Emerging markets aren t as risky as you think

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3 Emerging markets aren t as risky as you think Marc H. Goedhart and Peter Haden Are emerging markets riskier than developed ones? Not if you take a portfolio perspective on corporate investments. I nternational companies may be attracted to the promise of fastgrowing emerging markets, but they are unnecessarily cautious when assessing potential investments there. Certainly, some caution is understandable. High-profile setbacks in Russia, difficulties in managing operations in China, and the on-again, off-again performance of Latin America have heightened sensitivities to the risks of investing in the developing world. Unfortunately, the perception of elevated risk leads companies to reject good investment opportunities and to underestimate the performance of existing businesses. What should be a clinical evaluation of a company s many investment decisions gets distorted, affecting even the analyses used to evaluate a project s risk-and-return profile. As a result, analysts and business managers overestimate the risk premium, assigning it to levels that even substantial underlying risks would not justify. Thus they also grossly inflate assumptions about the cost of capital often pegging it at more than twice the level of similar projects in developed economies. We took a close look at the risk of doing business in emerging markets and found that when it is spread over a diverse portfolio of investments, it is really much more modest. While risk in any individual emerging market may be higher than it is in developed markets, it is seldom higher for each

4 THE McKINSEY QUARTERLY 23 SPECIAL EDITION: GLOBAL DIRECTIONS and every business within that individual market, let alone across all emerging markets. And while the cost of capital may be higher than it is in the United States and Europe, it is actually much closer to the levels of developed markets than many people routinely suppose. 1 A more systematic examination of the risk involved will illustrate why international companies should give emerging-market opportunities a second look. The risk of emerging-market investments No question emerging-market investments are exposed to additional risks, including accelerated inflation, exchange rate fluctuations, adverse repatriation laws and fiscal measures, and macroeconomic and political distress. These elements clearly call for a different approach to investment decisions. However, while individual risks in each country may be high, it is important to keep in mind that they have low correlations with each other. As a result, the overall performance of an emerging-market portfolio can be quite stable if investments are spread out over several countries. At one international consumer goods company, for example, returns on invested capital for the combined portfolio of emerging-market businesses have been as stable as those for developed markets in North America and Europe over the past 2 years (Exhibit 1). 2 We found similarly low correlations among GDP growth rates in emerging-market economies or between their growth rates and those of the United States and Europe over the past 15 years. These findings, we EXHIBIT 1 Smoothing out the risks Return on invested capital (ROIC) for international consumer goods company; index: combined-portfolio ROIC for developed markets = 1 in 1981 ROIC 1 for selected individual emerging markets 6 5 4 3 2 1 1 1981 Country A Country B Country C Country D Country E 1985 1989 1993 1997 21 ROIC 1 for combined portfolios 6 5 4 3 2 1 1 1981 Emerging markets Developed markets 1985 1989 1993 1997 21 1 Expressed in stable currency prior to indexing and adjusted for local accounting differences; combined portfolio includes additional countries not reflected in exhibit. 1 When expressed in the same stable currency, such as US dollars or euros. 2 All returns on capital are measured in a stable currency and adjusted for local accounting differences.

EMERGING MARKETS AREN T AS RISKY AS YOU THINK 5 believe, also hold for sectors other than consumer goods possibly even for banking and insurance, whose dependence on the financial system leaves them more exposed than sectors such as manufacturing or services. Moreover, country-specific risks can affect different businesses differently. In the case of one parent company, sustaining emerging-market businesses during a crisis not only demonstrated that it could counter country-specific risks but also strengthened its position as domestic funding for local competitors dried up. For this company, sales growth, when measured in a stable currency, tended to pick up strongly after a period of crisis a pattern that played out consistently EXHIBIT 2 Beta around the globe Beta 1 by country, 1987 22 Global beta Europe United States 1..93.84 through all the crises Jordan.6 the parent encountered Colombia.22 in emerging markets. Pakistan.37 Finally, academic research 3 into stock market returns over the past 2 years has turned up little correlation between returns on investments in emerging economies and those in the rest of the world. Simply put, a boom in developed markets does not indicate a probable boom in emerging markets. 4 Over time, the lack of a correlation has meant that emerging-market risk could be diversified away in investment portfolios. Indeed, India Chile Egypt Argentina Taiwan Venezuela Indonesia Malaysia Philippines China South Africa Mexico Turkey South Korea Thailand Brazil Hungary Poland Russia.43.5.52.55.79.79.82.87.94.97.98 1. 1.4 1.13 1.2 1.3 1.3 1.47 2.28 1 Measure of asset s risk relative to market; a given stock s beta is >1. if, over time, it moves ahead of market and <1. if it moves behind the market. Source: Thomson Financial; McKinsey analysis 3 See, for example, C. Mitchell Conover, Gerald R. Jensen, and Robert R. Johnson, Emerging markets: When are they worth it? Financial Analysts Journal, 22, Volume 58, Number 2, pp. 86 95. 4 As emerging-market economies increasingly integrate (and correlate) with those of global and developed markets, the relative risk of individual emerging economies should decline, and the cost of capital should not be significantly higher than it is in developed markets.

6 THE McKINSEY QUARTERLY 23 SPECIAL EDITION: GLOBAL DIRECTIONS according to McKinsey s analysis of annual returns over the past 15 years, a wide portfolio of emerging-market index investments has not been more risky than an investment in a single blue-chip corporation in the United States or Europe. 5 In fact, systematic measurements of risk find emergingmarket indexes to be, on the whole, less risky than a world portfolio over the past 15 years (Exhibit 2, on the previous page). A better way to measure emerging-market risk Actual risks in emerging markets may often be smaller than commonly assumed, at least for those corporations and shareholders that employ a portfolio approach to investing there. But how should the risks be reflected in emerging-market investment decisions and portfolio performance evaluations? Either a cash-flow-scenario approach or a country-risk-premium approach can produce accurate valuations if it takes into account findings on emerging-market investment risks. It is possible to illustrate how either approach might work for an investment, say, in two identical production plants, one in Europe and the other in an emerging economy (Exhibit 3). EXHIBIT 3 Analyzing market risk: Two approaches Cash-flow-scenario approach (for identical facilities) European market Emerging market Cash flows in perpetuity, 1 $ Cash flows in perpetuity, 2 $ Probability Year 1 Year 2 Year 3 Year 4... Probability Year 1 Year 2 Year 3 Year 4... Business as usual 1% 1 13 15 18 8% 1 13 15 18 Distressed business 2% 25 26 26 27 Expected cash flows 1 13 15 18 Cost of capital = 1.% Net present value = $1,333 85 87 89 92 Cost of capital = 1.% Net present value = $1,133 Country-risk-premium approach (for identical facilities) European market Emerging market Cash flows in perpetuity, 1 $ Cash flows in perpetuity, 1 $ Year 1 Year 2 Year 3 Year 4... Year 1 Year 2 Year 3 Year 4... Business as usual 1 13 15 18 1 13 15 18 Cost of capital = 1.% Net present value = $1,333 Cost of capital = 1.% Country risk premium = 1.3% Adjusted cost of capital = 11.3% Net present value = $1,133 1 Assumes cash flow growth in perpetuity of 2%. 2 Assumes cash flow growth in perpetuity of 2% and recovery under distress of 25% of business-as-usual cash flows. 5 All market returns are measured in US dollars.

EMERGING MARKETS AREN T AS RISKY AS YOU THINK 7 The cash-flow-scenario approach The cash-flow-scenario approach examines alternative possibilities for how future cash flows might develop. At a minimum, the approach should evaluate two scenarios: one assuming that cash flows develop according to the business plan that is, without local economic-distress risk and a second reflecting cash flows under adverse economic conditions. Setting up the parameters for scenario analysis is always subjective. Once key assumptions are established, however, comparisons among scenarios are valid. In our analyses, we assume for simplicity s sake that if adverse economic conditions develop in an emerging market, they will do so in the first year of a plant s operation. In reality, of course, an investment will face a possibility of distress in each and every year of its lifetime, but modeling risk over time would require much more complex calculations without having an effect on the basic results. We also assume that in most financial crises an emerging-market business would not wind up as entirely worthless, so we apply a 2 percent chance of financial distress, with the cash flow 75 percent lower than it would be in a business-as-usual scenario. As a consequence, the plant in the emerging economy could expect future cash flows significantly lower than those of its European equivalent. But because the country distress risk is diversifiable, the beta and the cost of capital are identical for both plants. Risk is taken into account, but not in the cost of capital. Instead, the risk is reflected in the expected value of future cash flows. As a result of this local economic-distress risk, the value of the emerging-market plant is indeed significantly lower than the value of its European sister plant. The country-risk-premium approach The second approach is simply to add a country risk premium to the cost of capital for comparable investments in developed markets. The resulting discount rate should then be applied to the business-as-usual cash flows without taking country risk into account in the cash flow projections. In our analysis, using the same plant net present value (NPV) that is used in the cash-flow-scenario approach led to an implied discount rate of 11.3 percent, reflecting a country risk premium of only 1.3 percent. Unfortunately, some practitioners make the mistake of adding the country risk premium to the cost of capital in order to discount the expected value of future cash flows, which already include the probability of distress, rather than to the promised cash flows under the business-as-usual scenario. The

8 THE McKINSEY QUARTERLY 23 SPECIAL EDITION: GLOBAL DIRECTIONS EXHIBIT 4 error results in a value that is too low because it accounts for the probability of a crisis twice. Others set the country risk premium too high. Even at the fairly high probability of distress and the conservatively low recovery rate 6 in our scenario above, the resulting 1.3 percent risk premium is still far lower than the double-digit premiums often proposed for emerging-market investments. To justify some of the higher premiums Problematic premiums Percent Risk premium 2 16 12 8 4 Double-digit risk premiums imply extremely high distress probability and low investment-recovery rates No recovery of investment 25% recovery of investment 2 4 6 8 1 Probability of distress we ve seen, the probability of a local economic crisis affecting an investment would need to be 8 percent or higher (Exhibit 4). The extremely high distress probabilities and low recovery rates implicit in double-digit risk premiums are inconsistent with our findings on the rather limited impact of country risk on the business performance of some international corporations. Aside from typical calculation errors, the country-risk-premium approach does have a fundamental flaw: there is no systematic methodology to calculate a precise country risk premium. While we were able, in our example, to reengineer the country risk premium because the true value of the plant was already known from the scenario approach, in most cases the true value of an investment is obviously not known. As a substitute, the country risk premium is sometimes set at the spread of the local-government debt rate 7 over the risk-free rate but that is reasonable only if the quality of local-government debt service is perfectly correlated with returns on corporate investments. Implications for evaluating financial performance Corporations face similar issues in evaluating historical emerging-market business performance in terms of economic profit 8 or some other compari- 6 The recovery rate here indicates the value of cash flows under the local-economic-distress scenario as a percentage of the cash flows under the business-plan scenario. 7 This is the promised yield rather than the expected yield on government bonds, further underlining the fact that the country-risk-premium-based cost of capital must be applied to promised (that is, business-as-usual) cash flows instead of expected cash flows, which already include the probability of distress. 8 Economic profit is a measure of periodic value creation, defined in the following way: ROIC invested capital weighted average cost of capital invested capital.

EMERGING MARKETS AREN T AS RISKY AS YOU THINK 9 son of returns on capital versus the cost of capital. Again, both the scenario approach and the country-risk-premium approach can be applied in principle. When returns on capital are assessed over longer periods of time, the cost of capital should be used without incorporating a country risk premium. That s because over longer periods of time a particular emerging market is more likely to experience some economic distress, and the risk will already be reflected in the data for the local assets under evaluation and in the historical business results. In contrast, it may make sense to incorporate some country risk premium when assessing returns on capital over shorter periods of time. If a crisis has not already materialized, the country-specific risk will not be incorporated in data for local assets. Of course, this premium should reflect realistic assumptions about the probability of distress and recovery rates. Because of the uncertainty surrounding the premium, the resulting short-term evaluation will be relatively inaccurate and must be interpreted with caution. Financialperformance assessments must explicitly account for local economic and business conditions in emerging markets, such as inflation and GDP development. And just as for any business with volatile results, short-term performance assessments can t rely on figures alone. A systematic assessment of the cost of capital for emerging markets may well reveal that it is lower if the diversification of portfolios and the true exposure to country risk are taken into account. Such assessments also illuminate the advantages of developing distress scenarios and of planning for financial upheavals. Marc Goedhart is an associate principal in McKinsey s Amsterdam office, and Peter Haden is a consultant in the London office. This article originally appeared in the spring 23 issue of McKinsey on Finance. Copyright 23 McKinsey & Company. All rights reserved.