Opportunities knock in China and emerging markets

Emerging market growth opportunities still exist if investors know where to look, writes Skye Macpherson.

There’s no doubt emerging economies have created significant investment opportunities over the last decade and despite suggestions that capitalising on this growth will become increasingly challenging, there is one way to tap into emerging markets which has largely been overlooked – hard and soft commodity equities.

Demand for these items is primarily being generated by the developing world, but meeting the required level of demand requires a global supply effort.

Urbanisation drives demand 

The ongoing urbanisation of China and many other emerging economies is the key driver of demand for food, metals and energy.

Today, the urban population represents more than 50 per cent of total population and according to the United Nations, 70 million people will be urbanised annually over the next 25 years.

This is the equivalent of more than three times Australia’s population improving their living standards each year via better housing and transport.

A key reason for relocation to urban environments is the quest for improved living standards – which includes higher incomes – and the difference between the two is significant. As at 31 December 2010 China’s National Bureau of Statistics reported the average Chinese urban income was Renminbi (RMB) 21,000 – almost three times the income earned in the country (refer to figure 1). 

As personal wealth increases, metal intensity per person rises. In most developed countries steel consumption tends to peak at around 1,100 kilograms per person per annum, but today in China steel intensity stands at less than half that figure.

However, unlike some of the metals where consumption reaches a natural peak, energy consumption continues to rise as wealth increases.

This rise correlates with increased use of heating, cooling and electronic equipment purchases such as computers and televisions, which we use every day.

Don’t underestimate Chinese aspirations

The aspirations of urbanised Chinese to improve living standards shouldn’t be underestimated and is particularly evident in the shift towards larger apartments for families. In 2001, just 33 per cent of urban homes had more than two rooms.

However, there’s been a push to upgrade the urban housing stock over the past decade.

Furthermore, despite home ownership being high in first-tier cities such as Beijing and Shanghai, in second-tier cities (characterised by Knight Frank as having a population greater than three million and GDP per capita of more than US$2,000 per person) and below, where 92 per cent of China’s population resides, home ownership remains below 25 per cent.

In fact, China has 93 cities with a population of one million or more and 20 cities with a population in excess of five million.

There’s also a very low level of penetration in consumer items that require raw materials in production, such as air-conditioners, washing machines, plasma televisions, vacuum cleaners and refrigerators. In addition, modes of transport are changing, with bicycles being upgraded to motorbikes and eventually cars.

In 2010 new car sales in China reached almost 14 million vehicles, making it the world’s largest car market, yet penetration is three cars per 100 people compared to 80 cars per 100 people in the US.

Furthermore, China has become the second largest importer of oil in the world, consuming as much energy as the United States, but its current oil demand intensity is only 2.5 barrels per person per annum relative to 22 barrels per person per annum in the US.

Rising wealth improves nutrition 

From an agricultural perspective, rising wealth is resulting in improved nutrition, via the consumption of more food and the introduction of protein.

This increase in demand for protein has an important multiplier effect on grain consumption because it generally takes two kilograms of grain to produce one kilogram of chicken, four kilograms of grain for one kilogram of pork, and seven kilograms of grain for one kilogram of beef.

Protein demand in China has risen dramatically over the last 20 years. The average growth rate for pork is 4.3 per cent per annum, beef is 9.2 percent and chicken is 7.2 percent.

Despite this growth, protein consumption, at 53 kilograms per person per annum, is significantly less than the 125 kilograms per person currently consumed in Hong Kong.

Demand remains robust

The drivers behind demand for hard and soft commodity equities remain very robust. China, India, and other populous nations such as Brazil and Indonesia, account for 43 per cent of the global population.

However, they all have a GDP per person of less than US$9,000 per annum. Consequently, there is still significant demand growth for food, metals and energy. 

While movements in commodity prices capture the attention of markets and drive sentiment in the short-term, what’s more interesting from an investor’s perspective is understanding how to access the underlying volume of growth for these raw materials.

By investing in companies that are increasing their production to meet demand – whether it’s in metals, energy or agricultural products – good investment returns can be achieved in the long term.

Structural drivers lead to superior returns

There are two key reasons why hard and soft commodity equities have delivered superior returns to global equities: 

• The significant demand for underlying commodities from emerging markets, and 
• The asset or resource owners have tended to make larger margins and delivered greater return on equity over time.

Also, hard and soft commodity equities provide other benefits to investors relative to emerging markets equities.

Firstly, commodity equities are listed on exchanges all over the world, providing investors with greater geographic diversification.

Secondly, while many of the companies in the hard and soft commodity equity sector supply the raw materials to emerging countries, many are listed on Western exchanges.

These exchanges have stringent standards regarding the treatment of minority shareholders and corporate governance, including the requirements for continuous disclosure and dissemination of information to all shareholders, tighter rules on insider trading and market manipulation, and more transparent corporate ownership structures.

For an equity investor this provides a way of gaining exposure to emerging market growth within the governance structures and regulatory environment of the developed world.

Emerging markets are behind the structural shift we are experiencing in the demand for food, metals and energy. By investing in hard and soft commodity equities, investors are afforded an alternative exposure to the ongoing growth that is anticipated from emerging markets.

Investors who want to gain exposure to this trend should seek out companies that are producing hard and soft commodities and who are growing their productive volumes to meet demand.

Skye Macpherson is a portfolio manager for Colonial First State Global Asset Management’s global resources fund.