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The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Dec. 5, 2012. With permission, we're reproducing it here in its original form.
Inequality exists in every emerging market, but rarely does it manifest itself as sharply as it did for me in Lima -- where a billboard of Kate Moss advertising luxury goods alongside the highway rose out of impromptu slums that the residents here call invasiones. Literally, invasions.
Those invasiones exist because people from rural Peru have been migrating to Lima in recent years to try and share in a piece of what's been a booming Peruvian economy. This growth was driven initially by rising commodity prices that begot a sharp increase in consumer bank lending, and therefore construction and consumption. Yet the fact that Peru's advances in recent years had not been more evenly distributed is what led in part to the election of leftist president Ollanta Humala in 2011, a result that caused Peru's stock exchange to experience its biggest one-day drop ever.
So many reactions are overreactions
That drop was an opportunity for anyone who had the foresight to take advantage of it because Humala has moved to the center, appointing moderate ministers and heeding the Central Bank in ways that won universal praise from every businessperson I talked to here, and the market resumed its steady rise. And that's good. Because the next step for Peru is to go from being a cyclical growth economy to a sustainable growth economy, and if the country can accomplish that, there is so much good that can come of it.
Indeed, so many of the companies I talked to here during my November 12-15 visit are preparing for this bright future. Consumer goods conglomerate Alicorp, for example, has made volume growth in excess of sales growth one of its most important near-term goals. For an industry that generally measures itself on the strength of its brands' pricing power, this is an interesting aspiration. It means that Alicorp wants to innovate lower-priced, value products in order to scoop up share among consumers who will only newly be able to afford any branded goods at all. In many countries, this is a segment large companies ignore. But Alicorp sees a growth opportunity because they expect these consumers to rapidly be able to afford Alicorp's higher-priced more profitable goods -- and they want to win their loyalty now.
Similarly, local Coca-Cola bottler Lindley Corp., a holding in one of our portfolios, is investing heavily in technology to expand distribution of glass bottles. Yes, the same glass bottles that today can be found only in antique shops in the United States. The reason is that while investment in glass bottles is initially more expensive for the company, it means consumers don't have to pay as much for disposable packing -- which means Lindley can lower effective prices for more price-sensitive consumers. For a company that prices its products 50% higher than rival Pepsi in Lima, this is a step to preserve market dominance and ultimately take an enormous step forward.
Finally, in the banking sector, local giant BCP is not content to sit on the nearly impenetrable franchise it has built up in wholesale banking in-country. Rather, it acquired a microfinance company and has said that it expects most of its future growth to come from that segment. But that is easier said than done in a sector that is becoming more and more competitive, with Mexican microfinance expert Compartamos SAB de CV, a portfolio holding, recently acquiring Peruvian microlender CREAR, and every other bank in the country seeking growth in the same space. But all are optimistic that they can achieve 20% or better loan growth rates without compromising credit quality, even if they give up market share simply because they see such an enormous long-term opportunity for the rise of a middle class in Peru. And a different middle class from the one the country has produced before, one contact told me. Until recently, Peruvians depended on jobs and favors from a handful of family dominated conglomerates. But now, thanks to the bank lending boom, there are more small business and more entrepreneurs -- and a middle class is emerging that is no longer dependent on certain entrenched interests.
The local edge
Of course, Peruvian companies aren't the only ones who see this opportunity emerging. Foreign investors and foreign companies are opening up shops in Peru daily because they see the same trends. But what makes the prospect of investing in local companies more interesting than in their multinational peers is because of the unique strategies they have to profit from it. I already mentioned Alicorp seeking lower selling prices and Lindley expanding production of glass bottles, actions that companies such as Kraft and Coca-Cola have tried to get away from. But there's also a story in distribution, where Alicorp and Lindley are doubling-down on their capabilities to distribute to small mom-and-pop stores, and Credicorp is hiring more third-party agentes, independent small business owners who can double as local bank tellers, while multinational competitors look to distribute via supermarkets or build expensive branches.
While the supermarket née hypermarket story has certainly taken off in some emerging markets, executives at Alicorp and Lindley don't see that experience being applicable to Peru. For one, given the country's geography, there aren't many places to put them that are convenient to consumers. Second, Peruvians don't tend to have a lot of room for storage at home, so many of their purchases are occasion-based rather than put on a Sunday shopping list. So instead of seeing economic growth beget big box retailers as it did in the U.S., these companies are preparing for a rapid proliferation of mom-and-pop stores -- and they want to have the distribution capacity in place to serve them.
This is one example of the importance of local knowledge in a fast-growing emerging market, which is why we seek to balance our international exposure across multinationals such as Nestle and hyperlocal firms such as Lindley. And it's also why we love to find companies like Lindley -- and also Guinness Nigeria -- that give us the best of both worlds: local expertise and a small-cap growth profile with the global strength and governance of a multinational parent.
Editor's note: Tim Hanson is not able to engage in discussion on the boards or in the comments section below. Tim does not own shares of any companies mentioned, but his wife owns shares of Coca-Cola.