Top-down, bottom-up or something in between?

Originally posted at Developing Insights Blog. The Developing Insights Blog (DI) is dedicated to emerging and frontier markets, which collectively will account for the majority of world output by 2020.

In Frontier and Emerging markets the cost of not understanding the big picture can be very painful. Countries with weak institutions, frequently coupled with very narrow export bases, can change quite rapidly on both the upside and the downside. This creates the potential for big losses in USD terms as well as numerous missed investment opportunities.

Graham and Dodd-style investing is predicated on the notion that value is recognized over the long term. As Benjamin Graham famously asserted, “in the short run, the market is a voting machine but in the long run, it is a weighing machine.” Implicit in that formulation are many developed market assumptions about political stability, exchange rate volatility, peaceful power transitions and a meaningful degree of economic policy consensus. Often, in a developing market context, those factors simply can’t be held constant. The ability to pursue a purist bottom-up strategy, devoid of political economy considerations and the macroeconomic fallout from poor policy, is severely constrained. If all risk is simply the variability of future outcomes then these additional “macro” considerations necessarily widen the band of potential returns for individual companies.

Alternately, training all the analytical firepower on macro issues can lead to problems as well. Emerging markets are notorious for their extreme dispersion – the spread between the performance of the best companies and the worst– even in countries where the balance of macroeconomic factors are positive. What to do? Our approach is rooted in fundamental company analysis; we scour markets for good companies first and perform inordinate diligence on the real world business and its prospects. However, we then employ what we call a “macro overlay”, highlighting the big picture variables that can frustrate the process of value realization for the individual company. One added benefit of assessing these variables is they often form into themes that narrow the bottom-up stock picking process. For example, declining commodity prices have resulted in low inflation in commodity-importing South Asian nations and are good for consumer stocks. Our macro overlay is also used to eliminate certain countries altogether, such as Iraq where the security situation prevents investors’ from conducting on the ground due-diligence and Ukraine where exceedingly high levels of toxic assets in the banking sector profoundly inhibit economic activity.

While it’s easy to see that macroeconomic fundamentals can impact company cash flows and the discount rates employed, developing markets often add important wrinkles. For example, a high fiscal deficit even in developed markets usually means that tax increases are on the table. However, in some developing markets, government revenue boards will immediately target Financials, Tobacco and Telecom companies to address the problem, or in more extreme cases simply resort to money printing. Extended periods of inflation make value realization quite challenging! And while a significant current account deficit in developed markets is not necessarily the end of the world, if it coincides with an inability to see capital account inflows — a common developing market theme — the resulting extreme imbalance can wreak havoc on exchange rates.

Let’s move away from theory and look at a few case studies. All three examples are from South Asia, my area of focus as an analyst.

The Return of Orthodox Policy

In 2013 a large number of political analysts had forecast a hung parliament in the run-up to Pakistan’s legislative elections. This came despite a highly unsuccessful stint at the helm of government by the Pakistan People’s Party (PPP). Widespread corruption allegations, an inability to exercise economic reforms demanded by the IMF and high inflation, due to printing large amounts of money to finance the country’s deficits, all lead to a decided lack of popularity. Despite this dynamic, the party was perceived to be entrenched.

The election results surprised most everyone as the conservative Pakistan Muslim League (PML-N) consolidated enough seats to form an independent government. The new government moved swiftly and entered a new IMF program to avoid a balance of payments crisis, injected liquidity into an energy sector burdened with circular debt and realigned towards orthodox economic policies overall. Unsurprisingly, stock market returns from the election date till end of 2014 were a massive 68% in local currency terms.

End of War

Sri Lanka experienced a major inflection point in 2009. In May of that year Sri Lanka’s civil war ended after a 26 year conflict. The war had led to massive expenditures by the government, with the bulk of the funds allocated to financing the fighting. The result was high levels of debt, a high fiscal deficit, lots of money printing and severe inflation. The end of the war was a watershed moment as the government could finally shift wasteful military expenditure and refocus on the development of the country, bringing large infrastructure projects to formerly war torn areas. The outcome was an immediate reduction in inflation as supply chains improved, a declining fiscal deficit and a big jump in GDP growth. Between the end of 2008 and early 2011, the equity market returned 381%. It’s worth mentioning that there was definitely an overreaction in equity prices, as the index is yet to exceed its 2011 high. Nevertheless, the structural change in the Sri Lankan economy caused by the end of the war transformed the fortunes of the country.

Structural Change

After two years of rule by an interim government backed by the army, Bangladesh held an election in December 2008 which resulted in the Awami League’s return to power with a massive majority, winning 76% of the electoral seats. On the new government’s immediate agenda was to increase power generation. But instead of building large, long-duration fixed asset power plants, they relied on oil-fueled rental power plants. The end result was a large change in the energy mix towards oil instead of natural gas. Meanwhile, oil prices which had hit $44 per barrel in early 2009 rose rapidly and exceeded $100 by the same time in 2011. This resulted in a deteriorating current account position and lead to currency depreciation of about 18% in 2011. In addition, the government couldn’t pass through the increased costs resulting in high subsidies financed by bank borrowing (crowding out the private sector). High double digit inflation coupled with this crowding out lead to a massive liquidity crunch as banks had to take time deposits at 14%. The country was forced to take IMF support and implement reforms such as energy price hikes and tight monetary policy to get the economy back on track. By 2013, the situation started to normalize, and from late 2013 to the end of 2014 the MSCI Bangladesh index returned an impressive 36%.

As these examples illustrate, economic conditions can change quite rapidly in developing markets. And these changes directly impact company fundamentals through cash flows or discount rates (i.e. risk free rates and risk premiums). Having a means of filtering the effects of global movements in interest rates, currencies and commodities can avoid costly investment errors.

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

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