Emerging Financial Markets 8: The Top-Down and Bottom-up Approaches

Prof. J.P. Mei

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Active Asset Management in Emerging Markets

The predictability of emerging market returns Market over-reaction or excessive risk

premium required by investors Time-varying expected return and risk require

a dynamic asset allocation model Objective: Outperform the benchmark with

careful risk management

Sorting by One Variable PE & DY: The HK experience The BEHV Paper

– Sorting by Different Variables

– Form portfolios and track returns out of sample

– Quarterly re-balancing

– High, Middle, and Low Portfolios and three weighting schemes

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5

T h e F u t u r e 1 0 - Y e a r R e t u r n s W h e n S t o c k s a r e

P u r c h a s e d a t D i f f e r e n t D / P i n H o n g K o n g

0 %

5 %

1 0 %

1 5 %

2 0 %

2 5 %

3 0 %

D Y > 6 D Y < 6 D Y < 5 D Y < 4 D Y < 3

H i g h Y i e ld < - - - - - - - - - - - - - - - - - - - - - - - - - - > L o w Y i e ld

5

T h e F u t u r e 1 0 - Y e a r R e t u r n s W h e n S t o c k s a r e

P u r c h a s e d a t D i f f e r e n t P / E i n H o n g K o n g

0 %

5 %

1 0 %

1 5 %

2 0 %

2 5 %

3 0 %

P E < 1 0 P E > 1 0 P E > 1 3 P E > 1 6 P E > 1 9

L o w M u l t i p l e < - - - - - - - - - - - - - - - - - - - - - - - - - - > H i g h M u l t i p l e

S o u r c e : M a l k i e l a n d M e i ( 1 9 9 8 )

The Smith Barney Model:Put It Together

What variables to use? How do we group them? What weight do we assign to each

group? What weight do we assign to each

variables within each group? Good modeling is similar to cooking.

The Smith Barney Model (50%, 5%, 20%, 5%, 20%)

Valuation: P/E, P/E(Forecasted), P/B and Earning Yield Gap

Growth: Earnings and GDP Growth for Next Year Risk: Current account/GDP, Real exchange rate

over-valuation, Beta Interest rate: Real Rate Change Momentum: Earnings revision and Price Change Question: How do they translate rankings into

weightings?

Strength and Weakness of The Smith Barney Model

Strong marketing appeal: Intuitive and easy to

understand.

Flexibility: variables and weights used can be

adjusted to changing market conditions.

Timely information: the use of market information

Multi-colinearity: Similar Information

Failure to adjust for political and other risk

factors.

Transaction cost could be higher than indexing. 4

A Cautious Note for the Value Approach

P/B does not work in every countries

P/Cash flow does not work everywhere

P/E Trailing & Prospective does not

work everywhere

Buy on dip, sell on rally may not work

(Thai example)

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THAILAND-DS MARKET $ - PRICE INDEXFROM 1-5-95 TO 2-28-00 WEEKLY

1995 1996 1997 1998 1999 20000

200

400

600

800

1000

1200

HIGH 1100.99 2-8-96 LOW 117.06 9-3-98 LAST 251.62Source: DATASTREAM

How to Allocate Resources Among Stock Pickers

The Bottom-Up Approach

Company Analysis and Stock Selection

Applying Valuation Models to Emerging Market Stocks (Mariscal & Lee Model)– A link between debt and equity market

– A framework to estimate country-risk adjusted PE

Price/Book Value (P/BV) and Price/Cash Flow (P/CF) Ratios

Industry Analysis: High growth potential

Overall portfolio balance 3

The Momentum Trading Strategy (Rowenhorst)

Sort all stocks by lagged returns into decile portfolios Adjust for beta risk Country neutral portfolio (sort by return in each

country) Size neutral portfolio (sort by return in each size

decile) Size/country neutral and risk adjustment The Momentum Strategy (Chan, Hammed, and Tong)

-Most profits come from Emerging markets.

-Hardly any trading profits after transaction costs.

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Size/country-neutral Relative Strength Portfolios