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Take a recent cover story in BusinessWeek. In apocalyptic tones, it warned readers that “multinationals from China, India, Brazil, Russia and even Egypt are coming on strong. They’re hungry – and want your customers”.
It’s right, of course. The emerging markets won’t be satisfied with providing cheap labour for developed-world firms indefinitely. Indeed, they’re not satisfied now – governments and business people in those countries have already built the first clutch of emerging-market giants, as we’ll see later. Many more are poised to make the leap from regional heavyweights to true multinationals.
But where BusinessWeek’s readers may be trembling at this prospect, MoneyWeek’s should be rejoicing. It’s just this type of shift in the global economy that brings big profit opportunities for investors willing to gamble that an upstart challenger can depose a complacent champion. This can be through being leaner and meaner – think of the Japanese carmakers outflanking Ford and GM. It can be through a sharper vision of the future, as when Microsoft replaced IBM as the driving force behind the personal-computer industry. But history tells us that no firm can afford to rest on its laurels, no matter how dominant its position may seem.
Rapidly Developing Economies
So who are these contenders for global supremacy? A recent report from Boston Consulting lists 100 firms from rapidly developing economies (RDEs) that are leading the pack when it comes to globalising their business. Most of the ‘RDE 100’ are little-known in the West – most familiar are state-controlled energy giants, such as Chinese oil firm CNPC/PetroChina and Russian gas group Gazprom. While many of these firms have produced excellent returns in recent years, they’re probably the least exciting of the group. After all, they’re explicitly instruments of government policy, out to secure natural resources for their nations. This has benefits – the support they get from their governments will be useful in the increasingly fierce scrabble for resources. But investors should never forget where they come in the pecking order. When state and shareholder interests coincide, everyone gains – but if they don’t, it’s not going to be the Politburo that loses out.
Fast-expanding private firms and those state-backed firms where there isn’t an obvious conflict of interest look more attractive. Take India’s Infosys, the IT outsourcing and call-centre group headed by Nandan Nilekani. Nilekani’s the man who gave Panglossian US commentator Thomas Friedman the idea for his ode to globalisation, The World is Flat, but don’t hold that against him. He’s also overseen Infosys’s growth into a $20bn market-cap firm whose revenues are rocketing; it took 23 years for revenues to reach $1bn and just two more to hit $2bn. But that’s nothing compared to the market he hopes to tap in the future. “Fifty per cent of global GDP is services and a lot of that is tradeable,” he tells
Jo Johnson in the FT. “Anything that can be sent over a wire can be outsourced, anything fungible is up for grabs, any tradeable service anywhere in the world.”
To take another example from India, there’s Mahindra & Mahindra. Farmers with cash to splash (or an understanding bank manager) have long lusted after tractors from US firms such as John Deere and New Holland, but these giants are now under attack in their home market from Mahindra, reports Pete Engardio in BusinessWeek. The Mahindra 5500 “is by far the best for the money”, says one satisfied customer. “It has more power and heavier steel.” Meanwhile, Brazil’s Embraer has displaced Canada’s Bombardier as the world’s third-largest aircraft-manufacturer. China’s Huawei Technologies, long sneered at as a mere copier of Western designs, shocked the telecoms world when it won some of the work on BT’s $19bn scheme to upgrade the UK’s telecoms network. And which firm makes more pianos than anyone else? Not some venerable name such as Baldwin, Bechstein or Steinway, but China’s Pearl River Piano Group.
Attractive cost savings
There are many, many more examples. The RDE 100 companies boosted sales by an average 24% a year between 2000 and 2004, says Boston Consulting. And they’re managing to build sales and stay profitable at the same time – operating margins were 20%, compared with 16% for US S&P 500 companies.So what gives these emerging multinationals an edge? The first and most obvious factor is cost. Because of their position in lower-cost developing countries, they can undercut Western firms on labour, property, equipment, raw materials and sometimes even financing. Labour might cost ten to 20 times less than in a developed economy, for example. Theoretically, Western firms can shift their operations to developing countries to get the same advantage. But even when they do, the local firm is usually able to keep a small cost advantage over the new arrival, says Boston Consulting.
A competitive edge
Then there’s the invaluable experience of growing up in a tough domestic market. Japanese and Korean firms who went international in the 1980s and 1990s had been nurtured by protectionism at home, but many of the latest crop have had to fight all their lives. In large, price-sensitive markets with demanding customers, they grind out profits at prices that would make developed world CEOs blanch. Indian generic drug-makers such as Ranbaxy Laboratories charge domestic customers 1%-2% of what US consumers pay, says BusinessWeek. Telecoms firms offer mobile services at tariffs that make European charges look even more of a rip-off than they do already. In this environment, many firms go to the wall – but those that survive are ready to take on the world.
But the challengers don’t have all the advantages. Emerging-market firms still struggle to handle complex supply chains with developing-world facilities. Recruiting world-class management is also a challenge. And few RDE 100 firms operate at the cutting edge of innovation. There are some exceptions, such as Brazilian oil major Petrobras, which is one of the world’s leaders in deep-water oil and gas extraction. But on the whole, emerging multinationals ply their trade at the bottom of the value chain.
What this means for the West
This provides some comfort to those who believe Western firms aren’t threatened by China and India. As far as they’re concerned, emerging nations are mopping up the high-manpower, low-margin work, leaving low-manpower, high-margin work for Western firms. “Owning the guy that says ‘I’ll take all the profits’ makes a lot more sense to us than owning the guy that says ‘I’ll take all the jobs’,” as economics consultancy GaveKal puts it.
GaveKal consistently produce intriguing research (if a trifle too optimistic for our tastes at MoneyWeek), but they’re missing an important point here. As George Karahalios points out in the latest issue of The Gloom, Boom & Doom Report, “when a newcomer company attacks an established dominant competitor, it usually does so by challenging at the lowest level of technological innovation”. Often incumbent firms will happily concede market share at this level, because profits are low and it seems unimportant to the overall business. But the new arrival now has a beachhead. It masses its troops, slowly conquers more territory and increases its firepower. Suddenly, the incumbent wakes up to find a much bigger threat parked on its lawn.
And the early signs of this escalation are in sight. Sure, the emerging giants are currently lagging in innovation, but by 2010 Chinese and Indian universities are expected to graduate 12 times as many engineers, mathematicians, technicians and scientists as US universities.
That army of techies won’t just be sitting around playing Tomb Raider.
The crucial step in the development of emerging-market giants is when they choose to go global. Many have access to vast, fast-growing domestic markets, enabling them to grow large and profitable without venturing overseas.
But being number one in China or India alone won’t give them the scale of a true global leader. In many cases, their domestic market has given them the opportunity to cross swords with established multinationals while they have the home advantage. But eventually, they must take the fight to the incumbents.
Some are further down this path than others. Boston Consulting sub-divides its RDE 100 elite into three different groups. The first have already gone global and are heavyweights within their industries. These include Mexico’s CEMEX, one of the world’s largest cement makers. CEMEX is already a global name after an aggressive expansion strategy that included the $5.8bn takeover of the UK’s RMC in 2005. Fewer investors will have heard of Johnson Electric, but the Hong Kong firm is number one in its niche, with a 40% share of the global market for small electric motors. Others that have made it to the top of the pile include Embraco, a Brazilian firm that has 25% of the global market for compressors.
Firms like these form a tiny proportion of emerging-market contenders. The next group are those that have global reach and are making rapid progress but don’t yet dominate their industry. These include Infosys and Chinese household-appliance maker Haier, both of which are now big names in the West. Others, such as Pearl River Pianos and Turkish consumer-goods firm Vestel, still have little international profile, but are successfully selling their products around the globe. Finally, and most numerous, there are the regional big-hitters just starting to look to global horizons. Few are familiar names at present, but ambitious firms, such as India’s Tata Motors and Egypt’s Orascom Telecom are worth watching.
Shareholder value
The big question is whether these firms can build shareholder value. Sixty of the RDE 100 are publicly quoted firms and recent performance has been impressive. Between January 2000 and March 2006, total shareholder return grew by more than 150%, says Boston Consulting. In the same period, the return on the Morgan Stanley Emerging Markets Index rose by 100%, while that of the S&P 500¬ fell slightly. Yet despite their spectacular growth, few are stockmarket heavyweights. The top 200 global firms by market capitalisation contain just 16 from emerging markets, says the FT.
And most of those are state-controlled energy firms; just two – Mexican telecoms firm América Móvil and Hong Kong conglomerate Hutchison Whampoa – were created by entrepreneurs. For those aspiring to true multinational status, there’s still a lot to be done.
And of course, not all the RDE 100 will make it. Once they realise the threat, incumbent multinationals will fight hard to hold on to their markets. US household-appliance manufacturer Whirlpool paid over the odds for rival Maytag last year, just to keep it out of the hands of Haier. Technology firm Cisco Systems is taking the fight to Huawei by attacking it in the Chinese market – although to do so, it’s formed an alliance with another fast-growing Chinese competitor, ZTE. And the emerging-market firms will make their own mistakes through poor acquisitions and overexpansion, as many Chinese electronics firms are finding to their cost.
It’s still early in the era of the emerging-market multinationals. Few are truly global and even fewer are close to being safe, blue-chip investments. But that will change; eventually, some of these new arrivals will attain the elite status of a Wal-Mart, a Toyota or an HSBC. Investors should already be thinking about who these firms will be.
Invest in emerging markets: the contenders
Most of the companies on Boston Consulting’s RDE 100 list (see www.bcg.com) have the potential to be excellent investments, but now may not be the best time to buy into all of them. Take Chinese household appliance and consumer electronics firms, for example. These operate in a brutally competitive domestic market and face big challenges in making their brands known globally. At this stage, it’s impossible to spot who the survivors will be. In addition, for many Chinese firms, such as Haier (1,169.HK, HK$0.26) the listed unit contains a relatively small and unattractive proportion of the whole group’s assets.
Since MoneyWeek is bullish on commodities, our first instinct
is to look for value among the natural resources firms. Unfortunately, many get their clout from being backed by the Chinese and Russian governments, rather than from being sound businesses. While it’s perfectly possible to make a persuasive case for owning shares in Gazprom (GAZP.RM, RB310) on the basis that it controls a huge chunk of the world’s energy reserves and has European gas buyers in a stranglehold, in terms of business quality, the company is not attractive.
However, there are exceptions. China’s CNOOC (883.HK, HK$6.7, 9.5 times forecast earnings) gets the benefits of government backing, but is generally thought to have better-quality management and more autonomy than its peers. Brazilian oil major Petrobras (PETR3.BZ, BRL48.5m, 6.9 times) is a great business, with expertise in deep-water work, and trades on a very attractive valuation. Its compatriot, Companhia Vale do Rio Doce (CVRD VALE3.BZ, BRL46.2, 9 times) is the world’s largest iron-ore producer and has ambitious expansion plans, as shown by its recent bid for Canadian miner Inco.
What about soft commodities and agriculture? There are several food producers and processors, such as Brazil’s Sadia (SDIA3.BZ, BRL6.2, 8.5 times) in the RDE 100, but a better play may be machinery manufacturers. These firms should benefit as more mechanised farming methods become increasingly important in developing nations. India’s Mahindra & Mahindra (MM.IN, RP657, 13.6 times) dominates its domestic market and has started a joint venture in China. It is also expanding into the US, where its strength in smaller tractors – which make up two-thirds of the American market – means it has the potential to become a major player. In other sectors, Indian pharmaceuticals companies pose a major threat to Western incumbents. Generic drug-makers such as Ranbaxy Pharmaceuticals (RNXY.IN, RP395, 26 times) and Dr Reddy’s Laboratories (DRRD.LN, RP710, 22 times) are major suppliers in the developing world and are successfully attacking both American and European markets. In such a cost-conscious business as generic drugs, their low-cost expertise will make them a major threat. The much-trumpeted IT services and out¬sourcing shift is another area of expertise for Indian firms and the boom in this has much further to run. Infosys (INFO.IN, RP1800, 28 times) and Wipro (WPRO.IN, RP525, 27 times) are the front-runners here; with forward p/es of under 30, they look reasonably priced for firms that may be the IT giants of the 21st century.
Emerging-market telecoms make an interesting, if riskier, play. Mexico’s América Móvil (AMXL.MM, MXN20.6, 20.9 times) has 100 million customers across 14 Latin American countries, while Egypt’s Orascom Telecom (ORAT.EY, EGP305, 14.3 times) operates in nine countries in Africa and the Middle East. The aggressive mergers and acquisitions strategies typical of telecoms firms – Orascom in particular has overstretched itself in the past – mean that this is not a sector for widows and orphans. But the growth potential is enormous; Orascom’s subscriber base was 41 million in the first half of 2006, up 93% year-on-year.
Note: The ticker codes given above are for these stocks’ domestic listings. Most are also available as American depositary receipts/global depositary receipts listed in the US, UK or Europe, which will generally be more convenient for UK investors.