VALUE: After Hours (S06 E44): Deep Value in Emerging Markets, China, India, Korea with Juan Torres Rodriguez, Schroeders

In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Juan Torres Rodriguez discuss:

Emerging Markets: 50% of Global GDP but Only 7% of Market Capitalization
Why China is the Deepest Value Market in Emerging Markets Today
Fallen Angels of Chinese Tech: Understanding Alibaba’s Restructuring
Value Opportunities in Emerging Markets
How Macro Factors Influence Value Investing in Emerging Markets
Understanding Emerging Markets, Frontier Markets, and Investment Challenges
Low Valuations in Emerging Markets Often Signal Fear, Not Opportunity
Value Opportunities in Emerging Markets
Diversifying Away from the US Is Painful but Necessary for Investors
Fallen Angels of Chinese Tech: Understanding Alibaba’s Restructuring
TSMC’s Dominance: What It Means for Emerging Market Investors
Joel Greenblatt’s Wisdom Applied to Emerging Market Investing
12 Leverage Points: A Countdown to Systemic Change
Speculation, Leverage, and Bitcoin: MicroStrategy’s Ecosystem in Focus
Are Emerging Market Banks Safe Investments? Key Factors to Consider
Why India Doesn’t Fit Into Deep Value Strategies
How to Build a Value Portfolio Across Emerging Market Countries and Industries
AI’s Impact on Emerging Markets
Emerging Market Opportunities: Why Indonesia, Brazil, and South Africa Stand Out

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:

Transcript

Tobias: This is Value: After Hours. I am Tobias Carlisle. Joined as always by my cohost, Jake Taylor. Our special guest today is Juan Torres Rodriguez. He’s portfolio manager of the Emerging Market Value Strategy at Schroeders. Welcome, Juan. Good to see you again.

Jake: Pretty good accent you tried to affect there, Toby.

[laughter]

Tobias: I try. I practice my Spanish every day, [unintelligible 00:00:33].

Jake: Yeah– [crosstalk]

Tobias: [crosstalk]

Juan: Yeah, you got that. You nailed that. And thank you very much for having me back. It’s a true honor to be a guest here again. I’m a big follower of you, guys, and have been following the show for a very long time. So, thank you very much for having me back.

Tobias: Well, we love having you on. I was just saying to you before we started, the reason that I like talking to Juan is because he runs THE most extreme version of value that you can possibly run. It’s emerging markets, deep value and pretty concentrated too.

Jake: It makes you feel like you’re doing something easy.

Tobias: I’m vanilla. I’m very vanilla.

Juan: [chuckles] Well, we were saying that one of the beauties about the emerging markets is that I think it aggregates all of the different human biases in one asset class. And that makes it great. If you like investing, if you like stock picking, if you like active management, that’s a great place to be, because it’s very inefficient. There’s less competition, there’s a lot of opportunities to be a great investor at price discovery.

===

Understanding Emerging Markets, Frontier Markets, and Investment Challenges

Tobias: Can you just tell us the markets that you focus on, your universe and where you look mostly?

Juan: So, our investable universe is emerging markets as defined by MSCI. That’s pretty much 25 countries in total. And then, you could potentially extend that a little bit farther to include some frontier markets. If the value emerging markets is very spicy, frontier markets are a whole different level.

Jake: [chuckles] Yeah. Everything’s an emerging market now, unless it’s not the US. It’s how it feels. [chuckles]

Juan: Well, yeah, that’s actually pretty true. But the one thing that I would say is that sometimes you need to think on your feet, and you cannot allow yourself to be guided by what third-party people say or the way that people might classify something. So, I’ll give you two examples. Sometimes Macau is not considered to be part of emerging markets. So, the question is, if it’s not an emerging market, what is it? It’s not a Portuguese colony anymore. And if you were to ask people in Macau, what country rules you, I’m pretty sure that they will give you a very good answer about that.

And then, the other one that it’s a little bit more tricky is Hong Kong. So, Hong Kong used to be part of– well, it used to be a colony, but then it went back to the Chinese. It was supposed to be very independent. People still sees it as a developed market region, and it’s not part of MSCI or the EM investable universe. But if it’s not Chinese, what is it? Certainly, it’s not British and certainly it’s not developed and just follow the news. And so, Hong Kong is an EM place as well. So, I think that sometimes one needs to think on your feet and not allow yourself to be guided by others classifications.

Tobias: When you look at places like Hong Kong or Macau, technically they fall outside of your investable universe. Are you able to invest in them?

Juan: So, Macau, I think is a little bit more straightforward. I think that there is less push back. Hong Kong, we can invest in all of Chinese companies listed in the Hong Kong market. But if I go and buy a Hong Kong real estate company or a property developer based in Hong Kong or a telecom company based in Hong Kong, then I might potentially get pushback. But again, if that’s not part of China, what is it?

Tobias: Can you just tell us the markets that you focus on, your universe and where you look mostly?

Jake: [chuckles] Yeah. Everything’s an emerging market now, unless it’s not the US. It’s how it feels. [chuckles]

Tobias: When you look at places like Hong Kong or Macau, technically they fall outside of your investable universe. Are you able to invest in them?

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Why China is the Deepest Value Market in Emerging Markets Today

Jake: What are your thoughts on China these days?

Juan: It’s the deepest value market in EM, and potentially, one of the cheapest markets in the world. There are many reasons as to why it has gotten where it is. There is a lot of uncertainty, there is a lot of fear, there’s a lot of human behavioral biases around China. Valuations are extremely cheap. It’s on the cheapest quintile of the EM universe is Hong Kong or companies listed in the Hong Kong market are some of the cheapest that you can find.

I was looking at these numbers last week. I think that the average CAPE in Hong Kong at the moment is something like 5.5 times. It’s really cheap. And that shows you how much uncertainty and fear there is.

===

Jake: There was a study I saw at one time that– I could see if I could dig it out and put in the show notes. But it looked at starting CAPE ratios, and then subsequent returns on 5-year, 10-year, 15-year, 20-year intervals. I believe it was after the 10-year interval, if you started at a CAPE like– I think it was 5 or less or maybe it was even 10 or less. I have to go back and look. But basically you’d never lost money in the entire dataset, because you just had such a low starting valuation.

Juan: We, in the value team, we run that type of analysis. We have it for the UK and for the US. We don’t have it for emerging markets. It’s more difficult to get it and aggregate it in emerging markets. But in the US and in more developed markets, if you are buying anything below five times, your annualized average return over the next 10 years should be very close to 14% to 15% dollars without any growth whatsoever.

Now the thing is, if you are buying below five times CAPE, there’s something really, really wrong happening. There’s a lot of fear. There’s a lot of uncertainty. And so, you really need to have a very strong stomach to actually go into the market, and pull the trigger, and just close your eyes and just buy.

Tobias: Your risk in something like that is sovereign usually, right? There’s coup or there’s a revolution, there’s a change of government.

Jake: Deeply macro.

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Low Valuations in Emerging Markets Often Signal Fear, Not Opportunity

Juan: Or, you can take it to sectors or individual companies. If you find a company trading less than five times, that company is potentially at the risk of bankruptcy or the sector is under a lot of stress. I don’t have the data in my head right now, but probably during COVID, you might have seen, at the sector aggregate level, something like that was pushed down a lot. Maybe energy or some of the industrial companies.

But yeah, in the context of emerging markets, your risk is around the country. A lot of the times, there is fear and uncertainty around a specific country or specific region, because something is happening that is creating that fear and uncertainty. And so, if you are very value driven, and you allow valuation to be your guide, and that’s your screening process, what tends to happen is that when there’s fear and uncertainty in one specific country, then your screen starts to populate with all sorts of companies in that specific country.

The one thing that I don’t get the quality growth side on emerging markets so much relative to value, but of course, I’m biased. But the reason I say that is if there’s fear and uncertainty, the market doesn’t care how good your company is. [Tobias laughs] It’s going to puke everything, the good and the bad. The fact that the company has very good management, or return on invested capital, or ROE or whatever is not going to save your capital from the fear and uncertainty and the pressure around it. And so, yeah.

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Value Opportunities in Emerging Markets

Tobias: So, how do you characterize what you’re looking for? You’re looking for undervaluation, but you’ve maybe got the advantage that you can look– because you’re already looking in an emerging market, you can find things that are really undiscovered gems that have the potential to grow over an extended period of time. Is that the sort of thing that you look for?

Juan: So, I think one of the misconceptions around doing value investing in the context of emerging markets is that people tend to think about value in EM as your state-owned enterprise, cyclical driven company. And yes, you do find those emerging markets and yes, if you buy them at the right price, you should do well over time. But the value opportunity is much broader than that, because the markets are so inefficient that it creates a lot of opportunities.

So, you will have your typical fallen angels. The best example of that is a company like Alibaba, which was one of the best companies in the world four years ago. And today, it’s hated by pretty much everyone. You have your cyclical companies. You have a lot of special situations, corporate action-driven type investments which are being screamed by either the company or the sell side, as in the corporate action that’s going to take place, and the market, for whatever reason, doesn’t act on it. There’s a lot of hidden growth, because EM tends to be thought of as a monolithic block. There are 25 plus markets and those markets are very, very different.

I ran this exercise the other day with a group of clients on Friday, where I was presenting EM investing, and I was doing this trivia quiz and I asked them, “Is there in common between a Chinese and a Colombian?” And there was silence. And then I said, “I will give you a clue.” Nothing. There’s nothing in [Jake laughs] common between Colombians and Chinese. There’s nothing. And so, there’s a lot of opportunities, but markets, we know that they always like to build stories and narratives, and there’s always a market that is part of that narrative.

So, four years ago, it was Chinese tech and China, and it was booming and no one could see any stop to the amount of growth that these companies could deliver. And today, it’s all about India, and TSMC, and Nvidia going into the supply chain and that kind of stuff. That means that many other markets tend to be ignored. There are very good companies with very good balance sheets, almost no debt, with a decent amount of growth happening that tend to be ignored by the market.

And then, the last bucket is a lot of businesses which are in structural challenge where you have a very clean balance sheet. A good example of that is Taiwanese old tech, where the profit stream is still very healthy, it’s creating a lot of cash flows, but it’s not growing anymore. They are reinvesting a lot on R&D. In many cases, doing a lot of buybacks, but they tend to be ignored by the market because they’re not growing anymore and they are not in the hype of the moment. And so, those can potentially be very lucrative. And then, what we try to or the aim is to build a portfolio that is catering to all of these different pockets. And those with different pockets will be playing a different role at different points in time.

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Diversifying Away from the US Is Painful but Necessary for Investors

Tobias: When you look at the opportunities that you find in those markets, how do you compare them to– I put this little post on Twitter over the weekend and it just showed, “The US valuations versus the rest of the world.” The performance of the US has been so outsized relative to the rest of the world that it’s extreme relative now to the rest of the world. And I said, “This is a mean reverting series.” I got about 50 comments on it explaining to me why I’m an idiot.

[laughter]

I don’t know. I have no idea. I have this like bias that these things ultimately, they probably should equilibrate a little bit. You can’t just have one grow forever away from the rest, or maybe you can, but how do you like–

These businesses in the US are like– Google and Microsoft, these are worldwide, very high return on invested capital, very deep moats. How do you then handicap everything else against those businesses? You’re not developed. That chart that I was showing was developed versus those other markets. Jake’s joke earlier, like, that there’s something to that. That’s very much the way that people see it, if it’s not the US, it’s not developed.

Juan: For capital allocators, the opportunity cost to have diversify away from the US over the last 10-years has been so painful that even if today they understand that they need to diversify away from their home buyers’ market. That decision is extremely painful, because it’s costing them so much.

Okay. The beauty of emerging markets is that you don’t get to have companies as powerful as those that you are finding today in the US. That’s a reality. Four years ago, you had the Chinese tech and we all know what happened to all of them that once Jack Ma pronounced the most expensive words in the history of finance. Everyone that thought that just because you were avoiding SOEs and you were investing in a private company got a little bit of a pullback to reality. If in a place like China, I’m pretty sure that in any place, if you go against the government or you say something that you’re not supposed to say, eventually, the government will actually put you in the right place. And that tends to happen.

So, outside of that, the only big company that you’re seeing at the moment with that sort of– It’s not even the same. It’s TSMC in Taiwan. TSMC Taiwan is the one company that it’s pretty much loved by every single emerging market investor in the world. If anyone from developed markets is investing in emerging markets, that’s the other company that they will look at. But companies with the economics and cash flow power generation that the US have seen with the Mag 7, I think that it’s difficult to find in EM. But even if that was the case, we are deep value investors and we only look at the cheapest quintile of the market. So, for us, whatever is happening with many of these companies, we don’t really pay attention to it.

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Emerging Markets: 50% of Global GDP but Only 7% of Market Capitalization

Jake: You guys want some numbers on this? This is from Grant’s Interest Rate Observer from– It’s a couple months ago, but I think it’s still representative. US’ representation of the ACWI right now is 64%, developed internationals at 28%, emerging markets 7%. Now, also, the emerging markets are 50% of world’s GDP, 55% of the world’s population and yet, 7% of the market capitalization. That’s a pretty big disconnect right between economic activity and then the capitalization of that economic activity.

Juan: I’ll tell you something else. I think that we live in a world where because there are trillion market cap companies, then everything else became a small cap. Sometimes people ask, “Oh, are you running a small cap fund in EM?” Well, no, these companies are pretty big.

Tobias: Not intentionally.

Jake: No, they were mid-caps. But now, they’re small caps.

Juan: Yeah, exactly. [Jake laughs] I don’t know what the right answer is, but something is wrong. Either something’s too big or the other stuff is too small, but it has gone too much to the extremes. Sometimes we tell people, “Look, the market cap of this company is XYZ, but these are pretty big companies where they operate.” These are banks with 50 million customer base, or operating a 50 million country, or they’re expanding to the region or whatever that is. It’s pretty big.

The population of Africa is 1.1 billion, and they only have growth going forward. It’s just that it’s going to be very bumpy. But people, we know how perceptions work.

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Fallen Angels of Chinese Tech: Understanding Alibaba’s Restructuring

Tobias: Yeah. Of course, it’s perception. It’s sentiment for the US, positive for the US and neutral to negative for the rest of the world. I just wonder what it takes to turn that around. I think that China is a reasonably good example of that, because China was not that long ago China was red hot-

Juan: Yeah, four year ago.

Tobias: -and Alibaba. Those companies were expensive for a very long time there. I remember going to those. There was a blog that used to track just the subsidiaries that Alibaba at that time, it–

Jake: Oh, yeah. I love this.

Tobias: Their main business seemed to be like opening subsidiaries every day. I just couldn’t understand the financial statements to kind of– And that was going through–

Jake: Wasn’t it like multiple per day were being created?

Tobias: Oh, yeah. It was many per day created, which possibly in a big enough enterprise. Maybe that’s happening. But it just seems like there’s something else going on. At that time, it was very, very popular. And then, when all of the heat comes out, and it gets cheap. It’s completely unlocked.

Jake: Nobody wants to touch it. Yeah. Charlie said, it’s still a damn retailer.

Juan: Yeah.

Tobias: I think, yeah.

Juan: You hear today, many people, when we talk about the markets and China saying that China is un-investable and saying that the problems are not cyclical, but structural that they’re going to fade Taiwan, that the tariff war against the US, what the US is going to do against. But they’re completely right.

Four years ago, five years ago, China was extremely hot and Chinese tech was extremely hot, so that the valuations were extreme. Many of these companies were trading at north of 50 times CAPE. And in some cases, they were trading at 100 CAPE. People could not see anything going wrong for them. And now, it has reversed.

Now, China’s never going to grow again. Alibaba is a utility that it will never grow again, despite the fact that it’s actually showing more growth than many companies in the markets and just no one wants touch it.

Jake: I’ve made the probably glib observation that, you know– well, maybe I won’t say that. Hold on, let me put a pin in that-

[laughter]

Jake: -and think about whether I want to say it again.

Tobias: Well, I was going to ask in something like Alibaba and various other of those companies around there. Has the growth slowed that much? Is it more perception and sentiment than it is business performance, or have they had a stumble business wise as well?

Juan: Look, it’s all about expectations. So, I think that the market is expecting the company to grow at 30% the top line per year basis, and they’re not doing any of that. They’re doing much less than that, but there are quarters where they grow between 5% and 10%, and sometimes a little bit more than that. I don’t think that that’s too much of an unhealthy growth rate if they can sustain that over time.

Now, I think that one of the problems with Alibaba and why we think of it as a little bit of a fallen angel, is that it’s going through a very painful restructuring. When Jack Ma had a fall from heavens, the company went into a down spin, and it’s been very messy. The management transition has been messy. They first announced that they were going to list many of the vehicles, so that the market could price all of those individual parts separately. Then they pull back from that, then they announce a dividend. They’re doing a share buyback.

The program, the size of that program at the moment is $26 billion. I always, always remember Jake saying once that when Warren Buffett was talking about an elephant size acquisition, that was the size of the acquisition, A $30 billion type company. $26 billion is a lot. They did $5 billion buybacks last quarter. That’s a lot. That’s very big. Even more, if you think that the median market cap company in EM is $2.5 billion. So, for whatever reason, people just don’t pay attention to any of that.

And then, on the fundamental side, yes, they are facing way more competition than they had before, and that competition is dragging a little bit of the growth and cloud is not growing as much as people would have expected. And for whatever reason, Alibaba and many of the Chinese businesses get compared to the more developed businesses in the US despite the fact that they have very different dynamics, and there are different fundamentals.

Jake: Alibaba has like $200 billion market cap. And if they’re buying back, call it, run rate $20 billion, that’s 10% of the company per year that they’re eating?

Juan: Yeah, exactly. And then, on top of that, they had a little bit of a small dividend. I think that it’s just a fallen angel. It was never as amazing as people thought it was four years ago, and it’s not as bad today as people think it is. It’s somewhere in between.

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TSMC’s Dominance: What It Means for Emerging Market Investors

Tobias: Has the problem for EM been that you have these companies like Alibaba that are just so massive relative to everything else that for a long time that was what drove performance, because that’s a big chunk of the market capitalization weighting of the index flows–

Jake: The Nortel in Canada problem.

Tobias: The extent to which flows go to EM, they go to these companies. And then, when these big companies stumble, that drags down the entire index, because they’re such a big part of it.

Juan: Yeah, maybe.

Jake: Tell that to people who like the NASDAQ, Toby.

Juan: [laughs]

Tobias: Yeah. Or, the S&P 500, to be fair.

Jake: Right.

Juan: Maybe. Look, one of the beauties of this industry, is that we know that we never learn. Four years ago, when Alibaba was at the peak of its popularity, it was 8% of the index and it was trading at, whatever, 50 times plus CAPE, and then it stumbled. But today, you have TSMC. It’s 10% of the index. And so, if you are going to tell me that China is un-investable, if you really believe that one of the reasons why it’s un-investable is that it’s going to invade Taiwan, you cannot have 10% of your portfolio in Taiwan in the largest company that actually happens to have a large manufacturing facilities in China.

Jake: It’s in the name.

Juan: Yeah, exactly. Exactly. And so, it’s just human behavior. It’s an amazing company, but it’s trading at 52 times CAPE.

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Tobias: Let me do a quick shoutout, and then I have some questions from the crowd.

Petah Tikva, Israel. What’s up? Beunas Tardes from Santo Domingo, Dominican Republic. Toronto. Valparaiso. What’s up, Mac? Andhra Pradesh, India. Houston. Gulf of Mexico. Brandon. Dubai. Nashville. Savonlinna, Finland. Good to see you again. Cincinnati. Toronto. Lausanne, Switzerland. Tallahassee. Gothenburg, Sweden. Columbus, Ohio. Wodonga, Austr alia. Tomball.

Jake: [crosstalk]

Tobias: I think that’s real. It’s hard to tell sometimes-

[laughter]

Tobias: -with the Australian ones. Nanoose Bay.

Jake: Not a serious place.

Tobias: No, there are no serious places in Australia. Salzburg, Austria. Flint, Michigan. Milton Keynes. Haifa, Israel. San Francisco. What’s up? Seattle. I think I got everybody. Sorry, if I missed you.

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How Macro Factors Influence Value Investing in Emerging Markets

So, I had this question too. Buffett says ignore macro, so all value guys say ignore macro. Can you as an emerging markets investor ignore macro, or do you have to know what’s going on at a government level, what’s going on at a currency level, what the federal, what the central bank’s going to do?

Jake: Currency discrepancies.

Juan: Look, I think that the way that we think about it is, the vast majority of emerging market investors try to do the following. They are top down at the first stage of their process where they try to get the macro right at the country level, and then they try to get the stock picking right in the countries that they believe that are going to do well.

Now, I think that, or in my personal opinion, that’s a very difficult exercise to get right. Because if it’s difficult to get right the macro in one country, I would say, I would claim, almost impossible to get it right within 25 different countries, plus all of those 25 countries are going to be very much influenced by what’s happening in the US. You need to understand the US, and then you need to apply that to the emerging markets asset class. But it would be very foolish to ignore the macro, because the macro can actually break you. At the end of the day, what matters is the dollar return.

So, the way that we look at it is we like to say that we are macro aware, we’re not macro led. We use macro as part of our portfolio construction discussions. So, we are stock pickers. We have a screen that will show us where value is taking us and we go to those places. A little bit the hope is that, because something is already happening at the country level, the stocks that are falling into the screen are already pricing a lot of the fear and uncertainty in that country, either because of geopolitical risk or because of macro risk. And that should be reflected in the currency, that’s going to be reflected in sovereign yields and that’s going to be reflected at the stock market level. Now, that’s not full protection, you can still get things wrong. Things can always get wrong even more.

Tobias: Things can get worse.

Juan: Exactly. But the expectation, is that to a certain extent, you are already picking from an investable universe where a lot of the negativity is already being priced in. And then, within that, we just allow valuation to be our guide. It’s all about being compensated for the risk that you’re taking.

Emerging markets is an amazing asset class to be an investor. It’s an amazing asset class to be a value investor, but it’s a risky asset class. Because it’s risky, you need to be compensated for those risks. We think and believe that buying at a very low price will compensate you many times for that risk, and will help you mitigate and protect you to a certain extent.

Jake: You have to have boots on the ground to get comfortable?

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Joel Greenblatt’s Wisdom Applied to Emerging Market Investing

Juan: I think that it’s important to talk to people. I think it’s important to understand this too. Joel Greenblatt, in his 1990 special situations book on the bankruptcy chapter, he said this phrase that I like to use in the context of emerging markets. “Approach them with an open mind, not a hole in your head.”

And so, for us, it doesn’t really matter if it’s a great company, if it’s in a structural challenge, it’s a fallen angel. Whatever there is, we go with the open mind of understanding that it is going to be a risky situation, and we need to be compensated for that risk. We are not in the game of holding anything for the next 20 years and thinking that this is going to be an amazing business because of its fundamentals. We just want to capture a company that is trading at a price that we believe is very cheap relative to the fundamentals of the business and whatever it’s offering. The hope, is that over time, we pick more winners than losers.

Tobias: I like to tell the story of the– There’s a fund. I won’t say the name of the fund, but they invested in Sino-Forest, which was a Canadian listed Chinese forest owner. They sent an analyst who went and saw the forest that the guide said that’s the forest that we own. And then, when it turned out that Sino-Forest didn’t in fact own that forest and the whole thing fell over, and they invested $100 million just before the whole thing fell over. And to me, that’s sort of– If someone’s intent on defrauding you, there’s really not much you can do beyond– I don’t even know what you can do.

Juan: I think that we tend to [crosstalk] invest in companies– Well, number one, the diversification plays a very big role. But we also try to invest at the company level, we try companies that don’t really carry that much debt. If someone is trying to fraud you, a balance sheet that is very lazy should not be a red flag in that regards. But you’re totally true.

And in places like China, sometimes it’s important we talk to as many people as possible. And in many, many instances the question is, “Have you actually been to these people’s office, to the company’s office? Have you seen the manufacturing plants? Have you talked to XYZ?” We try to talk to experts as well and we try to crosscheck as much as possible the information. But yeah, it’s a risk asset class. It’s an amazing asset class, but it’s a risk asset class.

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12 Leverage Points: A Countdown to Systemic Change

Tobias: JT, do you want to do top of the hour? You got some veggies?

Jake: I do.

Tobias: JT’s in London. JT and Juan are both in London, at the moment, in different– [crosstalk]

Jake: We should have just recorded it together [unintelligible [00:29:43] [Juan [laughs] All right. So, for today, we’re going to dive into, I think, a very interesting mental model which is from the world of systems thinking. I’m going to walk you through 12 different leverage points as identified by Donella Meadows in a 1999 essay she wrote called Leverage Points: Places to Intervene in a System. So, we’re going to count down backwards from number 12 to number 1.

But a little bit about Meadows before that might be somewhat of a familiar name from a book that she wrote called Thinking in Systems that was pretty popular in a lot of investment circles there for a while. But you might not know that she also co-authored another book that was called The Limits to Growth in 1972. It was one of those like Club of Rome type of, you know, a little bit Malthusian.

She taught at Dartmouth for 29 years. She was also really big into sustainability in farming, especially. She owned a farm, and lived on a farm and really was trying to focus on solutions that are about sustainable living, which is interesting to end up there.

So, anyway, let’s get on with our countdown of different leverage points within a system, going from weakest to strongest. So, number 1 is constraints and parameters. So, these are numbers and values that you can tweak, like tax rates, interest rates, pollution standards. And think of them as like adjusting the volume knob on your TV. It doesn’t really change the channel, but it does change the experience a little bit. These small changes can help, but it’s rarely addresses big, underlying key systematic issues.

Number 11 is buffers, and these are stabilizing stocks within a system. So, if you think about like stock and flow, like a river flowing and then a lake would be the stock, what is the rate of change between those things? A buffer is like that reservoir of water, let’s say, or like an inventory stockpile for a company, they add stability. But if they’re too large, they can also slow everything down and make a system unresponsive.

Inversely, if you think about businesses that run on just in time inventory management, theoretically, much more capital efficient, but as we saw during COVID, you get vulnerable to supply chain disruptions and now your business is screwed. So, these buffers are essential, but not really a golden ticket leverage point.

Number 10, is the actual structure of a system. This is where things start to get a little bit more interesting. If you imagine a city like Budapest, for instance, and the traffic is supposedly all the roads seem to flow through the city center. It’s the way that it’s structured. So, what ends up happening? Lots of congestion, pollution. It’s the structure of the roads, it’s the problem. Not really the speed limits or the cars.

Likewise, redesigning a structure like an energy grid or a supply chain can make things more efficient, but it also tends to be very capitally expensive, like it’s very expensive leverage point to change the structure. It can often just be tough to do, but it can have a big impact.

Number 9, delays. Every system has them. These are things that can take a really long time to show up. So, I’m going to be a little cheeky here. Imagine the overnight federal funds rate and the impact that it has on the economy as interest rates worked their way into every nook and cranny. Well, there’s delays on when you change the fed funds rate and when you actually start to see the economic things happening.

If you have these feedback loops out of sync and delays are too long, they can create oscillations within a system. So, think about like thermostat. If it was taking the temperature reading from a half an hour ago, it’s going to end up overshooting and undershooting a lot as it’s using an old number, and then you get these oscillations and it can actually, totally spin out of control.

Number 8, negative feedback loops. These are the unsung heroes of balance within a system. And negative, by the way, it’s not a judgment, that doesn’t mean good or bad. It just means that it moves in the opposite direction of the momentum of the system is taking it. So, negative feedback loops by correcting deviations.

Back to that thermostat example. If the temperature gets too hot or cold, it will then kick on the part of the system that will counteract that. You can think back to our– We did a segment on cybernetics a few months ago that we talked about this a fair amount. Sometimes loops can be weakened by external factors, like maybe government subsidies, or tariffs or whatever. What that does is is it change the signals that the market uses to figure out what to do next, what should we build more of or less of and this price of goods that fluctuates. You throw that out of whack, and now all of a sudden, you start getting weird things happening in the system.

Number 7, is the flip side of that, which are positive feedback loops. These are things that can end up spiraling out of control, because you get this runaway effect. Maybe it’s a global pandemic where the R squared takes you into everyone, all of a sudden, get these tipping points that happens. Maybe runaway nuclear reaction.

Eventually, there’s some bigger natural constraint that comes in, but oftentimes, it’s very painful to get to that. It would be nice if you could avoid it a lot. Maybe the most interesting one that I’ve seen recently on positive feedback loops is what’s happening with Michael Saylor’s micro strategy and bitcoin, where you get this reflexivity that’s one of the more pure versions of reflexivity I think I’ve ever seen, just basically levering up to buy bitcoin and then doing more leverage and then buying more and then, [chuckles] where does it stop? No one knows.

Number 6, is the structure of information flows. So, if people don’t have the right information, they can’t make very informed decisions. Think about this example. Like, where does a meter in household electricity usage? Like, where did you put the meter? They’ve done some studies like where they placed the meter in the hallway, and it turns out that when people can actually see what their consumption is, they end up use dramatically less electricity. That’s the structure of the information flow.

Whereas if the panel is on the side of the house, like, who knows? You don’t even think about it. So, this transparency can drive accountability, which is often a missing ingredient in improving a system.

Number 5, the rules of the system. We’re starting to get to some big stuff here. Laws, regulations, incentives. These are big leverage points by changing the rules. So, think about like Gorbachev reforming the USSR is a pretty prime example. You change these rules around information and economics, and it reshapes the entire system.

Number 4, is self-organization. So, this is how a system can adapt and evolve on its own without the tinkering of a master plan. Think of antibodies in the immune system. Think of ant colony. These self-organic systems, they’re very resilient, because they can adapt and find new ways to function. There’s this magic in diversity and experimentation that causes these little failures that can actually help find a path forward for the entire ant colony.

It’s not about controlling everything. It’s really about letting the system evolve in a way that builds resilience. Humans trading freely is a form of self-organization that’s really lifted billions of people out of poverty, the last couple hundred years.

Number 3, the goals of a system. Like, what’s the end game? What’s the objective? For a corporation, it might be making a profit. I don’t know what the government end game is. Maybe it’s to get more power and make itself bigger, I don’t know. But if you change the goals of the system, you change the entire behavior throughout the system.

Number 3, is mindset or the paradigm. This is an underlying invisible force that shapes everything within the system. It changes the rules, and the structures, and the goals and the behaviors based on the mindset or the paradigm. So, it’s like an operating system in a way running silently in the background.

So, if you want to change the entire system, you’ve got to understand sometimes, like, can you change the paradigm behind it? So, what’s maybe one underlying fundamental truth that we maybe don’t always recognize is like maybe this idea that growth is always good. If we believe that we need to always be growing, in terms of population, or GDP or your individual success, what does that mean? It means like we change all of our priorities, it changes where we put all of our efforts, that completely changes the system.

Maybe we build our cities, or our economies or all our policies in much different ways if growth wasn’t the number one thing we were aiming for. If it was sustainability, maybe we would do something completely different. So, you can see how that really tweaks the system. Ralph Waldo Emerson supposedly said, “The material world reflects the collective mindset of society.”

And then finally, the ultimate leverage point is the power to transcend paradigms or mindsets. So, when you realize that all these paradigms, worldviews, belief systems are just limited lenses in which we view the world, you get this magical unlock and you’re free to choose which paradigms do you want to use to interpret the world. Maybe there isn’t some Truth. Instead, you get to decide that there’s a power in this openness, and then you could kind of choose whatever paradigm you want that serves your own purposes.

So, I think these are 12 different leverage points as identified by Donella that I brought some of my own cheeky examples to. Hopefully, maybe this is like an Archimedial lever and a place to stand in which you might be able to move the world.

===

Speculation, Leverage, and Bitcoin: MicroStrategy’s Ecosystem in Focus

Tobias: Good one, JT. Have you been following that micro strategy, like that little ecosystem that’s developed there, Juan? Or, JT, have you guys followed that?

Jake: Unfortunately, I have.

Juan: I saw short clips of one of his interviews. I think it was on a podcast. I had to stop after a minute, like three or four.

Jake: Your brain was hurting?

Juan: Yeah, well, completely disconnected. I just couldn’t follow it anymore.

Tobias: Because there’s this–.

Jake: Was he talking about cost of capital and Buffett and they’re losing money because they–

Juan: Yeah, exactly. He was making some– [crosstalk] Yeah, exactly.

Jake: They have money? Therefore, they’re losing money?

Juan: No, because he has so much cash, treasuries and then he was trying to spread the math about that relative to what they could do if it was on bitcoin.

Tobias: 15% cost of capital on $300 billion earning, 5% at call or whatever it is. The ecosystem is interesting, because there’s bitcoin which is– We don’t really know what drives the price of bitcoin. People who own bitcoin can take what you’re going to send me and just delete that right now. I don’t care.

[laughter]

Tobias: Nobody knows. Nobody knows. And then, on top of that, MicroStrategy, they get three to one– The MicroStrategy is valued at three times it’s bitcoin holdings. So, it makes sense for them, like they should be selling MicroStrategy shares and buying bitcoin which keeps on then pushing up the price of MicroStrategy, and that’s created this feedback loop. And then, on top of that, there are these two times levered ETFs that own MicroStrategy.

Jake: Let’s go.

Tobias: There’s $9 billion in that ecosystem. There’s $9 billion in those two ETFs. So, as long as that all keeps going in one direction–

Jake: $9 million in those two ETFs already? Oh, my God.

Tobias: As long as it keeps on going in that direction, that’s up. Hang on, I’m trying to get up.

Jake: Up and to the right.

Tobias: Yeah. [Juan chuckles] It’s all good. But the moment that that turns around, that’s going to leave a crater. I just find it interesting.

Jake: You know what though? I have no idea when the merry go round stops on that. You could tell me that it’s a million-dollar bitcoin, and MSTR is a trillion-dollar company and I would say,-

Tobias: Why not?

Jake: -yeah, markets be crazy.

Tobias: Yeah, I don’t think that MicroStrategy–

Jake: At a zero a year from then.

Tobias: The thing about MicroStrategy, it’s not a donut. It’s not a zero. As long as there’s not much leverage in there, I don’t know what the leverage status is.

Jake: Oh, there is no much.

Juan: I don’t know anything about MicroStrategy, but when people have tried to explain or backtrack fundamental valuation on many of the crazy evaluations that have happened over the course of the last five years, Tesla being one of those examples, they have been proving wrong so far. It is where it is.

Tobias: Getting short? Getting shorted?

Jake: I would never short something like that. That is very dangerous.

Juan: Dangerous. Yeah.

Jake: Someone will make a ton of money, but there’s going to– [chuckles] I don’t know.

===

Juan: But I remember Jim Chain saying 10 years ago that, “If Tesla was not a short, what was?” and that didn’t go very well.

Tobias: The thing for Tesla though is it’s largely self-financing though. I think that the cash flow is like– I look at it every now and again, it’s been a little while, but I think that it might be slightly negative cash flow at the moment. But it’s largely self-financing. It’s got cash on the balance sheet. So, I think that it’s not a short on fundamentals anymore. You can short it on the valuation, but I think that’s dumb for the most part. It’s a hard way to make money.

But the problem for Tesla in some sense, is that the party has moved on a little bit, like it was in Nvidia. Now the party is in MicroStrategy. I still see Tesla’s had a pretty good run this year. It was up, I don’t know, but 50% maybe for the year, which is extraordinary or 50% from its low, something like that. It’s a pretty good run for the year. But it’s not MicroStrategy and it’s not Nvidia, which are like– That’s where the froth is. That’s where the party is.

Jake: 36 year to date for Tesla. This is just a quick, but I think there’s $4 billion-ish of debt at MicroStrategy.

Tobias: And how big is MicroStrategy?

Jake: Equity wise?

Tobias: Yeah. What’s the market cap?

Jake: Oh, gosh, I think it’s like–

Tobias: It’s like a $100 billion?

Jake: Yeah, $90 billion or something. Let me look. $80 billion.

Juan: Let’s go to emerging markets. It’s a simpler world in emerging markets.

[laughter]

Juan: It’s more plain vanilla. It’s just easy. Think about it. Banks in the emerging markets, they are so plain vanilla. It’s the way that banking was done 150 years ago. You take a deposit, you lend the deposit, you capture the spread. That’s it, in the vast majority of places.

Tobias: Yeah. That’s interesting, because that was one of the questions that Tyler Pharris, our unofficial producer, had for you, which I thought was a good one. I was going to throw it to you as well.

Jake: Pretend it was my own.

[laughter]

===

Are Emerging Market Banks Safe Investments? Key Factors to Consider

Tobias: Well, I gave him the shoutout. Pretend it’s– Pretend. Sorry, I’ve lost my train of thought. Yeah, “Do you buy financials in emerging markets, and then how do you go about doing that?” Because I think if anything– There’s a lot of potential for corruption and manipulation through the banks, and that’s been common in many emerging markets. But you’re saying that the– It’s been common in Australia. It’s not like it’s an emerging market phenomenon. You’re saying that it’s more like an old school, because they have less access to funding, so they’ve got to actually run it like a proper business.

Juan: Well, number one is, again, it’s not a monolithic block. So, it depends, kind of where you are. The depth of financial innovation and depth of financial markets across EM is not one. It’s 25 different countries, plus the frontiers. I would say that markets tend to be or banks tend to be more plain vanilla. It’s a function of where the country is under stage of development and their financial education.

So, I can say that, as a Colombian who was born and raised in Colombia and spent 28 years there, markets tend to be or financial products in Colombia need to be very plain vanilla, because otherwise, no one can do anything about it, because no one understands them. If you embed an option in a bond in Colombia, no one will be able to buy it. Well, that might be a little bit of–

Jake: [laughs] Short selling your countrymen– [crosstalk]

Juan: Yeah, exactly. I hope that I’m not offending anyone.

Jake: You [crosstalk] cancel.

Juan: Yeah, exactly. It just makes it much more difficult, because how are you going to value the options embedded in the bonds. That requires a market, that requires financial education. Many of these countries are not there yet.

When I was at uni 25 years ago, I remember a teacher saying that Colombia was something like 30 years behind Mexico, 50 years behind Brazil. That was 25 years ago. He was not even talking about the US. He was talking about LATAM financial marketplaces. And so, in many instances, banks are quite plain vanilla in their business models.

Now, a bank is a bank, and if you don’t know what’s happening with the credit portfolio, then you will run into trouble. If they don’t have credit policies that are in place and conservative and all of that, then they will go bankrupt. And that happens in every single economy. I’m just saying that you don’t find the financial engineering that you find in more developed advanced economies.

Jake: They probably don’t have proper trading books that you have to worry about.

Juan: No. The treasury is still a big part. So, I think that you need to be very careful. If you are a deep value investor and you say, “Oh, I don’t really care about the macro, I’m just going to do the stock picking,” and then you go and buy the largest bank in Kenya– Well, Kenya, if you look at that balance sheet of one of the largest banks in Kenya, the treasury is a big part of the assets. And that’s also a function of the fact that they are getting all of these deposits. They cannot lend the deposits. They don’t have anyone to actually take them on the loan book, so, they have to reinvest that in treasury, so the treasury is very big.

And then, if Kenya or any other country runs into a macro issue like the one that Kenya has been facing over the last few years, then the macro is important, because you are buying securities from the government that actually might not have the money to repay you. And so, one needs to be careful. But it’s still a bank. I think it’s less complex than what you might find in more developed markets.

===

Why India Doesn’t Fit Into Deep Value Strategies

Tobias: Does India fall into your– It’s an emerging market?

Juan: It does. We haven’t owned, bought any India, actually ever.

Jake: It’s not deep value enough?

Juan: Well, it’s the most expensive market in EM, one of the most expensive markets in the world. It was trading last week at 39 times CAPE. Now, there is fear and uncertainty everywhere in the world, and I’m pretty sure that if we were forced to go and look at India, we would be able to find something. It’s just that the opportunity set in the cheapest quintile across all EM is so rich at the moment that there is absolutely no need for us to spend time looking at India.

The other thing that I find quite interesting is, in the whole narrative camp of China as an un-investable, sometimes I hear some investors that say, especially in the US, where they are very concerned about valuation levels, so they want to diversify away their valuation risk away from the US. But China is un-investable, so they’re going to India. So, well, doubling down on the valuation risk on an emerging market country where you have all sorts of inefficiencies. And so, I don’t know, I find that interesting.

===

How to Build a Value Portfolio Across Emerging Market Countries and Industries

Tobias: How do you think about putting together a portfolio, or how do you then talk to clients about the portfolio? Because you’re saying you’re not going to have exposure to all of the 25 markets. Presumably, you’re not constructing to have exposure to every industry either. It’s almost special situations. You’re almost looking for individual examples of true undervaluation, and it doesn’t matter what country or what industry you find it in.

Juan: I think that you go where value is taking you, but you need to be well diversified, you have to have some country risk limits. We run the portfolio or we think about the portfolio, it’s a benchmark agnostic, the way that we construct it with a mindset in terms of measuring risk in absolute terms. And so, we have, as per our mandate, the maximum level or the maximum amount that we can allocate to any given countries is 15%.

China has a special case, because it was so big. It is still very big in the index. But when we started the fund a few years ago, it was very close to 40% and the rumors back then was that MCI wanted to increase the way to include the Asia’s. And so, we have a country risk limit in China that is 35%.

But our view now, even with that, the 25% of your capital in any of these countries is actually a lot. It’s a lot. It doesn’t really matter what you think about the country. It doesn’t really matter what you think about the company, or the management or its demographic prospects in the future, how much it’s going to grow. These markets are inherently risky, and one should never forget that and just size accordingly.

===

AI’s Impact on Emerging Markets

Tobias: Do you ever find things that you think could be potentially, globally dominant type companies? Do you ever find things that you think with a long enough runway, this is a Google or a Microsoft?

Juan: Nothing that comes to mind. [Jake chuckles] The best company at the moment is TSMC which I guess you– Well, Samsung, actually. Samsung. Samsung Electronics could be the one that could potentially be innovative enough to have that sort of– But then, you have the corporate governance issue. It’s a good company, but with a lot of governance risk. And so, yeah, that could be potentially the one. Yeah.

Tobias: What about some of those Chinese companies? I don’t know, I’m asking. But it seems like China is the country that has many companies that are the equivalent of the US size and reach. I get some language difficulties, I guess.

Juan: Yeah. I don’t really know–

Jake: New idea, maybe?

Juan: I don’t really know any of the expensive, very big companies, because they fall so out of my investable universe that I don’t tend to spend that much time looking at them. Tencent seems to be a good decent company, whether it can reach the point of having the economics that some of the big companies in the US might have. Who knows?

Now, artificial intelligence, it’s a whole new world. Who knows if someone can come up with something that it’s– But then, you have all the language barriers. Baidu has Ernie which is their artificial intelligence, like development. They’ve been investing in that for many years, and it seems to have very good prospects. Whether that will have the same power than the Americans that the American companies, I don’t know.

Jake: Yeah, it’s interesting. How do you feel like AI impacts developed versus theoretically less developed? I’ll cue that up with a little bit of a study that I read about– I believe it was, I can’t remember if it was McKinsey, or ECG or one of the consulting companies. But what they did is they took half the population and they everybody– They took, let’s say, it was 100 people counter-consultants, and then they had them all do work, and then they looked at the quality of the work and the amount of work that they did over a time period.

And then, they cut it in half and they gave half of them ChatGPT, the other half no. And then, they went and they did that same measurement against them, and then they looked at within those two buckets, who was good before and who wasn’t. Did the good people get really good with a new tool, or what did it look like? It turns out that actually the top end, the ceiling of the best people, didn’t move very much. But what it really did was the bottom end really brought them up much towards like where the middle was for the control group.

So, you had this tightening up of the outcomes from this new tool. Like, it really made everyone a little bit closer on even footing. So, I’d be curious if AI thesis that recognized that bringing up the bottom half, maybe it’s better for EM than it is for Facebook or something. I don’t know, it’s an interesting thought experiment.

Juan: Yeah, absolutely. Look, I always tell people– I’m Colombian, my manager is Russian. Even with all of the problems that each country is facing today, those countries are a much better place today than they were 40 years ago. That applies across all of EM with some specific examples.

The trend of direction in EM I think is to the left, going to the right. It’s just that it’s not a straight line. It’s very bumpy. When you are looking at it on a day-to-day basis, it just looks very chaotic. But the change is happening. It’s just that you need to isolate yourself and look at it from a different perspective.

Jake: Yeah. Slow, and it’s never in the news.

Juan: Exactly.

Jake: Little daily improvements.

===

Juan: The only thing that you see in the news is all of the bad stuff. So, I don’t know, I’ll give you an example. Everything is bad about China. A few months back, the Chinese change the retirement age. I think that they moved that– I’m going to get this wrong. But I think that for women it went up from 50 years or 55 years old to 60 or something. And then, it got very bad press here. But do you think about from a rational perspective, that doesn’t seem to be too bad, actually. [chuckles] And it’s happening all around the world, the fact that people are being asked to work more, because pension systems were not designed for you to live on holidays for 40 years. You were supposed to retire, enjoy four or five years, then die.

Jake: And then die.

Tobias: [laughs]

Jake: Get off–

Juan: That was the way that things were going. And now, it so happened that people are traveling and enjoying very good life, because quality of life has improved and healthcare systems have improved and all of that, and people are living longer. So, you need to work more. The narrative, it was presented with a bad press rather than something of a logical step.

===

Emerging Market Opportunities: Why Indonesia, Brazil, and South Africa Stand Out

Tobias: What countries outside of China, and India and the ones that are better known do you think are the most interesting in the emerging markets?

Juan: Well, emerging markets will always have something for anyone’s flavor.

Tobias: Yeah. Interesting is the loaded word, isn’t it?

Juan: Yeah.

Jake: Cheap. What’s cheap?

Juan: Well, Indonesia is pretty cheap. Brazil is looking attractive at the moment. South Africa, there’s always something in South Africa. Korea. It’s always–

Tobias: How is Korea emerging?

Juan: Well, because of the governance and because I think that Samsung Electronics is 70% of the entire market and so it cannot be upgraded for that. But I think that the governance on the stable structure, it’s one of the main reasons why that is the case. But Korea is always–

Jake: Any thoughts on Argentina and their new president and progress there, potentially?

Juan: Not really. He makes a lot of noise. He seems to be doing things right like the country seems to– It’s just a very complex situation. We looked at the banks just before he was elected. It’s just so difficult to get any valuation for you to not think that you are speculating on whatever outcome is going to happen.

Jake: Uh-huh.

Juan: It’s just complex. So, that’s a market where we have stayed away from. There are some markets in EM that are just very difficult. Turkey is very difficult. Brazil is difficult. If you think about Turkish five-year sovereign yields are trading or yielding you 18%–

Jake: Yeah. Real, what is it like negative–

Juan: Yeah. But then, if you were going to invest in any local equities, that internal rate of return needs to be much higher than that and that needs to be reflected in the valuations which is sometimes it’s not, so that makes it very difficult to allocate capital properly. I would say Indonesia, South Africa and Brazil at the moment, maybe Korea, potentially some of the most interesting ones.

But again, in many of these markets, even if they are expensive– Like Taiwan, Taiwan is very expensive. Taiwan is trading at 31 times. But within Taiwan, all of the old tech, you will find companies trading at 9, 10, 11 times CAPE. They’re not growing their cash calls. They’re buying back their shares. Maybe you can spot a really nice opportunity.

There is this company there called Coretronic. And over the last 10 years, they have lost– I think that 10 years ago, their top line was something like $89 billion or $81 billion Taiwanese dollars. The top line today is $39 billion dollars or something. It has lost revenues at 6% compounded per year. [chuckles] That company has delivered over the last five years something like 25% annualized returns in dollars.

The reason for that is eating itself alive, buying back shares. It has a super strong balance sheet with no debt whatsoever, and they are reinvesting a big chunk of their cash flow in R&D. So, you have a call option on whatever they might invent or whatever might happen in the future, and at the same time, they are allocating the capital to buy their shares very cheap.

Tobias: So, the pitch is, it’s deep value in an emerging market, and the revs have hived over the last 10 years.

[laughter]

Jake: Yeah. Other than that, how was the play, Mrs. Lincoln?

[laughter]

===

Juan: No. Look, emerging markets has been an underdog for the last 10 years. It has been a horrible asset class to be invested in. And then, doing value within emerging markets is the underdog of the underdog. So, it’s a risk asset. But I do think that it’s a great place for price discovery, and it’s a great place to do a stock picking and being a value investor.

Tobias: On that note, Juan, that’s all we’ve got time for today. Thank you very much. What’s the best way folks want to follow along with what you’re doing or get in touch?

Juan: Well, the best way is to follow The Value Perspective podcast or they can find me and my team on the Value Perspective website, which we’ve been running for, I think, the last 14 years. So, anyone that want to get in touch, they can reach out through there.

Tobias: JT, any final words?

Jake: Just appreciate Juan coming on. It’s always good to catch up.

Juan: Thank you very much for having me.

Tobias: Happy Thanksgiving to everybody. It’s coming up. Have a good time with the family. Switch off–

Jake: Yeah, disconnect from all this craziness and find some good mental space.

Tobias: Juan Torres Rodriguez, the portfolio manager of the Emerging Markets team at Schroeders, thank you very much.

Juan: Thank you very much.

Tobias: We’ll see everybody next time. Thanks, guys. If I can just figure out how to end it.

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