Weekend Reading #46 — Three Body Capital

This is the forty-sixth weekly edition of our newsletter, Weekend Reading, sent out on Saturday 7th December 2019. To receive a copy each week directly into your inbox, sign up here.

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What we're doing.

As a startup we pride ourselves on keeping costs low, but the beverage situation at our Camden HQ has become a bit of a comedy sketch, with guests politely leaving entire mugs of the black stuff untouched due to our insistence on serving them freeze-dried instant coffee. So this week, after some procrastination, we finally caved in and bought a coffee machine.

Those of you with plans to visit us will be relieved to know that we have invested in a Dualit coffee machine. It can handle capsules, pods and ground coffee (enabling us to keep a firm hand on the purse strings). And although we bought a refurbished version from Amazon to save a few extra quid and it therefore arrived without an instruction manual, we’ve just about got our heads around how to use the thing!

Since starting our business we’ve wanted to release a podcast. We love the format and believe it has incredible power to engage listeners, build trust and grow business. But we’re also conscious that there’s a lot of noise in the podcasting space. People are fond of saying that “podcasting is where blogging was in the early 2000s”, but in reality it is catching up FAST. We don’t want to add to the noise, so if we are going to produce audio it needs to be worthy of people’s time. If we were to produce audio content, the output would be a reflection of who we are as people, not some weird reverse-engineered attempt to acquire leads for our business.

Right now, we’re not sure how we can add value with a podcast, so we’re taking a backseat and seeing what we can learn from the plethora of wonderful shows that are already out there, like Hidden Forces with Demetri Kofinas, Ted Seides’ Capital Allocators, Sean Carroll’s Mindscape, Patrick O’Shaughnessy’s Invest Like The Best, Cal Fussman’s Big Questions, Freakonomics Radio and many others. If you have thoughts or ideas on how we can contribute meaningfully to the podcast landscape, please do drop us a line.

What we're watching.

We started watching Greatest Events of WWII In Colour at home whilst we multitasked, reading analyst reports, educating ourselves on tokenomics, replying to emails, writing blog posts about the conflation of luck and skill, reading up on quantum physics and other run-of-the-mill tasks required of hedge fund managers and dealmakers. We massively underestimated the power of the show and in doing so, did it a huge disservice. Seeing events like the D-Day landings, the Battle Of Midway and the Siege of Leningrad brought to life in colour makes them seem somehow more real. This isn’t television that you can have on whilst doing other things – it’s utterly gripping.

As we approach the festive season here in London it’s getting dark at 4pm. In the depths of Winter we always turn to comedy heroes like Michael Scott and Chandler Bing for a blast of positive energy and good times when the nights are drawing in. Revisiting shows like Friends reminds us of the timeless quality of great storytelling – it may have been filmed over 20 years ago but the social scenarios it explores remain relevant to this day. No wonder Netflix paid $100 million to keep Friends exclusively on its platform, and over £500 million to acquire global streaming rights for Seinfeld over 5 years.

It’s interesting to note that Netflix’s most watched shows aren’t Breaking Bad and Stranger Things. In fact, research from Nielson suggests that Netflix’s best performing original (Orange Is The New Black) ranks only 7th in its most watched programmes. 14 of the top 20 performing shows are library content, licenced from other rights holders. These programmes continue to rake in revenue for rights owners long after their heyday, but many of Netflix and Hulu’s most popular output is set to elude them over the coming years, as studios gear up to launch their own own streaming services. In fact, studios launching new streaming services have created TV shows and movies that account for nearly 40% of the viewing minutes on Netflix. The unavoidable loss of this library content explains why Netflix is spending so much on original programming.

What we're reading.

This week we finally got around to starting Ryan Holiday’s Perennial Seller. In a world of dubious self-help gurus and fake prophets, Holiday has carved out a niche as a writer who crafts well researched books on significant topics such as the application of ancient Greek philosophy to sports, entrepreneurship and contemporary life.

Now the man who brought stoicism to the NFL has created a book that explores the nature of timeless work. It features brilliant anecdotes and interviews with some of the world's greatest creatives, but it’s more than inspiring – it’s actually useful.

What we're listening to.

This week we’ve been stuck into Van Morrison’s new Record, Three Chords And The Truth. Our favourite track so far is “Fame Will Eat Your Soul”, which is a duet with someone whose legendary voice you might recognise. Van is a firm favourite of the team here at Three Body, and some of our number have seen him live on several occasions. He is always grumpy (as evidenced by a recent interview in The Guardian), always rushing to get through his set and pick up his pay cheque, but critically, always brilliant. He is also always touring and if you get the chance to see him live, you must go.

What we’re writing

Who cares about emerging markets?

First, a mea culpa.

The title of this blog post was consciously designed to suck you into our world. We enjoy asking unsettling questions because they challenge us to gain deeper understandings of “truths”, which are often simply stories that have become naturalised through repetition and institutional convenience.

As many of you will know, we cut our teeth in emerging markets. It’s a world we love, with a very special community of people and firms that are capable of creating huge amounts of value for investors and themselves. But it’s also fair to say that the worldview of emerging markets has become static. It’s an investment sub-category that has enjoyed huge growth and consolidation, becoming part of the furniture for the world’s largest allocators.

But we think that there is something very wrong with this approach. While we have been involved, emerging markets have gone from being a narrative of excitement and growth to one of cyclical opportunity at the mercy of the index providers. You want some Chinese internet? There’s an ETF for that. You want Indian consumer? Yep there’s one for that too. The ETF assortment is large and choices are plentiful, and this presents huge problems to EM's future as an asset class.

What constitutes "emerging" anyway?

Emerging markets arrived on the scene as a distinct equity segment with the launch of the MSCI Emerging Markets Index in December 1987. We believe everyone at Three Body Capital was alive back then, although Eugene is cutting it fine! At launch, the index included 10 countries and made up less than 1% of the global equity market (MSCI All Country World Index). The rest is history, and the MSCI EM index now comprises 24 countries and represents almost 12% of the MSCI ACWI Index.

Back in April 2019 we wrote an opinion piece on the blog lamenting the gradual demise of EM as an allocation category along with our view that traditional categories are dissolving, and we wanted to return to this topic with a specific focus on country weightings in the major EM indices.

Although indices like MSCI and FTSE continue to classify China as “emerging”, it’s becoming increasingly obvious to us that China may already have outgrown the tag. Okay, both MSCI and FTSE (amongst a series of other criteria) use Gross National Income (GNI) per capita thresholds (measured in US$ and adjusted in line with price inflation) to determine which countries are emerging, developed and frontier markets (and MSCI requires countries to have a GNI per capita 25% above the World Bank high income threshold for 3 consecutive years, amounting to US$ 15,294 per capita). The 2017 high income threshold was US$ 12,235 per capita, much higher than the average in China of US$8,690. So on this basis, there is much wood left to chop before China gets anywhere near to achieving developed market status. We are not here to quibble with FTSE and MSCI as they need their categorisation criteria and by the measures they apply, the results are apparent. But realistically speaking, is China really still an emerging market?

Market share.

Let's start with a few obvious observations.

Many things about what China does are quite rightly up for intense debate, but there is no doubt that China already enjoys huge influence on the world stage, projecting political and economic power outwards with increasing bravado. Its economy has rapidly gained ground on that of the US, though we’re not going to guesstimate when the smaller economy will overtake the larger, or even if it will at all. That depends on simply too many variables today. Suffice to say China’s economy has matured rapidly from an export driven model to one that prioritises domestic demand. It has the largest population (home to 18.5% of the world's people), the second largest land area (7% of the world’s land) and it is the third strongest military power (for now).

All of this is quite rightly reflected in China’s rising contribution to the MSCI EM index, which has grown from 0% before 1996 to a whopping 33% in March 2019, making it by far the largest country represented. In late November, MSCI added 204 China A shares to bring the China country weight to 33.7% of the EM index. And BMO has observed that if MSCI includes not only include A-shares traded via Stock Connect, but all free float onshore A-shares, the Chinese equity market would be US$3.5bn, making up roughly half of the EM index.

China may not have taken over the world just yet, but it’s taking over the index. As the “Reformed Broker” Joshua Brown has pointed out, “most emerging markets indexes are often China funds in disguise.”

So you want to be an EM fund manager?

It seems almost laughable to call China an “emerging market”, especially given how far ahead it is compared to many “developed” countries in many areas. We talk about China and the US today in the context of the Thucydides Trap. Most people consider China as a potential superpower and yet MSCI and FTSE classify China as an emerging market, according to their own predetermined criteria, of course. The investment management landscape continues to happily go along with this story (just following the guidelines, keep calm and carry on) because it perpetuates the status quo – at least, it has done until now.

But China’s allocation in the index, weighted by the market capitalisation of its companies, is distorting the broader EM asset class, with implications that go far beyond the daily machinations of fund managers and allocators. If you want to be an EM fund manager you had better forget all your years learning about places like Turkey, Indonesia, Poland, Russia, South Africa and other fascinating markets and quickly upskill on China – it will soon account for 50% of the index, so best you ingest thousands of years of history, culture and language, fast. Never mind local market knowledge and nuance.

China’s rise in the index weightings is no coincidence – Chinese policymakers have lobbied hard to get more names included in major indices, improving access to liquidity from institutional investors. This itself speaks of great power. But their gain is other countries’ loss.

Not only does China’s dominance over the main EM indices reduce capital inflows from foreign investors and much needed liquidity to exchanges, depriving other EM countries of investment. It also starves important markets from investor attention – research, trading, and intangible opportunities to connect and build relationships.

For their part, investors are faced with increased concentration (and specialisation) risk. Everyone piles into (and out of) the same names at the same time, exacerbating price distortions and ultimately making it harder for everyone to navigate primary markets and raise capital at a cost-effective level.

What next for EM as a category?

So, what of the future? China isn’t joining the developed market indices anytime soon. If and when it is upgraded, one hopes that the biggest winners won’t necessarily be Chinese companies – it might be firms in other emerging markets, which will benefit from increased inflows and investor focus. Or, the market might just not care about who gets left behind. We won’t know until it happens.

But let's be honest: this isn’t only about China. South Korea and Taiwan account for 24% of the MSCI EM Index too. Are these countries really emerging markets? Right now nearly 60% of the index comprises companies from the above three countries. This raises the question – what do emerging markets even stand for anymore? Long gone are the days of broad-based, breakneck growth opportunities running on the tailwinds of country macro and structural reform.

Let’s look at the data, which shows what happened to flows over the past 20 years or so. For all the sex appeal of emerging market investing, the flows tell a very different story.

(To be honest, we had an inkling that this might be true, but when we actually looked at the data the message was much more stark than initially expected).

Source: IMF World Economic Outlook Database Oct 2019

The flows indicate that the emerging markets narrative is well and truly dead. The chart above shows the outflows following the bull market in the 90s and the subsequent bull market in the first decade of the 2000s. Since then the tale has been one of pure woe. Apart from a brief and spectacular surge in 2016 and a small uptick this year, it appears that the structural narrative of emerging markets as a group is dead.

What is dead may never die.

“What is dead may never die.”
– Theon Greyjoy during his iconic baptism scene in the HBO series, Game of Thrones.

The emerging markets story has been dead for some time, but it has been petrified in time by the efforts of index providers and the industry that surrounds them. Because the index is there, it never dies. Its composition has changed dramatically as we have written about above, but the dance continues.

Some of the best fund managers in the business, many of whom we know, have had excellent performance for years, yet they have seen very little interest from investors. Does this mean that no one is even watching? Are the people who are investing in the ETF today looking for the sexy growth story as it used to be, or are they simply looking for an easy instrument to trade and punt the global cycle?

Are we talking ourselves out of a job?

Our view is that any grouping of stocks, sectors, or countries together is usually transient and that “emerging markets” as a buzzword has passed its expiry date. What emerging markets have always been about is growth and excitement. To capture this essence in the current incarnation of EM, one needs fewer positions, more carefully chosen, quite simply because fewer opportunities in the form of classic EM growth exist. We don’t need to have long positions in China just because MSCI says we should. We can happily short Russian stocks should we deem it appropriate per our investment process. And should we find digital assets to be the opportunity we suspect it might be, we want the freedom to be able to add positions (long and short) in an emerging ecosystem which may prove extremely lucrative whatever that investment subcategory may be called.

We are building a fund which invests not only in emerging markets but in emerging opportunities.

Our view is that there is always a bull market somewhere. We look for growth wherever we can find it.

Should Turkey have a positive political event, we will delightfully build positions there. Should Iran be reintegrated into the global sphere, we will be there too if our process takes us there. And China? Selectively and carefully there are great opportunities, both long and short.

So of course there will be a focus on the traditional emerging market geographies because there is still a lot of opportunity there. It is just that it is no longer as pervasive as it once was and we certainly aren't looking to MSCI to tell us how to go about constructing our portfolio. The opportunity set is far bigger than buzzwords and archaic top-down classifications and we believe that our history, our personalities and our investment process will deliver to us and our investors the returns that we seek.

Many readers will balk at this note, having been in the industry for a long time, but the elephant in the room should be called out. We are always available and would be delighted to discuss our thoughts on emerging opportunities any time as we work towards our fund launch in early 2020.