Emerging markets 'leapfrogging' normal development

Investing in developing economies when they are quickly catching up with – and in some cases, surpassing – the rest of the world

Andrew Willis 2 May, 2019 | 2:00PM

Note: This article is part of Morningstar Canada's Emerging Markets Week Special Report

Imagine taking a group of developing economies with billions of workers, consumers, and significant assets held back by inefficient infrastructure and lines of communication, and then swiftly injecting a dose of the latest digital efficiencies and cutting-edge innovations across multiple sectors.

That’s happening right now in emerging markets, as significant structural changes skip slow and expensive routes to sector development, boosting economic growth – and gains. It’s known as the ‘leapfrog effect’, and it has wide-ranging investment implications for both company fundamentals and macroeconomic considerations.

Investment game-changer

This rapid modernization – particularly in frontier emerging markets - changes the traditional investment thesis. Investors often use a comparison-based product or service penetration story that predicts growth rates of emerging industries and economies based on past growth trends of more developed markets, says Adam Kutas, portfolio manager for the Fidelity Frontier Emerging Markets Fund.

Investors might highlight that around 90% of homes in developed countries have a TV set, while the ownership statistic is 20% in Kenya. Accordingly, they might surmise that the opportunity for TV manufacturers in Kenya is much higher than in developed countries. This kind of story can be applied to almost every company and sector. And they might be wrong. “With the tremendous advancements in technology, this matching is unlikely to happen,” Kutas warns.

Instead, in a time when streaming services are taking over cable TV, cellphone towers are being built instead of landlines, and investors are using mobile payment apps instead of visiting the bank, Kutas suggests keeping a close eye on telecom, banking and power companies when investing in emerging markets.

Exponential economic effect

“The leapfrog effect has huge implications for the productivity of an economy,” says Kutas, adding that it provides a significant improvement and efficiencies at many levels, from consumer to industry.

Kutas uses an example of someone in Nairobi, who, in order to run an errand – paying a bill for example – would need to travel hours through traffic to reach a bank branch, losing hours of potential value creation. Mobile banking can accomplish the same result in minutes.

Just as the losses in efficiency in undeveloped economies are exponential and compound up through value chains to have major macro implications, so do the benefits from the leapfrog effect. Income per capita, the productivity of an economy and the localization of energy inputs are just some of the major macro influences of the leapfrog effect that Kutas outlines, pointing to an example of an island in the Philippines ramping up its solar power sources to 80% of supply thanks to an increased affordability of China-manufactured solar panels.

China’s “gift” to emerging markets

Where there is manufacturing, there is China. China plays a founding role in the leapfrog effect - Kutas calls it “China’s gift” - which has helped its rise as a superpower. Through a comprehensive, government and corporate-led capital investment culture, China has lowered the cost of key technological ingredients in the leapfrog effect.

China’s influence is garnering attention from the protagonist in the old emerging markets growth story. “The relationship between the U.S. and China has entered a more competitive phase,” reads a recent BlackRock Report, adding that investors are too narrowly focused on short-term trade deal developments and not on the multidimensional, long-term rivalry around technology. “The U.S. and China are competing to dominate the industries of the future.”

It seems that China is already ahead on a few dimensions and leapfrogging locally. Chelsey Tam, equity analyst with Morningstar says more advanced technologies – specifically related to the internet – were widely adopted to address previous problems such as cash and credit card transaction inefficiencies and constraints. The solutions led to advantages, especially in the mobile payment space, where entirely new products, services and revenue channels have blossomed.

How to play the leapfrog

In assessing the impact of the leapfrog effect in emerging markets, Kutas emphasizes that it’s a double-edged sword. You’ve got two key categories of implications to consider. On one hand, you’ll want to consider which businesses are benefiting from the leapfrog effect and enhance your exposure to either indirect benefactors or the direct contributors of the industry innovation. Some ideas could include industries tapped into their own sources of renewable energy, providers of solar panels, smartphones and e-commerce software.

On the other hand, Kutas says you’ll want to keep a watchful eye on which businesses are made redundant from the rapid changes. Investments in businesses with retail shopping and banking locations may be less relevant in a leapfrogging emerging economy – and in developed economies, once they catch up.

About Author

Andrew Willis

Andrew Willis  Andrew Willis is a content editor for Morningstar.ca.