In their latest episode of the VALUE: After Hours Podcast Jake Taylor and Tobias Carlisle are joined by special guest Juan Torres to discuss:
- Value Investing in Emerging Markets: Opportunities in Uncertainty
- How to Invest in China Despite Political Risks
- What Makes the US a Uniquely Fertile Ground for Startups?
- Reducing Type 1 Errors Significantly Improves Your Investment Performance
- Alibaba: A Lot More Interesting Than 3 Years Ago
- Why Value Investing and Emerging Markets Have Underperformed for 10+ Years
- How to Stay on the Right Side of Information Asymmetries in Deep Value Investing
- The Challenge of Valuing Companies with Exponential Growth Potential
- How to Protect Your Portfolio from Existential Risk
- Why Emerging Markets Are Not All Created Equal
- How to Screen For Emerging Markets Stocks
- Why Emerging Market Investors need English accounts
- How to Get Comfortable with International Financial Reporting Standards
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: And we are live. I am Tobias Carlisle. This is Value: After Hours. I’m joined as always, by my cohost, Jake Taylor, and our special guest today is Juan Torres.
Jake: Ooh, pretty good, Toby.
Tobias: He’s the portfolio manager in the Emerging Markets Deep Value Fund at Schroders. How are you, Juan? Good to see you.
Juan: Hey, Toby. How are you? Jake, pleasure to see you again.
Tobias: Juan calling in from the UK, so he’s it’s evening for you right now, right?
Juan: It is indeed. It’s 06:30 PM.
Tobias: JT’s always on the road. So, he’s in Florida in a helicopter telling us what the traffic’s like.
Jake: [laughs] Yeah. News, on top of the hour. [laughs]
Tobias: I’m in Los Angeles.
Jake: Yeah. Toby’s in, where he lives in, Los Angeles.
Tobias: Let us know where you’re calling in from. I’ll give you a shoutout in a moment. But Juan, tell us a little bit about Emerging Markets Deep Value. The two of the worst places to be in the world have been Emerging Markets and Deep Value. So, is Emerging Markets Deep Value just squared that performance, but it also means the opportunity set is the best of all of the possible combinations that you can find out there?
Jake: Yeah, you can’t get farther away from FAANG.
Juan: Yeah. We tend to joke that, if you would have been an emerging markets investor over the last 10 years, you would have been an underdog. If you would have been a value investor within emerging markets, you are the underdog of the underdog. I don’t think that there has been a worse place to be as an investor, but I think that if you are price driven, valuations look compelling, and the next 10 years might look very different from what the last 10 years have been.
There’s also the fact that I think that in the context of emerging markets, if you are doing value investing, and a lot of people are very top down macro driven in the context of the EM but, if you are doing value, many places in EM look alike what the US was in the 1930s when Benjamin Graham came up when he penned down what the philosophy of value investing was. And so, there’s a lot of uncertainty. The accounts are less readable than in the more developed markets. The accounting is not the best. The access to the annual reports is not great. All of those things drive less competition, which increases in efficiencies, and then it’s a great place to be if you like value investing.
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Why Value Investing and Emerging Markets Have Underperformed for 10+ Years
Tobias: Diagnose for us, if you will. Why value has been such a bad place to be and also why emerging markets stumbled over the last 10 years? Because it’s not always the case. We’ve gone through cycles where emerging markets and value have done very well, but it’s been an extended run, 10 years plus. Why do you think that is?
Jake: Dear Diary?
[laughter]Juan: Well, if you were to look at the last 20 years, not the last decade and you positioned yourself in 1999– [crosstalk]
Tobias: That’s 25 years ago.
Juan: Well, yeah. Okay, fair enough. If you were in 1999 still entering into the new decade, actually that first decade of the 2000s, the emerging markets did quite well. I think that potentially what you would have found in 1999 is that, from a valuation perspective, EM was relatively attractive to the rest of the world. Whereas at that same point in time, the US and specifically US tech was very expensive. Probably what happened is that over the course of the next 10 years, that equation changed and then EM became a little bit more expensive than was supposed to be and then developed markets probably after GFC came out a little bit cheap.
Now, what I’m a little bit unsure about what happens over the next 13 years is you do have to play with very low interest rates, which is the one thing that people have used to justify why value investing as an investment strategy hasn’t really worked out. But when you think about emerging markets, even though yields did come down, they were not zero in many of these places, and still value underperform over that specific period of time in many of these regions. And so, I’m going to stick with the fact that probably entering the decade value was not attractive in the context of EM, but there might have been more things at play and I’m not 100% sure what those could have been.
Now, if 1999, and maybe I am picking my point here, serves you as your historical point, then entering the 2020s, you were seeing a very similar situation where EM was actually quite depressed, the valuations were very attractive on a CAPE basis and that’s something that we look to a lot as our valuation metric. If you are buying into some of those lowest CAPEs in many places in emerald markets, then the annualized rate of return that you should get over the next 10 years should be quite attractive. We can just hope for it and we can just expect that the history repeats itself, but who knows?
Jake: Yeah. Remember how breathless people were in the mid aughts about the bricks? That was a real I think.
Juan: Yeah. I don’t remember when exactly the strategies from Goldman Sachs coined the BRIC name, but it’s probably in the very early 2010s. He coined the term. A lot of people got very excited with Brazil, Russia, China, India. Went there looking for yield or growth, probably growth. Pushed the valuations up. Made the entire market less attractive. I don’t know, I’m speculating here.
Tobias: Yeah, that’s interesting. They got there after the decade long run had been going and they weren’t looking so much at valuation. They were looking at growth prospects. It seems like valuation is a good place to start.
Juan: Well, yeah, but EM is always associated with growth for very good reasons. From a top-down perspective, given the point in their development cycle for many of these different countries, you would expect a lot of growth happening. I’m pretty sure that growth will come through. I’m Colombian, born and raised. Colombia, with all of its troubles, it’s a way better place today than it was in 1980 when I was born. I’m almost sure that that applies to every single country in the EM space with some very few exceptions, and one of those maybe being Venezuela, maybe Lebanon or countries like that. But even Russia today, I’m pretty sure that it’s a way better place than it was in 1980. Having said that, despite the association with growth, it’s a great place to hunt for value because it’s just driven by inefficiencies.
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Tobias: Let me give a shoutout to our listeners and then– I’ve got some more questions for you.
Jake: Out in all those emerging markets.
Tobias: Seattle. Brandon, Mississippi. Toronto. Pittsburgh. Dubai. Savonlinna, Finland. What’s up? Kennesaw. Medellin. Medellin? Where are you from? Where are you from?
Juan: I’m Bogotá.
Tobias: Kansas City. New Brunswick. Canada. London. What’s up? Helsinki. Houston. Nashville. Winnipeg. Cool. That’s a good spread. Banana, Queensland. There you go. Chapel Hill. Santa Domingo. Bellevue. Skipped a few. Sweden. Richmond, Virginia. Norberg, Sweden. Toronto. Thanks, guys. Good to see you all.
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How to Screen For Emerging Markets Stocks
Tobias: How do you do a search through EM? It’s not as easy to screen as the other places. So, what’s your search method when you guys are hunting through there?
Juan: We apply in EM the exact same screen that we apply for all of the other funds that are run by my team. We just screen for the cheapest quintile of the market. In the context of EM, that will give you 450 plus names. And then the next question is, how do you pick from those 450 names? On my first day on the job, Kevin Murphy, who is the co-head of my team, I asked him that question and he said, “Well, this is a value team, actually a pretty deep value team.
You can pick any name from that list. But if you pick number 449, having 448 cheaper names, that would be a little bit weird.” And so, usually, we concentrate on the top 50 names. With the passage of time, we develop a heat map that shows you countries and sectors. And so, actually, on that cheapest quintile, so you can see very clearly not only absolute valuations, but also relative valuations. And you can see what sectors and in what countries or in what regions value is screaming loud.
Jake: What does it look like today in rough generalities?
Juan: So, the entire market is trading at a CAPE of around 17 times. That cheapest quintile, on average, is at something very close to 7.5 times, which is actually quite low. And so, probably that 17 times doesn’t look as cheap. But the quintile, the cheapest quintile looks very attractive. And then what’s really interesting is that, the breadth of the opportunity is very wide. You have a lot of different companies coming across different sectors and different countries. And so, you don’t necessarily need to go and chase any specific sector in any specific country, because there’s a lot of opportunities to pick from. Now, having said that, this is emerging markets. It’s still a risky asset class. You need to pick your spots and do your work. There’s a lot of what value investors fear value traps in there.
Jake: I remember, at one point, I have to go back to look and see the specifics. But I did a little write up and study of CAPE. If I remember right, it was if you had a starting CAPE on your basket, your portfolio of under-five, there was no observed data points where you had lost money 10 years hence. Where if you went like CAPE under 10, there were still some chances where you’d had some bad 10-year stretches. But if you got cheap enough, there would been no observation of actually losing money. Rule number one.
Juan: Yeah. We use a CAPE chart to show the opportunity set and where it stands. We tend to show clients and potential investors that the lower the price that you pay on a CAPE basis, the higher your internal return should be over a 10-year period analyzed going forward. And so, I think that in the context of the US and even the UK, if you were to pay anything, or if you build your portfolio with stocks that are trading below seven times CAPE, your annualized return should be something very close to 12% or 14%. And then in the next bucket, which I don’t know, it goes from 7% to 10%, then it lowers down to 9%, 8%, to the point that if you’re paying above of 30, then the probability of you losing money tends to be high. Having said that, in my personal experience, buying things below five times requires a lot of stomach.
[laughter]Jake: That’s right.
Tobias: I’ve seen some research that CAPE between countries isn’t particularly useful. So, a 7 in one country is not meaningful relative to a 15 in another country. It’s relative to its own-
Jake: Historical?
Tobias: -average. Yeah, it’s to its own historical average. So, 17 might be the long run average in the states, but that could be expensive in another country if it got to 17. Have you observed that? Have you seen that research? Do you have any view?
Juan: I haven’t seen the research, but that’s exactly why instead of looking at the screen at the cheapest quintile just rank from most expensive to cheapest, 1 to 450, the screen heat map will actually provide you way more information, because you can say, “Well, Taiwan’s CAPE is at–” I’m going to throw a random number, 25. But then maybe tech in Taiwan is 40, and then maybe consumer discretionary or telecoms in Taiwan is 10, or maybe 15 or 16. Let’s say 17 to make it easier. So, 17, which is the median number for the entire space. Well, that 17 number potentially could be attractive relative where the entire Taiwanese market is, and maybe that’s a source for you to look for opportunities or ideas.
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How to Get Comfortable with International Financial Reporting Standards
Tobias: I’ve got a question here about accounting standards. How do you get comfortable with the different implementations of accounting? I guess, it’s mostly IFRS. Is that right? There’s only the US and Canada, a GAP. Everybody else is IFRS.
Juan: So, in many countries, it will be IFRS, but sometimes, they will have their own local accounting.
Tobias: There’s a variation of it, yeah, for every country [crosstalk]
Juan: In terms of like– [crosstalk] Well, that’s where the source of opportunity is. That’s why many people don’t feel comfortable looking into many of these companies, because they fear that those numbers are not going to be a good representation of what the business can do. What we tend to do is we don’t forecast. We tend to avoid forecasting as much as possible. We use base rates a lot, and we build models that are backward looking. And so, we are looking at the company in the context of its last at least 10 years. if we have data longer than that, then we try to build those models. The idea is to capture as much as possible the company going through more than one economic cycle.
Now, in the context of accounting, you need to do a lot of due diligence. But when you’re looking backwards, a lot of things will flag up. A company changing its auditor in 2014, that’s a red flag. And so, even if you are not an expert in the local accounting for that specific country, that’s a question that it’s very easy to ask, what happened there? And just that very small detail can open a whole can of worms. And so, we spend a lot of our time trying to understand the accounts and what they mean. But it’s a fair question. It is a challenge, but that’s also where the opportunity lies.
Tobias: What about big concentrated insiders? I think there’s a lot of owner-operator type investors who they control it. They might not even control a majority of the shares, but they control it through other means. How do you uncover that, or is that something that you’re concerned about, or do you look out for?
Juan: In the context of EM, what people fear the most are state owned enterprises.
Tobias: Okay.
Juan: That’s where you enter as a minority. We tend to say that Joel Greenblatt, in his Special Situation book, he had this phrase about bankruptcies. He used to say, “Go with an open mind, not a hole in your head.”
Tobias: [laughs]
Juan: I think that’s exactly what you need to do when you are applying value investing in emerging markets. Because if you go into a minority, thinking that you’re going to change the corporate governance for Chinese bank that it’s controlled by the state, that’s not going to happen. So, you need to be careful. I think that the best way to deal with those situations is not to avoid them. There’s a price for everything. You just need to make sure that you are being compensated for taking that specific risks.
The other thing that I would say though is that, a lot of people fear the SOEs, but the Chinese internet space was considered private. The fact that it was private when Jack Ma made the most expensive speech in the history of mankind didn’t save anyone’s capital or wealth from going down a lot. And so, it’s just about keeping your eyes very open.
Tobias: Does China fall within your investable universe?
Juan: It does. It’s actually quite a big market and a big constituent.
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How to Invest in China Despite Political Risks
Tobias: How do you approach China? Because it looks like there are lots of names that are cheap on a bottoms-up basis there, but like, you just alluded to some pretty real political risk there, how do you think about it?
Juan: So, when we started looking at the main markets in the context of my team, China was quite an expensive market. So, we actually couldn’t find that many ideas. As you probably know and you just made a reference to, it has been coming down quite a bit. So, the screen heat map is populating with China all over the place.
Jake: [laughs] Bright green.
Juan: Yeah, exactly. And so, when that starts to happen, then as a value investor, you go where value is taking you and then we have been spending a lot of our time looking for investment ideas in China. Do we shy away from China because of its geopolitical risk? No, I don’t think so. In the context of emerging markets is very big, it would be us ignoring the entire US. I don’t know, if it’s a like for like comparison, but it’s very big and very meaningful, and so I don’t think that you can do it. Even more if that’s where value is taking you, then again, you do your work and you try to determine and find out whether or not you’re being compensated for those risks.
The risk that you’re going to take, you take any position in that specific market. If it’s a private company, if it’s tech, if it’s an SOE, if it’s a utility, whatever the situation, we just try to be very much aware of the risk that we’re taking and just demand the compensation that we believe that we deserve for taking any particular risk. But that would apply to China or any other market in the context of–
Jake: Yeah, Ted Seides had an article. I don’t know, it must be going on a month ago now, where he was talking about that, every fund manager is facing one question right now, which is basically like, how much should you have allocated to the Magnificent 7? If you choose to have a lot allocated to it, and it does well, like, you’re going to look like a hero. And obviously, if it doesn’t do well and you had a lot allocated, it was obvious how expensive it was. It’s always in hindsight. I actually think there’s probably two important questions facing, especially more of a global allocator right now is, how much of the Magnificent 7 do you want exposure to and probably how much China do you want exposure to? I think those will be pretty big drivers of the next 10 years, if I had to guess.
Juan: Yeah. My co-manager, Vera German in the fund, she keeps telling everyone that would listen to her that the only question that you need to ask yourself in the context of EM is how to get China right. Because at the moment it looks very scary, but sometimes, the investments that you do today are the ones that will provide your returns in the future, because that’s how value works. And so, it feels very uncomfortable to look at China at the moment, but that’s where value is taking you. And so, you just go to where value takes you and try to do your best work at picking the most attractive mispriced situations, understanding that, you might be making some mistakes along the way.
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How to Protect Your Portfolio from Existential Risk
Tobias: How do you protect against that? Just the amount of exposure that you have, you have a cap on country level exposure or sector level exposure or industry? How does that work?
Juan: We have caps on the amount of capital that we can commit to any specific country and sector. Having said that, China is so big that China is its own individual case. I think that the best way to account for risk is to do a lot of work on the names that you’re buying, so you understand the situation. Going back to what I said before, go with an open mind, not a hole in your head, and just account for risk through portfolio construction. If you have a very risky situation, don’t make that risky situation. Even if you believe that it’s going to be a 10-bagger, don’t make it a large position in your fund, because you are going to put a lot of capital at risk.
So, if you believe that you’re being compensated for that risk, there’s a place for that position on the portfolio. Just wait it accordingly to the risk that you’re getting. In the context of EM, that’s what we tend to do. Not only on individual names, but say, a company operating in a country that is in a geopolitical difficult spot, then you can find the best compounder. It might not be the best capital location to put a lot of your money in that situation, because you don’t know probabilistically, a lot of things can go wrong.
Jake: Juan, do you think there’s any amount of work that you can do to actually wrap your mind around the existential risk of China?
Juan: No.
Jake: Probably not, right?
Juan: Probably, not. No.
Jake: At least not for us, mere mortals.
Juan: It’s such a complex situation moved by so many different variables, and so many different interests, and so many things can go– The probability map going forward is so wide that it’s just impossible to know. That’s why I think that the best thing that can protect you is a lower price. I used to use an example with Russia about the lower price, but then when Russia invaded, I threw that example to the window because– [crosstalk]
Jake: When it went to zero? [laughs]
Juan: Yeah, exactly. I think it was 1998. If you would have entered the market, the Russian market in 1998, when everyone was trying to get out because– [crosstalk]
Tobias: Was that the default?
Juan: They were about to default capital controls. There was a lot of fear in the market. I think that the CAPE at which you could have bought the entire Russian market was something like one time or two times. And then, if you would have done that, which would have required a lot of stomach, then you would have compounded for the next 20 years at 18% annualized in dollars, which would have beaten– I think I’m correct about saying this. it would have beaten every single index in the world, including the NASDAQ. I’m almost, almost sure about that.
So, the problem with that example, it was a very good example, but then Russia invaded Ukraine and it didn’t work out, because actually it zero everything. So, that’s why you need to be very, very careful. But the point is, in the context of China, you can use a lot of historical reference points to make up a narrative and a case on why nothing is going to happen. But again, a lot of things can happen. In a world probabilities, even if the probabilities are very low, it does exist and that scenario can play out.
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Alibaba: A Lot More Interesting Than 3 Years Ago
Tobias: Charlie Munger diagnosed the problem with Alibaba as being the fact that it’s still a retailer. How do you feel about that?
Jake: Goddamn retailer, actually.
Tobias: Goddamn retailer.
Jake: [laughs]
Juan: I think that there was a point in time where people were thinking about Alibaba as a company that was going to grow to the sky, and there was no limit to the growth that they were going to provide, and you were supposed to pay any price for it. I think that you could see that in the valuation and in the expectations. And then, who would have thought that one speech would just create so much havoc for everyone involved in that specific situation? I think that because humans are humans and we behave in a way that actually it’s expected in the way that we behave, now Alibaba has gone on the opposite direction. Now, people don’t believe in Alibaba. It’s never going to grow. People call it a utility.
Well, none of those extremes were truths. It’s not a utility, and probably was never going to grow to the moon. And so, the truth will lie somewhere in between. I think that at the moment, it’s more of a special situation, because it’s not breaking up, but it’s going to list a lot of the different assets you will get price discovery. Alibaba, the last quarter was growing at 14%. That’s not really bad. And so, I think that today’s price is more interesting than it was three years ago, before Jack Ma’s infamous speech.
Tobias: Munger’s bought it pretty beaten up, and then it’s fallen over more. I don’t know whether he got out square or a little bit ahead or a little bit down, I don’t know, but it seems to have grown and done fairly well through that period of time. So, it’s more directly just like general unhappiness with Chinese stocks or maybe Alibaba in particular. Is that fair? Do you think that was more a manifestation of political risk than it being a retailer, wasn’t it?
Juan: I think it was the perfect time bomb. Expectations were extremely high. Not only– [crosstalk]
Tobias: Munger didn’t put his position on until it had come. Munger put it off after it had been smoked post Jack Ma when it was pretty beaten up. It was a value stock at that point. We had this debate on this show quite a few times, whether the cheapness made up for the fact that there was this pretty significant political risk there. But clearly, the ruling party in China is prepared to step into these companies and make material changes to the owners and the managers. And so, it made it hard to know what you were buying. You made that point earlier that they’re not state owned, but they’re de facto state controlled.
Juan: I don’t know what point Charlie Munger came into the situation. I think that it was not an Alibaba specific case. I think that the entire tech space in China, the expectations were very high. Sometimes, people would compare the market size opportunity of something like Alibaba to Amazon. Those are two companies operating in two very different environments, and the rule of law in China is very, very different to the rule of law in the US. Actually, I think that if you were to read the risk section on the 20F of any Chinese listed company in the US, there’s a risk that says that actually the rule of law is nonexistent in many aspects of their business environment, which means that it can be either made up or changed. That’s actually what happened.
He upset someone very powerful. He didn’t like what he heard. He called off an IPO. Alipay was supposed to be the largest IPO in the history of financial markets, and he pulled it off one week before it actually happened. That would have never happened, I think, in the context of a market like the US. And so, I think that there’s a little bit of everything. It was expectations built into the names, into the sector, into China’s growth. Remember that at some point, everything that was associated with China was flying through the roof in the same way that artificial intelligence has an impact on companies. So, I think that all of that goes into the price. And then there’s on top of that, a lot of geopolitical noise around it. Now, what might happen with that remains to be seen.
Tobias: We say this on a day where Amazon’s just been sued for antitrust in its market’s place. Also, Musk has drawn some attention because there’s some people upset with what he’s done with Twitter, and so he’s had to deal with a lot of inquiries from the government in his other assets. I don’t know, if it’s an entirely political risk free the states, but yeah, it seems to be lower than China.
Juan: I don’t know, Jake, you mentioned on this podcast, actually, that people are sometimes maybe a little bit harsh the way that they judge how the Chinese political party is treating the Chinese billionaire tech guys. But again, going back in history to what the US was in the 19th centuries, the US state was very harsh on the barons towards the end of the 19th century and beginning of the 20th century.
Jake: Yeah, that’s right. The entire Sherman Antitrust Act basically was, if you rolled that out today, it would look probably somewhat CCP-ish.
Tobias: There’s a lot of political risk. There’s a lot of political risk whatever market you’re in.
Jake: Boy, imagine Fannie and Freddie preferred shareholders in-
Tobias: GM.
Jake: -US rule of law, where– Wait a second, you continue to scrape all these years later, you’re still scraping the cash out of that company and not sending it to us as the owners? Wow, that’s hard to believe in the United States.
Juan: [chuckles]
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How to Stay on the Right Side of Information Asymmetries in Deep Value Investing
Tobias: I’ve got a question here, Juan. How do you get comfortable that you know more than the locals do? Why when you find these things, are you confident that you’re able to diagnose that it is actually undervaluation, rather than just everybody knows political wise?
Jake: Can I reframe the question?
Tobias: Yeah, do it, please.
Jake: How do you stay on the right side of information asymmetries?
Tobias: That’s a much better question.
Juan: [laughs] It’s a very good question. Well, we do a lot of work on the individual names that we are investigating. We don’t really trade that much, because we are investing in deep value listed turnaround situations. We always take the view that whatever the situation is at a micro level, the company level, or the sector, or the country, it will take some time to sort out. So, you’re trying to buy into situations where- Well, number one, valuation is on your side, so you’re paying a very low price. That should protect you on the downside.
The second thing is we look a lot at balance sheets. For us, the strength of the balance sheet is very, very important. Actually, sometimes, people call us distress equity investors, but I don’t like the word distress, because that implies a lot of leverage in the situation. Actually, I think that if you were to look at the portfolios in any of the different funds in my team, what you will find is that those balance sheets tend to be more net cash than debt. The reason for that is if you have a lot of cash, then, or let me rephrase that. If you don’t have a lot of debt, then you have more time for you to turn around.
Then when it goes to specifically to the asymmetry of those specific names, I think that when you are doing a lot of historical research and you are not just looking at the last year or five years, if you’re actually going back 10 years in time or 15 years in time, you can uncover so many things. There’s a lot of history from these companies. You actually take the time to read the Sherman letter that’s available, and you go through the accounts, how the business changed. There’s a lot of information that sometimes might get lost. Then in very hairy situations, we do talk to experts, and we talk to people that are on the ground and we ask the question, does this company in China, have you been to their offices? Does this company actually exist? Have you talked to management? Have you seen them in person?
Again, you are never going to be fully protected. Again, it’s a risky asset class. If you’re doing the value in the context of a risky asset class, you’re running a risk. Important thing is that, you believe that you’re being compensated for that and you are going to get some of those situations wrong. But hopefully, in the context of a portfolio, you will do better than the market.
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Reducing Type 1 Errors Significantly Improves Your Investment Performance
Tobias: JT, have you got some veggies for us today?
Jake: I do. Before I get into those, I wanted to do a quick shoutout to my guys here that I’ve been staying with in Florida. These two guys, Paul and Rick, who originally, they met and worked together running the main guys at Notre Dame’s Endowment. They spun out of there now and they have their own thing going on, but they still teach a class at Notre Dame called The Art of Investing. They have great people coming through, it’s like, Todd Combs and the CEO of Booking. These guys know everybody. Don’t be surprised if you see these guys all over the place here soon, because they’re going to have a podcast coming out that’s associated with the interviews that they’re doing for this class. I think it’s going to be really good. So, Paul and Rick will be on your radar, I imagine. Don’t be surprised you heard it here first.
So, anyway, yeah, let’s get into some vegetables now. I should probably apologize a little bit, because we’re going to be talking about type 1 and type 2 errors, and we’re going to have a little scenario in here that has some numbers in it. I know sometimes numbers are hard to translate in an audio context. So, I’ll do my best to go slow and probably repeat numbers. Maybe writing them down might help if you really want to learn from this. But I’m basically stealing this little segment out of a book called What I Learned About Investing from Darwin by this India fund manager named Pulak Prasad. So, without further preamble, let’s get into it.
So, type 1 errors are those are where you’d be making a bad investment when you think that you’re making a good one, right? So, it’s like sins of commission. You buy something, you lose money on it. A type 2 error is when you reject a good investment idea, because you erroneously think it’s going to be bad, right? And so, these are the sins of O mission. We’re missing out on something that would have been good for us. Okay. So, it’s unlikely that you’re going to have this perfect calibration between type 1 and type 2 errors, because they’re like opposite ends of a teeter totter. So, I think it’s an important question to ask yourself is, which direction if you had to lean? And chances are you have to lean one way or the other, which one should you try to lean toward, type 1 or type 2?
So, what we’re going to do is run through a little bit of some scenario to show mathematically which way you should probably lean. Okay. So, let’s assume that your investable universe is 4,000 possible companies that you could buy. And to make the math easy, we’re going to also assume that 25% of these companies will provide us with a reasonable return over, let’s say, the next several years. They’re decent enough businesses, management is okay, acceptable growth rates, not crazy leverage, reasonably priced, whatever your version of what makes for a good investment. What we’re saying then to simplify is that 1,000 of the 4,000 companies are good investments, and 3,000 of the 4,000 are actually going to lead to bad results, okay? So, these are our two pools that we’re fishing in, basically.
Next, we’ll assume that you’re actually a pretty good investor, and you’re able to identify with 80% accuracy, which companies to put your money in and which to avoid at an 80% clip? So, you’re actually pretty good at picking and avoiding. Set another way your error rate is 20% for, both type 1 and type 2 errors, okay? So, what do you think is the probability then of making good investment, if it’s 80% hit rate?
Tobias: One in three.
Jake: One? Care to hazard, I guess?
Juan: I’m going to go with 15%.
Jake: Five-zero?
Juan: One-five.
Tobias: One-five.
Jake: One-five. Okay. You guys are both way too pessimistic.
[laughter]Jake: So, it’s actually 57%. I’ll walk you through the math of this real quick. So, remember, there are 1,000 good investments, and you commit a type 2 error at a 20% rate. So, you’re mistakenly rejecting 20% of these. You’re only correct in selecting 800 of those 1,000 companies, right? Is that making sense? Then there are also 3,000 bad investments, and you commit a type 1 error at a 20% rate where you mistakenly select 600 of those companies thinking that they’ll be good investments. So, the universe is then actually like 1,400 that you’re making, so it’s 800 plus 600, these two pools. And of those 1,400, only 800 actually are. So, 800 divided by 1,400 gives you a 57% hit rate, okay?
Tobias: Good one.
Juan: [chuckles] Interesting.
Jake: So, you have 80% accuracy and yet, you end up somehow closer to a coin flip. All right. Now, what if, and this is to get at, which way should we lean, what if you could magically reduce your error rate one side or the other, like, type 1 or type 2? So, let’s imagine first that you’re going to reduce your type 2 errors, and we’re going to take it down from 20% down to 10%. So, you want to focus on not missing out on those good opportunities, the big winners, okay? Of the 1,000 good investments, then you’ll select 900 of them, which is a 90% hit rate. Of the 3,000 bad investments, you’re still at that 20% rate, right? So, you’re at 600 that you thought were good are going to end up not being good of the 3,000.
So, you’ll have selected 1,500 investments, 600 plus 900, but only 900 of them are going to be good. So, you’re going to go 900 divided by 1,500, that gives you a 60% chance, okay? So, you’ve improved your probabilities then from 57% up to 60%, just a little marginal increase. Not that great. Now let’s imagine that you can reduce your type 1 errors from 20% down to 10%. So, you’re working hard to get better at rejecting bad investments, okay? Out of the 3,000 bad investments in that market, you’ll select 300 of them, right? This is that 10%. Your type 2 error stays at 20% because that’s not what we were focusing on, and so you’ll still erroneously reject 200 of the 1,000 good investments by making your 20% error rate, but you then therefore select 800 correctly.
All right. So, you’ll have selected then 1,100 businesses, 300 plus 800, but only 800 of them are actually good. So, 800 divided by 1,100 is actually 73%. So, we made a huge jump. We improved by 16% or 16 points basically instead of just 3%, by focusing on type 1 error reduction. So, I think this math shows, and obviously, this is a little bit of a hypothetical example, but I think the math is pretty clear that improving your rate of rejection of bad investments instead of focusing on not missing out on the good ones is the key, like the ticket to doing better in this game. So, the fear of losing money should trump the fear of missing out, if you have to choose between those two on the spectrum, which again, we always end up back at buffet, rule number one, don’t lose money. And that’s again, what we’re talking about. So, there’s a little hypothetical math for you on why you should probably lean one way or the other.
Tobias: That’s a good one. That’s very like Buffett says, “Lots more mistakes of a mission than commission.”
Juan: That’s really interesting. For someone who runs a podcast that talks a lot about probabilities, probabilities are really difficult to understand, and calculate, and all of that, but they are very powerful when you can actually understand what the math implies.
Jake: When hopefully, this was reasonably not too difficult to follow along with the numbers since they were such round numbers. But again, it is always hard to just say numbers and then picture them.
Tobias: That’s good. Thanks, JT.
Juan: The other thing is that even the improvement from 57% to 60% compounded, those three points would make a huge difference in the way that you will compound over the period of your career as an investor.
Jake: Yeah, but I’ll take the 16% improvement over the 3%, if I had my choice.
===
Tobias: Hey, Juan, how do you go from being in Colombia to being a fund manager, which is a very attractive role in one of the most storied names in value investment in London?
Juan: So, I have this story that it’s a little bit of a cliche. I swear to God it’s true.
Jake: [laughs]
Juan: I came to the UK to study an MBA in 2009, and joined Credit Suisse on the security side on investment banking division. I had never heard about value investing before. While waiting for a client meeting in their reception, I came across an article on The Economist that was talking about this hedge fund manager in the US that had written this book in the early 1990s, and that book was out of print and it would cost you $4,000 on eBay. I had never heard of this guy before and the book was, of course, Margin of Safety. Like many people that like this job, I like to read, and that caught my attention, and I got myself a PDF copy for free because $4,000 was a little bit steep.
Jake: We won’t tell anybody about your copyright infringement. [laughs]
Juan: Well, I’m a value investor, so I cannot actually psychologically afford to pay that.
Tobias: It’s a trophy asset that appreciates over time.
Jake: Yeah, beats your portfolio. [laughs]
Juan: Yeah, exactly. And so, I read the book. It sounds like a cliche, but that thing changed my life. For me, I can clearly remember, I just wanted to be a value investor after that. I didn’t care about corporate finance anymore, investment banking, the sell side. I just wanted to make a move on to the buy side and become a value investor. I was very lucky to transition to Pictet Asset management on an emerging markets fund working for the two long only global funds. I started reading everything that was available to buy investing, including Toby’s books, by the way. I only stopped when whatever I was reading was making a reference to something that I had already read. As part of that journey, I came across the Value Perspective blog, which was run by my current team at Schroders.
One day, they posted on the blog that they were looking for someone and they listed the characteristics of the person that they were looking for, but they didn’t advertise what the role was. It wasn’t clear if it was analyst, a PM, if analyst for what specific fund or sector. They just wanted someone that was interested and that believed that had those characteristics to send a CV and an investment idea. I did. I was very lucky to be picked to join the team in early 2017, and the rest is history.
Jake: Cinderella story.
[laughter]Juan: Well, that’s why I know that it’s a little bit of a cliche, but I can swear to God that it’s true. [laughs]
===
Why Emerging Market Investors need English accounts
Tobias: Does it help to be a Spanish speaker as you look at any of these EM countries?
Juan: No, not at all. Well, the only market that I would say is big in the context of EM– Well, you want to call LATAM.
Tobias: Brazil, Portuguese.
Juan: Brazil, Portuguese, so that doesn’t work. But in the context of how we operate in my team, one of the rules that we have is that you need to have English accounts in order for you to invest. It doesn’t matter if I can read the Spanish accounts. If my comanager cannot read the accounts– The reason for that is, there’s no outsourcing of responsibilities. Everyone needs to understand the risk that that person is taking, so that if you wake up one day and the stock is down 25%, you will have the stomach to enter into the situation and buy more, if you believe that there’s an overreaction. The only way for you to do that is actually to have done the work, and the due diligence, and the research yourself. Reading it from someone else is never going to be the same.
Tobias: How many companies does that exclude? What proportion of your investable universe don’t have English accounts?
Juan: I actually don’t know the exact number, but there are plenty of– [crosstalk]
Tobias: Roughly. Do you have a guess? A third?
Juan: Maybe a third. Yeah. I don’t know, I think that in the context of emerging markets, if you were to take the entire universe, counting everything, China and India, you will have more than 5,000 companies. We only care about the cheapest quintile or whatever that specific market which will give you– I’m going to say that, because in that very big market, you will have small caps, companies that don’t trade liquidity, and then the non-English accounts, or companies that don’t have the history that we require to enter into a situation. I’m going to say that 80% are rejected or fall out of the universe.
===
Tobias: There’s a little bit of debate in the comments about the numbers. So, Jake’s numbers were 4,000 investable universe. 3,000 were not going to work. 1,000 were going to work. You’re 80:20. So, you’re better off focusing on making fewer of the sins of co-mission on the ones that don’t work than you are concentrating on sins of omission on the ones that do work. And so, you get 16 points by improving the ones that don’t work rather than taking on the ones that do work, which adds three points. Is that fair, JT? Have I got it?
Jake: We could have cut out an extra five minutes. You could have just said that and we wouldn’t have to go through all the math.
Tobias: Yeah, I think that’s the main problem for investors. I think that’s really what Buffett has solved is that he focuses on– This is the focus of my new book that you should be spending your time focusing downside. [crosstalk]
Jake: When’s that coming out, by the way, my man?
Tobias: Every time I read it, it’s just not quite good enough. It’s hard, because I really, really want to get rid of it. I’m tired of it, [Jake laughs] but it’s just not good enough yet and I just won’t release until it is, because I’ve learned that these books hang around forever and they haunt you forever. So, I want to make sure that it’s good when it comes out. It needs help.
Jake: It’s the [crosstalk] that you’re capable of at this stage in kife.
Tobias: That’s right. I just read it and I fall asleep in a few parts of it, so I can’t put that out. I discussed this. Buffett makes that comment lots and lots of times, and I found the original source of those ideas, and some other things like that. So, that’s what’s in the book.
Jake: Ooh, spicy.
===
Value Investing in Emerging Markets: Opportunities in Uncertainty
Juan: Do you guys think that many successful investors start their career looking for the cigar butts on the very deep value side of the spectrum? But as they grow old, they move in that spectrum to the more quality compounding side. Do you think that’s because they have been burned a lot by the cigar butts, or is that as you grow old, your risk appetite declines to the point that you are not willing to take the cigar butt, or is there something about understanding the fact that compounding works better, if you get it right on the good ones?
Jake: I think there’s different paths there that all lead to out of cigar buttville. I would say one, you run into capital constraints. If it works for you and you build up a decent enough size, you really can’t deploy it. The strategy is constrained. Two, if you’re hanging around the investment game for long enough, you might start to recognize some privileged businesses and you might then realize like, “Wow, if I paid up even a little bit for this, it could work out pretty well.” So, you get a little bit more confidence, perhaps, in your ability to bet on special businesses that you wouldn’t do otherwise. And then, yeah, three, you flame out, and disappear, and we never hear from you again.
[laughter]Tobias: What do you think, Juan?
Jake: Yeah. What do you think, Juan?
Tobias: Do you still find cigar butts in EM land? Is that something that you invest in in EM land?
Juan: EM, it has everything. Em is very much associated with cyclical bad companies because it has a lot of materials, metals, commodities.
Jake: Commodities.
Tobias: Cyclicals.
Juan: Cyclicals, in general. But in the context of EM, you have 25 countries in very different stages of development. And in each specific country, you will have things– In every specific country, there will be fear and uncertainty. Where there is fear and uncertainty, you should find value, and you find everything. You find special situations. You find growth that no one’s paying attention to. You find companies that were good, but now they’re going through a rough patch. You find companies that are facing a structural decline. You find cyclical companies. The opportunities that tends to be very broad. And again, it tends to be inefficient, because there is less competition, because people fear the uncertainty that comes with the lack of either information, or availability of accounts, or the language, or whatever that is, the geopolitical spectrum, whatever that is.
So, I think that in the context of EM, you can still do very well with the cigar butts. But that’s a question that I’ve had in my mind lately, whether a lot of the value investors that did very well out of their careers doing the value, eventually, as they grew old, they migrated and you’re finding that with a lot of people, I guess.
Tobias: I’ve done that study where I just buy and never sell, and the things that work become gigantic parts of the portfolio, and the things that don’t wither away into nothing. So, just like, you look at the end and the portfolio looks like it’s Kelly bit weighted into the good stuff that’s worked.
Jake: You’re a genius.
[laughter]Tobias: Yeah, and you’ve bought all the compounders. But prospectively, they might not have looked that way. How do you fee–? [crosstalk]
===
What Makes the US a Uniquely Fertile Ground for Startups?
Jake: one thing that I’ve wondered about and bothers me is when we’re trying to make these predictions about, let’s say, especially an earlier stage business that’s going to get big and going to have some huge network effects or something, right? And people are very excited about it. I often wonder why you don’t see that same business just recreated in another country. And sometimes you do, obviously. Sometimes it works where you can just like, “Well, this is the Amazon of whatever country.” But a lot of times it doesn’t work again in what looks like very similar starting conditions. All of which is to say like, were you just lucky the first time when it did work? When we rolled the dice again in another country, it didn’t come up with such a huge winning outcome. It’s really hard then to recognize a priori, something that’s going to be this dominant business.
Juan: I think that maybe many of the situations are pinned down on the landscape in which these businesses are operating, and the rule of law, and the environment in which things are happening. And so, maybe despite the fact that you might see a lot of growth in that specific situation in one specific country, there are so many hurdles that that specific business or entrepreneur or business person needs to overcome that just things get in the way.
It’s a good question. I don’t think it relates only to emerging markets. You look at the startup scene outside of the US, it’s actually almost nonexistent. Not nonexistent, but more developed markets. You don’t see it in the same way that it’s happening in the US.
Tobias: It’s one of the points that I have made that the US seems uniquely able to produce these giant Google, Microsoft, Facebook that are international companies where there’s not a lot from Europe, not a lot in Asia. Although China does seem to have produced a lot of these very essentially a similar sort of business or it fills the same niche. It’s just serving China itself. I don’t know what the reason is, just weight of numbers or something?
Juan: Israel comes to mind as a tech hub that tends to do very well, but I think that the ecosystem is structured in a way to help them succeed. Just starting a new company in many markets, it has so many different hurdles that just from the starting point is just so difficult. Opening a bank account, I mean, the things that are very basic tend to be very difficult in many places.
===
Why Emerging Markets Are Not All Created Equal
Tobias: I got a good question here. “What is EM actually? To consider that many idiosyncratic economies (Hungary and Mexico are in the same category) as “one” is an issue in itself.” How do you feel about that?
Juan: The question is what is emerging markets?
Tobias: Yeah, what’s emerging markets? Do you think it’s like a grab bag of countries that they can be very different? Hungary and Mexico are both emerging markets. Taiwan is an emerging market besides some other country– [crosstalk]
Jake: Anything not in the US at this point is. [laughs]
Tobias: What makes it emerging? What is emerging?
Juan: So, now, we follow, what, MSCI classifies as core emerging markets because then you have frontier markets as well. I think that anything that comes into that specific bucket. People do tend to think about emerging markets as this monolithic block, and everything is the same, and everyone is equal. A Colombian, there’s no difference between Colombia and Mexico. They all speak Spanish. Actually, we are very, very different. Again, like I mentioned before, each country is at a very different stage in their development cycle, and that will create a different set of opportunities.
The other thing is, many times what happens in the country with EM that creates the opportunity is there’s a political event, someone gets elected that the market doesn’t like, and the entire market will sell off regardless of quality. And then you can make the most out of that situation and put your spots. But to answer the specific question in my case specifically is what MSCI defines as emerging market.
Tobias: Do you know how they make those determinations?
Juan: It’s based on the depth of the market, the liquidity, the number of names, their development. [crosstalk]
Tobias: Does it change over time? Do companies escape the emerging or the other way around?
Juan: Countries are upgraded or downgraded all the time. So, actually, Greece used to be part of the develop MSCI index until the crisis almost 10 years ago, and then it was downgraded. There are some countries that go from frontier to emerging market or then drop again, or maybe drop from even frontier market. I think that liquidity and market cap size has to do a lot with the capability of MCI to include them as an actual market.
Tobias: Greece been on a little bit of a run recently, hasn’t it? Greece’s been doing pretty well?
Juan: Yeah. The political, there were elections and people got very excited by the guy that was elected. It seems like it’s on the right path.
Jake: I thought it was because I visited. Didn’t that turn it around? I was kidding.
Juan: Yeah, of course. And that was very important. Everyone was very– [crosstalk]
Tobias: Powerful USDs.
Jake: Yeah. That was a key.
Tobias: You’re spending the USDS.
Juan: [laughs]
===
The Challenge of Valuing Companies with Exponential Growth Potential
Tobias: All right, fellas, any predictions for what’s going to happen over the next 10 years? Everybody here has already got their bets on. I’ll bet everybody here is deep value in emerging markets.
Jake: Oh, boy.
Tobias: How do we go wrong? In 10 years’ time, again lamenting the terrible performance of value over the last decade, where do we go wrong? What do we miss?
Jake: I’ll go first, Juan, while you’re–
Tobias: Yeah, go.
Jake: An implicit assumption within a value bet is that, you are on a natural upward glide path as a species, really, or a country, but the mean is gradually improving. You’re taking advantage of anytime, psychologically, it goes below that and then it catches back up with that. If the mean is on a gradual upward path, then you’re probably going to end up doing okay buying when it’s lower. If you’ve already peaked, perhaps, and I don’t know if this is like the running joke now about your wife asking you how many times you think about the Roman Empire per week.
[laughter]Jake: But if the answer is a lot, then– If that mean is actually pointed downward instead of upward, maybe there’s some question marks about like, how much is there when you rebound to a mean that’s lower, if you shouldn’t expect a lower return profile?
Juan: When you are starting evaluation that you say you cannot grow to the moon, because then you will grow to a point that you’re becoming bigger than the entire world. What if many of these companies have found growth that is not still to be priced outside of their niche markets where they can actually keep growing, catering, or penetrating new markets, and then that gets being pushed in terms of the valuation.
You as a value investor, you’re missing out because you cannot believe that Tesla insurance products are actually going to be a thing, because that’s not a thing. But actually, he manages to deliver because he goes instead of sleeping on the factory, he goes and sleeps on the office where they are building the insurance products until he pushes the insurance side of it, and then insurance becomes a thing. Then many of these companies that you are struggling to understand, how is it possible that they are not being pulled down by gravity or mean reversion actually keep going, and then you’re left out.
I guess, the other thing is passives are a very, very difficult competitor to bid and it’s just a self-enforcing momentum thing.
Tobias: Was.
Juan: Yeah.
Tobias: The Triumph of the Optimists that Dimson, Marsh, and Staunton, I think it is. Elroy Dimson has that document that comes out every year. Meb Faber is pretty good about tracking it when it comes out. They make the comparison of China and England there. And this is like a 10-year, 20-year-old comparison where they said, “The 100 years preceding China grew incredibly rapidly and England didn’t grow much.” But England’s stock market did very, very well over that full period of time and China’s did not do so well. I don’t know what that means. Maybe it’s a valuation rule of law, not a growth rate thing.
Jake: Yeah, Isn’t like GDP and stock market return-
Tobias: Yeah, inversely correlated.
Jake: -not correlated?
Tobias: Not to inverse. Yeah. The other thing is that a friend of mine just bought a Tesla and they went for the Tesla insurance, because it was less than half what the market rate was.
Jake: [laughs]
Tobias: They got quoted $400 a month for their insurance in the marketplace, because they’re expensive to insure. Then I think Tesla did it for $180 or something like that. I don’t know. Where’s Samson? Tesla starting to look pretty good, buddy.
Jake: Per Mr. Bloomstran, I don’t know if they have the capital to underwrite that much insurance. But I guess, we’ll all find out together.
Tobias: Long the car, short the stock or short the car, long the stock.
Jake: [laughs]
Tobias: Hey, Juan, thanks so much. This is very fun. If people want to get in contact with you, what’s the best way of doing it? Through Twitter?
Juan: I’m more active on my LinkedIn account.
Tobias: Okay.
Juan: They can also leave a comment on the Value Perspective podcast and the team will receive it, for sure.
Tobias: Awesome. Well, Juan Torres from Schroders Emerging Markets Value team, thank you very much. Always fun chatting to you.
Juan: Thank you very much, guys, for having me.
Tobias: And thanks, JT. We’ll see everybody again next week.
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