Month: December 2017

Deglobalization and Technological Disruption

Deglobalization and rapid technological change are likely to be the two main drivers of economic and stock market performance in emerging markets for the next five years. Every country faces different combinations of challenges and opportunities and how they deal with these will make a big difference in whether they prosper in our rapidly changing world.

Deglobalization

The intense globalization of the past decades, which had not been seen since the last decades of the 19th century, was a boon to the global economy, while at the same time dramatically redistributing relative income: to the poorer countries and away from the developed ones; and to super-wealthy individuals and away from everyone else. The political effects of this redistribution have become evident in recent years, leading to a dramatic corruption crack-down in China and the rise of populism in the West in the shape of Brexit and Donald Trump.

The clear beneficiaries of globalization were those manufacturing countries that integrated themselves in global value chains. These were mainly in Asia, though countries like Mexico and Turkey also participated. Some small, highly competitive countries also benefitted from better access for their exported goods. And, of course, consumers in developed economies benefitted from cheaper imports.

The relative losers were those countries that fought the trend (Brazil, India, South Africa, Venezuela, Indonesia, Russia) or were too small or uncompetitive to participate.

Unfortunately, those countries that did everything right during this cycle and participated fully in the upside of globalization may now have more to lose. Those countries highly integrated into global value chains and highly dependent on exports may now suffer relative underperformance unless they can find other sources of growth.

On the other hand, those countries that never embraced globalization –Brazil and India for example — may now be well positioned. Given the size of their domestic markets and ample growth opportunities that are unlinked to the global economy, they could still attract investments and thrive in a world where country-to-country trade deals based on reciprocal market access become more the norm.

China also seems well positioned. Given the size of its economy, further export-led growth was never going to be plausible. Moreover, the Chinese economy is coincidentally entering into a phase where it will be driven by domestic consumption and improvements to the “quality” of life.

Developed economies also are generally well positioned. Protectionism may lead initially to a welcomed increase in wages. Over time, it will trigger investments in automation technologies and accelerate the opportunities for “on-shoring,” the relocation of manufacturing closer to the customer in the developed countries. Two examples of this are: Adidas operating highly automated sneaker plants in Germany, and cloud computing and artificial intelligence undermining the low-value-added services of the Indian information technology industry.

Technology

There are two main thrusts of technological innovation that will dramatically impact emerging markets in coming years: 1. Artificial intelligence and robotics; and 2. Renewable energy.

With regards to technology, there are two factors to consider; whether a country can benefit as a developer of new technologies; and whether a country can successfully embrace the adoption of new technologies.

In terms of participating in the benefits of the development and commercialization of new technologies, it seems today that only East-Asian emerging markets (China, Korea, Taiwan) are well positioned to do so. China, following the path of its East-Asian neighbors and committing huge government support, is already becoming a leader in many technologies (internet, mobile telephony/5g, drones, high-speed trains, electric vehicles, solar and wind, among others).

In terms of the potential for countries to embrace new technologies, the path is much less clear.

New technologies offer enormous opportunities for emerging markets to leapfrog to state-of-the art conditions with much lower costs and vastly better productivity. For example, China has built a world class telecommunications network based on mobile technology without having had to make huge investments in fixed telephony networks. In Brazil, fixed lines are likely to become nothing more than a bad memory for people over 50 years of age. In Vietnam and India, the average person will have never experienced a fixed line. The potential for leap-frogging is the greatest in the poorer countries which have no attachment to legacy technologies, such as Africa, India and China.

A multitude of new technologies now being deployed will ramp-up dramatically in coming years, including cloud computing, artificial intelligence, drones, electric and autonomous vehicles, e.commerce, fintech, and battery-centric renewable energy. Many of these technologies will be very disruptive to businesses, that will lobby hard to protect legacy markets. Every country will deal differently with these disruptive forces, depending on the vision of policy makers and the power of entrenched interests to block change.

China has embraced technology for idiosyncratic reasons. China started from so low a level of economic development and the pace of change has been so fast that entrenched interests did not oppose new technologies. But that is not the case in most places, particularly the stagnant middle-income countries with powerful entrenched interests and rent-seeking politicians.

Take a country like Brazil. New technologies may face a phalanx of opposition from manufacturers, unions and local politicians, aimed at discouraging entrepreneurs. While in China, multinational automobile firms have quickly toed the Party line and committed to electricity vehicle investments, in Brazil they are likely to resist for as long as possible.

India is probably the country with most to gain from disruptive changes. It has a tech-savvy elite which has been instrumental in pushing for digitalization, such as the recently implemented AADHAAR national biometric digital identification program, which opens huge opportunities for digital commerce and fintech. With a very large proportion of its population with no access to basic public, financial and commercial services, AADHAAR provides significant opportunities for the Indian masses to gain access to state-of-the art technologies. This is now happening with smart-phones and will soon ramp up with battery-centric renewable energy and fintech services, giving countless isolated villagers access to modernity for the first time. Also, with only a fraction of the population currently with access to automobiles, in India there is no legacy infrastructure standing in the way of electric vehicles.

Though it is difficult to predict how things will play out, the following chart attempts to map-out how de-globalization and technological disruption may affect the major countries in emerging markets.

 

 

Fed Watch:

India Watch:

China Watch:

  • China’s commodity demand (Treasury)
  • Ground broken on China-Thai railroad (Caixing)
  • China’s new winter sports resort ( WIC)
  • China cannot be a global leader (China File)

China Technology Watch:

EM Investor Watch:

Technology Watch:

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:

 

 

 

 

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:

 

 

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: