For professional investors in Brazil

Innovation a catalyst for growth in emerging markets

While the pandemic has increased near-term risk, the rise of innovative and value-added industries should place the trajectory of emerging markets on more stable footing, Daniel Graña and Matt Culley argue.

Matthew Culley

Matthew Culley

Portfolio Manager | Research Analyst


Daniel J. Graña, CFA

Daniel J. Graña, CFA

Portfolio Manager, Emerging Market Equity


23 Sep 2022
10 minute read

Key takeaways:

  • Long fueled by the drivers of “convergence” and “outsourcing,” we believe emerging markets will increasingly rely upon value-added innovation for economic growth.
  • A young talent pool is leveraging technological advancements to provide solutions to unique, local business frictions.
  • Innovative EM companies stand to become global leaders as they tap their large domestic markets and adapt their businesses to other regions, including developed economies.

Emerging markets (EM), in our view, remain one of the more compelling themes in equities investing, but perhaps for reasons not fully appreciated by investors. At present, EMs as gauged by leading benchmarks encapsulate 24 countries and more than half the world’s population.  We think the size and growth rates of these regions alone should merit investors’ attention.

Despite these countries’ diverse social, economic, and political structures, over the years there has been surprising similarity in the underlying themes and opportunities for EM equities investment. Consistent with their “emerging” status, historically there have been two primary reasons for gaining equity exposure to EMs: outsourcing and convergence. With respect to the former, EMs have been a major beneficiary of the drive toward globalization as developed markets look for lower-cost ways to unearth and refine raw materials, manufacture products, and provide services. As incomes in EMs rise, so too does the demand for cars, smartphones, life insurance, and other middle-class outlays that drive convergence toward developed market penetration rates. These two factors have been the principal forces behind the impressive performance of several EM commodities, manufacturing, and outsourced services stocks over the past two decades.

And now there are three

While outsourcing and convergence remain core pillars of the EM opportunity set, we have begun to see the emergence of innovation as a third investable EM meta-theme. The last decade has witnessed innovative EM companies such as Alibaba and Tencent growing to become some of the largest companies in the world. We expect other companies to follow suit and believe that we are at the precipice of a broadening of EM-originated innovation that has the potential to reshape the social and economic order around the world.

The global economy is entering an unprecedented time for innovation. The so-called Fourth Industrial Revolution is enabling the homogenization of the physical, digital, and biological world. Importantly, these advancements are no longer the exclusive domain of developed markets. Instead, these global forces are coalescing to drive innovation in EMs as well.

The undercurrents that aided the outsourcing and convergence stories of the past decades – combined with consumer technology proliferation and Internet penetration – have set the stage for a profound change in how and where innovation happens. We are not alone in recognizing that demographics strongly favor EMs, given their materially younger populations and a shift in consumption toward the rapidly expanding generation of middle-class, digitally native consumers.

Figure 1: Global Internet users by region

Asia leads the word in Internet users, many of whom are younger, digitally native consumers who rely upon connectivity for many aspects of their professional and social lives.

Source: Internet World Stats, as of 31 March 2021.

Emerging countries are educating students in science, technology, engineering, and mathematics at a faster pace than any other region. These graduates are entering the workforce with the sum of nearly all information known to mankind at their fingertips. In contrast to years past, they are increasingly looking away from Western markets and toward home, seeing the combination of opportunity and resources available to build viable businesses that tackle local market challenges. This has led to scaled pools of talent, experienced entrepreneurs, and abundant venture capital to form the backdrop for sustained innovation for decades to come. Artificial intelligence (AI), Big Data, 5G, blockchain, nanotechnology, biotechnology, the Internet of Things (IoT), and quantum computing represent some of the enabling technologies supporting the transformation of human lives and enterprises that we are beginning to see originate out of the emerging world.

Figure 2: University enrollment in STEM curricula (millions)

Major Asian emerging markets are training students in science, technology, engineering, and math curricula at a higher rate than other regions.

Source: Bloomberg, as of 2021.

A springboard for productivity

We were struck by a recent conversation with a South Korean entrepreneur who noted that true innovation breaks trade-offs by eliminating the higher friction and stacked economics common of legacy market structures in EMs. Regulatory and business formation constructs developed over time to favor incumbents and stifled the competitiveness of small- and medium-size businesses. Technological advancement has the potential to shatter this unproductive paradigm. What has become so salient in EMs is that these innovations are driving inclusion – one of the most powerful forces in unlocking demand globally and an essential ingredient for economic growth. By broadening access and enabling participation by EM populations that are under- or unserved by existing institutional structures, innovation is adding benefits that are inherently different and complementary to the convergence and outsourcing stories of past decades.

Entrepreneurial fintech businesses are bringing an unbanked population into the financial system with the potential to elevate millions out of poverty. The application of blockchain technology across supply chains is enabling access to credit to an enormous group of underserved small businesses and could help alleviate failure rates that are much higher than in developed markets. Importantly, the shifting landscape for innovation is similarly enabling a positive environmental impact. Rather than balancing the inherent trade-off between economic growth and environmental harm, many innovators have made sustainability a positive input to their business model, rather than a negative output to be managed. This flips traditional environmental, social, and governance (ESG) investing on its head.

Local solutions to local challenges

Many business models prevalent in EMs have been imported from developed markets where they were forced to overcome intense competition to create differentiation by solving local market frictions. With the greater ease in which technology is diffused globally, an increasing number of businesses are finding their way into EMs – with varying degrees of success. Emerging markets have a long history of leapfrogging legacy technology generations, such as mobile networking superseding traditional wireline communication. But in many cases, we are presently seeing a complete bypass of traditional development, which is resulting in innovation scaling faster. Food delivery has grown at a dramatically rapid pace in China and penetration now stands far in excess of developed markets. In India, where restaurant penetration remains but a fraction of the Western world, with limited selection, we are seeing a strong adoption of cloud kitchens alongside the expansion of the major food delivery platforms. This has the dual benefits of increasing supply and selection for underserved consumers and also enabling enormous job growth in what has historically been a difficult industry for small business owners.

In Latin America, Brazilian logistics have long been underdeveloped, resulting in elongated and costly supply chains dominated by the state-run postal service and fragmented middlemen. Today, we are seeing the emergence of multiple digitally enabled logistics companies that are providing on-demand, intra-city services. Digital freight matching platforms are also on the rise. These companies pair shippers and truckers to significantly increase the efficiency and speed for the shipper and provide higher wages for drivers, all while circumventing the need to build the traditional multi-modal supply chain conglomerates prevalent in the U.S. and other developed markets.

Figure 3: Food delivery service users as a share of Internet users by region

The proliferation of food delivery in China vis-à-vis developed markets illustrates how seamlessly many of the country’s citizens have adapted to the digital economy.

Source: Company presentations, Bloomberg.

Healthcare joins the fray

As emerging markets compound their demographic advantages in education, we are seeing an explosion of new and innovative companies across the health care ecosystem. Increasingly, even Western-educated EM citizens are returning home to establish startups. Rather than joining well-known global leaders, or developing outsourced generic drug manufacturing facilities, true innovation is happening domestically. We recently spent time with the founder of a colorectal cancer screening company who has developed a patented technology to provide world-leading accuracy at costs that are a fraction of those in developed markets. While initially providing benefits for an at-risk population of 700 million in its home market, there are enormous opportunities to provide this technology on a global basis. With the lack of sufficient access to healthcare infrastructure across many countries, we are increasingly seeing unique business models emerging to utilize technology to address these gaps. By integrating telemedicine, e-pharmacy, digital recordkeeping, educational content, and AI-assisted decision making for providers, EM innovators are creating scalable solutions that create not only powerful business models, but more importantly, drive inclusion of the underserved into the health care ecosystem.

Figure 4: Annual new drug approvals in China

Chinese regulators have accelerated drug approvals with the objective of improving the health outcomes and quality of life of the country’s citizens, an aim that aligns with government policy.

Source: Jefferies, China NMPA.

Going global

Perhaps most exciting is the opportunity for many of these businesses to scale beyond local-to-local innovations and into local-to-global solutions providers. Many of the complex issues EM innovators have solved for can be applied back to developed markets to improve existing solutions that didn’t require breaking trade-offs.

We recently met with an emerging market software company that provides solutions to global multinationals seeking to grow their e-commerce operations in EMs. These global enterprises needed a solution that integrates multiple fragmented logistics providers, horizontal e-commerce marketplaces, brick-and-mortar stores, local banks, payment schemes, currencies, and many other ecosystem partners in a flexible, cloud-based solution. By providing this service across Latin America, this company has become recognized as a global leader by market intelligence firms and is increasingly expanding along with its customers into developed markets by displacing legacy models. This is just one of many differentiated companies that are beginning to arise across EMs that will have global implications.

We expect EM innovators to reshape the global equities investing landscape.  Benefiting from deep local markets, improving scale of engineering, and executive talent, we expect many more EM-domiciled companies to break into the ranks of both the largest (and most important) companies in the world over the coming decade. Successful identification and partnership with these companies has the potential to allow for substantial compounding of capital over long time periods. While these preconditions for a wave of EM-oriented innovation are coalescing today, the underlying drivers are durable, suggestive that this dynamic will likely become the new norm, and in the process, likely help many EM countries circumvent the middle-income trap that has previously hampered early waves of development.

IMPORTANT INFORMATION
Emerging market investments have historically been subject to significant gains and/or losses. As such, returns may be subject to volatility.
Environmental, Social and Governance (ESG) or sustainable investing considers factors beyond traditional financial analysis. This may limit available investments and cause performance and exposures to differ from, and potentially be more concentrated in certain areas than, the broader market.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.

Health care industries are subject to government regulation and reimbursement rates, as well as government approval of products and services, which could have a significant effect on price and availability, and can be significantly affected by rapid obsolescence and patent expirations.
Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

Marketing Communication.

 

Glossary

 

 

 

Important information

Please read the following important information regarding funds related to this article.

The Janus Henderson Fund (the “Fund”) is a Luxembourg SICAV incorporated on 26 September 2000, managed by Janus Henderson Investors Europe S.A. Janus Henderson Investors Europe S.A. may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions.
    Specific risks
  • Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • Shares of small and mid-size companies can be more volatile than shares of larger companies, and at times it may be difficult to value or to sell shares at desired times and prices, increasing the risk of losses.
  • Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
  • This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
  • The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets. These transaction costs are in addition to the Fund's Ongoing Charges.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Janus Henderson Investors Europe S.A. Janus Henderson Investors Europe S.A. may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions.
    Specific risks
  • Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
  • The Fund may invest in China A shares via a Stock Connect programme. This may introduce additional risks including operational, regulatory, liquidy and settlement risks.
  • If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
  • This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
  • The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.