Sunday, November 25, 2012

Are Stocks Set to Start Suffering From Emerging Market Exposure?

One of the investment themes of the decade has been the increase in correlation across geographies and asset classes. It seems that one region only needs to catch a cold before the whole world starts sneezing. European debt issues flare up and US markets take a hit. Is China slowing? Let’s sell off commodities. And it goes on. So how much truth is there in this argument and where are we now?

Before I humbly attempt to answer this question I want to point out that I think there is a lot of truth in this type of analysis. Global capital flows have created strong correlations and economic cycles do appear to be getting larger from peak to trough. With that said I think it’s important to understand that economies don’t always necessarily have to veer into crisis mode. There is room for analysis that involves appreciation of subtle changes in growth trajectories rather than boom and bust.

China Slowing, US Growing Moderately, but Upside for Europe?

This is pretty much how I see it. The argument is that China appears to have significantly over invested in fixed assets like property and could be headed for a slowdown in growth. Throw in skepticism over the efficacy of a communist government stimulating an economy and I find it hard to be optimistic over China in the mid-term.

However, there are more than a few indicators that suggest that the US economy is doing okay. Not great, but okay. A long period of slow steady growth coupled with low interest rates is not a bad environment for equities.

My view on Europe will invite derision but I am holding to it. Europe has been weak for a while so companies will start to “anniversary” easier comparables in their reporting. Moreover, they will have had time to restructure and refocus sales efforts in Europe from the South to the North. Furthermore, Europe is making liberalization measures. It is dealing with its debt burden and countries are adhering to the program.

Before anyone scoffs, I should point out that most countries in Northern Europe are in much better debt situations than the US. For example, Finland never breached the rules over deficit to GDP, not even at the height of the crisis. And with a bit of luck and political will Greece can finally be thrown out of a club that it should never have been let into. Europe has upside potential.

So How Does This View Affect Stocks?

Well to answer this you have to look into the global revenues of the stocks you hold and see where the long term trends have taken them. I want to share a few examples.

Here is a long term look at its trends in terms of geographic share of total revenues for Johnson & Johnson (NYSE: JNJ)

It’s not hard to see that despite the strong growth in APAC/Africa in recent years the overwhelming bulk of JNJ’s revenues still come from the Western world. Moreover, if you think about the kind of consumer health and medical device solutions that JNJ offers, it is not really that cyclically aligned to changes in growth in Asia. Putting together the favorable geographic distribution and end market demand suggests that JNJ can outperform in this environment.

Next up is Intel (NASDAQ: INTC).

This graph perfectly represents the shift in semiconductor and consumer electronics production to the Far East with Taiwan leading the way. Of course, what it doesn’t do is look at the ultimate end market demand but emerging markets do make up a large part of consumer electronics growth. Indeed, if companies in countries like Taiwan and China are seeing slowing growth they will cut back and reduce chip inventories accordingly. That is exactly what we are seeing at Intel now and since the enterprise PC market continues to stall. I would be cautious here.

The third company I want to look at is Pfizer (NYSE: PFE).

Pfizer has been making divestitures which have affected the geographic revenue mix but the trend is clear. It’s become much more of an international play. However, this is partly to do with patent expirations in its core US market. The good news is that the company has a strong pipeline and if Eliquis (blood thinner) and Tafocitinib (Rheumatoid Arthritis) it could kick start a huge change in sentiment over the stock.

Time to turn to a bellwether in General Electric (NYSE: GE).

I was surprised by how large a part of revenues the US still makes for GE. I know much of that is from the financial side but it still indicates that GE is largely a western economy play. The trend in marginal growth is favoring the pacific basin and GE would take a hit from a protracted slowdown in BRIC growth but it’s not disastrous.

However, I do have some concerns with GE. On the industrial side its two largest profit centers are aviation and energy infrastructure, both of which are somewhat reliant on emerging markets for growth. In addition the company hasn’t been executing particularly well in health care.

The Bottom Line

In conclusion if you share my view that emerging markets are going to provide the down side surprise in future than its time to start looking closely at exposures and the geographic mix of the companies that you hold. The good news is that not all companies are relying on emerging markets for growth, and ironically, thanks to China’s trade policies many of them do not have as much exposure there.

As investors our focus is always on whether the stock is the right price and even assuming a continued slowdown in the BRICs, many US companies look good value. In particular sectors like healthcare, food, US domestically focused stocks and some parts of technology look well placed to grow even with a slowdown in emerging markets.