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Aon Retirement and Investment Blog

The Changing Face of Emerging Market – Technology

The Changing Face of Emerging Markets - Technology
The leadership of global and US stock market returns by a narrow group of technology companies is well known. Similarly influential within their own universe is a subset of emerging market stocks, Baidu, Alibaba, TSMC (Taiwan Semiconductor Manufacturing Company), Tencent and Samsung Electronics—collectively known as the “BATTS”.
These names are emerging market technology companies, which have grown quickly since the financial crisis and reshaped the emerging markets benchmark. Their rise has taken the weight of Information Technology sector to 28% of the MSCI Emerging Markets Index, having being closer to 10% as recent as 2011. Over that same period, the combined weight of the Energy and Material sectors, often perceived as principle driver of emerging markets has fallen from 30% to under 15%.

This blog entry describes this in more detail and highlights some of the implications for the emerging markets asset class.
What are these companies?
To simplify, Alibaba can be viewed as the Amazon of China; alongside a gaming business and its other interests, Tencent plays the social media role in China, whilst Baidu can be seen as China’s Google. Samsung Electronics and TSMC are geared into the global technology supply chain. A sixth name is South African media-organization Naspers, nearly all of its market capitalization is comprised of its stake in the aforementioned Tencent.

The companies share similarities with their developed market counterparts, with high returns on capital, fast rates of growth and strong network effects[1], which have compounded their dominance and created monopolistic or oligopolistic profit pools in their core markets.
Whilst TSMC and Samsung Electronics compete on a global basis, the others tend to perform a role within their own market which more familiar organizations do in the west.  However, like the western innovators, the group is also encroaching beyond where a traditional ‘old technology’ or retailer company may have once operated. Financial transactions, cloud computing, artificial intelligence, electric and driverless cars, taxis and food delivery, travel and media are all addressable markets for one or more of these companies, and resultantly they are beginning to finally compete globally and with one another in newer business lines. Lastly, for the Chinese internet companies in particular, there is a familiar debate around valuation and the required rates of growth for the companies to grow into valuation multiples, 50+ times trailing earnings in the case of Alibaba.
What has been the impact of the companies?
The impact of these organizations on emerging market returns in recent times has been significant. The BATTS group, also including Naspers, has accounted for over one third of the MSCI Emerging Markets Index return for the year to date through to September, and the group represents around 20% of the index. Four of the companies each individually currently eclipse Russia in terms of index weighting.  The elevation to the top of the index has occurred primarily because of exceptional share price performance and underlying earnings growth, above 50% is typical. Additionally, it is only since 2015 that Alibaba and Baidu have had the opportunity to influence the index, as MSCI previously did not include US-listed Chinese shares in its main index. 
The experience of these companies for many emerging market investors has been positive. Sitting at the top of the index the companies have provided easy exposure to innovative parts of the global economy, and importantly the more attractive and growing parts of the Chinese economy - consumption. Passive exposure in China a few years ago was dominated by the big 5 Chinese state owned banks and large industrial companies, therefore distinctly lacking exposure to the ‘new China’. 
Whilst the experience to date for many investors has been positive, looking forward, exposure to these companies presents challenges and comes with risk. Increasing valuation risk also comes with questions of governance which hang over several of the companies. As these risks increase, active managers may instead look to perform their incremental research looking for the next technology leader; specialist Taiwanese component manufacturers supplying the likes of Tesla, still un-listed Indian internet/ecommerce companies with the same business models as Amazon, exploring the hundreds of A-Share technology companies listed on the Shenzhen Index, or assessing the listed and dominant technology companies in other emerging regions.
However, for many active managers, the immediate challenge is the changing face of the emerging markets benchmark. The BATTS group has resulted in an index that has become top heavy with conceptually more attractive businesses. Managers must allocate significant and increasing amounts of portfolio capital to these stocks to express a positive view, resulting in a reduction to many managers’ active share (which measures the extent that the manager’s portfolio differs from the benchmark). At the same time, as index weights in the companies have improved relative returns by over 9% through to September 2017, the opportunity cost to not participate in this group of stocks has been high, with relative performance in 2017 for active managers largely determined by whether the companies were held in portfolios or not.

The future impact of these companies to both passive and active investors may potentially be significant, and debate over the merits of these stocks is unlikely to go away any time soon, particularly if valuations continue to rise and comparisons are made to bubbles. What can be concluded now is that the rise of these companies recognises the changing driver of emerging markets growth.
The growth model that served emerging markets asset classes for much the last 15 years, fixed asset industrial investment and manufacturing and commodity exports, is giving ground to consumption and this is now being reflected in stock market indices. These technology companies that have grown feeding from Chinese and global consumer needs have largely displaced index positions of the energy and natural resource national champions, such as Gazprom of Russia and Petrobras and Vale of Brazil. Undoubtedly the extent of influence commodities have to emerging markets will evolve, and though influence will remain in the form of tax receipts and government spending, the emergence of these technology companies’ challenges and weakens the perceived linkage of emerging market equities stock returns and commodities.
James Jackson is a senior consultant and equity specialist in Aon Hewitt’s Global Investment Manager research team in London.

[1] A service that becomes more attractive and valuable as more people use that service.

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