Emerging markets present a perceived catch-22 to investors: On one hand, this is an asset class known for its dynamic long-term growth potential and diversification benefits. On the other hand, it is an asset class often perceived as inherently risky.

Especially now, as coronavirus has spiked index volatility levels, many investors are being deterred from diversifying into emerging markets. However, looking at an index to measure the merits of emerging markets equities may be limiting investors’ exposure to the potential benefits of this asset class, which is rife with investment opportunities that are participating in a wave of rapid economic development, digitalization, and rising consumer purchasing power.

WCM Investment Management sees things differently, believing the benchmarks are the risk. The shortcomings of a passive investment approach to emerging markets can be significant, according to Greg Ise, Portfolio Manager & Business Analyst at the California-based equity investment firm.

“If you look at the emerging markets indices, they tend to be dominated by lackluster businesses, including bureaucratic, state-owned enterprises (“SOEs”), and are likely to be overweight value-oriented, cyclical sectors that will slowly decline in relevance as emerging economies develop,” says Ise.

He points out that about 50% of the MSCI Emerging Markets Index is allocated to financials, telecommunications, energy, basic materials, heavy industry, and utilities companies. “These sectors grow slower than their underlying economies and are dominated by SOEs. SOEs operate for the state, rather than for private shareholders’ benefit,” says Ise.

On the contrary, emerging markets may also offer some of the most dynamic and fastest-growing businesses across the globe – companies that are leapfrogging the developed world in digital business models and/or creating entirely new services and industries.

These are the types of companies WCM looks to own in their concentrated portfolios.

“Which would you rather own,” asks Ise, “an oversized, bloated Chinese bank being forced to lend for political reasons, or a privately owned, motivated technology company bringing hundreds of millions of people into the digital age?”

WCM believes their distinct, research-driven investment process is paramount to achieving sustainable excess return and mitigating downside risk. Specifically, WCM focuses on uncovering companies with growing competitive advantages (a positive “moat trajectory”), characterized by strong, adaptable corporate cultures aligned with that competitive advantage, and all supported by durable global tailwinds.

Owning these types of businesses in a focused portfolio partners WCM’s investors with tomorrow’s leading companies, which potentially stand to benefit from a multi-decade tailwind of robust growth.

At the sector level, WCM’s Emerging Markets strategy looks very different from the benchmark. “A focus on innovation, long-term moat trajectory, and culture has led us to sectors like technology, healthcare, and consumer. I think those sectors are vastly underrepresented in the emerging markets indices, both in terms of their current, and more importantly, future relevance,” explains Ise.

Sector Allocation Difference of WCM Focused Emerging Markets Strategy
(as of September 30, 2020)

Source: WCM, MSCI, FactSet as of September 30, 2020

Megatrends and Growth Drivers
For the last twenty years, emerging market economies have substantially outgrown their developed market counterparts. Mike Tian, WCM Portfolio Manager & Business Analyst, points out that most observers expect more of the same for the foreseeable future, fueled by megatrends such as urbanization, digitalization, and the rise of the global middle class.

“As a consequence, companies that are positioned and able to take full advantage of these trends stand to generate strong and consistent revenue and earnings growth, which bodes well for investor returns in the long run,” says Tian.

It is difficult to overstate the growth potential of emerging markets. For example, in just the last twenty years, more than a billion people in emerging markets have joined the ranks of the middle class, nearly two billion have moved into cities, and nearly three billion have accessed the internet for the first time.¹

Superior Corporate Culture Search
For years, a critical pillar of WCM’s investment process has been its focus on culture and leadership (one part of which is governance). In the past, not many considered these factors, but nowadays they are receiving ever-increasing scrutiny due to the adoption of ESG frameworks by investors.

“We want to partner with capable and trustworthy management teams, running firms with cultures that are strong, adaptable, and aligned with long-term strategy. We believe this emphasis is even more important in emerging markets, where traditions and institutions of corporate governance are generally weaker,” says Tian.

Unlike developed markets, where management teams are largely professional, and capital markets are well regulated, successful companies in developing economies tend to be run by entrepreneurs – or families – who leave a larger imprint on the culture, governance, and the ultimate success of their firms.

“It is here we think our long experience, and our deep, boots-on-the-ground work, gives us an edge. We strive to understand how companies tick, from the decision making of top management all the way down to the motivations of frontline workers,” explains Ise.

Ultimately, WCM believes emerging market equities continue to offer long-term investors some of the best growth opportunities in the world. Following a distinct, disciplined active investment strategy, such as WCM’s, may be a smarter route to take than benchmark-bound passive strategies.