Category: Global Emerging Markets

Caution Is Merited For India’s Stock Market

The stock market of India today is probably the most hyped and loved by emerging markets investors. Investor enthusiasm is rooted in the assumption that the country’s high growth rate can be sustained by structural reforms aimed at boosting productivity and modernizing the economy.

As a low-income economy, India has considerable potential for boosting economic growth simply by narrowing the productivity gap that it has with more developed economies. Though India has many world class companies in sectors such as information technology, pharma, manufacturing and banking, much of the economy, particularly small-scale informal manufacturing and farming, suffers from abysmal levels of productivity. Stifling bureaucracy and corruption make operating a business very difficult in India and promote informality. India ranks 130th in The World Bank’s 2017 Ease of Doing Business survey, the worst of any large economy.

Since market-oriented reforms were first introduced in 1991, India has entered into an accelerated catch-up phase, enjoying GDP growth of 6-7%.  For the 2014-2018 period, GDP growth will average about 7% annually, making India the fastest growing large economy in the world. Moreover, in recent years India’s trade accounts and inflation have benefitted from low commodity prices.

In principle, higher GDP growth should justify higher stock market valuations. In many countries, there is a well-established and logical correlation between GDP growth and corporate earnings growth. A generally optimistic view of the potential for long-term growth in earnings has resulted in high multiples for Indian stocks. Moreover, the relatively high valuations in India may be validated by the corporate structure of the Indian market which is dominated by well-managed and profitable private companies operating in industries with stable growth characteristics, in contrast to the much higher concentration of cyclical businesses and mismanaged state-owned firms in the stock markets of Russia, China and Brazil.  We can see this in the chart below, which shows cyclically adjusted, 10-year average price earnings ratios (CAPE) for major emerging markets. India has traded at the highest PE multiples for this group of countries for the past 15 years, as the market has priced in high expected earnings growth and low expectations for future volatility. The market sees India as a “high quality” stock market, with high earnings and low volatility, in contrast to markets like Turkey, Brazil or Russia which are seen as low-growth and high volatility. The only other market currently held in such high esteem by investors is the Philippines.

However, investor enthusiasm for India’s stock market may be misplaced.

India, with its bouts of uncontrolled inflation, high fiscal deficits and elevated public debt levels, recurring balance of payments crises, currency volatility, extreme inequality,  complex democratic politics, and highly inefficient and corrupt bureaucracy, resembles Latin America more than it does East Asia. East Asia has benefited from strong commitments to competitive currencies, a financial system geared to support manufacturing, trade and small-scale farming, and widespread education, none of which are the reality in India or Latin America. Consequently, though India’s GDP growth may be relatively high, it is likely to be volatile, leading to choppy earnings growth for its listed companies.

Furthermore, high GDP growth may be more a curse than a blessing for many of India’s blue chips as it promotes more competition. In recent years, India is seeing many new entrants in sectors like consumer goods and banking. IT powerhouses like TCS and Infosys are threatened by disruption from cloud-based providers. India’s high growth and looser regulations are bringing more foreign competition in many industries (e.g., motor vehicles), potentially disrupting powerful incumbents over time.

In general, stock markets that are very popular with investors because of attractive growth prospects do not tend to perform well in the future. Nevertheless, though expensive relative to other emerging markets, the Indian stock market may continue to do well. It trades today at a CAPE valuation which is below its long-term average and about in the middle of its long-term range, which does not seem prohibitive at a time of very high asset prices around the world.

Still, from a relative performance point of view, there is a high probability that over the next 3-5 years, India will not perform as well as cyclically depressed markets such as Turkey, Russia and Brazil.

One of the ironies of investing in emerging markets is that high GDP growth most often results in excess investment and low future returns. The best stock market returns are often found in depressed cyclical markets which have seen a period of low investment and where companies stand to benefit from operating leverage during powerful cyclical rebounds.

India Watch:

China Watch:

China Technology Watch:

  • FT has lunch with JD.com’s Liu Qiangdong (FT)
  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

Technology Watch:

Investor Watch:

 

 

 

 

 

 

The Rise of Robots in Emerging Markets

 

The relentless rise of robotics in manufacturing around the world that is expected for the next decade will affect the development of emerging market economies in different ways. The “East-Asian Tigers,” including China, are embracing robotics full-heartedly as the way to preserve the manufacturing intensity of their economies and build global market share in medium and high-value added industries, like automobiles, electronics, semiconductors and batteries. Germany and Japan are also manufacturing powers determined to maintain their manufacturing base through innovative engineering.

Most middle-income countries throughout South-east Asia and Latin America are lagging seriously behind in the robotics race and may find it increasingly difficult to move up the value chain to compete for market share in many highly-automated industries. These middle-income countries also face rising competition in low-value-added manufacturing from the new wave of industrializing countries with significantly lower labor costs, such as Vietnam, Bangladesh, India, Pakistan  and Indonesia.

Until today, robot deployment has been highly concentrated in a few industries, namely motor vehicles, electronics and metal-working.

However, accelerating trends in robotics technology is changing this focus in important ways. For example, robot suppliers are beginning to offer automation solutions for clothing and shoe manufacturing, industries that today are highly dominated by low-income economies. This trend may allow for the preservation of these industries in current high-cost producers like China, and even relocation to Europe and North America, in a process dubbed “robot-shoring.”  Moreover,  teamed with computer-aided-design (CAD) and 3D printing, which dramatically accelerate product design, automated manufacturing in developed countries will permit much shorter production chains and give producers  greater ability to react quickly to consumer trends. This is particularly true for high fashion-content clothing and shoe-wear, so it should not be a surprise that Nike and Adidas are leading the “robot-shoring” trend.

Both Nike and Adidas are working with tech partners on solutions for automating the most labor-intensive part of the sneaker manufacturing process, the fusion of the many parts and layers that make up the upper part of the sneaker. Nike invested in 2013 in a company called Grabit that uses a process called eletroadhesion to use static electricity to manipulate soft materials like leather and cloth, and this year Grabit commissioned upper-assembling robots in Nike plants in Mexico and China that work at 20 times the pace of human workers. This is a significant step towards bringing back production closer to consumers in developed markets.

Adidas’s Speedfactory in Ansbach, Germany is another experiment towards using 3D Printing and robotics to bring back sneaker production home. Adidas has partnered with Oechsler Motion, a German machinery supplier, and plans to produce 500,000 units a year in 2018. A second plant is under construction in Atlanta. Adidas believes technology can solve a huge mismatch between the typical 18-month production chain with Asia and the 12-month “fashion-life” of a sneaker.

Another company, Softwear Automation of Atlanta, Georgia, is intent on using its “Sewbot” technology to disrupt the world apparel-making process and the lives of millions of $5/day sweatshop employees scattered around South-East Asia and Central America.. Sewbot has solved the difficult task of robot manipulation of fabric, and Softwear Automation claims to have dominated the automated production of T-shirts and denim bluejeans. The company estimates that its process is 17 times more productive than human labor. Tianyuan Garments, a large Chinese firm that supplies Adidas, is building a plant in Arkansas that will have 20 Sewbot production lines and aims to produce 1.2 million T-shirts a year. Tianyuan estimates human labor will amount to $0.33/shirt on its completely automated production line, which compares to about $0.33/shirt in Bangladesh, the current low-cost producer.

China has made robotics a key part of its government supported “Made in China 2025” plan, both in terms of usage and domestic supply. The goal is to make China one of the world’s top 10 most intensively automated nations by 2020, with 150 industrial robots per 10,000 employees, which compares to today’s leader South Korea, with 531 robot units, the USA with 176 robot units and Germany with 301 robot units.

In 2016 China led the world in terms of both the amount of new robots installed (87,000 units, of which 27,000 came from Chinese firms) and for the total stock of operational robots (340,000, +33% over 2015).

The deployment of manufacturing robots around the world is extreme in its geographic concentration. As the data from the International Federation of Robotics shows,  the great majority of robots are being deployed in East Asia, North America and Germany. Middle-income countries with significant manufacturing bases, such as Brazil, Thailand, Malaysia, Turkey and South Africa, and European powers like France and the U.K, are being left far behind. The positive exceptions are Italy and  Eastern Europe, perhaps because of the latter’s close integration with the German supply chain.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • China’s  Anyuang to make T-shirts with robots in Arkansas (Bloomberg)
  • China’ luxury consumer opportunity (McKinsey)
  • China bans ICOs (Bloomberg)
  • Seven reasons China banned ICOs (Fortune)
  • Michael Pettis on China’s slowing growth (Carnegie)
  • China bear turns bullish (Bloomberg)
  • The coming collapse of China’s Ponzi scheme  economy (SCMP)
  • China is going to hit a wall (FUW)
  • The global economy’s new rule maker (Project Syndicate)
  • Chinese millenials will drive global growth (SCMP)

China Technology Watch:

  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)
  • Chinese firms eyeing passenger drones (WIC)
  • Alibaba wants to bring big data to 1 million small shops (Caixing)
  • China’s  Anyuang to make T-shirts with robots in Arkansas (Bloomberg)

EM Investor Watch:

Technology Watch:

  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

 

 

 

 

 

 

Russia is becoming a food superpower (Bloomberg)

Norway’s sovereign fund drops EM bonds (Bloomberg)

Bull and bear markets and capital allocation (Absolute Returns)

Profit margins and mean reversion (Philosophical Econ)

The Growing Role of the ETF in Emerging Markets Investing

ETFs, exchange-traded funds that track indices and are traded like common stocks on stock exchanges, have become enormously popular over the past decade and are an increasingly disruptive influence on the traditional asset management industry. Global ETF assets surpassed $4 trillion in 2017, growing 36% year-on-year, and 2,034 ETFs trade in the U.S. alone. Cost and liquidity are the primary attraction of ETFs, with the largest S&P500 trackers charging fees as low as 0.04% per year.  ETFs have become increasingly important as allocation instruments used by financial advisors and individual investors. Moreover, they are now commonly used by active institutional investors and traders.

Emerging Markets have seen an onslaught of ETF products. In the U.S. alone there are currently 195 EM ETFs being actively traded, representing nearly $200 billion in assets. The category is amply dominated by Global Emerging Markets (GEM) funds, with 70% of the assets. Specific country ETFs, which are widely used by active macro investors, are the second largest group, with 21% of assets. Fundamental strategies, also known as “smart beta,” make up 8% of assets. There has been a proliferation of these products, many launched by traditional active managers, which seek to exploit a specific factor (eg, value, quality, dividends, low volatility…etc.) These products are attractive to issuers because they still command relatively high fees compared to standard GEM ETSs.  The remaining categories are surprisingly insignificant. Regional funds, which used to be a fundamental part of the EM asset class, represent only 3.3% of ETFs, and are highly dominated by Asia. In contrast to the U.S., sector funds play almost no role in EM ETFs. EM sub-categories (frontier and BRIC, mainly) also are of little importance.

The EM ETF category is very dominated by four massive and growing GEM funds: Vanguard’s VWO, Blackrock’s IEMG and EEM and Schwab’s SCHE.  Fees have consistently declined for the big funds, with Schwab at the current low of 13 basis points per year. Ishares’s EEM is a complete outlier in terms of fees in this group, charging  0.72% of assets. As the first GEM fund to be launched (2003), EEM probably has legacy cost issues. For the time being, EEM can sustain this situation because its huge daily volume makes it the vehicle of choice for large hedge funds and institutional traders and investors seeking exposure to emerging markets. To compensate for the inevitable decline of EEM, Blackrock launched IEMG in 2012, with fees in-line with the competition.

Specific country funds are dominated by Blackrock’s MSCI-based ishare funds. These products maintain relatively high fees because their liquidity makes them the vehicle of choice for macro-investors, traders and allocators. Outside of the ishare products, almost all the activity of significance is in Asia where a panoply of country specific “smart beta” and sector products have been developed for China and India.

Fundamental smart beta products have also prospered in the GEM space and sustain high fees. These funds are aimed mainly at individual investors and financial advisors. Product sponsors offer “alpha-generating” factor tilts and other characteristics considered attractive to investor, such as high dividends, “quality,” low volatility, currency hedging, environmental consciousness (ESG) and leverage. The category is dominated by multi-factor funds that tilt stock allocation in favor of a combination of the value, momentum, quality and low volatility factors. The largest fundamental ETFs are listed below.

 

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • New China Maglev train moves ahead (China Daily)
  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch:

Investor Watch:

Notable Quotes:

“I’m very optimistic about the prospects of the Artificial Intelligence industry in China, probably more so than back 20 years ago when china started with the online internet. The reason being two: one is you need data for AI development and we have tons of data whether its Alibaba’s transaction data, social network data from Wechat, etc. And on top of that when you are looking at the researchers and experts in that space many are Chinese and if you are looking at quotations in research papers the Chinese AI research in the world has a very decent market share. And so, with that I think we have a very good chance to take a lead. In fact, fundamentally what is AI in the whole science field: its mathematics and statistics and China has very strong talent in these two areas.” Sequoia China’s Neil Shen (The Economist)

“When it comes to assessing political matters (especially global geopolitics like the North Korea matter), we are very humble. We know that we don’t have a unique insight that we’d choose to bet on … We can also say that if the above things go badly, it would seem that gold (more than other safe haven assets like the dollar, yen, and treasuries) would benefit, so if you don’t have 5-10% of your assets in gold as a hedge, we’d suggest you relook at this. Don’t let traditional biases, rather than an excellent analysis, stand in the way of you doing this (and if you do have an excellent analysis of why you shouldn’t have such an allocation to gold, we’d appreciate you sharing it with us.)” Ray Dalio, Bridgewater

Notable Charts:

 

 

Emerging Markets Valuations in a Global Context

 

Successful investors are never shy to avoid expensive markets, preferring to build cash reserves to deploy when other investors are less greedy and more fearful. Much of the success of investors like Warren Buffett or Seth Klarman (Baupost) has come from having plenty of cash on hand when markets suffer cyclical downturns, like in 2000 and 2008. Klarman was once asked by a client why he should be paid his high fees for holding very large amounts of cash (sometimes well above 50%). His answer: “You are paying us to decide when to hold onto cash and when to invest.”

Well, it appears it may be happening again. It was revealed this week that Buffett’s Berkshire Hathaway holds over $100 billion in cash, and Klarman also has well over a quarter of his fund in cash.  Meanwhile individual investors have reduced cash to the lowest levels since the peak of the 2000 bubble.

Buffett and Klarman are not alone. It is commonly accepted by market historians, though certainly not by technicians and momentum traders, that the U.S. market is at very high levels. This view is based on the premise that market valuations mean-revert over time in a somewhat predictable fashion. Though valuations are by no means a timing instrument, they do have a good track record of predicting long-term (5-10 years) future returns. For example, Robert Schiller’s CAPE ratio (Shiller), which measures valuations based on 10-years of inflation-adjusted earnings, currently shows extraordinarily high levels, which at least in the past have been highly predictive of  low prospective returns.

Shiller CAPE Ratio

Crestmont Capital’s extremely thorough analysis of U.S. valuation (1926-2017) history points to a near certainty of lower than normal returns from current levels. Historical U.S stock market returns of 10.0%, came from nominal earnings growth (5.1%), price-earnings multiple expansion (0.6% annually, starting from a low level of 10.2 in 1926) and dividend yield (4.3%).  Annual Real GDP growth and inflation over the period averaged 3.3% and 2.9%, respectively, both of which are currently expected to be lower over the next ten years. The table below shows Crestmont’s absolute best case forecast for market returns for the next ten years to be in the order of 7.1%, well below historical levels. Earnings growth is optimistically assumed to grow 5.1%, in line with history, even though GDP growth and inflation are both likely to be lower. Price-earnings ratios are assumed to remain at the current very high levels. Dividend yield is determined by current valuations. Any contraction of PE levels or lower than historical earnings growth would result in lower returns.

The logic of Shiller’s CAPE and Crestmont’s analysis leads to forecasts of low expected returns for U.S. equities, and all other asset classes impacted by similar factors. For example, relying on historical analysis and reversion-to-the-mean assumptions, Jeremy Grantham’s GMO  (GMO) predicts abysmally low returns for almost all of the asset classes it follows.

Similar analysis produced by Research Affiliates points to equally poor results for the next decade: near zero real returns for U.S. stocks, 2%+ returns for international stocks and 6%+ stocks for emerging markets:

Both GMO and Research Affiliates highlight the relative attractiveness of emerging markets equities in a very low return world. An extended period of under-performance of emerging markets relative to the U.S. market in particular has created a significant gap for investors to exploit. Not only are emerging markets cheap relative to the U.S. and other developed markets, they also are inexpensive relative to their own history. On a cyclically adjusted basis (CAPE EM), valuations in EM are still below average and very far from historical peaks, in contrast to the U.S. which is well above average and near historical peaks. Price earnings ratios  for EM, are near historical averages, in a world where most asset prices are well above historical levels.

To conclude, a further comment on U.S. valuations is in order. It can be argued that current U.S. valuations reflect the reality of extraordinarily low interest rates. The puzzle lies in determining the cause of these low rates; is it Federal Reserve manipulation?; is it deflation caused by globalization and technology?; or does it point to low real growth in real GDP and earnings  in the future caused by demographics and low productivity? The answer to this puzzle will likely explain the short term course of the U.S. market.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch

  • Bangladesh’s rise to manufacturing powerhouse (FT)
  • Venezuela’s total collapse (Project Syndicate)
  • Venezuela was once Latin America’s richest country (WEFORUM)
  • Military unrest on the rise in Venezuela (Geopolitical Futures)
  • In Brazil highway robbery is a growth industry (Bloomberg)

Investor Watch:

Notable Quotes: (Avondale)

It’s a low return high risk world

  • “Markets normally respond to elevated uncertainty with lower asset prices and compensatorily higher returns. But that’s not what we are encountering today. We are living in a low-return, high risk world and an environment where most investors are happy to bear risk.” —Oaktree CEO Jay Steven Wintrob (Investment Management)

China is likely to lead the world in electrification

  • “China’s forecasted to lead the global trend in Powertrain electrification, representing over 50% of unit production in 2025, reflecting a 40 fold increase over today’s levels. We remain optimistic about the China market as a result of the underlying macro trends which include increased government focus on emissions regulations, which are increasing demand for China’s new energy vehicles” —Delphi CEO Kevin Clark (Auto Parts)

Australian Iron Ore is being sold to traders, not users

  • “what these guys are doing, these guys mean, for abundance of clarity, Fortescue, BHP and Rio Tinto, Vale and even the midget, Roy Hill, they sell to traders. And these traders do not have blast furnaces. They buy because it’s cheap to borrow money in Chinese banks. Then they put that iron ore in the ground, not in a blast furnace, at the port. And then they go back to the banks, and say, hey, I have collateral, can I borrow more? And the banker say, yes, and they borrow more, and they buy more for the same idiots…That’s my problem with the business in Australia. Then comes the question, will this be happening forever? Yes or no? Of course, the answer is no. One day, this bubble will burst. And on that day, people will say, oh, we are surprised that we are not seeing iron ore inventories going up.” —Cliffs Natural Resources CEO Lourenco Goncalves (Iron Ore)

Notable Charts:

The Lottery of Stock Picking

Academic research has highlighted the high risk of investing in individual stocks. Stock-specific risk, in contrast to market risk, can be diversified away, so investors are not compensated for taking it. One study by Blackstar Funds  (The Capitalism Distribution), for example, showed that for the period 1983-2006 the 3,000 largest U.S. stocks had an average return of -1.1% compared to a 12.8% return for the Russell 3000 Index. 39% of stocks lost money during this 25-year period and all of the market return could be attributed to 25% of the stocks. Like most indices used by investors the Russell 3000 is market-capitalization-weighted, which means that the losers have increasingly smaller weights in the index while the winners constantly increase their weight. The indices follow mechanically the trend-following rule of cutting losses and sticking with rising stocks.

Another study by Hendrik Bessembinder (Do Stocks Outperform Treasury Bills) provides more recent data. Bessembinder covered all U.S stocks for the 1926-2015 period. According to the study, only 42% of stocks beat the returns of 1-month Treasury bills and less than half of stocks achieve positive nominal returns over their lifetimes. Over this 90-year period, only 86 stocks accounted for 50% of returns and an incredible 96% of stocks did not surpass the returns of 1-month treasury bills. Bessembinder compares stock-picking by individuals as “lotterylike” behavior; the hope of picking an Amazon and seeing it appreciate by thousands of percent.

What can be said  about the experience of emerging markets? Our data history is short and complicated by frequent changes in the indices, including the addition and exclusion of entire countries. Nevertheless, looking at Ishares Emerging Markets (EEM), which is based on the MSCI EM Index, for the period starting at year-end 2016 until mid-year 2017, we can draw some interesting parallels.

  • Of the 274 stocks in the index in 2006 only 148 (54%) remained in July 2017. These 148 remaining stocks provided a nominal return of -46.1% over the period, compared to a 7.5% return (before dividends) of EEM.
  • Of the top 10 stocks in 2006 (Gazprom, Samsung, TSMC, Posco, Kookmin Bank, Lukoil, UMC. KEPCO, Chunghwa and Silicon Precision) all except for Samsung, TSMC and Chunghwa have underperformed, dramatically in the case of the commodity stocks, Kookmin and UMC.
  • Of the original stocks only a handful have had good performance: Naspers, TSMC, Samsung Electronics, Ambev and Steinhoff.
  • Positive returns can be attributed to a few stocks, mainly East Asian tech stocks: Tencent-Naspers, Alibaba, TSMC, Samsung Electronics, Hynix, Netease, JD.Com, Naver, CTRIP and Largan.

The case of South Africa’s NASPERS is an interesting illustration of the “lotterylike” nature of investing. NASPERS has long been Africa’s most important and valuable media company. Like almost all South African corporates it began reducing its domestic exposure some twenty years ago. Adopting a incubator-venture capital model, it adopted a shotgun strategy, investing in a multitude of media and e.commerce ventures around the world,  including a stake in China’s Tencent in 2001. NASPERS’s business in Africa has stagnated and most of its foreign investments have floundered, except for Tencent where it hit the jackpot. Naspers’s original $34 million investment in Tencent in now worth $120 billion. Interestingly, the entire market value of Naspers is only $88 billion, so the market gives little real or optional value for the remaining assets.

Most individuals and professionals alike don’t have an identifiable edge in picking stocks and are compelled to the exercise for the lottery-like thrill of hoping to pick a winner. Picking a winner and holding on to it can be hugely profitable and make a career.

Us Fed watch:

India Watch:

  • Outsourcers are returning to the U.S. (NYT)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

China Consumer Watch:

  • Starbucks bullish on China growth Caixing
  • China’s Wanda slims down (NY Times)

China Technology Watch:

  • China’s surveillance giant, Hikvision, is worth $55 billion (WIC)
  • China’s phones growing share in EM (SCMP)
  • Chinese cellphone brands account for half of global sales (SCMP)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch:

  • South Africa’s great reconciliation is coming apart (WSJ)
  • Brazilian billionaires swap assets (bloomberg)
  • EM Valuations strong buy signal (Wisdom Tree)
  • Revisiting Allocation decisions in EM (GMO)
  • EM ETFs don’t all track the same index (ETF.com)

Technology Watch:

  • Summer of Samsung (Bloomberg)
  • TVs are disappearing from American homes (Recode)

Investor Watch:

Notable Quotes: (Avondale)

This quarter may have been more challenging than advertised

“this indeed was another challenging quarter and as I think we all know, the industry continues to face global market volatility and we have seen a further slowdown in consumer demand in several key markets, most especially the U.S. Southeast Asia and South Pacific.” —Colgate CEO Ian Cook (Packaged Goods)

Healthcare: Birthrates around the world have been disappointing

“So we had kind of projected 2016 was going to be a flat birthrate year. In the second quarter, we got the final fourth quarter numbers that showed it down 2% for the fourth quarter, which brought the full year down 1%…Korea’s birthrate…was down 7%, which is a pretty big, big drop…we don’t really understand it at a deep enough consumer insight level…But a broad trend is that Millennials are having their children a little later.” —Kimberly Clark CEO Thomas Falk (Packaged Goods)

There’s a lot of capital sloshing around the world

“there is a lot of capital that’s being raised and has been raised. And in general, there is just a whole lot capital sloshing around the world, looking for returns. ” —Blackstone COO Tony James (Private Equity)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Charts:

 

 

 

 

 

 

 

 

 

 

 

Emerging Market Portfolio Managers Against the ETFs

In the world of emerging markets it has generally been presumed that managers can justify higher fees for this asset class because they add more value. It is argued that emerging markets are less efficient because they are complex and under-followed by professional investors.  The relatively scarce qualified portfolio managers and analysts with the skills and experience to navigate the territory should command higher compensation.

While low-cost indexed products have increasingly disrupted the asset management industry, the arguments in favor of active management for the emerging markets asset class have persisted: (Bloomberg)

  • Market inefficiency – More complexity and less professional analysis gives a tangible advantage to managers capable of conducting in-depth research.
  • Benchmark composition – The index benchmark is full of unattractive countries, sectors and companies, that can be avoided by skilled managers. For example, heavy index weightings in poorly managed state enterprises and commodity producers can be avoided to outperform.

Moreover, EM managers may have the advantage that because of its relatively short history as an asset class less academic research has been conducted on performance factors. While in the U.S. academic research has identified the performance “anomalies” caused by tilting portfolios for value, size, quality and momentum, these factors are less well understood in EM and may be easier to exploit by managers.

The evidence partially supports the argument that professional managers of emerging markets funds add value, at least in comparison to managers of U.S. domestic and international funds.

For example, the table below shows the latest results of Morningstar’s Active/Passive Barometer (Morningstar ). Active EM managers, despite higher fees, are seen to perform better than their peers in U.S. and International asset classes, with particularly impressive results over the three and five year periods. On an asset weighted basis, which gives greater consideration to the larger funds, performance is even better. (Note, the data does not consider the greater tax efficiency and lower acquisition costs for ETFs).

The SPIVA Scorecard published annually by S&P Dow Jones Indices (S&P Indices)  shows much less impressive results for EM active managers. SPIVA claims to have a more rigorous approach, adjusting results for survivor bias and for style (e.g., growth vs. value). The SPIVA scorecard shows EM active funds under-performing indices over all periods, largely in a fashion similar to U.S. and International funds. As with Morningstar, SPIVA shows larger managers with better results.

Part of the discrepancy between SPIVA and Morningstar can be explained by the significantly stronger performance of the S&P/IFCI EM Index used by SPIVA compared to the ETF composite used by Morningstar. This causes confusion as both ETFs and active funds use various indices, and neither study adjusts for this. In any case, both reports agree on several points. First, active managers have not created value over the long term; second, larger asset managers create more value. The better performance of the larger funds may show that larger managers with greater analytical resources can add more value.

The Morningstar report also points out that the primary source of outperformance relative to peers for active managers is lower fees. This may also explain the better performance of the larger managers, assuming that they are passing on the benefits of scale economies to clients.

Certainly, the disruptive influence of EM indexed products will not go away and may worsen. It may be that EM active managers have benefited of late from the bear market of the past five years for several reasons. First, during down markets active managers benefit from holding cash. This becomes a source of performance drag during bull markets, and we may have already seen this effect during 2016. Furthermore, assuming positive performance for EM equities, indexed products are likely to be more formidable competitors in coming years, as they tend to outperform in bull markets.

Index products should be easier to beat in a five-year bear market for EM like the one we saw between 2011-2016. The benchmarks which most active managers as well as ETFs observe are market cap-weighted indices, which makes them classic trend-following instruments. When markets are rising and flows are abundant, the index keeps on increasing position sizes in winners and reducing positions in laggards. This led to huge positions in commodity stocks in 2006-2007 and to very high weightings in tech companies today. During bull markets, most active investors become nervous about valuations and the size of positions and retreat ahead of the indices. In a bear market the process reverses. The index pressures prices by selling its largest most overvalued positions. The collapse of commodity stocks during 2012-2014 created “easy alpha” for managers who were comfortable in stepping aside and waiting for valuations to return to normal levels.

The dilemma for EM managers is the same faced by managers in all asset classes disrupted by low-cost index funds. To justify their existence managers have to take much more risk than they are comfortable with. The vast majority of professionally managed funds can be considered “closet index funds” in the sense that they manage around the index. The difference between the portfolio and the index is known as the “active risk.”  Many actively managed funds will have around 15% of active risk, the remainder of the portfolio mimicking the benchmark. The problem is that an ETF like Vanguard’s VWO, charges a management fee of only 14 basis points (0.14%), while the active manager charges, on average, 1.5%  even though  85% of his assets only mimic the benchmark. Clearly identifying this issue, a firm like Blackrock, which manages both ETFs and active funds, is moving aggressively into highly concentrated actively managed portfolios with very high levels of active risk.

However, moving to highly concentrated portfolios with high active risk is something that very few managers can countenance. AS GMO’s Jeremy Grantham  never tires of saying, the primary behavior driver of asset managers is career risk ( GMO ). Unfortunately, the proliferation of low-cost alternatives is undermining the economics of the asset management industry and decreasing job security just at the time that managers need to embrace risk.

Us Fed watch:

India Watch:

  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

China Technology Watch:

  • China outlines plans to be world leader in AI (Caixing Global)
  • Lenovo announces big push into AI (SCMP)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

  • Emerging Markets rally has “legs” (Van Eck)
  • Revisiting Allocation decisions in EM (GMO)
  • EM  breaks 10-year downtrend (The Reformed Broker)
  • The bullish case for EM (Mark Dow)
  • EM ETFs don’t all track the same index (ETF.com)

Investor Watch:

Notable Quotes: (Avondale)

 

Emerging markets have been weak for a long time: “since the financial crises, interest rates, currencies etcetera, we’ve had a prolonged period of about eight, nine years now where we have seen significant weakening of emerging market currencies…you actually see the volume component of these emerging markets continuing to be very, very low, while historically it was all volume-driven growth. I am convinced that that is coming back now.” —Unilever CEO Paul Polman (Packaged Goods)

China may be stabilizing: “China for example is actually much more stable than the last 12 to 18 months. I like what I’m seeing in China right now.” —Abbott CEO Miles White (Medical Device)

Chinese are still buying international assets: “we’re still seeing the trend of Chinese buying and international assets. ” —Goldman Sachs CFO Martin Chavez (Investment Bank)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Chart:

In Emerging Markets The Only Constant is Change

Antoine van Agtmael, the man who coined the term “emerging markets,” was a pioneer. His firm Emerging Markets Management was founded in 1988 to provide institutions access to what was at that time a very small emerging markets asset class, with fewer than 20 companies with revenues over $1 billion, almost all of them either banks or commodity producers. In his book, The Emerging Markets Century (2007), van Agtmael stressed the violent pace of change for the asset class. Fifteen years after launching the fund, 80% of the largest 100 companies had disappeared from the list. Not one of the top ten most valuable stocks remained 15 years later. Several factors drove this revolution, according to van Agtmael.

  • The move of China, Russia and Eastern Europe from centrally-planned to market-oriented economies and their integration into the global economy through trade and investments.
  • A neo-liberal wave of privatizations across emerging markets, leading to private investment in energy, telephone and power companies and a wave of public listings.
  • Improved economic policies and lower tariffs (The Washington Consensus), resulting in the control of hyperinflation in Argentina and Brazil, fiscal discipline and deleveraging in Asia and trade expansion.

The chart below  lists the top ten most valuable emerging market stocks in 1990 and 2005, taken from van Agtmael’s book. I have added the current standings, as of July 2017.

 

These lists give us several valuable insights on emerging markets investing.

  • Change is constant. The “revolution” continues. The 1990 list was dominated by Taiwan which was at the top of an epic stock market bubble. The 2005 list is dominated by commodity stocks, propped up by the China-induced commodity bubble. The current list is all China and tech. Emerging markets have their own version of FANG (Facebook, Apple, Netflix, Google), which is BATS (Baidu, Alibaba, Tencent, Samsung).
  • The drivers cited by van Agtmael have lost traction. We are seeing a backlash against neo-liberal reforms and globalization, and few privatizations. Countries with large domestic markets to protect and exploit are now seen to have the advantage.
  • Bubbles in specific geographies or segments can have a huge impact on performance. The 1990 list coincides with the peak of the great Taiwan bubble. Bubbles in Mexico (1992), Malaysia (1996), Brazil (1997), Korea (2005) had similar distortionary effects on the rankings. Same for the  commodity bubble (2005-2010), which rules the 2005 list. The 2017 list is greatly impacted by the current boom in tech stocks. There seems to always be a major bubble brewing somewhere in emerging markets.
  • There are fewer changes between the 2017 list and the 2005 list than there were between 2005 and 1990, with four stocks remaining on the list. All of the surviving stocks are either China or tech related, which may indicate we are seeing long-term secular shifts happening.
  • The expansion of China in general and China and tech in particular seem inexorable. Or are they? Only time will tell. Of the 2017 top ten, eight are essentially Chinese stocks, as Naspers’s value is mainly in its holdings in Tencent and Hon Hai’s operations are mainly based in China. Only Samsung and TSMC are independent of China. China’s market weight is likely to grow further, as its economy grows above the global average and benchmark indices include more Chinese stocks.
  • India’s absence is noteworthy. If the current hype on India is justified, ten years from now we will likely see a few Indian names on the list.

 

Us Fed watch:

Brazil Watch :

India Watch:

  • The Indian economy; a tale of two narratives (Livemint)
  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

  • China broad credit growth slows to zero (Variant Perception)
  • Making sense of China’s foreign M&A (McKinsey)
  • Zombies are dragging down China’s productivity (Bloomberg)
  • The CEO guide to China (McKinsey)
  • The Chinese bought $32 billion in U.S. residential real estate in 2016 (WSJ)
  • Xi’s Tiger Hunt (Sinocism)

China Technology Watch:

  • Chinese military drones gaining foreign markets at U.S. expense (WSJ)
  • JD.COM invests in drone delivery (China Daily)

China Consumer Watch:

  • Chinese have all the appliances they need (SCMP)
  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

Investor Watch:

Notable Charts:

 

The Case for Emerging Markets

Warren Buffett and Jorge Paulo Lehman, two of the best investors of the past decades, recently met with students at a conference at the Harvard Business School organized by Brazilian business students. Asked for their opinion on opportunities for investing in emerging markets, both Buffett and Lehman deflected the question, preferring to highlight a preference for the depth and wealth of opportunities available in the United States. “If we’re going to prospect,” Buffett said, “this is a huge, huge market, and if there is something modestly better where I don’t understand the culture that well or the laws of have an acquaintance with the business people and were missing that that doesn’t bother me at all.” “America”, he added, “is a pretty darn good place to invest.”
Should the individual investor follow the advice of the Sage of Omaha? Surely there is wisdom in investing in things that one understands, and the dynamism and diversity of the American capital markets are unsurpassed. Yet, there is a good case for allocating some capital outside the United States.
When Buffett started investing in the 1950s and 1960s the U.S. was a global hegemon with a preponderant economy and matchless capital markets, but today the global economy is increasingly driven by Asia. Aging populations, low productivity growth and high levels of debt in the U.S. and other developed countries point to slower growth than in the past. Younger populations and more opportunities for increasing productivity mean that emerging markets can count on relatively higher economic growth and expanding capital markets. Most of the wealth creation in the world today is being generated in Asia. Many traditional industries, such as oil and electricity, face declining volumes in developed markets, and will rely entirely on emerging markets to sustain any growth.
In addition to providing investors the opportunity to tap into the faster growing economies of the world, Emerging markets provides the investor with some diversification, the only “free lunch” in the investing world.
Notwithstanding Jorge Paulo Lehman’s appreciation for the depth and scale of the U.S. capital markets which he now finds indispensable to deploy the fire-power of 3G Capital, his partnership continues to treasure its Brazilian roots. The beer and food empire which now includes Budweiser and Kraft all started from nothing some 30 years ago in Brazil, and even today the group harnesses the best of Brazilian entrepreneurial creativity and dynamism. After the recent merger of ABInBev and SABMiller, Lehman’s beer juggernaut will have more than half of sales and practically all of its growth generated by its breweries in emerging markets. As Lehman told the Harvard students, though “America is wonderful compared to the rest of the world,” beer is not growing in developed markets, so ABInbev has gone to Africa in “a big way” where “there is a hot climate, young population” that will double from 1 billion to 2 billion in the next thirty years. AbInBev now has six of the top ten best-selling beer brands in China, the largest potential source of earnings growth for the global beer industry in the coming decade, and near-monopolistic positions in the African and Latin American continents.
This blog will explore the opportunities for investing in emerging markets created by entrepreneurs like Jorge Paulo Lehman. It will seek to educate the common investor about the main trends in these markets and explore the controversial issues that affect the investor in emerging markets.

Us Fed watch:
• Ady Barkan sees changes coming at the Fed (Fed Rethink Coming ).
• Ben Hunt on who is master of the FED( Tell My Horse).
• Larry Summers on Why the Fed is making a mistake(Larry Summers)
• Unprecedented valuations of financial assets (The Felder Report).

Emerging Markets Watch :
Bloomberg says BRICS are back in favor. (Bloomberg)

Brazil Watch :
• Brazil’s Argentina Moment Project Syndicate

India Watch :
• A New Emphasis on Gainful Employment In India McKinsey

• India’s PayTM said to seek license to offer money market fund. Bloomberg

China Technology Watch:

• China Shatters “Spooky Action at a Distance” Record, Preps for Quantum Internet  Scientific American

Commodity Watch:
• “The mining methods of the past have changed. And where we’re controlling mines from for the future from pit support is located in office buildings instead of the mine sites…I was talking to a customer last week about autonomy and they have a goal to be fully autonomous on every mine site by 2025. And they have thousands of pieces of equipment. So, you’ve got these bold goals being placed out there. So, clearly, the momentum is moving.” —Caterpillar Resource Industries President Denise Johnson (Mining)
• And this chart from Martin Katusa shows how weak demand and declining production costs lead to low prices, and commodity prices at all-time lows relative to the S&P 500.

• Fear is What Changed Saudi Arabia (WSJ)
• “You go to Asia. You go to Europe. You go to the Middle East. They realize the position of the U.S. in the world is different today because of this change in our energy position. Among other things, the sanctions on Iran would not have worked had it not been for shale, because you could not have replaced the Iranian oil that was taken off the market. And so now instead of just OPEC and non-OPEC, you have the big three. You have Saudi Arabia, you have Russia, and you have a country called the United States.”— Daniel Yergin, vice chairman, IHS Markit (WSJ)
• Measuring Labor Productivity in the Gold Mining Industry S&P Global Market Intelligence
• The Collapse of South Africa’s Mining Sector Valuewalk

Technology Disruption Watch:
• Amazon’s New Customer  Stratechery
• Why Amazon Bought WholeFoods L2

Anti-Globalization Watch:
• Commerce Secretary Wilbur Ross Talks Trade  WSJ

Notable Blogs:
• On My Radar: Investment Ideas — Notes from the 2017 Strategic Investment Conference   CMGwealth
• Peak Stimulus has Passed  CreditBubbleBulletin
• Yardeni on tech valuations Yardeni
• On momentum investing and buying all-time highs. Of dollars and data

Notable Quotes:
• “Xi’an only has a little over 40 Starbucks at the moment. This is definitely not enough. I think 400 would be more appropriate.” Wang Yongkank, Party Secretary of Xi’an, as reported by Week in China.
• “The reality is that as a planned economy and with the government having control of the major banks and large companies, a financial crisis is simply not in the cards.” Mark Mobius, Templeton Investments on China.

Notable Chart from Gavekal Research