Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
Anyone who is familiar with our investment process will know that at North of South we like to stress the importance of the cost of capital. A flexible methodology, which can accommodate the wide spectrum of sovereign macro conditions our corporates are exposed to, is critical to levelling the playing field for a dollar-based investor.
Our focus on this metric has a long history within the firm and has had a relevance to some of our broader asset allocations. We recall the significant long position built up in Credit Default Swaps (CDS) during 2006 and 2007 which proved prescient and a useful hedge during the GFC. In subsequent years, this instrument was somewhat discredited by issuing counterparties passing-on their own reduced creditworthiness as a loss to the CDS holder. Also when Greece defaulted in all but name, it caused bond losses which were not compensated by CDS payouts. However it remained both a useful barometer to equity valuations.
Domestic fixed income markets have a major influence on our stock valuation models with government bond yields providing the underpinning to our country cost of capital. Historically fixed income markets have been faster to react to brewing macro issues than equity markets. While this gap has narrowed over the years, there is still value in monitoring both, especially in markets that tend to see significant volatility. They can provide warnings to equity investors who ignore them at their peril.
For example, 10 year domestic bond yields in Turkey moved from around 9% in mid-2016 to 12% by the end of 2017. This was a clear reflection of deteriorating fundamentals. Meanwhile the Turkish equity market, even in US$ terms remained at higher levels until as late as March 2018.
Brazil is another market that has historically seen significant changes in its cost of capital – yet here 10 year bond yields declined from 12% to below 10% over the same period. While the Brazilian market had already outperformed Turkey by a reasonable margin, this widened significantly after March 2018. Of course Brazil still has some way to go to achieving stability of cost of capital and the broader sell-off also affected Brazilian assets. Unlike in Turkey however, the current account deficit is holding at below 1% of GDP and should provide stability once the presidential elections are out of the way.
More importantly, markets that enjoy a low and stable cost of capital have performed significantly better than the broader index – the Taiwanese market has outperformed the MSCI EM index by 14% in US$ since March 2018, remaining roughly unchanged despite the turbulence. Perhaps astoundingly, the Taiwanese market has even outperformed the S&P in US dollar terms since the end of 2015, showing that not all Emerging Markets are created equal.
Being a value investor does not mean being anti-growth. However it requires a significant degree of scepticism as to the ability to forecast very far into the future. This is why in our models we tend to fade the growth of stocks beyond a period of reasonable visibility - if we are able to buy stocks that look inexpensive even with modest assumptions, we are building in an extra margin of safety and upside. We will however miss out on stocks that are priced for near perfection and actually deliver it. While we believe that real value investing never went out of style, the market's focus on growth and quality alone has certainly been something of a headwind for disciplined investors. Inexpensive stocks have often remained inexpensive, while growth stocks have seen their market value increasing even faster than their earnings.
For example, Tencent currently trades at significantly higher multiples than it did five years ago. We do believe that this will eventually turn, providing value investors with a friendlier market environment that allows for a re-rating of underappreciated stocks relative to growth superstars. We will of course continue doing what we have always done – focus on acquiring undervalued cashflows discounted at the appropriate rate.
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