Diamond in the Rough: The Emerging Markets Consumer Story

Over the past few years, some investors have become frustrated with the underperformance of the emerging markets (EM)—especially when compared to the U.S. markets.¹ But there is a subset of the emerging markets, the EM consumers, that may offer a lot to get excited about. One of the major themes that we believe will drive much of the global economy over the coming years is the rise in potential growth from EM consumers. Given the youthful demographics of emerging markets and the potential for their low per capital incomes to catch up with those of the developed world, the likely ramifications of this trend could be large. More importantly, we note that the rise in the middle class in EM is more than a “sector” idea. Companies from a wide cross-section of the economy and markets—such as insurance companies, banks and health-care companies—could have as much potential to benefit from a growing emerging market middle class as a typical car company (Consumer Discretionary) or food company (Consumer Staples). The WisdomTree Emerging Markets Consumer Growth Fund (EMCG) seeks to broadly reflect the growth in purchasing power of consumers in these local economies by including a broad cross-section of sectors, outside of the typical Consumer Discretionary and Consumer Staples exposures. As of December 31, 2014, EMCG beat 96% of the 793 emerging markets open-ended (OE) mutual funds and exchange-traded funds (ETFs) in 2014 based on total return.² This, in our opinion, illustrates the strength of the EM consumer in the face of heightened uncertainty. In contrast, the Dow Jones Emerging Markets Consumer Titans 30 Index (DJECON) ranked 297 of 793 mangers and beat a paltry 63% of its peer group. Table 1 details the key rationale for EMCG’s 5.80% outperformance compared to the DJECON and its 6.26% outperformance against the MSCI Emerging Markets (MSCI EM) Index in 2014.   EMCG Beats 96% of Its Peers in 2014   Average Annual Returns as of 12/31/2014 • Performance Drivers—Explaining EMCG’s Sector Exposure Compared with MSCI EM: The MSCI EM Index has more than 20% of its exposure in the Energy and Materials sectors, the two worst-performing sectors in the MSCI EM Index in 2014.³ EMCG, on the other hand, excludes the aforementioned sectors and instead has approximately 65% of its weight in domestic demand sectors⁴. We believe that these sectors are consistent with the theme of growth in the emerging markets’ middle class and are therefore supportive of domestic demand.   • EMCG for Income Potential: Even though EMCG weights according to net income, which results in a lower P/E ratio (EMCG P/E 11.9x; DJECON P/E 25.1x), EMCG’s 2.6% dividend yield offers an important income buffer for those seeking exposure to the emerging markets. EMCG’s dividend yield is a full 0.7% higher than that of DJECON and is comparable with the MSCI EM Index’s dividend yield.   • An Emphasis on Quality: EMCG’s valuation story is incomplete without a discussion of quality. EMCG’s underlying index methodology rewards companies that show promise in terms of return on equtity (ROE) and return on assets (ROA). This combination of ROE and ROA not only rewards companies that are highly efficient in utilizing their assets and equities to generate net income, it also penalizes companies that employ immense leverage in doing so. As a result, EMCG has the highest ROE and ROA, at 18.1% and 8.1% respectively, compared with DJECON (ROE 14.2%, ROA 5.8%) or MSCI EM Index (ROE: 11.6%, ROA: 2.4%).⁵   In conclusion, EMCG’s construction has resulted in a vehicle that has had more attractive valuations and a higher quality bias than its peers. Its broader sector focus, outside of the two regular consumer sectors, has helped provide diversification and offer a potentially more robust way to access the EM consumer.         ¹Source: Bloomberg, references the fact that the MSCI Emerging Markets Index has lagged the S&P 500 Index over the most recent three-year period from 12/31/11–12/31/14. ²Source: Morningstar; refers to 12/31/13–12/31/14. ³Sources: Bloomberg, WisdomTree, as of 12/31/14. ⁴Domestic demand sectors are Consumer Staples, Consumer Discretionary, Telecommunication Services, Utilities and Health Care. ⁵Source: Bloomberg, as of 12/31/14.