Sunday, January 10, 2010

Neglect, Overreaction and Portfolio Diversification - Important Cornerstones of your EM strategy

Dear reader,

First of all a Happy New Year to all of you! Our last contribution appeared in the third week of December 2009. The period around X-mas and New Year is normally one of reflection. But that was not the reason for our time-out. And it is also not the explanation for our rather general and reflective piece below. What happened is that LMG got involved more seriously with a group of EM investors interested in an Emerging Markets application of our approach and investment models. As you might recall, our system covers more than 75 Emerging Nations. Today, in this contribution we explain the general linkage between our approach and how to apply it in Emerging Markets.

In our next contribution later this week we will then present to you excerpts of our presentation to this investor group, including details about the region/investments we picked.

The Global Credit Crisis started to hit us in 2007 and it wasn't until March/April 2009 before financial markets started their recovery. But still: a lot of investors stay at the sidelines, not certain if we are really talking about a true recovery or a 'technical rebound'.

At LMG we always believed that the Global Credit Crisis was an overreaction phenomenon. Just as much as excess valuations before the Crisis were. Compare it to the 1997-99 period with good returns after the recovery from Emerging Market related fears and crises (Ruble, Mexican Peso, Asia etc.) before we hit a more depressive period after Millennium fears set in. What would happen to the world when computers would not be able to handle the change from 1999 to 2000 with tons of software programs just using the last two digits of the year and this would translate into a change from 99 to 00 (i.e. back in time)? Well, the world didn't disappear or enter an apocalyptic scenario. And to a large extent bad returns and economic harsh times from 2000 to 2003 were caused by people believing that this might happen. In other words: the importance and influence of beliefs on real economic trends is not to be underestimated.
Image 1; Overreaction

Overreaction cycles: from too far up to too far down and back again

Richard Thaler

The old work by Werner de Bondt and Richard Thaler (see picture) back in the 1980s on Overreaction is illustrative. If you create portfolios of Winner stocks that went up most dramatically during the previous 3-5 year period, and do the same with Loser stocks, it is actually the Loser portfolios that outperform the Winner portfolios during the next 3-5 year period! Even after correction for risk. True, it is a portfolio analysis, because individual dispersion between holdings is larger in the Loser than in the Winner portfolio. The Loser portfolios might contain stocks that go bankrupt (-100% return). But this is compensated for by stocks that recover. Obviously one could optimize an Overreaction-based strategy by adding a bankruptcy indicator (e.g. using the work of New York University professor Ed Altman) and only invest in those 

Losers that still have an acceptable Bankruptcy Indicator score. But the bottom line remains the same: Investors do have a tendency to Overreact.

And it is not just Investors who suffer from this tendency. Just follow carefully the macroeconomic forecasts by Bureaus of Statistics or other think-tanks during the last 12 months. Most of the time they started to reduce their growth estimates and increase their unemployment estimates months after market trends were already moving in a downward direction in 2007 or 2008. In other words: these alleged forecasters were actually market followers! Same thing when markets started to recover after March/April 2009: months later the macro-economists and statisticians started to update their forecasts into something more positive. And a similar phenomenon appears when analyzing survey results of interviews about the expected economic climate or business climate with entrepreneurs. Why is this so?

To a certain extent the macro-forecasters or the average entrepreneur cannot help it. It is true that real economic trends are linked to financial market valuations. When markets are moving the wrong or right way, increased or decreased market valuations do have an impact on real economic actions of producers, consumers and governments that are logical and rational. 

Take investing during the first months or quarters of recovery. When the value of our firm's stocks is increasing again (finally!) vis-a-vis our debt, we do have more potential for increased borrowing and use this money for additional investments. Or when we use more of our -during the crisis deteriorated available reserves for direct, equity-paid new investments. Those new investments are done at a time when normally interest rates are relatively low (crisis period) with a lot of interesting opportunities available in the market (immediately after a crash or during a down period a lot of smaller firms or projects are available at a lower acquisition price!). The other way round: when markets are hitting the sky, sooner or later firms will invest in layers of investment that were actually not the smartest ones. Business cycles and human reactions / behavioral phenomena are therefore linked. Be it on the side of investors / entrepreneurs or in the forecaster community. It is just that 'smart money' investors and entrepreneurs see these trends a bit quicker than others. So what it is all about is a) find the 'smart money' investors and entrepreneurs and b) follow them by picking the correct projects / investable securities.

Neglect: One of the most important behavioral phenomena

But it is not only a rational linkage between the money flow of the smart money investors and their followers that somehow pops up in the analyses of the forecasters that makes them sometimes look like trend followers. There is also something else going on. Back in the 1980s when De Bondt and Thaler did their work on Overreaction there was also a period (mid 1980s) during which a lot of papers on 'Neglect' were published. In the 'Neglect' literature it was shown that risk-adjusted returns on portfolios of stocks that were followed by less analysts outperformed the ones that were followed by more analysts! In and of itself this is not illogical. 'Smart money' investing is about seeing things before others see it. When more analysts are following a stock or other type of asset, more information is disseminated. The relative value of excess information becomes smaller. And not just that: analysts and investors - be they institutional or private - are also human beings. Whenever you invest someone else's money you also take into consideration factors not directly related to the expected return-risk profile of your advice. You also think about job certainty. And the likelihood of being fired for a wrong advice concerning a big brand name stock/firm is much smaller than when recommending something totally unknown or recommending something known far before others are doing so. So, just like not all invested capital is 'smart money', not all analysts are 'smart advisers'! 

A Problem: Neglect and Our Admiration for the Prophets of Doom
So technically, when trying to become smart money, one should be going contra-cyclical. Look for opportunities in areas where others aren't looking yet. Look for Winners within the category of largest Losers, et cetera. Obviously, when doing so the importance of proper Risk Management and Portfolio Construction grows dramatically. But just as much as the 'not so smart' analysts above where actually not-so-dumb either when adding job-certainty related factors into the equation, we should keep in mind that going contra-cyclical is easier said than done. You need to have a mind set that enables you to be 'the only one at the party with a specific vision', understanding that your moment of glory will almost never be at that party itself but almost always - when you turn out to be right - at some future event. Maybe at a time when no one recalls that you were the one telling them so months or years earlier. The main reward is in that case a financial one: when your 'neglected' investment asset or market finally gains momentum when others discover it. Your price appreciation will in that case be anything in a range from substantial to impressive. Therefore: going anti-cyclical is a strategy for people that can sit-and-wait.

Funnily enough, there is one group of anti-cyclical investors that people do admire a lot. These are the Prophets of Doom. Investors or Market Watchers that forecast correctly that things will collapse are admired a lot. These Prophets of Doom do indeed make lots of money when they are right. But, normally things don't collapse. Countries, sectors, asset classes and individual securities do - on average - generate positive growth and returns. Even after correcting for risk. In a way you could say that this implies that Prophets of Doom 'invest' in their strategy by below-average or even negative returns during normal and boom periods, to achieve their gain in a doom period. Real smart money would only be a Prophet of Doom when doom periods are truly not that far ahead of us. A quick analysis will teach you that the list of alleged Prophets of Doom is filled with guys (and still not enough girls!) that almost always seem to be the negative party pooper.  And almost always are these Prophets not too transparent about their longer-term returns, i.e. the ones including the normal and boom periods. Prophets of Glory, the real optimists, will definitely do better as a group because this is a simple market law. When average returns corrected for risk are positive, with true collapse periods still being a rarity, the group of optimists has an easier game. We can understand this asymmetry in respect for and treatment of optimists versus pessimists when incorporating the fact that most people are risk-averse. We appreciate avoidance of a negative return of -10 percent far more than we appreciate an extra gain of 10 or even much more percent when still scoring a reasonable positive return. In other words: what makes us admire Prophets of Doom is something similar to what makes us love low volatility instruments: negative risk aversion.

But the one thing that is good about Prophets of Doom for investors that do want to apply a neglect-based strategy - be it for their whole portfolio or for just a part of it - is that they do have the mental power to be 'the only one at the party with a specific vision' most of the time.

Fall in Love with Neglect without falling in love
However, just like a doom-based strategy would not bring you good returns after risk correction when sticking to that approach all through the cycle, neither would holding your selection of 'Neglect'-based investments too long, when others start to discover them. In the end it is about a) finding things that others didn't find yet; and b) selling them when too many others start liking them.

Image 2: Growing Importance of Behavioral Literature
Here an important book by Richard Thaler (ed)

What these general lines about investment approach mean for EM investors
The world changed from a 2- to 3-block environment. In the old, market-value-based environment developed nations in North America, Europe, Asia (mainly Japan) and Oceania had a combined market weight of about 90-95 percent (US, Canada about 50; Europe 30 and Asia-developed 10-15). The rest of the world comprised of more than 150 nations with a total weight of 10 percent at best. The economic growth record of Emerging and Frontier Markets during the last 10-15 years has been such, that a GDP-weighted world would lead to totally different numbers. The combined GDP-weight of the Emerging and Frontier Markets is now about 30 percent. North America has a weight of about 35 percent and Europe-Asia-Oceania combined (Other Developed) 35 as well.

Image 3; The old 2-block-dominated world; MV Based

During the last 10-15 years we also saw an increased growth in the number of opportunities to invest in less-liquid or new asset classes. At the portfolio level this discovery or creation of new investment vehicles will give their valuation a boost since increased numbers of trend following investors will start adding them to their portfolios. With the fantastic growth stories of China, India and to a lesser extent Brazil and Russia as catalyst, this has led to the 'discovery' of Emerging Markets investments. Albeit that real EM success was still mainly in these BRIC nations. There is still a lot to be discovered. Actually, we are more afraid of signs of overreaction and 'too much' investment in large-cap growth stories within the BRIC countries. In other words: EM success should now be looked for in a) other countries and/or b) small- and mid-cap stocks in the BRIC nations. And we should not forget other asset classes: Emerging Market Debt, Micro Finance, Islamic Finance and EM Real Estate and Commodity Investments are very promising as well.

Image 4; The New World
Three blocks and GDP Based

Emerging and Frontier Markets do remain above-average in terms of risk profile when looking at individual investments, albeit that one of their interesting characteristics seems to be that - with an ongoing development of their financial systems - average risk levels seem to be lower than they used to be. Smart money investors should therefore create a diversified portfolio of EM holdings / asset class exposures.
But with their excess growth and much larger GDP than market value weight we are certain that most (read: almost all!) developed market investors invest too small a piece of their overall investable resources in these countries. This holds for both institutional and private investors. Our general approach above does also explain why the BRIC nations attracted most of the inflow and turned out to be the real big hit during the last 10 years. Frontier Markets were still one bridge too far. But when will this change? In our next contribution we will pay more attention to this detail question about picking the winning EM region for the next 5 years.

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