A recent article in the Economist highlighted the struggles of developed-country multinationals in emerging markets (see Emerge, Splurge, Purge). Multinationals struggling in emerging markets is nothing new. The surprising part to me is that we still haven’t learned our lesson from years of mistakes. Every wave of emerging market investment seems to be justified by some variant of the “this time will be different” meme—i.e., the opportunities are limitless and the risks are diminished. We’ve witnessed this type of behavior in the investment run up before the 1997-98 Asian financial crisis; the irrational exuberance leading up to the 2007-08 global financial crisis; and now, in the period of central bank easy money and yield chasing in the wake of the global financial crisis. But now, every time the Fed utters the word “taper”, markets in the emerging world wobble and multinationals suddenly discover that profitability in emerging markets has failed to live up to expectations. According to the Economist:
American firms made a 12% return on equity in 2012…But having grown fast, profits are now falling…There has been a long bout of share-price underperformance…Western firms with high emerging-market exposures [have] lagged the broader S&P 500 index by about 40% over three years…The emerging-market rush may end up like a giant version of the first internet boom 15 years ago.
The decline has been broad-based. Current laggards include some of the world’s largest, and best known, companies. For example, Proctor & Gamble’s global margins are half of its U.S. margins, and its performance in emerging markets is especially weak. Not only that, but Western multinationals have struggled in the previously high-flying BRIC economies—China, India, and Brazil, in particular. The root of the problem:
During a boom every firm thinks it can be a winner, leading to excess investment and saturation. The more capital-intensive the industry is, the greater the pain in store for its weakest members…most Western businesses have low gearing… Without their emerging-markets pep pill many firms would have dire revenue growth. The developing world has supplied 60-90% of the growth of Europe’s big firms in recent years.
One comment here: Growth is not the same thing as profitability. And managers often conflate the two. But beyond the obvious pursuit of growth, expressions of managerial hubris, and increased market volatility, multinational managers often make poor decisions about the underlying risks they will take on in emerging markets. Globalizing companies tend to systematically overestimate the benefits of entering emerging markets while underestimating the costs. This is because developed country multinationals bear heightened political, economic, regulatory, and cultural risk in emerging economies. And those risks are not adequately priced. As I’ve written before (see So You Want to Do Business In a Developing Country? or U.S. Banks Pin Hopes on Emerging Markets):
There are many compelling reasons that companies look to developing countries for growth. Less-developed countries hold the promise of large, fast-growing consumer markets (e.g., the BRICs); an abundance of cheap labor; and access to otherwise unavailable natural resources. Managers are often lured by this unbridled potential. But there is a reason these countries are considered “developing” – largely because of the under-developed state of their institutional environments… Although developing markets hold jaw-dropping potential, it often remains just that. Realizing potential from developing markets is incredibly challenging. Companies often find that the institutional (cultural, political, and economic) environments in the developing markets they enter…are so vastly different from anything that they encounter in their own domestic market (or even in other developed markets) that the costs involved in navigating them exceed even their most conservative estimates.
The takeaway here is that ventures into emerging markets should be considered with appropriate risk pricing tools. Judging by the recurring bouts of poor multinational performance in emerging markets, we haven’t quite reached that goal. But maybe, just maybe, next time will be different.