Taking A Different Angle On EM Exposure
The dramatic growth of emerging economies over the last decade has drawn the attention of investors worldwide. The International Monetary Fund recently projected a robust 6 percent growth rate of real GDP in emerging economies for 2013 compared with a modest projection of 2 percent for developed economies. In parallel with the growth of emerging economies has been an exponential rise in the market value of emerging markets equity offerings, resulting in a steady increase in emerging markets as a share of global equities.
Yet emerging markets equity still only accounts for around 14 percent of total global market capitalization by free float in the Russell Global Index. This percentage is surprisingly low given that emerging economies account for close to 50 percent of global GDP once exchange rates are adjusted for purchasing power parity. There is a substantial portion of emerging economy assets that are not yet directly investable through publicly traded equities because they are either government owned or privately held.
Additionally, there are indications that investors are running into capacity constraints in making allocations to emerging markets equities. A recent survey showed that as of June 2012, only 40 percent of active emerging markets products performing above median were open to new investors. The study reports “capacity as a key topic among consultants, managers and plans.”1
An Indirect Route To Gaining Exposure To Emerging Economic Growth
Recently, Russell has observed increased investor interest in developed-markets companies that have a substantial amount of business in emerging economies. A few years ago, the term “multinational” referred to a select group of mega-cap stocks. Today it is common for even a small company to have portions of its business abroad, and many have that business in emerging economies. Money managers and asset owners are aware of this shift, and have been giving the stocks in their portfolios fresh scrutiny as business in emerging markets is seen as both a return driver and risk factor for companies domiciled or traded in developed equity markets.
As a result, Russell Indexes has introduced the concept of a developed firm’s “geographic exposure” to emerging economies. This has the potential to give investors a new strategy that connects them to additional portions of emerging economic growth not covered directly by emerging markets equities.
There are several advantages to this strategy:
- It can allay often-voiced concerns about governance in emerging markets as developed markets equities are subject to developed-market regulatory standards of transparency and governance, giving investors a higher degree of comfort and assurance.
- Historically, developed-markets equities have experienced lower volatility and have offered greater liquidity than emerging markets equities.
- It avoids some of the currency risk of directly investing in emerging markets, as only a portion of each developed-market company is exposed to the lower liquidity and elevated hedging costs of emerging markets currencies.
- Some of the highest-quality and most stable developed-markets companies have made great inroads into emerging economies, so that investors can benefit from emerging economic growth through companies that are well-known to them.
- Asset owners in the public eye will be less directly tied to political controversies that occur with some frequency in emerging countries.
For these reasons, Russell has developed a compelling new methodology for quantifying a developed-market company’s exposure to emerging markets.
The Data Challenge
The geographic activity of a company may be defined in several ways, e.g., through the distribution of its revenues, profits or assets. A globally unified approach requires consistent data definition and availability across the publically available company financial statements and filings from many developed countries. This poses a significant challenge, and for that reason, index providers have chosen to use revenues to assist in identifying a company’s geographic exposure, as revenues are the most universally reported and consistently measured location-specific aspect of economic activity.
The first step in determining a company’s revenue from emerging countries is to obtain its financial statements. While access to financial statements for publically traded companies is relatively straightforward, regulations allow a wide latitude for reporting. Hypothetically, one company might report its revenue breakdown as 50 percent U.S.; 30 percent Asia; and 20 percent Europe, whereas another company might report 30 percent U.K.; 25 percent France; and 45 percent the rest of the world. A particularly challenging report was recently filed by computer company Dell (Figure 1).
Obviously, determining each company’s revenue derived specifically from emerging economies requires additional estimation. The construction of the four indexes described below required estimating emerging markets revenue for 91-95 percent of the constituents. This is a crucial step that differentiates the methodologies of competing index providers.
An index provider generally takes one of two approaches to estimate revenue. The first approach is to use GDP as a proxy. In the Dell example, if 70 percent of global ex-U.S. GDP is accounted for by emerging economies, then the estimate of Dell’s revenue from emerging markets is 51 percent X 70 percent = 36 percent. This has the advantage of allowing one to make estimates with readily available data, at low cost, and it is easy to backfill history and easy to explain. The disadvantage is that the estimates are likely to be crude and inaccurate in some cases.
Another approach, which has been chosen by Russell, is to engage in a deeper level of analysis using additional corporate information and more sophisticated algorithms for estimating a company’s sources of revenue when they are not directly reported. This deeper dive into the data promises much more accuracy. However, the detailed data required for the analysis only allows a few years of historical data to be created.