Category: Global Emerging Markets

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)

 

 

 

 

 

 

 

The increase in volatility in global financial markets over the past several weeks has raised concerns that the rally in emerging markets equities may come to an end. The market uncertainty is caused by the conflicting stances of U.S. monetary and fiscal policy; while the Federal Reserve is intent on tightening monetary policy, the Republican Administration has embarked on massive fiscal expansion. The fear is that fiscal pump-priming in an economy near full-capacity will boost inflation and compel the Fed to accelerate interest rate hikes, which could impact demand for riskier asset classes such as EM equities.

There is no question that the fiscal expansion being engineered by Washington is unusual policy this late in the business cycle. The current U.S. economic expansion, now in its ninth year, looks mature, given low unemployment and scarce idle capacity in the economy.  The Republicans hope to trigger a sustainable boost in U.S. GDP growth, to 3% or above. However, given expected labor force expansion of 0.5% and recent annual productivity growth of 1%, any growth above 2% will be ephemeral. Unless higher growth does materialize, the policy is expected to engender huge fiscal deficits in the years to come. This will happen at a time when private savings have collapsed to record low levels. This means that fiscal deficits will have to be financed by foreign savings, resulting from higher trade and current account deficits. U.S. personal savings and expected fiscal deficits are shown below.

In the past, rising current account deficits in the U.S. have been favorable for  emerging market asset prices. Large U.S. deficits signify a strong, late-cycle U.S. economy. This is typically accompanied by a weakening dollar and increased global liquidity,  which is  very beneficial for emerging markets. The last time we saw this was between 2003-2008 when twin deficits in the U.S. led to a weak dollar and booming asset prices in emerging markets. The reason that this happens is the following: 1. The overheated U.S. economy results in large current account deficits; 2. Surpluses accumulate in foreign central banks which intervene in currency markets to avoid accelerated appreciation; 3. These surpluses are very difficult to sterilize and stimulate credit and economic activity;4. As investors see currencies and markets appreciate they pile into the markets, causing additional upside pressure on asset prices.

As the U.S. economy strengthened over the past two years and the output gap was closed, this process already started. EM currencies and asset prices had reached very low levels in 2015. Now, after outperforming developed markets for two years, EM equities are no longer dirt cheap, but they are still very inexpensive relative to U.S. equities. We are probably about mid-cycle for EM. Economies are starting to gain some traction and equities are reasonably priced, at about historical averages. If the cycle progresses normally, we should see increasing liquidity push asset prices considerably higher for at least the next twelve months.

In contrast to the U.S., most EM economies are in the early or mid-stages of their business cycles, and the commodity-rich economies are just exiting from the deep slump caused by low commodity prices in recent years. Commodities also benefit from the overheated U.S. economy and the weak dollar, adding fuel to the emerging market cycle. The chart below shows were EM countries lie in the business cycle.

Of course, there are risks to this scenario. What could abort the global liquidity cycle?

• An acceleration in U.S. inflation, triggering more aggressive Fed policy is a possibility. If U.S. inflation where to spike above 3%, the Fed would likely respond aggressively and could provoke a recession.
• Trade Wars. U.S. tariffs and subsequent retaliations, would be inflationary and create uncertainty.

The most benign scenario for emerging markets is for a continuation of the trends of the past several years; this is a “Goldilocks” scenario of disappointing GDP growth and stubbornly low inflation, which allows the Fed to pursue its gradualist, “asset-friendly,” strategy. This is probably the most likely scenario at this time, and it could mean the extension of the business cycle for another year or two, in an environment of ample global liquidity.

Higher volatility in financial markets could also be a positive new element, to the extent that it caps enthusiasm for U.S. equities and allows emerging market equities to attract more flows and continue to outperform.

Fed Watch:

• Dalio on the business cycle (Linkedin)
• There will be no economic boom (Seeking Alpha)
• The U.S. business cycle (Seeking Alpha)
• Gary Shilling on the Fed (Shilling)
• World Finance in peril (Telegraph)

India Watch:

• India is starting to move the oil markets (Oil price)
• India needs to create salaried jobs (Livemint
• RBI warns on Modi’s budget (QZ)
• India’s protectionist budget (Swarajyamag)
• India launches Modicare (Swarajyama)

China Watch:

• China’s shadow banking system (BIS)
• Shandong Ruyi textile group buys Bally luxury shoes (SCMP)
• Cruise ship industry is booming (WSJ)
• China and free trade (NYtimes)

China Technology Watch:

• China is winning the battery war (WSJ)
• China and the AI war (Science Mag)
• Interview with JD.com’s Richard Liu (Youtube)

EM Investor Watch:

• The enlightenment is working (WSJ)
• Costa Rica runs 300 days on renewables (VT)
• Inflation stalks Macri in Argentina (WSJ)
• Why South Africa matters (FT)
• Which emerging market is emerging (Seeking Alpha)
• PDVSA’s workforce is jumping ship (Oil Price)
• Traders warn EM rally is ending (Bloomberg)
• Brazil’s hedge-funds boom again (Bloomberg)
• Reasons for Brazil’s credit dysfunction (AQ)
• Brazil’s PagSeguro IPOs on NYSE (Bloomberg)

Technology Watch:

• Renewable power costs in 2017 (Irena)
• Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

• The decline of buy and hold (Seeking Alpha)
• Munger says bitcoin is noxious poison (FT)
• On the future of active investing (Forbes)

 

 

 

Emerging markets have come out of a period of considerable underperformance relative to both the U.S. market and international developed markets. They have now outperformed for over two years, recovering some lost ground.

Valuations in emerging markets remain in line with historical norms, which is an aberration in a world of generally extreme asset prices. Strangely, while a very large growth premium is paid for growth assets in the U.S. market, that view has not benefited emerging markets, even though on average they have much higher GDP growth than developed markets.

EM’s poor performance over the past decade can largely be attributed to multiple contraction (The Past Ten Years in Emerging Markets). The graph below shows the evolution of the cyclically adjusted price to earnings (CAPE) ratio over this period. The average historical CAPE ratio for EM has been 14.4, which is exactly in line with the current level. After peaking in 2007, the CAPE for EM bottomed out in 2011-2013, at 10 times trailing earnings. We have already seen considerable multiple expansion since then, a consequence of the past two years of strong performance. Nevertheless, we can expect that, as always, valuations will peak this cycle well above the historical average, so additional multiple expansion is likely.

On a country-by-country basis, however, greater opportunities exist, and the investor can weigh his allocations accordingly.  The chart below shows how valuations have evolved over the past ten years for the primary EM countries. The first two columns on the left show the CAPE ratios at year-end 2007 and 2017, respectively. While the U.S. saw multiple expansion, every EM country saw multiple contraction over this period.  The next to last column on the right shows the country’s average CAPE for the past twenty years, and the last column shows how far the 2017 ratio is above or below the average.

Several conclusions can be drawn from this table.

• The U.S market is priced for perfection, and should be expected to provide very low returns for the next 7-10 years.
• “Risky” countries (commodity producers and those dependent on erratic foreign flows) offer significant upside to get back to average valuations. These “boom-to-bust” markets now stand to benefit from late-cycle effects of the U.S. economy, the weak dollar and strengthening commodity prices and will eventually trade at multiples above the historical average. This means high potential upside for stock prices in Russia, Brazil, Turkey, Malaysia , Chile and Colombia.
• Mexico has been overly punished because of concerns with President Trump and the 2018 presidential election, and it could rebound strongly.
• Indonesia and India are near normal valuations, and will need strong earnings growth and higher multiples to continue to outperform.
• Philippines is at a very high level of valuation. This “FIRE” (finance-insurance-real estate) economy/market has benefited from liquidity and low interest rates, as these activities are all highly leveraged. Of course, the opposite will occur on the downside.

Valuations, in general, and CAPE in particular, are not good timing tools. However, historical observation and the academic research done by Professor Robert Shiller and others show a high correlation between CAPE and future returns. In EM, investors are fickle and nervous and things tend to happen quicker than in developed markets, so CAPE is probably a good allocation tool for 3-5 year investment cycles.

India Watch:

• India’s manufacturing challenge (India Times)
• Modi at Davos (Economic Times)

China Watch:

• Couples not delivering on babies (Caixing)
• The world’s most valuable luxury good company (WIC)
• Making China Great Again (The New Yorker)

China Technology Watch:

• China now top producer of scientific articles (Nature)
• Tencent’s Wechat: an app and an app-store  at the same time (SCMP)
• China to test new Maglev train (Caixing)
• JD’s Liu goes to Davos (SCMP
• Smartphone sales fall in China for the first time (SCMP)
• Xiaomi gains top smartphone spot in India (SCMP)EM Investor Watch:

Technology Watch:

• Amazon’s new Go store (Stratechery)
• Renewable power costs in 2017 (Irena)
• Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

 

• Ben Carson on market drawdowns (Wealth of Common Sense)
• An interview with Ed Thorpe (http://AQR)
• Tech will revolutionize institutional investment (Institutional Investor)
• Shiller on CAPE ratios (Project Syndicate)
• Shiller on narrative (Chicago Booth)
• My favorite performance chart  (Wealth of Common Sense)
• U.S. future equity returns (Philosophical Economics)
• The Seven deadly sins (Mauldin Economics)

 

 

 

 

 

 

 

 

 

 

 

Ben Carslon ( Wealth of Common Sense blog) every year publishes a chart reviewing the performance of 10 asset classes over the past decade. It is a good reminder of how erratic annual returns can be. As shown in the chart below, even though emerging markets performed very poorly over the decade, the asset class was the best performer in three of the years and in the top half of the chart 50% of the time. Commodities were the worst performing asset class, which partially explains weak EM. This chart is U.S.-centric and expressed in US dollar terms, so the strength of the USD  over the period goes a long way to explaining the weak results for EM, commodities and international stocks.

A similar review of emerging markets organized by country is shown below. The returns are not strictly comparable to the previous chart, as these do not include dividends as part of the return. As in the previous chart, the annual returns are erratic and highly unpredictable. However, over the 10-year period, which is long enough to represent two normal 5-year investment cycles or a long 10-year cycle, the results are much less arbitrary.

Valuations do Matter

Though over the short-term valuations are a poor timing instrument, over ten-year periods they are very effective allocation tools. Looking at the Cyclically Adjusted Price Earnings Ratio (CAPE), which averages  inflation-adjusted earnings over the ten-year period, we can see that much of the performance differences can be attributed to the starting and ending points of valuations. The CAPE ratios for 2007 and 2017 are shown below. It must be noted that 2007 ended with very high valuations in most emerging markets, as this was the peak of U.S. Fed-induced “easy money” and commodity prices.

In  our sample, only the USA  (S&P 500) had an expansion in its CAPE ratio, and this explains almost all of its absolute and relative returns for the period. The best performing emerging market, Thailand, had a flat CAPE ratio, while every other market had a contraction in its CAPE ratio. The better performers had smaller contractions in their ratios, with the exception of Indonesia. The worst performers – Russia, Brazil, Turkey, Malaysia — had huge contractions in their CAPE ratios. Though India experienced a period of very high GDP growth and political stability, it could not overcome the anchor from its extreme valuations at the start of the period.

Commodities and Currencies Matter in Emerging Markets

The past ten years was a period of dollar strength and commodity weakness, both of which are correlated to poor performance for the EM asset class. With the exceptions of Indonesia, Peru and South Africa, all commodity-sensitive countries did poorly. Indonesia and Peru were supported by the large size of financials in their indexes, and South Africa is an anomaly because its market has become more correlated to China technology (Naspers-Tencent) than to the domestic economy.

And so do Politics and Governance

Russia, Brazil and Turkey all suffered from severe political instability during the period. Russia’s war with Ukraine and the following economic sanctions, Erdogan’s radicalization of Turkish politics, and Brazil’s economic mismanagement and corruption scandals, were all self-inflicted disasters that could not have been anticipated at the end of 2007.

 

Fed Watch:

• The coming melt-up in stocks (GMO)
• Unprepared for the next recession (Project Syndicat)
• Will wealth inequality end the bull market (Tony Isola)

India Watch:

• India’s manufacturing challenge (India Times)
• India’s bond rout (Bloomberg)
• India wearily eyes tech (MIT Tech Review)

China Watch:

• The world’s most valuable luxury good company (WIC)
• US politics gets in the way of Ant Financial’s US plans (SCMP)
• Making China Great Again (The New Yorker)

China Technology Watch:

• Chinese tech workers are flocking home  (Bloomberg)
• How China went from made in to created in (SCMP)

EM Investor Watch:

 

• Venezuela’s oil production collapse (Bloomberg)
• World Economic Forum, Manufacturing Report, 2018 (WEF)
• Pakistan ditches the dollar for China trade (CNBC)

Technology Watch:

• Renewable power costs in 2017 (Irena)
• Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

• Shiller on narrative (Chicago Booth)
• My favorite performance chart  (Wealth of Common Sense)
• U.S. future equity returns (Philosophical Economics)
• The Seven deadly sins (Mauldin Economics)

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:

• Today’s rational exuberance (Project Syndicate)
• The end of globalization as we know it (Barclays)

India Watch:

• India wearily eyes tech (MIT Tech Review)

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:

• Disruption – (CITI)
• Estonia, leapfrogging to a digital society (New Yorker)
• Fanuc’s robots are changing the world (Bloomberg)
• Battery costs coming down (Bloomberg)

 

 

 

 

 

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:

• Global risk-free rate hits 88-year low (Bank of England)

India Watch:

• India government to promote electric vehicles (Economic Times)

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:

• The rise of EM Asia  (Seeking Alpha)
• The emerging markets performance cycle (Wealth of common sense)
• Chile’s middle-income trap (Bloomberg) 
• How can Chile break out of its middle-income trap (Wiley)
•  Argentina leaves Evita behind (Bloomberg)
• Rebalancing China, surging India, where Russia? (World Bank)

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:

• How JPM forecasts markets  (Zero Hedge)
• What makes a safe asset safe? (Liberty Street Economics)  
• Is Buffett Bearish? (Brooklyn Investor)
• The end of the global free market (Advisor Perspective)
• This cycle is driven by China, Zulauf  (Macro Tourist)