Safe ways to invest in emerging markets

Canadian investors don’t need to be reminded about how poorly home markets have performed of late. The S&P/TSX Composite Index was up a meagre 0.4% for the first half of 2018 and as a trade war with our largest partner heats up the outlook looks anything but bright.

If it gathers steam, we can expect a weaker economy, lower dollar, rising inflation, and rising rates. It all adds up to lower profits and share prices for many domestic companies.

There is one way to mitigate the damage, if not entirely avoid it. It is to leave town and head farther afield. Diversification outside of Canada makes sense for many reasons. The main one is that the value of all Canadian stocks is 4% of the global pool. That means 96% of the opportunity lies somewhere else.

There are several options from which to choose when you decide to leave home, with pros and cons to each strategy. Exchange-traded funds (ETFs) are bets on countries or regions. Mutual funds carry higher fees than ETFs but are actively managed. American Depository Receipts (ADRs) are bought and sold like stocks and trade on U.S. exchanges.

But the safest approach is by investing in the big multinational players who are already operating in overseas markets and are expanding their presence as opportunities present themselves. These companies have established brands and have learned how to navigate the complexities of different cultures, languages, and tastes. As well, they have deep pockets and so can afford to make mistakes while continuing to pay dividends. They are well placed to take advantage of the trends that are driving emerging market economies forward.

The value of emerging market stocks is now a third of the global total. That is equal to the U.S., which is still home to largest pool of stock market capital. But emerging markets will soon surpass it.

Christine Lagarde, managing director of the International Monetary Fund, noted in a speech that as a group, developing economies account for almost 60% of global economic output, up from just under half only a decade ago. They have contributed more than 80% of global growth since the 2008 financial crisis.

Emerging or developing markets can be loosely defined as a group of countries in Asia, Latin America, and parts of Eastern Europe. They are not too rich, not too poor, and not too closed to foreign investment. Their regulatory and financial systems are not fully mature. They tend to have young, growing populations and rising incomes, generating demand for consumer products of all kinds.

The largest are China, India, Brazil, and Indonesia and these economies are rapidly forming the basis of a new middle class.

The emerging market story is very much about numbers. India has 1.3 billion people with a median age of 28. Canada has 36 million people with a median age of 41. About 10 million people join India’s labour pool each year. Canada’s entire workforce is about 18 million, so India adds an entire Canada every 1.8 years. Where will demand for basic household goods likely be?

All of these workers need a place to live, transportation to and from work, and household goods. They use the Internet and cell phones, look for ways to entertain themselves, and are starting to travel.

So, while Canada’s GDP is expected to grow by 1.9% this year, according to RBC Economics, the IMF sees 6.5% in China and 7.3% in India, which is now the global growth leader.

The perception of risk is one that stops many investors. These markets seem too far away, too unfamiliar, and too unpredictable. Customs and currencies are different, as are laws and politics. That’s why a first step through multinationals makes sense. Let them take the risk and piggyback on their success.

It’s worth noting that we often magnify the risks in emerging markets while minimizing them at home. It’s a question of perspective.

Start with valuations. The average p/e ratio for an American company is 25.7 after nine years of record low interest rates. That is well above the historic average of 15. Yet U.S. share prices continue to rise, stretching valuations even more. The Dow and Nasdaq continue to hit records, even when faced with a global trade war.

A stronger U.S. dollar has sent emerging market stocks lower as their profits translate into fewer dollars. But Canadians are expert at managing currency swings. Our dollar has dropped 30% from its peak of $1.07 U.S. in 2007. But we are still buying U.S. vacation properties, drinking Florida orange juice, and shopping across the border.

Even if your instinct is to still give these markets a pass, some of your money is already there through the Canada Pension Plan. The CPP Investment Board (CPPIB), which invests the CPP’s money, has 15.8% of its $355 billion portfolio in emerging economies, according to its 2018 annual report. That includes public and private shares, residential real estate, office buildings, factory space, shopping malls, toll roads, and other infrastructure investments. The CPPIB is one of the biggest owners of warehouse and logistic facilities in China.

CPPIB’s board recently endorsed a strategic plan that aims to have 33% of its portfolio in emerging markets by 2025, just seven years away. Its largest non-Canadian stock holding is India’s Kotak Mahindra Bank, worth $2.38 billion. Alphabet is its second largest foreign holding and China’s Alibaba is third. Way down the list are Apple and Facebook, at 11th and 12th respectively.

As a small investor you cannot compete with a pension fund. You do not have the time horizon, the access to private investments, and the ability to keep fees low. But you can benefit from their thinking. You may not be comfortable putting a third of your assets in emerging markets, but it’s worth a conversation with your advisor to discuss your risk tolerance and how you can safely go about it.

For a first dip, I suggest the three multinationals below as a safe way to test the waters. All three are benefiting from their emerging market strategies. They hold a lot of upside potential with limited downside risk. They all pay dividends, which are rising. Two are current Internet Wealth Builder picks. All three are likely to avoid the worst of a trade war and prosper in an uncertain economic climate.

Scotiabank (TSX, NYSE: BNS)
Originally recommended by Tom Slee on Jan. 16/11 (#21102) at C$56.83, US$57.84. Closed Friday at C$75.10, US$57.29.

Background: BNS is Canada’s third largest bank and its most international. It continues to expand abroad and gets about 50% of its revenue from outside Canada, with a strong presence in Latin America, especially Mexico, Peru, Chile, and Colombia.

Recent developments: For the quarter that ended on April 30, Scotiabank reported profit of nearly $2.2 billion ($1.70 a share) compared with $2.06 billion ($1.62 share) in the same quarter last year. Profit from international operations rose 14% to $675 million.
Acquisitions: This fiscal year, the bank has struck three Latin American deals. In December, BNS gained control of Chile’s BBVA bank, the country’s third largest, for $2.9-billion. The acquisition raises the bank’s Chile market share to 14%.

In January, BNS acquired the consumer and small enterprise operations of Citibank in Colombia through Banco Colpatria. Scotiabank acquired control of Banco Colpatria in 2012, which is Columbia’s fifth largest banking group.

In May, Scotiabank Peru, acquired 51% of Banco Cencosud, the country’s largest department store chain, which also offers credit cards and consumer loans. BNS will become the second-largest credit card issuer in Peru. All three further its Latin expansion strategy.

Dividend: Dividends have been increased in each of the last five years. The latest was a 3.8% boost with the April payment to $0.82 a share ($3.28 annually) to yield 4.4% annually. The stock trades at 10.7 times the bank’s projected 2018 earnings of $7.01 a share.

CAE (TSX, NYSE: CAE)

Originally recommended by Gordon Pape on March 20/17 (#21712) at C$19.58, US$14.69. Closed Friday at C$27.61, US$21.07.
Background: CAE is the world’s largest maker of flight simulators for civilian and military use. About 90% of revenues come from outside Canada, with 18% overall coming from China and other Asian countries. Commercial aviation is about 55% of revenue, military is 45%, and healthcare and medical simulation about 5%. CAE trains more than 100,000 pilots and aircrew a year at 67 training centres worldwide.

Performance: CAE shares have been on a roll this year helped by record orders for its simulators. The stock opened the year at about $23.50 and was trading on Friday at $27.61, up 17.5% year to date.

Recent developments: Last fall CAE bought control of a partly owned Asian Aviation Centre of Excellence in Malaysia, with other locations in Singapore and Vietnam, as well as an additional stake in another joint-venture training centre in the Philippines. CAE is benefiting from the global shortage of pilots needed to meet the demand for air travel. Much of that demand is coming from emerging markets where rising affluence means more people can afford to travel. The company has a strong order backlog worth $2.7 billion.

Dividend: The company pays a quarterly dividend of $0.09 per share ($0.32 a year) to yield 1.3% at the current price.
This article originally appeared in the April 9, 2018 Internet Wealth Builder newsletter.