The leopard and his spots: Deception in emerging markets

May 29, 2014 | Paul Moroz Print

In a recent National Geographic article, paleontologists reported the discovery of a new fossil. The 126 million year old creature was given the name Cretophasmomima melanogramma which sounds slightly more exotic than its meaning: ancient black-lined stick insect. This organism may be the earliest example of plant mimicry, a survival characteristic where one organism simulates another, e.g., a bug that looks like a twig has a better chance of not being eaten. Deception, it would appear, is not new to nature. And it continues today in many forms. For example, the benign red milk snake mimics the appearance of a poisonous coral snake (hoping to scare off predators), while the spots on a leopard break up its shape (dubbed disruptive camouflage) allowing it to hunt more effectively. Some things in nature are not what they appear to be – and the same can be said of investing in emerging markets.

Emerging markets are those countries that, by axiom, have yet to emerge. Therein lies the potential and the peril. In general, these are countries that tend to grow their economy at an above average rate and may offer more substantial investment potential, but they often have greater risks associated with them, typically with challenges around political stability, corporate governance and property rights. Brazil, Russia, India and China are all considered to be emerging markets. But simply assigning an investment to the “emerging markets bucket” is misleading. Detailed bottom-up analysis is required to understand the prospects of risk and return.

A common misunderstanding of emerging markets is the assumption that the location of a company’s headquarters determines the security’s actual exposure. Many companies headquartered in developed countries manage global operations that include emerging markets. Nike Inc., of running shoe fame, is a good example of this. Nike was incorporated in Oregon in 1971. It is an American brand. It trades on the New York Stock Exchange. The United States is a developed market. Surely it can’t be an emerging markets stock? Or are these spots masking the shape of the leopard.... As it turns out, close to 1/3 of Nike’s profits are from countries deemed emerging markets, including China. And what about BMW? German cars, German company, and German brand. Germany is a developed market, right? Not quite – China alone makes up 20% of BMW’s revenue.

As the world has globalized, this sort of deception is a common theme across equity investments. It is why we at Mawer spend so much time understanding the details of businesses and why we believe in putting together our portfolios on a stock by stock basis – an essential requirement for distinguishing branch from stick bug.


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