Nevertheless, it started from such a low point, after decades of devastating wars, that the country still has a lot of catching up to do. It is now moving up the supply chain and could be an early beneficiary of the USA-China tensions and the diversification of international supply chains.

Vietnam Overview

Vietnam is a country of 99 million people and a GDP of $469B ($1.4T in PPP), giving it the 15th largest population in the world and the 36th largest economy (26th by Purchasing Power Parity).

The country has traditionally been mostly agrarian, relying on advanced irrigation systems and a very warm and wet climate, ideal for rice farming.

Except for its impressive agricultural production, especially rice, the country is relatively poor in natural resources, with just a little bauxite (aluminum ore) and oil, mostly used domestically.

It mostly follows the South China Sea's western coast, with a mountainous interior and 2 major river deltas: the Red River Delta in the North and the Mekong River Delta in the South.

The country was scarred by the fallout of the Indochina War (with France: 1941-1954), the Vietnam War (with the USA: 1955-1975), and even a brief fight with China in 1979.

The country's first burst of growth came in 1990-1997, with 8% annual growth, following free-market reforms. It would, later on, slow down during crises, like the 1997 Asian financial crisis, then in 2000 and 2008. Overall, the country has sustained steady economic growth over that time, with an annual growth rate usually in the 7% range.

The main export is electronic & telecom equipment, often assembled in Vietnam to leverage the still relatively low labor costs, which became increasingly competitive as China became less and less cheap. The next largest export categories are clothing, footwear, furniture, and food products.

Tourism is also an important part of the economy (7.5% of GDP), or at least was before the Covid pandemic, with the large majority of tourists coming from Asia.

Vietnam has often been categorized as one of the "Tiger Cubs" (essentially the ASEAN), in reference to the previous 4 Asian Tigers (Hong Kong, Singapore, Taiwan, and South Korea).

The Tiger Cubs club has seen growth decelerate strongly in the last few years, with the exception of Vietnam, which is by far the best performing of these economies.

Vietnam's Strengths & Future

Vietnam's growth has been fueled by a few factors:

• It is located in Asia, close to most international supply chains.

• Labor costs are low and quality is relatively high.

• The economy has become very open.

• Vietnam has a young and growing population.

• The politics are stable and the environment is safe.

While these advantages still hold, the progressive development of the country makes them less crucial for the next step of Vietnamese development. The demographic transition is happening and salaries are rising. Luckily, the growth is supported by 2 new trends.

Going Up the Supply Chain

Following the blueprint established by Japan, South Korea, and China, Vietnam is now looking to become more than a mere assembler of goods manufactured somewhere else, or the maker of low-value and labor-intensive goods like clothing.

For example, it has become a key supplier to foreign firms for car parts, for a total of $4.4B in car parts exports in 2018.

West-China Tensions

Despite their "tense" common past, Vietnam is surprisingly friendly to the USA, seeing it as a counterbalance to an increasingly powerful and influential China.

Vietnam has been one of the prime beneficiaries of factories leaving China, looking for both cheaper labor and lower geopolitical risk.

The most likely scenario is for Vietnam to climb the supply in segments that are not too labor intensive, as its much smaller population, relatively well educated, is unlikely to be enough to absorb labor-intensive industries currently dominated by China (which is a role that India fits better).

Vietnam's Weaknesses

One key Vietnamese weakness in keeping growth stable and absorbing more of the added value is that most of its exports are currently controlled by foreign firms. They might set up shop in Vietnam, but they do not replace local champions.

Local firms are generally not up to the level of quality required to become independent suppliers. This might change over time, as more of the labor force is gaining experience, skills, and connections to start on their own. It is still just a (distant?) possibility for now.

Another key weakness is dependence on China. China provides 35% of Vietnam's imports. So when people look at Vietnam as an alternative to China, they might underestimate how much Vietnam functioning properly relies on keeping at least decent relations with China.

The last issue is that Vietnam needs to invest more massively in its infrastructure. Power demand has often caught up to max capacity, and the same can be said for logistics infrastructure (roads, railways, harbors). Strong investments by the government and local utilities will be needed, especially if the country moves toward more energy-intensive industries.

Company Spotlights

Vin Group (HOSE:VIC)

Vin Group is THE conglomerate of Vietnam and the closest the country has to a Korean chaebol (Samsung, LG, etc.) or a Japanese trading company. It represents around 12% of the main Vietnamese stock index (VN-Index) and 1.1% of the country's nominal GDP.

The company has an interesting history, having been founded by Vietnamese expats in Ukraine in 1993, before being brought back to Vietnam in 2000.

It is mostly active in real estate development and asset management (shopping malls, hotels, condos, etc.), but is also operating data management, wine selling, hospitals, university, and even manufacturing its own design of e-motorcycles and electric cars (VinFast, expected to IPO in 2023) and AI.

Due to this very diversified array of activities, the Vin Group is present in the daily lives of most Vietnamese. With its deep pockets, it is also one of the best candidates for real domestic innovation and taking control of industrial supply chains.

SABECO - Saigon Beer Alcohol Beverage Corp. (HOSE: SAB)

P/E: 20.35

Dividend yield: 2.11%

The 148-year-old company is dominating the local beer market. Considering how beer brands successfully keep out foreign competitors, this is a rather "moaty" business. Vietnam is also, surprisingly maybe, a "beer country", with beer accounting for 90% of alcohol sales.

The company's sales and profits have fully recovered from the Covid slump. The company is also investing heavily in its physical assets (breweries, automation, etc.) and its brand (sponsorship of the national football team, music festivals, etc.).

With rising national income, SABECO is well-positioned to capture an increasing budget on entrainment and consumption. SABECO's management also anticipates increasing consumption from women and young people.

GEMADEPT (HOSE:GMD)

P/E: 17.36

Dividend yield: 2.2%

Gemadept dominates the port operation and logistics businesses in Vietnam, a crucial role in a trade-dependent economy. It is well-positioned to gain from any increase in imports and exports.

It was among the first 3 companies to be privatized in 1993 and was publicly listed in 2002.

Due to its crucial role in the logistical chain, Gemadept essentially acts like a toll charge on the whole Vietnamese industrial sector. Its harbors are unique assets virtually impossible (or at least horribly costly) to replicate, especially the deep-sea harbor that opened in 2021.

More recently, the company has also gotten involved in real estate, with the development of a commercial center, offices, and a 5-star hotel, for a total investment of $280M.

ETFs

While Vietnam is usually included in Asian or ASEAN ETFs, there are a limited number of ETFs centered exclusively on the country.

VanEck Vietnam ETF (VNM)

Heavily tilted toward Vin Group and its subsidiaries, it also has a lot of exposure to the financial sector (51% of the whole ETF) and consumer non-durable goods (19%) sectors (partly through Masan Group Corporation, a retailer/supermarket chain).

So this might be a suitable ETF to bet on Vietnam's overall growth, but only as long as the Vin Group is doing well.

MSCI Vietnam ETF (VNAM)

The ETF top holdings are not very different from VNM, except for a larger exposure to real estate through Hoa Phat Group (9% instead of 6%). It is also more exposed to raw materials and energy.

Conclusion

Vietnam is a growth story that has not disappointed in the last 30 years.

Vietnam might, at this point, be a place where it is relatively easy to invest (no longer a frontier market, with exposure through ETFs) but with a lot of growth potential remaining.

It seems on the verge of starting a new chapter, looking to become a new South Korea or Taiwan in the next few decades. This lofty goal is achievable if the country manages to play its cards wisely and use geopolitical tensions to its advantage, but avoid getting caught in an actual conflict in the South China Sea.

A deep understanding of competitive advantages and local markets might be required for optimal stock picks of Vietnamese small caps. But the country's blue chip companies offer "simpler" opportunities as well, with large conglomerates, logistic companies, or consumer goods giants and retailers.

Finding Value in Emerging Markets

Stock Spotlight has regularly covered stocks in emerging markets, which can offer great companies at discounted prices. After a decade of outperformance for the US stock market, it might be time for emerging markets to shine. This cycle between emerging market (EM) vs the US tends to be roughly 10-15 years long, as you can see below. With the S&P500 outperformance stated in 2010, we are due for a reversal in trend.

Source: Western Southern

Past patterns may not be repeated, but the investing world extends beyond the US, and increasing numbers of investors are considering exposure in non-US markets!

Emerging Value
This is a series focused on opportunities in emerging markets. The goal is not to discuss breaking news. Instead, we will focus on long-term trends and lasting phenomena that will impact investing in a country or region. It will also look at a selection of companies that might be worth a closer look.

Today we are looking at a different type of profile, a little more entrepreneurial and more controversial as well, one that is discussed intensely in investing circles, with cohorts of both fans and haters.

I am, of course, speaking of Elon Musk, "Chief Twit", CEO of Tesla and SpaceX, and briefly the richest man in the world.

When talking of money and investing, we could do worse than look at the history of the richest man in the world. How did Elon Musk make his money, and what can investors learn from his spectacular rise? And why is he so controversial?

Who Is Elon Musk?

Musk was born in South Africa, to a relatively well-off family. He would start early on entrepreneurship, launching an arcade game franchise with his brother without telling his parents. He was also a self-admitted "geek", who learned programming on his own and liked to spend most of his time with books. He was also brutally bullied, including to the point of being sent to a hospital for several weeks.

He left South Africa for Canada, and then the US. There he briefly considered starting a Ph.D. in battery technology but realized "there was this thing called the Internet happening, and I had to be part of it".

From there on, he would successively start 2 Internet companies, and then Tesla, SpaceX, and a host of other "side businesses".

How Did Musk Make His Money?

In 1995, Musk built ZIP2, a sort of Internet Yellow Pages with his brother Kimbal. They sold it for $300M in 1999, near the peak of the Internet bubble.

He used that money to build X.com, which would later turn into PayPal after a merger with Peter Thiel's company, a competitor to X.com. eBay purchased PayPal for $1.5B.

Musk then founded SpaceX in 2002, and became an investor in Tesla in 2004, before taking over Tesla as the main shareholder and CEO.

He purchased Twitter for $44B in 2022, although it remains to be seen whether it will turn into a money-making or a money-burning venture.

Tesla has been the main driver of Musk's $188B fortune. Musk owns 23% of the dominant electric car manufacturer.

The 3 Sources of Musk's Success

There are three pillars to the Musk success story.

1. Entrepreneurs Beat Investors

The first characteristic of Musk's rise to wealth is his entrepreneurial activity. He made almost all his money from being the founder of highly successful companies.

Risk-taking might also as well be his middle name. He systematically re-invested all his fortune in new. Both Tesla and SpaceX were "weeks from bankruptcy" at points of their existence while rushing to launch a functional product that (literally) did not explode (SpaceX) or self-ignite (Telsa).

2. Trend Following

It is fair to say that Musk has a flair for smelling trending topics years ahead of their time. Internet in 1995, electric cars in 2004 (even before if you consider the interest in battery tech), and space tech in 2002.

Rising trends are a powerful force for growing money, both for entrepreneurs and investors, and Musk is maybe the poster child of this for an entire generation, having caught not one but 3 speculative bubbles in their earliest stages.

3. Work Ethic

No matter what people say about Musk, something to grant him is a borderline insane work ethic and self-driven passion for excellence. Like a 120-hour work week and a near-maniacal focus on efficiency and productivity.

This transfers down the hierarchy, as he is asking his employees to work as hard as himself. He is also famous for very challenging meetings, often putting employees in a tough spot, and for setting "impossible" tasks and deadlines.

The pressure can get worse, as he routinely knows intricate technical details himself, often challenging his engineers during meetings by knowing as much or more than them.

Musk had been ingesting Cantrell's textbooks on rocket-building and had transformed himself into an expert. "He knew everything," Cantrell told Esquire. "He'd been planning to build a rocket all along." And that's how SpaceX was born.

Inc.com

Musk is known to be a demanding and challenging boss, which can be an advantage if it gets the best out of employees and a disadvantage if they decide to go elsewhere.

What We Can Learn from Musk

Most of us are not going to replicate Musk's career, but there are lessons we can extract from it.

Entrepreneurship & Investing

The first lesson is that no matter how good an investor's returns can be, nothing will beat the returns of a successful entrepreneur. Musk, Bill Gates, and Jeff Bezos have each held the title of the richest man in the world. Each one of them is a successful business founder.

Most have also held onto their share for years, if not decades. Long-term holdings in successful companies can provide a much higher return than frequent trading will ever do. Initial investors in Tesla, Microsoft, or Amazon probably sold at some point, way too soon. Their founders did not.

The Trend Can Be Your Friend

Another lesson is that technological changes and rising sectors can make you a LOT of money, though it might be a good idea to cash out when it turns into an outright insane bubble.

Musk did that with Zip2 in 1999 and sold parts of his Tesla shares in 2020 and 2021. He might be riding a bubble, but he knows it's a bubble, instead of deluding himself with the "it's a new era" narrative.

“When looking at our actual profitability, it is very low at around 1% for the past year,” Musk says. “Investors are giving us a lot of credit for future profits, but if, at any point, they conclude that’s not going to happen, our stock will immediately get crushed like a soufflé under a sledgehammer!”

www.autoevolution.com

Many growth investors could learn from Musk's realism here.

A Good CEO Is a Workaholic?

For investors, Musk also illustrates the value of a founder and CEO who has his "skin in the game". While it might not be a healthy lifestyle, as shareholders, we might benefit from a CEO that lives and breathes his company in every moment.

Having the majority of management's net worth in the company's shares is also a good predictor of good governance.

The Musk Controversies

This could be a very long section, but we'll try to be brief!

Communication Style

The first thing that drew a lot of controversy toward Musk is his personal style. Part geeky with low social skills, part bombastic or even crass, it is certain to irk a lot of people.

The latest example was a change of Twitter's logo to a cryptocurrency meme image and removing the "w" from the company's headquarters sign.

Previous and more problematic issues relate to financial declarations, like the infamous "funding secured" tweet, which led to an SEC ban on tweeting about financial topics without Tesla's board approval...

Geniuses are often a little strange, and very rich people are often "eccentric". We can safely say Musk is a little of both and really seems to enjoy pushing people's buttons. He sometimes seems unaware that the free speech of a public company CEO is constrained by SEC regulations.

On the plus side, the endless media coverage has turned into the equivalent of tens of billions worth of free marketing for Tesla and Musk's other ventures (Tesla is the only car company spending nothing on advertising).

And with the Twitter takeover, controversies are guaranteed.

Investor Criticisms

As a counterweight to his many fans, Musk also has a cohort of haters. To them, he is a con artist, a scammer, and a fraud, and the same is said about his companies, especially Tesla.

There is a good argument that Tesla stock is in a bubble, with the company valued at one point higher than the rest of the automotive industry combined. Reliability issues and overpromising for features still not available years later *like full self-driving) is a genuine problem.

However, it seems Musk is such a polarizing figure it can make people rather irrational. And the dedicated "TeslaQ" short sellers have, more often than not, lost a lot of money betting against Musk.

For example, SpaceX has single-handily made viable reusable rockets, kicked off a new space race, and reduced the costs of reaching orbit by x10. Tesla proved that electric cars could be a highly profitable and functional product, and is now imitated by virtually every car manufacturer.

So it is more than a little extreme to claim that Elon Musk is just a scam artist who never created anything.

Conclusion

Elon Musk is a rather fascinating character and a sort of Rorschach test for investors: with the same public figure, different people can see completely different things.

Some will see a genius that will save the world from global warming, and disinformation and "make humans a multi-planetary species".

Others will see a grifter lying to investors and regulators, a dishonest figure that needs to be put behind bars.

There are more rational takeaways to learn from studying Musk and his companies' stocks:

• The strength of founder-led companies.

• The importance of long-term holding of quality companies.

• The power of catching rising trends early, along with the risk of irrational bubbles later.

• The value of a strong work ethic and leading by example.

• The potential of unconventional communication and "free" marketing, as well as its dangers.

• The need to stay rational instead of emotional in investing, about both what you might love or hate.

So love him or hate him, every investor can improve by studying Musk.

📚 (This article was largely written based on the book "Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic Future" by Ashlee Vance. This can be a good start if you want to read further about Elon Musk.)

This article originally appeared on FinMasters.com: Investor Profile: Elon Musk

Quick Stock Overview
Seibu by the numbers.

1. Executive Summary
A brief discussion of Seibu Holdings and its potential appeal to investors.

2. Extended Summary
A more detailed explanation of Seibu's business and competitive position.

3. The Great Reopening of Japan
Japan's post-Covid reopening, the weak Yen, and their impact on tourism.

4. Seibu Holdings
A diversified business covering the whole Japan tourism sector.

5. Seibu's Strategy
Strong synergy between all assets, and undervalued land assets.

6. Financials
Stabilizing balance sheet, back to green financials and undervalued market cap.

7. Conclusion

Quick Stock Overview

Ticker: 9024.T

Key Data

• Industry: Hotel / Railroad / Real Estate

• Market Capitalization ($M): 3,530

• Price to sales: 1.12

• Price to Free Cash Flow: -

• Dividend yield: 2.81%

• Sales ($M): 3,130

• Free cash flow/share: -

• P/E: 4.87

1. Executive Summary

Seibu Holdings is a Japanese hotel, railway, leisure activities, and real estate conglomerate. It operates 167km of railway and 83 hotels, most of which are in Japan. It also owns a total of 474 km2 of land, most of which is underutilized and undervalued.

The group suffered during the COVID pandemic, reaching an all-time low in January 2021. It also had to sell some of its hotels in early 2022 to stave off a liquidity crisis. Consequently, the group is trading at a low valuation, assuming little to no growth.

This valuation ignores the fact that Japan is now reopening and coming back to normal. Even the inbound tourist numbers of January 2023, up x83 year-to-year, are still much below the 2019 levels. So Seibu's results should be coming back to a more normal level, in line with its historical performances.

In addition, the Japanese tourism sector is boosted by the short-term trend of the weak yen and the long-term trend of Japanese culture's increasing popularity with younger (and even not-so-young anymore) generations.

Seibu's balance sheet is adequate, even if the group might need to roll over some short-term debt to stay liquid enough in 2023.

In the long run, Seibu's large land holdings are probably where most of the group's total value is locked. Even very conservative estimates indicate these lands could be worth as much as the entire current market cap and maybe several times more.

Seibu will be most fitting for investors with a very long-term focus, willing to trade off liquidity for higher long-term returns.

Read more

But this first part is as difficult in practice as it sounds easy in theory. So this article will go back to the basics. We're not looking at specific companies, we're looking at proven strategies for finding undervalued stocks and how to implement them successfully.

This is a central tenet of value investing, and growth investing as well. The difference is that value investors want the current value to be underestimated by the markets, while growth investors look for an underestimated future value.

Picking the Right Value Metric

Value investors have always focused on calculating financial metrics to determine which stocks are undervalued.

Some of these metrics preferred by Benjamin Graham are familiar to most investors, like the P/E ratio or positive earnings, or a good dividend yield. Others might be less familiar, like price to book value, current ratio, or debt to current assets ratio.

👉 What these ratios have in common is that they paint a picture of the company in 2 dimensions:

1. Risk: debt level, and current assets available will determine if a company would go under after just a few bad quarters. Higher risk makes a low valuation meaningless.

2. Profitability and returns to shareholders: if the risk is acceptable, the company needs to be priced cheaply compared to its profits. It is also best if shareholders' interests are taken into account by the company's management.

Such metrics have been used to find the elusive "margin of safety", which is so dear to great investors like Seth Klarman (follow the link for his full profile).

These ratios are useful but are less powerful than in the 1930s when Graham first wrote about them. This is because back then, they had to be manually calculated, and data had to be found on print first.

Internet databases and algorithmic comparators changed that. Now, a few dollars-a-month subscriptions can allow you to create a screener for any set of "value" indicators you can think of. As this tool became more widely used, the easy pick of "net-net" that made Graham rich became almost extinct. When everyone has access to the same information at the same time, it's hard to use the information to gain a meaningful advantage.

Valuation ratios are still important, but you can't expect them to tell you anything that the rest of the market doesn't already know.

The Macro Method

Stock picking is usually bottom-to-top. You find a potentially interesting company and look at its financials, and then at its industry and competitive position.

Another option is to start from the top. The idea is to find an entire segment of the economy that is undervalued or predict an important event that will affect the market massively, like a change in interest rate, a banking crisis, a war, etc...

The strength of this method is that it can be easier than finding a company that is undervalued. Sectors of the market are often undervalued or overvalued in turn, so there is virtually always one or several large undervalued sectors at any time.

The issue with that method is that it requires the ability to completely ignore the consensus when it is wrong. This can be rather psychologically taxing and hard to do in practice.

Timing will also be an issue. As the saying goes, "Markets can stay irrational longer than you can stay solvent". You can watch the movie The Big Short to see this problem in action, portraying the struggle of Michael Burry for his correct but early analysis of the 2008 real estate bubble (and Burry profile here).

When the approach is using an event-driven macro bet, it can get even more difficult. "Certain" predictions often fail. Irrationality can dominate the market, and international affairs and central bank policy are absurdly hard to predict correctly.

So while potentially very lucrative, this is also a strategy that can lose a fortune, and where humility will pay off. The ability to realize you are wrong soon enough is crucial here, as admitted by masters of this approach like George Soros or Stanley Druckenmiller.

📚 For more detail about this method, you can read our article on the topic: Investing in Hated Sectors: Finding Value in Unloved Stocks.

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The Quality-Driven Approach

We mention that the obvious bargains based on financial ratios have become harder to find as information becomes more widely available.

This was a problem for a disciple of Graham, a man you might have heard of in investing circles: Warren Buffett. Partially under the influence of his partner Charlie Munger, he started instead to focus on the quality of a business above price.

Or, as he put it, "A wonderful business at an okay price is far preferable to an okay business at a wonderful price".

The reason quality tends to outperform other approaches is that, over time, it dominates total returns. The initial purchase price is of little importance if a stock compounds by 25%+ yearly for decades, like, for example, Coca-Cola did for Buffett.

This has been a truly amazing method, and one used by many "super investors" in one form or another, depending on their perception of what defines "quality".

The difficult part here will be to develop the right temperament, a mix of extreme patience, confidence, and humility all at once.

Riding An Exponential

Some trends are bound for an upward trajectory. The internal combustion engine and radio in the 1930s. Microchips in the 1970s. The Internet in the 1990s. Social Media and e-commerce in the 2000s and 2010s.

In the same way that an undervalued sector will see all companies in that field rise at some point, technological revolutions can make a fortune for early investors.

The key is to correctly identify new technology, and distinguish revolution from fads.

For example, there was a bicycle investing bubble in the 1890s. A flood of new manufacturers broke the market and made no money. Bicycles are still around, but they are hardly money-makers for investors. Beauty and health products using radioactive radium were all the rage in the 1920s.

Another caveat is that most "revolutions" go through a bubble stage, like the dot-com bubble in 2000. No matter how important technology will be in the future, there is a point where valuations are too high, and a 60%-95% crash is likely. So most growth investors using this method will need to know when to leave for greener, safer pastures.

👉 The poster child of such an approach is certainly Cathie Wood, with all the upsides and risks it implies.

Using a Unique Advantage

The last option is to use unique knowledge or insight to spot an undervalued company. At a glance, this might seem reserved to experts, like engineers, scientists, or maybe bankers.

It is actually accessible to most people. A housewife will know more about baby products than most specialized marketing analysts. A painter or a plumber will know the quality of brands they use every day better than any hyper-specialized Wall Street analyst. A videogame geek probably knows minutes after a new game release is announced if it will sell well, judging from the reactions of the fans.

This is an approach that can also be combined with the other. For example, Buffett is famous for having stayed out of technology stocks for decades, just because "he did not get it". He preferred to stay in his "circle of competence" like insurance and consumer goods. A traveling salesman might know perfectly which ERP or CRM software is popular in his industry.

👉 A great teacher of this method was Peter Lynch, in his popular book "One Up On Wall Street".

Conclusion

Finding undervalued stocks is probably the most fundamental key to outsized investing success. And it should not be hard in theory. The problem is often that people try a little bit of everything. Instead, they should understand that great investors were always experts at one or two methods.

👉 So the best way is for investors to find what "click" the best with them.

• Are you passionate about history and economics? Then a macro approach might make sense.

• Are you very patient and unlikely to be swayed by stock price fluctuations? Then a long-term, quality-focused approach is probably for you.

• Do you have a unique insight about a specific field because of your job, hobby, or interests? Then Peter Lynch's method is something you should learn more about.

None of these strategies will find undervalued stocks on their own. You will still have to execute the strategy, and that takes discipline and hard work. Choosing a strategy is still an essential first step.

Happy investing!

Changing currency parity is also something investors in foreign markets need to keep in mind. It is worth paying attention to when a major currency loses value very quickly, it is worth paying attention.

The Japanese Yen has recently experienced such an episode, going from almost ¥103/USD in December 2020 to a low of ¥147/USD in October 2022. The Yen has recovered a little since but is still at a 20-year low point. 20%-50% moves between major world currencies are very rare events.

Why Did The Yen Fall?

Part of what shocked the financial market was the speed of the currency's movement. In less than 6 weeks, the yen's value against the USD lost more than 10% from ¥115 to ¥125 and kept falling.

So what triggered it?

It was a perfect storm of factors:

• The Fed raised rates quicker than the Japanese central bank.

• The US economy grew faster than the Japanese economy.

• Rising energy prices eroded the Japanese trade balance end competitiveness.

• The dollar gained strength against almost all the world's currencies.

Some of these causes have since weakened, explaining the partial recovery of the Yen. Energy prices, in particular, have moderated. But this is unlikely to be over.

The unfolding banking crisis stems largely from older government bonds losing value as interest rates rise. It's difficult to sell older bonds with low interest rates when newer bonds with high interest rates are easily available. That means that the immediate value of older bond portfolios drops rapidly.

This hurt banks that were holding large parts of their reserves in longer-term bonds. Japan has held rates low for much longer than any other country, and the ongoing rise in interest rates by the central bank of Japan is likely to cause similar effects.

Without going into a deep macroeconomic discussion, we can say that, in general, inflation with a high debt level is generally negative, especially if the central banks have to raise rates to fight inflation. And Japanese inflation finally picked up: "Japan CPI inflation hits 41-year high in Jan as BOJ changes loom"

So if this setup can cause bank failures in the US or Switzerland, Japan might be at risk as well.

Overall, while certainly not spelling total doom for the yen, the current trends are likely to keep the yen weakened against the dollar for a long time.

Economic Consequences

For the rest of this article, we will consider a Yen that stays weaker than in 2020 or 2021. This is not a "doomsday" scenario. just a weaker Yen staying at the current levels or a little lower.

The primary effect of a weaker currency is that imports become more expensive and exports become more competitive. This is because if a product is priced in yen, but sold in dollars, its export price suddenly goes down 20%-30%.

This is more than the average margin of most industries, making Japanese products suddenly more competitive.

The same phenomenon affects tourism. Hotels, restaurants, and entertainment in Japan, if measured in euros or dollars, are suddenly a lot cheaper.

Or, as the Hokkaido Backcountry Club put it:

Attention guests, we are confident that the borders will be open by next winter. This is the time to book your trip. The yen has never been weaker, and your dollar will never go further.

Hokkaido Backcountry Club

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Investing Takeaways

Because the change was so sudden, the business models and supply chains have not adjusted to it yet. This means shareholders in Japanese companies and investors need to prepare for a few changes.

The Risks

• Japanese companies relying on imported goods or services: If a local company sees all its suppliers' prices in Yen increase overnight by 20%-40%, this can devastate their margins.

• Energy-intensive business models: Japan is very dependent on imports for its energy supply. While the country is looking at restarting nuclear power plants, this will still hurt a lot of power-hungry manufacturing businesses.

• Heavy dollar-denominated debt: Any Japanese business with a lot of dollar debt will struggle, as the yen cost of the debt suddenly went up 30%-50%. This is probably not a common case, but it's something to keep in mind.

Opportunities

There are also beneficiaries of the yen's decrease in value.

Japanese Exporters

With exports cheaper, Japan's robust export economy should be able to capture more market share abroad. But this is true only for a limited set of Japanese exporters with the perfect trifecta:

1. Producing in Japan: they will benefit only if the costs are in yen.

2. Not exposed to energy prices, so nothing like metallurgy or car-making, for example.

3. Not needing to import raw materials and commodities priced in dollars.

Software companies and other asset-light companies that are not energy intensive would be best positioned to gain.

Tourism

The combination of re-opening post-Covid and cheaper prices in a period of global inflation is a powerful one. Tourism companies catering mostly to Westerners would be ideal, to not be exposed to possible geopolitical tensions with China.

Manpower-Intensive Industry

With Japanese workers suddenly cheaper relative to their international counterparts, a business model where human input is crucial will get more profitable. Again, this is true mostly for exporting companies.

Real Estate

Real assets denominated in dollars are on a discount from the yen fall. In addition, Japanese real estate is overall less pricey than most of the developed world markets, after the crazy 1980s bubble. The topic was discussed further by fellow Substack writer Rei Saito at KonichiValue.

"Friend-Shoring"

Tensions between the USA and its allies and the Eurasian powers are not getting better. Just look at the looming TikTok ban in the US and the recent visit of Xi Jinping to Russia. Japan could be a beneficiary of relocating supply chains out of China. Especially for tech segments high on automation and requiring a lot of technical talent, like semiconductors, batteries, renewables, etc.

A Few Companies to Look Into

Nintendo

This is one of the first ones to come to my mind, as this is a company we covered a while ago in the summer of 2021. Nintendo will soon be testing its ability to monetize its abundant and beloved Intellectual Property (IP) beyond video games, with the Super Mario Bros movie coming into cinema in a few weeks.

Nintendo fits the bill of an exporting company, with a large part of its profits made from human intellectual labor in producing software and unique IPs. This does not apply as much to its physical console production, but even these are not highly resource-intensive.

The cherry on the cake? Nintendo should also benefit from international tourists finally being able to visit the Nintendo Theme Park in Japan, which opened during Covid. Two other theme parks will also open, first in Hollywood in 2023, and then in Orlando in 2025.

Japanese Trading Companies

Also known as “Sogo Shosha”, they are some of the key intermediaries between Japanese SMEs and international markets. You can read more about the complex history and evolving business model of Sogo Shoshas in this article by fellow Substacker Value Punk.

Always one step ahead, Warren Buffett invested in these companies in 2020. Buffett's investments were in Mitsubishi Corp. (MSBHF), Mitsui & Co. (MITSY), Sumitomo Corp. (SSUMY), Itochu Corp. (ITOCY), and Marubeni Corp. (MARUY). Follow the link for a summary description of each company.

These companies are shrouded operators that are likely to find ways to benefit from an export boom. Many of these companies are likely to benefit from the "friend-shoring" trend mentioned above.

If you prefer not picking a winner but putting a bet on Japan exports in general, following Warren Buffett's footsteps can be a simpler option than stock picking.

Tourism

This is not a sector I've explored much in the past, so this is just a suggestion to look into by yourself. By searching the most valuable hotel companies in the world by market cap, one Japanese company stands out:

OLC Group (Oriental Land Company) is apparently the largest hotel company in the world. It mostly manages Disney resorts and theme parks in Japan. It could fit the bill of being focused on Western tourists. Still, a potential red flag could be a very high P/E at 107.

Another option could be Seibu Holding, a group managing a chain of hotels all over Japan, as well as railways and bus lanes. It recently had to sell 1/3 of its hotels to gather cash post-Covid. But the remaining portfolio of 45 hotels and leisure locations and touristic network might still be interesting with a current P/E of 4.5.

Conclusion

Japan has been out of favor with investors for almost 3 decades now, and demographic decline and a stagnant economy have given it a bad reputation.

But it is also a very beautiful, modern, and productive country. And the tides are turning if we are to judge by Warren Buffett finally investing in the country for the first time in a 70-year-long career.

Investors need to distinguish "the Japanese market" from specific opportunities. Currently, Japanese exports have a chance to shine from the yen devaluation. In addition, it also benefits from the rise of automation (negating worries about demographics) and the need to relocate supply chains to "friendly" countries.

The key will be to focus on well-capitalized and profitable companies to buffer any banking crisis risk. And to find the right mix of exposure to cheaper exports, but little exposure to rising import costs.

This could, in the future, make it one of the largest economies in the world, or maybe even the largest. It is currently poor on a per capita basis. So there are plenty of challenges in India, but also huge growth potential.

Could India replicate China's success and become a major economic power? And how can investors look to benefit from such a scenario?

India Overview

By most metrics, India is a giant. It has 1.4 billion people, is ranked as the 5th largest economy in the world, and has a territory of 3.2 million square kilometers, or a full 2% of the world's landmass, making it the 7th largest country.

It is bordered to its North by the Himalayan mountains, from which the all-important Ganges river flows, feeding a massive fertile plain. The south is dominated by hills and low mountains. The country is bordered to the North by China, Bhutan, and Nepal, to the West by arch-rival Pakistan, and to the East by Bangladesh and Myanmar.

India is a democracy, and a complex patchwork of ethnicity, religion, languages, cultures, and social orders. This makes it a very hard country for foreigners to understand and analyze. This extreme diversity is both a source of strength and weakness and is reflected in the federal nature of the country.

The level of development, culture, and lifestyle can vary significantly inside the country and between different states. As a rule of thumb, the Northern states are poorer than the Southern ones, with the exception of the states surrounding Dehli, the region containing the capital New Dehli. The richest state is on the Western coast, Goa, a former Portuguese colony.

Relations with its neighbors rank from poor (China) to very poor (Pakistan) to moderately okay (Bangladesh, Myanmar). Due to these overall poor relations, India is mostly looking overseas for partners and allies, notably in the West.

The position as the "world's largest democracy" and a key partner in Asia against China, as part of the "Quad" (Australia, USA, Japan, India), is a key component of India's geopolitical alignment. It is nevertheless part of multiple China-oriented organizations, including the SCO (Shanghai Cooperation Organization) and the BRICS (Brazil, Russia, India, China, and South Africa).

India's economy is dominated by the service sector (55.6% of GDP), followed by the industrial sector (26.3%) and the agricultural sector (18.1%). Some of the leading industries are telecommunications, automotive, and pharmaceuticals. Some of the leading services are software, customer management, and financial/fintech.

The economy is still growing very quickly, with a "slow" year being a forecasted 4.8% growth in 2024, compared to 7% in 2022. The country is somewhat dependent on imports for energy and also relies heavily on domestic coal production for generating electricity.

The Indian model of development has been to "leapfrog" directly toward a service economy, without first building heavy industries, with mixed results. While this created plenty of jobs and allowed growth, it created success in the IT industry; it also left the country with poor infrastructure, like clogged roads, outdated railroad systems, an unstable electric grid, and poor sanitation. A new emerging model is to focus on growing the economy while also boosting infrastructure investments.

Another hindrance to growth is a notoriously massive and all-encompassing bureaucracy. In the words of President Obama:

Despite its genuine economic progress, though, India remained a chaotic and impoverished place: largely divided by religion and caste, captive to the whims of corrupt local officials and power brokers, hamstrung by a parochial bureaucracy that was resistant to change.

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India's Strengths

With China now a world power able to directly rival the USA, India gets a lot of attention as the "next China". The comparison makes sense as India has many features in common with China a few decades ago:

• A massive and growing population: The average Indian is just 28 years old. The large population provides a deep labor pool and a large internal market.

• A good level of education: India is ranked 32 in the education ranking, putting it at the level of Poland (26), Portugal (25), and Brazil (36). Combined with the population size, this provides an enormous pool of skilled professionals whose talents are largely underused, leading to large-scale outmigration. India has the largest ever adolescent and youth population and the third-largest group of scientists and technicians in the world.

• A solid saving rate at 31% of Gross National Income, above Germany's (27%) and below China's (45%), providing capital for economic development.

• Upcoming plans for infrastructure: aware of the problem, the government is planning a massive infrastructure build-up through the "National Industrial Corridor Program". This should boost public spending and the overall efficiency of the economy.

India's Weaknesses

The main weaknesses and threats to India's economy are not so much economic as political and social.

• Internal divisions:

  • Religious tensions between the Hindu majority and Muslims, Christian, and Sikh minorities, led to frequent clashes, riots, forced conversion, and repressions.

  • Social divisions: urban vs. rural, men vs. women, poor inter-caste relations, the rivalry between states, there is no shortage of fracture lines in Indian society.

• Geopolitical rivalries: India is frequently clashing with its neighbors. Since the 1947 partition of India, the country has been at war with Pakistan 4 times, most recently in 1999, with ongoing tensions over the status of the Kashmir region. The China-India border is another flash point, with a clash between the two's armies as recently as December 2022. Both Pakistan and China are nuclear powers.

• Inefficient state and bureaucracy: even if democratic, the Indian state is relatively corrupt (ranked 85th on 180). This hinders entrepreneurship, initiative, and infrastructure building.

Middle-Income Trap

For many emerging economies, the danger of the middle-income trap is a serious one. This is where an economy develops up to a point, but then hits the ceiling and is unable to go up in the value chain.

"a country in the middle-income trap has lost its competitive edge in the export of manufactured goods due to rising wages, but is unable to keep up with more developed economies in the high-value-added market."

To some extent, India could look affected on a surface level. At the same time, its performance in high-value sectors like IT does not fit well with the middle-income trap thesis, as such Indian exports are competitive. Base commodities export is not a key part of the economy.

So solving corruption and internal tensions, and reducing bureaucracy should boost growth as the pre-existing base of high-performing specialists and industry is already in place.

Timing the Market?

The Nifty50, an index gathering the 50 largest companies in India, has recently hit an all-time high in early 2022 at 18,400, or a 6.5x performance since 2009. So there might be an argument that some of India's potential performance is already priced in.

In 2021, at lower stock market levels, the Reserve Bank of India was warning of a potential bubble. So while the long-term trajectory of India seems to be one of growth and development, some caution is advised in terms of market timing.

Company Spotlights

At this stage of growth, it is unclear which company could be the future Indian Alibaba, Huawei, or TSMC. So instead of making uncertain bets on technology and Indian development, large companies that will grow with the economy are probably a safer bet until more national champions emerge.

Reliance Industry (RIGD.IL)

The company is India's largest conglomerate and one of the country's most profitable companies, employing around 30,000 people. It is mostly active in telecommunication (mobile network & broadband) and energy & petrochemicals (especially refineries), but also retail.

India is still underequipped in cars and digital appliances, and economic development is likely to benefit Reliance. Internet penetration is just 47%, leaving 742 million with no use of the Internet in 2022. An extra 250 million new smartphone users are expected by 2026.

With a P/E of 23.6, Reliance does not seem cheap, but not overpriced either.

Its ownership of licenses for mobile and land-based Internet is likely going to prove quite valuable on the last spur of Internet utilization growth in India. This is one case where a slow liberalization bureaucracy could play in favor of investors.

Tata Group (TATAMOTORS.NS)

Another extremely large Indian conglomerate, Tata is not open to direct investment at the group level. Several subsidiaries are trading separately, in fact, a total of 29 different listings. Some of the most notable are described below.

Tata Motors

The owner of the brand Daewoo, Jaguar, and Land Rover, as well as joint ventures with Stellantis and Hitachi (for heavy construction equipment). The company produces around 1.1 million vehicles per year.

The company has historically struggled to be profitable and had a few low-cost car projects failing in the past, like the Tata Nano.

It is also active in the defense sector, a segment that might benefit from a push to localize weapons supply and reduce dependency on Russian suppliers, and with India the second largest army by personnel number, just before the USA and below China.

Tata Steel (TATASTEEL.NS)

The company operates in 26 countries, with a focus on India and Europe. It produces 30 million tons of steel yearly. It intends to double its Indian production by 2030 and reach a total production of 40 million tons of steel by the same date. It also plans to double its iron mining capacity from 30 mtpa (million tons per year) to 60-65 mtpa.

Some of its business in Europe is suffering from elevated energy prices, but that might be compensated by India sourcing cheap energy from Russia.

The current P/E at 4.47 is carried by rising steel prices. The cyclicality of the industry is something potential investors have to consider.

Adani Group (ADANIENT.NS)

This company is worth mentioning as it is at the center of maybe the largest-ever controversy in the Indian investing landscape, which you will not fail to hear about if looking into investing in India. Its stock chart was definitely an ... interesting one, from a low of INR141 in April 2020 to a high of 3,917 in November 2022, followed by a precipitous fall.

The crash was induced by a report from Hindenburg research, accusing Adani, the man behind the eponymous group, of "the largest con in corporate history".

I will leave it to readers to judge the veracity of these accusations and if the price fall is enough to justify the obvious risks attached to this stock. The current P/E ratio is still 90.

ETFs

If you want to invest in India as a whole, an ETF might be a better option.

First Trust India NIFTY 50 Equal Weight ETF

A common way is just to target the largest companies, similar to the S&P500 in the US. In India, it is the aforementioned NIFTY 50. For this, the First Trust ETF, with equal weight for each member of the Nifty 50, can be a good option.

Columbia India Consumer ETF

This is an ETF with equal weight on consumer companies in India. This makes it a bet on the rising purchasing power of Indian consumers. It is roughly equally split between discretionary items and consumer staples.

iShares MSCI India Small-Cap ETF

While it might be too risky to stock pick along smaller Indian companies, an ETF can spread this risk over the whole market. This iShares ETF is focused on Indian small caps, with a focus on industrials, financial services, basic materials, and healthcare.

India Internet & Ecommerce ETF

Because most of India's international competitiveness in India comes from the IT sector, this can be a center of interest for overseas investors. The largest holding of this ETF is Reliance (7.71%), followed by other IT companies and logistics, including railroads.

If India is to persist in relying mostly on this sector to fuel its growth, this is the ETF the most likely to capture these gains. So investing in it will depend mostly if you judge India's plans for rebalancing toward more industries, infrastructures, and "made in India" realistic.

Conclusion

India is a country with a lot of promise. It has also acquired a bit of a laggard reputation among its peers like China, Indonesia, and Vietnam. The persistence of corruption, bureaucracy, and a divided society are the major reasons for this relative underperformance.

Some level of geopolitical risk should also be included, even if, for now, India has craftily managed to strike a balance between the nascent Western and Eurasian blocs.

Nevertheless, from an investing standpoint, India has developed a lot, just not as quickly as China, the quickest development story in the entire history of the world. And contrary to more mature emerging markets, it still has tremendous space to grow before turning "emerged". Its unique development pattern should also protect it from the middle-income trap.

Investing targets are mostly large conglomerates for now, partially due to such corporations being more able to navigate the country's economic system. In the longer run, investors in India will want to diversify and capture early future national champions in technology, utilities, energy, consumer goods, localized e-commerce, etc...

Finding Value in Emerging Markets

Stock Spotlight has regularly covered stocks in emerging markets, which can offer great companies at discounted prices. After a decade of outperformance for the US stock market, it might be time for emerging markets to shine. This cycle between emerging market (EM) vs the US tends to be roughly 10-15y long, as you can see below. With the S&P500 outperformance started in 2010, we are due for a reversal in trend.

Source: Western Southern

Past patterns may not be repeated, but the investing world still extends beyond the US, and increasing numbers of investors are considering exposure in non-US markets!

Emerging Value
This is a series focused on opportunities in emerging markets. The goal is not to discuss breaking news. Instead, we will focus on long-term trends and lasting phenomena that will impact investing in a country or region. It will also look at a selection of companies that might be worth a deeper analysis.

Quick Stock Overview
CoolCo by the numbers.

1. Executive Summary
A brief discussion of CoolCo and its potential appeal to investors.

2. Extended Summary
A more detailed explanation of CoolCo's business and competitive position.

3. The Not-Over Energy Crisis
Europe's permanently increasing need for LNG.

4. The Coming Supply Chokepoint
Why shipping is the most in-demand part of the LNG supply chain.

5. CoolCo
A rare pure player in LNG shipping.

6. Financials
Growing cash flows, generous dividends, and low valuation.

7. Conclusion

Quick Stock Overview

Ticker: CLCO

Key Data

• Industry: Energy / Shipping

• Market Capitalization ($M): 687

• Price to sales: 4.26

• Price to Free Cash Flow: 5.97

• Dividend yield: 3.05% (12.5% annualized)

• Sales ($M): 161

• Free cash flow/share: $4.18

• P/E: 16.4

1. Executive Summary

The Ukraine war has put a spotlight on the danger of Europe's dependence on Russian energy supplies. This is especially true for natural gas, which the EU consumes in massive amounts to power it's electric grid, run its industries, and stay warm in winter.

The pipeline gas that Europe received from Russia was inexpensive, but a pipeline can only move gas from one source, and Russia's political instability makes dependence on Russian gas unacceptable. LNG terminals make an ideal alternative. An LNG terminal can receive gas from anywhere, avoiding the problem of being tied to a single supplier.

This led to a flurry of construction aimed at building infrastructure to receive and process LNG. This leaves one unsolved chokepoint that is little discussed: LNG shipping.

LNG can only be shipped on specialized vessels, and the current fleet is not dimensioned for the sudden surge in European demand. At the same time, shipbuilding capacity is not able to add new supply quickly, as it is already running at 100% capacity after many shipyards went bankrupt in the 2010s.

Worse, new pollution regulations are forcing the retirement of a large portion of the existing fleet.

This gives a unique opportunity for CoolCo, a pure play in LNG shipping. Its modern fleet is unaffected by pollution regulations. Its ships will be able to capture most of the upside when buyers outbid each other to obtain precious supplies ahead of the coming winters.

2. Extended Summary: Why CoolCo?

The Not-Over Energy Crisis

The Ukraine war has dramatically increased Europe's need for LNG. This has dramatically increased global demand, as Russia's pipeline gas cannot be redirected elsewhere for years. 75% of Russia's gas pipeline net runs to Europe, and the existing pipelines to Asia can carry only a small fraction of Russia's output.

This created a logistical nightmare for the EU.

The Coming Supply Chokepoint

Gas and LNG producers are expanding capacity as fast as they can. The EU has also rushed new facilities to process and collect this supply. But shipping is a chokepoint that cannot be solved as easily. Limited shipping capacity is leading to increasing day rates, multiplying the margins of LNG shipping companies.

CoolCo

CoolCo is one of the only publicly traded pure-play LNG carriers. It operates a modern fleet that will benefit from its competitors being forced to retire vessels due to new stringent pollution regulations. Increasing shipping day rates could bring its Free Cash Flow to Equity up to a 30-50% yield.

Financials

CoolCo has growing revenues, profit, and cash flows. It has some debt, but most repayment is scheduled for 2025 and 2027. Its policy is very shareholder friendly, with most free cash flow distributed in dividends and expected double-digit dividend yields.

A New Listing

CoolCo filed for a direct listing on the NYSE on February 14, 2023. The Company completed the regulatory process on March 10 and asked the SEC to declare its registration effective on March 14.

The registration has been approved, and CoolCo shares commenced trading on the NYSE on March 17, 2023, under the symbol CLCO. Trading on the Oslo exchange will continue.

Up until this time CoolCo has traded on the Oslo Euronext Growth exchange in Norway, restricting access for US investors and limiting the stock's visibility and profile.

Read more

Emerging markets can be tempting, but for many investors, they are a completely new world. Here are some points to consider as you build an emerging market portfolio.

Does Emerging Market Investing Work?

In our previous article on Brazil, we explained how the US and emerging markets tend to follow a roughly 10-year-long cycle of alternating performance.

Looking at an even longer timeline, the MSCI USA index has never been higher compared to the MSCI World Index in 50 years. So it might make sense to expect a reversion to the mean at some point in the future.

There are never any guarantees, but these indicators do suggest that exposure to a diversified emerging market portfolio is a rational move.

Understanding Emerging Markets

Here are some of the features that characterize emerging markets.

Strengths of Emerging Market Investing

One of the key characteristics of emerging markets is their growth profile. Most have shown 5-10% GDP growth over several decades. Investments in such countries have generally done well, as “a rising tide lifts all boats”.

They are also generally countries with young and growing populations. These demographic trends are supportive of economic growth.

Another factor that is very real but hard to quantify is the “grit” of emerging markets. People that have known dire poverty until 1-2 generations ago tend to be hard-working, resourceful, and ambitious. If the entire society is focused on seizing the opportunity and achieving economic growth, this usually pays off.

Dangers of Emerging Market Investing

The first risk with emerging markets is the same argument we started this article with. They tend to outperform in some periods and underperform in others. So investors need to acknowledge that cyclicality and avoid overstaying their welcome.

Another risk is that many emerging countries are not democratic or have weak rule of law. Corruption and legal instability are common, and forced nationalization is always possible. Paying attention to local politics and social situation is a must, as is a diversified portfolio that avoids overconcentration in a single market.

One last problem is the immaturity of these markets. Reporting standards may be low, regulation is often weak, and many companies might not publish their reports in English. Accounting practices might not be up to international standards. Governance might be less than ideal. Finding a broker giving access to these markets can be a challenge. Overall, emerging markets are more complicated and require a lot more due diligence.

Because of the weakness in reporting standards, the difficulty of gaining access to accurate information, and the challenge of finding a broker that handles emerging markets, emerging market portfolios rarely focus on individual stocks. ETFs are a more common vehicle.

Building an Emerging Market Portfolio

Here are some ways to build an emerging market portfolio:

Geographical Diversification

It is easy to see emerging markets as a uniform blob. Most of the time, though, sub-regions will have a common pattern not shared by others.

Historically, specific areas have been known to outperform or underperform for their own peculiar reasons. For example, the 1997 Asian financial crisis or the 1980s Latin American debt crisis.

With geopolitics once again relevant to markets, geographical diversification is a must for any emerging market portfolio. For example, South America and Africa would not be impacted the same way as Asia in case of a Taiwan crisis.

There are a number of common groupings, like the MINT (Mexico, Indonesia, Nigeria & Turkey), The BRICS (Brazil, Russia, India, China, and South Africa), or the “Next Eleven” ( Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey, and Vietnam).

Country Profile Diversification

Not all emerging markets are the same. Incorporating different macroeconomic profiles in a portfolio can help reduce volatility.

Commodity-Based Economies

Some emerging economies rely on commodities for 80%-90% of their exports. This is most common in Africa and some parts of South America.

This will mean that the economies and even the political stability of these countries are deeply tied to international commodity prices. Sometimes, only one commodity, like cacao, sugar, or palm oil, will be the backbone of the country’s prosperity.

Emerging Industrial Powers

The best example of economies that “emerged” using this template are Japan and South Korea. It is the path currently being followed by China or Poland. The economic growth is built on the back of its integration into the globalized economy, and its ability to manufacture goods at a competitive price.

The cost of labor, quality of infrastructure, political stability, corruption levels, and overall international competitiveness will determine the country’s future success.

Petrostates

Most common in the Arab Gulf region, these are countries whose main added value to the world economy is fossil fuels. These countries will prosper or suffer recession depending on global energy prices and the oil & gas supply and demand.

Middle-Income Countries

These could be called “semi-emerged countries”. They are more developed than most “developing markets”, but not to the West or Japan’s level of prosperity either.

They are at risk of the “middle-income trap“, which describes the situation of an economy failing to transition to high-added value goods, but also trying to develop and grow mainly or solely by exploiting cheap wages or commodity exports.

If they manage to escape this trap, they will go on to become fully developed countries. In many cases, this progress has been impeded by rule of law issues and the dominance of self-interested neo-feudal elites.

Sector Diversification

Not all emerging markets are producing the same goods or are active in the same sectors. Clothes manufacturing in Bangladesh had little to do with car parts manufacturing in Poland or Mexico or call centers in India.

A good emerging market portfolio should be diversified in multiple industries and economic sectors.

Following Known Templates

With globalization at full speed in the last decade, we now have a few proven successful development templates. This gives investors the chance to estimate which emerging markets are the most promising and which are at risk of soon stagnating.

Cheap Labor and Climbing the Industrial Value Chain

This is the pattern followed by Japan and South Korea. And currently imitated by China.

The idea is to first capitalize on cheap and abundant labor for industries like textiles, shoes, toys, and other simple manufactured goods, then progressively use the created capital to buy better machinery, finance R&D, and boost education.

This allows a country to start making more valuable products like cars, computer chips, appliances, TVs, ships, etc., and capture more of the added value on the way.

Service-Driven

This is the model followed by India. The idea is to directly skip the industrial stage and immediately target the growth of the service industry. This can include things like call centers, delocalized customer service, and software.

This is a more debated model, with the risk that the lack of an industrial base stays a handicap for the country. Good infrastructure, adequate education, and limited bureaucracy (quick Internet, stable power grid, good roads, clean water) are a must for it to succeed.

Many service-driven economies, notably India and the Philippines, also rely heavily on labor exports and remittances.

Infrastructure or Speculation-Driven

This is often the low-hanging fruit for many governments. Public spending on new highways, railroads, dams, real estate, etc., can create a lot of jobs and economic growth. And it “only” requires taking on a lot of debt.

This is by far the riskiest and less durable method of development. The resulting asset bubble tends to pop and might lead to decades-long periods of stagnation. Japan in the 1990s or Greece in the 2000s made that mistake, and it is possible that China is in a similar situation currently.

These economies can post exceptional growth figures for some time, which attracts many investors. If the investments driving the growth do not generate enough long-term ROI or if too much debt is incurred to finance them, this growth is not sustainable.

Specialization

This is usually a viable option only for small countries. It can be a focus on finance (Singapore) or IT (Estonia), or even tourism (Maldives, Belize). The idea is for the country to become excellent at ONE thing, counting on this sole activity to bring enough foreign currency to buy the other things the country needs and does not produce itself.

This can a sensible approach for small jurisdictions. Small countries with just a few million people will never be independent when it comes to the supply of chips, cars, or natural resources. So a good commercial balance and competitiveness in the chosen sector can be enough to produce quick results.

Sector Rotation with Development Stages

A good comparison to past patterns will also give investors an idea of what stage an emerging market is in. When a country starts developing, it usually sees a lot of growth in the same sectors for a given stage.

First, solving the most basic needs with a rise in:

• Cement consumption & production and real estate.

• Utilities (power, water).

• Agricultural tools and fertilizers.

• Simple consumer goods like AC, meat, bikes & motorcycles.

• Simple industrial equipment.

When the essential need of the population is more satisfied, other sectors take the relay, counting on the emerging middle class:

• Higher education.

• Basic healthcare.

• Advanced industrial equipment.

• Cars.

• Luxury goods (jewelry, imported liquor, …) and brands.

• Electronics.

• High-end real estate.

• Overseas and domestic tourism.

• Restaurants, cafes, and fast-food chains.

Finally, when a country really “emerged”, it starts to adopt developed countries’ consumption patterns.

This is also often a phase where the country is feared to soon “take over the world”, like Japan in the 1980s or China currently. While its growth is likely to actually slow down from there, contradicting simpler linear projections.

• “Luxury” healthcare like fertility clinics or cosmetic surgery

• Luxury cars.

• High-end electronics.

• Safety and social security nets (insurance, pensions, etc…).

• Sophisticated investments and finance.

• Legal services.

• Social media and entertainment.

Analyzing consumption and investment trends can help us understand the true development level of an economy.

Conclusion

Investing in emerging markets has been a very successful way to make money in the past decades. It is also now somewhat following well-studied and known patterns that can guide investors.

Nevertheless, this should not distract from inherent risks due to weaker rule of law or less than modern accounting practices. It is also possible that previous “recipes” fail due to the growing international tensions and the “deglobalization” trend.

As always, diversification will help reduce risks. Investors that spread their assets across several of the categories described above will see less volatility and less risk than those who focus on one type of emerging economy or a small group of emerging markets.

Emerging market investing requires more work, as each country has its own specific opportunities and problems. You can bypass some of that work with generalized emerging market ETFs or funds, but if you’re serious about emerging markets, you’ll want to look more closely at individual markets and their risks and opportunities.

Emerging Value

This is a series focused on opportunities in emerging markets. The goal is not to discuss breaking news. Instead, we will focus on long-term trends and lasting phenomena that impact investing in a country or region. It will also look at a selection of companies that might be worth a deeper look.

Before he became an author, Taleb was also a very good trader and developed a unique strategy to manage risk and benefit from unforeseen events.

Who Is Nassim Taleb?

Taleb was born in Lebanon to educated professional parents: an oncologist and an anthropologist. His family was influential in Lebanon, with a Lebanese supreme court justice and deputy prime ministers among his relatives.

Through training and early career, he is both a trader and a mathematician, with a specialization in statistics, derivative pricing, and the role of randomness. This background allowed him to hold multiple roles in risk management at firms like Deutsche Bank, BNP Paribas, and UBS.

He made most of his money during crashes, first in 1987, then in 2000. In 2007-2008, he was the chief advisor to several funds that brought returns of 65%-115%.

Nassim Taleb Core Thinking

The basis of Taleb's thinking is the mismatch between the models used in finance and real-world real risks. He explains that many events are possible but that this non-zero probability is ignored by most observers, who rely on faulty assumptions and/or datasets.

He nicknamed such an event "Black Swans." Until black-colored swans were discovered in Australia, we believed that all swans had to be white. It was not impossible for these birds to be black, but we built our conviction on an incomplete dataset.

The idea was detailed in his 2007 book The Black Swan: The Impact of the Highly Improbable. The book followed his 2001 Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets and cemented his reputation as a foundational thinker and philosopher.

The black swan theory emphasizes that what was previously considered impossible can suddenly become a reality. It is often the ones the less aware of the black swan possibility that are the most affected.

The theory became extremely popular in financial circles over time. Its publication coincided with the 2007 crisis, when it became obvious that the risk models used by the financial industry had not correctly measured the risk of a financial crisis, leaving complex derivative products like mortgage-backed securities heavily exposed.

This idea can extend way beyond the realm of financial modeling. It has even become popular to call any surprise event a black swan. The Covid pandemic is an example, although Taleb himself sees the pandemic not as a black swan but as a sign of a society that has grown more fragile.

Other Taleb Insights

The black swan theory is Taleb's most famous idea, but it's far from the only one. There are other recurring themes in his thinking.

Antifragility

Most risk management systems classify things into 2 categories: fragile and robust. Fragile items or portfolios will be damaged or destroyed by external shocks. Robust systems will survive shocks, even if they might be a little dented.

Taleb argues that there is a third category he calls antifragile, which thrives in a crisis. He expands this idea far beyond portfolio risk management, discussing how it can apply to entire companies or even nations and civilizations. He elaborated further on this idea in the book Antifragile: Things That Gain from Disorder.

Skin In The Game

This is a concept he actually touched upon in a previous book but really shaped into a full concept in one of his latest publications, the book published in 2018, Skin in the Game: The Hidden Asymmetries in Daily Life.

In the book, he argues for the need for decision-makers to be directly exposed to the consequences of their decisions for society to function. He also warns, in a theme that runs through most of his books, against the "intellectual-yet-idiots," well-educated intellectuals using complex models and thinking to arrive at blatantly wrong conclusions.

Why Does Nassim Taleb Matter?

Many of Taleb's ideas might, on a superficial level, seems obvious. But the more you think or read about them, the more you realize how profound they are.

For example, the idea of antifragility. Should we make our society antifragile, so it thrives when facing a pandemic, a hurricane, or a war? That sounds nice but at what cost? How do you balance the need for efficiency (often coming with increased fragility) with the need for antifragility?

Or how do you account for and plan for the risk of black swans, like the war in Ukraine or maybe even a Chinese invasion of Taiwan? For that matter, do the decision-makers on these issues have "skin in the game"?

Taleb's Style

One last thing worth noticing is Taleb's rather unique style of communication.

He can be very sarcastic or even outright insulting to people he disagrees with. Being called a "stupid idiot" is very possible if you interact with Taleb's Twitter profile. Random musings about the superiority of weightlifters over everyone else are also to be expected.

For this reason, he has often been criticized for being a little too confident or thinking too highly of himself. I think some of this criticism is justified; the man definitely seems to have an ego, combined with a rather aggressive style from his trading days.

I would not let that deter readers from his work. He is an insightful writer and there is plenty to learn from his work. Some of his most virulent critics have a personal beef against him after debating with him and not really enjoying the experience.

Nassim Taleb's Opinions on Current Markets

Taleb has centered his career and philosophy around risk management, so unsurprisingly, this is mostly his concern when it comes to today's markets.

He has stated that:

The stock market is way too overvalued for interest rates that are not 1%. I think that we may have a collapse in many, many prices

Nassim Taleb

Despite his skepticism of the US stock valuations, he is even more negative about other markets: "A positive for the U.S. is it is still considered the safest place to invest with the highest credit rating." Taleb believes things will be much worse in other countries such as Egypt, Europe, and even Japan...

Trading Using Taleb's Method

Taleb is not actively trading anymore, so there is no fund we can analyze to see how his opinions translate into actual holdings. However, we can look back at what he did when he was a trader.

A big part of his strategy relied on options, especially deeply out-of-the-money options. This is how he made millions in the "lucky" crash of 1987, more in one day than in the previous 5 years of work.

Investors willing to learn from Taleb not only philosophy but also trading will look at his barbell strategy. The idea is to be exposed to almost exclusively low-probability events.

So you might keep some very low-risk assets, like cash, to provide safety in case of unforeseen risks and very high-risk assets, like options or derivatives, to pump up your returns, with nothing in the middle.

Needless to say, this can be a rather complex method and not for the faint of heart. It was fitting for Taleb, a mathematician, and an aggressive and technical trader who enjoyed risk-taking but would not fit the large majority of investors.

Conclusion

Nassim Taleb is a very influential thinker, and rightly so. His books have changed how millions of people understand and manage risks.

His impact has expanded far beyond finance or economics and reached into politics, sociology, and even international affairs, to the point that the term "black swan event" is overused and stretched far from its original definition.

He has also a very assertive personality and can sound like a doomsayer at times.

Still, as one of the most famous risk experts in the world, we should listen to his warnings, keep ourselves ready for the inevitable black swans, and maybe even make our lives, portfolios, and society more antifragile.

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This article originally appeared on FinMasters.com: Investor Profile: Nassim Taleb

2023 looks set to be dominated by the same trends. Inflation is still high, and the Fed has signaled that it will continue hiking rates. Markets remain vulnerable.

With many of the influences that dominated 2022 set to carry on into 2023, it’s worth looking closely at the most successful funds of 2022 and the strategies that propelled them to their gains.

3 Top Performing Funds of 2022

Picking the top 3 funds for any period depends greatly on the criteria chosen. Should we include ETFs or just managed funds? Only active or also passive? Only equities or also bonds? Only US or anywhere in the world?

This list is designed to reflect what worked in 2022 and give us a full view of the possible strategies instead of focusing purely on performance on a percentage basis.

1. iShares MSCI Turkey ETF

With 106% returns in 2022, this ETF has outperformed the others by a wide margin. It was followed by a bunch of energy-focused ETFs returning 60%+.

The 2022 performance of the iShares MSCI Turkey ETF comes after a very long period of decline that started in 2012. Part of the reason for the performance was the fund hitting a low of $19.62/share on January 2022.

Some of the 2022 outperformance has faded due to the catastrophic earthquake that recently hit Turkey and Syria, the worst in decades. But this is obviously something that could not have been predicted and does not change the record-breaking returns of 2022.

Increasing trade with Russia due to the somewhat ambiguous position of Turkey in the Ukraine war helped boost Turkey’s businesses and may account in part for the surge in Turkish stocks.

Still, with inflation still not under control and an economy in poor shape, it is not clear if Turkey is out of the woods yet, or if this is a technical rebound in a still ongoing long-term decline. The gains in 2022 were impressive, but there is no assurance that they will be repeated in 2023.

We can deduce a lesson from this fund, but the lesson is not to rush out and buy Turkish shares. This fund staged a dramatic recovery after several years of losses. That doesn’t mean that every losing index will turn around and win, but it does underscore the reality that to buy low and sell high, you have to start by buying low.

Next year’s biggest winner may be languishing in an oversold state today.

2. Simplify Interest Rate Hedge ETF

The only ETF that came close to Turkey funds was a fund dedicated to hedging against rising interest rates risk: Simplify Interest Rate Hedge ETF.

It started the year at $37.54/share and went up to $85 in a brief spike, to then decline to then have a second spike just on 31st December 2022 at $71/share.

Inflation has been persistent in 2022, forcing central banks to raise rates. This has been devastating for bond investors and highly profitable for hedges against interest rates.

Inflation has slowed to some extent but remains at historically high levels. The Federal Reserve has signaled that rate hikes will continue, and most analysts expect high rates to prevail through 2023.

That does not necessarily mean that this fund will repeat its performance, but that performance does illustrate the value of locating investments that ride – or hedge against – rising macroeconomic trends.

3. iShares S&P 500 Energy Sector UCITS ETF

Energy was the great winner of 2022 among all sectors, with the iShares S&P 500 Energy Sector UCITS ETF returning 85% in 2022. Altogether, energy ETFs represent 8 of 10 of the best-performing ETFs in 2022.

Source: Trustnet

Obviously, the energy war by Russia on the EU was the driving factor, but so was the chronic under-investment in production capacity since the oil price crash in 2014. The rapid shift from tumbling demand and negative oil prices in 2020 to peak demand exacerbated by war put energy in a high-profit spotlight.

Beyond oil & gas, coal also performed very well, with stocks like Peabody (BTU), which almost tripled in 2022 and up 29x since its lowest point at the end of November 2020.

Common Features of Successful Funds in 2022

Recovering Hated Sectors

The common thread between Turkey and fossil fuels is that they are sectors that were deeply hated in 2020-2021 after a long decade of decline and underperformance. Starting price matters, and betting on a sector or country left for dead is often a winning strategy.

Interestingly, this outperformance happened even when the sectors in question were far from fully recovered. Turkey’s inflation was 64% in 2022, and oil prices have struggled to stay above $80/barrel despite repeated production cuts by the OPEC+ cartel (OPEC + Russia). They might still have potential before the trend reverses.

Macroeconomics

The other theme of 2022 was the return of macroeconomic risk. Both energy and inflation made a dramatic comeback after years of being irrelevant. The war in Ukraine, but also persistent underinvestment in commodities and infrastructure, played a big role in causing it.

This might still play a role in 2023, but with likely subtle variations around the same theme (see below).

Investing Ideas From The Lesson Of 2022

1. Buying When There is Blood on the Streets

The first idea is to look for sectors that are out of favor, with persistent losses for years, ready to turn around.

One possibility is cannabis, which has gone from low to lower for a while now. This is a vector that we covered recently in this report.

Another one could be Chinese tech. It has recovered a little from the lowest points but is still far from recovered. Some sectors of international or US tech might be also getting low, but they would not really fit the bill of “hated for years” as they all reached all-time highs in 2021. So for recently down tech, if their growth profile is still intact could be a good move. The next Stock Spotlight report will cover such an e-commerce company.

The most daring investors might even want to test their luck with really risky bets like Ukrainian stocks, certainly trading at a huge discount (justified, in my opinion). I would, however, not want more than 5% of a portfolio on this idea.

2. Persistent Trends

Energy

This might sound paradoxical, but when a 10-year-long trend reverses, it usually takes time to run before losing steam. So we could expect energy or inflation-driven investing ideas to work as well in 2023, even if maybe not to the extreme levels of 2022.

This is something we will discuss in an upcoming report looking into a company involved in the logistics of gas transportation to the EU.

Inflation

Inflation is a more tricky question as it hinges on so many variables:

• Central bank decisions

• Supply chain issues

• Energy costs

• Geopolitics

Because of the inherent incertitude in predicting any hyper-complex macro data point like inflation, I would not recommend going all in on this topic. Keeping an eye on its potential effects, both positive and negative, is nevertheless recommended.

3. Black Swans and Hidden Risks

What may be more relevant is looking at macro risks that markets are dismissing too easily. The world was complacent about “transitory” inflation for a while. Something similar but unrelated to inflation might play out in 2023.

Maybe an intensification of the US-China tensions is something that’s not getting enough attention. If the recent panic about spy balloons shows us something, it is that both countries’ defense and intelligence communities are on the edge.

Trouble in the Middle East is also an option, with the recent mysterious bombing of military factories in Iran. Food prices could become a global issue if the Ukraine situation continues to deteriorate.

4. Something New and Unpopular

The investing principles illustrated by the success of the largest funds can be deployed at a smaller scale. An off-the-radar country or a single company out of favor can provide good returns if the fundamentals have turned around, but the markets have yet to realize it.

This can also include very large companies, with Tesla, Meta, Warner or PayPal down by more than 60% in 2022 and among the top 20 worst-performing stocks for the year.

Keywords like “worst performance,” “crash,” “sinking or tanking markets,” or “death of X” could be good indicators of something ready to rebound, if not for 2023, then 2024. The key is to avoid or at least manage the potential value traps:

• Danish Stocks Are World’s Worst Performing in 2022 Rotation

• Forget Crypto Winter. In Biotech, It’s Been Freezing for Months

• 2022 was the year crypto came crashing down to Earth

• The cannabis collapse: Why weed stocks are crashing again

• Tech’s reality check: How the industry lost $7.4 trillion in one year

• Petro’s Dividend Taxes May Almost Kill Off Colombia Stock Market

• Brazil Markets Sink as Traders Mull Lula’s Plan to Beef Up State

Conclusion

With hindsight, it is easy to claim energy would be the winner of 2022. All it took was correctly predicting the invasion of Ukraine, the problem of a global underinvestment in production capacity, and China ending its COVID policies. Not many analysts got even one of those right, even less all.

As the saying goes, “predictions are hard, especially about the future.”

This is why portfolio construction, risk management, and margin of safety are such important concepts. For example, tech investors that took some chips off the table in 2021’s all-time highs are probably okay. So are investors in emerging markets that took distance from Russia early enough.

The trick is not to let caution turn into fear or paralysis. The too-good-to-be-true prices of energy stocks in early 2022 were NOT a mirage. Fast-growing and profitable tech companies are likely still a good deal, irrespective of recent price actions.

Maybe Columbia or Brazil will be 2023’s Turkey (we just published a full article covering Brazil’s risks and opportunities). Or Biotech turns around when no one pays attention to it.

Stock pickers willing to do the work can look for the intersection of several trends. South American energy companies, biotech specialized in cannabis, Danish tech companies, any combo that might make sense and detect a bombed out price for an otherwise good company.

Of course, there are no guarantees – there never are – but when markets are beaten down, there will be opportunities. Looking at what succeeded in similar conditions can help!

Learning from Markets
These articles look at recent and not-so-recent market history to learn timeless investing lessons. It will also thrive to articulate these lessons into ideas or trends relevant to today’s markets and investment strategies.

Let’s take a closer look at Brazil and its position in the emerging market investment landscape.

Brazil Overview

Brazil is the largest country in South America, more than half of the continent by surface area. It is split into 3 general regions:

• The Amazon basin: flat, sparsely populated, and mostly jungle.

• The Brazilian highlands: A rough mountainous terrain, mostly consisting of savannah. This is where most of the farming is being done. Poorly connected to the coastal cities.

• The coast: a narrow band of land between the sea and the highlands, where most of the large cities and population are located.

The country spent over three centuries as a colony of Portugal, relying heavily on the export of cash crops grown with slave labor. This left a pattern of underdeveloped infrastructure, poor access to inner regions, high inequality between the rich and poor, and a dependence on global commodity prices.

You can read a detailed explanation of Brazil’s geography and development challenges in this excellent article by Thomas Pueyo.

Source: Free World Maps

Brazil Population Density – Source: Wikipedia

Despite some struggle, Brazil is emerging as an important actor on the world stage. It is part of the extending BRICS (Brazil, Russia, India, China, South Africa) cluster, which is often cited as a representation of the economic emergence of the global south.

With the exception of China and India, these are mostly commodity-driven economies. The Brazilian economy is a good example of this, with its exports being almost exclusively crops, meat, wood, metal, and oil.

Source: Wikipedia

As a result, the investing sentiment about Brazil follows commodities prices, as illustrated by the covers of The Economist, first in 2009 (at a commodity price peak) and 2015 (at a low point for commodities). (The Economist covers are notorious for being artfully made and hilariously wrong in their timing, indicating the end of a trend).

Brazil has the largest economy in Latin America and the country is slowly taking up a leadership role in the region. With the recent tentative discussion of a common currency, the “Sur”, which could one day become a Euro-style common currency for South America.

Brazil’s Strengths

Brazil is attractive to investors for a number of macroeconomic reasons. They are all pretty self-explanatory:

• Global underinvestment in commodities has led to a short supply of key materials like copper and oil. Meanwhile, Brazil is one of the only countries to have massively invested in production growth and is poised to reap the benefit of this strategy.

• Neutrality in a world of rising geopolitical risks. Brazil is both geographically and politically separated from the current Russia-China vs US-EU-NATO tensions.

• Large, young, and growing population: Brazil has 217 million people, with 20% below 14 years old.

• Abundant energy: The country produces 88% of its electricity from hydropower. It also has the 15th largest oil reserves, behind Qatar. It also has a large and untapped potential for developing solar and wind power.

• Undervalued markets: many leading Brazilian companies are trading at single-digit P/E ratios despite giving double-digit dividends. This is mainly due to perceived political risks (see below).

Those points of attraction are offset by disadvantages, and we have to consider those as well.

Brazil’s Weaknesses

At the surface level, Brazil seems like a great place for investors. Young, growing, energy-rich, and undervalued. But those low valuations come from somewhere. There are also reasons to be wary of investing in Brazil.

Political Risk, Corruption & Instability

This is THE big negative point everyone will bring up about Brazil. The rule of law is elusive and the political culture is rife with corruption. The recent storming by protestors of the Congress, the Supreme Court, and the presidential palace is just one example of instability, though it must be said that the same thing happened in the USA!

The return of Luis Ignacio Lula da Silva into power has also been viewed as a potential negative by investors. His previous administration is regarded as marked by widespread corruption, even if some will claim these accusations were bogus and politically motivated. In any case, this further illustrates the political risk and division of the country.

Inflation and History of Poor Management

Recent Brazilian inflation rates have been mostly in the 3%-8% range, but the country also experienced out-of-control inflation of 2,000% in the 1990s. Overall, the country has historically had problems with poor economic management.

Brazil has suffered from a common issue in South America: the toxic mix of powerful vested interests of a small elite of landowners and rich families, which invariably provokes a socialist backlash among the poor.

This deep-rooted economic structure is the real cause of corruption and political instability. The wealthy can buy politicians and protect their interests, the left wants to loot national companies, and the rest of the population is forced to pick a side, even if it is a lose-lose situation for them.

Consequently, while improving, the country is still widely perceived as always at risk of falling to a Pinochet-style right-wing dictatorship or a Venezuela-style socialist takeover.

Middle-Income Trap & Commodity Exposure

So far, Brazil has been a textbook case of the middle-income trap. This is where an economy develops up to a point, but then hits the ceiling and is unable to go up in the value chain.

“a country in the middle-income trap has lost its competitive edge in the export of manufactured goods due to rising wages, but is unable to keep up with more developed economies in the high-value-added market.“

Poor education, dysfunctional institutions, and corruption are the main causes.

This leaves the country massively exposed to the global commodity cycle. When commodities do well, Brazil booms and produces a budget surplus, like the record $62B trade surplus in 2022. And the opposite happens when commodities prices slump.

This repeating cycle damages the long-term prospect of the economy, reinforcing the middle-income trap. It also exposes the country to risk from fluctuating currency values, as exports are typically priced in US dollars.

Risk Management

Investing in Brazil can be a high-stress venture. This is a market renowned for its volatility. It is also a market that has been essentially going sideways for the last 20 years. So from a trading point of view, managing a good entry point and knowing when to exit is crucial.

Source: iShares.com

At the same time, the price tag of a Brazil ETF does not tell the whole story. The persistent undervaluation means that dividend yields can be high, sometimes absurdly high, as we will see with Petrobras’ stock below. So good returns from Brazil are entirely possible even if stock prices are stagnant.

It is also likely that the political risk is a little overblown. If anything, the recent right-wing protests show that the country is unlikely to be easily turned into Venezuela by Lula.

So overall, success in Brazil investing will mostly come to astute cyclical investors, able to ignore the regular panic gripping the Brazilian stock market and be careful in their risk management.

Company Spotlights

Petrobras (PBR)

Petrobras may be the most discussed Brazilian company internationally. This is a giant among oil companies, and one of the only ones to have steadily growing production. Petrobras also increased reserves by 11% in 2021. Its reputation has also never fully recovered from a scandal of money laundering and corruption in the 2000s, which keeps its valuation depressed.

It is majority-owned by the Brazilian state, and if the dividends from the previous administration hold, it might yield an absurdly high 68% dividend yield in 2023. Critics will say it is equally likely to be looted by Lula and be worth zero. At a P/E of 2.17, it can nevertheless be attractive to daring deep-value investors.

In a move to appease investors’ fears, the new Lula-appointed CEO is promising to both embrace renewables (A Lula electoral promise) and also keep the oil & gas production growth on track.

Copel (ELP)

This is a stock we covered in a report in May 2021 report. It has gone up a little since and distributed a generous double-digit dividend. The company produces power from one of the world’s largest hydropower dams in the world.

It can make an attractive income-focused investment, especially for investors looking for carbon-neutral energy producers.

(Please note most stock data aggregators like Yahoo Finance or Stock Rover do not do a good job of compiling Copel data. I would recommend calculating its financial metrics manually).

Vale (VALE)

Vale is the world’s largest iron ore producer and the world’s largest nickel producer. It also produces copper, fertilizers, manganese, and coal. It is trading at a P/E of 4.37 and distributes a dividend of 4.38%. This is a rather simple business: Vale digs resources from the ground and sells them abroad, mostly to China.

The current valuation makes it look cheap, but investors will need to be able to properly assess where they are positioned in the commodities cycle to profit from it.

Vale has been also involved in 2 catastrophic tailing dam failures, killing 270 people and causing major pollution. This tarnished its reputation, or as the BBC put it “The pride of Brazil becomes its most hated company“. The case is still being judged in criminal court.

Ambev (ABEV)

Ambev is a beer and soft drink company selling all over South America and even in Canada, producing and selling brands like Budweiser, Corona, Pepsi, Lipton Ice Tea, Gatorade or Stella Artois, for a total of annual 270 million hectoliters. The company is controlled at 68% by AB-InBev (BUD), the biggest brewer in the world.

The company has been growing revenues, but profits are rather stagnant. Even then, its valuation seems reasonable, it offers a dividend yield of 5.77% and trades a P/E of 15.6.

Brasil Agro (LND)

Brasil Agro is a farming company controlling 18 large farms with a total of 275,000 hectares (680,000 acres) in Brazil, Paraguay, and Bolivia. It produces diverse crops (soy, corn, cotton, sugarcane, beans, cattle) in a range of climates. Soybeans represent the single largest product, at 39% of revenue.

The company trades at a P/E of 6.12 and distributes a dividend of 18.8%. This is a rather similar business to Vale, with dividends and profit tightly linked to the price of global commodities, in this case, food products rather than metals.

ETFs

If you want to invest in Brazil as a whole, an ETF might be a better option.

By very far, the most liquid and traded ETF is the iShares MSCI Brazil (EWZ). In addition to minerals and energy, it contains quite a bit of exposure to the country’s financial sector (25% of the ETF holdings), utilities, and 1/3 covering the rest of the economy.

Source: ETFdb.com

If you are looking for more diversified exposure to utilities (16.64%) and the economy as a whole, the iShares MSCI Brazil Small-Cap ETF (EWZS) is an option as well. It is also offering higher exposure to consumer non-durable products (7.46%), electronics, and transportation.

Source: ETFdb.com

An ETF will let you diversify your holdings, avoid concentration risk, and gain access to companies that don’t trade on US markets.

Conclusion

Brazil is a country with a lot of potential but also numerous risk factors.

It has a large population, plenty of natural resources, cheap energy, and growing oil production. When adding a geographical and geopolitical distance from the world trouble, it might seem like a safe haven in troubled times. High dividend yields contribute to the attractiveness of the country for investors. Long-term potential for growth beyond the middle trap income is something definitely not priced in either.

Still, these advantages are seemingly always at risk of dysfunctional political institutions and social instability. Currently, the country as a whole is essentially a bet on the commodity markets, and its largest companies reflect this status. If the world’s economy slows down, Brazil could find itself in the same trouble it was in 2015 in the last commodity slump.

The recent political contest between far-right Bolsonaro and far-left Lula has brought a lot of skepticism about Brazil. So it might be a good entry point, at peak pessimism. In any case, extreme volatility is almost a given.

As with most emerging markets, an investment in Brazil requires a keen sense of timing, a fairly high risk tolerance, and a modest portfolio allocation.

Finding Value in Emerging Markets

Stock Spotlight has regularly covered stocks in emerging markets, which can offer great companies at discounted prices. After a decade of outperformance for the US stock market, it might be time for emerging markets to shine. This cycle between emerging market (EM) vs the US tends to be roughly 10-15y long, as you can see below. With the S&P500 outperformance stated in 2010, we are due for a reversal in trend.

Source: Western Southern

Past patterns may not be repeated, but the investing world still extends beyond the US, and increasing numbers of investors are considering exposure in non-US markets!

Emerging Value
This is a series focused on opportunities in emerging markets. The goal is not to discuss breaking news. Instead, we will focus on long-term trends and lasting phenomena that will impact investing in a country or region. It will also look at a selection of companies that might be worth a deeper look.

Quick Stock Overview
Mercado Libre by the numbers.

1. Executive Summary
A brief discussion of Mercado Libre and its potential appeal to value investors.

2. Extended Summary
A more detailed explanation of Mercado Libre’s history and competitive position.

3. The Regional Giant
How Mercado Libre became the dominant actor of e-commerce in LATAM.

4. Mercado Libre’s Future Potential
The growth potential of Mercado Libre, its fintech segment, and the path to superapp.

5. Financials
Mercado Libre by the numbers: balance sheet, cash reserves, and valuation.

6. Conclusion
Why Mercado Libre is worth a closer look.

Quick Stock Overview

Ticker: MELI

Key Data

• Industry: E-commerce / Fintech

• Market Capitalization ($M): $55,945

• Price to sales: 5.9

• Price to Free Cash Flow: 35.9

• Dividend yield: -

• Sales ($M): 998

• Free cash flow/share: $31.38

• Equity per share: $32.43

• P/E: 207

• ROIC: 9.1%

• ROE: 16.6%

1. Executive Summary

E-commerce has taken over the world… at least the Western world and China. Other regions are just getting started. Even with the pandemic giving remote buying a significant boost, some areas of the world are only now reaching a point where e-commerce is starting to overtake brick-and-mortar retail.

One such region is Latin America. It is home to 656 million people, double the US population. It is also quickly developing and modernizing.

One company you might have never heard of is dominating Latin America’s e-commerce market: Mercado Libre.

It follows the simple but powerful model of imitating Amazon, while also adapting to the peculiarity of its home market. As a result, it has managed to absolutely outmatch Amazon and its other regional competitors in its home market.

The stock has now cooled off since the pandemic highs. If it was “just” the Amazon of Latin America, it would be an attractive investment, but not more than that. But it is also leading the fintech revolution in a region where half of the population has no bank account.

So Mercado Libre is best described as early Amazon + early Paypal merged into one company, with the potential to grow into THE tech company of the region and become the first LATAM super app.

In this report, we will take a deeper look at what has made the company successful and at its growth potential.

2. Extended Summary: Why MELI?

The Regional Giant

Mercado Libre has come to completely dominate e-commerce in the LATAM region, which offers one of the world’s greatest growth opportunities for e-commerce.

It has managed to keep out foreign giants like Amazon and eBay, as well as out-compete local alternatives, using a mix of imitation and a talent for solving the problems specific to South America, notably logistics and payment.

Logistics is now a solid moat, and payment has turned into a second profit center with even more growth on the horizon than e-commerce.

Mercado Libre Future Potential

The e-commerce segment is still growing fast and has the potential to do so for the next 10-20 years. The fintech section is highly profitable and growing at 50-60% per year, and is likely to become the source of the majority of net income for the company.

The Mercado Libre ecosystem is the best candidate for creating the first LATAM super app, imitating the success of companies like Alibaba and Tencent in China.

Financials

The company’s growth metrics are impressive, and it is strongly profitable and free cash flow positive. Debt is reasonable. Valuation is relatively high compared to free cash flow and sales, but still at a level that makes sense when taking into account the growth of the fintech segment.

3. The Regional Giant

A Difficult Start

If you would have had to guess where the Amazon of Latin America would be founded, you could have given a few reasonable guesses. Maybe Mexico for its proximity to the USA. Or Brazil, by far the largest country in the region.

You would probably not have expected it to come from is the perpetually dysfunctional Argentina. Since Mercado Libre was founded in 1999, Argentina has defaulted on its debt in 2001 and went through several debt restructurings in 2005, 2010, and 2015. It defaulted again in 2020 and might be headed for another round of hyperinflation.

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The visible part of the telecom industry is well known to consumers: think of Netflix, Facebook, etc.

We often don't think of the infrastructure that makes all of this possible. In this Industry Primer, we will look at how the telecom industry works and how you can evaluate investments in it.

An efficient telecommunications network is the foundation upon which an information society is built.

Talal Abu-Ghazaleh

Industry Structure

The telecom industry has seen a great deal of evolution from the old phone companies to the satellite communication and Internet providers of today. The industry has split into several groups.

Telecom Equipment Manufacturers

Before any company can sell communication services, the infrastructure needs to be there, which requires equipment like phone lines, servers, optical fiber, antennas, and much more. This is a sector with very specialized manufacturers, with usually just a handful of companies controlling each technical niche.

Some companies worth mentioning in this sector are:

• Motorola: a former mobile phone manufacturer, the American company is still a vital telecom equipment provider today.

• Ericsson: This Swedish company is one of the leading global equipment providers for advanced telecommunication, including 5G.

• Cisco: The leading provider of routers and switches.

• Qualcomm: The leading US supplier of connectivity for IoT (Internet of Things) and 5G equipment.

There are many other companies in this sector, most focused on a fairly narrow range of equipment.

Services and Infrastructure Operators

In the last two decades, a new type of telecom company has emerged. They are not manufacturers but also do not provide direct internet or phone to consumers. Instead, they operate infrastructure for the Internet provider.

A perfect example is the cell phone tower business. A service provider operates the towers and rents access to them to 3-4 different mobile operators. This spreads the costs of one tower between multiple clients and makes the mobile providers more efficient.

In that sense, the mobile tower company acts like a very specialized industrial real estate landlord. That's why they are often organized as a REIT.

American Tower is a good example of such a company in the US. More adventurous investors might be interested in foreign operators with more growth opportunities, like Africa-based Helios Tower.

Network Operators & Providers

These are the companies the final consumers usually interact with. They provide their users the actual mobile or Internet coverage or maybe cable TV.

They are usually very large companies, with valuations in the hundreds of billions of dollars. They often operate as monopolies or oligopolies, with no more than 2-3 providers usually dominating a country. Good examples of this sector are companies like AT&T, Verizon, Comcast, and Vodaphone. Foreign markets can also be attractive to investors, like Deutsche Telekom (Germany), Orange (France/EU), or Nippon Telegraph & Telephone Corp (Japan).

SaaS

A new type of telecom company has emerged in the last ten years: SaaS (Software as a Service). They replace some of the older options with Internet-based systems and blur the line between the telecom and tech sectors.

The pandemic made them a lot more popular and sped up the adoption of these solutions. A good example is Zoom, but there are also older solutions like Skype (part of Microsoft). Streaming device maker Roku is another one.

New segments like telemedicine software or remote education solutions are also possible opportunities in this sector.

Specialized Communication

The last sector is the telecommunication segment which responds to niche demand. This sector has two components.

The first part is satellite communication for remote regions. We covered this sector in our "Gilat Satellite Network" investing report of November 2021.

This is an interesting sector, but intense competition is expected to come from billionaire-owned space companies like the Starlink network from Elon Musk's SpaceX or the project Kuiper by Amazon/Blue Origin from Jeff Bezos.

Overall, the older technology based on geosynchronous satellites might need to adapt against broadband provided by low-Eart orbit satellite constellations.

The second part is secure military communication. The defense communications equipment market is expected to grow at 10% annually from 2019 to 2029.

The increasing usage of drones, network-centric armies, and electronic warfare will all boost the need for robust and secure military communication. Some of the most active companies in this sector are large defense contractors like BAE, Thales, or Raytheon, but smaller companies might be able to provide unique services for specific applications.

This can overlap with the first sector, as the intensive usage of the Starlink system by the Ukrainian army illustrated. SpaceX is also active with the recently revealed Starshield constellation.

Assessing Telecom Companies

Income investing: Large Operators & Manufacturers

The largest telecom companies are mostly defensive, income-focused investments. They are already dominant and have little room to grow their market share. They will mostly grow with the overall sector and the country's economy. This is also true for mature, large mobile tower companies.

These companies make good investments if they are priced relatively cheaply. A not-too-high level of debt and good service quality will be the selection criteria as well.

Manufacturers of equipment are a little riskier than companies like AT&T. Their technology might slowly become outdated, and they must keep reinvesting in R&D to stay ahead.

In addition, telecom is a politically sensitive topic, and some companies might be unable to access some markets in case of trade wars, as the ban on Huawei equipment in most of the West has shown.

Growth Investing: Foreign Operators & Innovators

Not all of the world is perfectly connected. Operators in emerging markets or outright under-developed regions like Africa can display strong growth profiles, similar to the one Western telecom companies had in the 1990s.

The difference is that, in this case, investors have the advantage of insight of knowing the path forward from past experience in the West. Especially interesting are companies focusing on mobile networks, as most of the developing world has gone directly went to smartphones without passing through the landline or cable network stage.

These markets also profit from a young population eager to communicate and bypass inefficient and outdated local institutions like banks, taxi monopolies, universities, etc.

The other sector of growth is companies with unique technological advantages. This might be very hard to quantify for investors without a technical background. Nevertheless, if a company holds unique patents or technology, it could experience explosive growth and capture market share for the incumbent manufacturers.

Specialized Providers

Suppliers to the military are likely to have a stable source of income from military contracts and are more like defense companies than pure telecom companies.

Satellite companies should be analyzed with caution to estimate if their specific business model and client base are threatened by the rise of Low-Earth orbit constellations. A fair level of understanding of the sector will be needed to avoid buying into value traps.

SaaS

SaaS companies have been treated by investors as tech companies more than telecom companies. This led to very pricey valuations during the pandemic, which has dramatically cooled off. That was predictable: a P/E of 235 for Zoom in 2020 never made any sense from a risk/reward perspective.

For SaaS solutions, the strength of the competitive moat is of prime importance. Before Zoom, there was Skype (which is still widely used for that matter), and after Zoom, something else might come.

The risk of tech giants launching their own competing products should also be remembered. When a company is already operating on Microsoft-provided cloud and Microsoft-provided email, it might as well prefer to stick to a Microsoft-provided call and meeting system.

Conclusion

The telecom sector is as foundational for modern economies as the utility sector. In many countries, it has stopped being a strong growth sector and has become more akin to a stable, dividend-focused type of investment. So this can be a great sector for investors looking for income and relative safety.

For technically-minded investors, it is also a sector rich with obscure niches and specialized suppliers that might give them an occasion to leverage their knowledge into an investing advantage.

Lastly, growth investors can find more options if they're willing to expand their horizons to more risky overseas jurisdictions. In emerging markets, connectivity is just beginning, with many networks still barely able to provide mobile internet out of the big cities, even less 4G or 5G.

These markets are also often semi-protected environments where foreign companies cannot really compete with local operators. Sticking to the largest local operators and geographical diversification will be essential to manage the risks inherent to developing markets.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process; they don't replace it.

Other industry primers:

• REITS

• Renewable energy

• Oil & gas

• Nuclear Energy

• Semiconductors

• Pharmaceuticals

• Biotech

• E-commerce

• Defense Industry

  ---

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Less well-known by the general public are some of Soros' associates. Stanley Druckenmiller is one of the most prominent among them.

Druckenmiller is as much an investing legend in investing as his former boss. His returns have been stellar, and he hasn't had a single losing year for 30 years. He has learned a lot from Soros and distilled that knowledge into his own very successful method.

Druckenmillers investing style and philosophy are unique, and unlike Soros, he is still an active investor and is very vocal about his opinion on markets. So there is a lot that can be learned from him, both from his past and current positions.

Who Is Stanley Druckenmiller?

Druckenmiller started his career as an oil analyst before becoming head of equity research at Pittsburg National Bank. He would, later on, be the manager of various investment funds, including its own Duquesne Capital Management. In 1988, George Soros hired him to become the lead portfolio manager at Quantum Fund.

He was from an average middle-class family, and his parent divorced when he was in elementary school.

Druckenmiller Track Record

Something really exceptional about Druckenmiller is that he never had a full year down. He had some losses, of course, but he would always turn back to a profit before the year's end. This put him in a class of his own.

He himself claims it is partly luck. And while another 12-month-long timeframe might have pointed to a loss, this is still exceptional.

The other remarkable metric is an average of 30% yearly return over three decades. This is more than almost ANY other famous investor, especially considering the size of the portfolio he manages and the duration of the outperformance.

👉 To put things in perspective, 30% yearly for 30 years can turn $10,000 into $26,000,000.

So even if his method could be hard to replicate, there is for sure something to learn from him.

"Breaking" the Bank of England

Under the direction of George Soros, Druckenmiller would be instrumental in "breaking the Bank of England" on Black Wednesday.

This was a bet that the exchange rate of the Pound Sterling could not be maintained relative to other European currencies, especially the German Deutschmark. Soros and Druckenmiller were sure the government decided parity was too high and could not hold, considering the poor performance of the British economy.

Initially, Druckenmiller wanted to put a $1.5B bet on this idea. But when Soros saw that the downside risk was limited, he pushed him to be much more daring. Druckenmiller would end up with a $10B short bet against the Pound Sterling.

This was a considerable amount, using borrowed money to bet more than the entire value of the Fund at the time. The key factor was that the downside risk was limited to a small amount, but a successful bet would provide a gain 40x bigger than the potential loss.

The timing had to be perfect, and Soros waited for 15th September 1992, when the President of the German central bank, the Bundesbank, declared that the pound was too strong and had to devalue. With everything already in place and prepared, Soros and Druckenmiller would move into action, putting massive pressure on the Pound.

Together with the Bundesbank declaration, this shattered the market trust in the ability of the UK to defend the Pound.

When the UK government had to devalue the pound by the largest amount ever recorded, Soros' fund registered a $1B gain in just one day. And this was in 1992, when $1B was a much more considerable amount of money than today.

Druckenmiller admits that he actually wasn't completely sure that the British Pound would fall, but what he did understand was the risk/reward ratio. He knew that if he was wrong, it would cost 50 basis points, but if he was right, he would make 2,000 basis points. This was a 40:1 risk/reward bet. Druckenmiller says this is actually the opposite of the gamble the Federal Reserve did in 2020 with its huge stimulus injection.

Yahoo Finance

Druckenmiller's Strategy

Druckenmiller investment strategy is complex, often mixing short and long bets on stocks, as well as extensive usage of leverage, especially for futures and currency trading (as we saw on the "breaking" of the Bank of England).

His focus is on predicting future market conditions in an 18-24 months timeframe.

His approach is a top-down method, focusing on macroeconomic imbalance more than the individual results of specific companies. Despite bearish tendencies, he considers that 90% of his money came from long bets.

His method relies on a few key points, with exceptional results also coming from an excellent execution of these basic principles:

1. Concentrated bets: a few quotes from Druckenmiller explain it best:

   • “The greatest investors make large concentrated bets where they have a lot of conviction”^[1]

   • "Put all your eggs in one basket and watch the basket very carefully"^[2]

   • "When you have tremendous conviction on a trade, you have to go for the jugular."^[3]

2. Multiple asset classes: he would simultaneously handle 5-6 asset classes. This helps him find opportunities and provides good liquidity if he changes his mind. It also allows him to avoid a sector entirely if it is turning risky.

3. Leverage & asymmetry: The idea is to win a LOT more when right than you lose when wrong. Adding leverage helps as well, supersizing the gains. The Bank of England bet was the perfect example of it. It is also remarkable that back then, Druckenmiller had to be encouraged by Soros to take an even larger bet. "The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity.".^[4]

4. Mental flexibility: he claims he is often wrong and sells as soon as a stock situation proves to have changed unexpectedly "if I have a thesis and it doesn’t bear out — which often happens with me, I’m often wrong — just get out and move on."

These method key points were partially picked from a longer 20-minute interview.

Druckenmiller's Opinions on Current Markets

Druckenmiller is a veteran trader, and the past outperformance of the market and inflationary environment reminds him of previous similar periods. As a result, he thinks that "There’s a high probability in my mind that the market, at best, is going to be kind of flat for 10 years, sort of like this ’66 to ’82 time period".^[5]

As he started his career in 1977, this is a warning we should maybe listen to, as he saw the end of that period firsthand.

He also believed in 2021 that we were in a new tech bubble, something the subsequent crash in tech equity and more recent tech layoffs might confirm. In the same interview, he also worried about geopolitics, focusing on Taiwan.

Of course, the man he admitting a natural pessimism and bearish tendencies, so we should take this into account. What is important is that he was never a doomsayer, either. Until now?

I am open minded to something really bad. This is an analysis harder than you’ve ever faced in 45 years, so please be open minded, because this not a story we have seen before so the outcome is not predictable.

We might see inflation, we might see deflation, it could be no growth like 1966-1982 or something much worse like the 1930s.

The Flying Frisby

Interestingly, he is rather positive about crypto as an asset class and admits he missed most of its spectacular rise.

The main reason behind his support of the crypto sector was because of the quasi-religious devotion of its supporters and the reckless money printing by the Fed under Jerome Powell. He is also not too sure how to play it, suspecting that Bitcoin and Ethereum are like Yahoo before the arrival of Google.

You can also see the top holdings of his family office, with the largest positions in Microsoft, Amazon, and Starbucks, but also the copper miner Freeport-McMoran.

Conclusion

Druckenmiller is a fascinating investor for me. He seems to have learned a lot from Soros, combining it with his own natural talent for investing. He describes himself as not so smart or an ace student and says that he had to pick the only university not requiring an SAT score.

What made Druckenmiller an exceptional investor is his mental discipline. He seems to have never made mistakes by getting emotional, except once, when in 2000, he "might have missed the top of the Dotcom Bubble by an hour."

His mental flexibility allows him to avoid major disasters and got him this legendary result of 4 decades without a calendar year down. The combination of exceptional daring and ultra-cautious risk management is a rare and powerful one.

The scope of his analyses is equally impressive. He studies everything from economic cycles, industry structure, macro environment, and currencies to technological innovation and uses this knowledge across almost all possible asset classes.

By his own admission, the force driving it is more of a passion for investing than greed. I believe it, as his method shows that he clearly mostly drives pleasure from getting it right (or not) and then moving on to the next puzzle.

I think Druckenmiller is a great model to look up to. For most investors, it might never be possible to imitate him perfectly, as most of his results seem to stem from a natural talent as much as training and discipline.

But we are still very likely to grow our performances by learning from him. After all, just a few years down and 15-20% yearly returns would fall well short of this role model. It would still put any investor in the top 5% or maybe even 1%!

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This article originally appeared on FinMasters.com: Investor Profile: Stanley Druckenmiller

Nevertheless, the need for the military is not going away anytime soon, as the war in Ukraine shows us. Any hopes for Fukuyama’s “End of history” are probably just that, hopes. The unfortunate truth is that national sovereignty and freedom are mostly earned – and often challenged – at gunpoint.

Only the dead have seen the end of war.

Plato

Defense spending worldwide – Source: Statista

Industry Structure

Over the last three decades, we have seen a consolidation trend in the industry, especially in the US defense industry. You can read more in this article about how many of the US suppliers to the military are now merged into just 5-6 megacorporations:

• Lockheed Martin

• Boeing

• Northrop Grumman

• Raytheon

• Huntington Ingalls Industries

• General Dynamics (we covered the General Dynamics investment case in this report in April 2021 report, with the stock up 32% since).

Most non-Western manufacturers are state-owned companies that are closed to investors. Beyond the US, other NATO countries and US allies have publicly listed defense companies, for example:

• France: Dassault, Airbus, and Thales

• Germany: Reinhmetall, Thyssenkrupp and MBDA

• UK: BAE Systems

• Italy: Leonardo

• Sweden: Saab.

The defense industry actually covers a multitude of subsectors, often categorized by technology:

• Aerospace (planes, satellites, missiles,…)

• Cyberdefense, Telecom, and AI

• Weapons (ammunition, artillery, guns, …)

• Vehicles (armored carriers, tanks, …)

• Maritime (ships, submarines, …)

• Logistics & Software

• Personal equipment (body armor, shoes, …)

• Sensors (optics, radars, etc…)

Because of consolidation, some products in these subsegments are either the monopoly of one company or a small oligopoly with 2-4 companies controlling the market, The more expensive the equipment, the smaller the number of suppliers usually is.

This gives the primary suppliers strong pricing power and a powerful moat, especially in times of crisis when government rushes to increase defense spending.

The Case for Defense Investing

One simple reason to invest in military spending is geopolitics. Russia comes to mind, but also Iran and North Korea, and, more importantly, China. It seems an arms race has started between the US and China and will last for a while. Just to give you some perspective, here is some of the most recent news about increases in military spending:

• Germany commits an additional €100 billion to defense spending.

• China boosts defense budget again, exceeding $208 billion.

• Senate panel approves record US military budget for 2022-2023 ($858B).

• Poland to increase defense spending to 3% of GDP from 2023 ($23B).

• France to request multibillion-dollar defense budget boost in 2023 ($44B).

• Japan Begins Defense Upgrade With 26% Spending Increase for 2023 (51B).

None of these budget increases have yet translated into increased earnings for defense firms. However, it could be said that the stock prices are already reflecting some of these increases.

Si vis pacem, para bellum
(If you want peace, prepare for war)

Vegetius

Defense Industry Advantages

The other reason for investing in this sector is the actual business case.

This is an industry with a strong focus on innovation, including technologies that can later be licensed to the civilian industry and find more peaceful applications. It is also focused on the long term and is known to be a great capital compounder.

The sector also has multiple strong moats relying on different forces:

• Substitution costs: armies often use the same basic design for several decades, upgrading it as new technology emerges: for example, the Abrams US main battle tank from General Dynamics was first designed in the 1970s.

• Regulations and compliance: procurement procedures from ministries of defense are notoriously complex and give large, established firms an advantage. It is also a factor of why lobbying and long-term relations with decision-makers (politicians and generals) can make a difference.

• Intellectual Property: trade secrets and patents are hard-to-replicate advantages favoring the incumbents.

• Unique manufacturing infrastructures. If a company has built nuclear submarines for decades, it will be almost unbeatable at this activity and might be the only one with the right shipyard and certifications to do so.

All of these factors protect established defense firms from competition.

Assessing Defense Companies

Here are some key points to consider when assessing defense companies:

National Profile

The first thing to consider when looking at a defense company is its nationality. As it will mostly depend on public spending, we must accurately assess the country’s finances and politics.

The ideal country for investors in defense would have a profile like this:

• Spends at least 1.5% to 2% of its GDP on its military budget and plans to increase it.

• Has a society-wide consensus on the necessity of military spending.

• A healthy economy and low or no deficit, with a reasonable debt load (meaning the current spending can be sustained).

• The 10 years geopolitical horizon with neighboring or competing powers is tense, implying no reduction in the military budget soon (sadly, this might be less relevant today, as it might be true for almost all countries).

Exports can be important contributors to a defense company’s bottom line. Export contracts often go on for years and include lucrative spare parts and service contracts. Still, considering how politically and diplomatically sensitive defense contracts tend to be, excessive reliance on exports might be tricky and unpredictable.

A large and healthy national economy supporting its defense champions makes for a safer investing case, with export contracts as a welcome bonus.

Business Profile

While the industry as a whole can be attractive, individual companies are a different matter. Competitive position is very important here. A good defense company should have several successful designs which have been adopted by multiple countries.

It should also be recognized as an innovator, and its new designs to be both cost-efficient and reliable. For example, recent issues with the development of (too?) complex and expensive weapons like the F-35 fighter jet or the Puma tank should be red flags, in my opinion.

Lastly, the company should be active in “trendy” sectors that reflect a growing military need (and spending). For example, sectors like space, cyber defense & AI, drones & air defense, and hypersonic missiles.

Valuation

Because the defense industry is relying on relatively constant military spending, we should not base valuation by counting on explosive growth. This means that even in the context of expected increasing militarization, valuation should still incorporate a margin of safety.

This is especially true as part of the past 2-3 decades’ growth has come from consolidation and cost optimization. With fewer targets for M&A, this might not be true in the future.

In addition, some supply problems for Ukraine might indicate that cost rationalization has been pushed too far, for example, too little spare capacity in ammunition manufacturing or the production of older designs interrupted and hard to restart from scratch.

In my opinion, this indicates that the peacetime era of ever-increasing ROIC is probably over.

So P/E ratio should be ideally in the single digits or the 10-15 range at most, not higher. Similarly, conservative ratios for price-to-free cash flow or price-to-sales should be preferred as well.

Portfolio Construction

It can be difficult for investors with no deep knowledge of the military to decide which stock to pick. Is this new tank plane a technological marvel or a breaking-down mess?

For this reason, I would suggest that amateur defense investors should stick to a panel of large, established companies. The inconvenient truth is almost regardless of the performance of individual equipment, and the largest firms will continue to win contracts with the military. Dedicated ETFs are also an option, like the iShares U.S. Aerospace & Defense ETF or the SPDR S&P Kensho Future Security ETF.

Some geographical diversification might be good as well, as European defense spending is likely to stay way above its historical average for the foreseeable future. Their stock prices might also be lower than the more well-known US giant defense suppliers.

More knowledgeable investors might want to focus on specific subsectors or designs. If you think that the future of naval warfare will be submarines, it will make sense to focus on shipbuilders with unique experiences and shipyards in that field. The same can be applied to air, space, or drone warfare.

Conclusion

The defense industry is a stable and steady sector, likely to compound over time and give some dividend income. It is also an antifragile investment and will likely perform best when world tensions are rising, and globalization is stalling. It could provide some help in keeping portfolio volatility down.

Is it ethical to invest in defense companies? This is mostly a philosophical question better left to each person. Your opinion will depend on how you see war: as a sometimes necessary task to defend freedom or as an inherently evil thing.

From a purely investing perspective, I consider the defense industry a viable option IF the price is right. National budgets and economies have limits, and forever-growing budgets for weapons should not be the sole reason to justify an investment in the sector. Innovative and efficient defense companies trading at reasonable prices are the best bets for steady returns over the long term.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.

Other industry primers:

• REITS

• Renewable energy

• Oil & gas

• Nuclear Energy

• Semiconductors

• Pharmaceuticals

• Biotech

• E-commerce

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This article originally appeared on FinMasters.com: Defense Industry Primer

2022 international news was dominated by the brutality of the war in Ukraine. As a result, the relationship between the USA and China has not been at the center of investors' attention. Especially as news about China was more focused on first the 20th communist party congress and then on the end of the COVID restrictions.

It would be a mistake to let our guard down. Relations between the two richest and most powerful countries on Earth have degraded steadily throughout the last year.

So as investors, the question we should ask is, "how can we avoid losing money and instead profit from the situation?"

New Lows in Bilateral Relations

For a long time, the USA and China had pretty efficient relations. The US brought technology and capital. China offered cheap production costs. These relations became more strained as China asserted itself as a world power.

In parallel, it has become normal in the US to see China not as a partner but as an "adversary." This started under Trump, with the then-president initiating trade wars. And it's still going on with Biden.

Most notably, sanctions on the semiconductor sector have gone from "only the most advanced chips" in 2018 to a move to destroy all chip manufacturing in China.

In a politically divided country, it might be the last bi-partisan consensus.

Taiwan

Beyond competition in trade and technology stands the question of Taiwan. De facto independent since 1945, Taiwan is still considered by China as a rebel province that WILL be brought back under the control of Beijing. Peacefully or not is the only open question for the Chinese leadership.

On the other side, the USA is highly reliant on Taiwan's production of semiconductors. It also sees the question of Taiwan's independence as a matter of principle. Something worth defending with US troops, according to Biden, even if his administration quickly backtracked.

In that context, the support China provides to Russia is only increasing the hostility and suspicion between the USA and China.

Ukraine War Fallout

No matter who wins in Ukraine, this will have negative consequences on China-USA relations.

If Ukraine wins, Russia will be severely weakened. This will make China more isolated and extra worried about being the next target of the US-led alliances and permanently losing any chance to regain control over Taiwan. Disruption in the Russian supply of oil, gas, metals, and food would make China especially vulnerable.

If Russia wins, it will make NATO aware of the need to re-arm and handle growing threats. The rhetoric against "non-democratic powers" and the threat they represent for the world will also go into overdrive. This will increase tensions with the Chinese Communist Party (CCP) and limit possibilities for diplomatic detente.

What to Expect?

At the heart of the tensions are two different incompatible objectives. The USA wants to maintain the post-Cold War, US-led order. China wants to create a "multipolar" world divided into spheres of influence.

There is also the replacement of the IMF, NATO, and World Bank with Russia and Chinese-led initiatives like the Shanghai Cooperation Organisation (SCO) and the Belt and Road Initiative (BRI).

So even if we (hopefully) avoid a Taiwan invasion and/or open war, we should not expect the situation to improve significantly. The two countries will be rivals and struggling to change the balance of power for a while.

We should invest accordingly.

What to Avoid

Before we look at ways to make money from all this, we should look at investing situations that we should avoid, knowing the tensions are not going away and are likely to get worse:

• Chinese companies with links to the military: Any company supplying equipment to the Chinese army is likely to be already under sanctions or will be in the future. It would make them un-investable for US citizens and corporations. This includes a lot of tech and AI companies.

• US-listed Chinese companies: delisting is an easy-to-implement threat and a good way to increase separations between the two economies. Investing in Chinese companies can be fine, but only for China-listed companies.

• US companies with more than 30% of revenues coming from China. US stocks whose price depends on growth coming from China are in the same situation.

• Taiwan-based companies: The island will be the focal point of two superpower rivalries. This means that we should see in the future some heightened tensions and a crisis of some sort that is likely to make investors panic and sell en mass. No matter how good the companies are, this is the same type of risk that investing in Ukraine or Russia in 2020-2021.

Many of these companies may appear to be fundamentally attractive based on financial results because the market is pricing in geopolitical risks. Those risks are still very real and should not be ignored.

Different Ways to Benefit From USA-China Tensions

The Internet and financial media are full of "doom and gloom" commentators. But money is usually made by finding the right opportunities instead. Luckily, there are plenty of options.

Re-Shoring & De-Globalization

With the pandemic and the war in Ukraine, Western governments have realized foreign supplies come with risks attached. Strategic supplies are likely to be brought back home. Building massive semiconductor factories in the US is just the beginning of this trend.

US and EU suppliers for industries like pharmaceutical and defense energy will likely see business booming in the 2020s and 2030s. The same old true for strategic natural resources like fossil fuels or rare earth metals. Probably anything energy-related as well, including renewables.

Chinese companies replacing Western suppliers can be an option too. For example, Goldman Sachs forecasts explosive growth for Chinese software companies and semiconductor suppliers in 2023.

Globalization Spreading Out of China

Many international firms will not bring production back home. Instead, they will diversify their geographical risks over many countries. In any case, China's labor was already getting too pricey.

So we should see a lot of industrial production relocate to cheaper locations. Apple moving out of China is going to be followed by many more.

The best places combine a few factors like cheap and large labor pools, good infrastructure, good energy supply, proximity to Western markets, and geopolitical neutrality.

A few of the areas to look out for are:

• India

• Indo-China /Mainland South-East Asia (Vietnam, Thailand, Laos, Cambodia)

• Malaysia

• Indonesia

• Brazil

• Turkey

• Mexico

Each of these countries will likely experience massive growth from factories moving out of China. There are several ways to play it out:

• A bet on the whole country's economy: general economic growth will translate into more income and investment. This will boost real estate prices and consumer spending from a rising middle class. REITs, dominant retail brands, banks, and healthcare should be the main winners from it.

• Local suppliers: who is the next local Foxconn positioned to provide full services to the moving corporations? If you can answer that question, you might have found a good long-term opportunity. High-quality local partners to international corporations usually grow A LOT and go up the value chain over time.

• Construction: Beyond existing real estate, new factories and an economic boom will need a lot of new buildings. Architects and builders see corresponding booming profits.

• Service providers: these could be law offices, HR services, industrial facilities, rental of office space, or anything a corporation moving business there will need. It includes logistics (railroad, harbors, trucking).

• Expat-focused services: there will be plenty of engineers and manager-level ex-pats moving into the country to supervise the building of the freshly moved operations. International schools, high-end real estate, specialty foods ... a lot of small but profitable niches will grow suddenly.

All of these sectors are likely to boom in the countries that move into China's "factory of the world" role.

Conclusion

After the fall of the Soviet Union, geopolitics did not matter for a decade or so. Idealists believed this was the "End of History." 2022 put this idea to rest completely.

But this is not a reason to panic either. The rise of China as a competing power will also redistribute the benefits of globalization more equally to the rest of the world. We should expect many other developing countries to get richer and more influential over time.

This is a great opportunity for investors. If you missed the rise of China or were too young to invest in it, it is time to correct that.

Countries like Indonesia, India, Vietnam, and Brazil will be the big winner of the US-China rivalry. Investors betting on them can ride this new great growth story with them.

Quick Stock Overview
CATL by the numbers.

1. Executive Summary
A brief discussion of CATL and its potential appeal to investors.

2. Extended Summary
A more detailed explanation of CATL's business and competitive position.

3. Powering the Electrification of China
A success story built on China's push for electrification.

4. A Deeply Technical Company
How CATL's culture led by engineers made it successful.

5. CATL's Future
Technological breakthroughs create the next step of the company's growth.

6. Financials
Exponential growth, massive investment, and a reasonable valuation.

7. Conclusion

Quick Stock Overview

Ticker: 300750.SZ

Key Data

• Industry: Batteries / Electric vehicles

• Market Capitalization ($M): 159,240

• Price to sales: 4.01

• Price to Free Cash Flow: -

• Dividend yield: 0.15%

• Sales ($M): 39,674

• Free cash flow/share: -

• P/E: 40

1. Executive Summary

Electric vehicles (EVs) are a growing trend in Western countries, led by high-end car brands like Tesla and, more recently, Audi, General Motors, and many others. But the real EV revolution is happening somewhere else, in China.

With China representing by far the largest EV market, it is not surprising that the largest battery manufacturer in the world is from there as well.

Battery tech is an ultra-competitive sector. Any advance in battery chemistry allows for more range, safer design, and cheaper vehicles. This also means intense requirements for a high R&D budget and economies of scale to beat aggressive competitors.

By controlling 1/3 of the world market, CATL can reach a scale and capacity that none of its competitors can rival.

Its newest technology is truly groundbreaking and should usher a turn for EVs from expensive innovation to everyday life items, as it can greatly reduce the current limitations of EVs.

In parallel, CATL will be able to grow in other new markets, like grid-scale energy storage, other types of vehicles (delivery, trucks, ships), and battery recycling. It is also starting to produce outside of China, trying to capture the quickly growing European market.

The company has a lot of cash on hand and a reasonable debt load. It is also profitable and growing rapidly. While not cheaply valued, it is now priced at a much more reasonable level than it has been in years.

2. Extended Summary: Why CATL?

Powering the Electrification of China

CATL has emerged in less than a decade from a spin-off from a Japanese consortium to the company producing 1/3 of all lithium batteries made in the world.

Its initial success was built on the back of generous state subsidies, but it is now standing on its own.

A Deeply Technical Company

The company is atypical in China, focusing on R&D and innovation. Through its technical excellence, it has brought almost every car maker in the world onto its customer list.

Through a company culture of openness and operational excellence, CATL has been able to keep these relationships growing and become the world leader among battery manufacturers, beating its Korean (LG Chem), Japanese (Panasonic), and American (Tesla) competitors.

CATL's Future

CATL's R&D effort is paying off, and the company can now manufacture a revolutionary "million-mile" battery with twice the energy density of previous technology. This will accelerate the growth of the EV market and open new opportunities for trucks, ships, and utility-scale energy storage.

The company is also proactively adapting to looming metal shortages (lithium copper, cobalt, nickel) thanks to prescient investments upstream in the supply chain (mining, processing) and fully developed recycling processes.

Filling an EV Investment Gap

EV manufacturers have been the darlings of the investment community for several years, with valuations often soaring far beyond rational levels.

Today's market is becoming increasingly challenging for EV makers. EV adoption is expanding rapidly, but large numbers of new companies and new models are entering the market, generating unprecedented competitive pressure. It remains unclear, for example, whether specialist EV makers can compete with the economies of scale that legacy automakers can bring to bear as they enter the EV market.

It's not clear who will dominate the EV market, but CATL clearly dominates the battery market and is well-positioned to continue doing so. That could make CATL a better bet than any single EV maker.

Financials

Revenues and net income are growing at an accelerating pace. So are investments in R&D and CAPEX spending. The company's balance sheet is very solid, with a massive amount of cash on hand and a reasonable debt load.

Valuation is not cheap, but not outrageous either, considering the growth profile. It is, in any case, a lot more sensible than at its peak in 2021, 50% above the current valuation.

3. Powering the Electrification of China

From Humble Beginnings to Giant

CATL is a rather new company by today's tech industry standards. Compared to Google or Amazon, founded in the 1990s, or even Tesla in 2003, the CATL foundation in 2011 is downright recent.

The company is a spin-off of Amperex Technology Limited (ATL), which produced batteries for small consumer electronics and was founded in 1999. CATL would go on to focus on electric car battery technology. ATL was incorporated into a Japanese consortium in 2005 and sold its last ownership in CATL in 2015.

From this early start, the company has grown into a key supplier of batteries for a very large array of car companies, including BMW, Daimler, Hyundai, Honda, Stellantis, Toyota, Volkswagen, Volvo, and - maybe the most spectacular achievement - Tesla, a company normally obsessed by vertical integration of its supply chain.

Read more

What Are Value Traps?

Value traps emerge when a stock looks cheap at first glance. The company may have unusually low valuation ratios, like P/E, price-to-sales, or price-to-book value. The problem is that later on, this low price becomes perfectly logical in face of declining business and earnings.

There are many reasons why a company that looks like a bargain turns out to be not a good deal. What they all have in common is a stock that never recovers or keeps declining even after it was judged “cheap” by value investors.

The problem with value traps is that they are only obvious with hindsight. By definition, good value stocks will share a lot in common with value traps. They seem cheap, they are out of favor among investors, and they usually have some bad news attached, justifying the current low prices.

How to Spot Value Traps

So how can you spot a value trap? The first thing is to understand that while good value stocks and value traps might share common quantitative metrics, they are very different from a qualitative point of view.

High-quality stocks with a temporarily depressed price will recover. Bad stocks with problems in the underlying business often keep getting worse.

🚩 Here are some of the qualitative characteristics that might indicate a stock is actually a value trap:

• Peak cycle: This is common in cyclical industries, like commodities, for example. High earnings might indicate the top of a cycle. From there, earnings will decline, and multiples will contract. This is a good way to have a stock price crashing by anywhere from 50%-90% simply out of cyclicality.

• Changing competitive situation: Looking at previous periods, the stock might seems cheap. It may have recently lost its competitive advantage, or its segment has fundamentally changed. Current earnings might just keep getting worse, with no end in sight.

• Hidden costs: Is the company reporting its real risk exposure honestly? This can happen with financials. For example, a bank may make loans that are not as safe as advertised. This is the kind of thing that happened in 2008 and led to the collapse of Lehman Brothers. Another example would be large pension costs not properly reported in the balance sheet.

• Hidden liabilities: This can be a problem for tech or industrial and chemical companies. Legal risks like lawsuits for causing cancer or losing a key patent are hidden liabilities as well. Investors in Monsanto/Bayer have lost a lot of money by neglecting this risk.

• Out-of-financial metrics risks: Maybe earnings are not as safe as they look. Is the company operating in a corrupt country? Then the price might reflect the risk of nationalization. Or maybe the majority shareholders do not respect minority shareholders’ interests.

• Are cash flow and earnings temporarily inflated? Maybe the company got a lot of cash this quarter from selling a part of the business. This might make the ratio looks good now, but it will not happen again. Did some event in the world push profitability up temporarily? A perfect example was the Covid pandemic, where some explosive growth for e-commerce and work-from-home stocks was never going to be sustainable for a longer timeframe.

The Thin Line Between Value and Value Traps

Looking at the list above, it might seem that protection from value traps is simple. Due diligence should be enough to spot hidden risks. But the truth is that most of these risks are usually discussed openly as the reason for the cheap price.

A good value investor is someone able to identify when the perceived risks are higher than the real ones. This is very subjective.

For example, the peak cycle issue might be happening. Or are there still 2-3 years left in this cycle? Which one is it? Getting the answer right can be the difference between a value trap and having spotted a 10-bagger (stock going up 10x).

Similarly, a jurisdiction risk might be exaggerated. Or not. A recent example was given to us with Russian stocks. Many value investors suffered considerable losses buying Russian stocks that were objectively very cheap. Then their value went to essentially zero if you are a Western investor due to sanctions.

The Russian example is very instructive.

Daring value investors betting on the country in the 1990s are hailed as visionary geniuses, with returns often in the 10x-100x in a decade or two.

Investors in Russian stocks in 2022 are mocked for their lack of insight.

I would argue that luck, more than skill or insight, is likely the difference between the 1990s and 2022 Russian stock investors.

What about Chinese stocks? Brazilians? Indonesians? Indians? Which are too risky and which are a bargain?

Predicting the future is hard, and price fluctuations and hindsight make people think of themselves as smarter than they are.

How to Survive Value Traps

A low price can be an opportunity. It can also be a warning sign: maybe the market sees something that you don’t.

Because value investors disagree with the broader market, they are doomed to stumble on value traps every so often. Even the best will get it wrong sometimes. So how do we solve this dilemma?

To me, the answer is in portfolio construction, asymmetry, mental flexibility, and skepticism.

Portfolio Management

The first component here will be diversification. A portfolio should not be an all-in bet on 1-3 stocks or just one theme. Of course, concentration might bring outstanding results, but it might also bring complete ruin. Only with hindsight will you know which one it is.

The important part is also to diversify the possible traps. So all possible types of diversification need to be done in parallel. Different countries, industries, company sizes, business models, and technology.

In appearance, this runs contrary to the “circle of competence” principle. I would argue that even with a narrow circle of competence, there is still plenty of options to diversify. Even if ultimately, a wider range of knowledge and experience, leading to a larger circle of competence, will be the best tool to keep diversifying.

Asymmetry

When looking at total returns, we look at the average of ALL returns. This means that if you put out 10 bets, and nine resulted in 100% losses, but one yielded 10x, you are even. If two yielded 10x, you are 10x up.

So an important part is to get the upside as open as possible and the downside as limited as possible. I would recommend reading Nassim Taleb on this idea, and more specifically, his book Skin in the Game: The Hidden Asymmetries in Daily Life, to understand further the concept of asymmetry in both investing and society.

Staying Flexible

Another factor is the ability to admit that you were wrong.

This was a central investing tenet of the legendary George Soros. He is famous for making billion-dollar bets, then giving up on them a month later when he changed his mind.

Most value traps don’t close on their victim suddenly like a bear trap. They are most often than not the result of a slow decline that never stops, akin to a slow-moving boa constrictor.

Admitting you are wrong is spotting the value trap. Getting out early is what will save you. Discipline, stop-loss orders, or the ability to see what you got wrong are vital survival tools.

I am only rich because I know when I’m wrong.

George Soros

Skepticism

It’s exciting to spot what seems to be an overlooked value stock. A ticker pops up on your screener, you look through the ratios, and for a moment, it seems like you’ve found the value investor’s holy grail: the stock everyone else has overlooked.

Before you rush out and buy, think twice. Either you have spotted something the entire market has missed, or the market sees something you don’t. Which is more likely?

Undervalued stocks do exist, but it’s extremely rare to find one that is radically or dramatically undervalued. If there’s a really large disparity between price and apparent value, it’s very likely that there’s something in the picture that you’re not seeing. Remember the old saying: if it seems too good to be true, it’s probably not true.

Conclusion

Value traps are something investors should be very wary of. At the same time, investors must recognize that almost all of them will fall into a value trap at some point in the future.

I will go as far as saying a value investor who does not have a good war story about a value trap is not a seasoned investor.

There’s no silver bullet that will protect you from value traps. Instead, reducing the damages they cause will rely on the whole toolkit available to investors: experience, deep knowledge of a sector, macro and micro analyses, accurate financial forecasts, mental flexibility, managing asymmetries, portfolio construction, and simple skepticism.

So the question is not, “Is it a value trap,” But more something around “How can I realize it early if it is a value trap, and then what can I do?”

Value traps are a part of life for investors, especially value investors. Learning to survive stepping on one is what will make a portfolio successful in the long run.

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The tide seems to have turned for some growth stocks. This makes it the perfect time to look at what works for growth investing strategies and their possible limits.

Growth vs. Value

Many investors treat value investing as the opposite of growth investing. These investing styles are different, but I would argue that all growth investing is ultimately value investing as well. The difference is that the value calculation is based on future value instead of current value.

This emphasis on the future is what makes growth investing both so appealing and so difficult.

The appeal is that future growth can outsize any other type of gain. Early investors in Facebook, Amazon, or Telsa are good examples of this.

The difficulty is that the future is, by definition, unknowable. So any lofty projection for the future might hit a brick wall of unexpected problems.

How to Succeed at Growth Investing

To succeed at growth investing, you need to pick companies that will be the winners in the future. Here are a few ways you can increase your chances of finding giants in the making.

1. The Right Trend

I intentionally wrote “trend” and not “technology.” The trend can be a specific technology like smartphones, electric cars, or semiconductors. It can also be the trend toward large supermarkets: Walmart used to be a small company with explosive growth. Starbucks was a small coffee chain selling “overpriced” drinks.

The key here is to identify a powerful trend in the economy, usually something that people are happily throwing money at. This doesn’t have to be tech-focused.

The ideal target is a general sector that is growing aggressively and has access to plenty of capital. This means the companies you pick can grow both in market share AND together with the whole sector.

2. Unique Advantage

Once a good trend is found, you need to find a company in it with a definitive competitive advantage. That advantage can be unique technology, but it can also be a better business model and economy of scale (Walmart, Cosco), an oligopoly or monopoly (Visa & Mastercard), or an exceptional customer experience (Starbucks).

The point is that we already know the sector is growing extremely quickly. In that context, the company with a hard-to-replicate advantage will most likely win the competitive race.

This creates a so-called flywheel effect: the more it grows, the strongest its unique advantage gets, the more of the sector it dominates, and the quicker it grows. Rinse and repeat.

3. Build Expertise

Because explosive growth is usually supported by dramatic changes and disruptions, it can be hard to understand what is happening.

Investors who develop a true expert view of the sectors they are most interested in have a real advantage. That can be a unique insight into the technology or a deep understanding of the business model of the innovators driving the growth.

Being an expert or becoming one will give investors an edge against generalists, who often miss factors that can disrupt the industry and make previous financial models obsolete.

Price Still Matters

Growth investors are an optimistic bunch. They don’t fear the future; they wait for it eagerly. This optimistic nature can lead them astray.

It is very common for growth stocks to be priced at higher valuations than more stable companies. This makes sense, as cash flows growing 20%-30% per year should be priced in the company valuation.

This does not mean that ANY price is okay for growth stocks. Too optimistic a valuation can lead to a bubble, especially when the valuation is based on hype and unrealistic expectations. This is the most valid criticism of growth investing.

The best example was during the dot.com bubble, where some stocks of large companies (not startups) reached absurdly high valuations.

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends.

That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate.

Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

The CEO of Sun Microsystem explained it simply

Any company trading at more than 10 times revenues is probably grossly overvalued. The same is true of anything with a P/E ratio over 100 or a price-to-free-cash-flow ratio over 50.

This is not a new or tech-related phenomenon. In the 1970s, the “Nifty-Fifty” stocks were equally overpriced and experienced declines of up to 90% in the following decade.

I will also point out that it is not about the quality of the company. Mcdonald’s or Disney in the Nifty-Fifty were great growth companies. But at the prices they traded back then, they were terrible investments.

The problem is that, maybe, if everything goes right, the company multiplies by 10x its sales in a decade before slowing growth, something exceptional indeed. With a price-to-sales ratio of 10, the company’s current valuation already prices in such lofty expectations. Anything less can lead to a terrible crash. And success would mean no capital gain at all. The risk-reward ratio is just awful in such a situation.

I suspect some of the high flyers of this era, like Tesla, Moderna, or Nvidia, might be in the same situation. You can believe that Tesla is a great company and still recognize that it is too pricey to be a good stock pick anymore.

Building a Growth Portfolio

It is very rare that only one sector of the economy is growing. For example, could you guess which US stock produced the highest returns from 1990 to 1998? You would likely expect some tech stock of the time, like Microsoft, considering that this was the time of the dot.com bubble.

It was actually Veritas, an oil service firm based in Houston, with an astonishing 146% annualized returns. 1.5x every year; 12x in 8 years!

Growth investors should not too enamored with one specific sector or technology. The future is very hard to predict. Even the best growth investor in the world will make some wrong calls. Diversifying both individual stock picks and sectors will be key to reducing risk.

The winners of the 90s were not just in tech but also in oil, biotech, retail, and financials.

Diversification is also key to improving returns. Growth investing can bring exceptional results from just a few stock picks. This means that the total returns are often driven by less than 5%-10% of the whole portfolio.

Many successful investors over the last 20 years will probably have most of their total gains coming from a handful of positions: Nvidia, Amazon, Tesla, or Bitcoin, for example.

At the time, these were risky bets. Almost no one put massive hopes on a low-margin computer card maker, a money-losing bookshop, a manufacturer of self-igniting sports cars, and obscure lines of code with no real purpose.

These investments succeeded, but many other speculative ventures did not. Growth investors can’t expect to get every call right. The goal is to pick enough winners to outweigh the inevitable losers.

By diversifying and having many different investments, you are more likely to see your net catch the very rare fish able to go up x100 or x1000 in 10-20 years.

Conclusion

Growth investing can be a very successful strategy. It is also perfectly suited for tech enthusiasts and people with a tendency toward optimism and thinking out of the box.

Returns in a growth portfolio will most likely come for “moonshots” IF the portfolio is diversified enough. High concentration is likely the road to ruin for growth investors. Unlike value investing, there is not really any “margin of safety” to rely on here.

The other factor is to beware of bubbly valuation. It is easy to think that the stock that just did x20 will do another x10 soon. Instant millionaires are tempted to believe they are geniuses and ignore the role played by luck. The exponential curve always stops somewhere.

For this reason, it might be best for successful growth investors to know when to take out some gains. And to remember to never tie their identity to their stock picks.

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This article originally appeared on FinMasters.com: Growth Investing Strategies That Work and Their Limits

Some are very data-based and very rational even if sometimes complex.

And some are ... of a more creative nature shall we say. In this article, we will look at some of the most original, absurd, or out-of-the-box economic indicators which have been proposed.

1. The Somewhat Serious Ones

Some indicators are not very easy to fit neatly into a mathematic formula, but might still contain valuable information. With investing as much an art as a science, they might even be useful.

The Big Mac Index

It is the idea that as Mcdonald's is present all over the world, the price of a basic burger should reflect the real cost of living in a country. This is not that far-fetched, as the company will always optimize to the max its supply chain and operation. It is also operating in a similar way everywhere and the basic Big Mac is also more or the same.

On the negative side, it might not be usable for countries like North Korea, but this is not really a star destination for investors anyway, is it?

The RV Index

RV's or mobile homes tend to be luxury purchases, done when people have spare cash and are planning long holidays and road trips. So it quite makes sense that record RV sales could indicate the market top.

This was quite the case in 2020 and 2021, but maybe all the hotels closing and flights being cumbersome or even risky with Covid had a lot to do with it.

Marine Advertisement Intensity Index

In bad economic times, enlisting might seem like a good way to get a job, benefits, an education, or all of the above at once. This is also when the Marines have little trouble finding enough recruits. So they run ads focused on toughness, and aggressivity, to scare off the potentially unmotivated or unfit candidates.

In periods of growth, they have the opposite problem of not having enough candidates. So they push ads with a more friendly tone, focused on self-accomplishment, able to convince the ensures that they should give it a try.

While this makes sense, this index might be a little too manipulative and militaristic for many.

Skyscraper Boom Indicator

When new records for the "world's tallest building" are reached, it might be an indication of too much money around and a market top.

Just before the onset of the Great Depression, three of the world's tallest buildings were under construction: 40th Wall Street, the Chrysler building, and the Empire State building. Similarly, the Burj Khalifa in Dubai was finished in 2010. The Petronas Towers in 1998 matched the Asian Financial Crisis of 1997.

Skyscrapers are rarely an efficient investment and more of a "vanity" project by whoever pushed for it, big bank, government, large corporation, etc... So it makes sense that they launch them at the height of exuberance before the bursting of a bubble.

For that matter, a similar idea exists for individual companies, the "curse of new HQ". For the same reason: a company flush with cash can waste it on new flashy, and spectacular headquarters. That money could have been better spent on R&D or growth or reducing debt.

2. The Really Wacky Ones

Economists are people too. And they can get bored and come up with some really outlandish ideas while still claiming to do their jobs. Here are some of the concepts that have been proposed and ring from bizarre to outright funny.

MUI - Men’s Underwear Index

In this theory, men's underwear sales are supposed to reflect consumer confidence and the state of the economy. Apparently, no less than Former Federal Reserve Chairman Alan Greenspan believed in it.

The idea is that this is a purchase men postpone during hard times. The same idea has been proposed for the sale of lipsticks. So maybe not that absurd after all.

Definitely not something we will see the IMF track any time soon.

The Hot Waitress/Waiter Index

As a warning, this index might be more than a little sexist. The idea is that during good economic times, women can pursue jobs in their preferred careers. But during layoffs and recession, "hot" women might be forced to take jobs in service they would have normally avoided. The same should be true for men for that matter.

An alternative version of this claim is that restaurant owners hire prettier waitresses when they feel they need more patrons. I let you see for further detail the NY Magazine investigation on the matter.

Not sure how this could translate into an actual investing strategy... Can be fun to collect data on it though.

The Hemline Theory

Hemlines are the distance between the ground and the bottom of a dress. Short skirts are supposed to be for economic growth. A Wharton economist created this theory in the 1920s, showing us the long history of wacky indicators.

A priori, you could think that shorter dresses are cheaper because they have less fabric, so it is somewhat contradictory. The idea was more that times with plenty of "festive" spirit like the Roaring Twenties (1920s) encourage a more "frivolous" and modern behavior.

Together with MUI, this would indicate that after 12 years of bull markets, we should see men with great underwear ... and girls with very short skirts ... Wait, maybe there is actually something there?

Tie Colors

This concept is that during prosperous periods, professionals can afford to get a little creative with their apparel. A fuchsia tie, a pink shirt, etc...

But when half of the company has been fired or will be soon, the survivors are likely to do everything to appear as professional as possible, serious, and downright boring. Like wearing black or dark color ties. Ties are also supposed to be slimmer during a recession.

So if your investment banker comes with a Star Wars tie at a meeting, is it time to sell?

The Olympics Indicator

Between the opening and closing of the Olympic Games, 18 of 26 games have turned out positive.

It might be that investors are optimistic when enjoying the games. Because of that markets are most of the time up, even so slightly, if you pick a random period of time.

Another version of it believes that the football world cup winner tends to outperform, with the country's market rising in tandem with the popular joy. Or maybe it is just the extra consumption of beer during the celebrations, who knows...

Conclusion

There is really no shortage of theories and fanciful ideas about how to gain unique insights into the economy. Even if we exclude the more superstitious fortune tellers and other astrologers.

The line between innovative thinking and ridiculous can be even somewhat blurry. Where would you fit the dresses' hemlines and men's underwear sales? But they can anyway make for fun small talk at parties.

When someone asks you what you think about the market: just ask them if they find the waitresses hot or to show you their underwear, and that only then, you will be able to give an answer.

Bonus points if the Olympics are coming soon.

☝️ While some of the more "serious" wacky indicators might actually be useful, they are far from reliable. We definitely do NOT recommend you take any investment decision using them.

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This article originally appeared on FinMasters.com: Spotting and Investing (or Trading) in a Market Bubble