Month: June 2019

Why Own Emerging Market Stocks?

 

After a decade of poor performance, it is understandable that emerging market stocks are not popular. Yet, if we look at the long-run, EM stocks have performed relatively well and provided useful diversification for investors.

The following chart shows the total return for both EM stocks and the U.S. market’s S&P500 for the 1988-2018 period, a period of 31 years that encompasses the modern history of emerging markets as an institutional asset class. The chart also shows the returns of a 50/50 portfolio re-balanced at the start of every year.

Even in the wake a a period of huge outperformance for the S&P500, EM stocks are still outperforming U.S. stocks by a slight margin over the period. However, they achieve this with deeper draw-downs (maximum loss during a year) and with greater volatility, two attributes that unsettle investors. The Sharpe Ratio (annualized return/standard deviation of annual returns) is much worse for emerging markets. Moreover, this is before considering the higher risk and cost of capital for investing in EM. When investing in EM, investors expect to be paid a premium to compensate for the higher risk, but this has not been the case over the period.

Nevertheless, EM does provide valuable diversification benefits. A simple annual re-balancing strategy (50% EM and 50% S&P500) enhances returns significantly, while providing a much more stable path of capital appreciation. This is because the two asset classes show highly uncorrelated returns over multi-year periods. During the period under consideration both asset classes individually go through extended periods of stagnation which are largely avoided through a re-balancing strategy.  For example, U.S. stocks provided zero returns between 1999 and 2009, a period which saw EM nearly triple in value. The following decade(2009-2018)  saw the reverse happen, with stagnation for EM stocks and high returns for U.S. stocks. The chart below illustrates the returns of EM, the S&P500 and an annual re-balancing strategy.

 

Trade Wars

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • China deepens financial links as it joins benchmarks (IMF)
  • The rise of factors in the China A share market (MSCI)
  • How does factor investing work in China (Indexology)
  • How smart-beta strategies work in China (Savvy Investor)
  • China’s healthcare sector (globalx)
  • China’s Communication Services Sector (globalx)
  • China’s rare earths strategy (China File)
  • China-India relations are stressed (Carnegie)
  • China opens yuan commodity futures (SCMP)

China Technology

  • Inside China’s biopharma market (McKinsey)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

 

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

 

 

 

 

 

 

 

The “Value” Opportunity in Emerging Markets

Investors categorize themselves as either in the “value” or “growth” camps. The “value” followers focus on stocks that are overlooked by investors and judged to be temporarily mispriced: this is akin to finding $100 bills on the sidewalk or, as value guru Ben Graham described it, picking up  “cigar butts” with one puff left in them. The “growth” proponents, on the other hand, look for companies with bright long-term prospects and the potential for compounding cash flow streams.  While value investors find the future to be opaque, growth investors visualize huge bonanzas on the horizon. Because growth investors see the future as much better than the present, they are happy to pay higher multiples on current earnings and owner’s equity (book value). Because of this, the investment industry has generally categorized “growth” stocks as those with high valuation multiples (price-to-earnings and price-to-book) relative to the market.

Looking at the historical record, “value” stocks have provided better returns than “growth” stocks. This is known in academia as the “value premium” and is attributed to value stocks being underpriced because they are riskier and unpopular while “growth” stocks are overpriced because of their notoriety and bright prospects. Glamorous growth stocks are sometimes compared to “lottery tickets” as they can generate the excitement of a potential huge pay-off in the future. One of the main features of “growth” stocks is that they benefit from low interest rate environments, such as the one we are currently experiencing; this is because the huge future pay-offs investors are counting on can be discounted at lower rates and are therefore worth much more.

Though the value premium is well-documented by academics and is persistent over time and geographies, it will not prevail at all times.  In fact, any “factor premium,” or for that matter any investment strategy,  will go through valuation cycles, from cheap to expensive and back again. Over the past decade, value has been in a severe declining cycle, becoming gradually cheaper relative to the market, setting itself up for another opportunity for investors to harvest premia.  The cyclical evolution of value over the past forty years is well depicted in the chart below from the asset-manager GMO, which shows that currently in both developed and emerging markets “value” is priced at a deep discounts to the market.

Value stocks in the U.S. have underperformed 9 of the past twelve years for an average of 2% annually, one of the longest losing streaks ever recorded. Over the past ten years, in non-U.S. developed markets and in emerging markets annualized value returns have lagged the market by 1.6% and 1.1%, respectively.

Predictably,  as “value”  has become cheaper it has also become less popular with investors. Over this period, assets in value funds have declined sharply relative to the market. In emerging markets, the decline of value has been particularly severe.

Historically, value investors have had a big role in emerging markets. Particularly in the 1990s, stocks in emerging markets were very inexpensive and in a process of re-rating in response to market reforms, privatizations and capital inflows. However, since the 2008 financial crisis, low GDP growth, reform-fatigue and the rise of the tech sector in Asia has changed the dynamics in favor of growth, both in developed and emerging markets. This has resulted in a sharp decline in “value” funds, with many losing assets and shutting down. Interestingly, in the ETF space, which is where almost all marginal flows have gone to over this period, there is not one traditional value fund offered.  Instead, the vast majority of assets are flowing into capitalization-weighted indices (MSCI EM, FTSE). Taking the place of “value,” the industry has promoted RAFI and multi-factor “smart-beta” ETFs.  RAFI, which stands for Research Affiliates Fundamental Index, is a partial “value” substitute to the extent that position sizes are determined by fundamental factors (sales, cash flow, book value and dividends) in contrast to the capitalization-weighted method most commonly used.  Multi-factor “smart-beta” funds, on the other hand, use a mix of “factors” such as price-momentum, sales growth, “quality” and low-volatility in addition to traditional value measures.

Assuming that markets and valuations will continue their historical patterns of mean-reversion, the current opportunity for outsized returns in emerging markets “value” stocks is substantial. Emerging Markets by themselves are already very cheap relative to developed markets, so the deep discount of the value segment provides a significant opportunity for extraordinary returns. Those few remaining funds that still specialize in buying discounted “value” stocks are likely to enjoy a very good run as other investors and ETFs start chasing the return of the “value” premium.

However, a word of caution is warranted. Value stocks are usually cheap for a reason and this is tied to the more problematic and stressed nature of the companies (e.g., more debt, cyclical margins, vulnerability to economic downturns). Given the current global slow-down and the rising risk of U.S. recession, “value” may still have another leg of underperformance. The currently undergoing and expressive decline of global interest rates also continues to favor long-duration “growth” stocks. In short, value may have to wait a while longer, but this will only make the upcoming opportunity even greater.

Trade Wars

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

 

  • The rise of factors in the China A share market (MSCI)
  • How does factor investing work in China (Indexology)
  • How smart-beta strategies work in China (Savvy Investor)
  • China’s healthcare sector (globalx)
  • China’s Communication Services Sector (globalx)
  • China’s rare earths strategy (China File)
  • China-India relations are stressed (Carnegie)
  • China opens yuan commodity futures (SCMP)
  • China’s private firms struggle under Xi regime (PIIE)
  • Chinese quants (Bloomberg)
  • Oddities of the Chinese stock market (Bloomberg)
  • China’s quant Goddess (Bloomberg)
  • Guide to Quant Investing (Bloomberg)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)

China Technology

  • Inside China’s biopharma market (McKinsey)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

 

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

 

 

 

 

Are Emerging Markets Stocks a Viable Asset Class?

It is a basic fact of investing that stock market returns are determined by earnings growth and the multiple that investors will pay for them. Over time corporate earnings generally grow in line with GDP growth, while the multiple put on earnings varies depending on how fearful or optimistic investors may be. Stock valuations may also be impacted by the cost of capital, so that investors will pay higher multiples on earnings when interest rates are low and vice versa. These relationships apply across all geographies, including emerging markets.

Valuations in emerging markets have persistently been lower than in the U.S. and other developed markets even though emerging market economies grow at nearly three times the rate. Relatively low valuations and high GDP growth are the perennial selling points for investing in EM stocks. However, at least for the past decade, returns in EM have lagged well behind those for U.S. stocks, and, understandably, this has raised concerns about the viability of the EM asset class.

However, there are good reasons to believe that the poor performance of EM stocks is temporary. Explanations for weak EM returns point to cyclical and circumstantial causes that should eventually revert.

First, the valuation gap between emerging markets and the U.S, market has widened considerably over the past ten years because of structural issues which are probably temporary. While EM stock markets continue to be dominated by low-growth capital intensive sectors (e.g. banking, manufacturing and natural resources), the U.S. stock market has been driven by “growthy” capital-light companies (e.g. Facebook, Apple, Netflix, Google). “Growth” stocks are long-duration assets (i.e., The concentration of cash flow and dividend payments are in the distant future) and therefore they benefit from the low discount rates implied by the current low inflation and  low interest rate environment. Concurrently, the combination of low-growth/low investment with historically low interest rates in the U.S. has resulted in unprecedented stock buy-back activity by U.S. corporations over the past seven years. This structural cause of EM underperformance is largely the same that has led to the poor relative returns of “value” vs. “growth” investing in the U.S. and global markets, since value stocks are also “short-duration” investments.

This importance of buy-backs is highlighted in a recent paper from analysts at ADIA, the Abu Dhabi Investment Authority (“Net Buy-Backs and the Seven Dwarfs”, Link). The ADIA researchers looked at the MSCI All Country World Index (ACWI) for the 1997-2017 period and determined that the primary determinant of country-specific returns was net buy-back activity (NBB), a measure of the net increase in issued stock in a market (e.g., IPOs, delistings, corporate buy-backs, mergers and acquisitions). Depending on the nature of the NBB, it may enhance or take away from shareholder returns. Markets where companies constantly issue stock –  either because they are in low-return capital-intensive businesses or because they lack capital discipline and shareholder alignment – do poorly. In this regard, the data shows evidence that poor corporate governance manifested by undisciplined capital management has suppressed returns in EM, with the result that earnings have grown at a rate well below GDP growth.

Over the period covered by the study this has especially been the case in China where huge and overpriced initial public offerings (IPOs) of state-owned companies (SOEs) have severely  hurt shareholder returns. The Philippines, Indonesia, Chile, Russia and Thailand have also suffered from negative effects of NBB. The data on NBBs for emerging markets from the ADIA study is shown in the chart below. NBBs had a an average negative 3.4% impact on annualized returns, with less than a third of EM countries showing positive NBBs. Given that stock buy-backs are rare in EM, those countries showing positive NBBs had this as a result of M&A activity and delistings (e.g., ABInbev’s takeover of Modelo in Mexico). The study’s total sample of 41 countries had a negative 2.2% impact on annual returns, slightly above the U.S. market’s negative 1.8%. Interestingly, NBBs for the U.S. market become hugely positive over the 2009-2019 decade and are a major reason for U.S. stocks outperformance over this period.

The second reason for the underperformance of EM stocks over the past decade is the mean-reversion of both valuations and the U.S. dollar.  The charts below show (left) the relative performance of the FTSE EM Index (VEIEX) and the S&P 500 (SPY) over the past twenty years and (right) the EM MSCI Currency Ratio which is the performance of the currencies in the EM stock index relative to the USD. The twenty-year period is neatly divided into the first 10 years of EM stock outperfomance and dollar weakness and the following ten years of EM stock weakness and USD strength.

The strength of the dollar has been a major headwind for EM stocks over the past ten years, reducing returns by 3% annually, as shown below.

Over this period, valuations in EM and the U.S. market follow highly divergent paths. The chart below shows the evolution of valuations for both markets using cyclically inflation-adjusted price-earnings ratios (CAPE), a measure that smoothes out earnings and provides a better basis for comparison. EM started with a very low CAPE ratio of 9.2x in 1999, which rose sharply to 19.6x in 2009 (after reaching a peak of 30x in 1997) and then falls back to 11.5x in 2019. S&P500 valuations start at a bubble -level ratio of 42x  in 1999, fall by half to 20.5x in 2009 and are currently at 29x today.

Conclusion

The outperformance of the U.S. market over the past ten years can be attributed to circumstances that are probably temporary. U.S. returns were boosted by the relatively low level of initial valuations 10 years ago, historically low interest rates over the period, buy-backs and a strong dollar. On the other hand, EM returns have been hurt by relatively high initial valuations, a strong dollar and negative net buy-backs. Predicting the next ten years is a fool’s errand, but low valuations, a weakening dollar and relatively high GDP growth may put the odds in favor of EM stock outperformance.

Trade Wars

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • China’s rare earths strategy (China File)
  • China opens yuan commodity futures (SCMP)
  • China’s voracious appetite for Russia’stimber (NYT)
  • China’s  control of the lithium battery chain (FT)
  • Australia turns to China (NYT)
  • China’s private firms struggle under Xi regime (PIIE)
  • Chinese quants (Bloomberg)
  • Oddities of the Chinese stock market (Bloomberg)
  • China’s quant Goddess (Bloomberg)
  • Guide to Quant Investing (Bloomberg)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)

China Technology

Brazil Watch

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing