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Fund Spy

You May Have More in Emerging Markets Than You Thought

Many funds are joining in the fun indirectly.

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Note: This article is part of Morningstar’s December 2013 Emerging-Markets Week special report. This article originally appeared Nov. 16, 2010.

There's good news for those interested in capitalizing on growth in emerging markets--you probably already have more exposure than you think. When you look at where companies sell their products, not simply where they are domiciled or on what stock exchange their shares trade, an interesting picture emerges.

If you focus purely on conventional labels, most diversified foreign-stock funds or world-stock funds don't have significant emerging-markets stakes. The typical foreign large-blend fund has less than 8% of its assets in emerging markets, and the average world-stock offering has less than 7%. (Not surprisingly, the average foreign large-growth fund has far more--at nearly 15% of assets.)

Economic Versus Equity Market Exposure
Because of these relatively small average weightings, the traditional view has been that to get significant emerging-markets exposure, investors would need to buy a diversified emerging-markets fund, or even a regional or single-country fund. This has tied in with the notion that regardless of where a company does business, its stock price will usually move with its home market. This has tended to be true especially in the short run, where emerging markets have often moved together during corrections.

Over the long haul, however, a company's value will depend more upon its cash flows and less on where it is headquartered. With this in mind, many equity managers have been looking for companies that will benefit from economic growth in emerging markets, regardless of where those companies are based.

This is the idea, for example, behind  American Funds New World's (NEWFX) unconventional approach. While the majority of its assets are invested in companies that are domiciled in emerging markets, a fourth to a half of its portfolio is typically found in developed-markets companies that do business in emerging markets. (The fund usually has 10%-20% of assets in bonds, too.)

This currently includes consumer-staples company  Nestle (NSRGY). It's headquartered in Switzerland but derives about a third of its sales from emerging markets. About 40% of Spanish telecom  Telefonica's (TEF) revenues come from Latin America.

Such Europe stocks, though, have been a slight drag on New World's performance relative to other emerging-markets funds, as emerging-markets equities have beaten developed-markets equities during the past decade. The fund has held its own, gaining more than 12% annually. But the average diversified emerging-markets fund has gained more than 14% per year during the past decade. Meanwhile, the typical foreign large-blend fund has struggled to keep pace with an interest-bearing checking account, gaining just 1% on an annualized basis during the past decade.

How Best to Play It
But while emerging markets' gross domestic product is almost certain to continue growing more quickly than developed markets' GDP, that doesn't guarantee that firms in developing countries are the only--or even the best--way to play that growth. Standard Chartered, for instance, is based in the United Kingdom, and its shares trade there, but it's a leading banker in Asia, the Middle East, and Africa, where most of its customers reside. On the other hand, Korea's Samsung Electronics gets about half of its revenues from developed markets.

Valuation is a key consideration, as well. Diversified foreign-stock managers looking for the best way to gain access to emerging markets sometimes find that developed-markets companies provide the cheaper path. Telefonica, which also owns a stake in  China Unicom (CHU), has a price/sales ratio of 1.4. The stock has been hurt by its connection to its home market, Spain. But Spain now accounts for less than half the company's revenues, and Telefonica is now the dominant player in Latin America (excluding Mexico). Meanwhile, Mexico-based  America Movil's (AMX) P/S is 3.2, more than twice Telefonica's. Granted, America Movil boasts a dominant position in Mexico, but a smaller share of its revenues come from the rest of Latin America than is the case with Telefonica.

Many mutual fund managers are looking to take a similar backdoor approach to emerging markets. For instance,  Harbor International (HIINX) is capitalizing on the growing middle class in China and Brazil, focusing on luxury-goods companies in China and banks in Brazil. Their thesis is that as consumer wealth grows in China, demand for premium products from companies such as spirits maker Pernod Ricard will likely increase.

Commodity plays are another avenue for those looking to tap into the developing world's growth. Many managers believe oil and other commodities will climb higher as emerging-markets demand increases for both energy and basic materials.  Causeway International Value (CIVVX), which doesn't invest in emerging markets directly, is taking this route. French oil-and-gas construction firm Technip, a top-10 holding, earns about three fourths of its revenue in emerging markets.

While their home markets are hurting, such European companies may potentially benefit from the declining euro, as well. Given China's midyear announcement that it will allow the yuan to gradually appreciate, both European and U.S. companies could have an easier time selling their products there and throughout Asia, as other regional currencies may move up with the yuan.

This points out how U.S. companies are just as inclined to benefit from emerging-markets growth, too. It's well known that S&P 500 Index components such as  Coca-Cola  (KO)(which gets about one half of its sales from emerging markets) and  Procter & Gamble (PG) (which gets about one third) are growing most quickly in developing countries. While these certainly are not pure emerging-markets plays, they still offer meaningful exposure.

Look Beyond the Domicile
Even those who do not own emerging-markets funds can still benefit from their economic growth. A secondary benefit of indirect exposure may be sidestepping some of the volatility that can sometimes accompany them. What's also clear is that the line continues to blur between emerging and developed markets. So, in order to get a handle on a fund's true geographic profile, one needs to go beyond just looking at the domicile of a portfolio's holdings.

Kevin McDevitt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.