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Built on BRICs

Created:
30 June 2006

They have no common language, practise different religions, operate distinct forms of government and have wildly different economies – so you have to ask: is there any sense in lumping together in one fund stocks from Brazil, Russia, India and China?

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Two Goldman Sachs economists, Dominic Wilson and Roopa Purushothaman, seem to think so. They started the trend in October 2003 with their research paper, Dreaming with BRICs: the path to 2050. In it, they modelled what the gross domestic product (GDP) and currencies of these four countries might do over the next half century.

Their results came with the usual caveats about long-term forecasts, but concluded that no miracle was needed for China and India to achieve what Korea and Taiwan have already done – even with far larger populations. And if a sizeable middle class, with typical consumption patterns, emerged in these countries, it would then fuel growth from the commodity-rich nations such as Brazil and Russia.

Mssrs Wilson and Purushothaman’s forecasts were startling. “If things go right,” they argued, “the BRICs could become a very important source of new global spending in the not too distant future. India’s economy, for instance, could be larger than Japan’s by 2032, and China’s larger than the US by 2041 (and larger than everyone else as early as 2016).”

The reason is not that the Chinese or Indians will be richer than Americans or Italians – in fact, the biggest economies of this coming century could still be full of relatively poor people, which will dramatically alter how companies develop and target new products.

Instead, the reason is simple demographics. Some 45 per cent of the world’s population lives in these countries. So, if their economies take off as Japan’s did in the 1960s, there will be hundreds of millions of people in the world with a lot more money to spend.

By 2015, the middle classes of these countries could reach 1bn people, points out  Christian Deseglise, managing director of global emerging markets for HSBC Halbis in New York. Some 800m of these would have emerged from poverty within eight or nine years. They should therefore trigger a dramatic increase in the demand for cars, telephones, life insurance, furniture and a diet richer in meat. “We would play this theme through financials and consumer credit, telecoms and consumer discretionary sectors,” says Mr Deseglise.

How to get exposureHow, then, can you play it? In an ideal world, there would be hundreds of pure-play consumer goods companies to invest in. As things stand, though, the choice is still small.

The range of allowable investments for an overseas investor in China is limited to a list decreed by the Chinese government. Most of these companies are large industrial concerns or energy stocks. In fact, across the BRIC markets, there are relatively few ways into the travel, media and leisure sectors.

One exception is LI-NING, China’s leading sportswear brand. But trading on a sky-high multiple of earnings, and with its work cut out to beat off competition from Nike, adidas and Puma, LI-NING makes an unattractive investment, says Mark Mobius, who has run Franklin Templeton’s emerging market funds for 20 years.

Indeed, it’s a similar story in Brazil, where pure exposure to the emergence of middle-class spending power is thin on the ground. One stock worth watching, says Dr Mobius, is Natura, a Brazilian cosmetics company, although its current rating puts him off buying it at the moment.

But opportunities will increase. While trade flows between the four BRIC countries are still relatively modest compared with their imports and exports to the US and Western Europe, that will almost certainly change. For all its size, China has comparatively little agricultural land. Research from Deutsche Bank this month highlighted the rapid rise in agricultural imports, from around $11bn in 2000 to nearer $28bn last year.

“With rapid urbanisation and the resulting loss of arable land, as well as soil erosion and impending water shortages, China’s agricultural sector is facing growing problems,” explain Deutsche Bank analysts Tamara Trinh and Silja Voss. China is already the world’s largest importer of cotton, wood and soybean.

And Brazil and India stand ready to fill the gap once China becomes a net importer of food. Brazil already exports huge amounts of soybean to China, which is used for both cooking and as animal feed. So, with less of the protectionism, tariffs and quota systems that choke off imports into the European Union and US, agricultural commodities could be boom markets for Brazil and other emerging economies.

In the past, fund managers have been unable to capitalise on such trends because farm production was small-scale and privately held. Now, though, there is a growing cluster of pure-play agricultural businesses listed on emerging-economy stock markets.

Michael Konstantinov, who helps run Allianz’s BRIC fund, is keen on Brazilian sugar producer Cosan, which listed in November 2005. The company plans to consolidate the fragmented sugar industry, and exploit Brazil’s huge competitive advantage in growing sugar cane – ideal climate, fertile land and cheap labour – to produce ethanol as well.

Around 75 per cent of new cars sold in Brazil now use ‘flex fuel’ engines, which can run on petrol, ethanol or any combination of both. So petrol in Brazil already contains 25 per cent ethanol, and the technology is taking off in the US and Japan.

Luiz Ribeiro, a senior equity portfolio manager for HSBC in São Paolo, says that Brazilian ethanol has a 40 per cent cost advantage over the US.

“The cost is good – ethanol is sold in Brazil at around 60 per cent of the cost of a litre of gasoline,” he says. “It is also more environmentally friendly because it reduces the greenhouse gases by 50 per cent and carbon monoxide, in particular, by 48 per cent.”

Cosan closed its first day of trading on the São Paolo stock exchange at BRL48. By April this year, it had shot up to BRL180, before falling to around BRL120 now.

This price fluctuation mirrors the heady gains and losses seen on most emerging markets over the past two years as investors have piled in. But Dr Mobius has a simple message for investors scared by the recent sharp falls. “If your view is six months, or two months, or one month, get out. You have no business being in emerging markets in the first place.” Trying to time markets is pointless, he believes, especially markets like these. A longer-term perspective – five years and more – is the proper kind of timeframe for an investor in emerging markets.

Dr Mobius remembers when $1m was a lot of money for his kind of fund. “Now, we talk about billions the way they talked about millions a few years ago,” he says. He accepts that the markets are more volatile now, and attributes it in part to the weight of highly-leveraged money from hedge funds, who hunt profits in the near term.

ProspectsGiven their longer-term view, the standard reaction from BRIC fund managers to the recent slump in share prices on emerging stock markets is to focus on the improved valuations now on offer. “Valuations are still reasonable,” says Mr Konstantinov.  He points out that Russian and Brazilian markets now trade on price-earnings (PE) ratios of between 8-9, China is on a PE ratio of 10-11 and India just a little higher on 13.

He also firmly believes that the capital markets of these countries offer unique opportunities. Beyond the wave of initial public offerings (IPOs), privatisations, start-ups and spin-offs, there are all the companies yet to float – or even to be established.

Each of the four BRIC countries has a huge domestic market. So the successful companies of the future will be the ones that are culturally attuned to their home consumers. Then, once they have exploited the enviable economies of scale, they should be able to leverage that business model to attack overseas markets.

If you think this all sounds too easy, you are probably right. Emerging markets are always at risk of a slowdown in global growth, something that rising interest rates would exacerbate. The Chinese banking system also carries an unquantifiable risk, given its trillions of dollars of non-performing loans. Set against that, though, are China’s massive foreign currency reserves, which could be used to help out any bank that ran into trouble.

Of course, the risk of adverse currency movements should feature prominently in the thinking of any short to medium-term investor, as well. That said, if the BRIC economies have truly reached an inflexion point, and continue their robust growth, their currencies are almost certain to strengthen.

In fact, this last possibility was one of the key points raised by Mssrs Wilson and Purushothaman back in 2003. They estimated that the BRIC’s real exchange rates could appreciate by 300 per cent over the next 50 years – helping to boost international returns by an average of 2.5 per cent a year.

Perhaps the biggest concern for a long-term investor is what the world will look like once 3bn people in Brazil, Russia, Indian and China are consuming energy, steel, plastic, timber, water, paper, fish and meat at the rate of the Western world’s blithe consumers.

Dr Mobius thinks that new, cleaner technologies will substitute dirty old ones and cites ethanol as an example. Only time will tell.

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