Emerging Markets: CRIB, PUPPIES, And A New BRIC?

Via Hedge Fund blog, an interesting commentary on

BRIC? My CRIB, Colombia, Romania, Indonesia and Bangladesh, is still performing well. In contrast to China hype, Colombia has been an ignored superstar. While it is certain that securities in Brazil, Russia, India and China offer vast alpha opportunities but as to beta prospects I have no idea. Producers are typically a better bet than consumers. Note the massive outperformance of South Africa and Australia over every other stock market for 100 years.

The PUPPIES position, carefully selected securities in Philippines, Ukraine, Peru, Pakistan, Israel, Estonia and Sri Lanka returned +1,000% for the decade. Ukraine bonds beat Ukraine stocks despite the PFTS being the top index so it was a NEGATIVE equity risk premium. Ghana continued to be negatively correlated. No subprime CDOs in Accra but having been the best stock market in 2008 it was the worst in 2009. Cocoa and gold demand rises in tough times. It’s best to transact securities directly on local exchanges when feasible.

BRIC for next decade? Bolivia, Rwanda, Iceland and Cambodia might be worth a bet and I own special situations in those countries. For any security to be a ten bagger, sentiment must be very negative when you buy. Preferably most people are unaware the country has investable opportunities. With an unhedged approach you could lose every cent but that is true anywhere. Iceland imploded in 2008 but Ukraine and Russia were depressed in 1998 and were two of the best performers in the subsequent decade. Take plenty of lithium when investing in Bolivia. Like anywhere it exhibits manic depressive traits.

Emerging markets have emerged. Most investors take huge opportunity risk overweighting “developed” nations due to home bias and capital-weighted nonsense. Why bet the country where you live will outperform? Why assume big markets will have the biggest returns? That is what “experts” recommend to their unfortunate clients. Optimists gamble on long only, realists hedge. Pessimists get richer.

Anyone treating emerging markets as an asset class knows NOTHING about emerging markets. Profitable investment requires careful country and security selection just like successful hedge fund investing needs skilled manager and strategy evaluation. Due to “professional” advice, many investors missed high returns while enduring the uncompensated risks of “safer” domestic markets. No lost decade for portfolios that ignored “global” benchmarks.

Buy the unpopular and short sell the trendy. The efficient frontier needs the frontiers. I’ve had great success investing in mis-valued securities in “obscure” places most have never heard of. Buy when 5 star hotels in a country are empty; get short when they are full. No luxury hotels and mutual fund jockeys can’t find it on a map? Fantastic. No direct flight? Back up the truck.

Recent herding has been to BIG emerging markets not the BEST emerging markets. Countries offer alpha capture opportunities from short and long security selection not passive buy and hold. Emerging market beta? NO. Emerging market alpha? YES. Pity those that believe street BRIC hype. Population, demographics, GDP growth and stock markets have little connection. Invest in the future not the past.

When China and India become the world’s biggest economies AGAIN so what? If you examine the last 20 centuries, the USA was largest for 1, the UK for 1 and China or India for the previous 18. Other things being equal the most populated nations MUST have the largest economies. As recently as 1700 China and India accounted for 50% of global GDP. The “Asian century” is simply reversion to the usual and half the world lives between Japan and Jordan, Turkey and Timor-Leste. The abnormal period was the “non-Asian” 19th and 20th centuries.

Most periods have been “Asian” since the Mesopotamia era when Iraq was the cradle of civilization. No doubt there were Babylon real estate brokers back then saying “House prices always rise over time”. They don’t. Subprime lending was around 5,000 years ago but few learnt the lessons. Those buying CDOs should have been looking at historical BIG DATA sets. Competent investors analyzed properly and got short. Most “correlation traders” used small sample sizes when they should have been looking at real estate time series starting in 3,000 BC.

Lost decade? For 2000s my pension grew nicely above actuarial expected return assumptions and at much less volatility than a risky long only portfolio. Not bad given the low market exposure and high manager diversification. I avoid traditional products due to the deep drawdowns and absence of skill so I use absolute return vendors for most strategies. My manager due diligence process, macro black boxes and micro risk metrics seem to have predictive value. In January 2000 and 2009 too many “experts” said avoid emerging markets and hedge funds! Absurd “advice” that has cost their unfortunate clients dearly. Investment science is much more difficult than rocket science. I follow geographic FACT not economic THEORY and prefer cautious alpha sourcing to risky beta gambling.

Lost century? A year or decade is just noise. Long term conservative investors like me study centuries. Back in 1900 anyone would have been asinine to miss the ASS fund. Australia, South Africa and Sweden have had the HIGHEST real returns over the last 110 years. Note they were not heavily populated countries then or now. Given sales product groupthink and herd mentality I assume an ASS ETF is in the product pipeline though an EWA, EZA and EWD basket is fine assuming you make the assumption that past is future. I don’t and have seen NO evidence that stocks are for the long run especially when everyone including famous university endowments need returns in the short run.

Global asset allocation based on capital-weighted beta is out of line with portfolio optimization. Any relative return benchmarked fund obeying global equity weights 20 years ago HAD to put 45% in Japanese equity beta and we know how that turned out. As elsewhere Japan is an alpha source and has been throughout the two decade bear market. Argentina in 1900 was a top ten economy yet was just downgraded from “emerging” to “frontier”. Like every country Argentina is a place for smart alpha not dumb beta. Everywhere is “investable” if the margin of safety for reward exceeds the risk. I first invested in Armenia back in 2003. Since then China GDP growth 9%, Armenia GDP growth 11% but economic expansion is not alpha mining.

????! Learn Mandarin but only after achieving fluency in Zulu, Swedish, Australian, Ukrainian, Spanish, Russian, Portuguese, Romanian, Indonesian, Armenian, Hindi, Urdu, Bengali, Quechua and Sinhala? If so many already speak a language well would knowing it really be an edge? Perhaps but mathematics is the most useful language to master in the financial world. Yet so few speak it fluently or can apply it to REALISTIC models of the world – including most quants. It’s time investors were less obsessed about asset classes and looked at strategies applied to alpha opportunity sets. Don’t allocate X% to “emerging markets”, fully invest in skill. It’s not WHAT but WHO you invest with and let them decide where.

Not much changes in investor behavior. A famous quantitative guru was blown up by the first actively managed emerging markets ETF. Isaac Newton got taken for the equivalent of USD $4 million in 1720 with South Sea Bubble shares. Isn’t today’s SPAC “a company for carrying out an undertaking of great advantage but nobody to know what it is”? Ignore labels, select good and bad listed and unlisted securities and hedge risk. I look for opportunities not asset allocation classifications but all countries are emergent markets.

Geographic constraints and arbitrary asset class names cost investors plenty. Why divide stocks into domestic and foreign? Why developed and developing? Or miss opportunities close to home? USA S&P 500 -1%, Canada S&P/TSX +5.6% or +9.1% in US$ but many USA investors completely missed Canadian stock market returns because they mistakenly split equities into USA and EAFE boxes. It is also time colonial, anglocentric terms like “Far East” were retired. On a sphere everywhere is far east of somewhere. I’m writing this in Beijing so New York is in the Far East for me, this week anyway.

Despite the archaic name, EFA is a good ETF for beta but it misses so much alpha available WITHIN its components. EEM and VWO obscure long/short opportunities INSIDE their security universes. The MSCI “World” has just 23 countries. Diversified? World? Even the ACWI “All-Country” World index only comprises 45. If you are a global investor then invest globally and evaluate opportunities from accurate perspectives.

GDP growth and investment opportunity sets are different. South Africa (nominal) and Australia (real) won the beta battle in the 20th century but are unlikely to ever be the largest economies even though much bigger in area than “European” maps show. You could have made similar arguments for the big BRIC in 1901 as in 2001 and lost a LOT of money later. Of course things may be different this time! “Frontier market” beta is supposedly available with FRN but its largest holdings are in Chile, Egypt and Poland which are emerged in my opinion like many other former “emerging” countries.

Unprecedented times? The historical parallels of 2000s with 1900s are interesting. 1900-1903 bad, 1903-1906 credit binge, 1907-1908 severe credit crisis, 1908-1909 strong “recovery”. Wasn’t the stock market crash of 1910 brought on by failed attempts at financial reform? Weren’t Russian and Chinese stocks and bonds considered core “long term” holdings in the 1900s? Anyone invested in passive “cheap” US equity index funds in 1905 would be waiting over thirty years for a sustained gain. That’s good compared to the returns foreign investors in German beta would see: almost -100% twice. Of course those who invested in Germany in the late 1940s made good money though not as much if they had bought Japan.

The division between developed and developing is outdated. Having invested in Indian stocks from when I lived near Dalal Street and Chinese, Russian and Brazilian stocks since the mid-1990s why are they STILL classified as “emerging”? Nowhere can be emerging for ever. Given their major roles in the world economy, it is anachronistic to refer to these and many other countries as “emerging”. All four had stock markets in 19th century. I saw a nice stock exchange in Saint Petersburg that was built back in 1810. Emerging for 200 years? I think not. Re-emerging maybe 15 years ago but mainstream now. Today’s emerging markets are the frontiers. Today’s frontiers are the pre-frontiers.

The beta mania hides the alpha available from security selection and arbitrage. Despite the “worst decade” claim, more than 100 USA stocks were up over 1,000% and many more went down to zero. The capital weighted S&P 500 -1% whereas S&P 500 equal weighted +4.54%. It was a fantastic decade for security selection in the USA. Same in Japan and Western Europe. Emerging markets or submerging markets don’t matter when you seek alpha.

Risk free bonds haven’t existed since the sovereign debt default by England in 1340. Nothing new about subprime loans to overleveraged nations. Thanks to financial INNOVATION we now have credit derivatives to hedge such risks. As I write this Greece is the “new” factor affecting markets yet Greece was in default for half the past 200 years. Everything is connected so everywhere needs to be tracked. Curious how “hedge funds” are considered so hazardous when “government bonds” have had a dire track record over the centuries. The true safe haven is investment SKILL not bonds.

Skill always has and always WILL have a great decade as there are more unskilled participants for the few skilled to extract the alpha from. In most countries public stocks, bonds, derivatives, futures, currencies, commodities, private equity and real estate offer alpha opportunities. Emerging markets “passive” long only is a bad idea if you wish to preserve your capital. Common sense investor Jack Bogle suggests “international” investing is unnecessary! Such advice is the antithesis of prudent diversification required in fiduciary portfolio construction. 10 billion would now be 45 billion to meet liabilities unlike the returns from his “low cost” asset allocation.

As a value investor the time to buy emerging market securities is when they are cheap and out of favor and vice versa for short selling. My best years for emerging markets alpha were 2008 and 1998 which were very negative years for beta. Investors want returns but that should not mean increasing risk by following the crowd. Emerging markets are not for buy and hold so it is sad to see repetition of such mistakes. Is it prudent to eschew bargain stocks but swarm in unhedged AFTER missing large percentages of the gains? The reason some thought there was an equity risk premium is because 1940-1980 was a bond bear market. Some say securities have no memory but it’s the passive crowd that has amnesia.

Invest off the radar screen. The highest returns in a country are achieved when the flights to it and premier hotels in the largest cities have plenty of room. Start to sell when you can’t get a reservation because the undiscovered has been discovered. My best investments have tended to be buying good managers in drawdowns and good securities in places “foreigners” aren’t going. When I tell someone “I’m investing in X” and they look at me like I am crazy then I know I am on the right track. Liquidity is important but that doesn’t mean the entire portfolio has to be liquid. I bought Vietnam distressed debt back in 1996 and sold out a few years later close to par yet even today the country is regarded as an “exotic” frontier. I haven’t invested outside this planet yet but will this century in the final frontier. Moon and Mars ETFs?

Inertia investing is more common than momentum investing. Innovation and new sources of return are routinely ignored. Having missed a lot of recent beta from emerging markets, the performance chasers are piling in again to long only index funds when they could instead be reducing risk and accessing alpha in skill based managers. Risk averse investors will be better off in skilled emerging market strategies NOT unskilled long only.

Status quo investors continue to use normal distribution curves to “measure” risk and Black-Scholes to “price” options. Busy people keep to QWERTY when they could type faster on DVORAK keyboards. Most still look at the world as those famous Belgians, Mercator and Ortelius, intended them to so long ago. Anyone unaware that Africa AFK is 14 times the size of Greenland should not be investing anywhere. I have been to every African country and once travelled overland from Cape Town down to Casablanca and back. It is a BIG place whatever ancient maps and antiquated asset allocations claim. South Africa should be renamed North Africa. North Dakota is south of South Dakota on my maps.

There is a global alpha opportunity set out there. I don’t know if this is another Asian century but it is definitely the Alpha century. Assets are abundant but skill is a rare natural resource with enormous growing demand. Alpha is more valuable than gold, oil, platinum, palladium, cerium or even californium which sells for $27 billion a kilo. In contrast 2 and 20 for “emerging” investment skill is a bargain. I don’t classify asset classes or countries into neat little boxes because they are all stigmerging markets in my experience. If you don’t have a stigmergent analytical tool set, stop investing right now and find someone that does.

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Wildcats & Black Sheep is a personal interest blog dedicated to the identification and evaluation of maverick investment opportunities arising in frontier - and, what some may consider to be, “rogue” or “black sheep” - markets around the world.

Focusing primarily on The New Seven Sisters - the largely state owned petroleum companies from the emerging world that have become key players in the oil & gas industry as identified by Carola Hoyos, Chief Energy Correspondent for The Financial Times - but spanning other nascent opportunities around the globe that may hold potential in the years ahead, Wildcats & Black Sheep is a place for the adventurous to contemplate & evaluate the emerging markets of tomorrow.