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The Best Emerging Market Play You Never Thought Of

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Investors agree that Western economies are going nowhere. Money is flowing into emerging markets at a record pace, as everyone from hedge fund managers to the man on the city bus look toward far-flung companies they've never heard of.

Not me, though.

I'm not writing off the U.K., Europe, or the U.S. I'm also well aware that GDP and favorable demographics aren't everything to an equity investor -- the price you pay for growth matters.

But I also believe some of the most attractive opportunities to play the very real emerging market story are right on our doorstep.

Over here, over there
When I visited London-based Diageo  (NYSE: DEO  ) last week, for instance, I sensed frustration that the market underestimates the long-term value of Diageo's brands in opening up new territories.

Now another company I own for its overseas growth potential is addressing this issue. U.K. grocery titan Tesco (TSCDY.PK) just hosted an analyst event in South Korea and China that's clearly aimed at waking up investors to its extraordinary rollout across Asia.

Did you know 31% Tesco's sales are achieved outside of the U.K.? That 22% of its profits are? Or that those figures were merely 10% and 5% a decade ago?

Tesco's familiarity can blind us to the scale of its overseas operations:

  • 65% of its selling space is outside the U.K.
  • More than half of Tesco's profit growth this year has come from Asia and Europe.
  • Tesco is either first or second-placed in nine international markets.
  • It's market leader in Malaysia, Thailand, and catching the top dog in South Korea.
  • Life-for-like sales at Tesco China are expanding at over 8% a year.

Profit potential
It's not going swimmingly in every foreign territory -- sales are remorselessly shrinking in Japan, and the woes of its U.S. Fresh'n'Easy business are well-known. But the potential in Asia dwarfs these hiccups.

Consider South Korea, for instance, where Tesco operates under the Homeplus brand. GDP has grown at 5.4% on a compound basis for four decades, and thanks to 118 hypermarkets and 245 express stores, Tesco already has 1 million square meters of South Korean floor space.

In 11 years, sales have risen from 100 million pounds to 4.5 billion pounds, and the territory now delivers 287 million pounds in profit. Yet with just 4.3% of the total retail market versus 4.8% for its leading rival, Tesco sees plenty more growth ahead.  

If you see a Tesco superstore outside every U.K. town and wonder where growth will come from, you're looking in the wrong place.

Made in Britain
In countries like South Korea, Tesco has seemingly achieved the grand prize of understanding local requirements, and addressing them with the logistical know-how it's perfected in the U.K.

Having pioneered the Clubcard concept in the U.K., for example, Tesco has deployed it in nine other countries. And where the U.K. operation invested more than 100 million pounds in ordering systems during the past decade, it costs just 2 million pounds to deploy them in a new country.

Famously, "retail is detail," and leveraging Tesco's U.K. smarts doesn't stop with the supply chain. By remodeling its South Korean aisle format along U.K. lines, it improved like-for-like sales by 10%.

Tesco the property giant
Naturally, it's the Chinese opportunity that's mouth-watering. Tesco says it has spent six years learning all about this vast country, that it's placed its bets in the fastest-growing regions, and that it has identified crucial differences between, say, the older, more conservative northern regions, and the younger, migration-fed south.

Big retailers are engaged in a land grab in China, which should see the number of hyper- and superstores more than triple from 2005's 1,000 to nearly 4,000 by 2014. To help it secure the best spots, Tesco will actually build many dozen of malls over the next five years, each featuring a Tesco hypermarket as an anchor tenant.

Consider that the 90 key cities on Tesco's radar have a combined population of 120 million (twice the U.K.), and you get a sense of how China could reshape this company in the long term.

Risking it
Of course, expansion on this scale isn't cheap -- and some analysts are already unhappy at how Tesco handles its capital expenditure via sales to joint ventures, for instance.

We'll have to wait for big returns, too. According to Tesco's figures, new stores don't become fully profitable for four years, which means a lot of up-front costs for jam further down the line. Overseas expansion will complicate Tesco's accounts for years to come, compared to Sainsbury or Morrison.

I think that's a price worth paying. With Tesco's international boss Philip Clarke due to take over at the top from the revered Sir Terry Leahy in March, it is clear where Tesco is placing its bets.

And at a prospective P/E of 12 with a 3.6% dividend yield, we're hardly being overcharged to go along for the ride.

More from Owain Bennallack:

This article has been adapted from our sister site across the pond, Fool U.K. Owain Bennallack owns shares in Tesco and Diageo. Diageo is a Motley Fool Income Investor recommendation. The Fool owns shares of Diageo. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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