Friday, April 8, 2011

Do You Know Where Your Value Fund Is?

Last week the topic of emerging markets came up on a radio show I host every Friday. Although we only skirt the issue on many occasions, this week the term "emerging markets" kept popping up during the course of conversation with Lauren Templeton and her husband Scott Phillips, both of Templeton Capital Management. These two are value investors and if you have never met one (or two), they offer an unique perspective on the world of investing that is counter to what many of us think it is.

Now I often mention that emerging markets are often mature well before they lose the emergent title. In fact, the grey area between when they cease to emerge and the point when they are considered developed is often prolonged, with noticeably slowing growth and maturing markets. But even then, the unrest that signals investors that there is still significant (and sometimes worthwhile) risk makes the investment worthwhile well past its prime.

For most investors these days, emerging markets are usually considered as the economies of Brazil, Russia, India and China, or what has become known as amongst investors, the BRIC countries. Many of the four nations have growing GDPs, some doubling every six to ten years. Compared to countries like the US, where GDP doubles about once a generation, it is easy to see why this fast past growth adds to the risk factors.

Growing pains aside, many of these nations still have governments that are either over-involved or not involved enough. Depending on who you speak with, this can be both a good thing and a bad thing. As David Brooks of the NYTimes recently suggested: "emergent systems are bottoms-up and top-down simultaneously". As long as we can't predict with any accuracy which will prevail or better which should prevail given our predisposition to the investment, emerging will always signify opportunity somewhere for the nimble footed investor.

The BRIC countries all run the risk of slowing down with the brakes of banking and government concern with growth and its stepchild inflation pushing hard on the pedal. Some see this as the initial signs that regulation will swoop in eventually, followed by over-regulation and that, value investors feel is the death knell for emergence. What makes a country emerge in the first place?

Chuan Li writing for the University of Iowa Center for International Finance and Development breaks it down into four simple, and easy enough for the average investor to understand. He writes: "Emerging markets stand out due to four major characteristics. First, they are regional economic powerhouses with large populations, large resource bases, and large markets. Second, they are transitional societies that are undertaking domestic economic and political reforms. Third, they are the world's fastest growing economies, contributing to a great deal of the world's explosive growth of trade. Fourth, they are critical participants in the world's major political, economic, and social affairs."

In other words, they have all been bitten by the capitalist bug. In the past, countries emerged with assistance. Now they emerge with investment. Companies swoop in and entice governments with their investment approach, the benefits that their involvement in the country will have on its people and that the system works best where the regulation hasn't yet developed to the point of constraint.

But that bug bite doesn't necessarily mean that the country will ever fully emerge. Political systems are delicate beasts that needs to be groomed and sold to the growing economic classes in many of these countries and even after decades of what appears to be peaceful expansion, the simple cost of producing enough to eat can bring the whole of this effort down. By this time, the emerging market investors have left the building. Confidence is a risky business in and of itself and needs to be sold to the growing middle class who for the first time, may have the feeling that they deserve even more.

As Investopedia describes the risks: "The possibility for some economies to fall back into a not-completely-resolved civil war or a revolution sparking a change in government could result in a return to nationalization, expropriation and the collapse of the capital market." Now you may ask, why bring up value investors?

For two reasons: First I always saw them as the patient investor, willing to research and parse every bit of information available, make a decision and quite possibly never see the need to rethink their position. Once made, value investors held their decision sacrosanct, quite possibly putting more money into the investment if the cost fell farther. And two, they always invoked the names of those who pioneers (Ben Graham, David Dodd, Sir John Templeton and most recently and possibly even more famous, Warren Buffet) as their only mentors; all other discussions were off the table.

The lines were blurred when the stocks they picked rose, turning their investments into profits and prompting their exit from the investment. And even though they considered what they did fundamentally sound, they chuckled albeit under their breath as they sold to new buyers. To find value, you must find someone who is willing to sell what you know is worthwhile. To sell that investment, you need to find a buyer who sees only the increased worth of the stock and makes the assumption that it is indeed a good buy if it is now worth more than it previously was.

It makes a growth investor think twice, an index investor think less, a technical investor to wonder what's next for the stock and to the portfolio investor an opportunity to add risk or as they prefer, diversify. But value investors seem to snub the rest of us a merely fools.

Here's a little quiz to help you decide where you fall on the investment curve. Consider Japan. The markets that track Japan have seen net outflows steadily increase over the last several weeks since the earthquake, tsunami and nuclear reactor problems swept its way into the world's focus. If the markets are as Jeff Sommers of the NYTimes recently described it: "It’s as if the world’s markets have been responding to the baton of a mercurial but authoritarian maestro, who changes direction often, but insists that all orchestra members play together as one" and Warren Buffet is spending time touting the investment opportunities in Japan, does investing there suggest value or virtuousness?

Japan is hardly considered emerging, even as they consider nationalizing their utilities, a hallmark of what is considered risk in emerging markets. Can rushing in at the point of this orchestrated exit be virtuous as some value investors suggest, infusing capital as a sign of their belief that the sell-off has gone too far? At what point can this sort of risk be explained away as "doing the right thing"?

Opportunity has often be the domain of the growth investor. Risk is why growth investors do what they do: selling when they perceive the risk to be too great and buying at the point where the risk subsides. Yet value investors claim to do the same sort of maneuvering. Acting less like the lion in pursuit of the wounded zebra and more like the vulture preparing to clean the carcass left behind, value investors create the illusion of running counter to the herd. Or in the orchestration of the markets, playing an instrument that doesn't jive with the whole.

While every investors plays a role in the orchestrated market, value investors seem to want no part of this group. Even as they write the next score for the investor musicians, they refuse to consider themselves for what they are. Backing their decisions with the fundamentals of research is not an excuse nor is it virtuous. It is simply embracing risk differently. Yes, Japan offers opportunities. But to suggest these opportunists are focused on the virtue rather than the profits masks the underlying bug bite: we are all in for the profit and with value investors, that profit is once again, based on your mistakes.

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