Since time immemorial man has looked for the next big idea and there have been financers wanting to get on the next gravy train. Oftentimes in the investment community, a story will peddle. One that has come to be a mainstay is either cellphones in India, cars in Brazil or some other consumable widget in a developing economy, and how those are set to grow since the penetration rates are so low.
Glossy presentations comparing penetration rates between developing and developed countries, the promise of outsized returns against smiling pictures of basket weavers toting next generation cellphones—if you are an investor in emerging markets, you have seen these missals once too many.
While there is no denying that emerging markets do have a huge potential for growth, we have often questioned the myth of the low penetration rates and the case of the magic gross domestic product (GDP) number. The magic GDP number is a mainstay of investment folklore. The premise is that at a certain GDP per capita, there is sufficient wealth created for the penetration rates to increase at an explosive pace. However, when you resort to an elusive GDP per capita to peddle your growth story, you know that the low hanging fruit has been picked off.
The fundamental flaw in viewing just these penetration rates is ironically the demographics—the linchpin of the whole emerging market argument. While most of these glossy dossiers speak of demographics and the bourgeois, what they overlook are the wide ranging income gaps between the haves and the have nots in these countries.
Countries such as India, China and Brazil have a majority population that is rural and relies on the agricultural economy. Admittedly, urbanization is on the rise but as is not uncommon knowledge, the majority in these countries would be content with having two square meals a day. Migrating them to the 4G network or up selling them the next economical car is a quantum leap. Instead of just having a blanket large population and citing low penetration rates, it might be worthwhile to gauge these rates against affordability metrics and how those are progressing.
A classic case is the auto penetration rate in Turkey. On the face of it, the penetration rate is at 10%—much lower than most developed countries. The low penetration rate, declining interest rates and a burgeoning middle class make for a classic emerging market story. However, the debilitating tax structure in Turkey puts a car purchase out of reach for most, resulting in minuscule improvements in the penetration rates because of poor affordability.
The magic GDP per capita number also falls flat here as Turkey’s GDP per capita is substantially high—about three times India’s—and fails to explain the low penetration rates. Even if GDP per capita is high, it might just fuel income inequality and need not guarantee a dramatic improvement in penetration rates. The rich will move on to their nth car but the low income population might still have to worry where their second meal will come from.
While demographics is a key selling point for most emerging market stories, ironically it is also the Achilles heel. Income and wealth inequality is not uncommon to most non-communist countries, but wretched poverty is common only to developing countries and to these masses, economic growth has meant little.
A common case study is the comparison between two former British colonies: Singapore and Jamaica. Both these countries started at comparable GDP per capita when they attained sovereignty. Both countries were faced with uneducated populations and poverty. Jamaica focused on its demographic bulge, and resorted to agriculture and natural resources, while Singapore focused on services and strict population control. Singapore enriched its existing population while Jamaica is still urbanizing its rural population. Today Singapore’s GDP per capita is eight times Jamaica’s.
The promise that urbanization will one day touch everyone’s lives is in no way definite. The companies that want to stake claim to your capital may well have the next cutting edge product, but is their addressable market ready to absorb and justify the investment and capital burn? Somewhere among the shiny presentations, look closer and you might well find a hint of the greasy salesman peddling the next sure-fire investment.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday. Send your comments to firstname.lastname@example.org