Investment Strategy

The best investments often look the worst

What do Russia, South Africa and Argentina all have in common? Surprisingly, all of their stock markets have performed better than the US market since as far back as 1998. That’s a period of 16 years, or roughly half a generation. Who, in the late 1990s, would have predicted that outcome? Practically no one. So, what can we learn from it today?

I came across this surprising insight almost by accident. It would be fair to say I stumbled across it, really. I was looking for examples of how country stock markets had performed after major crises, or dramatic political and economic changes.

Often, the easiest time for investors to make big money is shortly after a major meltdown. Prices crash too hard during the panic, and then bounce (usually) once everyone realises that the worst case scenario isn’t going to happen.

It turns out that stock markets in many countries that are usually seen as high risk, and that have gone through hard times, have actually outperformed the country viewed by most as the safest place to invest. This is using MSCI index data, which has the advantage of all being calculated in US dollars. In other words it compares apples to apples.

Source: MSCI

The USA, after all, is by far the world’s largest economy: nearly a quarter of world GDP and roughly twice the size of second placed China. That means it has a vast home market for its corporations to tap into.

Also its stock market is not far shy of half the market capitalisation of the entire world, meaning a huge portion of institutional assets are always going to be invested there (the same can’t be said for smaller countries).

This is because professional portfolio managers rarely stray far from global weightings in their asset allocations. In fact, collectively speaking, they can’t stray far, since their vast pools of money dominate the markets, and hence define those weightings.

(Market capitalisation refers to the market value of traded shares, at current market prices. For a company it is the share price multiplied by the number of shares. For a country it is the market capitalisation of all the individual companies that have shares traded on public markets. And for the world it’s the sum of all the countries.)

Also, the Federal Reserve is the issuer of the world’s most important reserve currency, the US dollar, which is also the main currency used in international trade. Put simply, there are always people around the world that want or need dollars.

Plus there is little physical risk to the USA’s borders. It has vast oceans to East and West, friendlies to the north and a relatively weak and poor southern neighbour. If that wasn’t enough, in 2013 the USA spent 37% of the world’s entire military budget, which is as much as the next 9 countries combined.

So what am I comparing it with? What are these upstart countries that have better performing stock markets than the world’s biggest economic and military powerhouse?

Some of you may point to these countries being commodity rich. South Africa has its precious metals mining, Russia its oil and gas and Argentina its agricultural land. (Of course they all have much more than that, but space doesn’t permit a detailed discussion.)

So is it simply a case of a commodities boom holding the key? I suspect not. First, the US is also a commodities powerhouse. Second, commodities haven’t been booming for all that time.

The political and financial upheavals have been massive in each country. South Africa transitioned from the “apartheid” political system of racial discrimination during the early 1990s. Russia was the core of the Soviet Union, which collapsed in 1991, and its economy has been transitioning from a state-owned monopoly to a market based system ever since. There was a major meltdown in 1998, when the country defaulted on its debt.

Ok, so Russia had it’s crisis in 1998, so this is measuring the performance since that market bottom. But even if we go back to January 1995, which is the first data available and 1998 pre-crisis, Russia has massively outperformed the US market.

Russian stocks are up 9 times over that period, versus four times in the US. And that’s even when Russian stocks currently trade with a P/E that’s a third of the US level (see below).

Argentina has been through various phases. Its currency was pegged to the US dollar during the 90s, in a reaction to the hyperinflation of the 1980s. Unfortunately the dollar was strong which made exports uncompetitive on world markets, commodity prices were weak which reduced foreign currency earnings, and the country racked up unsustainable dollar debts.

The result was a massive debt default ($100 billion) and currency devaluation in 2001/2002 that it’s still digesting to this day. In fact it already has a crisis of sorts going on, as government money printing has led to consumer price inflation of around 35% a year (measured in Argentine pesos).

So on the face of it, it’s surprising that these stock markets have done so well relative to the USA. They’ve all experienced major upheavals of one type or another. But the big, overarching trend is one of going from bad to less bad.

Even Argentina, whose financial condition is currently looking a little shaky, has improved since the days of military dictatorship and hyperflation during the 1970s and 1980s.

On the other hand, the USA (and other developed countries) are still engaged in a process of going from good to less good, as they continue to live beyond their means and pile on more and more debt.

(This is not just a market phenomenon: I believe there is a secular trend of declining living standards in most developed countries, as the middle class is very slowly but very surely squeezed in multiple ways. But it’s a very slow process. So slow, in fact, that most of the people affected don’t even notice. Yet.)

So I continue to believe that selected stock markets of less developed countries will be the best places to invest in the coming years and decades. Of course not all of them will work out well. But the powerful combination of younger, faster growing populations and improving productivity, from a still low base, provides a strong following wind to inflate the sails of their economic growth.

I’ve recommended Russian stocks before, as the market is incredibly cheap by any valuation yardstick. For example, data from the Financial Times puts the P/E ratio at just 6.1. Perhaps the crisis in Ukraine has reduced the chance of any quick price recovery to sensible levels, but it should work out well in the medium to long term.

South Africa looks like an unconvincing destination right now, with a high stock market P/E of 17. And Argentina’s market trades with a P/E of 14.4, which is nowhere near low enough to get excited, given its current financial difficulties.

So even if the economic and profit outlook is encouraging, you need to be selective if you want the best investment results. I always recommend sticking to a rigorous value investing discipline, which means only buying when the markets are offering you the gift of low prices. And if you can’t find bargains then keep your powder dry until some come along.

The US stock market is most definitely not a bargain at the moment. It has a high P/E of 19.7. Earnings have in fact been falling there recently according to research by Albert Edwards at Societe Generale (a French bank).

Hopes – for that is what they are – for higher prices all seem to hang on continued money printing by the Federal Reserve (so called “QE”). Relying on uncertain decisions made by committees of career bureaucrats never struck me as a good investment tactic.

The point is you often get the best results from investing in the places that look the worst, and the worst results from places that investors are currently in love with. My advice is to ignore the daily noise, look at the big picture, and stay disciplined on the price you pay. You may just be pleasantly surprised by the results.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.