Emerging Markets Investing: Getting the Big Picture Right is the Most Important Variable
At the 67th CFA Institute Annual Conference, fund manager Arjun Divecha introduced his presentation with a quip: “When it comes to emerging markets, never fall in love, only date . . . and date promiscuously.” The crowd chuckled. Divecha explained that he had spent a great deal of time thinking about why some countries are poor and some countries are rich. Ultimately, he concluded that poor countries lack the institutions necessary to survive long periods of bad government. The crowd laughed again, but Divecha, who oversees emerging markets strategies as chair of GMO’s board of directors, assured the audience that he was serious. As an example, he cited Brazil, which had 16 very good years and then slid backward following bad leadership.
Getting the big picture right in emerging markets is by far the most important determinant of successful investing, Divecha contended. Consequently, his investments focus only on countries and sectors, rather than a more exhaustive bottom-up analysis of individual securities. The criteria he uses to evaluate countries are intriguing: current account balances, federal budget deficits and surpluses, foreign exchange (FX) reserves to defend against currency attack, and government debt-to-GDP ratios. In essence, these criteria describe the financial flexibility of each country. Greater deficits mean less prosperity. Greater FX reserves mean that a government has more wherewithal to support the value of its currency. And, of course, greater government debt relative to GDP means a greater burden on the private sector, all else equal.
As an example of how the fortunes of a country can change, Divecha cited Mexico’s recent announcement that it will be opening up its energy sector to foreign development. He sees this as a transformative change for the country, which had kept the sector under government control since 1939. The move should positively impact each of the four variables that he watches closely and is a bullish sign for Mexico.
In addition to performing country and sector analysis, Divecha operates as a value investor and believes that one can make more money when perceptions of stocks go from awful to merely bad. In contrast, high-growth stocks often have high expectations built into the stock price, setting investors up for disappointment. Thus, he also seeks stocks with “cheap” valuations.
Where is he finding opportunity these days? In Russian energy stocks, believe it or not. The crisis between Russia and Ukraine has focused the world on the prospect of sanctions against Russia from developed countries, such as the United States and Europe. In light of the recent tensions, Russian energy stocks have sold off materially. However, he argued that geopolitical risk is a great risk to take on because it can be easily diversified. What impact could the Russia–Ukraine conflict have on elections in India, for instance? In Divecha’s view, Vladimir Putin is not looking to revive the Cold War, and so he sees the situation in Ukraine as more or less an isolated conflict.
Consequently, Divecha favors companies like Rosneft, Lukoil, Surgutneft, Gazprom, and Novatek, which have p/e multiples ranging from 2–5x earnings. These stocks also have attractive dividend yields at 2%–7%, he said. Of course, if Russian troops cross into Ukraine, the move would easily violate his thesis — in which case, Divecha would “break up” with his Russian energy stocks and begin “dating” in other parts of the world.
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Photo credit: W. Scott Mitchell
