by Ben Inker, GMO LLC
Emerging Value and Margin of Superiority
Why would a value manager buy more of an asset that has just gone up?
Long-time GMO clients have become accustomed to a certain kind of behavior from our asset allocation portfolios. If they are reading stories about how well an asset class has been doing, chances are pretty good that their next account statement will show that we are a seller of that asset (assuming we owned some in the first place). If, on the other hand, headlines are about how horribly things are going for an asset class, our clients have come to expect to see us buying in the coming quarters. But recently we made a move across a number of our asset allocation portfolios that goes counter to that general pattern.
After a strong first half of 2017 for emerging equities that saw them rise over 18%, we actually bought more emerging in early July. It seems like a non-intuitive move for us to make, but we believe it is the correct one despite the fact that the prospective returns to emerging equities have dropped a bit since the beginning of the year. Even though the absolute expected return for emerging market value stocks has decreased, we believe the margin of superiority of emerging value over other assets has actually increased. As its superiority is higher and emerging-specific risk is relatively benign, our willingness to bear its risk has increased at the margin, which created the opportunity for us to increase our allocation. Emerging value is extraordinary today
There are a couple of important points to make about our decision to buy more emerging recently. The first is that despite the strong returns of emerging equities so far this year, the group we are most interested in, emerging value, hasn’t been particularly extraordinary. MSCI Emerging is indeed up over 18% through the first half of the year, but value has underperformed by 4.8% in the period and 3.5% of the returns to emerging were due to currency moves. That leaves emerging value up about 10% in local terms, about on par with stocks around the world. Given that fair value for the group compounds at around 6% real annually or 3% in a half year, this means emerging value should have gotten about 6% more expensive over the period, which would cause its forecast to drop by around 0.8%, all else equal.1 In this particular period, all else has been more or less equal and the forecast has indeed gone down by 0.8%, from 7% to 6.2%. Our next favorite equity assets, EAFE value and US quality, have seen their forecasts fall by 0.3% and 1.1%, respectively.