Theme Investing Capitalizing on global trends

August 2010 I e m e r g i n g m A r k e t e q u i t y

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Introduction Since 2007, emerging market consumers have been outspending U.S. consumers. By 2020, more than 50% of the population of Japan will be of retirement age. By 2030, almost 60% of the world’s population will live in towns and cities.

In this paper, we look at how theme investing can help investors capitalize on these shifting patterns of globalization, demographics and urbanization, and examine how these trends are contributing to two of the key themes powering equity markets today—consumption and infrastructure.

Consumption

the rise of the emerging market consumerEmerging market countries are set to dominate consumption in the future. In 2007, emerging market consumers began to outspend their U.S. counterparts.1 By 2015, they are forecast to account for 37% of global consumption,2 as rising incomes, growing middle classes and rapid economic growth spur demand.

For InsTITuTIonal use only

Authors

richard TitheringtonPortfolio Manager, Emerging Markets Infrastructure Fund Chief Investment Officer and Head of the Emerging Markets Equity Team

Peter KirkmanPortfolio Manager, Global Consumer Trends FundGlobal Equities Team

1 Source: The Economist, April 2010.2 Source: Credit Suisse.

22%

34%

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12%

Europe

Emerging Markets

Japan

U.S.

Other Industrial

20%

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6%

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2005 Forecast 2015

Source: Credit Suisse, Economics department research.

exhibit 1: emerging mArkets will dominAte future consumPtion

Theme Investing

2 | Theme Investing: Capitalizing on global trends

Even during the financial crisis, emerging market consumers kept buying, helping to buffer many emerging economies from the global recession. Indeed, as exhibit 2 shows, while sales of consumer goods in developed markets fell 14% between 2007 and 2009, demand in emerging markets kept growing, increasing 11%.

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exhibit 2: emerging mArket consumers kePt buying through the crisis

Analysis based on 254 members of the MSCI All Country World Consumer Discretionary index. Source: Company reports, MSCI, Compustat, Worldscope, Bloomberg, J.P. Morgan.

The potential market for companies seeking to sell to emerg-ing market consumers is huge: populations already vastly out-strip those in the developed world and are growing much fast-er. In India and China, hundreds of millions of people will enter the middle classes in the coming decades.3

exploiting the consumption themeTheme investing provides the opportunity to exploit the rising power of the emerging market consumer, as well as offering a new way to benefit from the trends driving more mature west-ern markets. Investors should be looking to avoid short-term fads, instead seeking to profit from persistent, long-term trends with the ability to produce sustainable returns.

For example, Starbucks effectively created a new category, convincing millions of people that they needed to buy a cup of hot milk with a shot of espresso every day—creating a spend-ing habit that had not previously existed. Spotting these trends early provides a durable source of returns for investors.

Some of the trends we believe will shape the consumer landscape in the coming decades include:

aspirational demand

By 2030, two billion people are forecast to move from the lower- to the middle-class income bracket, changing buying patterns around the globe as people aspire to higher stan-dards of living. One way of accessing this trend is through western companies selling into emerging markets. Most of the world’s biggest brands are owned by western companies, and as wealth levels rise in developing markets their inhabitants aspire to own these branded goods.

However, the aspiration trend is not only about luxury goods. As emerging markets develop, their citizens often aspire to what those in the developed world regard as basic necessities. In China, for example, only 6% of babies wear disposable dia-pers, compared with 90% in the UK. With 40 million babies in China, the growth potential for diaper companies selling into the market is considerable.

Demographics

One of the benefits of using demographic trends to assess investments is their predictability. Demographic factors are rational and quantifiable drivers of economic change. Aging populations drive changes in buying patterns, transforming the economy of a country and opening up new revenue streams.

In the introduction, we noted that more than 50% of the Japanese population will be of retirement age by 2020. Theme investors can use this information to predict changing con-sumption patterns. Companies that produce hip replacements and other musculoskeletal solutions, for example, can be expected to experience much faster growth and increased revenue streams as populations age.

Health and wellness

Health and wellness is an observable trend across the globe. In developed markets, people want to live as long as possible and look as good as they can, boosting demand for products perceived as offering lifestyle improvements. In the U.S., sales of organic food have increased from under USD 4 billion to almost USD 16 billion in the past ten years, reflecting the trend for healthier eating.

In emerging markets, meanwhile, meeting basic sanitary needs remains a key challenge. Tissue paper, for example,

3 Source: ‘The world turned upside down’ in the Economist, 17 April 2010.4 “First break all the rules: The charms of frugal innovation” in The

Economist, April 17, 2010.

J.P. Morgan Asset Management | 3

is a growth market in China, as is shampoo. In India, compa-nies offering innovative, low-cost water purification systems and heart monitoring equipment are providing solutions to some of the country’s most pressing health problems.4

Infrastructure

the emerging markets building boom

Driven by many of the same forces that are powering the consumption theme—changing demographics, globalization, urbanization—infrastructure is becoming an increasingly important emerging market theme, creating opportunities for investors as governments and companies build the roads, power stations and ports needed to support the next phase of growth.

China, for example, is currently building 57 new airports, and is developing the world’s largest, fastest, most technologically sophisticated rail network at a cost of USD 300 billion. In Brazil, meanwhile, up to USD 50 billion of investment is esti-mated to be needed to improve infrastructure before the 2014 World Cup, while USD 15 billion will be invested in Rio de Janeiro ahead of the 2016 Olympic Games.

urbanization—placing a strain on emerging market cities

The need for new infrastructure is driven by rapid industrial-ization and urbanization. The United Nations anticipates that

by 2030, almost 60% of the planet’s inhabitants will live in towns and cities.5 Emerging urban populations are projected to grow between 133% and 150% faster than current overall population growth, with more than 350 million people—equiv-alent to half the population of Europe—moving to urban areas between 2010 and 2015.

The urbanization trend is being driven by the industrialization of emerging nations. People are lured from the countryside to urban centers by the prospect of better wages and improved quality of life. This in turn increases demand for goods, lead-ing to further industrialization and creating more jobs—the virtuous circle of emerging market development.

In 1975 the United Nations estimated that only three cities had a population of more than ten million people: Tokyo, New York and Mexico City. By 2005, that number had risen to 20, and by 2025, the UN estimates the total will be 29. Of these, 24 will be in the emerging world. By 2050, emerging market city dwellers are expected to make up 83% of the world’s urban population.5

Urbanization means emerging markets have readily available labor forces, keeping wage costs cheap and allowing compa-nies to expand rapidly—key competitive advantages in the global marketplace. However, the influx of new inhabitants places a strain on basic services in the cities—public transport, roads, electricity, water—creating a pressing demand for investment in infrastructure.

exhibit 3: urbAnizAtion: 350 million PeoPle heAded for the cities in the next five yeArs

Source: World Bank, January 2008.

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Emerging regions−urban populationTotal change from prior five year period−urban population

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5 Source: United Nations.

Theme Investing

4 | Theme Investing: Capitalizing on global trends

globalization—investment needed to sustain growth

Meanwhile, growing demand for emerging market exports has overstretched local infrastructure, which is already weak in many cases as a result of years of underinvestment. Emerging economies have a pressing need for increased capacity if they are to maintain and extend their competitive advantage. As a result, investment in power stations, airports, railways and other infrastructure has become a key priority for regional businesses and governments, with spending projected to reach USD 21.7 trillion over the next decade.6

Many emerging market countries have undergone meaningful economic and structural reforms over the past decade, increas-ing their ability to fund large infrastructure investments. In contrast to the majority of developed markets, the pace of expenditure in emerging markets has only been quickened by the financial crisis, as many governments have used infrastruc-ture investment as a means of stimulating economic growth.

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exhibit 4: infrAstructure sPending is Projected to grow

Source: Morgan Stanley Research.

Accessing the infrastructure themeInfrastructure investment creates a virtuous circle, allowing for greater industrialization and urbanization, which then drives the need for further investment. As a result, companies with exposure to the infrastructure theme are typically grow-ing faster than the broader market. For investors, the infra-structure theme offers broad opportunities across multiple emerging market sectors—from construction companies to utilities, from airport operators to financing providers—in a tangible growth area.

For example, the construction of a new highway in an emerging market country creates multiple investment opportunities, ben-efiting companies in diverse industries: the commodity produc-ers who provide the raw materials, the construction contractor and the highway tollbooth operator, among many others.

Theme Investing Within a PortfolioThe twin themes of consumption and infrastructure inform and enhance each other. By boosting employment and improv-ing economic capacity, infrastructure spending increases wealth and stimulates consumption. In turn, robust consump-tion contributes to economic stability, providing governments and businesses with the means to invest in infrastructure.

Within a portfolio, too, the consumption and infrastructure themes complement each other: emerging market consump-tion is a long-term secular trend, as seen in the financial crisis when strong domestic demand helped to insulate emerging economies from global trade winds. Infrastructure, meanwhile, is also a structural theme, but offers greater cyclical exposure. Both themes offer strong growth potential for investors with long-term investment horizons who are prepared to take on higher risk in pursuit of higher returns.

To take full advantage of the many opportunities offered by theme investing, bottom-up management is vital—particularly in inherently inefficient emerging markets. A top-down manager who allocates to the industrial engineering sector, for example, will not fully capture the many cross-sector opportunities offered by the infrastructure theme. Instead, it is important to find a bottom-up manager capable of scruti-nizing individual companies and discovering those that truly offer the ability to benefit from shifting economic trends, whatever sector or country they fall in.

theme investing At A glAnce

seeks to capitalize on structural shifts in the global economy•

Taps into the growing spending power of the emerging •market consumer

Benefits from rising global demand for infrastructure•

Provides access to truly long-term investment opportunities•

6 Source: Morgan Stanley.

Theme Investing

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Any forecasts, figures, opinions or investment techniques and strategies set out, unless otherwise stated, are J.P. Morgan Asset Management’s own as at August 2010. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. They may be subject to change without reference or notification to you. The views contained herein are not to be taken as an advice or recommendation to buy or sell any invest-ment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate and investors may not get back the full amount invested. Both past performance and yield are not necessarily a guide to future performance. Exchange rate variations may cause the value of investments to increase or decrease. Investments in smaller companies may involve a higher degree of risk as they are usually more sensitive to market movements. Investments in emerging markets may be more volatile and therefore the risk to your capital could be greater. Further, the economic and political situations in emerging markets may be more volatile than in established economies and these may adversely influence the value of investments made. Real estate and infrastructure investing may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector. Real estate and infrastructure investing may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrower. You should also note that if you contact J.P. Morgan Asset Management by telephone those lines could be recorded and may be monitored for security and training purposes.

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richard Titherington, Managing Director, is the Chief Investment Officer and Head of the Emerging Markets Equity Team. An employee since 1986, Richard transferred to the Pacific Regional Group in 1994. He was appointed as a manag-ing director in April 2001 and appointed head of the global emerging markets business in December 2001. Prior to 1994 Richard was a U.S. and international pension fund manager, working in the UK until he transferred to Hong Kong in 1992. Before joining the firm, Richard spent two years as an analyst with UKPI in London. Richard obtained an M.A. in politics, phi-losophy and economics from Oxford University.

Peter Kirkman, Managing Director, is a global portfolio man-ager in the Global Equities Team in New York. An employee since 2001, Peter was previously the chief investment officer and the senior portfolio manager of the Fleming Japan Team. Before joining the firm, he was the senior portfolio manager of Japan Equities at the Trust Company of the West (TCW) in London and a portfolio manager in Japan Equities at Prudential UK. Peter holds a B.Sc. (Hons) in accountancy from the University of East Anglia and an M.Phil. in management studies from Cambridge University. He is also an associate of the U.K. Society of Investment Professionals (ASIP).