Last year, Frontier Investment Consulting’s deputy managing director, Kristian Fok, and head of investment research, Kim Bowater, undertook a study trip to China and India, which they have since ameliorated with extensive manager interviews and deskstop research. The asset consultant recently released to clients a comprehensive report on how best to build investment exposure to these emerging powers, which KIM BOWATER summarises below.
The concept of the BRICs countries (Brazil, Russia, China and India) was first coined by Goldman Sachs some years ago. The BRICs argument was that these large emerging markets would, over the coming decades, grow to be among the primary drivers of the global economy. While views on the fortunes of individual countries may vary over time, this idea continues to gain traction today in our own region in relation to China and India. These two countries are of particular significance as their large size means that their continued economic growth will create a meaningful shift in the balance of the world economy. The economic growth to date, and future growth potential, of China and India remains strong and well documented. Debate on specific risks to this growth potential have varied prior to and throughout the global financial crisis.
However, it is clear that these countries managed to avoid many of the problems that led to the financial crisis, and have demonstrated some resilience relative to developed economies. In relation to China, it is unlikely that this one market can rescue the entire global economy from current difficulties, and its own GDP growth may be lower than desired by its government in the near term. However, there appears to be a reasonable likelihood of China continuing to grow at a reasonable pace, despite the risks of falling exports and rising debt that may not be well targeted economically. While less strong fiscally, India’s more internal economy also has its own momentum and the basic drivers for the growth premise, such as its demographic advantage, remain in place.
Beyond the headlines Overall, we find the case for growth in China and India to be reasonably compelling. However, it is not a simple story and different risks face China and India, both in terms of ability to achieve outsized growth over the medium term, and in responding to the global financial crisis in the shorter term. There are also ESG (environmental, social and governance) risks that are heightened for emerging markets, including China and India. In particular, governance risks need to be considered carefully from an investment perspective. For the growth part of Australian superannuation portfolios, despite allocations to emerging market equities in many portfolios, current direct investor exposure to China and India is quite low and an increased tilt to these markets has some merit. We are cognisant, however, of indirect exposure to China, in particular via existing investments in Australia and globally, for example via resource stocks.
There are also second order effects across the global economy, and a broader global sentiment effect that has led to markets moving in tandem to Chinese news. This tempers our view on the size of a specific tilt, as the China and India growth theme does not exist in isolation of other existing investments held by superannuation funds. Ac tive and lis ted the way to go From an access perspective, there are attractions in using listed equity markets to achieve an increased tilt to China and India. The benefits of liquidity and low costs are significant relative to unlisted opportunities. We see advantages in an active management approach as GDP growth will not naturally transfer to aggregate stock market returns. In China in particular, companies may also have other objectives than simply return on equity.
Additionally, in highly volatile markets, a focus on valuations and downside risk management is also critical. There are also flexibility advantages in investing in China and India via a diversified emerging market portfolio, rather than a country specific allocation. The significant rally in these two markets over 2009, high volatility and valuation cycles mean that there is a benefit in having the ability to decide not to invest in these markets from time to time based on bottom up fundamentals. Investing in unlisted asset classes is another way to access growth in China and India. Frontier’s experience over the past decade and longer in unlisted investments makes us cautious of the combination of heightened structural risks in emerging markets with the illiquidity of these investments.
Structural risks are significant and include regulatory, legal, political risks, maturity of capital markets, ability to repatriate capital or income, foreign exchange risks, fairness, transparency and cultural and language barriers. These risks must be assessed carefully at the individual investment level as they can significantly impact the return potential of an investment. Whatever the apparent attractiveness of an investment, investment discipline requires the same high standards of manager quality as are applied globally, local expertise, appropriate return targets and alignment with local interests as critical hurdles for unlisted investments in China and India. In private equity, managers are less tested in these markets relative to developed markets like the US and Australia.
While there is merit in being able to more specifically target investment opportunities, the current reliance on the IPO market for exits makes private equity a less compelling opportunity relative to listed markets. Asian exposures are also slowly increasing in global private equity portfolios and allocations will grow over time without the need for targeted investments. Infrastructure investing looks attractive in both India and China from a demand perspective. There are significant requirements for new infrastructure, and assets with greater income protection can also benefit from the growth potential of these markets. India is more attractive than China in this asset class, as it has a longer history and more established framework for private infrastructure ownership, and a heightened need for private capital to fund infrastructure requirements.
China may make sense on a case by case basis. As infrastructure in these markets is mainly greenfields, any investment will be a higher risk, growth investment relative to existing core, established infrastructure assets. While the opportunity appears strong, the infrastructure theme is also captured in other investments, including some global equity portfolios. Property investing is a localised and competitive market, and we believe there are greater structural and investment risks compared to infrastructure. While select attractive opportunities to invest in Chinese or Indian property may arise from time to time that overcome some of the inherent risks, the returns for such an investment need to be commensurately high, and this is a significant hurdle for investors. Given the significant risks involved for unlisted property, this may be better achieved via a REITs allocation.