This post explains how I select emerging markets for my global portfolio. My selection process employs a GARP approach — Growth at A Reasonable Price. Basically, I like to invest in markets that have above average growth potential but are trading at below average valuations. Currently, I update the allocation every six months.
From the outset I should warn you that the method I follow to select emerging markets does not always out-perform and sometimes it selects very non-consensus markets. The current selection affords a good example. Here is the most recent portfolio update of the EM portfolio as of end-Dec 2017.
You will notice that I have some very out-of-favour markets in this list.
Okay, so how did I arrive at my portfolio of these six markets?
Traditionally, emerging markets have been prone to currency crises and one of the key requirements for an EM portfolio has been to avoid currency risk. One of the best ways to minimize currency risk is to invest in markets that are cheapest on a currency-adjusted basis.
To get the currency-adjusted valuation we adjust the price-to-book value for each market for changes in the real exchange rate. If the exchange rate is expensive, so is the market. Fig 1 illustrates what currency-adjusted valuations look like, using Indonesia as an example . This chart has lines showing two separate valuations.
Fig 1. Currency adjusted valuation – Indonesia
The dark blue line shows the normalized price-to-book ratio of MSCI Indonesia adjusted for changes in the real effective exchange rate (REER). The light blue line shows Indonesia’s relative P/BV versus the EM Index once again adjusted for the REER.
Indonesia is sitting on historically fair valuations on both measures. A reading of zero is historically fair, while positive is expensive and negative is cheap.
However, whether a market is truly cheap or not also depends on fundamentals. A low real exchange rate sometimes reflects economic weakness and vice versa. Rather than get bogged down in complicated factors such as productivity or the terms of trade, I prefer to focus on profitability. Corporate profitability is the best gauge of whether or not movement in the real exchange rate reflects a change in fundamentals. If a country’s real exchange rate really is cheap, companies based in that country should be highly profitable.
In order to derive my market selection I combine valuation information for each market, such as is shown in Fig 1, with information on the relative growth potential of each market. This approach allows me to find which markets offer GARP (growth at a reasonable price).
Fig 2 we show the cumulative return performance of two different GARP EM strategies which combine the currency-adjusted valuation with corporate profitability.
Fig 2. A GARP approach to EM market selection has generated good return in the past
The first is called the EM GARP Basket. This strategy entails buying and holding cheaper-than-average markets using the REER adjusted value measure shown in Fig 1. A restriction is that we only hold markets that rank in the top-eight for sustainable growth. Sustainable growth is given by a markets return on equity and dividend payout ratio. It is a GARP basket because we are filtering for both growth and value.
The second strategy, called the EM Relative GARP Basket, is the same as the first except: (1) I use the normalized relative P/BV for each market versus the P/BV of the MSCI EM Index (the light blue line in Fig 1), and (2) I include only those markets that have under-performed the MSCI EM Index over the past 12 months – i.e. laggards.
Currently the EM GARP Basket is holding Korea, Turkey, Russia and Hungary. The EM Relative GARP Basket is holding these four markets plus Peru and Argentina.
The GARP approach to market selection performed well in former years, returning 17.7% and 15.3%, respectively, for the two strategies versus just 4.9% for the EM Index. Return is high because the GARP approach helps to avoid currency risk by buying markets already seen as risky. Naturally, however, past performance is not a guarantee of future returns.
While the GARP Basket tends to perform more strongly than the Relative GARP Basket of laggards, the latter performs better in bear markets. A combination of the two strategies has therefore tended to outperform in most market conditions. That is why I use both strategies in my EM portfolio selection. Fig 3 shows the historical excess return of my EM allocation strategy versus the MSCI EM Index.
Fig 3. The combined GARP strategies provide downside protection from currency risk in bear markets
The combined strategies performed strongly in the bear markets of 2000-2003, 2007-2008 and 2015-2016. One of the few situations when the combined strategies tends to underperform is when the market is bouncing from a bear market low.
In general, I will follow the country selection suggested by the GARP process when forming my EM portfolio.