Questioning the idea that emerging markets are inherently more dangerous than developed markets.
“October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”
As Twain wryly noted, risk doesn’t fall into one neat bucket that an investor can simply avoid. This quote resonates with us on a couple levels. If danger exists at any time, couldn’t the same be said about places too? As we allocate to companies within emerging markets, what makes Brazil seem like a “particularly dangerous” place to invest versus Germany? Yes, emerging markets can be volatile, but so can the U.S., Japan, and the U.K. Weren’t U.S. bank stocks one of the worst sectors to be invested in circa 2008?
We’re here to question the idea that emerging markets are inherently more dangerous than developed markets. Risks abound everywhere, and it pays to do your homework. While the global backdrop has changed over time, the way we look at the world—or company valuations for that matter—has not.
Early start It took a lot of fortitude to endeavor upon a truly global, unconstrained equity strategy five years ago—global growth was fragile and risk assets were experiencing a lot of market volatility. As long-term investors, we were focused on finding good businesses that were trading below their intrinsic values. Emerging markets particularly got a bad rap following the 2013 taper tantrum, and even five years later, we’ve found the stigma has been hard to shake. We still continue to hear emerging markets mischaracterized as "risky" and "volatile" even though some of these countries have pristine investment-grade credit ratings. Malaysia and Mexico come to mind.
Beyond common beliefs We want to disabuse some of the misconceptions regarding emerging markets. Emerging markets are different than they were two decades ago, let alone five years ago; however, we still hear about the crises of the 1990s, like Mexico’s Tequila Crisis. A couple of months ago, I wrote earlier in the year about how Mexican banks learned their lesson from the 1994 crisis and have since remained conservatively capitalized. We’ve heard the horror stories in emerging markets, where a company borrowed in the wrong currency or had kleptocratic governance. We do our homework and avoid those companies. For instance, there are debt-free companies run for shareholders in emerging markets, and kleptocracies in the U.S.—we obviously don’t own these.
Today’s emerging markets represent arguably half the world's economy, and represent an incredibly diverse opportunity set for an investor willing to do the work. Emerging markets are nuanced—Poland is different from Malaysia. Brazil is different from Indonesia. India is India. China is China. In the universe we use, there are 21 distinct emerging countries and there are, for example, 50 investable companies in Indonesia that we believe we can distinguish between using our rigorous research process. For example, we own a large and growing company in “risky” and “volatile” India; its biggest problem is too much cash. And when we look at India at a higher, macro level, we are encouraged by government’s efforts to improve the country’s business climate, particularly by implementing broader tax reform.
And yet, we now live in a world where any individual investor can just push a button and buy some exchange-traded fund (ETF) that represents basically half the world's economy. So, yes, there will be correlated volatility in these places. In our experience, we have indeed seen periods where they have all correlated. We’ve also seen periods where developed markets have correlated, for example, in early 2016. Also recall that the biggest short-term hit in the last five years was in “rock-solid” developed imperial Great Britain, where the currency alone dropped 12% overnight in June 2016. Did the pound’s rapid descent make the U.K. a “peculiarly dangerous” place to invest? If that is true, the same could be said about anywhere—almost every market has experienced short-term volatility at some point.
Compared to what? As global growth continues to take off, even traditional “safe-haven” assets like German Bunds and Japanese Government Bonds could experience volatility as yields rise in 2018 and beyond. Volatility isn’t exclusive to one region or one asset class. Anywhere in the world could be “peculiarly dangerous” at any given time. Rather than labeling an asset class or region as “good” or “bad,” we are firm believers in doing our research to find the right exposures, which will often include a healthy dose of emerging economies.