Random thoughts on Emerging Markets, Contrarian investing and Circle of competence
Since I have started the blog, I have been actively avoiding (or even shorting) anything which has significant Emerging markets exposure. This was quite a controversial strategy as for the last few years, investing in Emerging markets or companies with high Emerging market exposure was considered to be one of “THE” no-brainers in investing, along with commodities and residential real estate. Who doesn’t remember the famous “cleanest dirty shirt” slogan from Pimco’s El Erian ?
The momentum of Emerging markets carried them over the Eurozone crisis up until the end of 2012. Interestingly, even after first warning signs emerged like falling commodity prices, free-falling orders for companies like Caterpilar, the Batista bankruptcy etc. last year, the story of the “Emerging market consumer” and the swift transformation from investment led economies into happy consumer countries seemed to be still alive.
Now however, at least in the public perception, people are surprised that the infamous “decoupling” of the BRICs & Co was (as always) more wishful thinking than anything else. Interestingly again, the mood quickly turns from “no brainer” to “full panic”. On the other hand, European stocks, which 2 years ago were seen as total disaster, are touted as the most promising asset class despite being now much more expensive than 2 years ago.
As a contrarian investor, this is the time when one should pay attention and prepare oneself. On the one side, current sentiment tells me that I should become more careful with my high percentage of European stocks, on the other hand, I think it will be a good time trying to expand my circle of competence and start to look more into stocks with Emerging Markets exposure.
However, as a contrarian investor, one should be aware that one is always too early, both in the way in and the way out. This is basically the opposite side of the momentum investor. Psychologically, in my experience, most stock investors seek “instant” gratification. If you buy a new stock, you want the stock go up directly in order to have positive feedback on your thesis. Very few people can stomach declining share prices especially for new investments. In institutional environments there is a very high implicit pressure to invest into stocks with positive momentum as this increases the likelihood to look good in the short-term and this is all that counts, even in many so-called “value investing” outfits.
Back to Emerging markets: The truth is, I know very little about Emerging markets. I have documented one attempt with Pharmstandard as a special situation, where I was clearly luck to get out in time. So one clearly needs to have some sort of strategy.
In principal, there are various ways to gain exposure to Emerging markets:
1. diversified funds/ETFs of Emerging market stocks
2. single emerging markets stocks which are traded on accessible stock exchanges
3. Companies in developed markets with significant EM exposure
Personally, I think it makes most sense to extend the circle of competence in little steps. So investing in a company based for instance in China, where I have no clue how the market works and which is active in an industry where I don not have a lot of experience might be a very bad idea or the equivalent of pure gambling. One should also avoid obvious “compromised” sectors like German listed Chinese companies as the likelihood of systematic fraud is too high in my opinion.
The diversified approach has also big problems. In many markets, for instance Turkey, banks have a huge weight in the indices. As banks are the most vulnerable companies in a real crisis, index investing often turns out to be a suboptimal approach.
This leaves in my opinion two alternatives:
A) Invest in EM companies where I know the sector / business very well
B) Invest in developed market companies with significant EM exposure
Strategy B) in the current stage is relatively difficult, as especially in the consumer and automobile sector, people seem not to believe in any crisis or downturn. Yes, companies like Adidas, Yum or Volkswagen have underperformed the DAX this year, but they are not cheap.
Strategy A) has the drawback that often only a few companies are easily available to invest. In Turkey for instance, there is only a handful companies traded outside Turkey and one might not easily find traded ones in the prefered sectors.
One important caveat: In my experience, both booms and busts take longer to play out as everyone thinks. So there is absolutely no hurry to fully jump into EM stocks now. On the other hand it is very unrealistic to actually identify the low point. So once a certain investment is identified which is attractive, one should buy without trying to time the market.
In any case, for the rest 2014 I will try to look at the one or another company with significant EM exposure instead of chasing the few remaining undervalued European or American stocks. I might even start positions in some and prepare for a lot of pain, both for missing a continuing rally in Europe and for losses in new investments. But that is what contrarian investing is all about.