Emerging Markets – The Competitive Advantage

emerging markets competitive advantageThis article is Part 3 of a 3 part series on Emerging Markets Exposure: Where & How Much?

Incumbent (Local) Firms Lose Their Competitive Advantage in a Growing Market 

The business development stage of an emerging market country/region helps us decide whether direct versus indirect investment is best. Companies with the best competitive advantage will prevail in the long-run. The strongest indicator of competitive advantage is economies of scale, which allows a company greater ability to lower prices to gain market share. An indicator of economies of scale is the measure of fixed costs as a percentage of sales.

Imagine an emerging market with three stages of economic development – Stage 2 has tripled the sales of Stage 1 and Stage 3 has ten times the sales of Stage 1. Assume there is an incumbent (local) company and a new market entrant (multinational) company. Incumbent firms lose their competitive advantage in a growing market (in this case measured by fixed costs as a percentage of sales).

STAGE 1 ECONOMY

Entrant Incumbent Incumbent’s Advantage
Sales 500 2500 2000
Fixed Costs 100 100
FC/Sales 20% 4% 16%
STAGE 2 ECONOMY Entrant Incumbent Incumbent’s Advantage
Sales 1500 7500 6000
Fixed Costs 100 100
FC/Sales 6.7% 1.3% 5.4%
STAGE 3 ECONOMY Entrant Incumbent Incumbent’s Advantage
Sales 5000 25000 20000
Fixed Costs 100 100
FC/Sales 2% 0.4% 1.6%

Multinational (Indirect) Exposure Is Better Once an Emerging Economy Starts To Mature 

Let’s continue with our example. At any three stages, the incumbent (local) company and/or its government may deter multinational competition through tariffs, taxes, product dumping, or unfavorable legislation. The multinational company can fail if it lacks a cultural understanding of the region. Let’s assume there are no barriers to entry and market growth is enough (4%+) to attract a multinational. As the market expands, there is an evolution from accelerating to slowing to stable growth. The market matures over time as economic profits go from “abnormally high” to “above normal” to “normal”. Stock selection is tougher in the Stage 2 economy because it is unclear which company will prevail. In Stage 3 (intense competition), the multinational company usually prevails due to superior economies of scale coupled with better management, operational, marketing and distribution capabilities. Therefore multinational (indirect) exposure is usually better in a mature market. Stock selection is easier in Stage 3 as there is greater clarity regarding market share and profit.

Our 10-Point Decision Framework: Direct Versus Indirect Emerging Markets Exposure

Stage 1 Economy Stage 2 Economy Stage 3 Economy
Defensive Mechanisms To Multinational Entry Tariffs, Taxes, Dumping, Political Tariffs, Taxes, Dumping,      Political Tariffs, Taxes, Dumping, Political
Other Impediments Cultural Understanding Cultural Understanding Cultural Understanding
Market Growth Unattractive Stagnant (No Advance) N/A N/A
Market Growth Attractive (greater than 4%) Accelerating Growth Accelerating Growth (Start) to      Slowing Growth (Mid to Late) Stable Growth            (Mature Market)
Market Participants Incumbents (Local) Incumbents (Local)            Multinationals (Foreign) Incumbents (Local)           Multinationals (Foreign)
Competitive Advantage Incumbents (Local) Incumbents Lose Ground     Multinationals Gain Ground Multinationals
Competition/Price Pressure Limited Growing Intense
Economic Profits Abnormally High Above Normal Normal
Stock Selection EASIER                      (May Be Limited Choice) TOUGHER EASIER
Choice Of Exposure DIRECT DIRECT (Start) to                INDIRECT (Mid to Late) INDIRECT

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