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September 11, 2018

Navigating the Treacherous Waters of Emerging Markets

by Steven Carroll.

While investors in developed markets remain largely blessed with fair winds and a following sea, the same is clearly no longer true of emerging markets, where there are significant stresses appearing in many asset classes including equities, currencies and bonds. It looks like emerging markets investors will continue to face challenges, as they are being driven by the economic recovery of the United States, which in turn is delivering the unwinding of quantitative easing and the normalization of short term interest rates.

These challenges are occurring as the way in which Emerging Markets investors operate is itself changing fundamentally. Travelling across Asia Pacific, it is fascinating to observe the nature of the investment process evolve; increasing sophistication is evident in both security selection and portfolio construction. A decade ago, the investment process likely relied on management meetings and fundamental analysis; today a hybrid investment process (often shortened to ‘quantamental’) is now in the ascent.

Whether or not one agrees that “data is the new oil,” it is clear that increasing quantities of data support the investment decision maker. Thomson Reuters has long been a provider of content that supports the buyside equities and credit market decision marker.  I outline two of our content sets that are particularly relevant in periods of elevated volatility — just as we’d started talking of end of cycle constructs like the new normal, fear has returned to the markets.

First do no harm

Across key metrics, Thomson Reuters calculates its own proprietary estimates that place more weight on recent forecasts and better analysts, augmented with an algorithm that excludes estimates that predate significant new market information. This new consensus allows one to understand stocks with a statistically significant chance of beating or missing earnings expectations (or revenue, cash flow, dividend, etc.).

The primary use case here is risk management, though this data can be used as a screening tool for long and short ideas. Recent market performance has highlighted the sharp downside moves that can occur where equities miss their earnings number, particularly equities where market expectations and valuations are elevated. Thomson Reuters has recently released a research note that examines the accuracy of the Smart Estimate in predicting negative surprises and the results remain robust, with a 73% accuracy rate in predicting a negative surprise when our predicted surprise is >-2%.

Faith in the numbers

According to Warren Buffett, “only when the tide goes out do you understand who has been swimming naked.” As a bear market sets in for emerging markets, another means of assessing earnings risk is through an examination of the quality, or sustainability, of reported earnings. StarMine offers an Earnings Quality model that assesses earnings sustainability based on accruals, cash flows and a Du Pont assessment of the operating efficiency of a company.

As one of our recent research notes highlights: Earnings Quality tends to perform extremely well as a factor in difficult market conditions and an examination of recent performance of the model bears this out – across the Emerging Markets universe there is a 31% decile spread between the performance of the top and bottom deciles over the trailing 12 months. Intuitively this makes perfect sense, as portfolio managers tilt their portfolios to companies with conservative accounting, strong cash flows and a strong operating model. Notably, the performance of the top decile is actually positive, a significant accomplishment given that many emerging market indices are down significantly over a trailing 12 month time frame.

No silver bullet

There is no single factor that provides a silver bullet during periods of volatility and market dislocation, however there are models that can help orient portfolios towards safer companies likely to outperform, helping portfolio managers avoid the temptation to “catch a falling knife,” as the saying goes.

Every investment approach has drawbacks and in this example one may end up positioned defensively as the market sees a relief rally. However in an environment where US interest rates continue to rise, trade tensions simmer and falling currencies add additional stresses to those firms with a revenue/debt mismatch – Thomson Reuters offers critical insight into security selection, whether driven by quantitative or fundamental investment processes.

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StarMine models and components are available via Thomson Reuters Eikon, our Quantitative Database, QA Direct; and via FTP feed. The aggregated StarMine content grouped by business classification, geography, index and portfolio can be found in the Eikon Aggregates App. ETPs and Thomson Reuters indices are also available in Eikon.

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