A Bay Street investor we know took a tour of China last year, as is the fashionable thing for money managers to do these days. During his trip, he met a partner from one of the Big Four accounting firms.
How, the investor wondered, do Chinese bookkeeping practices differ from those in the developed world? "In two ways," the accountant replied. "Accuracy and reliability."
Yes, emerging markets are an exciting and perilous thing, full of immense rewards, traps and the just plain bizarre. On the white-hot Shanghai Stock Exchange (up 44 per cent this year), you'll find ventures like the Daying Modern Agricultural Co., which, apparently, develops real estate, raises poultry, and makes kitchen utensils, among other activities: a company that will raise a chicken and then sell you a knife to cut it with.
This is an unusual combination, and Daying has an unusual history, to say the least; one of its backers was arrested a couple of years ago and accused of stripping assets from the company. But who are we to argue? The stock is up 309 per cent this year and sells for 76 times earnings -- assuming you can believe the financial statements, of course. The people who place their bets in the unregulated casino that is China's domestic stock market seem like a nervy lot.
Not so the investors in places like Argentina, Russia, Egypt, Mexico and elsewhere, where a wave of panic selling is only now subsiding. India's key equity benchmark, the Sensex 30 index, had fallen 20 per cent from its spring peak before a sharp rebound on Friday. Even developed countries have emerging markets of a sort -- the TSX Venture Exchange in Canada, the Russell 2000 index of small-capitalization companies in the U.S. -- and all endured the same short, sharp correction of May.
What's going on? How does a selloff spread from Mumbai to Moscow to Vancouver? Call it the return of the risk premium, and it's a healthy, necessary event that ought to do good things for your portfolio.
"Risk premium" is one of those terms that financial types like to throw around, but the concept is simple. Think of it as an investor's danger pay: It's the compensation you get for holding a riskier asset. After the bursting of the telecom bubble, you could buy the bonds of some telecom companies carrying rich double-digit yields, even as short-term interest rates were creeping down to 1 or 2 per cent. That's a fat risk premium, and when many of those companies survived or restructured, their bondholders did very well.
Emerging markets almost always carry a risk premium, which is another way of saying it costs less to buy a dollar of assets or earnings in Mexico City than in New York, all else being equal. And that's reasonable, given the risks -- looser regulation, weaker accounting, volatile currencies and so on. Once in a while, the premium disappears entirely. That last happened in the mid-1990s.
Mexico's tequila crisis in 1994 and the so-called "Asian flu" of 1997-98 brought investors back to reality, and a huge risk premium emerged. For a time in the late 1990s, emerging markets companies were selling at a fraction of their price of their peers in the developed world. If an investor had to pay, say, $3 for a U.S. company with a dollar of net assets, it could buy a similar Thai company for $1.
By most measures, emerging markets stayed in the woods -- i.e., were cheaper than their historic norms -- until last year, according to data from MFS Investment Management. The absurd rallies early this year in markets like Saudi Arabia and Russia -- which is still up 127 per cent in the past year -- only made them more overvalued. In Canada, a similar thing was happening: The Venture Exchange ran up 65 per cent in about 6½ months.
Markets vacillate between favouring quality companies and speculative ones. In virtually every country, the latter group has prevailed in 2006. May's correction restored order, a little bit. It didn't make stocks cheap, but it blew away some of the froth. That can only be good for future returns.
Derek DeCloet