Month: March 2018

The debate over active versus passive portfolio management has been raging for many years.  In emerging markets, it is frequently argued that greater market inefficiencies can be exploited by the skilled manager. Though active managers have been losing assets to passively managed indexed products, an important place remains for managers who offer idiosyncratic strategies which can create alpha over the long-term. In fact, the proliferation of low-cost indexed products should benefit the active managers that are able to differentiate themselves and generate value.

Active managers with genuine alpha-generating skill (the ability to consistently outperform their benchmarks over time) could theoretically benefit from the current environment for several reasons.

First, passive products are a continuing menace to the marketing-driven closet-indexers that have largely dominated the industry. As these products are being replaced by passively-managed funds, competition for well crafted active products with skillful managers should decrease.

Second, it is increasingly evident that the flows into passive products that are almost always based on market -capitalization-weighted indexes are creating significant market distortions. By design, cap-weighted indexes are driven by absolute momentum, as money flows into the best performing stocks and out of the laggards. This tends to happen gradually in a bull-market like we have seen in recent years but could reverse more abruptly if we were to suffer a market drawdown caused by a recession or another reason. Skilled active managers might well be adept at exploiting these market distortions at that time.

A good reminder of the travails facing active managers is the annual report by SPIVA Scorecard of U.S. -managed mutual funds which is produced by S&P Dow Jones Indices, one of the largest providers of indices in the U.S. market. The latest report was published last week (SPIVA). The SPIVA Scorecard is considered the best measure of active performance because it compares a funds performance to its style category (ie., a U.S. small cap manager to the S&P500 Small Cap Index) and it adjusts for survivorship bias. This latter adjustment is particularly important for measuring long-term performance since for long periods (10-15 years) it is the case in many of the investment categories followed by SPIVA that close to half the funds have disappeared, presumably because of poor performance.

The chart below shows the results from the 2017 SPIVA scorecard. The data shows the percentage of funds that under-perform their indices. Though the 1-year numbers are relatively positive for active managers, 3-years and beyond show much worse results.the US market, where nearly 90% of managers underperform over 10 years. The U.S. numbers are very relevant because the S&P 500 index is by far the most followed benchmark in the U.S. market. In international markets, however, the MSCI benchmarks are the most commonly used by managers, so that certain distortions may exist in the SPIVA analysis.

This is particularly true in emerging markets, where the S&P/IFCI Composite Index used by SPIVA for comparative purposes is not at all commonly used as a benchmark by investors, the MSCI EM and FTSE-Russell EM being highly dominant. For an unexplained reason, the S&P/IFCI Composite Index performance numbers have been consistently higher than either the MSCI EM or FTSE, which results in the SPIVA Scorecard making EM managers look worse than they really are.

Comparing active returns to the more appropriate MSCI EM benchmark paints a slightly different story.

As shown below, EM funds do on average underperform the MSCI Index. However, on an asset weighted basis, funds actually manage to beat the index over the past five years and nearly track the benchmark  on a 10-year basis. Given the high concentration of assets in the hands of relatively few managers, this is probably a fairer basis of analysis. It indicates that those firms with more assets may have two advantages. First, they may have superior resources to support the large cost-base necessary to hire highly-skilled managers and conduct serious fundamental analysis around the EM world. Second, they may also pass on their scale benefit to clients by lowering fees.

Several observations can be made on these results.

• The numbers show that there is alpha-generating capacity in the emerging market asset class, probably to a significantly higher degree than in the U.S. market. Before fees, most managers are generating significant levels of value-added. The larger managers show significant skill in exploiting what may be greater inefficiencies in emerging markets. However, most of this alpha-generation is kept in house to compensate portfolio managers and analyst and costly marketing organizations, so that the mutual fund investor does not reap the benefits. Despite pressure from ETFs, fees remain high, ranging from 1% to well over 2%. Of course, this is true only for mutual fund investors. Large institutional clients can negotiate much lower fees, and therefore capture a lot more of the alpha-generation.
• EM ETF’s are getting cheaper. Franklin Templeton’s recently launched EM country ETFs have net fees of 0.19%. S&P500 tracking ETFs are approaching zero cost, and surely fees will continue to fall for EM funds, as well.
• Moreover, the tax advantages of ETFs relative to mutual funds are still poorly understood by investors. Mutual funds are required to pay out all capital gains on an annual basis. Given the high average turnover of managed funds, capital gains can be significant. Not only, do ETFs normally have very low turnover but investors are not liable for capital gains taxes, and these can add up to significant amounts. This advantage for ETF’s translates into around an additional 1.0% annual return advantage for the ETF compared with the mutual fund. Again, this is an issue of little relevance to many institutional investors.
• In the future, successful mutual fund products will have to continue to lower expenses by reducing fees and turnover. They will also have to concentrate portfolios and make them markedly different from the indices.
• The investor should look for highly idiosyncratic funds (dissimilar from the benchmark) that follow a simple and understandable strategy that can be consistently followed over time to produce replicable results. These funds should also have a fee-structure, that aligns the interest of the manager and the investor, and that allows a significant portion of the alpha to be captured by the investor.

Fed Watch:

• US focus on trade gap misses the target (WSJ)
• The end of the liberal world order (Project Syndicate)

India Watch:

• India eases sugar exports (Reuters)
• India illustrates EM opportunities (Blackrock)

China Watch:

• Blackrock expects China’s market opening (Caixing)
• Yuan oil futures start trading in Shanghai (SCMP)
• China will tighten financial regulation (Caixing)
• Asset Management supervision rules tightened (Caixing)
• China cuts business taxes (Caixing)
• China’s oversupply of shared-bikes (The Atlantic)
• Facial recognition tools China’s surveillance state (The Atlantic)
• US aims to block China industrial policy (NYtimes)
• China term-limits and leadership quality (Project Syndicate)
• US tariffs aim at China’s industrial policy (FT)
• How to avoid a trade war (Project Syndicate)
• Trump will lose his trade war with China (SCMP)

China Technology Watch:

• China moves up the value chain (bloomberg)
• Qudian’s CEO joins $1 salary club (WIC)
• FCC wants to block China tech titans (Bloomberg)
• US FCC seeks to shut out Huawei (NYtimes)
• Huawei plans $20 billion in R&D in 2018 (FT)
• China wants its own chips in driverless cars (bloomberg)

Technology Watch

• Waymo driverless cars ambitious plans (The Atlantic)
• Electric vehicle trends (McKinsey)

EM Investor Watch

• The history of Singapore, the miracle of Asia (Youtube)
• Saudi Arabia will enter FTSE EM Index (FT
• Vietnam to promote private sector (FT)
• Trade wars in a tri-polar world (FT)
• Thailand’s economic transformation (Opengovasia)

Investor Watch:

• James Donald of Lazard on Emerging Markets (bloomberg)
• EM stocks are still relatively cheap (SCMP)

 

 

 

 

The first quarter of 2018 has been a wild ride for emerging markets investors.  An early January surge was followed by a 10% correction in February, as EM stocks reacted to the return of volatility in the U.S. markets. In recent weeks, concerns with global trade wars and slowing growth in China and Europe have dampened enthusiasm. Signs of rising risk aversion can be seen in the strengthening dollar and falling commodity prices. Any confirmation of this trend would be worrisome for emerging markets investors.

Nevertheless, the odds still appear to favor an extension of the rally in emerging markets which has resulted in over two and half years of strong outperformance for EM.

First, the assumption continues to be that Trump’s trade-war talk is largely posturing and that common sense will prevail. Recent evidence that NAFTA talks are making good progress points in that direction.

Second, as confirmed by Fed Chairman Powell this week, U.S. growth prospects are strong while inflation continues to be tame. In fact, as the IMF stated in its most recent forecast, the global growth outlook continues to be healthy, and inflationary pressures mild. The combination of (1) a vigorous late-cycle U.S. economy fueled by fiscal deficits and declining private savings and (2) solid global growth is very supportive of a weakening dollar, rising commodity prices and buoyant asset prices in emerging markets.

Third, in a world of high asset prices, emerging markets are reasonably priced both relative to their own history and relative to other markets such as U.S. equities. The chart below compares EM valuations to the S&P500. While cyclically-adjusted price-earnings ratios (10-year average of inflation-adjusted earnings) for the S&P500 are 30% above both the historical average and the average for the past 15 years, EM is in line with the historical average and 8% below the average of the past 15 years. The 12-month forward looking PE for EM is an undemanding 12.2, vs a relatively high 17.5 for the U.S. Bear in mind that many EM countries are in early stages of their business cycles and can expect cyclical improvements in margins and profits, while the U.S. is in the later stages of its business cycle and can expect the opposite.

Given the diversity of countries in the emerging markets equities asset class, the investor taking a top-down point of view can improve returns by concentrating investments in the markets displaying cheap valuations, improving economic conditions and liquidity-driven momentum. This can be achieved at low cost and effort through ETF country-index products. More ambitious investors can further enhance returns by tilting the portfolio to additional factors (e.g., value, quality, etc…) and also by picking stocks with extraordinary upside potential.

The results of a top-down analytical process is shown in the chart below. Though considered a Frontier Market, Argentina is included because it is widely believed that it will be soon included in the EM indices. Countries are ranked based on three criteria:

• Valuation – Current CAPE valuation relative to history and to the past 15-years, plus a mean-reversion factor.
• Macro – A measure of where the country lies in its business cycle.
• Liquidity – A measure of liquidity factors driving upside momentum in asset prices.

 

The results show that today in emerging markets the vast majority of countries show good characteristics. At the top of the list (3-ranking) are countries that trade at low valuations and appear to have both the business cycle and liquidity flows in their favor. These are mainly commodity producers like Chile and Brazil that were hit by the sharp downturn in commodity prices in 2014-2015.

Indonesia, Colombia and Mexico all sport attractive valuations and macro-characteristics, but are burdened by week flows. These can change quickly, so investors should keep a close eye on these markets.

Both Taiwan and Korea have benefitted handsomely from the strong tech cycle and may be set to take a breather.

At the bottom of the rankings, the Philippines, with high valuations and late in the business cycle, and Argentina, with valuations ahead of fundamentals, are vulnerable.

Investors should concentrate their emerging market holdings in those countries with rankings of two and three and stay clear of those with negative rankings.

 

Fed Watch:

• Global growth accelerates (Bloomberg)
• Explaining the weak dollar (Project Syndicate)

India Watch:

• India illustrates EM opportunities (Blackrock)
• India needs growth (Livemint)
• Tata launches new electric sedan (Economic Times)

China Watch:

• What the West doesn’t get about Xi  (NYtimes)
• Interview with CEO of Mengniu, China’s leading dairy firm (McKinsey)
• The complex ties between China and Australia (WIC)
• The turning point for land-reform (Caixing)
• Chinese firms dominate video-streaming in China (SCMP)
• Hillhouse capital raises record PE fund for China (FT)

China Technology Watch:

• China wants to set the standards for AI (Technology Review)
• Watch China to see the future of digital innovation (AllianceBernstein)
• Naspers to sell $10.6 billion of Tencent stock (SCMP)
• China drives AI into healthcare diagnostics (Tech Review)
• Geely’s Global Rise (WSJ)
• Kuka’s rise in China with Medea (SCMP)

EM Investor Watch

• Thailand’s economic transformation (Opengovasia)
• Wisdom Tree’s SOE-free EM fund shines (Wisdom Tree)
• The future of manufacturing in Africa (SET)
• Insider trading in the Mexican market (bloomberg)
• In Brazil nostalgia grows for law and order (Washington Post)

Investor Watch:

• James Donald of Lazard on Emerging Markets (bloomberg)
• EM stocks are still relatively cheap (SCMP)
• Blackrock’s quant strategy (FT)
• Soros-Rogers interview (Twitter)
• Li Ka Shing call it a day (SCMP)
• Electric vehicles will be cheaper than regular cars in 7 years (Bloomberg)
• Will China out-innovate the West (Project Syndicate)
• Momentum Investing is Easy – So Why Does it Work (Behavioral Investment)

 

 

 

 

Over the long term, stocks that trade at low multiples of earnings or net worth (book equity) have consistently outperformed the general market. This is known in investing as the “value premium,” and it is explained by the general public’s tendency to overvalue high profile, “growthy” stories. Simply put, investors prefer the glamorous stocks in the news, which gives an opportunity for contrarian investors to buy obscure and unpopular stocks at big discounts. However, now for over a decade value has performed poorly relative to the market, and this inevitably has raised the question of whether the value premium no longer exists.

The chart below, from Causeway Capital’s recent paper “The Compelling Case for Value” (Causeway) shows the long-term outperformance of value over growth stocks for the MSCI World Index. Similar results can be shown for the U.S. market and emerging markets.

However, over the past ten years the results have been very different, with growth more than doubling the returns of value across most markets.

MSCI, 10-year Annualized Return

There are two main arguments that are made to explain the recent underperformance of value.

• The increasing prevalence of companies with little need for capital. If a company like Amazon can grow its business entirely with third-party capital (eg suppliers), then surely a price-to-book multiple becomes irrelevant. Warren Buffett, the most famous value investor of them all, recognized this at his shareholder assembly last year when he heaped praise on tech hegemons. Buffett said these companies were the “ideal business,” because they get very high returns for little capital. “I believe that probably the five largest American companies by market cap…if you take those five companies, essentially you could run them with no equity capital at all. None,”  said Buffett.  This is a remarkable statement from someone who, to this day, focuses much of his activity on capital-intensive businesses like railroads, utilities and manufacturers.
• Low growth and low interest rates. Growth companies have benefited from  an unusually favorable environment. As the rate of GDP growth has fallen sharply over the past decade, it is plausible that those few companies able to achieve high growth could command higher premiums. This has happened at a time when interest rates have been at record lows, which means that this growth is discounted at record low rates.

Of course, we can’t know if these arguments will make sense in the future. Particularly in the case of low interests, it is likely that we will look back on recent years as exceptional, not a new normal.

Part of the issue with “value,” has to do with the definition of the term. Most value benchmarks rely exclusively on the price-to-book ratio. However, many successful  “value” investors have long migrated to different indicators. Buffett, for example, since the 1970s has focused on “relative value,” looking for  “wonderful companies at reasonable prices.”  Similalry, Joel Greenblatt’s “magic formula” picks quality companies (high returns on capital) at relatively low prices. Dimensional Fund Advisors (DFA), a prominent “quant”  value manager, introduces several indicators in its rules-based quant model to improve on the price-to-book metric. By doing this DFA has achieved much better performance in its “smart-beta” EM value fund (3.33% annualized for the past ten years vs -1.3% for the price-to-book based MSCI EM).

However, seeking explanations for value’s underperformance may be an exercise in futility. Paradoxically, it is exactly the long periods of anomalous underperformance that allows for any investment factor to perform over time. If any strategy was easy to pursue, it would quickly be arbitraged away. For example, Joel Greenblatt points to long periods of underperformance for his “magic formula” as the primary reason for why it continues to sustain results. Hugely successful value investors such as Seth Klarman of Baupost and Buffett himself,  have had long periods of underperformance, which might well have ended their careers at typical investment firms.

One of the most difficult challenges any investor faces during the allocation process is determining whether long-term parameters for valuations are still valid. The fear always lurks that the world has changed. The investor always struggles between accepting the usefulness of real historical data and being flexible enough to appreciate that valuation paradigms may evolve in compex adaptive systems like stock markers.

In the case of emerging markets today, I think it is reasonable to at least tilt portfolios towards value. I prefer relative value, but there is also a good case to be made for also owning low-price-to-book stocks. As the following chart from Pictet Asset Management shows, EM Value relative to EM Growth is approaching historical lows, and this at a time when GDP growth in emerging market economies is accelerating. This is not surprising, given that recent EM performance has been driven by Chinese tech stocks.

In a related topic, a recent paper by Michael Kepler and Peter Encinosa of Kepler Asset Management provides a detailed look at the “value” experience in emerging markets for the  MSCI Emerging Markets Index since 1988    (The Journal of Investing). To begin with, the authors note that the MSCI EM index has outperformed the MSCI World Index by more than 3% annually over the period (9.63% vs. 6.38%). However, this outperformance is achieved with much higher volatility (standard deviation of monthly returns of 6.71% for EM vs. 4.31% for the World). Volatility is a huge problem for most investors because it leads to emotionally adverse behavior, essentially panic selling at the bottom and buying at the top.

In their article, Kepler and Encinosa plot the relationship between price-to-book and future 4-year stock returns for both the MSCI World and MSCI EM. The plots shown below give a valuable perspective on the relative opportunities.

 

First for MSCI World, the regression analysis  using data between 1969-2016 shows an expected return of 8.5% annually for a price to book of 2.14, with a range of possible outcomes from -2.1% to +20.1%. At current valuations of 2.4 time book (February 2018), the expected return declines to below 7% annually, and possible downside of 8% and upside of 18%.

For MSCI EM, the regression analysis using more limited data  between 1988-2016 shows an expected return of 12% annually for the next four years for a price-to-book value of 1.56, with a range of possible outcomes of -8.8% annually to +36.9% annually. At current valuations of 1.81x book, expected returns are closer to 9% with a range of outcomes of -12% to +30%.

 

Fed Watch:

• The myth of sound U.S. fundametals (Project Syndicate)

India Watch:

• An Indian nightmare (Foreign Affairs)
• The fraud at Punjab Bank (Bloomberg)
• India’s digital revolution (13D)

China Watch:

• Herding Grey Rhinos (Geopolitical Futures)
• Xi’s digital dictatorship (Project Syndicate)
• China has already won the global trade war (SCMP)
• China breaks record for monthy cinema billings (SCMP)
• China detains oil firm founder (SCMP)

China Technology Watch:

• Ten Chinese firms vying to beat Tesla (SCMP)
• Shanghai give go-ahead for driverless car road tests (SCMP)
• China on the leading edge of science (The Guardian)

EM Investor Watch:

• No one is listening to Jeremy Grantham (Institutional Invstor)
• The compelling case for value in global stocks (Causeway)
• The fall of the Gupta’s in South Africa (FT)
• Unlocking Indonesia’s digital opportunity (McKinsey)

 

Investor Watch:

• Interview with Paul Tudor Jones (Zero Hedge)
• A Criticism of CAPE ratios (FT)
• Credit Suisse Global Investment Report (Credit Suiss)