Quarterly Letter

Emerging Value and Margin of Superiority
Why would a value manager buy more of an asset that has just gone up?

Ben Inker

Long-time GMO clients have become accustomed to a certain kind of behavior from our asset allocation portfolios. If they are reading stories about how well an asset class has been doing, chances are pretty good that their next account statement will show that we are a seller of that asset (assuming we owned some in the first place). If, on the other hand, headlines are about how horribly things are going for an asset class, our clients have come to expect to see us buying in the coming quarters. But recently we made a move across a number of our asset allocation portfolios that goes counter to that general pattern. After a strong first half of 2017 for emerging equities that saw them rise over 18%, we actually bought more emerging in early July. It seems like a non-intuitive move for us to make, but we believe it is the correct one despite the fact that the prospective returns to emerging equities have dropped a bit since the beginning of the year. Even though the absolute expected return for emerging market value stocks has decreased, we believe the margin of superiority of emerging value over other assets has actually increased. As its superiority is higher and emerging-specific risk is relatively benign, our willingness to bear its risk has increased at the margin, which created the opportunity for us to increase our allocation.

Emerging value is extraordinary today
There are a couple of important points to make about our decision to buy more emerging recently. The first is that despite the strong returns of emerging equities so far this year, the group we are most interested in, emerging value, hasn’t been particularly extraordinary. MSCI Emerging is indeed up over 18% through the first half of the year, but value has underperformed by 4.8% in the period and 3.5% of the returns to emerging were due to currency moves. That leaves emerging value up about 10% in local terms, about on par with stocks around the world. Given that fair value for the group compounds at around 6% real annually or 3% in a half year, this means emerging value should have gotten about 6% more expensive over the period, which would cause its forecast to drop by around 0.8%, all else equal.1 In this particular period, all else has been more or less equal and the forecast has indeed gone down by 0.8%, from 7% to 6.2%. Our next favorite equity assets, EAFE value and US quality, have seen their forecasts fall by 0.3% and 1.1%, respectively.

But the second point to make is that we have tried to learn the lessons of history with regard to how to use value to actually outperform. As I wrote a few years ago in “Divesting when Discomfited” and touched again on last year in “Keeping the Faith,” one of the key aspects of value as a selection technique is that lagged value works every bit as well as – and sometimes better than – today’s value. As a result, when putting together our portfolios we react not just to today’s forecast but to the average of the forecasts over the last year. And on this basis, emerging value has done something fairly remarkable. Emerging value today is not the cheapest we have ever seen it; not only was it cheaper at the beginning of the year and at some points in 2016, but it was significantly cheaper than today in both the financial crisis and the 2002-03 period. Actually, in February 2009, almost every single risky asset class we had a forecast for had a higher forecast than emerging value does today!2 But, on a measure that really matters to us for portfolio construction, emerging value today is the best asset we have ever seen. That measure is its “margin of superiority” – the amount by which it is better than the next best asset on our forecasts.3

As you can see, much of the time our favorite asset is only a little better than the next best. On those occasions, the cost of diversifying from our favorite asset is fairly low and the benefits of diversification tend to dominate. Of course, we should own plenty of our favorite asset, but not necessarily a lot more than we own of the next best. Today, emerging value is a lot better than anything else, so the drop-off in expected return going from it to the next best asset is severe. How much of it should we hold? That answer, in the end, must come down to risk.

The risk of emerging
There is little question that emerging market value is not only a risky asset, but probably the riskiest of the risky assets we routinely buy in our portfolios. We should expect worse performance from them in the event of a global economic crisis than even other types of equities. Furthermore, emerging economies are subject to home-grown crises, and in periods like 1997-98 or 2014-16 have shown themselves capable of substantial losses even when other risky assets are doing well or at least a lot less badly.

But depending on your definition of risk, 1997-98 was either a big problem or a small one. Let’s first think in terms of running an equity portfolio against an MSCI ACWI benchmark.4 If your view of risk as a portfolio manager is underperforming ACWI, the worst thing that ever happened to emerging was the period from the summer of 1997 to the fall of 1998. In that period, ACWI rose by 4% and MSCI Emerging fell by 48%. It’s a stunningly bad event in relative terms.5 If that didn’t cause equity managers to recognize the risk of betting on emerging, I don’t know what it would take! You could say that it was just as bad in absolute terms, and in a sense that is true. A 48% absolute loss is a big deal in anybody’s book. But given that it was basically an emerging-specific problem, the loss was unlikely to lead to a big drawdown in your overall portfolio. Exhibit 2 shows the returns to various assets during the time period of emerging’s disaster.

Other than emerging equity and debt, this was a pretty decent time to be an investor. When one thinks about the real risks for a long-term investor, the risks that really matter are events that cause sufficiently acute losses across the portfolio to require a behavior change in spending, or events that cause losses that are not reversed even in the long term. The 1997-98 loss, as bad as it was for emerging, has not meant any permanent loss for emerging market investors. Since the start of 1997, MSCI emerging has mildly outperformed ACWI, even including that large drawdown. As for emerging debt, the other material loser in the period, since 1997 it has been the best performing of all of the asset classes we track, despite its losses in 1997-98. Emerging equities and debt are volatile assets and move somewhat to an “emerging” rhythm. This means that the potential for them to underperform other assets is quite material, but so is their ability to beat them. In other words, for an investor more concerned with absolute risk and return than relative, they can offer valuable diversification.