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Great Expectations Misapplied (GEM) - Investing in the GEM Equity Paradox.

  • Apr 2023
  • | Jonathan Asante
  • | Global Emerging Markets team

“The common prosperity we desire is not egalitarianism. To use an analogy, we will first make the pie bigger, and then divide it properly through reasonable institutional arrangements.” - Xi Jinping, January 2022

Sitting in the marketing department of the average funds management company thirty years ago things looked good for your new GEM Funds business.  Latin America had emerged from decades of military dictatorship and hyperinflation.  The Soviet system had collapsed, with hundreds of millions of people poised to reconnect with Western Europe.  Further East, Taiwan, Korea and the so called ‘Tiger Nations’ of Southeast Asia had successfully joined the global supply chain offering cheaper goods than the Japanese and the reforms of Deng Xiaoping had succeeded in correcting decades of Maoist disaster for China’s people.  By 1991 even that most sluggish of free marketeers, India, had started to reduce government involvement in some parts of the economy while opening itself up to the world.   Finally in 1994 the brutal regime of Apartheid ended.  Nelson Mandela became South Africa’s first black President and then perhaps the most remarkable figure of the twentieth century unexpectedly embraced business as a major driver of freedom.

Pitch books were printed, investment teams assembled, and salespeople dispatched armed with one main argument: that in the post-Communist era many lower income countries would pursue economic policies which allowed more of their population access to opportunity.  This would mean economic growth, lots of it and the way to capture growth was to own equities.  Hundreds of billions if not trillions of dollars of high fee earning GEM equity funds have been sold as a result.

The GEM Paradox

The idea that people would get better off turned out to be true enough for lower income countries with large populations.  Even some of the worst-run, most crisis prone places (Egypt, Nigeria, Russia, and Pakistan to name a few) were able to improve measured GDP per head off their low base faster than the developed world could off its high base.  Others, particularly in Southern Asia, did very well indeed in this regard.  While there is clearly a long way to go, the rise out of poverty of hundreds of millions in Asia and Latin America represents arguably one of humanity’s greatest achievements.

GDP per Head in 2021 over GDP per Head in 1990

 

Population 1990

Ratio 2021 to 1990

 

Population 1990

Ratio 2021 to 1990 GDP

Vietnam

66m

38.7x

Russia

148m

3.5x

Bangladesh

107m

8.3x

Mexico

82m

3.1x

Indonesia

182m

7.4x

US

248m

2.9x

India

870m

6.1x

China

1153m

2.8x

Egypt

57m

5.8x

Brazil

151m

2.8x

Peru

22m

5.5x

Turkey

54m

2.8x

South Korea

40m

5.3x

Argentina

33m

2.5x

Thailand

55m

4.6x

UK

57m

2.4x

Pakistan

115m

4.3x

Germany

79m

2.3x

The Philippines

62m

4.2x

South Africa

40m

2.2x

Ethiopia

48m

3.6x

France

56m

2.0x

Nigeria

95m

3.6x

Japan

124

1.5x

Source: CCAM, World Bank and “Population Pyramids of the World from 1950 to 2100” © 2023 by PopulationPyramid.net, made available under a Creative Commons license CC BY 3.0 IGO: http://creativecommons.org/licenses/by/3.0/igo/

But despite there being enough growth to go around, foreign investors tracking the MSCI GEM index did not earn better returns - the last decade has delivered a particularly weak outcome.  The apparent failure of GEM indices to offer superior long-term returns even as economies expanded faster than in the rest of the world appears at first sight to be a paradox in need of explanation.

What Were the Reasons for it?

We believe there were four main reasons for the disappointing index outcome and that understanding them provides a clear idea of how better to invest in lower income countries for the next ten, twenty or thirty years.  Making acceptable returns for clients from investing in lower income countries lies at the heart of the approach we have developed over the last two decades.

1. The GEM Index Wasn’t Devised to Make Clients Money

It may now seem absurd but twenty or thirty years ago stocks in China and India were only tiny parts of the GEM Index as they were not deemed greatly investible.  This suggests that index construction may well have been based on what was easiest to access and measure at the time, which often had very little to do with what was going to make money for clients in the longer term.  Perhaps consequently, the GEM index has also tended to strongly favour overly popular countries and sectors at the precisely wrong moments.  All the following were significant index constituents just before they collapsed: Mexico in 1994, Malaysia in 1997, Resources companies in 2007 and China’s large Information-Capture companies in 2020.

2. Company Quality Was Often Not Good Enough to Sustain Returns for Owner

Many big companies listed in emerging markets did not possess sufficiently strong governance to provide long term returns for their foreign minority shareholders.  Franchises built by oligarchies through political patronage or worse, have tended not to excel in the long run while those more directly related to government, such as the huge state-owned banks listed in many GEM stock markets, have in the end found it hard to dance to the tune of both minority shareholders and their political masters.   Over the years we have identified only a small proportion of the companies listed in emerging markets possessing both sufficiently robust governance and franchise strength to be investible.  Unsurprisingly these have often delivered strong share price performance over the long term.  

3. Global Multinationals Were Effective GEM Operators Too

Some of the world’s best companies were doing business with lower income countries many decades before fund managers started peddling the opportunity and those who succeeded now have a significant part of their businesses in GEM while being still listed on developed world stock exchanges.   These global businesses are often less nimble than their smaller GEM counterparts but are generally stronger at building the hugely profitable brands to which customers aspire as they get better off.  Their governance sometimes stands up to scrutiny better than many (but not all) listed GEM companies.  Over the last two decades we have found companies such as these in Germany, Switzerland, Japan, Sweden, Denmark, and the US.  The shares of the best GEM-focussed global multi-nationals may have amply rewarded their investors but have not been captured at all by most GEM fund managers as they simply were not present in the GEM index.  The process of economic integration that these companies have driven although slowed by the rise of nationalist politicians, is likely far from over.  As might be expected this has also been a two-way process which has seen a remarkable emergence from humble beginnings in poorer countries of sustainably competitive multinational companies in IT services, electronics and even the food and drinks industry.

4. Economic Freedom on The Wane

By 2013 it was painfully apparent that the improvement in institutional governance forming the basis of the original GEM story was becoming doubtful.  Some leaders of major lower income economies appeared far less tolerant of freedom.  The powerful elites backing them often looked to be closing ranks to extract more of the ‘growing pie’ for themselves in a way that bore little resemblance to the ‘reasonable institutional arrangement’ described in the quote above.  The worsening backdrop for the rule of law implied waning opportunity for those companies not prepared to play the game but then agreeing to ‘playing the game’ would usually imply that they were not investible for us.  Four years later, the jailing of the leader of Samsung, arguably the GEM universe’s most visibly successful group, powerfully demonstrated the extent to which governance had stalled.

Addressing the GEM Paradox Through an Investment Approach

It is our belief that economic progress will continue for many people in lower income countries sometimes despite the actions of wayward political leaders.   Our approach to benefitting from this tailwind for clients can be described in the following points.

  1. Invest in the best quality companies where shareholders will be allowed to benefit from growth in lower income economies.
  2. Recognise that these companies are now as likely to be listed in developed as in emerging stock markets.
  3. Ignore indices when building GEM portfolios - the index may well continue to be a poor representation of the true investment opportunity.

These three points are simple to understand but hard to implement.  Not owning the many poorer quality companies that will become very popular from time to time in the GEM Index requires the fund manager to be able to strongly lag risk-loving markets without being fired and this is partly why so many are unable to do so.  As we have been fortunate to discover, however, once the trust of clients is truly earned a virtuous circle has been possible where better long-term returns can be made owning less risky companies whose success enhances rather hinders the chances for the billions of people striving to improve their lot in lower income countries.

Important Information

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