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Erik van Dijk
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Hi! I am Erik L. van Dijk, principal at LMG Emerge. LMG Emerge is an internationally-operating institutional investment consultant with offices in the Netherlands and at Mauritius. Our clients are pension plans and other institutional investors, family offices and HNW individuals. In close... More
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LMG Emerge
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LMG Emerge - New Economies
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Asset Pricing and Risk in Emerging and Frontier Markets
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  • Using the Dividend Discount Model to Derive Interesting Conclusions about Developed and Emerging Markets Stocks

    In this contribution we use the Dividend Discount Model to derive a set of interesting conclusions. It looks as if stocks are about to enter a good period, but beware: Emerging Markets stocks will remain more sensitive to changes in market climate.

    Introduction: The Dividend Discount Model

    The Dividend Discount Model (DDM) dates back to scientific work in the 1950s, with Prof. Myron Gordon playing a central role in its development. Basically, the DDM states that the price of a stock equals the net present value of its future dividends. Of course, the bulk of investors will not hold stocks until the end of time and decide to sell shares somewhere in the finite future. But at that moment, its fair value price will be equal to the net present value of future dividends plus expected sales price for the next investor in line. Result: in the end we can substitute the sales price component by future dividend series, so that in the end the following equation holds:

    Price = D1/(1+k) + D2/(1+k)^2 + ..... D(inf)/(1+k)^inf

    With stable dividends D1=D2=D3.....=D(inf) this translates into Price = D/k and with a stable growth rate g in which Dn = (1+g)*(D(n-1)) this translates into Price = D(k-g).

    Under the influence of growing interest in the Capital Asset Pricing Model that looked more at returns than prices and because it was clear that fair values and actual market prices could deviate substantially - and as will become clear later in this article, this tendency might even be growing! -, the interest in DDM has deteriorated somewhat. But we felt that it is an interesting tool to analyze some important sensitivities of stocks, especially when comparing 'the average' developed market stock with 'the average' emerging market stock.

    DDM comparison of two stocks, one from a Developed and one from an Emerging Market environment

    In this entry we compare two stocks. Let's assume that they are energy stocks. Both post an earnings per share (EPS) of USD 1. The first firm is a developed market firm (let's say its name is DMF). For longer periods during its history this was a stock characterized by a below-average risk because of the defensive qualities of the energy sector. But recently its market risk has moved toward 'average' with the market risk indicator BETA now equal to 1.0. Reasons for this gradual shift towards 'average' are first of all competition from energy stocks in Emerging Markets who now - due to globalization and the growing demand for energy products in the world - turn out to be fierce competitors. DMF is a mature firm that pays out 50 percent of its earnings in dividend. GDP growth rates of the mature economy that DMF belongs to normally range between 1 and 4 percent. DMF is a good firm, definitely a market leader in its own right, and we do therefore believe that - taking into account growing energy demand as well - that DMF can post a 5 percent growth rate per annum.

    Its natural Emerging Market competitor is EMF. This firm post an EPS of USD 1 as well. But the market risk is still higher with a BETA of 1.5. Traditionally the correlation of Emerging Market stocks with the Global Market has been lower, but recently - due to globalization - the correlation coefficient is creeping up. Knowing that the market risk factor BETA is by definition equal to r x (vola(EMF)/vola(WRLD)) with vola(EMF) representing the volatility of EMF and vola(WRLD) the volatility of the global stock market index, we assume that this increase in correlation implies that the tendency of gradual volatility decrease at EMF due to ongoing development of financial markets within the Emerging countries is to such an extent compensated that BETA is still above average. We believe that this is a pattern that will be reality for most Emerging Markets countries for quite a few years to come.

    To finalize the calculation of the relevant discount rate for our DDM for EMF and DMF we need to make base assumptions for the Risk-free Rate (Rf) and the Required Market Rate of Return (Rm). For the Risk-free Rate we use a rate of 5 percent per annum. For the required rate of return on the market we use 12 percent. That might seem to be a bit high, leaving us with a historically high Equity Risk Premium. But then again: don't forget that we are dealing with a period immediately after a Global Crisis and one in which the world is changing. For the first time ever the dominance of Developed Nations is challenged by Emerging Nations. That will translate into uncertainty and it is not unlikely that this will translate into nervousness and relatively high required rates of return on equity. Table 1 below gives the base data and calculates fair values.


    Table 1; Base Data - Dividend Discount application

     

    Using the base data we can derive that the fair values for DMF and EMF are USD 7.14 and USD 4.55 respectively. DMF is less risky and it pays out a higher dividend. This translates into a higher valuation. When comparing the Price Earnings Ratios with those in the market today, we can conclude that our required rate of return of 12 percent for the market is maybe a big too high. If we replace the 12 percent rate by a rate of 10 percent, we reach the remarkable conclusion that the two stocks DMF and EMF have the same value! With a required market rate of return of 10 percent, both have a fair value share price of USD 10. In other words: EMF benefits much more from a lower required Equity Risk Premium than DMF. As a result, its higher expected growth rate and lower payout ratio compensate for its higher risk and lower initial dividends when comparing it with DMF.

    Using a required market rate of return of 10 percent did translate into a P/E of 10 for the two energy stocks. More in line with valuation for developed and emerging market energy stocks today. And if we reduce the required rate of return Rm further to 9 percent per annum, the stock price for EMF increases further to 25 - with an accompanying PE of 25 - and that of DMF increases to 12.5 with an accompanying PE of 12.5 Looking at our little DDM we could therefore conclude that markets are currently using a required rate of return somewhere in the 9-10 percent region.

    But what is interesting to see, is the sensitivity of valuations to little changes in the relevant parameters. The model indicates clearly how both bottom-up, fundamental indicators and top-down valuation factors play a role when deriving share prices with the DDM. The payout ratio, the earnings growth rate and the stock beta are 3 examples of bottom-up fundamentals. The risk-free rate Rf and the required market rate of return Rm are two examples of top-down macro indicators.

    In the remainder of this note we will analyze the impact of these five indicators on our two representative stocks DMF and EMF. What are the most important factors when it comes to sensitivity of valuation to changes in the underlying indicators? Is there a difference between the sensitivities of the Emerging and Developed Markets stocks? In the following paragraphs we will first look at the impact of individual factors. In the concluding paragraph we will then compare them with each other.

    Sensitivity to Earnings Growth

    In table 2 we show in the first part of the table how share prices change when we change the earnings growth rate with 1 percent steps over an interval ranging from 1 percent to 11 percent. The gray cells indicate our base positions for DMF and EMF. In the second part of the table we analyze the price change in case of a 1 percentage point disappointing or surprising growth outcome (i.e. a surprise of 1 granularity compared to the gray equilibrium value). All other factors related to the base scenario are left unchanged.


    Table 2 Sensitivity to changes in earnings growth

    The Emerging Market stock EMF - with its higher expected earnings growth rate - is slightly more sensitive to earnings growth surprises or disappointments than the developed market stock DMF. To some extent this is not really a surprise, because EMF - with its lower pay out ratio - will use a relatively larger part of this retained earnings for (higher) earnings growth in the future.

    However, when looking at the minimal versus maximal growth rates (1 versus 11 percent) and the accompanying stock price, we see that the range for DMF goes from USD 4.55 (coincidentally the base price for EMF!) to USD 50 for the developed market stock versus a range from USD 1.72 to USD 5.56 for EMF. In other words: when looking at the total bandwidth DMF is more sensitive to growth. This is related to the lower risk profile of DMF.

    Sensitivity to market risk BETA

    In table 3 we analyze the sensitivity of both stocks to changes in market risk, BETA.


    Table 3; Sensitivity to Market Risk: BETA

    The Emerging Markets stock EMF can not reach BETA levels of 0.6 or 0.7 with the data set used here. Those kind of low risk levels are impossible with the growth data used. Higher growth translates into higher potential disappointments and that leads to a lower limit for BETA. The sensitivity of EMF to BETA changes is larger. And with current risk levels of EMF being relatively high - with risk reductions as a result of financial market developments in Emerging Markets being more likely than increases - one might expect that improved developments within the financial systems in Emerging Markets will translate into upward adjustments in share prices. However: the likelihood of this to happen is not as big as what lots of scholars expected some 10 years ago. Reason: globalization has led to increased correlation of Emerging Markets stocks with the World Index as well, and only to the extent that volatility reductions more than compensate for increased correlations, will BETA reduction really materialize. But we believe that stocks in relatively stable, defensive industries within Emerging Markets will still have sufficient BETA reduction potential.

    The other way round: stocks in developed markets are also faced with growing complexities of a Globalizing world. They will either have to opt for a specialization into the direction of 'high yield' / lower risk stocks (larger payouts, less growth, lower risk) or - through increased investments in Emerging Markets - try to re-ignite growth. The latter will lead to increasing risk levels, but the successful firms will be capable of compensating this with ofsetting additional growth through their affiliates in Emerging Markets.

    Sensitivity to Payout Ratios: Growth Stocks versus Yield Stocks

    The last lines of the previous paragraph hinted on something important. In a Globalizing world cross-border specialization of firms will also include opting for one of two feasible business models. Firms that believe that they are strong in finding new growth opportunities (either at home or in Emerging Markets with their above-average growth rates) could keep their payout ratios relatively low and use the retained earnings for above-average investments in future growth.

    The other way round - and that is especially so in an environment that due to demographic factors will probably be characterized by historically low average interest rates - firms could also opt for relatively high payout ratios. This will lead to interesting dividend yields that will make this type of stock a nice alternative for fixed income securities. These stocks will not show spectacular earnings growth, but the relatively low risk and attractive dividend yields will make them an attractive market niche for investors looking for stable returns. Especially firms from developed markets in industries that have matured might opt for this business model. A good example of firms that have gone this way are the tobacco and cigarette producers. After periods of above-average growth health factors have suppressed their growth in developed nations with substitute demand from Emerging Markets consumers not strong enough to compensate for lost demand from developed nations. For many years stocks like British American Tobacco and others have provided their investors with interesting alternatives to regular fixed income securities. But with expected interest rates in the future probably - on average - lower than what we have seen in the past 50 years due to demographic factors, the market interest in high yielding stocks will increase further.


    Table 4; Sensitivity to Payout Ratios

    When looking at the overall bandwidth for payout ratios between 70 percent and 20 percent there isn't much of a difference in sensitivity when comparing DMF and EMF. The range of fair value prices for DMF goes from USD 2.86 to USD 10 and for EMF it goes from USD 3.64 to USD 12.73.

    However, the average emerging market firm is currently keeping its payout ratios lower than the average developed market stock. Logical, financial markets in emerging countries are far less developed. It is not so easy to issue new stocks just as easily and/or attract loans. And it is not just because of money supply factors in financial markets that firms in Emerging countries keep their payout ratios lower. They do of course - in their faster growing markets - also have more interesting investment opportunities.

    So, when looking at payout rate sensitivity we see that this is a factor twice as important in Emerging Markets as it is in Developed Markets. Actually, as we will see later when comparing the various sensitivities, Payout Ratio is the second most important factor of the five we are analyzing. And the most important bottom-up variable. It helps explain why Emerging Markets firms that opt for higher dividend do normally do so well in the market. Dividends are a scarce resource in these markets. A scarce resource that translates into lower relative risk and stocks of a 'value' type. These Emerging markets 'value' stocks form an attractive outperforming category within Emerging Markets portfolios. On the other hand: make sure that you invest in higher yielding stocks in Emerging Markets that know what they are doing. If the CFO is not planning the firm's dividend policy carefully, reductions in payout ratios later will lead to substantial price drops.

    Sensitivity to changes in the Risk-free Rate

    The first of the two macro variables that we will look at, interest rates, turns out to be the least important of the 5 factors under study. Amazingly, changes in the interest rate are not important at all when studying the valuation of DMF. When the risk-free rate Rf increases by 1 percent, this will be compensated for by a reduction in the  equity risk premium of exactly the same amount as a result of which our stock DMF is not affected since it had a BETA of 1.0.

    The Emerging Markets stock EMF is however affected, because its BETA was unequal to 1.0. With its above-average BETA the negative impact of an increase in interest rates of the equity risk premium was more important than the increase in the risk-free rate itself. Result: increased interest rates make the valuation gap between DMF and EMF smaller.


    Table 5; Sensitivity to Interest Rate Changes

    But Table 5 shows it clearly: unless we incorporate the impact of interest rates on other factors (i.e. more than one change at the same time), interest rate changes are not the most important factor.

    Sensitivity to changes in the required rate of return Rm

    The last factor that we analyze is the one that we already started with: changes in the required rate of return in the market Rm. Table 6 shows that this is the most important factor of all for both DMF and EMF. What rate of return do investors demand on their equity investments? As we know from the Global Crisis and its aftermath on the one hand (nervous market climate, high required rate of return) and the build-up to the Crisis (exuberance, relatively low required return) on the other, we know that changes in market sentiment can quickly translate low valuations into high ones and vice versa. The speed with which these changes might happen is a function of investor nervousness. And in this world of Global Change, with Emerging nations now for the first time demanding a large share of the world in a world that went from two dominating power blocs (USA and Europe) to one in which now Emerging Nations are also approximately of equal importance (with a GDP weight of about 35 percent) it is more than likely that nervousness will remain relatively high.

    And this will translate into a valuation situation in which it is most important to get the global market climate right. When the sentiment is relatively good, overweigh Emerging Markets but make sure that you reduce your EM overweight when the sentiment changes and uncertainty returns. It is not surprising that in this market environment precious metals like Gold did so well recently.


    Table 6; Sensitivity to Required Market Return Changes


    Evaluation: Comparing the sensitivities

    In table 7 we compare the various sensitivities. We do so by first looking at the bandwidth between a 1 granularity surprise and 1 granularity disappointment in the tables 2 to 6. Then we rank the 5 different sensitivities for both developed and emerging markets. The Required Rate of Return Rm is the most important factor and Interest Rate Sensitivity is the least important factor for both EMF and DMF, with the caveat being that interest rate sensitivity can become more important if accompanied by other changes. But in this analysis we focused on individual changes in each of the 5 variables while keeping the other 4 stable.


    Table 7; Sensitivities Compared

    In the last 2 columns of table 7 we look at the differential sensitivities. Emerging Markets stocks like EMF are always more sensitive than comparable stocks from developed markets. That is a fact of life that all investors in these stocks should never forget when comparing them with developed market stocks. However, there are two factors - one macro and one micro - where the differential impact is far bigger than for the other three. The first one is the required rate of market return, indicating that Emerging Markets stocks will remain more sensitive to positive surprises in periods of positive momentum and negative surprises in cases of panics. The second one is related to dividend policy. When stocks in Emerging Markets will increase their payout the signaling effect is far bigger than what Western investors might be used to in their own markets. And the other way round: the negative signal related to a reduced payout will cut deep in Emerging Markets.

    It is nice to get this overview of sensitivities using the Dividend Discount Model. We conclude with the following set of general conclusions that you should keep in mind when investing in a portfolio of Emerging and Developed Markets stocks:

     

    1. Notwithstanding their above-average growth rates and good developments, stocks from Emerging Markets countries will continue to be far more sensitive to changes in relevant macro and micro variables than stocks from Developed Markets.
    2. In a Changing World characterized by Globalization and a change from a Two- to Three-bloc equilibrium in which Emerging Markets as a group will demand a fair share of the action, nervousness, confusion, exuberance and panic will not disappear but if anything play a bigger role.
    3. This will translate into higher average volatility and relatively longer and more periods during which fair value prices can deviate substantially from market prices.
    4. This will provide opportunities for smart-money investors while at the same time making markets more complicated for non-specialists.
    5. Investors who want to make use of the deviations from fair value do best to build diversified portfolios using a disciplined valuation methodology in which mean-reversion plays an important role.
    6. Although the Dividend Discount Model is nothing more or less but a theoretical valuation framework, it can help us get a good overview of market sensitivities and that is of extreme importance in a Globalizing world in which international dependencies of stocks and factors will grow.
    7. When applying the simple model presented here, it looks as if today's investors demand a 9-10 percent required rate of return Rm.
    8. When comparing this with today's risk-free interest rate levels, this translates into a historically high equity risk premium.
    9. The equity risk premium might drop due to increases in interest rates, but it is far more likely that investors will reduce the required rate of return as a result of which we might enter a relatively good period for stocks.


    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jan 23 3:59 PM | Link | Comment!
  • Happy Holidays!


    Happy Holidays on behalf of all of us at LMG Emerge

    We hope that 2011 will be a great year for you and your family


    We enjoyed serving you.

    The LMG Team: Erik, Andre, Eloise, Noah and Erika


    Dec 24 11:43 AM | Link | Comment!
  • How to Not Find the Right Investment Advisers - Reflections about Madoff and Deserts

     

    It happens all the time, and it will happen again.

     

    The end-of-year period around Xmas is a good one for a reflective note. This was the year of the big Bernie Madoff scam. Why do even intelligent people continue to fall for Pyramid scams? Answer: because the Investment Game is not a simple one. Performance analysis of good investments in either individual stocks or bonds or mutual fund strategies is a profession. But yet, and that is the sad thing for professionals in the financial industry: unlike in the medical profession, too many amateurs believe they can do it. Would you consider doing some complicated surgery yourself? Nope. Would you consider putting all your money in 'that fantastic investment strategy that brings you 30-40 percent per annum guaranteed?'. Too many people do the latter.

     

    Even Bernie Madoff didn't get away with things. Sooner or later all Pyramids collapse.

     

    But OK, this story has been told so often. And we won't go into details here. Pyramid games stand a chance because of a mixture of 2 things:

     

    1. Investors are still very sensitive to 'form' instead of 'content'. In our last entries to this blog we talked about that, quoting academic research that confirmed investors' sensitivity to form-related factors like Age of the Adviser, Power Dressing, Size of his/her Portfolio, Look and Feel of the Office etc.
    2. Performance analysis is a complicated thing. You need to look at Return, Risk (in several dimensions), compare things with the right peer group and analyze sensitivity to market factors.

    It is definitely true that the bulk of investors reduce point 2 to an analysis of historical return graphs. So if someone made a relatively high return over the last couple of years, he has to be good!!

     

    Sure? I don't think so. Our database of good, licensed investors contains some 1,000 providers with on average about 10 strategies each. That is 10,000 individual financial products that passed our first tests. Now let us assume that - like in so many fields - for every reasonable or good professional there are 10 crooks out there.

     

    That would lead to a sample of 10,000 potential 'scam' or 'lousy' investment advisers. Of course: the bulk of them is just plain mediocre, but still....Quite a few of them will be professionals or amateurs that somehow have the charisma to have others follow them, even when performance is not of the highest quality after correction for risk.

     

    If we assume that a dollar return of 10% per annum for stocks is 'average' over a longer period of time (looking into our database with information covering the last 100 or so years we see that this is not a bad assumption) and a volatility of standard deviation of 40% we know from Statistics that 2/3rds of all managers will score returns between -30% and plus 50%. This implies that 1/3rd is either totally lousy, bringing in returns of less than -30% per annum, or fantastic: scoring more than 50% per annum.

     

    Result: the group with returns less than -30% will shut up. The group with returns above +50% per annum will make sure people know. They are the champs. Fantastic!

     

    This means that after one year, there are 10,000/6 = 1667 (rounded) managers with more than 50% return. Now, obviously average returns are not 10% each year. But let's assume that on average it is a fair estimate to assume that the group of managers scoring fantastic returns of more than 50 percent per annum will be bigger in good years and less good in bad years. But OK, in the mixture of good and bad those with some buffer due to good performance in the (recent) past will get away with things in less good years, won't they? You can't win in every year.

     

    Now, continuing the math assuming for simplicity sake that we can use the average return as our basis for all consecutive years, we can find out that after 5 years we are left with one manager who scored returns of more than 50 percent in every year !!! That is a cumulative total return equal to 1.50^5-1 = 659.4 percent (rounded). Far more than 5 x 50%, due to the compounded return effect.

     

    We are not using any knowledge about expertise etc here. Just a simple characteristic of statistical data. And since we did not use knowledge about expertise but just statistics, it is equally well possible that our 'good' manager will be in the minus 30% group in year 6 as it is that he is in the positive group. So another 50% annual return is just as likely every year as a -30%. Random statistics is a neat game that in the end will reverse toward the mean.

     

    If everyone were just investing with his/her own money and not in a situation in which he/she could impress others there is nothing wrong with this. But it is tricky in a situation in which investors follow gurus. A lot of those 'scam' guys will be considered stars simply because of their good historical returns in combination with charisma and non-investment-related 'form' factors.

     

    Voila: that explains the opportunities out there for the Madoffs of this world. Not just the opportunity to attract investment money without solid strategy, but even worse: also the opportunity to rob the system by extracting amounts from the system that were never earned. Or: other possibility in Pyramid games, to trigger excitement further by using some of the new inflows of the growing group of followers to pay out some dividend to the smaller first group, so that you create 'disciples' who help spread the gospel ('They really did it! These guys are fantastic!').

     

    But things get even more scary.

     

    This morning the financial newspaper reported that the Dutch regulator did fine an investor for stock price orchestration. During a period of 1.5 years he did more than 500 transactions (buying one share on each occasion) in one relatively unknown and illiquid stock and almost 1,000 in another. His total costs of buying these 1,500 shares was marginal.

     

    But the costs to society could be huge. Idea? Think of this. In a time in which people are already disappointed or dissatisfied with the behavior of the big, boring banks who always advise those same group of stocks that anyone can think of (large and mid caps, blue chips etc) this guy came up with two unknown shares!! ''Waw, he dug so deep to get all this unknown information!' You can almost hear people get enthusiastic.

     

    So, at the beginning of his buy rounds (i.e. before buying one share) he - with at that time still not so much followers - reports that he bought those stocks for his strategy. In the reports on his website he will then start to follow the shares and the portfolio performance. What will happen? Remember that the stocks are unknown and illiquid.

     

    A combination of two things:

    1. Even his small individual transactions on the buy side will sooner or later lead to upward share pressure.
    2. Sooner or later actions by 'followers' will start to appear, thereby increasing things further.

    And that is the time when our friend reaches guru status. He will maybe get to a point where some followers want him to invest for them. Find new stars!

     

    As you understand the reason why everyone, including the star manager, in this case are fooling themselves is quite simple. In an illiquid market you make your own price. So the positive return looks nice, but the moment you want to use it to get out, negative price pressure will make it very difficult to really benefit from the price increase. This was not a price increase 'carried' by positive firm news other than the increased trading which we created ourselves in the first place. It provides the manager and his followers of the first hour with an opportunity to exit. Simply make sure that gradually but slowly you become a bit more opaque. Tell them a bit less about what is going on, i.e. use part of the liquidity for your own exit from the desert.

     

    I am not saying anything more. But do you now understand why there are so many unknown 'advisers' with fantastic Penny Stocks advises? Be careful, enjoy a well-deserved great Holiday Season and make sure that one way or another you get your performance analysis right! And let us make sure that regulators around the world get sufficient power to fight scams like this one. Powers in terms of fighting them ex-post, and powers in terms of demanding more transparency up-front.

     

    Even a little bit of liquidity can become expensive in the desert. But after it dries up you probably still die a terrible death. Better not to go into the desert in the first place, unless you ensure yourself of sufficient REAL liquidity.




    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: LMG is an investment consultant working solely with institutional investors and asset managers. We hope that this reflective piece will help private investors by making them less sensitive to the 'guru' effect.
    Dec 21 8:35 AM | Link | Comment!
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