Asian Emerging Markets Will Grow on You
Saturna Capital Corporation
By Peter Nielsen & Bryce Fegley
January 3, 2011
A year has passed since Saturna put staff on the ground in the heart of Kuala Lumpur, Malaysia, at the offices of our subsidiary, Saturna Sdn. Bhd. As expected, we have gained valuable insight into the emerging markets of Asia. We find the key to unlocking the opportunities these markets have to offer is an understanding of the intersection of market structure, demographics, economic growth, and asset allocation. Our analysis of trends in these four areas reveals an economic environment with favorable prospects for long-term growth.
1. Market Structure: Control is dispersing.
The first thing to notice about Asia (excluding Japan) is that company ownership is heavily concentrated, with the largest shareholder frequently controlling the majority of shares. In contrast, equity ownership in the U.S. is widely dispersed. Only a handful of companies in the S&P 500 have more than 20% of their market capitalization locked up in the control of a single party. The biggest of these include the Walton family’s 47% stake in Walmart, Larry Ellison’s 22% ownership of Oracle, and Jeff Bezos’ almost 20% holding in Amazon.com. Oh, and we had better not forget the U.S. government’s 86% stake in AIG. But apart from these exceptions, ownership is broadly scattered among institutional managers and individual investors in the U.S., and to a slightly lesser extent, in other developed markets such as the U.K., Europe, and Japan.
The world’s first and second largest companies are a study of contrasts. Exxon Mobil, the world’s largest company by market capitalization ($362 billion), has no single shareholder that owns more than 1% of its shares. The next largest company, PetroChina (market cap $311 billion) has almost 98% of its shares locked up by the Chinese government.
With different levels of control come different types of risk. In developed markets, corporate governance problems usually arise from the principalagent conflict, where dispersed investors may find it difficult to collectively police company executives.
In developing Asian companies with majority control in the hands of the government, or a family bloc, the agent conflict disappears — owners have much more control over managers. But it is supplanted by a different set of conflicts, particularly related party transactions, between public companies controlled by the same family or government, or between related individuals involved in business transactions with those companies. Regulators in a number of Asian countries have recognized this problem and created strict disclosure and voting requirements for related party transactions. However, in both types of control situations the same general paradox arises: minority investors may find little added value in scrutinizing agent conflicts or related party transactions, especially in the context of a well diversified portfolio. Perceived risk may not outweigh the burden of oversight, which introduces the potential for abuse.
The following table summarizes ownership data, ranked by free-float shares1 as a percentage of total shares outstanding, for the members of the primary index in various developed and Asian economies
Dispersion of ownership is strongly correlated with per capita GDP, which makes sense because poor countries typically lack the developed financial markets that make widespread ownership possible. Singapore stands out as an exception, with a combination of the highest per capita GDP, well developed capital markets, and high ownership concentration.
Indeed, in the aftermath of the global financial crisis, governments in Asia, particularly China, veered toward the brand of “state capitalism” most successfully championed by Singapore, and in supposed opposition to the type of cowboy capitalism that underpinned the “wild west” housing markets of the United States. This raises an interesting point that relates again to AIG: so-called state capitalism as practiced explicitly in Asia also received implicit endorsement in both the U.S. and Europe during the height of the banking crisis. The very concept of “too big to fail” implies that the government owns the credit risk of companies and banks that are deemed to qualify, even if it does not own the companies themselves. Investor perception that a company is too big to fail may have the same effect on lowering its cost of capital as would be the case if the government owned shares directly. The differences between the types of capitalism endorsed in the east and west are not always yin and yang.
Without developed capital markets, only the government, founding families, or foreign investors will have the capacity to own companies. Asian governments in developing economies understandably prefer to hold control of companies in key industries if the alternative is to cede control to foreign investors. The key takeaway here is that the risks associated with concentrated ownership are not as exotic as they appear at first glance and in any case will be tempered as rising per capita GDP gradually “democratizes” these markets.
2. Demographics: Emerging Asia is aging well.
The great decline in infant and childhood mortality rates has led to the rapid growth of the world’s population over the past six decades. Global infant mortality in 1950 was 15.2%, and is now 4.3%. In developed countries, the infant mortality rate was 5.9% in 1950 and is now just 0.6%. Declining birth rates are strongly correlated with rising income; however, childhood mortality has decreased more quickly than incomes have risen in Asia, and as a result of this lag, population growth rates in Asia’s three most populous countries have more than doubled those of developed countries over the last sixty years.
The age structure of Asia’s population reveals some important information in understanding its growth potential. There are several interesting ways to slice it: median age, dependency ratio, and something called the Demi-Ashton ratio.
Median age in China is rising rapidly as a result of its one-child policy. In 1970 China’s median age was just 19.7 years, this year it is 34.2, and by 2050 it will rise to 45.2 years. This trend helps to explain China’s heavy preference for savings as opposed to consumption: the current population cannot rely on its offspring for support in old age.
Other developing Asian countries will age more gradually due to higher birth rates.
A country’s dependency ratio expresses the number of working age adults (aged 15-64) divided by the number of dependents (children 14 and younger, plus those 65 or older). A low dependency ratio should leave a population with more wealth to channel to productive investment.
Dependency ratios in most Asian countries will fall or remain flat over the next 15 years, while they will begin to rise in the developed world.
A market strategist named Ajay Kapur of Mirae Asset Financial Group coined the term “Demi-Ashton ratio” last year to playfully refer to the ratio of the population in their 40s (i.e., Demi Moore) to those in their 20s (i.e., Ashton Kutcher)2. The idea behind examining this ratio is that populations with high and rising Demi-Ashton ratios have a favorable concentration of prime earners (those in their 40s), and should have the capacity to devote more income to productivity enhancing investments, thus driving up real economic growth. In addition, the preference for investment should further boost stock prices by driving down risk premiums. This theory seems to have worked in the United States as a reliable predictor of long-term real stock market returns, and has intuitive appeal economically.
Economic growth in developed countries has been relatively weak over the last ten years while growth in Asia has been blistering. A comparison of growth with change in Demi-Ashton ratios adds further evidence to support the theory. In the next ten years, increases in the Demi-Ashton ratio look promising for China, Indonesia, Philippines and Malaysia, and the ratio will rebound in developed countries (particularly Japan). However, with dependency ratios also expected to rise in developed countries, and to fall in developing Asia, the demographic structure may tip to Asia’s favor.
3. Economic Growth: The way is paved.
Improved political stability, the collapse of central planning via successful marketoriented reforms, and globalization have paved the way for rapid real economic growth in much of the developing world. High economic growth rates are likely to continue because productivity enhancing technology is already available — it is only a matter of investment for adoption of the technology. In contrast, developed markets in North America, Europe, and Japan already utilize the best available technology. The demographic factors analyzed above suggest a favorable investment climate in developing Asia. On the other hand, growing dependency ratios in developed economies could hamper productivity improvements by channeling more resources to consumption of costly health care and interest payments. Given this situation, it is natural that developing countries in Asia and elsewhere will catch up with an ever-growing share of world economic output.
4. Asset Allocation: Investibility is improving.
While Asia is home to more than half of the world’s population, its economic footprint is proportionally much smaller. Measurements of its float adjusted market capitalization are smaller still, limiting “investibility.” Total float adjusted market capitalizations of developing Asian countries, defined here as China, India, Indonesia, Malaysia, Philippines, and Thailand, add up to just 4.5% of global market capitalization.
A typical recommendation for a balanced asset allocation in the U.S. that includes developing markets will look something like the pie chart below.
If recommended exposure to developing Asian markets is limited to an allocation of 5%, the typical investor might ask, “Why bother?” There are a couple of compelling reasons:
First, at the end of 2009, the GDP of developing Asia was slightly more than half that of the U.S. The forecast above would bring developing Asia’s GDP to more than 85% that of the U.S. by 2020. Float adjusted market cap, or “investibility,” is important because too many investors chasing too few shares can push up valuations and drive down expected returns, even when underlying economic prospects are superior. But growth prospects and the large discrepancy between the 4.5% float adjusted market cap and 12.8% GDP suggest that investors at least consider overweighting developing Asian equities — when valuations are attractive — at levels closer to their economic footprint. Furthermore, investibility is likely to increase as capital markets develop, per capita GDP rises, and ownership grows more dispersed as it has in developed markets.
Second, the very fact that most U.S. investors deny specific attention to developing Asian equities in their asset allocation suggests opportunities exist to uncover value. Large investment houses may find little reason to devote resources to analysis of developing Asia when it makes up such a small portion of client portfolios. This leaves a window open to firms, like Saturna, that are willing to take a close look at these markets to find undervalued companies doing business in an attractive economic environment. Developing Asian countries have solid, long-term economic growth prospects buttressed by favorable demographic trends. While it is true that the publicly available float of stocks is low compared to contribution to global growth, investibility should increase as economic growth continues to outpace the developing world, and as capital markets develop. As this occurs, U.S. investors are likely to increasingly seek the wisdom of firms with experience and track records investing in Asia — which is why we are there.
(c) Saturna Capital Corporation