A few months ago, local brokers in Manila were wondering what was I doing in their city. Apparently I was a year late. While in 2017 the local bourse jumped 25%, since January 2018 the MSCI Philippines index had fallen 15%.
As they went on to explain, foreign investors tend to invest in the Philippines in waves. And I had missed the last one. When it comes to emerging markets, foreigners tend to focus more on trading than investing. It’s hard to blame them.
The US-dollar annualised return of the MSCI Emerging Markets index has been 3.8% over the past ten years, compared with the MSCI World Index at 7.7%. This suggests that trading has likely worked better than buying and holding. The risk of a permanent loss of capital is also higher than in developed markets.
Emerging markets are riskier
Governments frequently intervene in many emerging markets. This covers everything from unfavourable regulation to the Chinese government’s direct intervention in the sharemarket and even the risk of expropriation in some more fragile political environments.
Corporate governance standards are still low. If the government is not running the show, then a controlling family most likely is. Minority shareholders’ interests can often take a back seat. Liquidity is also low. It can take only a few relatively small trades to move stock prices meaningfully.
Finally, investors are exposed to local currency depreciation. This can quickly wipe out the value of their investments. The fall over the last six months of the Argentine peso and the Turkish lira by 50% and 34% compared to the US dollar is emblematic.
These risks are all real for overseas investors. But they also should be well understood. When investors face riskier investments they should demand higher returns. Which implies paying lower prices.
The low returns of the past decade* suggest investors were overpaying for stocks in emerging markets.
Economic growth and stock market performance
An explanation could be that most investors are attracted to the growth of emerging economies. But there is no evidence of a correlation between GDP growth and stock market returns (if anything, there is some evidence of a negative correlation). Studies have shown that workers and consumers often benefit the most from economic growth. Not shareholders.
Growing economies usually attract a lot of capital, and often the returns on that capital end up being worse than in slower-growing economies due to fast change and ferocious competition. Investors tend to focus too much on sales growth and too little on industry structures and company-specific competitive advantages, which eventually determine whether growth translates into profits.
The case for emerging markets
All that said, with prices down so far this year and investors bailing out of emerging markets en masse, might now be the time to consider an increased allocation?
Maybe. If you are considering it, here are some of my thoughts after dipping a few toes in the water and losing the odd piece of skin.
Investing in emerging markets shouldn’t be any different than investing in developed ones. You estimate the present value of an investment’s cash flows and buy at a discount to that value to compensate for the many risks. Keeping this in mind, there are a number of specific things to consider when looking for value in emerging markets.
You should be looking for much bigger discounts to compensate for the higher number of investments that are likely to go wrong.
If you can hedge the currency at a reasonable cost, it probably pays to do so. You might give up some of the upside but this would give you some protection from the extreme downside.
Look for companies that have automatic stabilisers. Meaning, for example, that a lower currency could help the business perform better. This is usually true for exporters provided that most of the production inputs are sourced locally. Avoid companies with foreign currency borrowings but mostly local operations.
Portfolio weighting to any one country should be small enough that you can stomach a loss of close to 100% – treat country exposure as you would one individual risky stock.
And finally, use volatility as your friend. While the average return hasn’t been great, the volatility over the past ten years has meant that you could have entered and left on numerous occasions as other investors’ enthusiasm has waxed and waned and done much better than average.
The time to visit your Filipino brokers is precisely when they are most surprised to see you there**.
* The MSCI Emerging Markets index returned 10.8% per year since its inception in 1987. This performance is nothing to be sneezed at. But considering that developed markets returned over the same period 8.0% per year at a fraction of the risk, emerging markets’ performance remains disappointing.
** We did end up making a small investment. It is currently in the process of being taken over, at a nice premium to our purchase price, but a big discount to our estimate of value.
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