1st Quarter 2014

The US stock market continued to add to last year’s gains during the first quarter, returning 2.0%. In a reversal from 2013, value outperformed growth with many last year’s top performing technology stocks undergoing significant corrections. Developed foreign markets also delivered positive performance. Most emerging markets continued to decline, with negative sentiment exacerbated by the Russian annexation of Crimea. Interest rates moderated with the yield on the Ten Year Treasury falling by approximately a quarter point. Credit spreads continued to narrow with average yields on BB-rated corporates falling to 5.2%.

Is the Market Rigged?

A recent 60 Minutes segment on Michael Lewis’s new book about high frequency trading played on public distrust of Wall Street and oversimplified a rather complex issue. While no doubt there are firms out there attempting to front run large institutional investors, the piece glossed over the ‘arms race’ nature of this competition. Brad Katsuyama, who Lewis profiles in the book, is an entrepreneur who created an effective countermeasure in this trading arms race. The key point remains that trading costs are dramatically lower than they were 10 or 20 years ago when high frequency trading did not exist. One issue that the segment does illustrate, however, is the liquidity issues faced by investment managers when they become too large. Firms use the multiple trading pools where the high frequency traders lurk because they need to trade larger volumes of shares than could simply clear a single exchange.

Emerging vs Developed Market Growth

The US economy continues to support record corporate profits and fears of a dramatic slowdown in China have so far failed to materialize. With most equity valuations just on the far side of fair, this environment needs to continue for markets to continue to perform. Chinese growth remains the largest risk to the global economy. In addition to the well-known trade linkages with commodity producing countries such as Brazil and Australia, China has been investing considerable amounts in developing manufacturing capacity and importing goods from other developing countries. The emerging markets currently are struggling in this transition period where growth is shifting away from China and the raw materials suppliers within its orbit and toward Southeast Asia, East Africa and the Pacific Coast of Latin America. China struggles with trying to stem chronic over-investment in infrastructure and steer its economy more toward domestic consumption. The countries of the so-called “Fragile Five”: Brazil, India, Indonesia, South Africa and Turkey, face the opposite problem, having dramatically increased consumption at the expense of domestic saving and investment. These problems resulted in the sharp currency declines that drove the poor performance of emerging markets last year. With these concerns over emerging markets, investor focus has understandably shifted to faster growing stocks domiciled in the US. In what has been termed Tech Bubble 2.0 in the financial press, the valuations of emerging technology stocks, particularly those in the cloud computing and social networking sectors, have been reaching levels not seen since the late 1990s. The success of Twitter and Facebook’s public offerings has spurred a host of new companies funded by venture capital, including a Justin Bieber-backed ‘selfie’ network entitled Shots of Me. Companies able to be tagged with sexy catch phrases such as Big Data, Personal Genomics or 3D Printing are becoming sufficient to attract large amounts of capital and steep valuations. Much like the Tech Bubble 1.0, this frenzy is happening against a backdrop of real innovation and technological disruption. Advances in artificial intelligence, data collection and storage, robotics and a host of other disciplines will create enormous amounts of wealth and change the way business is done across a host of industries.

Investing in a fast growing business in a developed market such as the United States requires investors to assume some combination of technology and business model risk. In a mature economy it is difficult to find companies with proven business models and established products and services able to sustainably grow faster than the broad economy. Understanding this fact, mature businesses in the developed world, such as Coca Cola and Nestle, have long oriented their growth plans toward consumers in developing countries. Developed market firms able to generate high growth rates must necessarily do so either through a new technology or a new way of delivering an existing good or service. Emerging market equities offer a counterpart to these risks. Rather than unproven business models or technologies, emerging market companies typically are engaged in very prosaic businesses manufacturing or retailing food, clothing, entertainment and other basic necessities. These companies possess very few business model or technology risks, rather the risks stem from the macroeconomic environment in which they operate and basic corporate governance issues. The macroeconomic risks of emerging markets can be diversified to no less degree than the business model and technology risks of growth stocks in developed markets. While the fading of China as the primary driver of emerging markets creates new risks, it also enhances the diversification potential. For example economic issues in Turkey have little bearing on Mexico or The Philippines.

The top performing Technology stock in the Russell 1000 Growth Index last year was Pandora Media Inc, the creator of the eponymous internet music service. While Pandora has a large customer base, the firm is dependent upon content providers, largely the major music labels, to continue to provide their catalogs at terms that allow Pandora to make a profit. It is not certain whether internet radio will prove to be a sustainable, profitable business model in the marketplace. Furthermore, Pandora’s business model faces stiff competition from Spotify, Apple and several other firms. Despite this business model risk, Pandora’s stock appreciated 190% and the company trades at 156 times consensus estimates of 2014 earnings.

Panama is termed a Frontier Market, a nomenclature used to denote countries with capital markets too undeveloped to be regarded as “emerging”. Aside from the canal, the country is remembered by most for its former dictator Manuel Noriega and the US military action that removed him from power in 1989. Panama is also home to the headquarters of Copa Airlines, a regional Latin American airline that returned 63% in 2013 despite the generally poor environment for emerging market stocks. The firm has a near monopoly on a host of regional Latin American routes and therefore has considerable pricing power in setting fares. Earnings per share have been growing above 10%. Copa also participates in a code share arrangement with United Airlines. As Panama lacks a liquid stock exchange, the company lists its shares on the New York Stock Exchange and complies with all the reporting requirements required of US domiciled companies. The stock currently trades at 13 times estimates of 2014 earnings and carries a 2.7% dividend yield.

The intent of providing these examples is not to make specific investment recommendations, rather to illustrate the point that developed and emerging market companies have different sets of risks. Currently the market appears to be discounting emerging market risks more steeply, perhaps rightly so given the risks in China. Portfolios benefit from the diversification available from owning both types of investments. The fact that US growth stocks are currently in favor and emerging market stocks are not makes it more likely that emerging market stocks will provide higher returns in the future. Remaining diversified across a portfolio of high quality businesses while retaining a reserve of bonds adequate for several years of liquidity needs remains the best option for dealing with what may be volatile markets in the future.