM-Ranks include Nestle India (94) and Procter & Gamble Hygiene and Health Care (95). Both of these companies are subsidiaries of Nestle SA (Switzerland) and Procter & Gamble (US) respectively. They own some of the consumer products we see all around us. For instance, Procter & Gamble owns Oral-B, Pampers and Pantene. Furthermore, Nestle India produces KitKat, as well Maggi - a popular brand of noodles. Therefore, investors that want to gain exposure to growth in emerging markets may want to take a closer look at companies like these.

High Flyers in the Far East

The Singapore stock exchange is also home to a number of High Flying stocks, including Thai Beverage. The company has an overall QM-Rank of 95 and, like Dabur in India, is well placed to take advantage of consumer growth. This is because Thai Beverage is one of the largest beverage companies in East Asia.

Terry Smith is particularly bullish about local breweries in emerging markets. One might expect that Western breweries like Heineken would be able to take advantage of consumer demand in the Far East. However, local producers enjoy significant barriers to entry which protect them from international competition. Smith explains that Asia has witnessed “a proliferation of local beer brands which is perhaps hardly surprising for a product which is bulky, low value, perishable, often transported in glass containers and dominated by local tastes.”

As a result of these factors, Smith explains that ‘in every major beer market in the world, the leading brand is local’. As such, local breweries like Thai Beverage are likely to be amongst the main benefactors as Asia’s middle class grows and splashes out on beer and spirits.

Jim O’Neil is bullish about South Korea. He has named Korea alongside Turkey as one of the N-11 economies, and predicts that in terms of income per capita, Korea will ‘overtake every member of the current G7 except the United States’ by 2050. One of the consumer defensive stocks that would benefit from this trend is Amorepacific. The company is listed in Seoul and owns over 30 well known cosmetic brands. The company also has a foothold in the region’s largest economic powerhouse, China, where it makes nearly 10% of its revenue. Amorepacific has an overall QM-Rank of 98.

High Momentum, High Quality, Low Volatility Stocks

In this brief review, we’ve focused on stocks in the consumer defensive sector because they are more exposed to demographic trends in emerging markets, particularly the growth of a consumer class. Furthermore, we set out to identify shares that may produce strong and stable returns against the backdrop of economic uncertainty in Europe.

One problem with High Flying stocks in general is that they tend to be expensive and therefore have further to fall if they hit problems. This is particularly true if the High Flyers are cyclical stocks - like automobiles and housebuilders. The earnings of these companies are more sensitive to the peaks and troughs of the business cycle, so their share prices can fall sharply during a recession. By contrast, consumer defensives are more stable. Compared to cyclical stocks, consumer defensives generate revenues and profits that are relatively consistent throughout the business cycle.

Defensive companies usually have more stable share prices too. Indeed, in past bear markets investors tended to pile out of cyclicals and into defensives on the basis that people will always need consumer goods. As Peter Lynch put it, ‘no matter how bad things get, people still eat cornflakes.’ In fact, most of the companies we mentioned in this article have a Beta that is less than 1, as we can see from the table below.

Beta is essentially a measure of volatility. If a stock is more volatile than the market, it will have a Beta greater than 1. If a stock is less volatile then it will have a Beta of less than 1. We can’t predict where share prices will go next. However, in the past low Beta stocks have usually been more stable during a recession.

Interestingly, Ulker Biskuvi Sanayi has a negative Beta. Negative Betas are possible for investments that tend to go up when the market goes down, and vice versa. Indeed, Ulker’s share price has appreciated over the past year (by 30%) even though Turkey’s BIST 100 Index is down 6% over the same period.

So as Britain prepares to leave the EU, investors may want to do some more research around High Flying defensive stocks in emerging markets. There is no guarantee that these stocks will keep on going up. However, these companies could offer the best of both worlds: on the upside, their growth is likely to be supported by economic growth in developing nations; on the downside, defensive stocks might provide protection during a bear market.

Users that wanted to find High Flyers may want to check out our StockRank portal. I’ve also put together this screen, which aims to identify defensive stocks in emerging markets that have a high QM-Rank - see here.