market folly

We're posting notes from the London Value Investor Conference 2016.  Next up is James Montier of GMO who talked about emerging markets.


James Montier's London Value Investor Conference Presentation

It is hard to be a contrarian investor. Human nature makes us feel safer and warmer in the middle of the herd. The Institutional imperative means it is better to fail conventionally than to succeed unconventionally. Asset managers tend to play it safe. As Jeremy Grantham has noted career risk produces conformity and anchoring among investment managers . Montier pointed out that value metrics can provide investors with a powerful alternative anchor that can be used as strong form of behavioural self-defence.


Investment idea: Emerging Markets  

Earlier in the year GMO were considering whether or not to put money to work in emerging markets. EM had been hated by investors in recent years and Graham and Dodd P/E ratios showed them as undervalued. It looked as though value stocks in emerging countries were particularly cheap which got them more excited. The value proposition in EM looked the best it had been for many years.

They stripped out financials and resources stocks from their analysis because both sectors are hard to value.  It is difficult to value resource companies as future returns are tied to the price of the underlying assets such oil or gold. Financials are opaque because of the difficulty of knowing what assets they hold. After they had stripped out financials and resource stocks they concluded that EM still looked cheap.

Montier’s team asked themselves how could they be wrong? A question Montier said investors do not ask enough. They thought perhaps that EM equities have not been equity like? Perhaps they were not like developed equities? Their results showed that EM equities were indeed like developed equities at least in terms of earnings yield – with a 6.5% average annual return. 

They asked whether the average future conditions for EM going forward were likely to be similar to the average past conditions? They had been looking at the last 15 years in particular and they wondered if that period was normal? They asked what sort of growth would be required over the next 10 years in EM to make them feel comfortable that today’s prices offered a good value?

They concluded earlier in the year that about 1.5% real growth would do it. That did not seem like a huge hurdle, however, when they went back and looked at the last 15 years they was surprised to find that the EM value subgroup had only grown at 1.5% per annum in real terms. That tempered their enthusiasm a bit. It made them conclude that EM valuations were fair but not cheap. Compared to the opportunity set faced by investors today, though, EM appeared to be preferable to other assets.

They also started to worry that looking back 15 years was not long enough especially as the Asian currency crisis of 1997 was excluded from the data. This gave them further pause for thought as earnings yields in that period were crushed. He pointed out that it is also important to balance this with the recognition that EM economies are in better health than they were back in the late 1990s. For example, today most EM countries run a current account surplus rather than deficit and there are less fixed exchange rates. They also worried about the high level of private sector debt at a macro level but were relieved to find that it did not show up in the balance sheets of individual companies that make up the MSCI emerging index.

Even if they were right about valuations in local terms could they still lose on the currencies? They found that the EM currencies had already fallen a lot from expensive to fair value. This meant that if they fell further they would have the reassurance of knowing that the currencies were cheap and should mean revert at some point - a temporary but not a permanent impairment of capital.

In the end they decided they would buy some emerging equities but they tempered their buying because of the negatives they had found around earnings.



Be sure to check out the rest of the presentations from the London Value Investor Conference.