(Some) emerging markets showing value

High valuations

Not much news today, so instead here's a brief glimpse into what I've been investing in recently outside of property (no advice here: I don't know your personal situation, and even if I did, a weblog is no place to go for personal investment advice!). 

A while back I attended a seminar in Brisbane where the presenter highlighted that although the US stock market was up by about 250 per cent through this cycle so far, there was 'still time to get in' before the peak, especially because some previous cycles have delivered even greater returns.  

Of course, there then followed the obligatory pitch to invest in their US stocks fund. 

The problem with this flawed line of thinking is that everyone apparently thinks they will get out before the crunch comes; but by definition this cannot be so, and instead they're left as a bagholder. 

Now, a lot of people talk about value investing, but in reality they're often circling the same few stocks as everyone else, effectively in a game of pass the parcel.

But what's really changed over the past couple of decades is that these days you can invest globally relatively easily, and you can invest in diversified products such as index funds or ETFs that can sometimes help to reduce risk. 

How is it possible to be genuinely contrarian, and actually invest for value, at a stage in the cycle when most developed markets aren't cheap?

One place to look is at emerging markets, while also holding back some cash for when the US finally experiences a significant correction, bringing down the Australian market and others with it. 

Diamond dogs

You might recall one of the market 'dogs' we invested in last year was Turkey (see, for example, here and here) following the country's high-profile currency and debt crisis. 

The contrarian approach involves being able to separate the noise (daily crisis reporting!) from the signal (entire market on sale!). 

The Turkey ETF has rebounded pretty nicely from $18 to $25, so that's performed well as expected.

Pakistan has been another investment we've been into more recently. 

As interest rates were hiked from 8 per cent to above 13 per cent the local bourse in Pakistan has experienced an enormous drawdown, which is not totally irrational (after all, why bother to invest in stocks when cash is paying such handsome returns?).

The market dogs strategy doesn't spend too much time trying to predict how or why the stock market will recover, just that when you are buying with a PE ratio of 7 or 8 and with a dividend yield of 9 to 10 per cent, the market will probably recover some time fairly soon. 

And indeed, the Pakistan ETF (PAK) has rebounded nicely enough from $5.50 to $6.60 so far, despite remaining cheap. 

When you back-test this approach across developed markets, emerging markets, asset classes, and sectors, you'll find that the worst performers most often (though not always) rebound within 12 to 24 months (though of course you can afford to be reasonably patient when you're getting dividend returns of 9½ per cent). 

Risk management

There are a couple of common criticisms of this approach, including one's ability or otherwise to time the market, and the volatility and risks inherent in emerging markets. 

Firstly, it is a truism to say that you can't time the market. 

You can never pick the exact bottom of the market, that's undoubtedly true.

But by staging your entry to a position you can get near enough to the bottom to capture most of the upside and expected future returns, and then simply allow mean reversion to do its thing. 

Now I've long been interested in buying ETFs at good prices, but I should say here that it wasn't me that helped to codify this idea into a systematic investment approach, it was my colleague Stephen Moriarty that brought it all together into a timeless and repeatable strategy.  

And there are a number of ways in which Steve taught me to manage risk.

Diversification is one of the 8 key investment principles, for example: you should only have a certain portion of your capital in any one investment, you can invest in products such as ETFs that are themselves diversified, you can diversify over time by staging your entry into an investment.

You should also rebalance your portfolio quarterly or annually to ensure that you don't become too much exposed to any one position.

Academic papers tends to define risk as volatility, but that's quite a narrow definition and just one of the risks to be managed.

After all, while emerging markets might be more volatile, I've never once heard of anyone complaining about volatility when the market is on the way up. 

And if you want diversification to reduce volatility, one of the emerging markets ETFs I invest in via Vanguard has more than 1,350 stocks in it (and since emerging markets tend not to like trade wars, it's offering reasonable value too). 

In the meantime, it's a good time to exhibit patience and wait for more attractive valuations in the developed world, which will come around again in time, as they always do.

There's a lot of peace in mind in this approach, too: when the media is screeching about the end of the world and the 'horror' of stock markets crashing (getting cheaper), you'll have plenty of dry powder to mop up all of the best opportunities, just when everyone else is panicking and getting out.