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Venture capital in emerging markets
VC clone home
Making money by bringing old ideas to new markets
SOME venture capitalists call it “geo-arbitrage”; others know it as “tropicalisation”. The term refers to the practice of backing start-ups that take an established business model and adapt it to an emerging market. Whatever you call it, it is becoming a bigger part of the venture-capital industry as competition at home forces Silicon Valley investors to look farther afield.
Julio Vasconcellos, one of the founders of Peixe Urbano, a Brazilian site offering users discounted deals, is thrilled by the “huge flood” of American investors he has noticed coming to Brazil, for instance. No wonder. Some of them, including Benchmark Capital and General Atlantic, have invested in his own company alongside Brazilian venture capitalists. The financiers have reason to be upbeat, too. Peixe Urbano is a clone of Groupon, an American start-up that went public last year; its business model is one they know can take off.
The idea of tropicalisation has been around for a while. It has already been lucrative for venture capitalists in India and China. Take Baidu, a Chinese interpretation of Google, which made early venture investors a killing; or Alibaba.com, a Chinese version of eBay, an online-auction site. Now venture capitalists are looking at other markets, including Brazil, Indonesia, Russia, South Africa and Turkey. Last year $3.4 billion of venture-capital deals were done in emerging markets, more than double the amount in 2008.
This push into emerging markets has gained momentum because venture capital is experiencing problems in its traditional markets. Silicon Valley was once so inward-looking that venture capitalists used to say they would not back a start-up unless they could cycle to its office. But valuations in North America have risen for both early-stage and later-stage investments (see chart), making it much harder to make great returns.
That is partly because there are too many firms; 369 of them are currently in the market trying to raise $50 billion, according to Preqin, a research firm. There is a lot less competition in emerging markets. The pressure from investors is also rising. A damning new report by the Kauffman Foundation, an outfit which promotes entrepreneurship, analysed its venture-capital portfolio and concluded that 62 out of 100 funds failed to exceed the returns offered by the public market.
Most venture-capital firms do not head abroad with the sole aim of looking for copycats, but plenty of their investments end up that way. Douglas Leone of Sequoia Capital, a big venture-capital firm, reckons that in emerging markets like China around 50% of start-ups backed by foreign venture capitalists in the internet and mobile sectors are copycats, and in markets like Brazil it is closer to 70%.
That is not so surprising. Backing tested concepts mitigates the risk inherent in start-ups and means companies are likely to grow quickly, because the original firm has already worked out the kinks. Often the originator of the business does not have the expertise to enter new countries quickly, so copycats can get there first.
They can also gain an edge by tailoring businesses to local habits. Flipkart, an online-commerce site in India founded by two former Amazon employees, has received funding from Tiger Global, a New York-based hedge fund that specialises in this kind of investing, and Accel Partners, a venture-capital firm. Flipkart has taken off in part because credit cards are less common in India and it offers the option of payment on delivery.
Another example is Trendyol, a Turkish “flash sale” site that mimics Vente-privee.com and Gilt Groupe, which popularised the idea of time-limited online sales of designer clothing. But Trendyol, whose backers include Kleiner Perkins Caufield & Byers, also sells its own mass-market clothing line, with seasonal designs “crowdsourced” from users in Turkey.
There are different ways to play the copycat game. Rocket Internet, started by the Samwer brothers—Alexander, Marc and Oliver—in Germany, is a cloning “factory” that copies American and European businesses, hiring entrepreneurs to run them and exporting these start-ups to emerging markets as fast as possible so they are the first entrants. More traditional venture capitalists are setting up offices and selectively backing local entrepreneurs. American venture investors often prefer to bring in a local partner to provide more consistent mentorship to these entrepreneurs and give advice on how to navigate the domestic market.
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Such advice can be valuable, given the specific risks of setting up in emerging markets. First, companies can take longer to get off their feet, given grinding local bureaucracy. “An eight-year fund might not be sufficient in Brazil,” says José Luiz Osorio of Jardim Botânico, a Brazilian seed investor. Second, there are cultural barriers: it can be hard to recruit employees to work for an unknown company in exchange for equity, for instance. Third, exiting through large initial public offerings is unlikely in countries like Turkey and Brazil, where IPO activity is muted and investors like to buy well-known firms; that means venture firms are reliant on strategic buyers to gobble up their creations.
Tropicalisation piles on an additional set of risks. Copycats can easily lose share when the original company eventually enters the local market. Sonico, once the Facebook of Latin America, got “pummelled” when Facebook arrived, says Nenad Marovac of DN Capital, which was behind Sonico. And even if they can see off competition, the copycats are unlikely to be mega-blockbusters because, by definition, they are not new. “With innovation you have a global upside, but with copycat innovation you have geographical limits,” says Eric Archer of Monashees Capital, a Brazilian venture firm.
It will not be long before emerging markets spawn their own innovations that can be trotted out on a global scale. That would be closer to the spirit of venture capital, which is supposed to ferret out and fund new ideas, not imitations. Until then, however, tropicalisation is set to become an ever more popular strategy. Copy that.
This article appeared in the Finance and economics section of the print edition under the headline “VC clone home”
Demystifying Emerging Markets: How to Invest Wisely Abroad
Emerging markets offer investors some of the best long-term growth opportunities, but the risk and volatility can be high.
The risks can be reduced, however, with proper analysis. And the volatility can present amazing entry points for disciplined investors.
This guide provides an overview of how to analyze and invest in emerging markets, mostly via emerging markets ETFs.
Of course, the topic is large enough that no individual guide on the subject could possibly be complete. But what this approach does is basically apply engineering analysis to the problem, meaning it breaks the difficulty down into small parts that can be individually solved more simply.
That’s a key way for investors to think about emerging markets- there are basically four layers of risk involved that can be analyzed separately and then put together for an overall view.
Start from the beginning, or jump straight to the section you want.
Why Invest in Emerging Markets?
In short, the reason to invest in emerging markets is that on average they have more than twice the annual GDP growth as advanced markets:
They have higher population growth, and higher per-capita GDP growth, which makes for much faster overall growth compared to slow-growing wealthy nations.
For this reason, emerging markets are becoming a larger and larger share of the world’s market capitalization:
And this has translated well into stock returns. The MSCI Emerging Markets index produced nearly 10% annualized returns from 2000 until now, compared to just over 5% annualized returns for the MSCI World index.
In addition, right now emerging markets are cheap despite that higher growth. Although they’ve outperformed as a group since 2000, they’ve underperformed over the past 5-10 years.
For example, China, India, and Brazil’s stock market capitalizations as a percentage of GDP are all much lower than they were during their period of overvaluation in 2007:
Data Source: World Bank, MSCI, Author’s Calculations
The MSCI emerging markets index is trading for an average price-to-earnings ratio of under 14, and a forward price-to-earnings ratio of under 12. The price-to-book ratio is under 1.7.
This compares favorably to the United States stock market, which has much higher price-to-earnings (20) and price-to-book (3.5) despite much lower GDP growth.
Several emerging markets also have higher dividend yields than most companies in the United States.
And despite those low valuations, over 25% of the market capitalization in emerging markets is in the combined technology/communication industry, compared to about 30% for the United States and 10% for Europe.
Emerging markets are very likely a good place to be invested over the next 10-20 years. However, it’s important to be aware of the risks and volatility so that you can navigate them successfully.
Emerging Market Pyramid of Risk
Emerging markets have more layers of risk than domestic stocks or foreign developed stocks.
This is both a problem to be aware of, and an opportunity to profit from.
According to research by Ben Carlson of Ritholtz Wealth Management, approximately every two years, emerging markets have a big 20%+ sell-off:
However, he also found that for investors that buy every time there is a 20%+ emerging market sell-off, their median one-year return is 23%, and their median five-year return is 44%.
More simply, you can hold a diversified portfolio and re-balance occasionally, so that you naturally buy more into emerging markets when they are cheap and sell a bit when they are high. Automatic re-balancing is a smart way to invest money.
But why are there so many 20%+ sell-offs? Every two years seems like a lot. Here’s a visual description of the major emerging market risks:
Layer 1: Company Fundamentals
The first layer of risk is how well a company or economy performs fundamentally. This applies whether you’re investing in a specific company, or investing in a whole country or region’s economy with an ETF.
Fundamental performance refers to things like earnings growth rates, changes in debt levels, and that sort of thing. The first step to picking good investments is being correct about the forward underlying performance of the thing you’re investing in.
Layer 2: Market Valuations
The second layer of risk is that even if an investment’s fundamentals go the way you expect, reductions in the market valuation of that entity may move against you.
For example, suppose you invest in a company that makes $5 in earnings per share annually, and the share price is $100. The stock therefore has a price-to-earnings ratio of 20x. Let’s say you expect it to grow earnings by 8% per year for the next decade, so you make an investment.
If you are correct, then after ten years of 8% annualized earnings growth, the company’s earnings per share will be $10.79 per year. If the stock still has a 20x price-to-earnings ratio, the share price should be $215.80, implying that you earned 8% annualized returns on your stock investment.
However, if for some reason the market is only paying a 15x price-to-earnings ratio for the stock ten years from now, then the stock price would be only $161.85. Your annualized rate of return on the stock would therefore only be about 5% per year, despite the fact that earnings indeed compounded by 8%.
In this case, you were correct about the company’s forward performance, but nonetheless didn’t get the returns you wanted because the market applies different valuations to stocks over time depending on all sorts of rational and fickle reasons.
Therefore, enterprising investors must buy the right stock or ETF at the right price in order to have solid returns.
Layer 3: Exchange Rates
When you invest internationally, in addition to fundamental risk and market valuation risk, you also have exposure to the pros and cons of varying currency exchange rates.
Suppose, for example, that you invest in a Japanese company, and its fundamental performance goes exactly how you expect, and its price-to-earnings ratio increases because you bought at a great price. Let’s say earnings grew by 8% per year and its price-to-earnings ratio increased from 15x to 20x. This should be an awesome investment.
However, if the Japanese yen weakens considerably compared to your home currency, let’s say the US dollar, your investment might lose value to you in dollars anyway, even if the investment worked out well in terms of yen. And as a US investor in this case, it’s dollars that you care about and pay your expenses with.
In 2020, you could trade one dollar for 76 yen. That was the exchange rate. In 2020, this figure changed to one dollar for 124 yen. That’s a 63% de-valuation of the yen to the dollar in four years. It’s no wonder that American stocks massively outperformed Japanese stocks from 2020 for American investors.
This works the other way as well. If you were a Japanese investor in 2020, and bought American stocks, you did very well for yourself over the next several years. The fundamentals of your investment were good, the valuation increased, and the foreign currency strengthened which accelerated your yen-denominated returns in a major way.
American holders of foreign stocks did very well in 2020, as another example, because the US dollar weakened compared to many foreign currencies.
Over the long term, stable currencies tend to revert to the mean. Exchange rates over 10-year periods between major currencies look like waves, rising and falling. But if you want to make good returns in a specific time period, it’s useful to pay attention to markets that have currencies that are strengthening compared to your home currency.
Lastly, some emerging market countries, both sovereign entities and corporations therein, hold debt in foreign currencies like US dollars, and their currencies tend to be less stable than currencies from highly developed nations. If their home currency that most of their revenue comes from weakens, but the foreign currency of their debt does not, it can dramatically increase their real debt burden and raise their risk of default.
This is what happened in 2020- a strong dollar combined with sell-offs in emerging market currencies made countries like Argentina (with high government debt in U.S. dollars) and Turkey (with high corporate debt in U.S. dollars) run into major problems.
Layer 4: Capital Flow
The final layer of risk applies mostly to emerging markets.
For many smaller countries in the middle stages of development, a large portion of the market capitalization of their stocks is held by foreign investors from advanced, wealthy nations, rather than by locals.
When institutions and investors from wealthy nations re-arrange their portfolios, it could result in significant capital inflows or outflows to certain countries.
For example, Thai citizens and institutions have very little impact on the U.S. stock market. But U.S. citizens and institutions hold a considerable share of Thailand equities (even as a small part of their overall portfolios), and if American investors decide to allocate less money to Thailand stocks, or less money to emerging market stocks in general, the valuations on Thailand stocks could fall rapidly.
To quantify that, total US household net worth is over $100 trillion. The market capitalization of all companies in Thailand is about $550 billion. Thailand represents about 4% of the FTSE emerging market index. If American portfolios decrease their average emerging market allocation from 5% of net worth to 2% of net worth, that’s a $3 trillion outflow of capital from emerging markets, of which $120 billion would be withdrawn from Thailand. That’s more than a 20% decrease in valuations for Thai stocks.
European investors, Japanese investors, and other wealthy nation investors add to that. If worldwide portfolios trim or add positions in emerging markets, even as a small portion of their portfolios, it makes a big difference for the valuations in the stock markets of emerging economies because of the sheer amount of capital that is moving around relative to the size of the markets.
In addition to major currency swings, capital inflow and outflow plays a part in why emerging markets can be so volatile. But this also gives enterprising investors attractive entry points when valuations are low.
5 Things to Check For Any Emerging Market
Some countries have better risk/reward ratios than others.
You can invest in a broad emerging markets ETF, or you can invest more specifically in single-country ETFs or individual emerging market companies. If you want, you can do a bit of both, so that you’re broadly invested but also emphasize certain areas.
Either way, the more you know about what’s happening in various countries, the more confident you can be in your investments, and the more resilient you will be when you see big emerging market sell-offs. You’ll hopefully see opportunity rather than fear.
While there are tons of metrics you can analyze for any country, here is the basic set you should be aware of to start with:
First, make sure you’re aware of the population trends of the country. Countries with increasing populations have an easier time growing their GDP. Trading Economics is a good data source for this stat and many others here.
Next, check GDP growth rates. The IMF regularly releases “World Economic Outlook” reports in their dataset which include forward estimates of the GDP growth rates of every country.
The Bank for International Settlements has data on the debt levels as a percentage of GDP for most major countries.
You can look up government debt as a percentage of GDP, household debt as a percentage of GDP, and corporate debt as a percentage of GDP.
This way, you can see where there may be debt bubbles, what countries are relatively debt-free, and what countries are mainly relying on debt for growth in recent years.
Look up the balance of trade on Trading Economics or the CIA World Factbook to see whether the country you’re interested in has a trade deficit or a trade surplus.
Is it producing more than it consumes, or the other way around? A trade surplus, or a relatively equal balance near zero, shows that a country is economically competitive.
You should also check the current account to see the net inflow or outflow of investments.
I recommend reading my full article on why trade balances and current accounts matter.
One of the biggest tools a country has to protect the value of its currency is its foreign reserves. If their currency weakens, they can sell some of their foreign reserves and buy some domestic currency to strengthen it.
It’s therefore useful to look up the size of a country’s foreign reserves relative to the size of its GDP on Trading Economics or another source. Thailand, for example, has foreign reserves equal to about 45% of its GDP, which is high. Turkey, on the other hand, only has foreign reserves equal to 15% of its GDP, which is low.
You can also check the inflation rates, interest rates, and historical exchange-rate charts. XE is a good source for historical exchange rate data.
Lastly, it’s important to be aware of the stock valuations of the country you’re interested in investing with, or average emerging market stock valuations as a whole.
The World Bank has a good chart/data set for stock market capitalizations as a percentage of GDP, so you can see the trend over time.
You can google, “MSCI [country] index” and see MSCI’s PDF fact sheet about any country. It’s updated monthly, and shows the price-to-earnings, forward price-to-earnings, and price-to-book ratios of the nation’s stock index. You can also look at iShares single country ETFs to see their statistics on their holdings.
My Favorite Emerging Markets ETFs
The easiest way to invest in emerging markets is to buy a broad emerging market ETF.
Best Broad Emerging Markets ETFs:
- Vanguard FTSE Emerging Markets ETF (VWO)
- iShares Core MSCI Emerging Markets ETF (IEMG)
- Schwab Emerging Markets ETF (SCHE)
- WisdomTree Emerging Markets Ex State Owned (XSOE)
These are simple, diversified, and have extremely low expense ratios. See my full list of the best ETFs for more information and examples.
FTSE and MSCI are the two major index lists that international/emerging funds tend to follow. There are a lot of minor differences, but the biggest is that FTSE considers South Korea to be a developed country, while MSCI still considers it to be emerging. Vanguard mostly follows FTSE indices while iShares mostly follows MSCI.
The WisdomTree XSOE fund is a bit different because it excludes state-owned enterprises, meaning companies with more than 20% government ownership. It has a slightly higher expense ratio at 0.32%, but has mildly outperformed most other broad emerging markets index funds since inception due to its exclusion of government enterprises.
One issue with broad emerging markets ETFs, even though they are great for most people, is that because they are weighted by market capitalization, they are heavily focused in China, South Korea, India, and a few others. If you want more even exposure, or wish to invest in a specific country, then there are single-country and region-specific ETFs you can choose from.
Best Region-Specific and Single-Country ETFs:
- Franklin Libertyshares Single-Country ETFs
- iShares Single-Country ETFs
- VanEck Vectors Single-Country ETFs
Franklin Libertyshares are the newest ones with the lowest expense ratios (0.09%-0.19%), but they have low liquidity.
The iShares range of single-country ETFs is more extensive and with higher liquidity, and includes some countries like Thailand that Franklin doesn’t have. However, both the iShares and VanEck ones are much more expensive (often 0.49-0.69% expense ratios).
Having emerging markets as part of your portfolio is smart, because it gives you exposure to the bulk of where most of the world’s economic growth is coming from over the next couple decades.
Volatility should be seen as an opportunity for portfolio re-balancing or major entry points, rather than be viewed as something to be avoided.
When you know the growth rates, debt levels, currency resources, balance of trade, and stock valuations of a country, you have a pretty strong snapshot that can show you the potential of a country’s stock market performance over the next 5-10 years. None of these are short-term indicators, but they give you can idea of how the country’s market will do over the long-term.
For most people, sticking to emerging market ETFs is the way to go, for diversification and simplicity. However, the broad emerging markets funds, which are heavily-concentrated in China, may or may not be the best ones. Investors wishing to focus more heavily on other countries, like perhaps India, may wish to also purchase some single-country ETFs.
Imperfect Competition in Financial Markets and Capital Structure
35 Pages Posted: 14 Oct 2004
Sciences Po; Centre for Economic Policy Research (CEPR)
University of Adelaide – School of Economics
Date Written: August 2007
We consider a model of corporate finance with imperfectly competitive financial intermediaries. Firms can finance projects either via debt or via equity. Because of asymmetric information about firms’ growth opportunities, equity financing involves a dilution cost. Nevertheless, equity emerges in equilibrium whenever financial intermediaries have sufficient market power. In the latter case, best firms issue debt while the less profitable firms are equity-financed. We also show that strategic interaction between oligopolistic intermediaries results in multiple equilibria. If one intermediary chooses to buy more debt, the price of debt decreases, so the best equity-issuing firms switch from equity to debt financing. This in turn decreases average quality of equity-financed pool, so other intermediaries also shift towards more debt.
Keywords: Capital structure, pecking order theory of finance, oligopoly in financial markets, second degree price discrimination
JEL Classification: D43, G32, L13
Transformation in Emerging Markets: From Growth to Competitiveness
Emerging markets have driven growth for many multinational corporations (MNCs) for years, and they will continue to do so. But these are turbulent times as commodity prices plunge, currencies are devalued, and equity markets gyrate. The profitability of many MNCs’ operations is already under attack, and future performance will be challenged by slower macroeconomic growth, increasing costs, and heightened competition from local companies, which are rapidly gaining scale, experience, and capability. To reduce these pressures, companies will have to focus much more on improving their competitiveness through constant productivity gains.
Most MNCs have emphasized growth in emerging markets at the expense of other metrics, such as operating margins. Shifting the emphasis to include profitability requires implementing process discipline, leveraging scale, and instituting behaviors that focus on constant efficiency gains. Such changes are not easily achieved. For many MNCs, a fundamental transformation will be necessary, executed market by market.
The Changing Nature of Growth and Competition in Emerging Markets
For years, the BRICS (Brazil, Russia, India, China, and South Africa) were synonymous with broad-based, rapid growth. Not anymore. Data for 2020 from Oxford Economics shows China’s GDP growth slowing to 6.5%, South Africa eking out a percentage point or two, Brazil flat, and Russia actually contracting. Growth in other emerging markets, especially those with commodity-dependent economies, has slowed as well.
The economics of emerging markets are also becoming more challenging. China is losing its cost competitiveness in exports thanks to rising labor costs, as well as higher energy costs than those in countries such as the U.S. and Mexico. China has plenty of company: the cost advantages of Brazil, Russia, Poland, and other countries are also diminishing.
Despite the slowdown, this is certainly not the time for MNCs to retreat; if anything, it may be a good opportunity for reengagement, as we have observed before. Some 300 million additional households will enter the consuming class in emerging markets during this decade. The populations of less developed countries are still growing four times faster than those of their developed counterparts: by 2020, 6.4 billion people (out of 7.5 billion worldwide) will be living in emerging markets. These economies will add more than 600 million urban dwellers between now and 2020. An increasing number of free-trade agreements will help contribute to sustainable economic growth. Still, these markets present big challenges for MNCs—the biggest having to do with competition, costs, and shifting relationships with key stakeholders such as employees and governments.
Competition. Most MNCs now face a fast-rising number of agile and aggressive local competitors that are winning share in many industries. The number of companies in Asia with more than $1 billion in annual revenues jumped sixfold to 1,015 between 2003 and 2020 and doubled in Latin America, Africa, and the Middle East to a total of almost 700. And these are not only companies making simple low-cost products or commodity components; many are in sophisticated segments of the engineering and manufacturing sectors. For example, emerging-market-based companies now control between 30% and 80% of the global markets for rolling stock, onshore wind-power equipment, coal power-generation equipment, wireless telecommunications equipment, and photovoltaic equipment. Their competitive prowess is typically rooted in three factors: a significant cost advantage owing to small overheads, lower wages, and lower R&D costs; a deep understanding of local markets and strong relationships with local stakeholders, including both customers and suppliers; and a nimble and aggressive corporate culture, which enables quick decision-making and significant risk-taking.
As the search for growth pushes many MNCs into middle markets in emerging economies—where they seek new middle-class consumers in B2C businesses and small-business customers in B2B—these companies run head-on into local competitors. Middle markets are tough, and in our experience most MNCs have struggled to make money in them. Prices are often only 50% to 70% of those in “high end” markets, where MNCs have traditionally focused. In mobile handsets in Asia, for example, local (mostly Chinese) competitors have erased profits in the lower price segments. In banking, new local operating models based on digital or mobile technologies are constantly pushing down price points. And in many infrastructure projects in emerging markets, competition from local companies has made it much harder for global players to bid successfully.
Costs. MNCs also face profitability pressures owing to flattening revenues and rising factor costs. Data from the European Union Chamber of Commerce in China shows 40% of European MNCs reporting flat or declining revenues in China in 2020, 2020, and 2020. EBIT margins have contracted over the same period, compared with the companies’ worldwide averages. Only 28% of European MNCs are optimistic about their profitability prospects in the next two years, compared with 36% in 2020. Almost one-quarter of companies are actually pessimistic about profitability.
On the manufacturing side, many emerging markets, such as China and Brazil, are no longer the labor bargains they once were, thanks primarily to rising wages. Productivity-adjusted manufacturing wages in China almost tripled from $4.35 to $12.87 per hour between 2004 and 2020; they are now higher than those of Asian neighbors such as Vietnam and India—and roughly on a par with those in Mexico. Manufacturing costs in Brazil jumped 25% over the same period. Workers with the engineering and technical skills that many MNCs need are still few in number, making finding, hiring, training, and retaining them expensive. In addition, their productivity significantly trails the productivity of skilled workers in developed markets.
Relationships with Stakeholders. Adding to these challenges, MNCs are losing their allure for local employees precisely at a time when they need skilled managers and staff on whom they can place added responsibility. And once-welcoming governments are becoming less accommodating as economies mature. Governments feel more confident in their ability to regulate and influence markets, and local companies have become more numerous, more competitive, and more deliberate in lobbying for their benefits. Governments in many emerging markets are less hesitant to flex their muscles, and their actions or interventions usually favor local players. Unpredictability in the regulatory arena, including tariffs, import duties, licenses, and local content requirements, for example, are another source of frequent frustration for MNCs. Governments’ actions are often beyond MNCs’ control, of course, but they underscore the need to improve performance.
Time to Reengage with, Not Retreat from, Emerging Markets
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