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Factor Investing in Emerging Markets

Over the past fifty years, financial economists in academia have built mathematical models to explain how excess returns can be obtained by investors in “efficient” markets. The Capital Asset Pricing Model (CAPM), developed during the 1960s, was the first formal model that sought to explain asset prices as a function of risk and return. According to this simple model, the equity market as a whole has a systemic return which is the excess return over a risk-free asset (i.e Treasury Bills) that an investor needs to assume the greater risk of the stock market. Market risk is called BETA in the model, with the risk free asset having a BETA of zero, the  market a BETA of one and riskier assets a BETA above one. BETA itself is  measured in terms of the correlation of an asset to the market and how volatile it is relative to the market.

Though the CAPM model remains the pillar of modern finance, academics have punched many holes in its one-factor (BETA) structure. A generation of finance PHDs have come up with “anomalies” in CAPM, which are additional factors that explain excess returns in a persistent manner over time, sectors and geographies. Initially small-capitalization stocks and value stocks (low price-to-book-value or low price-to-earnings relative to the market) where identified as generating a return premium. Then momentum (the tendency of rising stocks to keep rising and falling stocks to keep falling) gained acceptance, followed by quality and profitability. In recent years, academics have gone wild identifying multitudes of new factors, but most of these seem redundant, and the focus by investors is on the initial five.

The excess return premiums over the risk-free rate which investors expect from these factors (based on historical empirical evidence) are the following (Source, Your Complete guide to Factor-based Investing, Berkin&Swedroe):

Not only do the factors provide excess return premiums (for example, smalls caps add 3.3% of excess return), they also show negative correlations to the market excess return (BETA). This means that by tilting a portfolio to a specific factor the investor can expect to have both higher returns or lower volatility.

Given that the validity of these factors assumes prevalence over geographies, an investor should expect to find them in emerging markets. What is the evidence?;

The most recent academic research –”Size, Value, and Momentum in Emerging Market Stock Returns: Integrated or Segmented Pricing?”(SSN) , by Matthias X. Hanauer, Martin Linhart ( February 2015), analyzed the July 1996 to June 2012 period and found strong  value and momentum effects. However, they identified only a weaker size effect, and that only in Asia.

Lazard Asset Management, a prominent value manager, studied a similar time period (December 1999 to September 2015) and reached essentially the same conclusion (LAM). Lazard found a large value premium, best exploited through low PE and high dividend stocks (not low price/book). Lazard also found lower but still high momentum and quality premiums. Interestingly, these styles are negatively correlated to value in EM: momentum and quality perform strongly in rising markets, while value is resilient in down markets. Therefore, combining these factors can provide diversification benefits.

The absence of a premium for small-cap stocks in emerging markets would be surprising as this factor is highly prevalent over time in both the U.S. and international markets. Dimensional Fund Advisors (DFA) Management, a quant manager with exceptional academic credentials, has had a small cap EM fund (DEMSX) since 1998 that has performed poorly compared to its emerging market product (DFETX), as shown below:

Source: Yahoo Finance

However, emerging markets small caps have had very good relative performance since 2010, as shown below with DFA’s funds. Given the lack of long-term data for emerging markets, it is certainly plausible that a small-cap premium will materialize over time.

 

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:

EM Investor Watch:

Technology Watch:

Investor Watch:

 

 

Putin’s Embrace of “One Belt, One Road”

The national identity of Russia is intrinsically tied to the mastery  of the Eurasian steppes, the grassland plains that  stretch from Hungary to Northern China. The territorial expansion of Moscow, from the 16th century onward, required  wresting control of the steppes away from the Mongols and securing the fertile black earth plains of modern-day Ukraine and Central Russia. The eventual collapse of the Mongol empire in the 17th century allowed the extension of the Russian empire to the pacific. Russian geo-political control over the steppes, Siberia and the Pacific coast has been largely uncontested for centuries.

However, the economic rise of China over the past decades and its increasingly outward-looking pretensions, as highlighted by President Xi Jinping’s ambitious “One Belt, One Road Initiative” (OBOR) changes everything for Russia.  While Russia has seen the steppes mainly for their value in securing geopolitical control of the Eurasian center, Xi envisions a return to the commercial dynamism of the historical Silk Road, which united the Far East with the Middle East and Europe for centuries, until the collapse of the Mongol empire. The Chinese have been aggressively executing Xi’s vision, building infrastructure to connect China with the West and becoming the largest investor in the natural resources of the former Soviet Republics.

Surprisingly, perhaps because of pragmatism and acceptance of Xi’s promise that the OBOR is aimed at benefiting all participants equally, so far there appears to be little resistance on the part of Russia to Xi’s grand and transformative plan. To the contrary, there has been a rapprochement between Putin and Xi, who have met on frequent occasions over the past several years. In a recent state visit to Moscow, Xi announced $10 billion in agreements for OBOR-related infrastructure investments and told the media that relations between the two countries were currently at their “best time in history” and that Russia and China were each other’s “most trustworthy strategic partners.”

Russia’s cuddling up with China is probably its best strategic option at this time. First, neither China nor Russia have to worry about business relations being undermined by volatile domestic politics or high-minded demands for human rights, and, in that sense, they see themselves as reliable partners. Second, both parties have an interest in weakening what they consider to be the arbitrary and hegemonic power of the United States. For example, both would like to see a weakening of dominance of the U.S. dollar and America’s discretionary control of the global financial system, so it is no surprise that Russia is accepting payment in yuan for commodities and that China is setting up a Petro-yuan-gold trading infrastructure in Shanghai and Hong Kong to facilitate non-dollar transactions.

Most importantly, however, is the fact that Asia will be the driving force of global growth and that its center of activity will be in China and its Far East neighbors. Driven by China, Asia’s share of world GDP will grow to 35% by 2022 (IMF forecast), and almost all of global growth in marginal output will come from Asia.  With its abundant energy, mineral and farm resources, Russia is best positioned to meet growing demand for natural resources in Asia.

A remarkable essay written by President Putin this week clearly states Russia’s current state of mind regarding Asia, and the seemingly total embrace of Xi’s OBOR vision. In a remarkable turn of events, Putin and Xi have become the defenders of open markets and predictable rules of commerce, in stark contrast to Donald Trumps “America First” ideology.

Putin writes: (excerpts, full note available here.)

“As a major Eurasian power with vast Far Eastern territories that boast significant potential, Russia has a stake in the successful future of the Asia-Pacific region, and in promoting sustainable and comprehensive growth throughout its territory. We believe that effective economic integration based on the principles of openness, mutual benefit and the universal rules of the World Trade Organization is the primary means of achieving this goal.

We support the idea of forming an Asia-Pacific free-trade area. We believe this is in our practical interest and represents an opportunity to strengthen our positions in the region’s rapidly growing markets. Indeed, over the past five years, the share of APEC economies in Russia’s foreign trade has increased from 23 percent to 31 percent, and from 17 percent to 24 percent in exports. We have no intention of stopping there…

On a related note, I would like to mention our idea to create the Greater Eurasian Partnership. We suggested forming it on the basis of the Eurasian Economic Union and China’s Belt and Road initiative. To reiterate, this is a flexible modern project open to other participants.

Comprehensive development of infrastructure, including transportation, telecommunications and energy, will serve as the basis for effective integration. Today, Russia is modernizing its sea and air ports in the Russian Far East, developing transcontinental rail routes, and building new gas and oil pipelines. We are committed to bilateral and multilateral infrastructure projects that will link our economies and markets — such as the Energy Super Ring that unites Russia, China, Japan and the Republic of Korea, and the Sakhalin-Hokkaido transport link.

We are particularly focused on integrating Russia’s Siberian and Far Eastern territories into this broader network. This includes a range of measures to enhance the investment appeal of our regions and to integrate Russian enterprises into international production chains.

For Russia, the development of our Far East is a national priority for the 21st century. We are talking about creating territories of advanced economic growth in that region, pursuing large-scale development of natural resources and supporting advanced high-tech industries, as well as investing in human capital, education and health care, and forming competitive research centers…

We intend to engage in substantive discussions on all these topics at the 25th APEC Economic Leaders’ Meeting this week. I am confident that, acting together, we will find solutions to the challenge of supporting the steady, balanced and harmonious growth of our shared region, and securing its prosperity. Russia is ready for such a collaborative effort.”

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • Google tries to enter China again with AI Bloomberg)
  • How China will rate its citizens with AI technology (Wired)
  • China’s focus on practical AI application (Arxiv.org)

EM Investor Watch:

Technology Watch:

  • The power plant of the future is your home  (WEF)
  • The Future of the car, Bob Lutz (Auto News)

Commodity Watch:

Investor Watch:

  • ETFs are no bonanza for Wall Street (WSJ)
  • Jeremy Grantham, why this time is different (WSJ)
  • Isaac Newton’s lesson on financial gravity (WSJ)
  • Caxton Partners on macro investing (Bruce Kovner)
  • The frustrating law of active management (Thinknewfound)
  • Fees on active share eat up returns (Thinknewfound)
  • What makes a great investor (Macro-ops)
  • Buffett and the power of compounding (Collaborative Fund)

 

 

 

 

 

 

 

 

 

 

 

 

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: