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.

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The difficult job of assessing governments

Assessing the performance of an employee is not the most difficult job (caveats exist!!!) in the world despite the subjective judgments involved. Nevertheless, I find that in Bangladesh (and possibly the world) top management and HR often fails in awarding the good performers and penalizing the bad ones. Rather, either nepotism wins or employees are promoted by ‘socialism’ which usually means that age determines position and rank.

When we extend the challenge to analyzing companies, it becomes slightly more difficult. However, it’s still quite doable by using a number or relative (benchmarking against key competitors) and absolute (Total shareholder returns, RoIC, Profit growth etc) metrics.

The toughest of these all is assessing the performance of a government in my view. The challenges actually start from the very basic level as we are still not sure if GDP growth is the single best indicator of economic progress. On top of that consider that, calculation methodologies and data collection ability also differs greatly between countries. Morten Jerven has done some great work on GDP calculation of African economies that highlights this challenge.

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Why We Should Stay Away from Emerging Markets

Tahsanul Hoque, Guest post - The Asif Khan BlogTahsanul Hoque is currently working in Internal Accounts Payable in Morgan Stanley. He is a postgraduate of Ohio State University in Finance and a graduate of North South University. Even though he is a banker by profession he is also an avid investor by choice.

 

Most global stock investors are now well familiar with how their investments started 2014 after a phenomenal bull market of 2013. With US Fed taper in the horizon forcing a currency crisis in some emerging economies and S&P 500 going down by nearly 6% at peak, you must be wondering what you should do with your investment portfolio. You must be wondering that the good things have to come to an end at some point, right?

I have recently advised a strategy in my blog regarding why you should remain in US capital markets for now.  But what should you do if you are thinking about putting more money in emerging markets? You may think this is the good time to buy emerging stocks, since they are now very cheap. Emerging markets after all the big buzzwords on everybody’s lips. While on technical terms they are now cheaper compared to other major global stock indices, you should avoid investing in them unless you are a short term trader.

Under performance of EM even during the supposedly golden times

Let’s look at some popular Exchange Traded Funds on emerging market stocks in Wall Street and Europe and their performance over last 5 years.

 Exchange Traded Funds on emerging market stocks in Wall Street and Europe and their performance over last 5 years.
Google Finance
 Exchange Traded Funds on emerging market stocks in Wall Street and Europe and their performance over last 5 years.
Google Finance

Now you do not need a Bachelors in Finance or Economics to notice the general trend of these investment performance since 2010 (2009 was the only year where they performed well in these graphs). In most cases, the long term investor did not see any gains by investing in broad based emerging market funds. It seems to be they are in a slow bear market since middle of 2011. (Mainly due to unfavorable currency conversion issues with these investments)

Further federal reserve tapering on the cards

Remember the big picture in these graphs is that US Federal Reserve did not yet begin their tapering on full fledge. Instead the hot money from Quantitative Easing have been pouring into these investments during this timeframe. The slow tapering has just started for 2 months. Do you think the emerging market funds can manage to gain with Federal Reserve slowly withdrawing their stimulus? Think again. Your money is better invested somewhere else.

Chinese entrepreneurs diversifying outside China is a leading indicator

On the other hand, rich Chinese entrepreneurs are hastily trying to make other countries their second home. This is a subjective issue but sometimes these give some indications.

It does not take too long to notice these emerging markets have structural problems that need to be corrected by their government. So till then, it is better to avoid them.

What should we do?

Instead invest heavily more in US markets or frontier markets. Even though they also face headwinds from Fed tapering, the underlying short and medium term fundamentals are good enough to support these stocks. See these funds and their performance.

Instead invest heavily more in US markets or frontier markets. -The Asif Khan Blog
Google Finance

I still believe that over the very long run, emerging markets will be the leader in global investments. Ultimately the developed countries and their insatiable appetite for debt is not sustainable in the very long run and this will lead to major de-leveraging. However, as long as emerging economies do not increase their domestic consumption, as long as they remain export focused only with developed countries, I do not see them growing to be a major leader too soon. It will happen ultimately but not in the near future that is for sure. So for now avoid these markets. But if you are still a believer in Emerging markets for short to medium term horizon, I suggest you look at Emerging market Technology ETFs (such as CQQQ)

Disclosure: Please take your investment decision with your own knowledge and analysis. The analysis given is the author’s own independent view.

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Bottom up “beta” for emerging and frontier markets

Valuation experts and also the CFA textbooks mention that it might be unwise to use to regression beta for emerging and frontier markets. There are quite a number of reasons as to why they are advocating this. I just wanted to quickly show readers how I use bottom up betas for countries like Bangladesh.

My logic is pretty simple.

1. I try to assign a beta of close to or below ‘1’ for the very large cap names. For e.g. I would probably use close to ‘1’ or less for Grameenphone which has the largest market cap in Bangladesh.

2. The other element in place is risk. Companies with higher business, operating and financial risk should have higher betas. For example a consumer staple would have less beta than a consumer discretionary which would see earnings volatility if business cycle is volatile.

I could have written much more on this topic. However, it is much easier to read what the real guru “Aswath Damodaran” has to say on the subject.

 

 

 

 

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Special: Bangladesh Macroeconomic Outlook for 2014

This is a report I prepared for BRAC EPL Stock Brokerage. With special permission and by deleting some content I am reprinting the report here. Note that this is just a macroeconomic analysis and in no way gives any stock recommendation. Also, remember that macroeconomic conditions are dynamic and things might have changed from the date of publishing (Jan 15, 2014).

Bangladesh Macroeconomy, Frontier, Strategy, Stock MarketSummary of Report

We see 2014 to be very important in deciding the future of the country and politics could play a major role in that. Economic activity in terms of investment, credit growth, import etc is likely to be subdued at least till the first half of the year. On the bright side, the strong foreign exchange reserve minimizes the risk of a currency crisis, while relatively benign inflation will allow space for monetary stimulus. Furthermore recent developments in the political arena show that the worst case scenario is a low possibility as the opposition has called off strikes till further notice.

Despite a relatively mixed outlook in terms of economy, we do expect total corporate earnings of the listed universe to show growth after three consecutive down years (primarily due to financial sector earnings drop).

However, the 12M trailing P/E multiple of 18.2x indicates that some of this growth has already been discounted in the market.  A quicker resolution to the political stalemate will be an upside risk in our view. Things to observe carefully would be the 1. Political developments 2. Health of the banking sector and the 3. RMG sector which came under increased scrutiny in 2013

 

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Aswath Damodaran on cost of equity in frontier markets

Aswath Damodaran on cost of equity in frontier markets -The Asif Khan BlogAswath Damodaran is one of the foremost experts on asset valuation in the world. He is a Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. He has written some of the most popular books on valuation and corporate finance. He has a widely followed blog called Musings on Markets which I strongly recommend my readers to check out.

I had emailed him with a question about cost of equity calculation problem in frontier economies like Bangladesh yesterday. To my utter surprise he replied to my email within a day and granted me permission to post it in this blog.

Let me first explain what the big deal is about cost of equity calculation in frontier economies. Experts have frequently argued that traditional method of deriving “Cost of equity” can fail significantly in frontier/emerging market. They mention 3 main reasons for that.

1. First, the comparable government security in an emerging market may not exactly be risk free. We have seen many sovereign default in the world already. You can see a comprehensive list here.

2. Secondly, there may be limited/questionable estimate of average stock market return in most emerging or frontier markets

3. It may be impossible or difficult to estimate beta because the historical data or expected future returns relative to predicted average stock market index returns needed to estimate project’s beta does not exist. (This portion quoted from this website

The problem is actually larger in the case of Bangladesh due to a number of factors and I would assume that its the same for many frontier countries. That is exactly why I decided to email him. I am putting the exact email exchange word by word.

Asif Khan

Dear Sir,

I know you get this a lot but I am a huge fan of yours. I have read quite a number of your books and have asked many people to follow your blog. I am personally trying to build an education portal (finance, economics, CFA etc) to promote quality and practical education in Bangladesh. I am getting good response not only from Bangladesh but also from around the world in terms of views and comments.

I think what could help my cause is a small guest post from you as you are a legend on valuation. I also know the perfect question that needs to be addressed and I think you will find it interesting. The question is

How to derive the cost of equity in Bangladesh?

The challenges we face are

1.        Our stock indices (DGEN) were calculated very incorrectly which is why they introduced a new index called DSEX but they never provided the historical data. So we really can’t calculate beta. Also as per your book it is better to use bottom up beta in frontier markets.

2.        We don’t have a treasury yield curve based on market pricing. The yield curve that we have, only reflects the cut off yield at the auction date.

3.        There is almost no appetite for long term bonds in the financial community who have very short term liabilities. So using the 10 year government bond as proxy would be difficult. As an example the 10 year government bond yield is around 12% whereas the inflation rate and the 91 day t-bill are both hovering around 7.5%. So using 12% will show most equities as overvalued.

Would really appreciate it if you could tell us how to derive cost of equity in such circumstances.

Aswath Damodaran

My suggestion is that you create a synthetic risk free rate by adding the expected inflation rate (I will assume that it is 7.50%) to a good estimate of a true real risk free rate (I use the US TIPs rate of 1.5%). That will give you a risk free rate of 9%.

The local stock indices are irrelevant and you can use a bottom up beta across emerging markets.

I still have not figured out what could be a good proxy for the true real risk free rate in Bangladesh. Will keep working on it and if I get a convincing answer I will surely update this post.

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