Emerging Markets: a great money making opportunity too impressive to neglect…

The June 2011 edition of Institutional Investor magazine featured an article that highlighted the relevance of investing in emerging markets and I summarize the rationale as follows:

• The economies of the emerging markets are growing and their debt and fiscal positions are relatively better; and
• Institutional investors are underallocated to emerging markets and many are increasing their emerging market exposure

The combination of those two trends would be expected to drive up valuations, thereby driving investment returns but also increasing the risk of overpriced markets.  As a result, whereas investors may have historically played emerging markets for “beta” by investing in indices and large caps, the value of being more selective in these markets is likely to increase in importance.  We believe that investors should be increasing their investments in emerging markets but doing so selectively.
The following are some selected excerpts from the article:

• “Emerging and developing markets are expected to grow by 6.5 percent this year, nearly three times as fast as the 2.4 percent pace of the advanced economies, according to the International Monetary Fund.”
• Joyce Chang is global head of emerging-markets and credit research at JPMorgan Chase & Co. in New York.  “’EM countries continue to look better on the debt and fiscal front as developed market debt and fiscal positions have deteriorated over the last three years.” says Chang.
•  Timothy Moe, chief Asia-Pacific strategist of Goldman Sachs, forecasts that “Over the next 20 years…Although developed markets are likely to more than double in size, to $66 trillion, capitalization of the emerging markets should grow nearly sixfold, to $80 trillion.”
• “To be sure, the growth of emerging-markets investing does face challenges.  Some investors and analysts warn about the danger of lofty valuations, which in many countries exceed those in developed Western markets.”
• Yngve Slyngstad is CEO of Norges Bank Investment Management, the manager of Norway’s giant sovereign wealth fund.  “Slyngstad is looking to pursue diversification across a broader front.  Last month he went to the Ministry of Finance and requested authorization to substantially increase the emerging-markets allocation of the Government Pension Fund Global, as the sovereign fund is called, because of the growing size of  those countries in the global economy.  The fund has roughly $50 billion of its $555 billion in assets in emerging markets or in companies heavily involved in those markets.  Slyngstad wants to increase that figure by two thirds, to almost $85 billion, by the end of next year.” 
• “In addition to expanding the fund’s emerging equity allocation, Slyngstad wants to put more of that exposure in the hands of dedicated emerging-markets managers.  He believes most emerging markets are less efficient than their developed world counterparts, providing an opportunity for knowledgeable local managers to generate alpha.”
•  “As more institutions look to emulate active emerging-markets players like the Norwegian fund, the potential for further capital flows to these economies is great.”
•  “The University of Notre Dame, which has almost 16 percent of its $7 billion portfolio in emerging markets, is looking to increase that weighting, possibly doubling it in the next five to seven years, with private equity accounting for half of the growth.”
• Newlight Associates is a New York investment firm that specializes in emerging growth stocks.  “’Investors who neglected the emerging markets in 2009 missed one of the great moneymaking opportunities of the decade,’ says Newlight’s Raucci. "Those who continue to neglect the EM going forward do so at their peril.”

 
 *Source: 6Upta, Udayan. "Bric and Beyond". Institutional Investor. June 2011

Defining Risk

The link that follows is to an article about a recent report by Fidelity about 5 key risks to retirement income.  What I found interesting is that not one of the referenced risks is "portfolio value volatility"; and yet, our industry has broadly defined "risk" as meaning "portfolio value volatility" such that a "low volatility portfolio" is considered "low risk" and a "high volatility portfolio" is considered "high risk".  If one thinks about retirement income and "longevity risk" and "inflation risk", investing in a "low volatility portfolio" may actually be "high risk".  Could the overwhelming industry focus on "volatility" actually be creating greater long-term risk for clients?


http://www.advisor.ca/investments/market-insights/five-key-risks-to-retirement-income-%e2%80%93-part-1-53675

Guaranteed returns may be riskier than you think

I found the article titled “Boomers shaken by 2008 rout” published on June 21, 2011 on Advisor.ca to be quite disturbing. 

http://www.advisor.ca/news/industry-news/boomers-remain-shaken-by-2008-rout-51457

The current economic pressures, which are making it more challenging to save, when combined with risk-averse investing, could be a recipe for future retirement savings deficits.  In this regard, I recently read an article that I thought did a great job of articulating something that I have been having a hard time putting into words.  In summary, the writer said that there are basically 3 ways to fund retirement:

• Save more;
• Retire later; and
• Earn a higher rate of return.

Current economic pressures (unemployment, sandwich generation, etc.) make it harder to save more.  Retiring later is far from certain as it depends on health and continued employability.  Therefore, it is imperative that people manage the returns they earn on their savings.

Earning 2-3% so as to avoid risk very often means one of two things:

• Accepting the certainty of a lower standard of living in the future; or
• Betting that one will remain healthy and sufficiently employable to work longer and retire later.

That doesn’t sound like risk reduction to me.

The writer goes on to observe that it is no wonder that older people fall prey to investment scams – when confronted with the realities associated with years of safe 2-3% returns, they become more vulnerable and are more likely to chase “too good to be true” scams.

http://guardian.co.tt/business-guardian/2011/06/16/finding-strategy-works-you

While, in the short-run, investing in good quality equities may entail more volatility than investing in GIC’s, in the long-run there is an argument that it is actually a lower risk strategy.  I have a difficulty classifying a strategy as “low risk” if the consequence of it is very risky – and yet, that is exactly what is happening all too often.  Consider the following illustration:  A person needs $50,000 per year to live.  In scenario A, they invest in the “low risk” portfolio which will ensure that they run out of money in 20 years.  In scenario B, they invest in a portfolio which is expected to never run out but which may run out in 15 years.  Which is more risky?

It is easy to advise people to “save more” and “play it safe” – but I wouldn’t want to pay for that advice.  A financial advisor who can design a portfolio that helps a client prepare sufficiently for a quality retirement without overly sacrificing enjoyment today – that I would pay for.

Macro fear makes it a good time to buy.

The most popular headline on Bloomberg on Monday June 13, 2011 was:
 
“’Perfect Storm’ May Threaten Global Economy”,  based on comments from Nouriel Roubini. 
 
For those who choose to read on a bit further, they would read the following:
 
“There’s a one-in-three chance the factors will combine to stunt growth from 2013, Roubini said in a June 11 interview in Singapore. Other possible outcomes are “anemic but OK” global growth or an “optimistic” scenario in which the expansion improves.”   
 
Said another way, there is two-in-three chance that growth beyond 2013 will be good.
 
We are now over 3 years past the start of the “financial crisis” and over 2 years past the bottom of the crisis.  The economy and markets move in cycles and not linearly with, on average, at least one downturn per decade.  Therefore, one would not have to be prescient to predict that there will be another economic and market downturn during the next 7 years.  The question is whether that expectation is sufficient justification for not investing or disinvesting.  History suggests that the gains to be made in between downturns dramatically exceed the losses during downturns.  Doesn’t that history suggest that, notwithstanding the likelihood of a downturn somewhere in the future, the way to earn attractive investment returns is to be invested during the up-cycle, especially when fear drives the prices of quality businesses down?

Warren Buffett visited India last week

(The link should take you to a transcript and video link to one of his interviews. There are many more on the site.)

http://www.moneycontrol.com/news/business/buffett-charms-india-says-this-isdream-market-for-investors_531481.html

The reference to India being a "dream market for investors" is consistent with our belief that India presents many good investment opportunities.

In this video and the others available on the site, Buffett makes a number of other comments that are vintage Buffett and yet still relevant and insightful. Below, I note a number of them that I found particularly relevant.

• Optimistic on the world -- India growth is not at the expense of US growth or vice versa. It is a growing pie.
  
• Monetary and fiscal stimulus are easy to measure but the real driver of growth is creative, passionate people.
  
• Corruption does not only happen in India. It takes place all over the world. Even Berkshire Hathaway is not 100 % immune. Berkshire Hathaway tries to only partner with honest partners, communicate its expectations of good behavior and detect/deal with instances of bad behavior as quickly as possible.
  
• He likes businesses led by people who "love their businesses". Family owned/managed businesses where the family has the passion and the competency to manage the business and, for one reason or another, are looking for outside investors are great -- not easy to find, but great.
  
• Stay within circle of competence. Where he is not an expert in the business, he has invested in people who are -- feels he is pretty good at that.

Things are not always "normal"

As investors, we subscribe to certain principles that may not seem relevant through "normal" times.

But, as the last few years have reminded us, things are not always "normal" and it is the periods of turmoil that we must use to remind us of the relevance of our principles and protect ourselves from permanent losses of capital.

For example, we prefer to invest in businesses in which management has a large ownership interest; i.e. they have more to gain and lose based on the company’s long-term value than they stand to gain from growing their compensation by increasing the size, complexity and/or short-term performance of the company. The financial crisis reinforced our conviction around this principle.

More recently, the events taking place in Egypt, Libya, etc. have reinforced our conviction around investing in countries that we believe to have “functioning democracies” and a “growing middle class”.  We believe that increasing levels of information, education and communications capabilities are increasing the instability of countries with high concentrations of wealth and power.  I think that it is this principle that Warren Buffet was referring to when he made the following reference to the “American System”:

“’There is a resiliency to the American system,’ he added. ‘It does work. It sputters from time to time, it will sputter from time to time, but you don't want to get worried.’” 

http://www.reuters.com/article/2011/03/02/berkshire-buffett-idUSN0218786020110302?pageNumber=1

Mr. Buffett also reinforces our belief that investments in quality businesses can actually reduce the risks associated with inflation and rising interest rates. He maintained that stocks are a better investment over the long term than bonds, saying "it's a terrible mistake to buy into fixed-dollar investments at current rates.”

http://www.reuters.com/article/2011/03/02/berkshire-buffett-idUSN0218786020110302?pageNumber=2

At a more tactical level, the recent events in the mid-east also serve to reinforce our belief in the value of oil reserves in regions that are geo-politically stable, Canada being one of them.

“If Demography Is Destiny, Then India Has the Edge”

Business Week recently published an interesting article entitled “If Demography Is Destiny, Then India Has the Edge”.  Make sure to look at the chart that is part of the article.  The article can be found at:

 

 

http://www.businessweek.com/magazine/content/11_04/b4212009727572.htm

Keeping Company Valuations in Context

As we all know, any valuation metric needs to be kept in context. In assessing the P/E of Adani Enterprises, the following context should be noted:

• The year-end in March 31 which means that the 2012 fiscal year really represents 1 year forward earnings.
  
• The expected growth rate. In this case, India is experiencing real GDP growth in the 8-9% range. In addition, the company’s investments in coal mining, power generation, ports and real estate are just starting to kick in. The mean analyst estimates on Thomson are calling for EPS to almost double from March 2011 to March 2012.
  
• Adani is primarily in infrastructure type businesses which tend to produce more predictable recurring cash flows.
  
• Upside optionality based on asset potential and capital capacity.

Looking ahead to 2011

As we start 2011, it is a good time to think about the context in which we invest.  Here are a few articles that are generally consistent with my thinking.

Moderately positive expectations as North America approaches 3rd year of recovery.
http://www.bloomberg.com/news/2010-12-31/wait-til-next-year-for-new-normal-as-s-p-index-gains-86-since-march-2009.html

Growth in India.
http://www.theglobeandmail.com/report-on-business/economy/india-asias-other-economic-powerhouse/article1853707/page1/
 
Debt worries persist.
http://www.theglobeandmail.com/report-on-business/europes-debt-woes-could-be-harbinger/article1854721/page2/