Emerging Financial Markets 8: The Top-Down and Bottom-up Approaches Prof. J.P. Mei

2 Active Asset Management in Emerging Markets u u The predictability of emerging market returns u u Market over-reaction or excessive risk premium required by investors u u Time-varying expected return and risk require a dynamic asset allocation model u u Objective: Outperform the benchmark with careful risk management

Sorting by One Variable u u PE & DY: The HK experience u u The BEHV Paper – –Sorting by Different Variables – –Form portfolios and track returns out of sample – –Quarterly re-balancing – –High, Middle, and Low Portfolios and three weighting schemes 3

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The Smith Barney Model: Put It Together u u What variables to use? u u How do we group them? u u What weight do we assign to each group? u u What weight do we assign to each variables within each group? u u Good modeling is similar to cooking.

The Smith Barney Model (50%, 5%, 20%, 5%, 20%) u u Valuation: P/E, P/E(Forecasted), P/B and Earning Yield Gap u u Growth: Earnings and GDP Growth for Next Year u u Risk: Current account/GDP, Real exchange rate over-valuation, Beta u u Interest rate: Real Rate Change u u Momentum: Earnings revision and Price Change u u Question: How do they translate rankings into weightings?

Strength and Weakness of The Smith Barney Model u u Strong marketing appeal: Intuitive and easy to understand. u u Flexibility: variables and weights used can be adjusted to changing market conditions. u u Timely information: the use of market information u u Multi-colinearity: Similar Information u u Failure to adjust for political and other risk factors. u u Transaction cost could be higher than indexing. 4

A Cautious Note for the Value Approach u u P/B does not work in every countries u u P/Cash flow does not work everywhere u u P/E Trailing & Prospective does not work everywhere u u Buy on dip, sell on rally may not work (Thai example) 5

How to Allocate Resources Among Stock Pickers

The Bottom-Up Approach u u Company Analysis and Stock Selection u u Applying Valuation Models to Emerging Market Stocks (Mariscal & Lee Model) – –A link between debt and equity market – –A framework to estimate country-risk adjusted PE u u Price/Book Value (P/BV) and Price/Cash Flow (P/CF) Ratios u u Industry Analysis: High growth potential u u Overall portfolio balance 3

The Momentum Trading Strategy (Rowenhorst) u u Sort all stocks by lagged returns into decile portfolios u u Adjust for beta risk u u Country neutral portfolio (sort by return in each country) u u Size neutral portfolio (sort by return in each size decile) u u Size/country neutral and risk adjustment u u The Momentum Strategy (Chan, Hammed, and Tong) -Most profits come from Emerging markets. -Hardly any trading profits after transaction costs. 4

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Size/country-neutral Relative Strength Portfolios