Monday, September 7, 2009

It was one of those it 'us' or is it 'them'?

Last Friday our four Emerging Markets portfolios finished their first 'live' week. We will follow them during the weeks and months ahead and compare their performance with that of the following four benchmarks:
  • Cash / Money Market
    • As you might recall from our earlier blog entries, part of the money was left in a money market account. Reason: we were not that certain yet that all crisis is behind us. This translated into a 5.9% cash balance within the Morningstar Best Ideas portfolio; a 10.0% cash balance in the EmergingMarketsWinners portfolio; and a balance of 11.1% cash in the EmergingMarketsLosers and Next11 portfolios. Obviously, one of the 'investor types' that might be following our performance is the standard, savings-oriented investor that would have put his/her money in a savings account. That is why we take a standard savings account (in US Dollars) as benchmark #1. With markets gradually, but slowly recovering after the crisis period and Bernanke and his team doing all they can to keep interest rates low, the expectation is that this benchmark will bring the lowest return, albeit with by far the lowest risk.
  • MSCI Emerging Markets
    • Index provider MSCI Barra has the biggest name in the institutional investment community when it comes to reliable benchmarks. The developed market benchmarks of MSCI are already 40 years old and the index provider has shown to be serious about the creation of 'data-snooping'-free indexes that give a fair picture of what happened in a particular market during a specific period. The MSCI Emerging Markets Index encompasses all Emerging Markets, based on their relative market weights. This is of course an obvious benchmark candidate. If our four portfolios are 'picked' in a savvy way, they should be highly-correlated with the MSCI Emerging Markets index, for sure. However, the excess return generated would be an indicator of stock-picking quality. 
  • MSCI Frontier Markets
    • The smaller Emerging, or Frontier Markets are covered in the MSCI Frontier Index. Since we are also playing with Goldman's Next-11 idea (with Frontier economies playing a role in that), we feel that it is also good to see if the smaller countries will do indeed a better job than the bigger ones. A phenomenon that we already know from developed countries, but with the Emerging Markets - with the exception maybe of the BRIC nations (Brazil, Russia, India and China) and Taiwan and South Korea hardly that emerging anymore, we are wondering if there is something like a 'small country' effect already going on.
  • MSCI World
    • And last but not least, we have to compare our performance with what is going on in the Developed Markets of course. The MSCI World Index is MSCI's broad index of developed markets, with the US, UK, Japan, Germany and France as obvious largest index contributors. Stock markets in developed nations do normally show lower volatility (measured as the standard deviation of stock returns) and market risk (measured by the beta coefficient) than Emerging Markets and Frontier Markets do. This index is therefore - within the asset class 'equities' - also a normal comparative benchmark for the four portfolios that we are tracking. The 'normal' expectation would be that our four portfolios would in the longer run do a better job, albeit that they would realize this result after a far bumpier ride.
The chart shows the performance of the four test portfolios and the four benchmarks during the first week. (Note: to see a bigger version of the chart; just click on it)

And it was indeed 'one of those famous weeks'. Why? Well, first of all, of the four test portfolios the one created using the 'best stock picks' of the 'best specialists' working as analyst in the 'best' Morningstar Funds did worst! And that was not because it was an improperly diversified portfolio. As you might recall from our first blog entry last week, there are 17 different holdings in the Morningstar Best Ideas/Favorites (MORFAV) portfolio, whereas the other three test portfolios are less diversified with 10 or 11 holdings. It was also not because of the difference in asset allocation. The MORFAV portfolio had less cash than the other three and actually, the cash benchmark (CASH) did less well than the MSCI Emerging Markets (MSCIEM). A cash investor would have made 0.19% in week 36 vis-a-vis a 0.22% return for the Emerging Markets equity investor. 

The MSCI Frontier Index (MSCIFM) lost some money (-0.64%). But both developing nations-focused equity indexes did actually do a reasonable job vis-a-vis the MSCI World (MSCIWRLD). The developed market index lost 1.71% in week 36. 

So, what made us sigh 'it was one of those weeks'? Well, the three portfolios that we created by simply adopting relatively naive ideas ('buy big stocks from a) Winner; b) Loser and c) Next-11 countries') outperformed the MORFAV portfolio easily, albeit that all three of them did less good than either the MSCIEM or MSCIFM portfolios. It is of course still early and we cannot deduct too much after one week of performance, but isn't it remarkable that the behavior of our four emerging market test portfolios seems to be more in line with what is going on in developed nations than with that in their own indexes?

How is that possible? Well, one thing that characterizes all four test portfolios is that the stocks in these portfolios are all relatively 'big'. The stocks are market leaders in their countries: highly liquid, above-average visibility and below-average risk profile. The type of stocks Western investors (be they institutional or private) would buy in 'strange', foreign countries. To a certain extent big Western investors do have to act that way. The smallest stocks might simply be too illiquid and/or they might not be available to Western investors. On the other hand - and that is a somewhat less nicer way of saying things - it is also possible that the Western investors themselves withdrew money in a kind of panic. And there were some things going on that might have led to fears or - after the good weeks that we have behind us - profit taking. First, there was the unrest in Western China, where the party leadership replaced a local hot shot in quite an aggressive manner, once again indicating that China holds different views about good politics than many European nations or the US do. Second, there was the ongoing unrest in Gabon, Africa where Omar Bongo's son feels that he is the best candidate to become the country's new leader. This at a time when investigations are going on in France to show how corrupt his father was. Oil company Total has already urged its French executives to return to France. And the fact that Ali Bongo - the son - himself has a track record showing that he brought the late Michael Jackson in the beginning of the 1990s to the poor country, is also probably more indicative of his own consumption habits than of popular demands. And last but not least, the opposition believes that the election results are everything but fair and reliable. In Venezuela there was turbulence with large groups of protagonists of Chavez flocking the street, demanding that the president gets extra time as the country's leader. Even if that would require changing the law. His opponents march the street against this, saying that there is no reason to change the law. And Chavez himself wants to re-direct attention away from this domestic turbulence to international politics, where he believes that the US is acting against the interest of the people and the 'Bolivarian revolution' while at the same time protecting the interest of big multinational companies. And then there was the British turbulence related to the Lockerbie-Libya deal: did the Brown-adminstration allow an oil-for-justice kind of deal?

Anyway, it was a week in which the news about Emerging Markets was mainly political and 'not so nice' if we want to use an understatement. Combining that with the fact that we have a period behind us in which markets were recovering from the damage done by the Global Credit Crisis, we can understand that there was profit taking going on.

Does that mean that we are stepping into these markets at the wrong moment? Not necessarily. True, the second half of the year is often considered less good than the first half. Seasonal patterns in stock markets are widely documented. September - November is normally not exactly the best period. So: in case we do score some good - above-expectation - returns during this period we could consider taking some profit and holding the proceeds in cash until December. But it is of course too early to do more than just create a 'strategy'.

With respect to the mechanics of our strategic approach, we will run our portfolio using the following mechanical rules:
  1. We introduce a stop-loss equal to 70%. This implies that we will sell a stock when its loss reaches 30 percent compared to the acquisition price.
  2. When we realize a return of +30% we introduce a decision moment where we either a) sell the holding, or b) increase the stop-loss by 30% and keep it. We will opt for a) if there is no great news for the country or stock in the near (next one-two years) future; and b) otherwise.
  3. With respect to diversification: we don't want our portfolio to be too fragmented or too sensitive to large holdings. The test portfolios will take profit (i.e. reduce the portfolio weight) whenever a specific stock holding has a weight larger than 20% of the portfolio. If the weight is smaller than 2% we will either sell the holding or buy extra to be above the 2% cut-off rate.
Obviously, these rules are not tested in week 1. But it is good to make them clear right now. We want this simple live test to be something that can help the average investor understand Emerging Markets while at the same time working on real investment portfolios. 

We finish this article by listing the top 3 stocks in the various test portfolios during the first week and the three biggest loser stocks. All returns are week 36 returns re-calculated in US Dollars.

The three winners were:

National Bank of Pakistan (PAK) + 14.59%
Mercantil Servicios Financieros (VEN) + 9.73%
China Construction Bank (CHI) + 4.61%

The three losers:

Turkiye Is Bankasi (TUR) - 10.67%
Cemex (MEX) -6.73%
Gazprom (RUS) -6.18% 

There was something like a 'sector' effect going on here. All three winners are financial firms. National Bank of Pakistan was by far the best performing stock. This stock, chosen not by the specialists for the Morningstar portfolio but by us for our 'naive' EmergInvest Loser and Next-11 portfolios, will be highlighted in our next blog entry as our first Stock of the Week. An almost 15 percent return in US Dollars in one week time is a good score to warrant that treatment!

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