Grantham on Emerging Markets and Career Risk

[NomadicRiley]

(2nd article in the PDF)

 

https://www.gmo.com/docs/default-source/public-commentary/gmo-quarterly-letter.pdf?sfvrsn=48

 

Anyone know what GMO uses as their index/fund/etf for "Emerging Markets Value"?

[Read the Footnotes]

GMO has their own Emerging funds for institutional investors, they also offer private funds, if you can meet a $1MM or $5MM minimum. The last time I looked I found there are a couple of ways small investors can get access to GMO's strategies but they are broad asset allocation strategies not limited to EM. Though their commentary is very useful, it's important to keep in mind who their audience is for their white papers. Most of their communication is primarily aimed at potential and current institutional clients.

 

The EM benchmarks GMO uses for performance comparison are:

http://us.spindices.com/indices/equity/sp-ifci-composite-price-index-in-us-dollar

https://www.msci.com/emerging-markets (and variants)

 

If I were a HNWI looking to increase my exposure to emerging markets value, I would look in to these opportunities:

 

https://bonhoeffercapital.com

http://www.acipartnership.com/about_us.php

 

 

[NomadicRiley]

Thank you for the additional details.  I was confused because in their previous "7 year forecasts", I had only ever seen them have a category for Emerging Markets, not Emerging Markets Value.

[Read the Footnotes]

Ah, that makes sense. They have many more forecasts that they share with clients which are not widely disseminated. Occasionally they share with non-clients additional forecasts for an extra asset class or two.

 

In the past their slide decks that I saw would frequently contain forecasts for 40 different asset classes, or more.

[cubsfan]

I love Grantham - imagine you are the pension fund manager for Joseph Stalin: you under-perform his target benchmark, and you are shot. You over-perform, and you get a Black Sea vacation, and a dacha in the country.

Now that is real career risk!

[Jurgis]

I love Grantham - imagine you are the pension fund manager for Joseph Stalin: you under-perform his target benchmark, and you are shot. You over-perform, and you get a Black Sea vacation, and a dacha in the country.

Now that is real career risk!

 

If you're in Saudi Arabia maybe you get house arrest in Ritz Carlton... as a first step...  ::)

[Broeb22]

Have recent events in emerging markets pushed people to look a little closer? If so, what are you finding?

 

I’ve made a few purchases of companies in emerging markets that are more consumer focused, such as JD in China, PAGS in Brazil, and DAVA in Eastern Europe. None of these are cheap by any stretch, but are all in my opinion strong businesses whose growth will make their multiples look cheap in a couple years.

 

I welcome any company specific bear arguments, commentaries on EM in general, or new ideas...

 

I heard a PM talk about Loma Nebra on a Grant’s podcast...it’s a cement producer, but doesn’t generate much cash.

[sarganaga]

This is what I'm using for Emerging Market exposure ... First Trust Emerging Market Small Cap AlphaDex (FEMS) , which blends value & momentum factors. Not especially pleased with the .8% management fee, but I don't think I could come close to duplicating this on my own & it's cheaper than what the hedge fund/mutual/private account wizards charge.

Nice metrics according to Morningstar http://portfolios.morningstar.com/fund/summary?t=FEMS&region=usa&culture=en_US

 

 

 

mid 6 figure position fwiw

[thelads]

I am certainly no expert in EM. Grantham may well be, and probably is right, about forward returns 10 years and more further out. However, the path risk is very big. One thing that I have not seen mentioned nearly enough is the growth and structure of debt markets in the various markets / geographies we call EM. Frankly, I think you would be shocked at how little, on average, the debt funds who traffic in EM corporate, or Quasi-Sovereign bonds / debt actually know about the legal standing of their creditor positions. How the restructuring / bankruptcy processes work, and their real rights. As importantly, they seem to have disregarded what may happen in terms of the wait period if you see a lot of defaults. This is just my humble opinion, but most don't know what they own at all (from an accounting perspective) nor their rights (when things really go wrong) and also have the wrong liquidity. This is a market that really only developed in the past 15 or so years (Sovereign / Government Bonds are a different matter).

 

That is not a good fact pattern. The implications of this over a 10 year period aren't neccesarily bad. But for the coming 2-3 years, if things should get bad, or if debt funding is withdrawn it could be catastrophic. Any big decline in such credit products are very likely to affect the end economies and the equity markets associated. It would be naive in my opinion to think otherwise. However, I think that would present an incredible buying opportunity in a lot of names.

 

Please don't get me wrong, there are many many great companies who will have a minor hiccup and just move on. They tend to have survived far worse than what I envision. But their price will get hit for sure. I mention this as people always seem to say, before an event, that they are fine with the vol, and the path risk and what not. They tend to think and behave differently when events happen. It's human nature, I am no different. With that in mind, I fear waving stuff in here in EM - though I know of a few good companies in different geographies.

 

Anyhow - just an opinion, and not a terribly strong or deeply entrenched one. Just based on some minor study and anecdotes.

[Guest]

lads,

 

good to see you posting again. A little over a year ago you talked about the risk of emerging markets and helped me keep my position small. Thanks for all the insight! it's much appreciated! :)

[kab60]

Have recent events in emerging markets pushed people to look a little closer? If so, what are you finding?

 

I’ve made a few purchases of companies in emerging markets that are more consumer focused, such as JD in China, PAGS in Brazil, and DAVA in Eastern Europe. None of these are cheap by any stretch, but are all in my opinion strong businesses whose growth will make their multiples look cheap in a couple years.

 

I welcome any company specific bear arguments, commentaries on EM in general, or new ideas...

 

I heard a PM talk about Loma Nebra on a Grant’s podcast...it’s a cement producer, but doesn’t generate much cash.

I took a small position in Despegar recently. Leading LatAM OTA with Expedia and Tiger Global both having stakes (Tiger plus 40 pct.). They're net cash (some 300m held in USD). CFO recently left, which is a negative, and insiders don't own nearly as much as I'd like, but I think it's somewhat interesting though valuation isn't on the cheap side (unless you do a relative valuation and compare to Booking/Expedia on an EV/Sales ratio). It's basically a proven business model, and their leading position+net cash balance sheet should make them come out stronger (if LatAm ever gets better). According to management they're taking share, and they're the lowest cost producer whatever that means in the OTA industry. It's a small position for me and I haven't really figured out why exactly they hold that view (that they're the lowest cost producer nor if they can keep that spot).

[thelads]

Oh I am glad to hear it was of some assistance Stahleyp! Good to chat to you again.

[Broeb22]

 

I took a small position in Despegar recently. Leading LatAM OTA with Expedia and Tiger Global both having stakes (Tiger plus 40 pct.). They're net cash (some 300m held in USD). CFO recently left, which is a negative, and insiders don't own nearly as much as I'd like, but I think it's somewhat interesting though valuation isn't on the cheap side (unless you do a relative valuation and compare to Booking/Expedia on an EV/Sales ratio). It's basically a proven business model, and their leading position+net cash balance sheet should make them come out stronger (if LatAm ever gets better). According to management they're taking share, and they're the lowest cost producer whatever that means in the OTA industry. It's a small position for me and I haven't really figured out why exactly they hold that view (that they're the lowest cost producer nor if they can keep that spot).

 

Despegar is interesting. I think it could get more interesting as they just filed an S-3. From what I understand Tiger Global is liquidating their fund that holds this (which has a vintage around 2010), so there will likely be some more pressure in the short-term, providing an interesting buying opportunity.

 

[kab60]

Despegar is interesting. I think it could get more interesting as they just filed an S-3. From what I understand Tiger Global is liquidating their fund that holds this (which has a vintage around 2010), so there will likely be some more pressure in the short-term, providing an interesting buying opportunity.

It seems you're right. This thing keeps getting hammered. Glad I made this a small position - better lucky than good I suppose.

[DocSnowball]

I am certainly no expert in EM. Grantham may well be, and probably is right, about forward returns 10 years and more further out. However, the path risk is very big. One thing that I have not seen mentioned nearly enough is the growth and structure of debt markets in the various markets / geographies we call EM. Frankly, I think you would be shocked at how little, on average, the debt funds who traffic in EM corporate, or Quasi-Sovereign bonds / debt actually know about the legal standing of their creditor positions. How the restructuring / bankruptcy processes work, and their real rights. As importantly, they seem to have disregarded what may happen in terms of the wait period if you see a lot of defaults. This is just my humble opinion, but most don't know what they own at all (from an accounting perspective) nor their rights (when things really go wrong) and also have the wrong liquidity. This is a market that really only developed in the past 15 or so years (Sovereign / Government Bonds are a different matter).

 

That is not a good fact pattern. The implications of this over a 10 year period aren't neccesarily bad. But for the coming 2-3 years, if things should get bad, or if debt funding is withdrawn it could be catastrophic. Any big decline in such credit products are very likely to affect the end economies and the equity markets associated. It would be naive in my opinion to think otherwise. However, I think that would present an incredible buying opportunity in a lot of names.

 

Please don't get me wrong, there are many many great companies who will have a minor hiccup and just move on. They tend to have survived far worse than what I envision. But their price will get hit for sure. I mention this as people always seem to say, before an event, that they are fine with the vol, and the path risk and what not. They tend to think and behave differently when events happen. It's human nature, I am no different. With that in mind, I fear waving stuff in here in EM - though I know of a few good companies in different geographies.

 

Anyhow - just an opinion, and not a terribly strong or deeply entrenched one. Just based on some minor study and anecdotes.

 

The article is a very interesting read, although the graphs where they show expected dividend and capital returns are difficult to understand (so I can't accept them at face value).

 

Re: your comments: What is the probability you are considering for the middle paragraph scenario? Can you help me, a novice who is starting at 0% non-US equity allocation and desiring to build a 20-30% EM asset allocation over the next year or two, understand this in terms of key metrics to follow? Is there a metric that measures corporate debt ratio to national GDP or some other metric in say India or China that can help understand and quantify this risk better? Thanks for your efforts and comments

 

Edit: Starting to read this...

Lessons Unlearned? Corporate Debt in Emerging Markets

https://www.hbs.edu/faculty/Publication%20Files/17-097_723806cb-9ad0-4d42-b57c-90040627b89b.pdf

[thelads]

Hi DocSnowball,

 

Thanks for the HBS paper. I have not seen that. I will read it today. Just based on the title, I think they have the right theme. I don't have figures I can share in an easy format, without putting in a presentation I did for my prior employer, and I would be violating an agreement with them on that basis. Regardless, the general trend for EM corporate debt since 2003 is that it had grown over 10 fold between then and 2015. It has grown further from there. That is true in each of the 3 major geographic blocks. Investment Grade Corporate debt in the Developed markets have just over doubled over the same period, while HY has a little less than doubled. That is an enormous growth rate for EM. What is more, you saw some real abuses with some of the issues that came. Have a look at what happened to the Sugar and Ethanol names in Brazil that all came in 2013, and how quickly they were broken.

 

In that period of growth, the market went from a non-event, that hardly traded, especially compared to Sovereign debt, to a large market in its own right. When you see such explosive growth of debt in a given area (Mortgages, The Energy Space - yes there is overlap here - though less than you might expect) it is usually a sign enthusiasm has gotten ahead of reality. More insidious, think of the people who invested in the space in 2003-2006? Their expertise, etc. It tended to be in narrow areas, and the market was heavily weighted to very high quality credits. That is not the case now. But think about who the PM's in that space are now? What experience they have. They may be very very intelligent. The ones I have met are. But that is no salve. Their experience is of an ever growing market, where, bar the odd blow up, the trend has been up up and away. The best move has been to participate. Given the growth in outright volume, number of sectors, number of companies etc, not to mention number of countries, can they really understand and navigate things. Do you think they really know what they own? I think these are all reasonable questions to ask. I met with lots of people in the space. Spent a fair amount of time in Latam (over a month in different visits) the same in E. Europe and some time in Asia. Anecdotally, from that experience, I would say on average, and certainly at the margin, people do not know what they own. They are not great analysts outright when compared to those looking at DM credit, or equity, and the things they are dealing with are far more complex, and in areas where corporate governance is often terrible. That is what I mean by a bad fact pattern.

 

Another point is that there is virtually no distressed money dedicated to the space. sure, it can come in from the US if things get very bad, but prices would need to be a lot lot lower. Two large well regarded funds I know off have taken some serious licks when they have ventured in here in the past 3-4 years. That will make the hurdle much higher for their peers looking forward. Why does that matter? Well, it means when things break - you don't have buyers step in until prices gap far far lower. Think 90 cents, to 10 cents, in 2 - 3 trades. If that happens on a bunch of names, funds that have thus far looked reasonably conservative start to look like lunatics. Such a sequence of events is unlikely to inspire confidence. Lets say it spreads, and the credit markets effectively shut down, or do so for 80% of potential borrowers; is it reasonable to expect the equity markets will hold up? I think not.

 

Some anecdotal cases you can look at are: OGX (DIP providers lost 100% of their money after the initial default) / OSX 3 (Check out the bonds there - disaster), OGIMK (one of the 1mdb bonds in Malaysia) and the ARALCO and GVO bonds. Those are just symptomatic. There are worse examples. Another anecdote is from Brazil. The Bankruptcy laws were changed in 2006 or so, and updated to improve workouts. It was a good idea. However, a restructuring there will take a minimum of 7 years. Often a lot longer. In addition, equity often trumps creditors, which many foreigners don't fully appreciate. But I digress. If you look at Petrobras or other quasi sovereigns, the bankruptcy law does not provide for such entities. It is akin to Fannie and Freddie in 2009. There was no provision to cover it. I have spoken to dozens of investors in the credit for that company. Only 1 new this point. That is astonishing to me. Though not entirely surprising.

 

The same massive growth, ignorance, complacency, etc have happened in other large debt growth areas, S&L's in the 80's, Cable and Media in the late 90's / early 2000's, Mortgage Product and Structured Products in the mid 2000's, energy debt more recently. That is all I am trying to get at. I hope that in some way gets at your question. You can look at Debt / GDP, etc, and that will have grown. But I don't think it will act as a predictive signal. I think it is country by country. Brazil looked terrible in this regard. Some others look the same. China is somewhat unique and has its own issues. India is entirely different again. Not to say it will be immune, but it has done very little of this, and demographics and other factors seem very favorable to me actually. Though in any calamity, all markets associated with the moniker EM will suffer I believe.

 

For whatever it is worth, I may be quite biased. So take it with a pinch of salt. I had advocated setting up a business with a mild short bias (it is hard to short in the space) and build infrastructure and experience, and local partner relationships ahead of a calamitous event. This was back in early 2015. So far that really hasn't transpired. If this or the coming 6 months are as bad as it gets, then I am simply wrong.

[Spekulatius]

Thelads, Great post! HY with it’s record low  spreads and probably lose covenants is probably the biggest bubble out there and the EM‘s are part of it. The EM debt seems particularly dangerous given how capital can move in and out of them. In fact EM‘s can easily become a roach motel. At some point, very interesting deals will be available.

[thelads]

Yes I could not agree more on the roach motel you suggest in EM - and the likely opportunities that will come. It could be fantastic. As for HY - I agree there also. Even options on CDS in HY indices are aggressively priced, which I find remarkable.

[DocSnowball]

Thelads - appreciate your reply and the granular details. I am approaching this from an asset allocation point of view, and not finding good alternative investments in my circle of competence areas of US biotech for the last few months. Mismatching of debt to current and future earnings, possibly made worse by rising interest rates and falling currencies, leading to the possibility of a near-term liquidity crisis is certainly an area of concern. Being a medical person, I also feel the the risks of "fever (pandemic), famine, and war" also have to be considered in EM. And may I add risk of nationalization of assets given our FnF experience from the financial crisis in the US. Grantham may have gotten the current and future earnings part right, question is whether they have attributed a risk discount appropriately.

 

I may not be smart enough to time the market, but I will look to slowly dollar cost average once the potential returns from dividends and earnings growth match the risk of temporary decline in valuation. Will try to keep looking for key metrics or areas that may help make these decisions.

[thowed]

Thanks all - very interesting points about EM debt, which is something I'm ashamed to say I haven't been considering.

 

I am a fan of EM, but do a lot of fund research to find the smartest people choosing the highest quality sustainable growth (non-tech) companies (this generally works best for me in the long-term).  Of course this style doesn't generally come at bargain prices.

 

So DocSnowball, if you want to drip in, that would be my suggestion.  First State are my go-to organisation for this, though I don't know where you're based - I'm not sure what they're like for US investors (their funds tend to be Irish domiciled).  They have excellent Indian and China funds, and some more general Asia-Pacific ones.  They won't shoot out the lights in a roaring bull market, but will protect your capital better in a down-turn.

 

There are some good smaller funds (usually Cayman-based) but these have a relatively high minimum.

 

For me at the moment, I think India has a lot of quality, family-run (i.e long-term focused) companies, China A-Shares has some great stock-picking opportunities (but you need someone who can really spot the rare beasts with decent corporate governance), and Vietnam is very interesting for a number of reasons, though again not many people can navigate the corporate governance issues.

 

The rest of EM is too tricky for me.

[DocSnowball]

Refreshing this thread with recent changes in market valuations. Also David Swensen's latest portfolio is 60% VWO (Vanguard emerging markets) and 20% EFA (iShares ex-US developed markets). I realize these are pure asset allocation level choices albeit based on the same thesis as Grantham. Both are at or near 5 year lows.

 

How does one value these markets, meaning are you simply adding default risk to the US equity risk premiums to get to a ERP for these like Professor Damodaran does, or is there a better way to judge whether they are fairly valued or under/over valued? Either way the long term returns >5-10 year timeframe do appear to be better than US markets if one is a passive investor and can slowly drip in.