LONDON (Reuters) - A broad collapse of company profits in the developing world shows no sign of abating, forcing investors to tilt portfolios towards sectors such as healthcare or consumer goods where margins are more robust.
What is evolving is in effect, a two-speed asset class.
Profits in emerging markets have been sharply squeezed in recent years, leading stocks to underperform their developed world peers and slashing return on equity, a measure of how well firms use shareholders’ equity to make profits.
Emerging markets ROE is a fifth below pre-2008 levels.
But despite general weakness, some companies have paid rich dividends, especially those in sectors which benefit from the slow rebalancing of emerging economies towards consumption.
“You want to be in sectors that sell to the people who benefit from wage inflation: consumers,” said John Lomax, head of emerging equity strategy at HSBC.
“There is a big pool of money and not many stories that are working ... effectively you have a two-speed EM where things that work are in demand and becoming more expensive.”
Russian supermarket chain Magnit (MGNT.MM) saw profits jump 28 percent in the first quarter and its shares have returned 190 percent since April 2010, according to Morgan Stanley.
Magnit has already rallied 50 percent this year, compared with a 2013 loss of 5 percent in the broader Moscow stock index, pushing its share price to a whopping 22 times earnings.
But results from other companies have been dismal.
Data from Thomson Reuters Starmine shows more than half of emerging market firms that have reported results for the first quarter of 2013 have missed earnings forecasts, while net profits have undershot estimates by over 20 percent on average.
In contrast, 70 percent of U.S. companies have beaten forecasts, with profits an average 5 percent more than expected.
But earnings for emerging market firms making consumer staples, or essential goods, exceeded estimates by 6 percent, prompting analysts to raise second quarter profit forecasts for the sector by 18 percent, Starmine shows.
High unemployment in struggling Western economies has helped companies boost profits by depressing wages, but a shortage of skilled workers in many emerging markets countries is pushing up pay, making it hard for firms to cut costs.
Emerging companies’ gross revenues before costs have only undershot expectations by about 2 percent, HSBC’s Lomax noted, suggesting they are struggling to convert revenues into profit.
“Sales are holding up but margins continue to be squeezed. This is a big constraint on emerging markets’ outlook,” he said.
The Magnit example highlights the price and performance premium for companies that are perceived to be delivering.
“I would love to buy a cheap stock that also enjoys a steady and sustainable increase in ROE, but stocks and sectors that have demonstrated that in Asia have been rewarded and they are normally priced appropriately,” said John Crawford, who oversees $3 billion in Asian equities at Henderson Global Investors.
Crawford views the repricing of consumer stocks, especially in Asia, as a long-term trend driven by governments’ efforts to shift away from exports as the chief engine of growth.
Increasing minimum wages to raise disposable income is part of that strategy. Soapmakers and supermarkets may gain but at the expense of sectors that are already on razor-thin margins.
Food and beverage companies have returned 70 percent since April 2010 while food retailers returned 65 percent, according to Morgan Stanley. In the same period, materials shares lost almost 20 percent and energy has returned minus 11 percent.
Brewer Ambev, Mexican bottler Femsa and Indian tobacco firm ITC top Morgan Stanley’s list of winners since mid-2010, while losers include Brazilian energy giant Petrobras, Korean steelmaker POSCO and India’s Reliance.
After three years of underperformance in emerging markets stock indices, there may be light at the end of the tunnel.
JPMorgan Asset Management attributes the emerging earnings slump to cyclical rather than structural factors, meaning it should start to ease as global economic growth recovers.
Downward pressure on earnings has not subsided, its strategists say, but in the past three months fewer countries and sectors have been hit by earnings downgrades, with new revisions largely concentrated in the materials sector.
Waj Hashmi, a fund manager at Schroders says the investment cuts and wage savings that have supported Western firms’ robust margins and superior profits cannot continue indefinitely.
“Can the same outperformance against emerging markets in terms of margins continue from here?” he said. “It may, but it is going to get tougher.”
Editing by Catherine Evans