We’ve been picking apart and chewing on a bit of a sacred cow. The most commonly held view is that stocks from countries with strong currencies make better investments than their weak currency cousins. In fact the evidence points precisely the other way. Stocks from countries with the weakest currencies are usually the best performers. Today: more proof and some thoughts on why this is so.
Last time I left you with an observation that staggered me when I first noticed it. Argentine stocks have massively outperformed both US and Swiss stocks since December 1987 (the earliest available data), even when both are measured in US dollars (see here if you missed it).
Argentina is a serial basket case when it comes to economic and financial matters, although now appears to be on the mend (until next time…). As I pointed out before, one Argentine peso from 1987 would be worth only three thousandths of one percent as much today, in US dollar terms (it’s down 99.997%). So how on earth could Argentine stocks have done so well?
This is not a marginal result either. Total dollar profits over those 28 and a bit years from the MSCI Argentina index – including price moves and dividend income – were 3.3 times the equivalent US index and 2.8 times the Swiss index.
Over the intervening years the US market has seen three major bull markets (1987-2000, 2002-2007, 2009-2015) one bear market (2000-2002) and one severe crash (late 2007 to early 2009).
Also, the start of the time series is shortly after “Black Monday” on 19th October 1987, and the period around it. That was when the US market fell 23% in a short time.
In other words the US market started low and ended high, yet has still been left for dust by its small South American cousin.
The end of the time series, today, sees the US market trading at extremely high valuations by any measure you care to choose (my latest take on it can be found here). In other words the US market started low and ended high, yet has still been left for dust by its small South American cousin.
So let’s dig a little deeper, and see if there was something special about Argentina, or whether this applies in other weak currency countries.
First off, Argentina was in the grip of hyperinflation between 1987 and the end of 1991, with rates peaking in March 1989. The currency, and the economy, were in meltdown. This led to extraordinary buying opportunities.
Well-known investment guru Marc Faber identified a phenomenon that he calls the “paradox of inflation” in his excellent book “Tomorrow’s Gold: Asia’s age of discovery”, first published in December 2002.
Despite the title, most of the book concerns itself with the historical study of market booms and busts: from British canals to US railroads to the hyperinflation in 1920s Germany. If you can get hold of a copy it’s highly recommended (I’ve read it twice).
Faber visited Argentina in 1988. According to him the inflation rate was 600% a year at that time and you could buy the entire Argentine stock market for just US$750 million.
Six years later in 1994, when inflation had been brought down to less than 10%, the stock market was worth US$34 billion, or 45 times as much! Molinos, an Argentine food company founded in 1902, went from US$20 million market capitalisation in 1987 to US$515 million in 1994 – up nearly 26 times in US dollar terms.
Faber highlights some other examples of hyperinflationary bargains as well, and the huge profits on offer as the disease is tamed. Between 1991 and 1994 the Peruvian stock market went up over eight times in US dollar terms. During the famous hyperinflation in Germany you could have bought the market in October 1922 and made over 14 times your money – in US dollars – in just the following 13 months.
The point is that high or hyperinflation often leads to a complete lack of confidence. Stock prices may be going up in weak local currency terms, but losing a huge amount in stronger foreign currency terms, such as when measured in US dollars.
This can offer exceptional buying opportunities as stocks achieve extreme under valuations in the markets relative to the companies’ long term potential.
This can offer exceptional buying opportunities as stocks achieve extreme under valuations in the markets relative to the companies’ long term potential. Eventually moves are taken to tame the inflation, confidence returns, and (hard currency) prices soar. The profits can be massive.
Obviously hyperinflations are extreme conditions where people will do anything to dump the local currency. A barber in Buenos Aires once told me how he survived the hyperinflation in the late 1980s. He used to cut hair in the morning and take payment in local currency. Every afternoon he would buy his daily groceries, before prices rose again overnight. Any spare cash was exchanged for dollars the same day.
But what about less extreme conditions, where currencies are simply weak, losing perhaps 10%, 20%, even 50% in a year? It turns out the stocks of these countries also have an excellent track record. This is something you really need to understand as an investor.
Here’s a couple of examples. First let’s look at my current favourite bargain basement opportunity, Russia. (See “Why I’m still buying Russia and selling the USA” for a recent update.)
The Russian rouble has been pretty weak over time. Since the beginning of 1994 it’s lost around 96% – mostly during the 1998 Russian crisis, when the country defaulted on its debts, and then in the past couple of years as commodity prices collapsed.
Also Russian stocks are currently cheap, with a P/E that’s about a third of the US level. Despite this, the total return from Russian stocks has matched US stocks over the past 21 years (and a bit).
The following chart compares the MSCI Russia (in orange) to the MSCI USA (in green) since the end of 1994. Both include price moves and dividends, and are measured in US dollars.
Clearly Russian stocks have been pretty volatile, and you’d need a strong stomach to stick with them through thick and thin. There was a huge crash in 1998 during the debt crisis, a massive boom until mid-2008 during the commodity bubble, another bust due to the panic of the global financial crisis, a sharp recovery until second quarter 2011 and then a bear market since.
Over the next few years I expect cheap Russian stocks to rise sharply and expensive US stocks to head sideways or downwards. Russia will once again be left clearly in the lead over the long sweep, despite the history of a weak currency.
Here’s another one: India. This time we can look back to the end of 1992. The Indian rupee has lost 65% against the US dollar since then. But Indian stocks, measured in US dollars, have kept up well with US stocks. See the next chart comparing the MSCI India index (orange) with the MSCI USA (green).
And here’s another: Indonesia. The Indonesian rupiah lost around 85% almost overnight during the 1997 Asian crisis, before recovering substantially and then slowly depreciating over time. Overall it’s down 85-90% since 1987 (earliest data available), when the next chart comparing its stock market to the US starts.
Again, Indonesian stocks have matched US stocks in US dollar terms, despite the slumping currency. But let’s home in on a specific episode to really highlight the potential of stocks from countries with weak currencies.
Indonesia’s big currency collapse was in 1997. The stock market crashed even in local currency, but even more in US dollar terms. It lost a massive 93% between June 1997 and September 1998.
After the crash things settled down and the market took off again. It proved to be a spectacular buying opportunity. Despite another crash in 2008, and a weak market since April 2013 (when Indonesian stocks were distinctly expensive), the MSCI Indonesia is up nearly 24 times since September 1998, measured in US dollars and including dividends.
The US market is up a measly 2.6 times by comparison. In other words, after the huge currency drop had happened – and despite ongoing erosion of the rupiah since then – Indonesian stocks outperformed US stocks by a factor of over 9 times over seventeen and a half years.
I’ve just given you four examples of stock markets that have performed well over many decades, despite having weak local currencies: Argentina, Russia, India and Indonesia.
But are these isolated instances? Have I just cherry picked the data?
Actually no. The most authoritative source for this is a study done by investment bank Credit Suisse a couple of years ago. Their analysts scrutinised the performance of 23 emerging markets between 1976 and 2013 inclusive, which is 38 years of data (and many hundreds of individual data points).
Stocks from the countries with the weakest currencies in the preceding year went on to have the strongest dollar returns over the following five years, on average.
The results were clear and conclusive. Stocks from the countries with the weakest currencies in the preceding year went on to have the strongest dollar returns over the following five years, on average.
Here’s the chart that summarises their results. They grouped all the data points into quintiles, from weakest to strongest currency countries. Each quintile is 20% of the data points, starting with the weakest 20% of currencies and ending with the strongest 20% of currencies during each point in the time series.
You can see that the weakest currency quintile returned nearly 35% a year on average over the following five years. That was followed by the second weakest quintile with over 20%. The strongest currency countries also did well, but there is no question that it was the weakest 40% that did best.
Of course this is only on average. It won’t work every time – but that’s what diversification is for. You work out your investment strategy, put your money to work, and if the strategy is a good one then most of the investments will perform strongly. The winners will more than make up for the losers.
Put this all together and it’s strong evidence that the countries that have just had the weakest currencies usually go on to have the best stock market performance over the medium term.
“Just had” is the crucial point here. Severe or extreme currency weakness is usually met with corrective policy measures at some point. Price inflation is brought under control, the exchange rate stabilises and the economy gets back to real growth. Confidence returns, profits grow, and the oversold stock market moves to higher valuation multiples.
So despite what many, even most people think the historical record is clear. Investing in the stocks of countries that have had weak currencies is likely to be one of the most profitable investment strategies around.
Just make sure you’re prepared to wait for a few years for it to work out, and ignore the short term price swings. Fortune favours the brave.
Stay tuned OfWealthers,