When I first started investing in emerging market equities in the 1980s, I brought the traditional tool kit of an institutional investor. This was a “Graham-and-Doddsville” view of the world, the same mindset applied by Warren Buffett: find “quality” companies – defined as ones with trustworthy management/controlling shareholders and profitable businesses in sectors with good growth characteristics – and ride them to compounding heaven.
At that time, I invested in Latin America, and, fortunately, good companies at low valuations were abundant. Latin America was coming out of the 1981-83 debt crisis and experiencing high levels of economic and policy volatility. The Brazilian market was dominated by individual investors who looked for yield and by traders who played short-term trends. “Quality” growth companies with good prospects were not really on the radar of these investors.
In the mid-1980s, both the World Bank’s IFC and MSCI introduced emerging markets stock indices for institutional investors, and, as a positive narrative grew on investing in developing countries (higher GDP growth leads to higher returns), portfolio capital started to flow into Latin America and other emerging markets. This was a time when macro hedge fund managers, such as George Soros, also started to deploy significant capital in these markets.
Lo and behold, emerging market stock prices surged. Five years after the launch of the MSCI Index in 1987, it had appreciated by over 6 times, as shown in the chart below of the Global Financial Data’s Composite EM Index.
As usually happens when new assets classes are created (e.g. Bitcoin), investors struggled to anchor valuations and they put long-horizon hopes well ahead of cool-headed skepticism. During the 1990-95 period large U.S. and European pension and endowment funds began allocating to emerging markets stocks, and flows rushed into markets like Brazil. Fundamental investment strategies worked very well, and the valuation parameters for the “quality” gems which institutional investors looked for expanded by 3 to 4 times. Investors like myself felt smart and perfectly justified in charging 2-3% management fees for our services (today EM ETFs can be bought free of commission with management fees as low a 7 basis points, or 0.07%). I was convinced that my quality stocks would compound for ever in a “buy-and-hold” strategy, and this made me quite reluctant to take profits despite high valuations.
To make a long story short, the 1993 highs were not breached until 2004, eleven years later. It turned out that all was not a bed of roses in EM investing. The “Tequila” crisis in Mexico in 1994 was followed by the Asian crisis in 1997-1998 and the Russian crisis in 1999. The capital that poured into EM stocks during 1992-95 had terrible returns and what was left of it was largely sent back to safer shores.
Emerging market stocks bottomed in 2001. With the rise of China and the initiation of a commodity super-cycle, a new EM bull market got under way, not unlike the previous one. During 2004-2007, institutional investors came roaring back into emerging markets, making stocks like Mexico’s America Movil key holdings in global and even U.S. domestic portfolios (by the way, America Movil today trades at less than half the price of it 2007 high). The MSCI EM index peaked in 2012 and then did not breach that level until 2019, and this only because of the boom in Chinese tech stocks. Leaving out the Asian tech sector, most emerging markets indices are still well below the levels of ten years ago.
The boom-to-bust nature of emerging markets investing is a quandary for investors. Institutional investors typically are not well positioned to deal with this dynamic because the business dictates that inflows are concentrated at cycle tops and outflows peak when prices are collapsing. Also, many institutional investors endeavor to add value through fundamental research with a long-term focus, which makes analysts and managers oblivious to cyclical reversions (The latest fad in EM investing has been Chinese tech stocks).
So, what should an investor do to avoid the drawdowns in emerging market stocks? Several investors have proposed rational approaches that are likely to succeed. GMO, a Boston-based value investor, recommends a two-pillared quantitative model that (1) pinpoints macro-economic risks and (2) monitors country-sector valuations, the premise being that success lies in owning cheap stocks in countries with low macro risk (GMO). Verdad Capital’s Dan Rasmussen recently has offered an elegant systematic framework to harvest EM equity alpha by limiting market exposure only to high-return post crisis environments (Verdad Capital). My own approach is similar. I focus on (1) Global macro (USD flows); (2) Country macro (growth trends, current and fiscal accounts, debt dynamics); and (3) Valuation (CAPE relative to country history.) This model can be run effectively in a systematic manner. Stock picking can be added as a fourth stage of the model, and my experience is that a combination of systematic algorithmic tools and discretionary research (focusing on management quality and growth prospects) is most effective.
This approach requires a change in the buy-and-hold mindset to a disciplined focus on valuation parameters. It entails more turnover than a buy-and-hold approach, and therefore may be best suited for small-to- medium-sized funds (e.g. family offices).
Let’s look at Brazil to see how simple valuation tools can be used to exploit cycles.
The chart below shows the dollarized performance of the Bovespa index since 1967. That year is significant as it corresponds with the beginning of the “Brazilian Economic Miracle,” a period of nearly a decade of very high GDP growth. It was also a market bottom for the Bovespa, which had treaded water for the previous ten years. Not surprisingly, the stock market did very well from that point, appreciating by nearly twenty-fold over the next 4.5 years. Though Brazil would never again see this kind of “Asian- Tiger” GDP growth levels, the Bovespa has repeated these boom-to-bust cycles another five times, if we assume that another cycle began in 2016. Each one of these cycles has produced enormous returns over brief, but investable periods.
The Bovespa compounded at 11.3% annually over this period, which compares to 7.3% for the S&P500 (before dividends, which have been 85 basis points higher in Brazil.) However, the investor in Brazil experienced much greater volatility. Moreover, the Bovespa had negative performance in 24 years (compared to twelve for the S&P500) and suffered much greater drawdowns. Also, if we change the beginning of the calculation from the bottom of the 1967-1972 cycle to the top, then returns for the 1971-2020 period are only 5% a year. This highlights perfectly the importance of getting the cycles right.
Traditional buy-and-hold institutional investors are highly disadvantaged at playing the cycle game, as it is usually at the peak of the cycles that they are able to raise more funds and they are obliged to deploy them. On the other hand, in Brazil a generation of macro hedge fund traders hit pay dirt in the 1983-1997 decade, systematically playing the cycles in an anti-buy-and-hold framework. In fact, these investors exploited the gullible foreign institutional investors, feeding them stories and front-running their flows. Knowing when to cash out of the market has been the key to success for Brazilian traders.
Fortunately, market cycles are often clearly marked by valuation signals. Invariably, the great cycles of the Bovespa have started when valuations were very low and the currency highly depreciated. The dollarized cyclically adjusted price earnings ratio (CAPE) is a simple methodology that has clearly identified the key trading points, as it smoothens out the highly cyclical path of earnings in Brazil as well as the persistent multi-year trends of BRL relative to the dollar.
The chart below shows both PE and CAPE multiples for Brazil over the 1986-2020 period. Referring back to the previous chart, it is clear that the CAPE has proven to be well suited for identifying market extremes in 1990 (buy), 1997 (sell), 2002 (buy), 2008 (sell), 2010 (sell) and 2016 (buy). The CAPE therefore can be useful to evaluate valuation risk in specific countries (measuring levels relative to history).
Combining a macro framework with a CAPE valuation methodology works well to capture market surges and avoid steep drawdowns in Brazil and across emerging markets. This approach is systematic and easy to implement and can be effectively incorporated into a global allocation strategy .