Sunday, September 13, 2009

Back on track after a good week

Performance Week 37 (Sep 5 - Sep 11)

Although we would normally not expect any good returns in this week based on the news, things did go quite well. Remarkable, because it was also the week of September 11 and that might have given investors the idea to sit and wait. At the same token, there wasn't really that much good news. But the dollar went down a bit and that might have helped quite a few of the firms in our portfolios, albeit that currency returns were definitely not the overriding theme in week 37 (September 5-September 11).

As shown in graph 1 below, all 4 model portfolios with Emerging Markets exposure did quite well. The red bars represent the return in week 37 and all four show a neat rebound after the negative returns in week 36 (August 28-September 4). Cumulatively, we are back on track with positive returns after 2 weeks that are now in line with - or higher than - what we can expect from a year money market interest at the moment with the annualized money market rate now at 1.70%.As the graph indicates, our money market exposure ('CASH') is by far the safest investment but also the one that is now lagging quite far behind.

Graph 1; Portfolio Performance after first 2 weeks

When comparing our portfolios with other benchmark than CASH, we see that the MSCI World Index (MSCIWRLD) had a good week as well, albeit that its rebound was less spectacular than what we saw in our Emerging Markets model portfolios. The MSCI World showed a 4.08% weekly return in week 37 after a negative -1.71% in week 36. The MSCI Emerging Markets Index (MSCIEM) - the broad index with all Emerging Markets represented in it - is so far the best portfolio. But that is mainly related to its better start in week 36 as we saw in our earlier blog entry last week. But a 5.03% return after 2 weeks is of course fantastic by all standards and it indicates a trend that we can not extrapolate into the future for let's say the next 50 weeks so as to arrive at an annualized return of more than 250% (Note: 1.0503^26 - 1 = 258.22%). But the combination of a) recovering markets in developing countries after the Global Credit Crisis and b) recovering currencies compared to the US Dollar (only the Mexican peso and the Kuwait dinar show small minuses of -0.64% and -0.10% respectively after week 36 and week 37, with all the other currencies either stable or showing a positive currency return) will provide us with sufficient potential for good returns. Sure, economically most countries will still struggle with the macroeconomic consequences of the Global Credit Crisis and this will continue into 2010 - and maybe even into 2011 in countries where the government and monetary authorities fail to take proper actions - but we shouldn't forget that a lot of this is already priced into market valuations.


The best portfolio in week 37 was our Morningstar Best Ideas (MORFAV) portfolio. It rebounded with a weekly return of 5.46% after a bad start in week 36 (-1.90%). This kind of mean-reversion in stock prices is pretty normal when looking at shorter term return patters. Especially in less liquid markets: when people exaggerate (as they often do!) and panic they sell too much, too quickly with demand by more courageous investors needing some time and/or with smart investors and brokers/traders simply waiting because they know that the panicky colleagues will want to get out too fast. Good recovery in the Chinese and Russian markets helped the MORFAV portfolio with ICICI Bank, China Construction Bank (both China) and Gazprom (Russia) being the three best performing stocks now. 

Another clear example of mean-reversion, albeit at the macro level is the fact that our Emerging Markets Losers portfolio (EMLOS) is now the best performing of the four that we created with a cumulative performance of 3.81%. The mean-reversion play in the EMLOS portfolio is directly related to the fact that we selected countries here on the basis of the cumulative index loss they suffered during the last 12 months. I.e. the model stock portfolio doing best after 2 weeks is the one with representatives from the countries that did worst during the last 12 months (up to end-of-month August 2009, when we created the portfolio).

So, all in all we can look back at a good start of our investment adventure(s). True, we are lagging behind MSCIEM, but don't forget that this is a portfolio solely consisting of equity whereas our four portfolios do contain a CASH allocation ranging from 6-11% depending on the portfolio. This reduces the risk in our portfolios compared to the MSCIEM broad index portfolio. There are two reasons for our more careful approach:
  1. We knew upfront that we would not be creating such a broad index with hundreds of stocks like MSCIEM. Why? Because we wanted to track a portfolio that any investor - not just big, instutional investors - could follow and our mimic for his/her own purposes.
  2. Second, because we are recovering from a big Global Crisis with the Macroeconomic Outlook in many countries still difficult we also didn't want to be 'too quick and eager', especially not because we are going into the second half of the year. Academic research has indicated that so-called seasonal patterns like the 'Part-of-the-Year' effect are still important. Investors tend to get less return (some say even no return at all!) during the period from June/July to November/December. With us starting our little experiment in August we just have to be careful. 
But there is more: our CASH allocation alone is not sufficient to explain why the four portfolios are lagging the MSCIEM a bit. As we saw in last week's entry (Sep 6) to this blog, the broad and diversified index portfolio scored its 'plus' of +0.22% in week 36 basically due to the fact that it had a far larger allocation of smaller stocks than we have. That is why we asked ourselves the question 'Is it one of those weeks again?'. When things get scary, the fears in Emerging Markets - as visible in negative returns - are often caused by foreign investors withdrawing their funds. Still, a lot of Western investors tend to think that 'things are like in the old days'. Longer-term risk analysis does however show that the trend from a Two- to Three-block World - one of the major research themes at the Lodewijk Meijer Group - is already visible when looking at volatility.

Graph 2 - derived from old LMG Compendeon research into trends in Emerging Markets - shows the volatility development during the period 1988 (1) to 2008 (11). 

Graph 2 Volatility levels in selected developing countries
Technical note: volatility levels are monthly figures, based on a 36-months rolling window. If you want to translate things to annualized figures, you need to multiply by 3.464, i.e. the square root of 12, so as to complete the transformation from monthly to annualized window.
Interpretation example: a maximum volatility level of 15-16 percent per annum for the average Emerging Market (see yellow line in graph 2) translates into an annualized volatility of 50-55%. A huge number indicating how risky developing countries' equity markets can be. On the other hand, the lower levels seen in the period 2001-2007 translate into risk levels that are not that much higher than those in developed nations anymore. But the behavior of Emerging Markets in the Global Crisis indicates that we have to maintain a certain risk focus.

The yellow/bold line indicates the (equally-weighted) average volatility level for the 8 developing countries selected. Around a volatility level of 15-16 per cent per month lies a kind of maximum, that was reached in the period 1990-1992 and 1999-2001. The big global crisis period did lead to volatility increases since the second half of 2007, but things were rather 'well-behaved'. The panic was not so large as to shoot us quickly back to old levels. We do therefore conclude that - on average - Emerging Markets as a group will see their volatility levels go down, albeit that mean-reversion patterns in volatility will remain. Just like they do in developed markets.

Graph 2 shows clearly how risk in these markets has been coming down during the period in which their economies grew, political systems (on average) became more stable and the BRIC (Brazil, Russia, India and China) nations started to become true catalysts of growth on a global scale. The fact that most banks and other financial institutions in Emerging Markets didn't join their Western counterparts in the exaggerated race for 'more' (via creation of new structured finance and other products with derivative content that were not properly constructed from a risk point of view, but very interesting taking into account the bonus structure of boards of directors in the creating institutions!) has also played a role, because in almost all countries in the world the financial industry is one of the leading ones as far as stock markets are concerned. The interest in Islamic Finance has grown during the last few years, partly as a result of the problems with bad loans that Western banks have to deal with and partly because the approach warrants more attention in the first place. This is not the blog entry to discuss Islamic Finance in more depth, but we will definitely pay attention to it in a future entry. After all: the best stock after the first 2 weeks is still National Bank of Pakistan (see our previous blog entry), a bank that offers both regular and Islamic Finance products.

The graph does also show that:
  1. Both Brazil and Russia have brought down their average risk levels dramatically, from highs that were totally unknown to other nations. This goes back to the period where Brazil had huge problems with its monetary and debt policy (beginning of the 1990s) and for Russia it was the period of the Ruble crisis and uncertainty concerning Jeltsin's policy, privatizations, actions of oligarchs et cetera. It is indicative of a big market appreciation for both president Lula in Brazil and Vladimir Putin in Russia. It is not coincidental that Gazprom was one of our best performing stocks this week (and Russia one of the best performing countries!), exactly during the period when Putin started to hint toward him maybe running for president again after finishing this term as prime minister.
  2. Turkey is - on average - one of the most risky countries. The average risk level in Turkey is higher than in other countries, which is clearly visible from graph 2. See also how Turkey was most affected by the Global Crisis. Turkey - torn between the Middle East and Islamic politics on the one hand, and EU on the other - is always a very unclear market as far as macro-trends are concerned. So, basically: also here no big surprise that it is Turkish stock performance that is so-far disappointing within our four model portfolios.

Frontier Markets
The least performing portfolio is our Next-11 portfolio covering the Frontier theme. Here we are dealing with stocks from countries that do have a lot of potential in the longer run, but that are not yet 'tiger' economies with huge growth rates. They do however have the potential with large, relatively young populations and reasonable - or even good - education standards (see also our Education blog). But it is clear that it is not just us doing a bit less good in Frontier Markets. The MSCIFM portfolio is lagging behind as well. Actually, it is doing hardly better than CASH during this period in which Equities were doing great! A closer look teaches us that we are actually - when comparing our Next-11 portfolio (EMNXT11) with the MSCIFM as most representative benchmark - doing a good job. The cumulative performance of the EMNXT11 is 1.09% higher in 2 weeks than the return on the benchmark; and that with an 11 percent CASH holding in it. That the Frontier Markets weren't showing a better start is not that surprising. It is not impossible that investors - after the Global Crisis - follow a mirror-image patter of market re-entry. Behavioral finance teaches us that people - when confronted with situations that lead to panic - first 'act' rigorously (via selling off holdings in those nations) in periphery markets. These markets do then show the largest price drop. When returning to the market, the 'bravest' of the 'scary' investors start with small allocations in the biggest, safest periphery markets. I.e. the big and solid ones. It is therefore not surprising that China did such a good job during 2009. Any investor - be it a private investor with Do-it-yourself strategy or an institutional one - can 'defend' exposure to the Chinese market these days. China - also our County of the Month September at LMG World TV (our social network) - is 'hot'. And China will - sooner or later - take the number one spot in the world as biggest economy. China is almost alone, by itself, strong enough to warrant our Lodewijk Meijer Group philosophy of a Changing World (from Two to Three blocks). But as interesting as this longer term trend is, as investors in the market we need to keep in mind that we are not the only one out there knowing this.

When every one believes that China is good, prices will increase and returns will be fantastic during the period in which growing numbers of investors increase their China allocation. When Chinese firms deliver, this will translate into great returns. However, sooner or later investor demand will be saturated and/or Chinese growth will leave its 'tiger' phase and reach a more stable, but mature (i.e. lower) level. So: China in our portfolio? Yes, definitely! But will China be an 'easy win'? Hopefully, but we will not be surprised if our winning stocks come from somewhere else.

Individual stock performance in our portfolios
Just like we did in last week's entry, we finish this article with an analysis of the three best and three worst performing stocks (cumulatively after weeks 36 and 37) in our four model portfolios:

Top-3 stocks week 36 and week 37:
  1. National Bank of Pakistan (PAK) + 16.91%
  2. Mercantil Servicios Financieros (VEN) + 14.21%
  3. ICICI Bank (CHI) + 10.96%
All three winners posted returns 2-3 times higher than the MSCIEM leading benchmark portfolio.

Bottom-3 stocks week 36 and week 37:
  1. Turkiye Is Bankasi (TUR) - 7.72%
  2. CEMEX (Mex) -5.93%
  3. Orascom Telecom Holding (EGY) -2.50%
When adding up the combined returns of the three 'losers' (-16.15%)  and the three 'winners'  (+42.08%) we get an average 'extreme' stock return of -16.15% + 42.08% = 25.93% divided by 6 = 4.32%. Higher than the average return after 2 weeks of our average model portfolio. Conclusion, our extreme stock picks didn't do a bad job and were not contributing negatively to our overall portfolio performance.

With National Bank of Pakistan (last week's winner) already being analyzed in our previous entry, we will pay more attention to the Venezuelan firm Mercantil Servicios Financieros (MSF) in a separate analysis during the coming week.  

Venezuela and its stocks normally get far less attention than the country's president Hugo Chavez, so we wouldn't be surprised if a closer look at MSF will give us some new insights.

Let's hope that the next weeks will go as well as this one!!



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