Weekend Reading #12
Find below the twelfth edition of our weekly newsletter, Weekend Reading, sent out on Saturday 13th April 2019. Sign up here and receive a copy each week direct to your inbox.
* * * * *
Back to the future of emerging markets.
Once upon a time, emerging markets were about one thing and one thing only – sex appeal.
Investors are always looking to invest in something new and exciting to get higher rates of growth. In the early 2000s, the global macro backdrop was set up to deliver a (seemingly) structural shift in the way developing countries operated their economies. Widely applied Washington Consensus style reforms, rampant globalisation and the rise of China all came together to light a fire under a new asset class from the soft ashes of the 1997 Asian financial crisis and the dot com bust. Enter Jim O’Neil with his pop culture BRIC acronym and the rest is history.
Positioning was modest in the early 2000s and the resultant boom, albeit with the volatility one would expect, ensued for the first decade of the new millennium. Yet in the decade after, EM became an established investment category. Gone was the sense of wonder, excitement and intellectual curiosity espoused by pioneers like Jim Rogers and Mark Mobius – for the wider investment management profession, EM has become just another asset class to overweight and underweight in a classic asset allocation model depending on the trajectory of the global cycle (if anyone can understand what this is to start with). Emerging markets ceased to be a new way of looking at the world. They became just another asset class.
The very word ‘emerging’ implies that at some stage the transformation to a developed state will be complete. This is the problem. According to whose standards do we gauge this? The Americans? MSCI? The Chinese? Aren't the Chinese still emerging themselves? If this is the case, then what will the fully developed state of the Middle Kingdom be if after five thousand years of advanced civilisation it is still emerging? If anything, the Chinese will tell you that they have been civilised far longer than Western countries. Who knows? Every view is relative to another. What about Taiwan and Korea? Honestly, does it even matter?
The fall of emerging markets has been well documented of late, despite this year’s ebullient surge (after last year’s plunge). Turkey was a poster child for EM reform in the early 2000s and it’s been painful to see the country regress in recent years. So too South Africa and Brazil, which have lurched from crisis to opportunity and back again. The media is never sure – at the same time blaming political authoritarianism and dipping growth rates in cornerstone economies like China. In our view there is another, more insidious culprit for EM equities’ poor performance. After all we are investing in stocks, not countries. That culprit is indexation.
Indexation has provided investors with a brutally effective and cheap way to access entire markets and investment categories, but in doing so, it has denatured the investment process and encouraged a one-size-fits-all approach to EM. In the early days, indices were appropriate measures of performance and effective ways of capturing the opportunity, as the argument could be made that the very largest companies, usually government owned and recently privatised banks, telcos and utilities presented substantial upside due to reformist policies. As time went on, these became (in many instances) the very companies to avoid due to government interference and poor management.
To unpack the assertion that indexation is harming EM, consider the construction of a dam - something that happens quite a lot in emerging markets. After a dam is built and the surrounding land has been flooded, the flora and fauna of the landscape are decimated and the ecosystem cannot correct itself. This is precisely what happened in emerging Markets. Indexation has flooded EM with investment flows, massive and fickle. Bottom-up investment managers struggle to operate in this desolate wasteland, since value and growth cannot compete with the brute force of capital being pumped into and out of developing markets with alarming alacrity. Many smaller companies are being starved of a key capital raising mechanism as a result of the concentration of flow to the top index names, depriving them of the resources they need to expand operations and drive the structural growth story on a micro level.
Faced with non-linear rates of change, EM and country level indices have failed to reflect the reality on the ground. Asset managers who invest around benchmarks perpetuate the errors, backing companies that are often disconnected, even opposed to growth, as they attempt to keep up with the ever-moving target of the index itself. The dictionary definition of a vicious circle is ‘a sequence of reciprocal cause and effect in which two or more elements intensify and aggravate each other, leading inexorably to a worsening of the situation.’ That’s a pretty good way of thinking about indexation and EM.
We are building our business on emerging markets.
We are not talking down EM; quite the opposite. We’ve spent our entire careers in this space and are doubling down with the launch of Three Body Capital.
The term ‘emerging markets’ has always been a crude (but useful) over-simplification of complex countries, economies, political systems and ways of looking at the world. EM is about grouping countries with shared characteristics, but who can say that the 23 countries represented in the index share the same qualities? China and Turkey might have similar nominal GDP per capita, but one is an ascendant global superpower and the other is undergoing ongoing economic and political upheaval. Even Jim O’Neil admits he only got 2 out of 4 right.
Emerging markets attract us because they offer the chance to roll up our sleeves and spot opportunities. We don’t want to sit on our hands and buy the index. We are now going full circle, back to the start of the story. Investors should avoid the conventions, ‘rules’ and long held cognitive biases that demand broad exposure to EM as an asset class and go back to basics, seeking to dig up buried treasure and focus on growth.
Change is accelerating.
We believe a concentrated and thematic approach to finding the best bottom-up opportunities in EM is the correct approach. We believe the world is changing faster than ever before and the biggest changes will be felt in emerging markets given the lower bases and relatively anaemic legacy infrastructure and systems that exist in many emerging countries. This will return us all to the root of why we invest in emerging markets in the first place. We want the sex appeal of growth and we want it from the best companies. And we want to further capitalise on the destruction of the worst companies who, despite the low hanging fruit of growth, are simply unable to adapt and compete their way to a new plateau.
It’s not just emerging markets that have changed since we started out in the business. Our industry has changed, too. We firmly believe that conventional active management frameworks are no longer relevant in a world dominated by indexation and passive flows. We need to rethink EM investing from the ground up, and this means going back to first principles and re-evaluating the investment process, fee structure and company culture required to deliver alpha for investors. And that’s exactly what we’re doing at Three Body Capital.
As always, we would love to discuss our ideas with our investors. Please get in touch by hitting reply and dropping us a note with your thoughts – we’d love to hear from you.
What we're doing.
This week we welcomed a new member to the Three Body Capital family. Lupo Maltzahn joins as COO and we're incredibly excited about working with him to execute our ambitious plans for the business. Before coming onboard, Lupo was a senior partner at Accenture, where he spent the last 15 years growing and running major consulting businesses, including the UK and Ireland Strategy practice. He also has 25 years’ experience as an investor and advisor, with a track record of guiding technology-driven transformation in the wealth management sector. Welcome Lupo!
What we're reading.
“I have a foreboding of an America in my children's or grandchildren's time – when the United States is a service and information economy; when nearly all the manufacturing industries have slipped away to other countries; when awesome technological powers are in the hands of a very few, and no one representing the public interest can even grasp the issues; when the people have lost the ability to set their own agendas or knowledgeably question those in authority; when, clutching our crystals and nervously consulting our horoscopes, our critical faculties in decline, unable to distinguish between what feels good and what's true, we slide, almost without noticing, back into superstition and darkness."
This extract from Carl Sagan's wonderful debunking of pseudoscience, "The Demon-Haunted World: Science as a Candle in the Dark" is pretty scary. Sagan was right and wrong – technology is no longer the preserve of the few – it's scaled across huge populations globally, enabling people in EM to recover ground versus developed economies. But being "unable to distinguish between what feels good and what's true" is a major problem for billions of people right now, addicted to the convenience of smartphone apps that sell their data to the highest bidder.
What we're watching.
There are many ways to enjoy the rise and collapse of Theranos and its extraordinary (not in a good way) founder, Elizabeth Holmes. If podcasts are your thing, start with ABC’s The Dropout. If you like long-form prose, check out John Carreyrou’s Bad Blood. But for those of you who want a whistle-stop tour of this incredible story, we suggest you try Alex Gibney’s new HBO documentary The Inventor: Out for Blood in Silicon Valley. It's a gripping exploration of the psychology of deception – and a warning to investors everywhere.
What we're listening to.
We love Patrick O'Shaughnessy's podcast, Invest Like The Best. Andthis interviewwith Geoffrey Batt on the nature of transformational returns is a cracker! The Iraqi equities market is a PROPER frontier market – one that Batt has managed to build a sustainable business around. A testament to the power of long-term thinking.