Finding high-calibre growth companies in emerging markets

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All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.

To succeed in emerging markets, you need to be adaptable and open-minded as to where growth might come from.

A Dutch economist gave the sector its name about 40 years ago after he was struck by the investment potential of some of the world’s fastest-developing countries. But a series of shocks – including the 1980s’ Latin American debt crisis, the 1990s’ Asian financial crisis and concerns about higher US interest rates in 2013 – have repeatedly driven investors to withdraw their capital, causing a pattern of boom-and-bust.

“Some investors will tell you that macroeconomics doesn’t matter and it’s all about just finding great companies and focusing on fundamentals, but I would respectfully tell you that it does matter in emerging markets,” says Will Sutcliffe, head of Baillie Gifford’s Emerging Markets Equities Team.

Pick the right companies but at the wrong moment and currency moves coupled with stricter lending criteria can send the value of emerging market stocks and bonds into a tailspin. But, as Sutcliffe tells our Short Briefings on Long Term Thinking podcast, the results can be stellar when both factors work in your favour. And there are signs to suggest such a period is on the horizon.

“We’re still below the 2007 peak in the MSCI Emerging Markets Index at a time when other global stock markets have done well, and more capital has left emerging markets than flowed in for the best part of a decade,” Sutcliffe says.

The result is that asset prices appear undervalued when compared to other markets. But when you look to the state of the emerging markets’ economies, you find resilience rather than weakness.

“We’ve just been through the steepest rate hiking cycle in a generation, and many of the biggest emerging markets economies not only survived but thrived,” Sutcliffe says.

“We’re also seeing far more world-class companies coming through. The process started years back in South Korea and Taiwan, spread into China and now seems to be extending into India, parts of south-east Asia and Brazil.”

Computer chips and cheap deals

Sutcliffe draws on more than two decades of emerging markets investing experience to lead his team in identifying which companies qualify for that status. But there is no doubting the credentials of their largest holding. Taiwan Semiconductor Manufacturing Corporation, better known as TSMC, has close to a 60 per cent market share in manufacturing chips for third parties and counts Apple, NVIDIA and Qualcomm among its biggest clients.

“It's been in our portfolio since the 1990s,” says Sutcliffe. “When we first brought it, it was about twice the size of its nearest competitor, UMC [United Microelectronic Corporation]. Now, it’s about six times the size. It got there by doubling down every time there was a down cycle when its competitors retrenched.”

Despite having a market capitalisation of around 21tn TWD ($650bn), making TSMC one of the world’s top 10 most valuable listed firms, Sutcliffe believes it still has significant growth potential.

“Nobody knows what the new digital age will look like or which of the AI applications will be most successful, but we do have a good idea TSMC will be making the semiconductors powering them,” he adds. “And I think the market still misses how much value it could create in the decade ahead.”

In consumer brands, Sutcliffe gives PDD Holdings as an example of a domestic firm taking share from western rivals. The Emerging Markets Team originally invested in the company because of the growth prospects of its Chinese shopping platform, Pinduoduo. But the rise of Temu, PDD’s international offering, has radically exceeded expectations.

Temu’s app frequently ranks higher than Amazon and eBay in download charts and entices customers to make repeat purchases by offering special deals on the goods merchants list on its service.

“When we first took our investment at the start of 2023, we regarded Temu as having zero, potentially even negative, value,” says Sutcliffe. “But it’s become clear that the division alone is a very substantial part of PDD’s overall value.”

Cosmetics and credit

Natura is an even more recent purchase. A change of management and direction at the Brazilian beauty firm sparked interest. And Baillie Gifford’s Emerging Markets Growth Fund and Emerging Markets Large Companies Fund took stakes in March of this year.

“Natura lost its way over the past decade with a series of ‘di-worsifications’ – including purchasing Body Shop in the UK and Aesop in Australia – but it’s now reversed those and got back to its core Brazilian cosmetics business,” Sutcliffe says.

“It’s complex and messy, and the stock has been trading at a stupidly low multiple¹ as a result. But that’s the appeal from our perspective.”

By contrast, Indian companies with low price-to-earnings ratios are challenging to find. The country has many promising startups and its larger brands benefit from the public’s growing amount of disposable income, but Sutcliffe reflects that much of this potential is already reflected in valuations.

However, he highlights Jio Financial Services as an example of one company whose prospects were too bright to ignore, leading to his team purchasing shares for several funds last July.

“There are hundreds of fintech companies in India,” Sutcliffe says. “What makes this one special is that it’s backed by Reliance Industries and has access to all its data. We’re talking about 400 million telecoms customers and 200 million retail customers: that’s a very powerful combination.”

Energy transition

The Emerging Markets Team is also a longstanding shareholder in Reliance Industries itself. Despite diversification, the firm still makes most of its revenue from petrochemicals. Investing in a fossil fuel producer raises climate-related concerns, but Sutcliffe suggests selling out would be counterproductive to our clients and society.

“We do invest in carbon-intensive businesses,” he explains. “If we think they can manage the energy transition, then the most powerful thing we can do as long-term investors is to support them.

“Reliance is using the cash flows from its heavy-emitting, carbon-intensive petrochemical operation to create a telecoms network that is changing the lives of hundreds of millions of Indians, as well as investing billions of dollars into becoming India’s largest solar and battery company. It’s a complex issue, but backing that direction of travel is something we’re keen to do.”

Tilt to emerging markets

The performance of benchmark emerging market indices may have been lacklustre this past decade, but Sutcliffe suggests his team’s expertise in finding exceptional companies combined with more favourable macroeconomic conditions could make the next 10 years a very different prospect.

“If you think about the renewable transition, we're going to require an awful lot of critical minerals, including copper and nickel,” he says.

“If you think about developed market re-industrialisation, we’re going to need an awful lot of steel and cement. And if you think about AI, we’re going to need lots of semiconductors.

“So when I think about all those things, the idea that the world's centre of economic gravity will continue to tilt towards emerging markets seems very plausible.”

Words by Leo Kelion

[1] A reference to price-to-earnings – a financial ratio that measures a company's share price relative to its earnings per share.

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