Category: Investing

The Past Ten Years in Emerging Markets

 

 

Ben Carslon ( Wealth of Common Sense blog) every year publishes a chart reviewing the performance of 10 asset classes over the past decade. It is a good reminder of how erratic annual returns can be. As shown in the chart below, even though emerging markets performed very poorly over the decade, the asset class was the best performer in three of the years and in the top half of the chart 50% of the time. Commodities were the worst performing asset class, which partially explains weak EM. This chart is U.S.-centric and expressed in US dollar terms, so the strength of the USD  over the period goes a long way to explaining the weak results for EM, commodities and international stocks.

A similar review of emerging markets organized by country is shown below. The returns are not strictly comparable to the previous chart, as these do not include dividends as part of the return. As in the previous chart, the annual returns are erratic and highly unpredictable. However, over the 10-year period, which is long enough to represent two normal 5-year investment cycles or a long 10-year cycle, the results are much less arbitrary.

Valuations do Matter

Though over the short-term valuations are a poor timing instrument, over ten-year periods they are very effective allocation tools. Looking at the Cyclically Adjusted Price Earnings Ratio (CAPE), which averages  inflation-adjusted earnings over the ten-year period, we can see that much of the performance differences can be attributed to the starting and ending points of valuations. The CAPE ratios for 2007 and 2017 are shown below. It must be noted that 2007 ended with very high valuations in most emerging markets, as this was the peak of U.S. Fed-induced “easy money” and commodity prices.

In  our sample, only the USA  (S&P 500) had an expansion in its CAPE ratio, and this explains almost all of its absolute and relative returns for the period. The best performing emerging market, Thailand, had a flat CAPE ratio, while every other market had a contraction in its CAPE ratio. The better performers had smaller contractions in their ratios, with the exception of Indonesia. The worst performers – Russia, Brazil, Turkey, Malaysia — had huge contractions in their CAPE ratios. Though India experienced a period of very high GDP growth and political stability, it could not overcome the anchor from its extreme valuations at the start of the period.

Commodities and Currencies Matter in Emerging Markets

The past ten years was a period of dollar strength and commodity weakness, both of which are correlated to poor performance for the EM asset class. With the exceptions of Indonesia, Peru and South Africa, all commodity-sensitive countries did poorly. Indonesia and Peru were supported by the large size of financials in their indexes, and South Africa is an anomaly because its market has become more correlated to China technology (Naspers-Tencent) than to the domestic economy.

And so do Politics and Governance

Russia, Brazil and Turkey all suffered from severe political instability during the period. Russia’s war with Ukraine and the following economic sanctions, Erdogan’s radicalization of Turkish politics, and Brazil’s economic mismanagement and corruption scandals, were all self-inflicted disasters that could not have been anticipated at the end of 2007.

 

Fed Watch:

India Watch:

China Watch:

  • The world’s most valuable luxury good company (WIC)
  • US politics gets in the way of Ant Financial’s US plans (SCMP)
  • Making China Great Again (The New Yorker)

China Technology Watch:

  • Chinese tech workers are flocking home  (Bloomberg)
  • How China went from made in to created in (SCMP)

EM Investor Watch:

 

  • Venezuela’s oil production collapse (Bloomberg)
  • World Economic Forum, Manufacturing Report, 2018 (WEF)
  • Pakistan ditches the dollar for China trade (CNBC)

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

Picking Stocks

Many active portfolio managers describe themselves as “bottom up” investors, by which they mean that their process begins with picking individual stocks that are fundamentally mispriced. However, the evidence shows that successful investing does not start with stock picking, but rather with a firm set of principles and exploitable factors. For example, Warren Buffet, considered by many the best stock picker of his generation, has been known to buy a stock after only a brief conversation because he can quickly fit the idea into his very defined philosophical framework.

The investors first task should be to define an investment policy and a process which is simple and replicable. The second task, refered to as asset allocation, is to construct a portfolio of assets that matches risk appetite and tolerance for drawdowns by diversifying into non-correlated cash flow streams. The third task is to identify the securities, including stocks, to implement the strategy. It is at this point that stock picking acumen comes into play, giving the investor the opportunity to use skill to garner excess return (“alpha”) beyond what is available through indexing strategies.

Quant strategies are already very good at exploiting at very low cost the market return (beta) and factors such as value, size, momentum and quality. Therefore, the successful stock picker needs to focus on segments of the market that are “inefficient” because of the behavioral biases of both institutional and individual investors. Computers are not particularly adept at reading human emotions, judging human character and seeing the future, so in these matters portfolio managers still have a significant advantage.

The behavioral biases that can be exploited are:

  • Short-termism – the great majority of institutional investors and all of the Wall Street “sell side” brokerages are focused on the next 3-6 months. Enormous resources are spent on this time frame, so the market is extremely efficient and alpha is scarce. But if the investor can look forward, the competition for alpha declines precipitously as duration increases. Time-horizon arbitrage is a lonely occupation in the investing world, so there is alpha to collect.
  • Herding – Investors like to move in herds. As Keynes once noted, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to success unconventionally.” Contrarians are rare in the investing world, so they can harvest alpha through mean-reversion strategies, which go against the herd.

The independent investor should also narrow his focus to segments of the market that are richer with alpha. Buffett, for example, says that from the start he eliminates 90% of the stocks in the market, the “too difficult” pile. He focuses all his attention on the remaining 10%. This pool of stocks, which he names his “circle of competence,” are companies that have simple business models and returns that are both high and sustainable. The sustainability of high returns exists because of a “moat” that defends against competitive pressure.

While most investors have portfolios heavily laden with market risk (beta) and factors that can be easily replicated by quants, the skilled stock-picker should focus on high-return prospects; “fishing where the fish are,” so to speak.

The key to alpha generation is to exploit human foibles in areas of the market that offer high potential, following strategies that cannot be easily replicated by the quants and their computers.

The first step is to define the “circle of competence.” In my emerging markets investments I initially reduce the universe to the 10% of profitable companies (historical basis). These companies, which have shown the ability to makes good returns on capital over the past 5-10 years , can be called the “Legacy Moat.”

The second step is to run a value screen on the Legacy Moat, and eliminate the more expensive stocks. This can be done simply with something like Greenblatt’s “magic formula,” or, for example, by eliminating high PE ratio or high price-to-book stocks. The list of stocks, narrowed to 5% of the universe, already should provide significant alpha based on the value and quality factors. Unfortunately, up to now the process can also be easily replicated by a computer.

The third step is to subjectively review the stocks on qualitative grounds, entering into issues where computers provide little insight.

The questions to be asked are highly subjective in nature:

  1. Is the moat sustainable?
  2. How much can the business grow and for how long can capital be redeployed at high rates?
  3. What is the “character” of managers/owners? Do they have integrity? Will they make good capital allocation decisions?

None of these questions is easy to answer, but this is where the portfolio manager can add  value.

The third step will narrow the list to 1% of the total stock universe. These businesses which have high returns, sustainable moats and the ability to reinvest can be called “moat compounders.”  These are the most extraordinary businesses if they have long runways (e.g. Walmart in 1970, Indian banks today.) Particularly in the medium-cap world and in emerging markets, these opportunities are not well followed and can be very under-priced. Typically these businesses have one of three moats: network effects (e.g. Facebook, Tencent); scale advantage (E.g. Amazon, Alibaba, Ambev); or valuable intangible assets  like brands (e.g. Coca Cola, Banco Itau).

Identifying moat compounders is not easy, but skillful investors do have an edge. First, by being exclusively focused on this “fishing ground,” they improve their chances from the start. Second, by  studying the nature of moats they become experts at identifying them. Third, they can take a long-term view, allowing for compounding effects to materialize. Fourth, they can exploit the moods of the market, as the herd moves on the “fear and greed” spectrum.

There is one additional segment worth mentioning that can provide significant alpha for the stock picker.  This is the “legacy moats” that do not have reinvestment opportunities but do have exceptional capital allocators. These legacy moats can be great investments if capital is redistributed to investors or redeployed effectively in M&A. This is the model followed over three decades by Brazil’s Jorge Paulo Lehman, as he buys mature businesses (e.g. beer) and redeploys cash flow into M&A opportunities.

Fed Watch:

India Watch:

China Watch

  • China’s new winter sports resort ( WIC)
  • China cannot be a global leader (China File)
  • China forms a Cement giant with eye on Silk Road (SCMP
  • Starbucks opens its largest store in Shanghai (FT)
  • China and India lead in growth in parcels shipped (Business Wire)

China Technology Watch:

  • China’s two largest trucking aggregators merge (WIC)
  • The battle between Alibaba and Tencent (WIC)
  • China-U.S. competition for AI (AXIOS)
  • China’s AI Awakening (MIT Tech Review)

EM Investor Watch:

 

  • GMO goes all-in on EM (GMO)
  • The end of globalization as we know it (Barclays)
  • Demographics will reverse major trends (BIS)
  • Venezuela’s farming disaster (Bloomberg)

Technology Watch:

 

 

 

 

Using Momentum in Emerging Markets

 

Momentum investing relies on inertia: the directional tendency of investment performance. What has been doing well will tend to continue doing well; what is doing badly will tend to continue doing badly.  Momentum investors seek to catch long rising trends, and quit losing trades. The famous classical economist, David Ricardo, summed it up well in 1838 when he said what has become a mantra for momentum investors: “Cut your losses; let your profits run on.”

An elite cohort of investors have embraced this style of investing, including Richard Driehaus, Paul Tudor Jones, George Soros and Stanley Druckenmiller, some working purely on a technical basis, others combining momentum with fundamentals.

Like all anomalies in efficient markets, the momentum factor creates excess returns because of behavioral reasons. Successful investors learn to exploit systematic and predictable irrational human behavior. A typical trend evolves as follows:

Phase 1- Anchoring and under-reaction- Prices initially lag fundamentals, allowing early movers to position themselves well ahead of the crowd.

Phase2- Herding  and over-reaction – As prices start moving higher, investors join the heard, eventually over-reacting.

In an effort to show how common investors, without the trading smarts or resources of a Soros, could successfully use momentum to enhance returns, Gary Antonacci proposed  “Dual Momentum Investing,” in an article and subsequently a book.

Antonacci’s Global Equities Momentum (GEM) portfolio builds a portfolio with three assets: U.S. stocks, international stocks and U.S. bonds. For the retail investor he recommends using low-cost ETFs: for example, VOO for U.S. stocks; VEU for non-U.S. stocks and AGG for U.S. aggregate bonds.

Antonacci named his system “Dual Momentum” because he uses both relative momentum (the measure of the performance of an asset relative to another asset) and absolute momentum ( the measure of performance relative to the risk-free rate – absolute excess return.)

To keep the process very simple to implement, he used a 12-month look-back period and an easy to execute buy and sell system.

  • Every month the investor places all funds in the equity ETF that has the best 12-month performance relative to the other equity ETFs, unless the absolute performance is worse than the return of six-month U.S. Treasuries (as measured by BIL ETF).
  • If absolute performance is below the BIL ETF, then the investor places all funds in AGG, the aggregate bond index.

The simple process aims to position the investor to benefit from long rising trends while avoiding drawdowns. The process is fully automated, eliminating human behavioral reactions.

Antonacci looks at results from 1974 to October 2013. During this period, the portfolio was invested 41% of the time in U.S. stocks, 29% in international stocks and 30% in U.S. bonds. The portfolio was switched 1.3 times per year.

The portfolio outperformed the global benchmark (MSCI All Country World Index – ACWI) by 7.6% annually for the period, with consistent outperformance every decade. It accomplished this with much lower volatility (standard deviation of GEM is 12.64% vs. 15.56%.) More importantly, the maximum drawdown (decline in the value of the fund) was 17.8%, vs. 60% for ACWI.

Antonacci does not recommend using emerging markets in his GEM portfolio, beyond what is already included in the ACWI. He claims that emerging markets have become more correlated in recent years and do not add value.

To evaluate this claim, I ran Antonocci’s system, including emerging markets as a third asset class in addition to U.S. stocks and the MSCI developed market Index. I suspected that Antonacci’s view on the high correlation was influenced by the very high down-side correlation during the 2008-09 financial crisis. Historically, correlations have been relatively low, particularly on the upside, and the high volatility of emerging markets should be exploitable by the GEM process.

From 1999 to October 2017 (admittedly a short period) the GEM Plus EM portfolio produced impressive results, as shown below. The investments are implemented using the SPY ETF (S&P), VTMGX (EAFE), and VEIEX (EM).

  • The expanded GEM portfolio generated significant excess return by riding long dominant upswings for EM and the S&P and avoiding downturns by  reallocating to U.S. bonds. By doing this it avoided massive drawdowns in the early 2000s and during the financial crisis of 2008-09. Given the very high correlation that markets have shown during downturns, the option of holding U.S. bonds for 18% of the time-period reduced the funds maximum drawdown dramatically.
  • Switches from one asset to another occured 1.49 times per year, compared to 1.3 times per year for Antonacci’s portfolio. This is because of the addition of a third asset.

These momentum strategies seem well suited for the market environment of the past decades which has been marked by large drawdowns and sustained trends. They also provide downside protection from the very high current asset prices around the world.  For tax-shielded investors, the advantages are clearly compelling, somewhat less so for taxed investors. The strategy would work poorly if market leadership were to change frequently, creating false signals.

Fed Watch:

India Watch:

China Watch:

  • China’s Transsion leads mobile phone sales in Africa (FT)
  • China transforms the trucking business (Bloomberg)
  • China needs centrally controlled deleveraging (Bloomberg)
  • World Bank, China 2030 (World Bank)
  • The coming China trade war (IRA)

 

China Technology Watch:

  • Chinese Surveillance camera’s are found on U.S. army bases (WSj)
  • Hisense buys Toshiba’s TV business (Caixing)

EM Investor Watch:

Technology Watch:

  • Fanuc’s robots are changing the world (Bloomberg)

Commodity Watch:

  • There is more farmland then previously thought (Bloomberg)
  • Australia’s economy is a house of cards (Linkedin)

Investor Watch:

 

 

 

 

 

 

 

 

 

 

 

India’s Star Rises in the World Bank’s Doing Business 2018 Survey

The World Bank has conducted its “Ease of Doing Business” survey for fifteen years, providing a comparative view of business regulation around the world over an extended period of time. The survey is aimed at providing a comparative basis to help policy makers address issues that impact entrepreneurial activity. The rankings resulting from the survey are an important indication of how business-friendly countries are and how successful they can be in attracting the entrepreneurial capital to succeed in an increasingly competitive global environment. The survey ranks 190 countries. The top thirty can be considered an elite in terms of providing a regulatory environment amenable to business. A top 50 ranking is good. A ranking above 100 indicates that a country’s business community is crippled by bureaucracy and rent-seeking agents. A poor ranking is particularly debilitating for a small country that does not have the market scale and diversity to attract capital that large countries like Brazil, China and India have.

There were several important revelations from the 2018 survey published this week.

  • India improved its ranking from 130th to 100th, which is a significant improvement. This confirms a recent trend and lends credence to the government’s very ambitious objective of improving the country’s ranking to 50 during the current Modi Administration.
  • India’s improvement highlights Brazil’s sorry performance. Brazil and India have long been competing for the position of lowest ranked of the major emerging market economies. Brazil fell two points in the latest ranking, to 125th and now has a secure hold on the bottom rung.
  • Indonesia, the third of the large emerging markets economies with consistently poor scores over the history of the survey, has been steadily improving its performance for the past six years, and reached 72nd in 2018, which compares to 129th in 2012.
  • Asia, by and large, provides good business regulation and is improving. In addition to India and Indonesia, Vietnam is showing steady improvements and now has a ranking of 68, compared to 99 in 2014. China also is gradually improving. Taiwan, Malaysia, Thailand and South Korea are all elite in terms of business regulation.
  • The Philippines provide somewhat of a glaring exception in Asia. Though the country has improved significantly from the very low ranking of 2011, it has significantly deteriorated over the past four years, and it obtained a ranking of 113th in the 2018 survey. Given how competitive the Asian region is and the improving trends, the Philippines appear to be at a growing disadvantage.
  • In Europe, the remarkable trend is the surge of Russia and much of Eastern Europe. At a 2018 ranking of 35th, Russia is approaching the “elite” countries in terms of the quality of business regulation. Russia has improved every year since 2012, when it ranked at 123rd. Poland’s ranking at 27th secures an “elite” standing. Moreover, the improvements in Eastern Europe are much more profound. Georgia, Macedonia, Estonia, Lithuania and Latvia all rank in the top twenty, ahead of most Western European countries, including Germany, and are well ahead of the Mediterranean countries, France, Spain, Italy, Greece and Turkey.
  • South Africa appears to be on a ruinous path. Its ranking has fallen steadily for nine years, taking the country from elite status to 82nd.
  • Latin America is also on a steady decline, losing competitiveness to the other regions of the world. Mexico is the only bright spot, just because it has maintained its decent ranking around the 50th level. Chile, Peru and Colombia have all seen consistent and worrisome declines in recent years. Argentina and Brazil are secure in their abysmal rankings, near the bottom for economies of this relative importance. Not to mention, Venezuela which is essentially closed for business. With a wave of business-friendly governments now rising to power in Latin America, it will be interesting to see if these negative trends can be reverted in upcoming surveys.

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • How China will rate its citizens with AI technology (Wired)
  • China’s focus on practical AI application (Arxiv.org)
  • China and Russia invest in face-recognition start-up (Bloomberg)
  • Automaker Changan to go 100% electric (Caixing)

EM Investor Watch:

Technology Watch:

Commodity 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:

 

 

 

 

 

 

 

 

 

 

 

Emerging Market Portfolio Managers Against the ETFs

In the world of emerging markets it has generally been presumed that managers can justify higher fees for this asset class because they add more value. It is argued that emerging markets are less efficient because they are complex and under-followed by professional investors.  The relatively scarce qualified portfolio managers and analysts with the skills and experience to navigate the territory should command higher compensation.

While low-cost indexed products have increasingly disrupted the asset management industry, the arguments in favor of active management for the emerging markets asset class have persisted: (Bloomberg)

  • Market inefficiency – More complexity and less professional analysis gives a tangible advantage to managers capable of conducting in-depth research.
  • Benchmark composition – The index benchmark is full of unattractive countries, sectors and companies, that can be avoided by skilled managers. For example, heavy index weightings in poorly managed state enterprises and commodity producers can be avoided to outperform.

Moreover, EM managers may have the advantage that because of its relatively short history as an asset class less academic research has been conducted on performance factors. While in the U.S. academic research has identified the performance “anomalies” caused by tilting portfolios for value, size, quality and momentum, these factors are less well understood in EM and may be easier to exploit by managers.

The evidence partially supports the argument that professional managers of emerging markets funds add value, at least in comparison to managers of U.S. domestic and international funds.

For example, the table below shows the latest results of Morningstar’s Active/Passive Barometer (Morningstar ). Active EM managers, despite higher fees, are seen to perform better than their peers in U.S. and International asset classes, with particularly impressive results over the three and five year periods. On an asset weighted basis, which gives greater consideration to the larger funds, performance is even better. (Note, the data does not consider the greater tax efficiency and lower acquisition costs for ETFs).

The SPIVA Scorecard published annually by S&P Dow Jones Indices (S&P Indices)  shows much less impressive results for EM active managers. SPIVA claims to have a more rigorous approach, adjusting results for survivor bias and for style (e.g., growth vs. value). The SPIVA scorecard shows EM active funds under-performing indices over all periods, largely in a fashion similar to U.S. and International funds. As with Morningstar, SPIVA shows larger managers with better results.

Part of the discrepancy between SPIVA and Morningstar can be explained by the significantly stronger performance of the S&P/IFCI EM Index used by SPIVA compared to the ETF composite used by Morningstar. This causes confusion as both ETFs and active funds use various indices, and neither study adjusts for this. In any case, both reports agree on several points. First, active managers have not created value over the long term; second, larger asset managers create more value. The better performance of the larger funds may show that larger managers with greater analytical resources can add more value.

The Morningstar report also points out that the primary source of outperformance relative to peers for active managers is lower fees. This may also explain the better performance of the larger managers, assuming that they are passing on the benefits of scale economies to clients.

Certainly, the disruptive influence of EM indexed products will not go away and may worsen. It may be that EM active managers have benefited of late from the bear market of the past five years for several reasons. First, during down markets active managers benefit from holding cash. This becomes a source of performance drag during bull markets, and we may have already seen this effect during 2016. Furthermore, assuming positive performance for EM equities, indexed products are likely to be more formidable competitors in coming years, as they tend to outperform in bull markets.

Index products should be easier to beat in a five-year bear market for EM like the one we saw between 2011-2016. The benchmarks which most active managers as well as ETFs observe are market cap-weighted indices, which makes them classic trend-following instruments. When markets are rising and flows are abundant, the index keeps on increasing position sizes in winners and reducing positions in laggards. This led to huge positions in commodity stocks in 2006-2007 and to very high weightings in tech companies today. During bull markets, most active investors become nervous about valuations and the size of positions and retreat ahead of the indices. In a bear market the process reverses. The index pressures prices by selling its largest most overvalued positions. The collapse of commodity stocks during 2012-2014 created “easy alpha” for managers who were comfortable in stepping aside and waiting for valuations to return to normal levels.

The dilemma for EM managers is the same faced by managers in all asset classes disrupted by low-cost index funds. To justify their existence managers have to take much more risk than they are comfortable with. The vast majority of professionally managed funds can be considered “closet index funds” in the sense that they manage around the index. The difference between the portfolio and the index is known as the “active risk.”  Many actively managed funds will have around 15% of active risk, the remainder of the portfolio mimicking the benchmark. The problem is that an ETF like Vanguard’s VWO, charges a management fee of only 14 basis points (0.14%), while the active manager charges, on average, 1.5%  even though  85% of his assets only mimic the benchmark. Clearly identifying this issue, a firm like Blackrock, which manages both ETFs and active funds, is moving aggressively into highly concentrated actively managed portfolios with very high levels of active risk.

However, moving to highly concentrated portfolios with high active risk is something that very few managers can countenance. AS GMO’s Jeremy Grantham  never tires of saying, the primary behavior driver of asset managers is career risk ( GMO ). Unfortunately, the proliferation of low-cost alternatives is undermining the economics of the asset management industry and decreasing job security just at the time that managers need to embrace risk.

Us Fed watch:

India Watch:

  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

China Technology Watch:

  • China outlines plans to be world leader in AI (Caixing Global)
  • Lenovo announces big push into AI (SCMP)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

  • Emerging Markets rally has “legs” (Van Eck)
  • Revisiting Allocation decisions in EM (GMO)
  • EM  breaks 10-year downtrend (The Reformed Broker)
  • The bullish case for EM (Mark Dow)
  • EM ETFs don’t all track the same index (ETF.com)

Investor Watch:

Notable Quotes: (Avondale)

 

Emerging markets have been weak for a long time: “since the financial crises, interest rates, currencies etcetera, we’ve had a prolonged period of about eight, nine years now where we have seen significant weakening of emerging market currencies…you actually see the volume component of these emerging markets continuing to be very, very low, while historically it was all volume-driven growth. I am convinced that that is coming back now.” —Unilever CEO Paul Polman (Packaged Goods)

China may be stabilizing: “China for example is actually much more stable than the last 12 to 18 months. I like what I’m seeing in China right now.” —Abbott CEO Miles White (Medical Device)

Chinese are still buying international assets: “we’re still seeing the trend of Chinese buying and international assets. ” —Goldman Sachs CFO Martin Chavez (Investment Bank)

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

Notable Chart:

Learning to Love Volatility in Emerging Markets

Though economic and currency volatility may reduce the long-term sustainable GDP growth of countries like Brazil ( Brazil’s Economic Stagnation), paradoxically,  volatility is also the primary source of returns for the emerging markets investor. Economic booms, with rising stock markets and strengthening currencies, are invariably followed by busts, with collapsing markets and weaker currencies. For the investor who measures returns in dollar terms, the more volatile emerging markets provide turbo-charged results both on the way up and the way down. Learning to love that volatility is often the key to success.

Brazil is one stock market that is marked by enormous swings. Since 1990 Brazil has seen three market collapses; -88% in 1997, -76% in 2008, and -88% in 2011 (all measured in USD terms). Brazil also had a 80% collapse in the seventies and an 88% drawdown concluding in 1990. It seems that about once a decade, a period that should be well within a reasonable time horizon for most investors,  an investor in Brazil suffers  losses of between 80-90% in terms of U.S. dollars.. But Brazil is far from being unique in emerging markets in this regard. Since 1990, there have been 41 cases of a stock markets losing more than 50% of their value, with an average drawdown of 72%. Over this period, Turkey and Argentina are the champs, each experiencing six drawdowns of over 50%.

On the positive side, drawdowns are followed by bull markets, like day follows night. Over the next two and half years following the 41 market bottoms, investor see average returns of over 500%. Every Brazilian collapse has been followed by a extraordinary bull market:

  • 1983 bottom (-80%), followed by 14x return of capital
  • 1991 bottom (-87%), followed by 24x return of capital
  • 2002 bottom (-83%), followed by 17x return of capital

For the value investor, the brutality and frequency of emerging market drawdowns creates a dilemma. Value investors, indoctrinated by Warren Buffett’s consistent wisdom, believe in investing for the long-term. For example, two commonly cited quotes from Buffett are:

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 year;”

And “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

An emerging markets investor could follow Buffet’s advice, patiently sitting through the drawdowns. By sticking with only the highest quality companies, the drawdowns can be minimized. The astute investor can also improve returns by trimming positions when valuations are high and taking advantage of market meltdowns to add to positions.

However, an alternative and often more productive better way to invest in emerging markets is to learn to love the volatility and skillfully harness it as the major source of returns.  Emerging markets, like commodities, often experience extreme cyclicality with predictable patterns. Investors that are aware of the patterns, can exploit them repeatedly. As commodity markets investor Martin Katusa says, investors in markets characterized by extreme cyclicality can best be “be approached with a ‘rent, don’t own” mentality.”

A strategy which may be anathema to value investors but is very effective in emerging markets and commodity investing is to marry a valuation process with basic trend-following techniques. An investor can patiently wait for a market to meltdown and then watch like a hawk for an entry point to ride the inevitable bounce-back. Typically, good entry points are created when a market has reached extraordinarily low valuations and is showing signs of trending up. Market bottom valuations, in my view, are often signaled by cyclically adjusted price/earnings ratios (like the CAPE Schiller ratio), which should be dollarized to fully measure the volatility of the markets. Timing decisions can be influenced by simple trend-following indicators, like the 50-day or 200-day moving average.

The advantage of patiently waiting for markets to bounce back before deploying capital is that the investor does not experience massive losses of capital on the downside. The absolute investor without concern for benchmarks is in a better position to do this than most institutional investors who are not willing or permitted to stray from their benchmarks for long periods of time.

Us Fed watch:

Brazil Watch :

  • China’s Fosun looking at Brazil Healthcare (SCMP)
  • IMF On Latin America Currency Flexibility ( IMF)

Mexico Watch:

  • WEF Tourism Competitiveness Report shows Mexico’s Rise (WEFORUM)
  • Mexico’s surprising oil finds (NY Times)

India Watch:

China Watch:

  • Mark Mobius on China  (Templeton)
  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • Chinese train maker expands U.S. market  (China Daily) 
  • China Launches new generation bullet train (WIC)
  • Beijing Subway Blocks ApplePay WIC
  • JD.COM invests in drone delivery (China Daily)
  • China plans $108 BB investments in chips (WSJ)

China Consumer Watch:

  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)
  • China rises in global tourism competitiveness (China Daily)

Korea Watch:

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Guru Watch:

  • An Interview with Peter Bernstein (Jason Zweig)
  • Chano’s sees weak U.S. economy (Inetenomics)Notable Charts:
  • China Inverted yield Curve signals slowdown
  • Commodities at record low valuations relative to the S&P 500

Notable Quotes:

  • When markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepted theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)