beyondbrics

Never mind the quality. Just feel the width. That’s the message from a Citigroup report on companies in Asian emerging markets.

The authors claim investors focus too much on these companies’ profit margins – and worry about the pressure they are coming under from rising commodity prices. Instead, they should look at the track record – and see that over the years returns to shareholders have had little to do with margins and lots to do with volume growth.

Citigroup said in its report on Tuesday that companies in Asian EMs have behaved differently from their rivals in the US and Europe, where ebit margins have hit record levels. As the chart below shows (click to enlarge), in Asian EMs they have been falling since the 1990s but return on capital – and therefore returns to shareholders – has been rising, driven by increasing sales at home and abroad.

Markus Rosgen and colleagues wrote:

In order to gain market share, Asia has gone for volume over margin. Make lesson a per unit basis but sell more of them. The expectation by corporates is that “eventually” I will own 100% or at least a large enough slug of the market and thereby gain pricing power. As yet, ownership of the market place has eluded Asian manufacturers and so has pricing power. Lack of brand recognition/names has until now meant the region is more of a price taker and not a price setter. Prices have fallen and with it volume has increased. So compared to margins in the early 1990’s, these are now lower but asset turn is up substantially.

The trends have been magnified by the rise of cyclical stocks, such as export manufacturers, in the stock markets at the expense of banks and property groups. But the overall decline in margins is unmistakable:

So what does that mean for investment strategy? Citigroup concludes that it is better to focus on low-margin than high-margin corporates in the region.

A reasonable inference to draw from the data. But it isn’t the last word. The last decade saw unprecedented GDP growth around the world - boosting the sales of companies that went for volume. But the trickier conditions of the post-crisis period may mean that the rules of the 2000s have to be revised.

In any case, as Citigroup argues, the low-margin high-volume approach doesn’t mean the region’s corporates are immune to oil shocks. Just that oil shocks have to be serious enough not just to squeeze margins by raising input costs but to kill demand from customers. And stock markets have not fully priced this risk:

Where the region is thus vulnerable is a demand chock. Oil at a level which causes a recession leads to a collapse of both margins and asset turn. The residual, earnings, just disappears. Is the region priced for this eventuality? No. At 2x P/BV Asia ex is a long way off the levels seen during economic recessions (range of 1-1.3x P/BV).  If we look purely at oil price spikes, there have been 5 of these since the mid 1970’s the average valuations at the peak of the spikes has been 1.7x P/BV. Clearly with everyday that goes by and oil moves ever higher, the risks for the region increase and current multiples do not fully account for that risk.

So a report that begins with a rather positive premise for the region – that its companies did very well by adopting a different strategy from their European and US rivals in the 2000s – actually ends on a rather sober note. But it is right to do so. At $150 a barrel oil, all bets are off.