Archive for the Asset Allocation Category

Smaller Frontier Markets: Hidden Opportunity or Totally Uninteresting? The Trinidad Case

Posted in Asset Allocation, Emerging Markets, Portfolio Optimization, Risk Management, Uncategorized with tags , , , , , , , , , , , on April 2, 2009 by evd101

By Erik L. van Dijk


In the first entry to this blog we presented one of Goldman Sachs’s Next-11 countries, Iran, as an interesting ‘neglected country’ for speculative investors. On the one hand, we saw an economy built on huge oil and gas reserves (which provide a kind of collateral or put option to your investment strategy in the country) and on the other we saw growing signs of structural talks between the US and other Western nations with Iran in the political arena. The fact that Frontier economies like Iran and others (Kazakhstan, Vietnam, Saudi Arabia are also well-known representatives in this category) have a relatively low correlation with the MSCI World index and even with the MSCI Emerging Markets index are of interest to large investors that want to diversify their portfolio. But we also know that smaller economies are more sensitive to the potential risk of growing protectionism in a world that is struggling with the credit crisis. We did therefore decide that it might be good to look at a smaller Frontier Market as well, to see how things are going there.

Our Emerging Markets unit decided on Trinidad and Tobago. On the one hand (see also below) the country is not a tourism-dominated, one-dimensional banana republic, but one of the richest Caribbean nations with an economy built on strong oil and gas reserves. On the other, we see a relatively stable political situation, a leading role within the CARICOM (the regional cooperative entity between some 15 Caribbean states) and an English-speaking population. When we add to that a legal system that has tight links with British rules, it makes for a Frontier market that is definitely ‘unknown’ and ‘neglected’, but also not ”scary” like so many other exotic nations in this group.

In our databases we have daily stock market information about Trinidad and Tobago (TT) starting from May 2005. Almost 4 years of data split up in a good period for world exchanges (2005-2006-beginning 2007) and a disastrous one (second half 2007 and especially 2008-09). A relatively short period, but definitely an interesting one when trying to get a feel for Frontier Market investing, its opportunities and its dangers.

When we look at the index information (in USD) over this period, it is not surprising that the net result for the period is not a good one for global equities. The effect of the credit crisis is clearly visible in the numbers. The MSCI World index generated an annualized return of minus 7.82% for the period. When we compare that with the plus 8-10% positive return normally expected for global equities, it is clear that we are dealing with a dramatic  outlier here. Everybody states that when the rich, developed world is sneezing, smaller Emerging nations are catching a cold. Now, when we look at the annualized return over the period for the MSCI Emerging Markets index we derive a figure of 2.58% positive (!). So notwithstanding the fact that Emerging Markets did indeed drop a bit more than developed ones in the  2008-09 (until March 27)  period (-58.87% compared to -51.81%), their positive net result indicates that the value gain in the May 2005 – Dec 2007 period compensated for that. It was the period when the BRIC nations gave the leading Emerging Markets economies their new catalyst role. Obviously, some (e.g. Russia) suffered more than others, but all in all the correlation with developed nations was quite high, and return differentials not that big and there wasn’t really a big cold. When we look at the MSCI Frontier Markets index we see where the old adage about sneezing and catching a cold comes from: the smaller developing economies in this index were the ones struggling. The MSCI Frontier Markets index lost on average minus 14.65% on an annualized basis during the period May 2005 – End of March 2009! Trinidad and Tobago (TT in the remainder of the entry) was actually a big outperformer with an annualized return of minus 7.65% for their equally-weighted First tier stock market index and minus 8.03% for the marketvalue-weighted one. Lodewijk Meijer decided to look at both equal-weighting and value-weighting due to the fact that the TT stock market index is to quite some extent bank/other financials-dominated. But analysis made clear that although the banks and other financials did indeed suffer quite a bit, their story wasn’t as bad as that of many of their huge US and European colleagues that ended up at the brink of bankruptcy.

So, in and of itself the performance of the TT exchange wasn’t good. Relatively speaking the7 percent outperformance compared to the Frontier index was interesting, and so was the countries solid oil- and gas-based economic basis. If we add to that government initiatives to play a larger role within CARICOM on the one hand and ideas about setting up a regional International Financial Centre (IFC) on the other, we found it interesting enough to present TT as our representative small frontier market. And besides: don’t forget that the main stock market wisdom says that you have to buy low and sell high. So one could also present the bad performance of the Frontier Markets as an opportunity to step in if you believe with us that mean-reversion of global markets will indeed set in in 2009 (6-12 months before seeing the first signs of the economic recovery that normally follows the stock markets).

But it is not just that: we also looked at volatility (measured as the standard deviation of return) as absolute risk indicator and beta (indicator of systematic risk, measured as percentage average return when the world index changes 1%). High volatilities and high betas are then indicative of risky markets and low volatilities and betas of less risky markets. Since we compare things with the MSCI World index when calculating betas, the MSCI World has – by definition – a beta of 1. The MSCI World had a volatility of 20.53% annualized for the whole period and 32.76% for the 2008-09 period. That is a huge number. The 32.76% translates into an almost 35 percent likelihood that the actual realized return will fall outside an interval ranging from -22.76% to +42.76% when you expect a 10% return on stocks. I am sure that none of us will mind a more than +42.76% return with a probability of almost 17.5%, but there is a similar chance of ending up with another terrible year of more than a 22.76% loss! This is indicative of the turbulence in the global economy, with especially larger countries now being very nervous due to enormous tension of their financial systems, the unwinding of struggling hedge funds et cetera. In normal situations the Emerging Markets would have both higher betas and higher volatilities. But the beta for the period was actually 0.972, i.e. the Emerging Markets reacted more or less the same to bad or good news as the developed ones. Their normal excess country and firm risk  (in general) was compensated by the fact that our financial system in the West was under enormous pressure. The volatility was still higher in Emerging Markets, but actually not that much: 26.60% in EMs for the overall 2005(May)-2009(March) period (versus 20.53% for the MSCI World). And in the 2008-09(March) period the EMs went up to a volatility of 39.27% versus 32.76% for the MSCI World. It is indicative of a changing world in which the New World Order (with bigger role for China, India, Brazil and Russia) is gradually but slowly happening. And that will make Frontier investing more interesting as well. The BRIC nations are known to be more active with investments in the Frontier markets, see for instance how the Chinese and some Sovereign Wealth Funds are increasing their influence in Africa.

Frontier Markets are amazing when looking at their risk profile. They are the least risky ones when taking a first look at volatility and beta. The beta was relatively stable for the period (0.178 for the overall period and 0.188 for 2008-09). Far lower than the beta for Emerging Markets or the MSCI World. And the volatility was only 17.74% and 24.15% respectively!

How is that possible? Where is the investment risk when opting for a Frontier Markets strategy? Are they really less risky? Yes and no. They are less risky in that these numbers are correct. They do move less when analyzing day-to-day or week-to-week price movements. But what is going on here is to quite some extent related to illiquidity and thin trading. You can compare investing in Frontier Market public equities quite a bit with private equity in Western nations. Share trading is thin and that suggests a peacefulness that is only there as long as new news items aren’t too big or investor-induced portfolio trades (for non-firm or non-country related factors) not too dramatic.

Lesson 1 for the investors:

Never forget about illiquidity of Frontier Markets

When you go there, be sure to have a longer-term strategy based on fundamental (i.e. not speculative, trading-oriented) factors, especially when you are big.

When you are too big: forget about it.

And that brings us automatically to lesson 1 for the frontier country.

Lesson 1 for the country:

Make sure you create trust in your exchange.

And also ensure sufficient liquidity!

 And that is where TT has its main problem. Volatility levels during the period for the average firm in the market were so low that you might almost think that TT stocks were bonds. When looking to daily data the volatility was 4.78% over the period as a whole and 5.47% for the 2008-09 period. Academics have written tons of papers about the adjustments that are necessary to correct for thin trading, with the work of Scholes and Williams in the second half of the 1970s basically being the start. Without going into detail in this direction, we would like to compare the low volatility and systematic risk with what you could see in private equity strategies. In private equity we do not have daily price quotes as a result of which annualized return and risk levels are based on far less data points with a larger interval between them. To some extent the situation here is similar. Abou 3-3.5% is the turnover (as percentage of market capitalization of stocks) at the TT stock exchange. Compare that to the 50-100% rate seen on most Western developed exchanges! It is much closer to the 0 percent liquidity of private equity.

Question then: is the ultra-low liquidity enough reason to forget about a country? The answer is no. Frontier Market investors should know that the characteristics of investments in these markets do have quite some similarity with private equity. In and of itself that is not necessarily bad. Especially now, low correlations and low betas (TT has a beta of about 0 with the MSCI World) are qualities that can be of interest when creating diversfied portfolios. However, the investor should at all times be aware of this aspect of Frontier Market investing. Don’t do it when you don’t have the time to wait and/or the advisor with fundamental knowledge of the markets to support you.

Trinidad: The Country

Columbus arrived in Trinidad in 1498. The Island state has an overall size of just 2000 square miles, neatly situated outside the famous Caribbean hurricane belt. Initially the Spaniards occupied the country, but they never took the colonization very serious. In 1797 the territory became a British colony, a situation that lasted until its independence in 1962. Ever since the linkage with the UK has been prominent, with the British Privy Council for instance being the highest Court of Appeal, with the Caribbean Court of Justice (2005) – an institution of the regional cooperative body CARICOM – now being prepared to replace it. Politically this strong linkage with the UK has ensured relative stability in a democratic system in which not more than 2-3 political parties seemed to play an important role. It was only in 1990 that a Muslim movement led by Yasin Abu Bakr (Lennox Phillips) created some turmoil through a 6 day coup effort. But even in this case, the TT definition of turmoil turned out to be nothing like what we have seen elsewhere in Emerging and Frontier economies. Helped by large oil and gas reserves, the increase in oil prices in the 1970s and again in the period 2003-2007 has led to a tremendous increase in average wealth with now an income per capita in USD of $ 18,600. As is normally the case, political stability and wealth increase were highly correlated.

The small Island state (1.2 million people, of which 96 percent lives at Trinidad and only 4 percent at Tobago) has a remarkably mixed population, with 80% being of Indo-TT or Afro-TT descent. The Indian group is the larger of the two by a small margin. The other 20 percent is made up of Europeans (whites), Chinese, Syrians and Lebanese and mixed people. With political parties to some extent catering to the needs of ethnical and to some extent also religious groups, it is quite remarkable that the political situation is as stable as it is. And there isn’t really any reason to believe that this will not continue.

The only worry seems to be that the population is not growing at all with the relatively small (for Frontier Markets standards) net population growth rate due to births minus deaths being compensated by net emigration to (mainly) the UK, US and Canada. That could create problems for an economy with ambitious growth targets.

Trinidad: The Economy

TT has a GDP of US $ 24.2 billion. The GDP growth rate dropped recently from 8% to 5% and we foresee a further drop to about 3-3.5% due to the strong linkage with oil and gas. But it is still a growth rate and that is something that a lot of countries cannot show anymore in this period of crisis and turmoil that we are in. Governnment debt is low at 28% of GDP. The proven oil reserves are some 728.3 million barrel and gas reserves are at 481.3 billion cu m. Nothing like the huge reserve numbers we showed earlier for Iran, but still in general with a bit fantasy you could say that it is like a smaller version of Iran. Neglected, but with a nice collateral and in this case (to compensate for the smaller collateral) a situation where no one in the world has any problem with this sympathetic Island of steel drums, soca, calypso and limbo (contrary to what people think about the Islamic Republic).

Gas is recently getting more important than oil, with the country now being responsible for some 70% of the US imports of LNG. Oil and gas are responsible for 40% of GDP and 80% of total exports. But only 5 percent of employment is related to these industries and that helps explain the emigration trends.

But the government is trying to create a diversified economy, which looks like anything but a tropical island resort. Sure, Tobago is to a large extent tourism-oriented, but Trinidad has expanded in the following sectors: petrochemicals and plastics, manufacturing (steel, aluminum), cement and food and beverages. And even the old agricultural sector (a very important part of the economy before oil and gas prices started to rise in the 1970s) is not insignificant, with citrus, coffee, cocoa, rice and poultry being important crops.

The country posted a US $ 5.7 billion current account surplus over 2008, which is about 22.5% of GDP with the US being the most important trading partner (57.5% of exports and 20.2% of imports). For more detailed information we refer the reader to the CIA Factbook.

Not surprisingly with the US being so important and with economic results being relatively OK, the country had no difficulty to maintain a more-or-less stable exchange rate vis-a-vis the US Dollar. The TT dollar sells for about 6.2-6.3 to the US dollar ever since 2004.

The ambitious government of Patrick Manning, the prime minister, has indicated that its target is to become a developed nation by 2020. From frontier to developed in 15 years. Not impossible (look at Singapore), but a lot has still to be done. Especially in the financial system, and a government white paper, written in 2004, shows that the government is aware of this. The ambitious goal is to transform TT into an International Financial Centre (IFC) for the region. This regional approach of the government does also show a sense of realism (TT as stand-alone entity is probably too small to achieve very ambitious goals). But creating this IFC is easier said than done, knowing that we come from a low base in the financial sector and that regional cooperation through CARICOM implies that some 15 nations one way or another have to cooperate.

But there are a few factors that might help the government. First, due to the economic development in South America (mainly Brazil of course) and its strategic location between South America and the US, the interest in the region is indeed growing. Not just from regional parties, but also from Europe. The latter is also helped by actions from various European governments against tax havens like Luxemburg, Switzerland, Monaco, Liechtenstein et cetera. The region is already known for having a few alternative tax havens here (Cayman Islands, Virgin Islands, Barbados, Turks and Caicos et cetera) and TT will not copy their effort, but when international money flows will lead to a net inflow into the Caribbean area, the better developed nations will benefit if-and-only-if they do provide the financial infrastructure for the regional money inflow. Something similar happened to Singapore in Asia and Dubai in the Middle East. And that is the two examples that the TT government probably has in mind. What are the odds?

Trinidad: The Exchange

When comparing Dubai with Singapore as the two main examples we would like to use for TT, there are a few differences and they are important. Singapore has been successful because it was capable of not just transitioning the economy (with a huge role as regional transportation hub via the harbour and its prestigious Singapore Airlines), but also as financial center with a well-respected, developed stock exchange.  The creation of strong Sovereign Wealth Funds like GSIC and Temasek played an important role as well.

The Dubai story is younger of course, but we are not convinced yet that this ”walking on two legs” (economy and exchange) is successfully implemented here already. There is still a long way to go.

The same holds for TT. The first tier of the TT stock exchange lists some 30 stocks with a total market capitalization of TT $ 73.5 billion as of March 27, 2009. That translates into some US $ 12 billion, i.e. about 50 percent of GDP. A stock market size of 50 percent of GDP is reasonably OK for Emerging or Frontier Markets standards, but still low compared to levels in developed nations. And the reason is immediately clear when analyzing the group of 30 Tier 1 firms. With oil and gas being the main drivers of the economy, they are more or less absent from the exchange. A lot of economic activity is done by affiliates of foreign oil/gas companies and the main exception is Neal and Massy Holdings (NML). The NML conglomerate (with activities in other industries as well) is in market cap only 6.7% of the exchange, but holds an 18.4% stake of total annualized turnover. What is needed are more listed proxies for these two most important sectors of the economy.

In this respect, TT resembles Iran a bit. The Tehran Stock Exchange is also dominated by firms outside the oil and gas sector (with Iran Telecom since its IPO in 2008 being dominant). But countries that want to grow their economy and financial sector should be aware of the fact that international investors do not really like exchanges that are not a good proxy for the underlying economy.

Lesson 2 for the Country:

Do what is needed to increase the percentage of oil and gas related listings and trading at the Exchange

In terms of market capitalization the following 5 firms are the most important ones:

  1. Republic Bank TT $ 13.8 billion (=18.8%)
  2. First Caribbean International Bank TT $ 13.7 billion (= 18.6%)
  3. ANSA McAl TT $ 7.7 billion (= 10.4%)
  4. Scotiabank Trinidad and Tobago TT $ 4.9 billion (= 6.7%)
  5. Neal and Massy Holdings TT$ 4.9 billion (= 6.7%)

And in terms of stock market turnover, the top-5 is as follows:

  1. Republic Bank TT $ 604.1 million (= 31.2%)
  2. Neal and Massy Holdings TT $ 357.0 million (= 18.4%)
  3. Sagicor Financial Corporation TT $ 197.2 million (= 10.2%)
  4. Guardian Holdings TT $ 175.2 million (= 9.0%)
  5. Trinidad Cement TT $ 78.8 million (= 4.1%)

The much lower numbers of the turnover are illustrative of the illiquidity problem. In line with the government plans to stimulate the financial industry, both the market value and turnover lists show 3 financial firms: Republic Bank, First Caribbean International Bank and Scotiabank TT in the market value list; and Republic Bank, Sagicor and Guardian in the turnover-based list.

When looking at stock market performance over the period 2005(May)-2009(March), the top 5 performers were:

  1. Readymix West Indies (0.51% of the mv weight and 0.75% of the turnover weight) +37.67% annualized
  2. Trinidad Publishing Company (1.24% of mv and 0.28% of turnover) + 19.24% annualized
  3. Williams LJ B (0.05% of mv and 0.03% of turnover) + 11.34% annualized
  4. ANSA Merchant Bank (3.32% of mv and 0.69% of turnover) + 10.19% annualized
  5. Angostura Holdings (1.82% of mv and 0.68% of turnover) +8.60% annualized

In other words: the five best performing stocks were all relatively small (or less tradeable part of a bigger entity). Readymix is a cement producer, Trinidad Publishing Company is itself part of the also listed ANSA McAl conglomerate with the bulk of shares still being owned by the latter. LJ Williams is a trading / manufacturing conglomerate. ANSA Merchant Bank is just like Trinidad Publishing Company also part of ANSA McAl. Angostura is one of the main producers in the beverage sector.

The worst performers were mainly in the financial industry, albeit not necessarily the general banks.

Challenges for the Country

The big challenge for the country, when embarking on this route towards developed status by 2020, is how to attract foreign capital. Foreign – if possible institutional – capital will not only boost the economy, it will also provide it with the necesary seal of approval when moving towards International Financial Centre status within the region. Foreign ‘neglect’ by portfolio investors will automatically be interpreted as a logical confirmation of the ‘neglected country’ status.

But, to attract foreign capital, the stock market infrastructure needs to be improved. The 2008 survey by Transparency International from Berlin (Germany) gave the country a score of 3.6 on a scale from 10 (perfect) to 1 (totally corrupt). With that number the country ranks at place 72 in the world. The score is equal to that of China and Mexico. It is not dramatic, spot 72 in a list with 180 countries, but it is definitely not good enough if your ambition is to become a regional financial center.  

But there are good initiatives on its way or they have already been started. One of them is the creation of a Caribbean Procurement Institute in close cooperation with specialists from abroad. Assuming that TT can be successful in creating an improved regulatory framework, the next step is to ensure that there is enough to invest in for the foreigners.

Something that makes sense also when comparing it with the structure of the underlying economy. Some kind of (semi-)government vehicle could do the trick for the oil and gas sector, i.e. through some energy fund. An IPO of (part of) the telecom provider TSTT would also be an interesting idea, basically copying the example of Iran.

Fears about the outflow of capital are not valid in a country with such a huge current account surplus and a relatively small public debt service. The improvements in regulatory framework and liquidity of the exchange will translate in a reduced corporate cost of capital as well, thereby stimulating the economic growth further.

The expansion of the exchange and improvement of average liquidity of the available listings will also help in strengthening the case for the IFC when having to negotiate about it with the other CARICOM nations. In and of itself we do believe that TT does have the potential to become an important factor in the region. But to get from potential to realization in what has to be political lobbying with about a dozen of other nations will only work when the first seeds are sown. The economy is interesting for Frontier standards, but we at Lodewijk Meijer are less convinced that the financial system is as interesting yet.

That is not to say that knowledgeable investors should avoid investment in the country, if they want to allocate to Frontier Markets. But, only if you really have expertise in the country and a long term outlook (because of the illiquid trading) a direct investment in the stock exchange could be considered. There are some investment fund opportunities available. But they are illiquid as well. The alternative is to buy a stake in a mix of Neal and Massy (proxying the oil / gas industry next to some other industries where they are active), ANSA McAL (itself also a diversfied portfolio) and one of the banks (Republic Bank) as reasonable portfolio following the fate of TT in its quest for regional economic leadership. 

Challenges for Frontier Investors

TT is not different from any other Frontier economy in this respect. Thin trading, unclarity about rules and regulations and a developing financial industry with probably on average still quite a bit to learn compared to standards at home are all factors that Western investors willing to invest in the country will have to deal with. But for a long term investor, carefully following the macroeconomic story and politics while closely working together with a local/regional specialist it might be worth the effort.

The world is changing. Emerging Markets are here to stay in the New World Order and selected Frontier Markets are definitely gemstones in the years to come. Those with a solid economic base or commodity reserves might be the first to benefit from the globalization of investment portfolios of Western pension plans and Sovereign Wealth Funds from other places on the globe. Although of course relatively small, TT’s role in the Caribbean might make it a valid building block within a Caribbean Frontier portfolio. We at Lodewijk Meijer will carefully watch developments for you.

What we can learn from the Credit Crisis

Posted in Asset Allocation, Emerging Markets with tags , , , , , on March 6, 2009 by evd101

By Erik L. van Dijk


On Feb 11, 2009 one the brighest minds in asset allocation, Robert Arnott, gave an interview to US market information provider Morningstar. Arnott, the founder/former CEO of First Quadrant, a firm specializing in asset allocation strategies, made a few things clear:

1) As we already knew from earlier work from French scholar Prof. Bruno Solnik, the only thing that will certainly go up in a period of crisis is global correlation levels. With the exception of maybe gold and frontier markets that are truly secluded – like for instance the IR Iran, the topic of our previous post – everything will one way or another be hurt. Even the Fixed Income markets are not really providing investors with a safe alternative in a period when panic strikes, risk premiums go up and even the safest of the safe end up in big turmoil. The developments in the financial sector were indicative in this respect.

2) When looking at a Diversification 101 lesson that can be learned from our own Harry Markowitz’ s work, or from any MBA text book, the basic idea ‘Stocks for the long run, and Fixed Income and other securities for the periods in between when stocks are not delivering’ is fine. However, we should never forget to define our risk budget in a clear way and above all: stick to it.

3) With respect to 2): the lesson to be learned from Behavioral Finance is that people tend to overestimate their skills in good times, and then – when disappointed – turn to a kind of total disbelief in their own or other’s skills. The outbreak of panic that will follow can lead to disasters, similar to what can be seen in tragic accidents in football or soccer stadiums, when a little fire can cause many deaths in the audience. Not because of the fire itself, but because – in panic – most people want to leave via the same exit. It is the stampede that follows that kills, not the fire. Actually: if all those people running away from the scene would have joined forces, take of their jackets and throw them on the fire it is quite certain that the problem would be solved. The big killer in the crisis is the actions/trades of the ones in panic.

4) So basically, what will happen then, when markets slide into an enormous downfall because of the massive sell-off of shares with all ‘smart’ loss-takers thinking the same smart thing at the same time – as a result of which it is not that smart anymore – is that a situation is created in which smart money can earn a lot. Real winners are made in periods of crisis, not in normal periods. However, when everybody gets crazy and the savvy hold their breath and wait for the bottom level of the market to arise, we should be aware of the fact that the best investors that want to wither the storms by telling their followers that markets are exaggerating will look just as wrong as bad investors do in a normal period. Distinguishing between a top-level investor and an idiot becomes harder in a crisis period.

5) And there will be chances, a lot. Especially further from home, in niche markets that are allegedly risky in the eyes of the global investment community. It is a given that both private and institutional investors tend to have a stronger home bias in crisis times than in other periods. Result: the sell-off was largest in the Emerging and Frontier markets, notwithstanding the fact that economic growth numbers in these markets were not as bad as those in the West. And this is especially strange when also taking into account that these countries have a much smaller percentage of their market cap weights in financials, the sector were it all begun in the 2007/08 (and maybe 09?) market meltdown. I am sure that there will be blue chip investment opportunities in market leaders in Emerging Markets at a price of 3-5 times earnings. PE’s that low do not make sense, and neither does the  fact that the global market cap weight of Emerging Markets is down to 7 percent, a similar level as before the 1997-98 Emerging Market crisis. Things are really different in these countries this time around. China, India, Brazil and Russia (the BRIC nations) are big players now with solid economic home bases, notwithstanding their short term problems because of the crisis. Oil and gas prices are higher than back then and will definitely go up again to levels that might not be as high as what they were last year, but still.

6) But now we have another problem that haunts us. It is risk budgeting related. Institutional investors work with risk budgets, and they should. The ones that apply this technique in a prudent way and directly link it into their asset liability modelling should actually apply the technique in such a way that they do – as an average over the cycle – take a bit more risk when prices are low and less when prices are high. Unfortunately, we often see the opposite. Above average risk taking in times of positive momentum and high stock price levels and below average risk taking when prices are low. Reason being primarily that it is easier to convince the board to allow more risk when you can show nice, upwardly pointing stock price graphs than when you see disastrous graphs with share prices going down, lots of firms going bankrupt et cetera. Psychologically, investment specialists in the pension plan community are normally not fired when buying stocks with nice track records too high (”How could I have known that some kind of change of fortune was on its way? All colleagues were buying this stock too!”), but when something goes wrong with their investment advice when things are going down the drain, the risk of being fired is much higher. This kind of people risk, is a behavioral factor that is still playing an important role in day-to-day institutional money management. Actually, a much bigger role than it should.

7) Now, the problem with market extremes is the following. A simple mathematical exercise will provide you with a clear example:

When prices drop 10 percent (from 100 to 90), we need an 11 percent (10/90) increase to be back at the 100 level. When prices drop 20 percent (from 100 to 80) we need a 25 percent increase (20/80) to be back at the 100 level. When prices drop 50 percent (from 100 to 50) we need a 100 percent increase (50/50) to get back to the 100 level, et cetera.

In other words: the rebound of a market has to be bigger the bigger the crisis is. And the current one was and is big.

8 ) Now, another characteristic of crisis periods is that most risk indicators – like market volatility – go up tremendously. Often to levels 50 or more percent higher than normal. This will imply that market participants that are willing and able to take the plunge and act countercyclically to be among the first to benefit from the crisis will need big risk budgets to benefit. And often, besides being counterintuitive because of the personal risk involved, they don’t have space for that after the calamities that have happened during the crisis.

9) This will in turn imply that two things are really important during the recovery period after a crisis:

9a) Try to find recovery opportunites that add as little additional risk to your portfolio as possible. That is why actually some frontier markets might be of extreme interest (low correlations; compare Iran in our previous post), or asset classes that normally get a relatively low weight.

9b) Buy quality for the longer run. One of the characteristics of a crisis is that people in panic don’t care about anything anymore. For them shares are not securities that entitle them to a share in the firm’s profit, but lottery tickets or casino games that only cost them money. And not just that, they are financial instruments that embarrass them. Sell, sell, sell! But this implies that – when the crisis reaches its end – the battle field will be full with quality firms with now amazingly high dividend yiels (often many times higher than the interest rates available in the market), low PEs and huge potential for growth in the years ahead of us. These strong firms will have themselves nice opportunities to acquire struggling colleagues so as to stimulate revenue growth further, et cetera. In other words: it is the period when the difference between growth and value stocks, and growth and value markets is smaller than ever. Use that fact.

10) Are guys like Arnott and ourselves optimists? Nope, we are just the ‘boring guys’ (Harry Markowitz once used this phrase). Most people – be they institutional or private investors – don’t like what we do in good times (since we don’t take enough risk and are not willing to pay 50-100 times earnings for great momentum stocks in IT, Biotech et cetera) and neither do they like our relative calmness in periods of collapse and crisis. This is not the end of the world, just the end of momentum hunters that went in too late when markets were going up, and now go out too quickly when markets go down. Since we do not know exactly when the shift into upwardly trending markets will be there, it is quite well possible that we will be too early. If that is the case, we will loose a bit before we will win. That is the price of being a smart asset allocator: people will not really like you in the upward phase of a cycle and neither will they in a crisis period. They will only love you over the whole cycle, and even more so over more cycles. This is about sticking to a long-term rational philosophy in which the technique of how to do things is universal and eternal. The individual stocks, asset classes, countries that we like and don’t like do however change, because they will be going through phases. Paul Kennedy’s book The Rise and Fall of the Great Powers gives a good example of how this same line of reasoning applies in history and politics as well.

11) Last but not least: it is not the end of the world. The growing opportunity set is already visible. Be prepared – if and only if you do have space in your risk budget – to try something, but be also prepared to buy things you didn’t buy before. Fundamental indexing is an interesting tool to help you now. Analyzing the difference between stock markets based on market value weights vis-a-vis fundamental weights based on PE, PC, PB, dividend yield, earnings growth and/or revenues might reveal easily where the opportunities are. At the same token, we should concentrate again on Emerging Markets: the fundamental weights of this part of the world are indeed already in the 30-35 percent area with market cap weights now as low as 5-10 percent. That is a huge mismatch. In other words: due to behavioral factors too much money flew back into Western stock markets or savings accounts when things went wrong. Now, with rock-bottom stock price levels and interest rates, it might be worth the effort to look for the true gem stones in the emerging markets. But, never ever forget the risk budget. And the old Markowitz diversifications lessons: when understanding that Gazprom in Russia is now really to cheap, don’t put all available equity money in that stock but add the best opportunity in an country/industry least correlated with Russia and Oil/Gas that also provides you with a quality bet. Optimization and risk management become more important in a period like the one immediately after the crisis, because a good approach in that area will help you recover quicker with relatively less risk which will improve the return/risk profile of the portfolio substantially. And that is really necesssary after the disaster of the crisis period that has just ended.

For the full 4-5 minute interview of Arnott with Morningstar CLICK HERE.