June 2020 – The Emerging Markets Investor

The Death of Value Investing (and Emerging Markets)?

The current investment environment, with its apparent disconnect between economic and financial conditions, has been discomfiting for some of the world’s most famous investors. “Has Warren Buffett Lost His Mojo?” the Financial Times asked this week, accusing the Sage of Omaha of poor timing and awful stock picking. Two hedge fund titans, Paul Tudor Jones and Stan Druckerman, recently both owned up to be out of sync with the markets. Druckenmiller apologized for being “far too cautious” and having “missed a great opportunity.” Jones, speaking to The Economic Club of New York, said: “If there was a franchise for humble pie, oh my lord they’d be a mile long to own that, because we all had huge gulps of it — me included.” And, now, Jeremy Grantham, the modern doyen of value investors, has said that, even though “value” stocks have had a epic run of poor performance, “this time may be different” and he is not confident that they will bounce back. Grantham warns that cheap stocks are cheap for good reasons and investors should be careful before selling the high-flying FAANG stocks which are driving the markets upwards.

Grantham is a founder of GMO, a Boston-based asset management firm which has made its reputation over many decades by sticking to its value methodology through cycles. Grantham’s brilliant essays on investing have been required reading for a generation of “value” investors.

Value investing – defined as stock-picking based on quantitative metrics of cheapness (price-to-book, price-to-earnings, price-to-sales, etc…) — has been a very successful strategy over the years. The superior performance of value stocks over time — the value premium – is well documented in academic research. However, over the past ten years, the strategy has lagged badly, raising claims of “the death of value.”

Grantham’s Case for “This Time is Different.”

In the past, value investors would relish a period of underperformance, believing that mean reversion would work its magic. However, this time Grantham is not convinced. Even though this crisis is the “fourth major event” of his career and the previous three created enormous opportunities for value investors, Grantham thinks this one is the most “uncertain” because the world may have fundamentally changed.

In a very thoughtful interview on the “Invest Like the Best Podcast” (Link) Grantham says that the value premium of the past may have been a temporary aberration. Value stocks are cheap as a reflection of the market’s disgust and there is no intrinsic reason that they should provide higher returns, Grantham says. The strategy worked in the past because:

“The general caliber of competition back in those days was very weak and therefore if you did decent analysis, looked for value you could find it. So we were able to build simple mechanistic models by giving points for cheap book and so on and have a win on a very broad basis, so we could manage a lot of money. And we were winning 2 out of 3 years and adding a few points on average per year.”

However, that era came to an end about 20 years ago, according to Grantham. The “simpleminded” nature of the strategy was made evident by academic research and arbitraged away by quantitative investors:

“Too many machines were picking it up, too many quants, too much money, and pretty soon the historical aversion to cheap stocks had disappeared because they acquired the reputation for having won. The quants made it clear they understood that for 1800 years into the mist of time these were factors that worked, and indeed academics wrote it up and got a lot of credit for such a simpleminded idea.”

Moreover, several other factors have contributed to making the investment environment less friendly for value investors, Grantham says:

The U.S. has drifted away from a healthy capitalistic system, experiencing a gradual increase in the power of big corporations: “the degree of corporate influence over government and regulation has climbed which facilitates monopoly. The willingness of the justice department to break companies up has declined, not surpringly, under those conditions.” This has resulted in a a “weakening in competitive spirit and speed. Conservatism and high return is put ahead now of growth and being the first and the biggest at something new.”
The Federal Reserve has become a dominant presence in the markets. In the past, value investors could ignore the Fed in expectation that the market would self-correct, but now the Fed rules the market.
The market leaders today – the FAANGs (Facebook, Amazon, Apple, Neflix and Google) – “ are unlike anything that ever walked the face of the earth. They generate market cap out of thin air, their use of assets is unlike anything it used to be; it’s not about traditional capital being depreciated and replaced and cranking out widgets, it’s all about intangible capital and brand and speed and using your brains to innovate.”

How much of an aberration is value’s recent underperformance?

In a recent paper, “Factor Performance 2010-2019: A Lost Decade? “ David Blitz, Head of Quantitative Research at Robeco in the Netherlands, argues that the recent troubles of value are not unusual. Value’s poor results over the past decade are typical when the market is very strong and dominated by other factors such as momentum and profitability. As the table below shows, value also performed poorly in 1990-1999, a similar period when the stock market was driven higher by high-growth technology stocks. The data is from the Kenneth French Data Library.

The chart below is from Your Complete Guide to Factor Investing by Andrew Berkin and Larry Swedroe, which looked at the data for a 90-year period, through 2017. On the right side, we can see the value premium harvested over this period. It is important to see the premiums in the context of the data on the right side of the chart which shows the probability of negative premiums over different periods. We can see that value has had a 14% chance of providing negative premiums over any 10-year period, and a six percent chance over any twenty-year period.

Therefore, long periods of negative premiums are not extraordinary. Moreover, we can probably say that these periods of underperformance are a necessary condition for the factor to work over time, because we should not expect anything easy to work in investing. Therefore, “no pain, no gain,” and one should not expect to harvest the value premium without facing the risk of long periods of failure.

The “Death of Value” and Emerging Markets

It is no coincidence that emerging market stocks and value have both performed very poorly over the past decade. To a considerable degree, they are tied at the hip, both representing exposure to more risky and more cyclical segments of the market (though this has been somewhat mitigated in recent years with the rise of Chinese tech stocks). The chart below shows the annual returns by decade for emerging market stocks and the S&P 500, since the launch of the MSCI EM Index at the start of 1987. If we compare these returns with those from the first chart from the Robeco paper, we can see that EM stocks and value both perform relatively well in decades when the S&P 500 does poorly. Both value and EM are “risk-on” trades, that do poorly in those decades of “American Exceptionalism” when investors are enamored with American growth stocks. We are coming out of such a decade, when the FAANGs, turboed by record-low interest rates, have dominated the markets.

No surprisingly, EM value stocks have done even worse over this past decade, as can be seen in the following chart, which compares the returns of the FTSE-Russel EM Index with that of the Dimensional EM Value Fund.

In conclusion, investors in emerging market stocks must hope that Grantham is wrong and that “This time is different” continues to be the four most dangerous words in the English language, as Sir John Templeton once said.

This hope is founded on the expectation that a combination of the following events will materialize:

The FAANGS will peter out, weighed down by valuation, size and regulatory pressure.
American Exceptionalism will take a rest.
The U.S. economy will slow, the dollar will weaken and commodity prices will rise.
Global growth will accelerate relative to the U.S. economy.

Are Brazilian Stocks Cheap?

Brazilian stocks have rallied by over 50% since March 24, driven by bottom-fishers and a new generation of avid speculators trading through online brokers. The Brazilian trade has similarities with the “dash-to-trash” trade that has pushed up the worst performers and “zombie” stocks of the U.S. market (cruise-lines, airlines, malls, etc…). Brazilian stocks have also benefited from a weakening dollar, which, in itself, is a reflection of increasing investor appetite for risk.

The “risk-on” trade is underpinned by the following narrative:

The Covid-19 pandemic is in retreat, and vaccines and therapeutics are forthcoming. This implies a “V-shaped” recovery of the economy.
The U.S. Fed is fully committed to propping-up financial markets and provides a “put” which provides downside protection.

Moreover, according to the bullish-case, emerging markets such as Brazil from now on will benefit from a strong tail-wind from the following forces:

Strong stimulus in China, which is evident from rapid credit growth (27% y/y) and surging cement and steel sales. China appears to be implementing a mini-version of its gargantuan 2009 stimulus.
Commodity prices, which are at decade lows, will be pushed up by Chinese stimulus. We can see this already in iron ore and copper prices, which are both well off the bottom and trending higher.
After a decade-long strengthening, the dollar may have started a down cycle. This would be caused by a combination of (1) the reckless implementation of Modern Monetary Theory in the U.S. (eg. fiscal deficits financed by money printing) and (2) improving growth prospects outside the U.S.
Record-low interest rates around the world and persistent deflationary trends are allowing EM central banks to reduce benchmark interest rates. This is particularly true in Brazil where interest rates at historical lows are pushing the rentier class into stocks.

Finally, the bulls believe that a great rotation has started, from expensive “growth” stocks (eg, FAANGS) into dirt-cheap “value” stocks. This rotation has been happening in recent weeks and partially explains the rise in Brazilian stocks. Emerging markets in general and Brazil in particular would greatly benefit from such a rotation. This is because, aside from China, Korea, and Taiwan, which have buoyant tech sectors, growth stocks are exceedingly uncommon in emerging markets.

For the current rally in Brazilian stocks to continue this narrative will have to be confirmed. Given the enormous lack of visibility on several issues, however, a cautious positioning is warranted. In particular, the continued virulence of COVID-19 across many emerging markets, and especially Brazil, is of great concern, and the risk of a second-wave later this year is real.

Moreover, the bulls may not be giving proper consideration to the disastrous impact that the pandemic has wrought on present economic output and future growth prospects. Both the OECD and the World Bank this week released growth forecasts for Brazil pointing to the devastating effect of the pandemic this year and slow recovery next year. These forecasts are shown below.

Furthermore, the crisis will have a very debilitating effect on Brazil’s fiscal accounts and result in a massive increase in the debt-to-GDP ratio. This ratio has been ramping-up dangerously for the past five years and will surpass 100% of GDP over the short-term. The very high levels of debt in Brazil can be expected to significantly reduce the potential for GDP growth in the years to come. This is shown in the chart below.

Furthermore, the claim that Brazilian assets are cheap should be qualified.

First, let’s look at Brazilian stocks on a historical basis. The chart below shows price-earnings ratio (PE) and cyclically-adjusted price-earnings ratios (CAPE) for Brazil, with 2020 numbers from sell-side estimates. Based on history, Brazilian stocks appear relatively close to historical averages.

The following chart, based on MSCI data and sell-side estimates, shows the MSCI Brazil index and Brazilian GDP (LHS) and earnings (RHS), all in USD terms. What the chart shows is that the perceived cheapness of Brazilian stocks is the result of a decade of currency weakness and GDP stagnation, which have led to no earnings growth.

The unfortunate reality is that Brazil has undergone a disastrous lost decade, as far as corporate profits are concerned. Given the Coronavirus, the expected slow recovery and the poor prospects for GDP because of excessive debt, there is no clear end in sight for these woes. Remember that Brazil’s stock market is largely composed of banks, commodity producers and mature consumer businesses, none of which are benefited by the global environment of low growth and disruption. The chart below shows historical and expected MSCI Brazil dollar earnings. These assume a gradual appreciation of the BRL over the 2020-2029 period.

Applying a CAPE methodology to this earnings forecast, we put a Brazilian normalized CAPE ratio of 13.6x on 2027 CAPE earnings (10-year average inflation adjusted earnings), which gives us a target MSCI Brazil index value of 2383 in 2027, vs. today’s 1633. This translates into an expected annual total real return of 5.7% (including dividends). Needless to say, these expected returns are not enticing.

Of course, these kind of forecasts are full of pitfalls. Many things could happen to improve the prospects for Brazil. These are the primary ones:

A strong weakening of the USD and sharp rise in commodity prices could dramatically improve economic growth, liquidity, the debt profile and earnings. This is not currently in analysts earnings forecasts, but the chances of this happening in coming years are relatively good.
Successful economic reforms implemented in Brazil. Low-hanging fruit to increase productivity and growth potential are enormous. For example, Brazil has an abysmal ranking of 124^th in the World Bank’s Doing Business ranking and has made no progress over the past 15 years.
Successful financial repression, to allow a managed reduction in government debt.
An innovation renaissance in Brazil, resulting in “new economy” companies. If Argentina could spawn a Mercado Libre, perhaps Brazil will do the same.

Hamilton, Xi Jinping and Microchips

Alexander Hamilton, the first Secretary of the Treasury of the United States (1789), argued for tariffs and subsidies to promote domestic industry. In a society dominated by farmers and powerful commodity exporters (cotton and tobacco), this was not an easy argument to make. Nevertheless, the case made by Hamilton in his seminal “Report on Manufacturers” had a profound influence on policy makers for the next century. Hamilton argued that the case for free trade made by Adam Smith relied on ideal conditions that did not exist in the real world of commerce. He asserted that Britain, which was the main trading partner of the United States, imposed “injurious impediments” on commodity exports from the United States and “bestowed gratuities and remunerations” in support of its own manufacturers. Hamilton argued subsidies were fundamental for “military and essential supplies” of importance to national security. His report to Congress singled out coal, raw wool, sail cloth, cotton manufacturers and glass (windows and bottles) as industries meriting subsidies. He also encouraged support for “infant manufacturers”: “new inventions…particularly those which relate to machinery.” In response to criticism of the fiscal burden of these subsidies, Hamilton responded: “There is no purpose to which public money can be more beneficially applied, than to the acquisition of a new and useful branch of industry; no consideration more valuable, than a permanent addition to the general stock of productive labor.”

The U.S. heeded Hamilton’s recommendations throughout during the 19^th century and until W.W. II, sheltering its industry behind a wall of tariffs. The German economist Friedrich List applied Hamilton’s framework to the case of Germany in the 1840s in his book The National System of Political Economy (1841). List echoed Hamilton in arguing that Britain’s defense of “laissez faire” economics was a disingenuous stratagem to contain the development of rivals. He promoted the idea of state-fostered industrial planning as necessary for a country to achieve the capability to compete on equal terms with foreign industries. To transition an economy to the more developed stage, List argued, it is imperative that governments (1) develop public infrastructure, (2) provide incentives for savings and for the accumulation of capital and the channeling of capital into productive industries and (3) promote “mental capital” (education and research). List’s ideas, which came to be known as the German Model, were very influential during Bismark’s Germany (1870s) and Japan’s industrialization (1860s) and later for the development models espoused by Taiwan, Korea, and Singapore. In developmental economics, this model is known as the East Asian Model of Capitalism. Since its opening under Deng Xiaoping in the 1980s, China has, by-and-large, followed the course of its East Asian neighbors, with astonishing results.

The success of the East Asian Model of Capitalism is an anomaly in developmental economics which is not easy to explain. Korea, Taiwan and Singapore are the only countries in the 20^th Century that have joined the club of developed industrialized nations, leaving behind other emerging markets which cannot overcome the “Middle-Income Trap” and the myriad other forces which impede economic convergence (Eastern Europe, with its rapid integration with Western Europe is a different case). Many of the policies pursued by the East Asians have been tried, to one degree or another, in most developing countries, but have tended to mainly benefit entrenched elites at the expense of the public. For example, Brazil adopted something quite similar to the East Asian Model framework in the late sixties and enjoyed a decade of high growth labeled the Brazilian “Economic Miracle.” However, political and economic instability, malinvestment and corruption have discredited the model in Brazil. In a bizarre evolution, Brazil has now gone to the opposite extreme and is flirting with Chicago School free-marketism. The one fundamental success which Brazil had in terms of promoting a world class company in a frontier industry, the aeronautics concern, Embraer, has lost government support.

One of the main challenges of development that the East Asian model seeks to address is the creation of world class companies in “infant industries.” Naturally, the targeted sectors change constantly. What Treasury Secretary Hamilton considered to be critical for national security and to ensure industrial development (coal, sail cloth, glass) is now considered mundane. Fifty years ago, every country wanted to dominate the steel and automobiles industries; these are now considered mature and of lesser importance.

In harmony with Hamilton, China has boldly outlined its own list of essential “infant industries” in its “Made in China 2025” initiative. China today finds itself in a position similar to that the U.S. faced relative to Britain in the 19^th Century, and which Germany and Japan faced relative to Britain and the U.S. in the late 19^th Century and the first half of the 20^th Century. As is to be expected, the dominant commercial power of today (United States) preaches free trade and reacts with outrage to the newcomers use of tariff and subsidies to support “infant manufacturers.” China, like the U.S., Japan and Germany did before, objects that the U.S. is determined to unfairly contain its development. This dynamic between rising states and hegemons is a recurring pattern described as “the Thucydides Trap” by Harvard’s Graham Allison in his book Destined for War. Thucydides, an historian of ancient Greece, attributed the cause of the Peloponnesian Wars to Sparta’s inability to accept the rise of Athens as an equal. In his book, Allisson reviews 16 cases of rivalries between rising and established powers over the past 500 years, and he notes that 12 of the cases ended in wars.

Semiconductors are a pillar of “Made in China 2025.” If sail-cloth and coal were considered vital in Hamilton’s time, it is no wonder that semiconductors are the same for China today. Semiconductors are the “new oil” because they are at the core of the modern economy and drive all critical frontier technologies (communications, 5G, quantum computing, artificial intelligence, autonomous vehicles, drones, etc…), many of which have obvious military uses. No country can aspire to play a leading role in any of these industries without having secure access to state-of-the-art microchips. China imported $350 billion in semiconductors in 2019, almost entirely from the United States, Taiwan and Korea. Furthermore, it relies on U.S. technology for the vast majority of its own semiconductor industry, which is two to three generations behind market leaders.

One of the main fronts of the semiconductor industry wars is currently being fought in East Asia, so it is interesting to understand the history.

Korea and Taiwan are key global players in semiconductors. Both countries singled out semiconductors in their industrial planning and provided vital government support (logistics, financial, fiscal, R&D). In 1974, following the government designation of electronics as one of six strategic industries, Korea’s Samsung entered the memory chip industry (integrated circuits) by partnering with Kang Ki-Dong, an electronic engineer with a PHD from Ohio State University, who had worked at Motorola before starting a chip fabrication line in Korea. Samsung faced huge challenges in securing technology and invested heavily to reverse engineer advanced technologies. Defying the odds, by 1993, Samsung Electronics became the largest manufacturer of memory chips in the world. Samsung today is one of the very few fully integrated semiconductor firms, from foundry to design.

Taiwan Semiconductor Manufacturing Company (TSMC) is another outstanding outcome of the East Asian Model. TSMC is now the world’s most valuable semiconductor firm, with a market value of $240 billion. It was founded by Morris Chang, a native of China who studied electrical engineering as an undergraduate at MIT and as a doctoral students at Stanford University. Chang worked for decades for Texas Instruments, an American company at the forefront of semiconductor technology, and he rose to the ranks of senior management after making important contributions to the company’s success. Chang was eventually lured to Taiwan to head the country’s technology research institute (ITRI). With extensive logistical and financial support and subsidies from the government, Chang started TSMC in 1987. TSMC has been hugely successful, carving for itself a niche as the dominant independent semiconductor foundry (both Intel and Samsung are fully integrated) and as the primary supplier to independent chip designers. In fact, because of the importance it has for “fab-less” U.S. chip designers, TSMC is a significant geopolitical concern for the United States, given Taiwan’s unique relationship with the mainland.

Neither Samsung Electronics nor TSMC were sure bets. In addition to requiring massive and long-term government support, they faced stiff competition from established players and frequent litigation for patent infringement. They would never have been successful without extensive access to American technology and American markets

China’s leading semiconductor firm, SMIC (Semiconductor Manufacturing International Corporation), has an origin story similar to TSMC’s. The company was founded by Richard Chang (no relation to Morris Chang), a native of Taiwan, who also studied electrical engineering in the U.S. and worked at Texas instruments for over 20 years. Like Morris Chang, he was lured back to Taiwan by ITRI where he ran a rival to TSMC until the two government-supported firms were merged. Finally, with the support of the Shanghai government and financial investors from the U.S., Taiwan and Singapore, he took on the mission to create a Chinese version of TSMC. SMIC has basically followed TSMC’s non-integrated foundry model, with the objective of providing a domestic alternative for Chinese chip designers.

However, in spite of abundant capital and government support, SMIC has not found it easy to follow in TSMC’s path. From its start in 2001, SMIC encountered obstacles rooted in the different objectives of its shareholders: financial backers saw a road to quick profits for SMIC in using older generation technology that could easily be secured from the U.S.; government backers wanted the company to invest heavily to climb the technology ladder and promote regional dispersion in collaboration with municipalities. Richard Chang left SMIC in 2009 having failed in reconciling the interests of the different shareholders.

Moreover, from the beginning SMIC has been stalled by restricted access to advanced technologies, always remaining two generations behind the industry leaders. Unlike TSMC, the company was severely handicapped by export restrictions tied to the Wassenaar Arrangement (WA), a multinational pact set up in 1996 to limit dissemination of technology that could have military use. SMIC also was embroiled in litigation with TSMC and other technology suppliers who were determined to slow its progress.

SMIC’s difficulties highlight some of the particular barriers that China faces in climbing the technology ladder to compete in strategic industries. Most importantly, unlike Korea and Taiwan, which are important strategic geopolitical allies of the United States, China has been considered to be a rival and a potential threat to Pacific Basin stability. The United States is disposed to promoting the development and prosperity of South Korea and Taiwan to an extent that it will never be for China which is much bigger and a much greater ideological and commercial adversary. Inevitably, as China’s economic clout grows and its diplomacy becomes more assertive, the probability of confrontation with the U.S. becomes more likely.

The arrival on the scene of Xi Jinping as paramount leader in 2012 brought a new sense of nationalism, bravado and urgency to China’s government and contributed to triggering a more confrontational relationship with the U.S. This became immediately apparent in semiconductor policy with the announcement in 2013 of the new Guidelines to Promote National Integrated Circuit Industry (National IC Plan) and the establishment of the National Integrated Circuit Investment Fund (National IC Fund). China’s growing dependence on semiconductor imports ($311 billion in 2018) was identified as a serious vulnerability to be addressed through the identification of “national champions,” increased investment in research and the promotion of both inbound and outbound FDI. This was followed in 2015 by the “Made in China 2025” initiative, setting a roadmap for “the main segments of the IC industry . . . to reach advanced international levels” by 2030.

Xi’s ambitions have ruffled feathers in Washington. The Office of the United States Trade Representative (USTR) recently commented: “China’s strategy calls for creating a closed-loop semiconductor manufacturing ecosystem with self-sufficiency at every stage of the manufacturing process—from IC design and manufacturing to packaging and testing, and the production of related materials and equipment.” According to the U.S. based Semiconductor Industry Association, China threatens to :

“ (1) force the creation of market demand for China’s indigenous semiconductor products; (2) gradually restrict or block market access for foreign semiconductor products as competing domestic products emerge; (3) force the transfer of technology; and (4) grow non-market based domestic capacity, thereby disrupting the fabric of the global semiconductor value chain.”

As the China-U.S. relationship has spiraled downwards during the Trump Administration, the U.S. has become increasingly determined to thwart China’s “Made in China” initiative. The U.S has campaigned aggressively against Huawei, China’s leader in both 5G technology and smartphones, blocking its sales in the U.S. and lobbying for other countries to do the same, and cutting off its access to Google’s software for its smartphones.

The Bureau of Industry and Security (BIS), an agency under the US Department of Commerce, has put Huawei on an Entity List, requiring that any US firm wanting to sell American tech components or software to Huawei obtain a license from the U.S. government. Moreover, the BIS announced that all foreign firms that supply semiconductors to Huawey will also need a license if they in any way rely on U.S technology, which they all do.

The BIS licensing requirement puts China’s technology development at the mercy of America’s increasingly jingoistic politicians. For China’s leaders it confirms their worst fears that the U.S. will stop at nothing to contain Chinese development.

Ironically, the only certain consequence of the U.S.’s war against Chinese technology companies is that it will motivate China to double down on its efforts to reach the technological frontier in the key industries of the future.

Two weeks ago, SMIC announced that it has secured an additional $2.2 from government funds to accelerate investment. SMIC now appears to be the domestic champion in the sector.

The U.S. and China appear to be entering into a “great decoupling” with profound consequences for global trade and the tech sector.