I wanted to take some time to discuss 3 things when investing in Emerging Markets that are not widely discussed. The impetus for this article was driven by my blog post at the beginning of 2018 titled, “How to invest when inflation picks up“, in which I said that because I was bullish on commodity prices, I was going long Brazil. Brazil has a very commodity driven economy (oil, metals & mining, agriculture) and my view was that a rebound in commodity prices would result in Brazil’s economy improving and its stock market should improve as well.
That call has not come to fruition yet, as shown by the Brazil ETF EWZ being down 21% since that call. And here are 3 lessons I think are important when investing in emerging markets, of which the first will relate to why my call on Brazil has been wrong so far.
1. Changes in currency can have a big impact on results
I would say a central reason why my call on Brazil has been wrong is because of currency. The Real (Brazil’s currency) has been very volatile and has depreciated against the dollar since the slowdown in China started to occur in 2015 along with the commodity bust, which put Brazil in a deep recession. Recently, a trucker strike derailed plans to get the economy back on the path to recovery and sent the currency tumbling again.
What this has meant for my dollar investment is also depreciation… Let’s use an example to see why: say a stock in Brazil was trading for 100 BRL when the USD/BRL rate was at 3.00. I place an $10,000 order, exchaning my dollars for 30,000 BRL and buy 300 shares. In local currency terms, lets say the stock goes up 10%, such that the quoted price is 110 BRL. I should have made $1,000 bucks on my investment, right?
Nope. If the BRL depreciated like it did in the chart above from 3.00 to 3.85, I’d be sitting on a pretty poor return actually, as shown below.
Alas, this would mean even though I was right on stock selection, the currency movements negatively impacted my returns. This is partially why with all the global currency volatility, currency hedged ETFs are launching all over.
Do I advocate for currency hedges? Sometimes. It depends on the time-horizon. A long term investor may look at the levels of the BRL to the USD and see this as a buying opportunity and therefore, you can be right on stock selection AND the currency may be in your favor which would boost returns.
However, I don’t think anyway can really tell me where a currency will be in 10 years, so I won’t opine on that. What I will say is that our return thresholds should be much higher when investing in Brazil than lets say the US or another developed economy like Germany. I don’t know what the currency will do over the next 2-3 years, but what I do know is that the real will depreciate over time relative to the dollar. No one questions that the inflation rate in Brazil will be higher than the US over the long run and that should mean that over time, the real should depreciate relative to the USD.
In sum, you have to be aware of currency, especially volatile ones. You’re taking a risk, so we should get paid for that.
2. Just because you’re buying a company’s stock overseas, it does not mean you are afforded the same protections as the US.
Alibaba’s stock is up 25% in the past year and has ~doubled since IPO’ing in 2014. But did you know that if you hold BABA which trades on the NYSE, you actually don’t own Alibaba at all? China forbids foreign investors from owning certain types of companies. As such, you aren’t really buying Alibaba. You are buying a holding company that has a claim on Chinese subsidiaries profits, but no economic interest. The risk here is that China comes in and says that is not allowed and guess what? You own nothing. The New York Times reported on how China has not actually weighed in on this. You may also want to check out the risk factors of Alibaba’s 10-k entitled, “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations”.
I don’t mean to pick on BABA here (Tencent, Baidu, JD.com each have this problem as well), but the risk here might be higher than you think. Lots of people would say, “look China is relaxing its command economy and moving more to a free market. They wouldn’t do something like that.”
And to that I say, look at Russia. In the 1990’s, following the “end” of the Cold War, Russia issued privatization vouchers that allowed investors to actually own former State Owned Enterprises. This was a huge step for Russia and it seemed like the old communist power would be relaxing its grip on businesses. But I encourage you to study what happened when Russia deemed it needed to re-control “strategic sectors”. Yuko Oil Company is a fascinating case study.
In a very brief summary, Yuko went to the private markets and quickly adopted transparent rules and practices, became one of the world’s largest non-state owned oil companies, and even had 5 Americans on its board. The company was paying dividends and growing internationally as well.
When Putin came to power, things quickly changed. The CEO of Yukos was arrested for tax evasion and fraud and Yukos was slapped with a $27 billion fine which was higher than its total revenues for the past 2 years. Yukos was forced to break up and its shares were frozen (to prevent a foreign company like Exxon from buying them). Eventually, Yukos declared bankruptcy. Many viewed this as a direct attack on the CEO of Yukos who was gaining political power.
In sum, I think its important to remember these risk factors and not get too comfortable in international / emerging markets that are known to have limited privileges to foreign investors.
3. Active management makes sense in Emerging Markets
So much has been written on active vs. passive investing in the US, it is actually making me nauseous. But I think this is a good topic to end on for this post, because it sums up the previous points here. An active manager can weigh the impact of currency on a potential investment. They can weigh the political changes that are happening in the base of a country. And lastly, they are paid to do work on changes in the tastes of the economy.
One area of research I always try to look for is primary work. That is, if I buy the stock of a company, particularly one oriented to consumers, I want to conduct surveys on what its consumer say about the actual product and understand if that helps or hurts the investment decision in any way. It’s also important to remember that sometimes we take for granted the tidal shift occurring in the U.S. such as Amazon, Netflix, or Apple because we interact with those products and see them on TV everyday. But how can you tell what type of products they are using in India or China without being there? Did you know Netflix and Apple are not the primary sources of products in those countries? They have their own.
Tastes change and they change quickly, so in my view, unless you’re traveling to the country often, you are paying an active manager to do that work. Indexes are backward looking (i.e. they weight the companies that have performed the best in the past at the top in a market cap weighted index), so they do not always calculate the risks mentioned herein. Sometimes they don’t include the entire universe, which can limit returns or at least potential for higher returns.
And as a result, we can see in the chart below that it pays to pay the higher management fee for active. This chart (taken from AllianceBernstein) shows that “70% of active managers in emerging equities have beaten the benchmark over the five-year period ended March 31, 2017, while 66% have outperformed over 10 years, net of fees. On a rolling five-year basis, the percent of active managers outperforming the EM index has never fallen below 50%”.
Hope this was helpful for you. Please let me know if you have any questions or comments.