Month: August 2017

The Bullish Case for Brazilian Stocks

Brazil is coming out of one of the worst economic slumps in its history, after having lost more than 7% of its GDP over the past three years. A huge binge caused by a boom in commodity prices (2004-2011) which led to hot-money capital inflows and excessive credit and consumption was followed by a large hangover, made much worse by a political crisis and a draconian monetary policy of extremely high real interest rates. But all downturns come to an end, and Brazil is now poised to start a new growth cycle on solid ground. Corporates now have very lean cost structures, and they will see significant margin leverage as sales recover. Profits are very depressed; in 2016 they were at 2005 levels. At the same time, the market is inexpensive relative to its history and one of the cheapest in the world, so there are good prospects for both vigorous profits growth and multiple expansion over the coming years.

It can be argued that the past 10-15 years were wasted by Brazil. The Workers Party (PT) governments of Presidents Lula and Rousseff coasted on the reforms passed by the previous administration and sat back to enjoy high commodity prices and ample foreign capital inflows.  Several important achievements of the previous government, such as depoliticized regulatory agencies and the professionalization of public companies, were discarded, and new reforms were taken off the agenda. The PT focused mainly on a multitude of poorly-designed social welfare programs and corporate subsidies, without consideration for the fiscal consequences. When commodity prices retreated and the mismanagement and corruption of the public sector was revealed, the party came to an end.

The interim president Michel Temer, who replaced Rousseff after her impeachment, has made good progress towards putting Brazil’s economy back on the right track. For the first time in nearly twenty years, Brazil now has a reform agenda and a real opportunity to break out of economic stagnation (Brazil’s Economic Stagnation). An inbred love for experimental developmental economics and a complacency facilitated by the commodity boom and Petrobras’s oil finds, seem to finally have been replaced by a new realism and a desire to follow market economics. The country has woken up to the evidence that Argentina and Venezuela are not better models to follow than Chile and Mexico, and that wholesale antagonization of the U.S. leads nowhere.

Temer has already secured passage of a “fiscal responsibility law” which limits public spending increases to inflation and provides a possible anchor to a future of fiscal rectitude.

Temer has also brought competent management back to the state-owned national oil company  Petrobras, the electricity-holding Eletrobras and other public entities. Petrobras has started a process of selling non-core distribution and refinery assets, to focus on managing the development of its prodigious deep-water oil reserves. Temer has also proposed privatizing Eletrobras, a state electricity conglomerate that has long been a hotbed of patronage for politicians. Moreover, additional privatizations and infrastructure concessions once again are being advanced. It appears that these will be done in a manner to promote investment and efficiency, not for the convenience of corrupt construction companies and their political friends, as was the case during the Lula and Rousseff governments.

The good news for the stock market is that there are plenty of low-hanging fruits for Brazil to collect.

First, after this dire 3-year economic recession Brazil will enjoy a natural rebound. That alone should guarantee moderate growth in coming years. The negative effects of low commodity prices have already been felt and these are likely to stabilize from now on.

Second, important reforms of social security and labor are likely to pass. Consensus appears to have evolved in favor of these fundamental reforms. Social security reform is vital to stabilize fiscal spending. A labor reform could create enormous opportunities to create jobs in the formal economy.

Third, productivity is very low (at about a quarter of US levels) and productivity growth has been abysmal. Brazil has huge potential to increase productivity by pursuing two tracks:

  • Lower tariff and non-tariff barriers to open the economy. Brazil can take advantage of the enormous presence of mutinationals and the scale of their Brazilian businesses to promote integration into global supply chains and increase exports. For example, the auto industry currently has very low productivity and is mainly domestic focused.
  • Brazil has a pathetically low rank in the World Banks’s “ease of doing business survey”, and has seen no progress over the past decade. It has the worse ranking in Latin America and one of the worse for the main emerging markets. A methodical approach towards deregulation and tax-simplification would quickly yield high dividends.

World Bank’s Cost of Doing Business Country Rankings

Fourth the stocks market is inexpensive relative to both its history and other stock markets.

  • Dollarized earnings rebounded strongly in 2016 and will rise another 20% this year, but they remain below the level of 2005 and at about half the level of 2010-11. With very lean cost structures, companies will see better margins and earnings as the recovery progresses.
  • Cyclically adjusted price earnings (CAPE) ratios on a dollarized basis are cheap relative to Brazil’s stock market history as well as compared to other markets. In a world of very high assets prices caused by the impact of monetary policies on the pricing curve for capital duration and risk, emerging markets equities in general and Brazilian equities  in particular still trade below long term averages. Though CAPE ratios in general are not a good timing tool, they are very predictive of market performance on a 7-10 year basis in developed markets and a 3-5 year basis in emerging markets where cycles tend to be shorter and more abrupt.

There are sufficient risks in Brazil so that the market will face a wall of worry. At the top of the list is the outcome of next year’s presidential election. A successful run by Lula, a low probability at this time because of his legal problems, would certainly unsettle the markets.

Longer term, Brazil faces two fundamental issues.

  • A chronically overvalued currency. It is an absurdity that Brazil has the sixth  most expensive BigMac in the world, a reflection of the very high costs of doing business and an over-valued currency. Policymakers need to constantly remind themselves of former Finance Minister Mario Simonsen’s dictum, “A inflação incomoda, mas o câmbio mata. (Inflation is a nuisance but the foreign exchange rate kills.“ )

x

  • Pro-cyclical policies. Every cycle, Brazil ‘s politicians increase spending during the boom times and then are forced to retrench during the busts. As John Maynard Keynes wisely noted, “The boom, not the slump, is the right time for austerity at the Treasury.”

 

Us Fed watch:

India Watch:

  • India’s rural distress puzzle (livemint)
  • The battle for India’s gold market (Bloomberg)
  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The coming clash of empires, Gavekal  (Zero Hedge)
  • The global economy’s new rule maker (Project Syndicate)
  • Chinese millenials will drive global growth (SCMP)
  • China’s booming pet-care industry (WIC)
  • Hyundai feels the wrath of China (Caixing)

China Technology Watch:

  • Chinese firms eyeing passinger drones (WIC)
  • China military focuses on drone swarms (FT)
  • Big data war in China (WIC)
  • Qualcomm plays the China tech game (WIC)
  • Alibaba wants to bring big data to 1 million small shops (Caixing)

EM Investor Watch:

Technology Watch:

  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

China’s “Inevitable” Rise Through Protectionism

 

China’s rise as an economic power increasingly threatens the Asian and global geopolitical balance of power.  The growing realization in Washington that China’s ascent may be inevitable is based on the acknowledgement that Chinese policy makers are on a coherent and proven path of development, previously followed by the United States itself and later by Japan and the newly minted Asian tigers (Taiwan, South Korea, Hong Kong and Singapore). Japan and the Asian tigers were politically aligned with and militarily dependent on the United States and did not have the scale to upset the global order, but a resurgent China is a different matter.

The uniqueness of China’s rise cannot be over-emphasized. Every other country that has successfully broken out of the “middle-income trap” during the post-war period (the Asian tigers, Israel and today several eastern European countries) (China, the middle income trap and beyond) has done so with strong political, military and financial support from the United States. Most countries are not successful at building the institutions and executing the policies required to graduate beyond middle-income status, and many formerly “miracle economies,” face stagnation. Brazil is a case in point. Despite great natural resources and a vibrant entrepreneurial class, incoherent populist policies, an expansive state bureaucracy and oppressive taxes and regulations on business have caused stagnation since the early 1980’s. The result of Brazil’s stagnation at a time of great dynamism for China is an astonishing reversal in the relative importance of both countries to the global economy.

Source: World Bank

The Chinese model follows the well-worn protectionist path, embraced by the United States in the 19th century.  Once Great Britain had been well-established as the global hegemon, it espoused free-trade to facilitate the dissemination of its industrial production. The liberated Americans would have none of it. Alexander Hamilton’s Report on Manufacturers, submitted to Congress in 1791, which called for imports tariff and non-tariff barriers and subsidies for infant industries and innovation, provides a blueprint for the policies now followed by China. On the other hand, the U.S. as the new hegemon, has now assumed the role of the promoter of free trade.

China, with its huge market and high growth, has the same ability to attract capital and technology on its own terms that the U.S. had in the 19th Century. The Chinese have studied history and are simply following the path taken by the U.S. and the Asian Tigers. The Chinese know that to continue their rise they must now dominate high-value-added and technology-intensive industries, and they are determined to provide the protection and subsidies to facilitate this. In 2015, the government announced its Made in China 2025 and Internet Plus initiatives which aim to transform the country into a high-tech superpower by integrating artificial intelligence, robotics and social media. The plans are unabashedly protectionist and aim to substitute high tech imports by using the full regulatory and financial power of the state. This strategy of state supported industrial planning follows what Japan and Korea have assiduously done in the past, most recently with Korea’s full-fledged effort since 2001 to dominate robotics.

China’s plans have alarmed the world’s leading technology providers, such as the U.S., Japan, Germany and South Korea, and led to protests. President Trump last week signed an executive order asking his trade office to investigate China for theft of American technology and intellectual property.  But it is unlikely that China will change its path because it has history on its side and it believes that rival nations and corporations will cooperate to gain access to its markets. Moreover, there is no denying that the results of the policy so far are encouraging.

Many leading industries in the world today, from airplanes to internet search engines, have winner-take-all characteristics because of enormous capital intensity and/or network effects. China’s decision to restrict the freedom of American internet and ecommerce firms has promoted a vibrant domestic environment for tech start-ups unique in the world outside of Silicon Valley, and it has greatly facilitated the success of companies like Baidu, Tencent and Alibaba which are today the only global rivals to America’s tech hegemons.

The enormous amount of mobile phone and internet users, 751 million at last count, and the massive amounts of data they generate positions Chinese companies to become dominant players in the “internet of things,” artificial intelligence , data mining and related services. Neil Shen of Sequoia China, a leading venture capital investor in technology firms in China, succinctly states the bull case for the sector:

“I’m very optimistic about the prospects of the Artificial Intelligence industry in China, probably more so than back 20 years ago when china started with the online internet. The reasons being two: one is you need data for AI development and we have tons of data whether its Alibaba’s transaction data, social network data from Wechat, etc. And on top of that when you are looking at the researchers and experts in that space many are Chinese and if you are looking at quotations in research papers the Chinese AI research in the world has a very decent market share. And so, with that I think we have a very good chance to take a lead. In fact, fundamentally what is AI in the whole science field: its mathematics and statistics and China has very strong talent in these two areas.” Sequoia China’s Neil Shen (Bloomberg Interview).

China’s support of leading-edge practical technologies through subsidies, financing, R&D support, import protection and the leveraging of its huge market and the state’s purchasing power has led to significant breakthroughs. For example:

  • High-speed trains – Fuxing, the latest generation of Chinese bullet trains, with a maximum speed of 400 km/hour, was recently launched on the Shanghai-Beijing route, cutting travel time to 4 ½ hours. Fuxing is said to be 84% home-made standardized design, in contrast to previous generations which relied heavily on Japanese and French technology. The name, Fuxing, which means “revival,” is politically-loaded.(Caixin)
  • Over the past ten years, China has become the global leader in all aspects of the use and manufacturing of solar power. China is the world’s largest producer of photovoltaic power, and on track to add 40 gigawatts of capacity this year in its domestic market.
  • China also leads the world in the production and use of wind power and smart grid technologies.
  • China has become the global leader in the use and manufacturing of electric vehicles, selling 507,000 units in 2016, compared to 222,000 in Europe and 157,130 in the U.S.
  • China owns 70% of the world’s commercial drone market. For drones with communication-ability selling above $500/unit, Shenzen’s DJI is estimated to have around 70% of the U.S. market. DJI has become so dominant that competitors are abandoning hardware manufacturing to focus on software applications exclusively. Chinese military drones, with similar range and effectiveness as the U.S. military’s Predator and Reaper drones but selling at a fraction of the cost, have been gaining significant foreign market share, at the expense of the U.S. (WSJ).
  • Surveillance technology – Shenzen’s Hikvision, a subsidiary of CETC, a state conglomerate with close ties to the military, has become a global leader in internet-based digital surveillance systems which are being widely deployed in China and other countries through CCTV, ATMs and mobile phone applications. The company has become a leader in facial recognition and data harvesting.
  • Facial recognition – Beijing-based Megvii’s Face++ is the world’s largest face-recognition technology platform, currently used by more than 300,000 developers in 150 countries to identify faces, images, text and documents, such as government IDs. Baidu and SenseTime are also important players in this space.
  • Mobile Telephony – Chinese firms control over half the global market for mobile phones, with growing domination in emerging markets. China aims to be a leader in 5G mobile networks, and plans to spend $250 billion to have an operative system over the next five years.
  • Quantum Telecommunications – China appears to have the lead in the development of the new technology, “hackproof” quantum communications . China is said to be near completion of a 2,000 km “unhackable” fiber network linking Shanghai and Beijing. Moreover, Chinese researchers recently announced a breakthrough in successfully teleporting “entangled” photons from a quantum satellite 480 km above the earth to two terrestrial stations 1,200 km apart, and the government plans the deployment of a fleet of quantum-enabled satellites linking China nationwide and with Asia and Europe by 2020. The idea is to control a Chinese-centric hack-proof, cybersecure global network.

There are two new priority areas were the Chinese state is committed to deploying its financial and protectionist might:

  • Semiconductors – China has made it a national security priority to control the semiconductor supply chain. The government is lavishing money on the country’s chip makers, including $22 billion on state-owned Tsinghua Unigroup. Some 20 fabs are currently under construction in China. (WSJ)
  • Artificial Intelligence – China’s State Council in June announced a plan to provide tax benefits and state support to make China a global leader in AI by 2025 and Chinese companies major players in self-driving cars, smart robotics, wearable devices and virtual reality.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

EM Investor Watch:

Investor Watch:

The Growing Role of the ETF in Emerging Markets Investing

ETFs, exchange-traded funds that track indices and are traded like common stocks on stock exchanges, have become enormously popular over the past decade and are an increasingly disruptive influence on the traditional asset management industry. Global ETF assets surpassed $4 trillion in 2017, growing 36% year-on-year, and 2,034 ETFs trade in the U.S. alone. Cost and liquidity are the primary attraction of ETFs, with the largest S&P500 trackers charging fees as low as 0.04% per year.  ETFs have become increasingly important as allocation instruments used by financial advisors and individual investors. Moreover, they are now commonly used by active institutional investors and traders.

Emerging Markets have seen an onslaught of ETF products. In the U.S. alone there are currently 195 EM ETFs being actively traded, representing nearly $200 billion in assets. The category is amply dominated by Global Emerging Markets (GEM) funds, with 70% of the assets. Specific country ETFs, which are widely used by active macro investors, are the second largest group, with 21% of assets. Fundamental strategies, also known as “smart beta,” make up 8% of assets. There has been a proliferation of these products, many launched by traditional active managers, which seek to exploit a specific factor (eg, value, quality, dividends, low volatility…etc.) These products are attractive to issuers because they still command relatively high fees compared to standard GEM ETSs.  The remaining categories are surprisingly insignificant. Regional funds, which used to be a fundamental part of the EM asset class, represent only 3.3% of ETFs, and are highly dominated by Asia. In contrast to the U.S., sector funds play almost no role in EM ETFs. EM sub-categories (frontier and BRIC, mainly) also are of little importance.

The EM ETF category is very dominated by four massive and growing GEM funds: Vanguard’s VWO, Blackrock’s IEMG and EEM and Schwab’s SCHE.  Fees have consistently declined for the big funds, with Schwab at the current low of 13 basis points per year. Ishares’s EEM is a complete outlier in terms of fees in this group, charging  0.72% of assets. As the first GEM fund to be launched (2003), EEM probably has legacy cost issues. For the time being, EEM can sustain this situation because its huge daily volume makes it the vehicle of choice for large hedge funds and institutional traders and investors seeking exposure to emerging markets. To compensate for the inevitable decline of EEM, Blackrock launched IEMG in 2012, with fees in-line with the competition.

Specific country funds are dominated by Blackrock’s MSCI-based ishare funds. These products maintain relatively high fees because their liquidity makes them the vehicle of choice for macro-investors, traders and allocators. Outside of the ishare products, almost all the activity of significance is in Asia where a panoply of country specific “smart beta” and sector products have been developed for China and India.

Fundamental smart beta products have also prospered in the GEM space and sustain high fees. These funds are aimed mainly at individual investors and financial advisors. Product sponsors offer “alpha-generating” factor tilts and other characteristics considered attractive to investor, such as high dividends, “quality,” low volatility, currency hedging, environmental consciousness (ESG) and leverage. The category is dominated by multi-factor funds that tilt stock allocation in favor of a combination of the value, momentum, quality and low volatility factors. The largest fundamental ETFs are listed below.

 

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • New China Maglev train moves ahead (China Daily)
  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch:

Investor Watch:

Notable Quotes:

“I’m very optimistic about the prospects of the Artificial Intelligence industry in China, probably more so than back 20 years ago when china started with the online internet. The reason being two: one is you need data for AI development and we have tons of data whether its Alibaba’s transaction data, social network data from Wechat, etc. And on top of that when you are looking at the researchers and experts in that space many are Chinese and if you are looking at quotations in research papers the Chinese AI research in the world has a very decent market share. And so, with that I think we have a very good chance to take a lead. In fact, fundamentally what is AI in the whole science field: its mathematics and statistics and China has very strong talent in these two areas.” Sequoia China’s Neil Shen (The Economist)

“When it comes to assessing political matters (especially global geopolitics like the North Korea matter), we are very humble. We know that we don’t have a unique insight that we’d choose to bet on … We can also say that if the above things go badly, it would seem that gold (more than other safe haven assets like the dollar, yen, and treasuries) would benefit, so if you don’t have 5-10% of your assets in gold as a hedge, we’d suggest you relook at this. Don’t let traditional biases, rather than an excellent analysis, stand in the way of you doing this (and if you do have an excellent analysis of why you shouldn’t have such an allocation to gold, we’d appreciate you sharing it with us.)” Ray Dalio, Bridgewater

Notable Charts:

 

 

Emerging Markets Valuations in a Global Context

 

Successful investors are never shy to avoid expensive markets, preferring to build cash reserves to deploy when other investors are less greedy and more fearful. Much of the success of investors like Warren Buffett or Seth Klarman (Baupost) has come from having plenty of cash on hand when markets suffer cyclical downturns, like in 2000 and 2008. Klarman was once asked by a client why he should be paid his high fees for holding very large amounts of cash (sometimes well above 50%). His answer: “You are paying us to decide when to hold onto cash and when to invest.”

Well, it appears it may be happening again. It was revealed this week that Buffett’s Berkshire Hathaway holds over $100 billion in cash, and Klarman also has well over a quarter of his fund in cash.  Meanwhile individual investors have reduced cash to the lowest levels since the peak of the 2000 bubble.

Buffett and Klarman are not alone. It is commonly accepted by market historians, though certainly not by technicians and momentum traders, that the U.S. market is at very high levels. This view is based on the premise that market valuations mean-revert over time in a somewhat predictable fashion. Though valuations are by no means a timing instrument, they do have a good track record of predicting long-term (5-10 years) future returns. For example, Robert Schiller’s CAPE ratio (Shiller), which measures valuations based on 10-years of inflation-adjusted earnings, currently shows extraordinarily high levels, which at least in the past have been highly predictive of  low prospective returns.

Shiller CAPE Ratio

Crestmont Capital’s extremely thorough analysis of U.S. valuation (1926-2017) history points to a near certainty of lower than normal returns from current levels. Historical U.S stock market returns of 10.0%, came from nominal earnings growth (5.1%), price-earnings multiple expansion (0.6% annually, starting from a low level of 10.2 in 1926) and dividend yield (4.3%).  Annual Real GDP growth and inflation over the period averaged 3.3% and 2.9%, respectively, both of which are currently expected to be lower over the next ten years. The table below shows Crestmont’s absolute best case forecast for market returns for the next ten years to be in the order of 7.1%, well below historical levels. Earnings growth is optimistically assumed to grow 5.1%, in line with history, even though GDP growth and inflation are both likely to be lower. Price-earnings ratios are assumed to remain at the current very high levels. Dividend yield is determined by current valuations. Any contraction of PE levels or lower than historical earnings growth would result in lower returns.

The logic of Shiller’s CAPE and Crestmont’s analysis leads to forecasts of low expected returns for U.S. equities, and all other asset classes impacted by similar factors. For example, relying on historical analysis and reversion-to-the-mean assumptions, Jeremy Grantham’s GMO  (GMO) predicts abysmally low returns for almost all of the asset classes it follows.

Similar analysis produced by Research Affiliates points to equally poor results for the next decade: near zero real returns for U.S. stocks, 2%+ returns for international stocks and 6%+ stocks for emerging markets:

Both GMO and Research Affiliates highlight the relative attractiveness of emerging markets equities in a very low return world. An extended period of under-performance of emerging markets relative to the U.S. market in particular has created a significant gap for investors to exploit. Not only are emerging markets cheap relative to the U.S. and other developed markets, they also are inexpensive relative to their own history. On a cyclically adjusted basis (CAPE EM), valuations in EM are still below average and very far from historical peaks, in contrast to the U.S. which is well above average and near historical peaks. Price earnings ratios  for EM, are near historical averages, in a world where most asset prices are well above historical levels.

To conclude, a further comment on U.S. valuations is in order. It can be argued that current U.S. valuations reflect the reality of extraordinarily low interest rates. The puzzle lies in determining the cause of these low rates; is it Federal Reserve manipulation?; is it deflation caused by globalization and technology?; or does it point to low real growth in real GDP and earnings  in the future caused by demographics and low productivity? The answer to this puzzle will likely explain the short term course of the U.S. market.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch

  • Bangladesh’s rise to manufacturing powerhouse (FT)
  • Venezuela’s total collapse (Project Syndicate)
  • Venezuela was once Latin America’s richest country (WEFORUM)
  • Military unrest on the rise in Venezuela (Geopolitical Futures)
  • In Brazil highway robbery is a growth industry (Bloomberg)

Investor Watch:

Notable Quotes: (Avondale)

It’s a low return high risk world

  • “Markets normally respond to elevated uncertainty with lower asset prices and compensatorily higher returns. But that’s not what we are encountering today. We are living in a low-return, high risk world and an environment where most investors are happy to bear risk.” —Oaktree CEO Jay Steven Wintrob (Investment Management)

China is likely to lead the world in electrification

  • “China’s forecasted to lead the global trend in Powertrain electrification, representing over 50% of unit production in 2025, reflecting a 40 fold increase over today’s levels. We remain optimistic about the China market as a result of the underlying macro trends which include increased government focus on emissions regulations, which are increasing demand for China’s new energy vehicles” —Delphi CEO Kevin Clark (Auto Parts)

Australian Iron Ore is being sold to traders, not users

  • “what these guys are doing, these guys mean, for abundance of clarity, Fortescue, BHP and Rio Tinto, Vale and even the midget, Roy Hill, they sell to traders. And these traders do not have blast furnaces. They buy because it’s cheap to borrow money in Chinese banks. Then they put that iron ore in the ground, not in a blast furnace, at the port. And then they go back to the banks, and say, hey, I have collateral, can I borrow more? And the banker say, yes, and they borrow more, and they buy more for the same idiots…That’s my problem with the business in Australia. Then comes the question, will this be happening forever? Yes or no? Of course, the answer is no. One day, this bubble will burst. And on that day, people will say, oh, we are surprised that we are not seeing iron ore inventories going up.” —Cliffs Natural Resources CEO Lourenco Goncalves (Iron Ore)

Notable Charts:

The Lottery of Stock Picking

Academic research has highlighted the high risk of investing in individual stocks. Stock-specific risk, in contrast to market risk, can be diversified away, so investors are not compensated for taking it. One study by Blackstar Funds  (The Capitalism Distribution), for example, showed that for the period 1983-2006 the 3,000 largest U.S. stocks had an average return of -1.1% compared to a 12.8% return for the Russell 3000 Index. 39% of stocks lost money during this 25-year period and all of the market return could be attributed to 25% of the stocks. Like most indices used by investors the Russell 3000 is market-capitalization-weighted, which means that the losers have increasingly smaller weights in the index while the winners constantly increase their weight. The indices follow mechanically the trend-following rule of cutting losses and sticking with rising stocks.

Another study by Hendrik Bessembinder (Do Stocks Outperform Treasury Bills) provides more recent data. Bessembinder covered all U.S stocks for the 1926-2015 period. According to the study, only 42% of stocks beat the returns of 1-month Treasury bills and less than half of stocks achieve positive nominal returns over their lifetimes. Over this 90-year period, only 86 stocks accounted for 50% of returns and an incredible 96% of stocks did not surpass the returns of 1-month treasury bills. Bessembinder compares stock-picking by individuals as “lotterylike” behavior; the hope of picking an Amazon and seeing it appreciate by thousands of percent.

What can be said  about the experience of emerging markets? Our data history is short and complicated by frequent changes in the indices, including the addition and exclusion of entire countries. Nevertheless, looking at Ishares Emerging Markets (EEM), which is based on the MSCI EM Index, for the period starting at year-end 2016 until mid-year 2017, we can draw some interesting parallels.

  • Of the 274 stocks in the index in 2006 only 148 (54%) remained in July 2017. These 148 remaining stocks provided a nominal return of -46.1% over the period, compared to a 7.5% return (before dividends) of EEM.
  • Of the top 10 stocks in 2006 (Gazprom, Samsung, TSMC, Posco, Kookmin Bank, Lukoil, UMC. KEPCO, Chunghwa and Silicon Precision) all except for Samsung, TSMC and Chunghwa have underperformed, dramatically in the case of the commodity stocks, Kookmin and UMC.
  • Of the original stocks only a handful have had good performance: Naspers, TSMC, Samsung Electronics, Ambev and Steinhoff.
  • Positive returns can be attributed to a few stocks, mainly East Asian tech stocks: Tencent-Naspers, Alibaba, TSMC, Samsung Electronics, Hynix, Netease, JD.Com, Naver, CTRIP and Largan.

The case of South Africa’s NASPERS is an interesting illustration of the “lotterylike” nature of investing. NASPERS has long been Africa’s most important and valuable media company. Like almost all South African corporates it began reducing its domestic exposure some twenty years ago. Adopting a incubator-venture capital model, it adopted a shotgun strategy, investing in a multitude of media and e.commerce ventures around the world,  including a stake in China’s Tencent in 2001. NASPERS’s business in Africa has stagnated and most of its foreign investments have floundered, except for Tencent where it hit the jackpot. Naspers’s original $34 million investment in Tencent in now worth $120 billion. Interestingly, the entire market value of Naspers is only $88 billion, so the market gives little real or optional value for the remaining assets.

Most individuals and professionals alike don’t have an identifiable edge in picking stocks and are compelled to the exercise for the lottery-like thrill of hoping to pick a winner. Picking a winner and holding on to it can be hugely profitable and make a career.

Us Fed watch:

India Watch:

  • Outsourcers are returning to the U.S. (NYT)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

China Consumer Watch:

  • Starbucks bullish on China growth Caixing
  • China’s Wanda slims down (NY Times)

China Technology Watch:

  • China’s surveillance giant, Hikvision, is worth $55 billion (WIC)
  • China’s phones growing share in EM (SCMP)
  • Chinese cellphone brands account for half of global sales (SCMP)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch:

  • South Africa’s great reconciliation is coming apart (WSJ)
  • Brazilian billionaires swap assets (bloomberg)
  • EM Valuations strong buy signal (Wisdom Tree)
  • Revisiting Allocation decisions in EM (GMO)
  • EM ETFs don’t all track the same index (ETF.com)

Technology Watch:

  • Summer of Samsung (Bloomberg)
  • TVs are disappearing from American homes (Recode)

Investor Watch:

Notable Quotes: (Avondale)

This quarter may have been more challenging than advertised

“this indeed was another challenging quarter and as I think we all know, the industry continues to face global market volatility and we have seen a further slowdown in consumer demand in several key markets, most especially the U.S. Southeast Asia and South Pacific.” —Colgate CEO Ian Cook (Packaged Goods)

Healthcare: Birthrates around the world have been disappointing

“So we had kind of projected 2016 was going to be a flat birthrate year. In the second quarter, we got the final fourth quarter numbers that showed it down 2% for the fourth quarter, which brought the full year down 1%…Korea’s birthrate…was down 7%, which is a pretty big, big drop…we don’t really understand it at a deep enough consumer insight level…But a broad trend is that Millennials are having their children a little later.” —Kimberly Clark CEO Thomas Falk (Packaged Goods)

There’s a lot of capital sloshing around the world

“there is a lot of capital that’s being raised and has been raised. And in general, there is just a whole lot capital sloshing around the world, looking for returns. ” —Blackstone COO Tony James (Private Equity)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Charts: