Penetration rates for goods and services are low and the high level of informality in emerging market countries often raises the barriers to entry substantially. This facilitates a benign competitive environment, allowing dominant companies to generate high margins and strong free cash flow.
Our investment philosophy is focused on seeking high-quality companies to invest in and owning them for the long term. In our view, the best businesses to own are those that can deploy capital at high, incremental rates of return and are stewarded by outstanding people. We have often found these “structural compounders” among the leading consumer companies in emerging markets. Penetration rates for goods and services are low, which provide a favourable long-term demand backdrop, and the high level of informality in emerging market countries often raises the barriers to entry substantially. This facilitates a benign competitive environment, allowing dominant companies to generate high margins and strong free cash flow, which in turn leads to high returns for the owners of these businesses.
Along this theme, we own several restaurant groups that operate in emerging markets and benefit from these characteristics. The first is Yum China, which operates the KFC and Pizza Hut franchises in China and is the largest restaurant group in the country. Despite its size, the management announced plans to open an additional 1,000 stores in 2021, and have confidence in the group’s continued expansion. According to their analysis there are still 800 cities across China where KFC or Pizza Hut is not present, which implies plenty of room to grow.
Another restaurant company, Alsea, is a quick-service restaurant group based in Mexico. Alsea operates popular restaurant and coffee concepts such as Starbucks, Dominos, Burger King and Chili’s in Mexico and across the Latin America region (including Argentina, Chile and Colombia). As the market is still vastly underpenetrated (for instance, Mexico only has five Starbucks outlets per million people, as opposed to 43 in the US or 15 in the UK), we believe there is plenty of growth left in the sector to ensure solid cash flow expansion in years to come.
Moving onto the fast-moving consumer goods (FMCG) category, growth can usually be explained by some combination of the following three conditions: increasing penetration (more consumers use the product), increasing consumption (existing consumers buy more) and premiumisation (consumers upgrade to value-added products which command higher unit prices). We believe Colgate-Palmolive India should continue to benefit from all three trends in the coming years.
Its entrenched Colgate brand occupies the number one spot across the country and the company has been ranked “Most Trusted Brand” in oral care for several years – even being endorsed by more than 70% of dentists in India. A relentless focus on brand building (Colgate spends around 15% of sales on advertising and promotion, significantly more than peers), combined with a strong distribution advantage (reaching 240 million households across India via 6 million points of sales), has cemented Colgate’s dominant position of more than 50% market share in the Indian market.
The businesses that we own are market leaders in attractive categories with significant competitive advantages, which allow them to generate high returns on invested capital and strong free cash flows (FCF). Further, we believe they have plenty of scope to grow in the coming 3-5 years, are led by some of the best management teams in emerging markets, and the majority have a net cash position and are thus ideally positioned to weather a crisis. Despite the short-term market volatility, we believe this should bode well for longer-term returns.
Source: UNFPA, company reports, FSSA Investment Managers. Company data retrieved from company annual reports or other such investor reports. Financial metrics and valuations are from FactSet and Bloomberg. As at end September 2021 or otherwise noted. Note: Reference to specific securities (if any) is included for the purpose of illustration only and should not be construed as a recommendation to buy or sell the same. All securities mentioned herein may or may not form part of the holdings of FSSA Investment Managers’ portfolios at a certain point in time, and the holdings may change over time.
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