CHAPTER 13
Emerging Markets
EMERGING MARKETS STRATEGIES involve primarily long investments in the securities of companies in countries with developing, or emerging, financial markets. Managers make particular use of specialized knowledge and an on-the-ground presence in markets where financial information is often scarce. Such knowledge and presence creates an informational edge that allows them to take advantage of mispricings caused by emerging markets inefficiencies. GLOBAL INVESTORS make profits by mining these markets for undervalued assets and purchasing them before the market corrects itself. Because of the less developed and less liquid nature of these markets, emerging markets securities are generally more volatile than securities traded in developed markets. Managers can be differentiated by country exposures and types of instruments utilized.
EMERGING MARKETS can be a difficult investment arena because they often present illiquidity, limited market infrastructure, few investment options, likelihood of political turmoil, and barriers to information access. As a result, investors expose themselves to far greater risks than when they invest in more developed markets. However, the same factors that create risks can also produce very attractive investment opportunities. Because they are primarily long-only, emerging markets strategies are widely shared by mutual fund managers and hedge fund managers.
CORE STRATEGY
There are different types of emerging markets, but all of them share certain investment features. The majority of these features are the direct result of MARKET INEFFICIENCIES. Market inefficiencies result when information on companies is unavailable, hard to come by, or wrong, and therefore assets often remain undervalued. Emerging markets specialists who can mine these markets for undervalued assets and purchase them before the market corrects itself may be rewarded with large investment returns.
Emerging markets are distinguished from both traditional agricultural economies and highly developed economies. They are not simply making the historical transition from an agricultural to an industrialized economy. Rather, most emerging markets are developed to some extent, but their economy is being restructured on the free market model. The emerging market that was “created” in Russia in the 1990s is a perfect example. Many of these countries are learning to function by using the market model rather than some form of bureaucratic control. These markets are changing rapidly at both the macroeconomic level and the company level. They are not entirely trusted by free market investors and are usually trying to change investor sentiment through political and economic reforms. However, the reforms may not be uniformly applied or accepted.
Most emerging markets do not have sophisticated SECURITIES MARKET INFRASTRUCTURE, though many have vastly improved since the early 1990s. Securities market infrastructure includes accounting standards, the availability of trading and financial information, and sophistication of available financial instruments. Ideally, investors can obtain information about company decisions and actions and results the company has produced. Because this information is not easily available in emerging markets, specialists who are willing to generate their own research can find assets that the market has undervalued due to misperceived or limited information.
The dynamics of emerging markets can be hard to understand. Because these markets are highly volatile, participants often misjudge what they perceive to be economic decline and corruption. For example, Asia experienced a major shock to its economies and markets from 1997 to 1998. Some investors ignored Asia’s problems prior to the difficulties, and some ignored its rebound potential after the crash. The Asian markets were slow to recover on a macroeconomic level, but that recovery presented excellent investment opportunities for diligent, value-oriented money managers who were not scared off by the macro trends. One approach that emerging markets specialists use to take advantage of such situations is to invest early in markets undergoing political and economic transformations. Often, the assets they select have excellent return potential, not only because they are strong companies, but also because the available information has been distorted by former political systems, a lack of technology, or underdeveloped capital market structures.
Some emerging markets specialists confine their analysis to country level dynamics using sovereign debt or equity indexes as a proxy for the fortunes of the country. Other emerging markets specialists concentrate on analyzing company fundamentals to identify investments that will allow them to extract the most value from inefficient emerging markets. They anticipate taking advantage of the lack of information flow that keeps all but a few enterprises out of the spotlight and many of them trading at a fraction of their intrinsic value. They must develop a mechanism for uncovering information, because by the time ideas become available to the broader marketplace, much of the potential for returns is gone. To uncover ideas, they not only read newspapers, periodicals, trade journals, and online sources but also travel through the countries to meet with local managers and government administrators and keep in constant communication with a network of brokers and contacts in the various markets to discuss political, economic, and market events and specific investment opportunities. The most important component of emerging markets research is an on-the-ground presence in the market, especially on-site visits before committing capital.
Emerging markets fund managers can invest globally, regionally (e.g., in Latin America), or in a single country (e.g., Russia). Other participants include those who allocate capital on a selective global basis, shifting their focus based on the changing attractiveness of different markets and asset classes. Some of them treat emerging markets as one potential asset class along with developed markets and fixed-income investments. They allocate capital to emerging markets when they believe that this asset class offers attractive potential returns compared with investment opportunities in other asset classes. Similarly, regional managers allocate among countries within their region where they perceive the greatest opportunities to invest, and single-country managers invest in the best choices within a single country.
INVESTMENT PROCESS
Emerging markets specialists try to capitalize on their ability to gather information in markets in which information does not yet flow as freely as in developed markets. To take advantage of this inefficiency, they engage in fundamental bottom-up research to identify undervalued stocks.
First, they develop early relationships with local brokers, industry participants, and government officials; identify recently or soon-to-be privatized companies; and look at financial reports of companies to understand the variability of their returns and their use of capital. Then they look at the business of the company and assess customers, competitors, and industry trends to determine what to expect in the future. Next, they try to quantify these various issues to determine whether the company is really creating value or simply growing by issuing equity and debt. Finally, after determining growth prospects, the appropriate rates to discount possible risks, and expected currency rates, they invest only if the stock appears to be undervalued to ensure a good margin of safety.
Emerging markets specialists use rigorous fundamental analysis to estimate the value of financial assets as they believe the market will reflect that estimated asset value in the long run. Thus, they make investments when they believe the market has misvalued a security and sell or reassess when the investment approaches their valuation targets. On the downside, they usually sell if a security declines more than a set stop-loss amount, declines for unexpected reasons, or a material factor changes their valuation. Emerging markets specialists buy securities when one or several of the following criteria are met: they are undervalued on an earnings and/or net asset basis, they have projected high growth in earnings and sales, they are dominant in a product or industry, management is progressive toward shareholder rights, they have good prospects for increased liquidity, or their financials are improving toward international accounting standards. They sell securities when they are overvalued relative to their industry, market, or other companies in the fund; the market poses an unacceptable risk; or the fundamentals of the market, industry, or company deteriorate. They will give emerging markets positions more latitude than they would give a position in a developed market because emerging markets are prone to erratic behavior. Overall, emerging markets specialists try to grow the number of attractive positions in their portfolios while opportunistically paring out those that have become fully valued.
Emerging markets specialists may have biases toward particular industries. They look for businesses that they understand and management teams that are honest, dedicated to their work, and oriented toward a free market model. They seek diversity and invest across sectors they find promising and undervalued.
Many emerging markets have a limited financial infrastructure in place that doesn’t allow money managers to short sell and hedge, but those that do charge high premiums. Some managers also hedge by shorting American Depositary Receipts (ADRs). An ADR is a U.S. exchange-traded security representing ownership in a foreign company. Hedging can help eliminate short-term volatility but may reduce the performance of a portfolio in the long run. In addition, factors other than fundamental value may temporarily move prices in emerging markets. Consequently, to short sell and hedge effectively emerging markets specialists must take into account liquidity flows, unexpected political developments, and changes in emerging markets risk premiums.
Money managers use leverage, when it is available, only when they think they can segment the risk of a particular investment and leverage the attractive risk. Flawed assessment of risk combined with leverage can be disastrous, as was witnessed in the erosion of hedge funds with leveraged investments in Russia during the collapse of its markets in the summer of 1998. Generally speaking, most emerging markets specialists do not use leverage because it would magnify the already highly volatile nature of these markets.
RISK CONTROL
Emerging markets are often thought of as inherently volatile and risky. An event can create correlations between asset positions that usually would not exist in more developed markets. Stock prices in emerging markets can become depressed for reasons other than the underlying company losing real value. Emerging markets specialists attempt to control these risks by diversifying the exposure in their portfolio across companies, industries, or markets; attempting to purchase assets at low valuation levels to provide a margin for error; segmenting risk by building a portfolio with different kinds of risk; and hedging long exposures where possible and appropriate. They try to buy assets with prices that will not all move together in response to market forces, and they are careful to make sure that long and short positions do not represent the same investment idea. Why? Because this uniformity would magnify risk rather than reduce it. Not only can a portfolio with diverse positions reap the rewards of long-term return potential, it can also withstand unexpected short-term pricing risks or risks peculiar to an individual market. To restrict maximum exposure to any one country or company, some emerging markets specialists use macroeconomic weighting models. In general, they keep enough positions in their fund to get the benefits of diversification, but few enough so that each position is meaningful to the fund’s return. Although traditional investors manage risk by looking at volatility and how assets have correlated historically, that approach will often ignore new relationships developing between different assets. Consequently, in addition to traditional measures, some emerging markets specialists use their own forecasts and intuition to estimate future volatility and correlation between assets.
The inherent volatility in emerging markets is the price of having exposure to undervalued, high-growth investment opportunities. Because the emerging markets strategy is generally a long-run strategy, emerging markets specialists see the numerous steep declines that punctuate the general long-term ascent of these economies as great opportunities to buy cheap assets. In the long term, an emerging market usually becomes less volatile as it develops a larger private sector and domestic capital becomes a larger portion of market capitalization.
MANAGER EXAMPLE
In 1997, CODAD, a Colombian construction company, was rebuilding runway number one and building runway number two at the Eldorado airport in Bogotá. It issued a $165 million project finance bond in 1999, CODAD 10.19 percent of 5/31/11. It received a BBB rating by S&P in part due to a guarantee from a backing by AeroCivil, the Columbian equivalent of the Federal Aviation Authority in the United States. It was an emerging markets security with a BBB rating, so a number of rules-based investors purchased this issue. Because CODAD was no longer going to access the capital markets, over the next year or so it simply stopped sending financials to S&P and was removed from that rating system, while continuing “profitable” operations and continuing to pay its 10.19 percent coupon. Becoming a nonrated security forced the rules-based investors to liquidate their holdings.
Throughout this time, the fund’s managers were aware of CODAD but had not made an investment. When managers received a call from a current block holder, the bonds were offered at 0.70; they declined to purchase the bonds but decided to update their research in order to value the securities. During the research they placed value in the fact that the bonds were partially backed by AeroCivil, and ultimately uncovered a healthy financial situation. They also realized S&P had dropped them due to a lack of reporting and not due to financial concerns. Under the terms of the bond’s indenture this was a technical default without CODAD having actually missed any coupon payments. With these limited risks they believed the bonds were worth between 0.50 and 0.60. Thus, they went back to the seller and bid 0.50. After a number of negotiations, they purchased the bonds for 0.50 and began the process of contacting the company officials about reporting financials to S&P. When reporting was resumed, the bonds were promptly rated BB and ultimately sold to a rules-based investor for 0.77, booking a 54 percent profit over a nine-month time frame while receiving a 10.19 percent coupon.1
ADVANTAGES / DISADVANTAGES
Emerging markets can be difficult investments because of the paucity of information, poor accounting, lack of proper legal systems, unsophisticated local investors, political and economic turmoil, and companies with dishonest and unqualified managers. As a result, nonspecialists expose themselves to far greater risks when they invest in emerging markets than when they invest in more developed markets. However, emerging markets specialists find these markets appealing because of the profit possibilities that these same difficulties create. What some would call difficulties, emerging markets specialists call opportunities. A market that is volatile and unpredictable in the short run because information about companies is hard to come by and distortions run rampant is also a market full of mispricings; this creates significant openings for investors willing to do the extra work to uncover hidden situations. The structural changes in these markets create inefficiencies that are eventually driven out, yielding outstanding returns to those who invest in the early stages.
PERFORMANCE
As shown in FIGURE 13.1, from January 1990 to December 2004, emerging markets funds recorded average annualized returns of 15.37, with an annualized standard deviation of 14.93. These returns were nearly 4.5 percent higher than the S&P 500 index of blue-chip stocks for the same period, at virtually the same level of volatility. Although the strategy lost 33 percent in 1998, it rebounded strongly in 1999 with a 56 percent return. The three years that followed produced a total net return that was basically flat, but the strategy returned to its high-performance roots in 2003 and 2004, producing 39.36 and 18.8 percent, respectively. These figures underscore the point that investment in emerging markets comes with great risk, but more often than not, produces great reward.
FIGURE 13.2 shows the total strategy assets and net asset flows per year from 1990 to 2004 for emerging markets. The year-end asset total equals the previous year’s asset size plus annual performance plus net asset flows. The continued imbalance of inflows and outflows from emerging markets illustrates the volatile nature of the strategy’s investments. However, interest peaked in 2004 with inflows following the exceptional performance of 2003, when the strategy returned 39 percent.
FIGURE 13.3 on the following page shows the return distribution for emerging markets compared to the overall hedge fund industry, stocks, and bonds. Although the stock market has produced its majority of monthly returns in the 0 to 2 percent range, emerging markets has actually registered more of its returns in the 2 to 4 percent range. In addition, the strategy has produced flat-to-positive performance in over 68 percent of the months since January 1990, whereas the S&P 500 index has produced the same performance in less than 64 percent of the months over the same time span.
FIGURE 13.4 shows the average upside and downside capture since 1990 for emerging markets funds. Although the strategy outperforms the hedge fund industry as a whole during up months, it averages a loss of 1.24 percent during down months, as compared to the hedge fund industry, which averages a 0.45 percent loss. However, the strategy trails the stock market by less than 1 percent during up months, and its average loss during down months is almost a third less than that of the S&P 500.
SUMMARY POINTS
PROFIT OPPORTUNITY
• Emerging markets specialists use specialized knowledge and an on-the-ground presence in markets in which financial information is often scarce to create an informational advantage that helps uncover mispricings caused by emerging markets inefficiencies.
• Most emerging markets are developed to some extent, but their economies are being restructured on the free market model.
• Because these markets are highly volatile, the participants often mistakenly perceive economic decline and corruption.
• Markets that are volatile and unpredictable in the short run, because information about companies is hard to come by and often distorted, are also markets full of mispricings that provide investment opportunities.
SOURCE OF RETURN
• Because emerging markets do not have sophisticated securities market infrastructure, specialists who are willing to generate their own information by doing their own research in the country can find assets that the market has undervalued due to a lack of, or poorly understood, information.
• Emerging markets specialists can capture superior returns in the long run by venturing carefully into areas of the market in which information can be obtained but is not readily available. They must develop a mechanism for uncovering information, because by the time ideas become available in the marketplace, much of the potential for returns is gone.
• The inherent volatility in emerging markets is the price of having exposure to undervalued, high-growth investment opportunities.
• The structural changes in these markets create inefficiencies that are eventually driven out, yielding outstanding returns to those who invested in the early stages.
INVESTMENT PROCESS
• Emerging markets specialists concentrate on analyzing company fundamentals to extract the most value from inefficient emerging markets.
• The most important component of emerging markets research is an on-the-ground presence in the market.
• Often, the costs outweigh the benefits of short selling and hedging in emerging markets, but as these financial markets get more sophisticated and transaction costs drop, short selling and hedging will become more prevalent.
KEY TERMS
Emerging market. A market that is changing rapidly at the macroeconomic and company level, usually because it is restructuring on the free market model.
Global investors. Investors who consider emerging markets to be one potential asset class, along with developed markets and fixed-income securities, and allocate capital to emerging markets when they believe that they offer attractive potential returns compared with other asset classes.
Market inefficiencies. Pricing disparities caused by a lack of information about a market or company or by a distortion of the information that is available.
Securities market infrastructure. The means of making investments and tracking financial information, including accounting standards, availability of trading and financial information, and sophistication of available financial instruments.
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