The rise of emerging markets has transformed the global economy and the way investors allocate capital over the past 25 years.  Emerging markets have become increasingly synchronised reflecting their enhanced integration into global trade and capital flows, with China at the epicentre of this shift.  As measured by purchasing power parity (PPP), China has risen from less than 3% of global economic output in the early 1980’s to around 16% in 2014.
Many of these countries are forecasted to grow significantly over the decades to come. According to the IMF and PwC, developing economies are set to incrementally increase their share of global GDP on a PPP basis.

Figure 1. Global GDP Forecasts
Sources. IMF WEO database (October 2014) for 2014 estimates, PwC projections for 2030 and 2050
Capital has flowed into emerging markets during the past two decades, as institutional and retail investors flocked to the growth story and increasing relevance of these economies within a global context.  Nonetheless, there are ominous signs that the spectacular rise of the developing world is starting to unravel, with emerging markets suffering a net outflow of capital in 2015 for the first time since the 1980’s. Part of this is down to the US Federal Reserve raising interest rates, the significant moves in the US dollar over the past 18 months and the effects of quantitative easing on risk assets.

Figure 2. Capital Flows to Emerging Markets
Sources. IIF, FT
So where does this leave emerging markets, in terms of an allocation within portfolios?
From our perspective the most important point is not where a stock is listed, but the breakdown of where it generates its revenue from.  Our style bias towards owning high quality businesses with high free cash flow conversion ratios, attractive operating margins and high returns on capital at reasonable valuations has led us away from direct emerging market exposure. Even though we have minimal direct emerging market exposure with less than 7%, on a revenue look-through basis we have roughly 25% exposure through the multi-national companies we hold in our global equity portfolio.
Secondly, it is important to note that there is not necessarily a discernible link between economic growth and investment returns. That said, as can been seen from the capital flows into emerging market equities and debt since the turn of the millennium, that investors have allocated significant capital into these economies in search of investment returns and yield.
Yum! Brands is a company we hold within the Clime International Fund that is listed in the US, yet derives over 70% of its revenue from its Chinese business.  Yum! Brands are one of the world’s largest restaurant companies with over 41,000 restaurants in more than 125 countries. Their restaurant brands, KFC, Pizza Hut and Taco Bell, are the global leaders of the chicken, pizza and Mexican-style food categories.  A comparable direct emerging market company would be Jollibee Food, which is listed in the Philippines. The company is the owner of a multinational chain of American-style fast food restaurants, having expanded into international locations in Brunei, Hong Kong, China, Kuwait, Qatar, Saudi Arabia, Singapore, Vietnam, the United Arab Emirates, and the United States. The company has achieved attractive double digit revenue growth, high returns on capital and produced an average return on equity of close to 20% since 2010.
This begs the question of why do we not own Jollibee Food? This ultimately comes down to valuation, with Jollibee Food trading on a free cash flow yield of just 1.7% compared to Yum! Brands, which is trading on a yield of 3.9%.
To conclude, it is unsurprising that the end of quantitative easing in the US and subsequent strength of the US dollar along with the US Fed raising interest rates has led to the flight of capital out of emerging markets. This perhaps confirms the premise that investing in emerging markets is inherently more risky than the developed world and under this scenario it is not surprising to see many retail and institutional investors reduce their direct exposure to emerging markets.
Allocations to emerging market risk assets are at multi-year lows and no doubt many investors prefer to gain exposure through developed market companies.  Over the long-term this dynamic will likely change as emerging economies and their capital markets develop.
Written by Louis Jamieson, Sanlam Private Investments – UK, Clime international fund partner. The following article was originally published in StocksInValue.
Disclosure: Clime Asset Management owns YUM on behalf of various mandates for which it acts as investment manager.