“It’s cockamamie idea. For starters, what’s the difference between six and three months? … Either way we’re talking about a very short-term period,” said Ed Yardeni, founder and chief investment strategist at Yardeni Research about whether public companies should report less or more frequently. In other words, reducing reporting frequency by three months is probably not going to remove short-term distractions for those running companies nor better-orient corporations to have a more long-term view, favored by the likes of Warren Buffett, Jamie Dimon of JPMorgan Chase and Indira Nooyi of Pepsico. On the contrary, Yardeni suggests, it could invite investor backlash, since “investors need timely, accurate financial information to make informed investment decisions”, according to the Council of Institutional Investors (CII). The fear of (institutional) investors’ “informed investment decisions” in a rather short time-frame, keeps money managers and thus companies on egg shells. Any knee-jerk reaction to a missed quarter or adverse news, sets off a chain-reaction that ripples across markets leading to a self-reinforcing phenomenon with everyone screaming “sell”, to the benefit of perhaps only short-sellers!
Sensing this (among a host of other widely-speculated reasons), Elon Musk stunned investors lately (only to reverse course recently) with a plan to take Tesla private, a move he said would benefit shareholders by removing short-term pressures. What probably is no surprise, is the downtrend in public listings, globally led by DM. Not only is Wilshire 5000 really 3500 stocks since its creation in 1974 due to mergers, bankruptcies and take-private actions, IPO volumes have been weaker since 2014 as per Dealogic. This is due to founders wanting to keep greater control over their companies as well as seeking to avoid burdensome reporting and compliance obligations of public listings. With the growth of private markets for equity and (tax-friendly) debt, companies can also meet their capital needs outside the public domain, especially when businesses need capital more for intangible needs-intellectual property (patents, brands, etc.) than for building and machinery. As for strategic acquisitions (ex. mega-mergers), private debt helps replace situations where historically stock could have been currency.
Less frequent reporting or merely extending “quarterly capitalism”, should probably not be the crux of the issue to encourage long-term thinking. Long-term thinking should happily arise from an investor. If investors have a long enough time horizon (not necessarily “forever” as quipped by Warren Buffet), as most institutional investors do, it should automatically shape their long-term thinking. This cannot be truer when it comes to investing in emerging markets. By definition, emerging markets are an epitome of secular growth, that are waiting to be tapped into at the grassroots in many economies, beyond the concentration in just a few FANGS/BAT-like stocks pegged to hopes of their endless growth where the going is good till it is not. Investors often follow market-friendly enticements (Shanghai-HK Stock Connect, China A-Share inclusion in MSCI EM Index, etc.) aimed to attract overseas (institutional) investors to improve the depth of EM markets. Often institutional investors suffer from self-inflicting pain (and lamenting as heard recently in many circles) by joining the ranks of millions of local retail investors and subjecting themselves to uncontrollable risks stemming from (often self-perpetrated) passive reverse flows, or for that matter retail sentiments.
With rising economic growth and higher savings rates (China, India being classic examples) accompanied with improving financial literacy (albeit from a very low base) and reduced trading costs, many EM countries have witnessed a growing legion of retail investors representing 40-60% of trading volume (World Federation of Exchanges-WEF) as in Thailand, Indonesia, and India, and accounting for over 80% in China. To the extent that examples such as India’s Systematic Investment Plan (SIP) provide market stability in the face of fluctuating foreign flows, it is laudable for it reflects wealth creation toward pursuing personal aspirations by its teeming millions. However, this comes mixed with bouts of overconfidence, sensation-seeking and irrational trading behavior i.e. overreaction, that often depicts a casino-like mind-set that we have commonly observed in many markets from Brazil to China. These type of “noise-trades” lead to correlated trading activity posing a systemic risk, as well-chronicled in academic literature (e.g. Kumar, Alok, and Charles M. C. Lee, 2005, Retail investor sentiment and return co-movements, Journal of Finance; Thierry Foucault & David Sraer & David J. Thesmar, 2011. “Individual Investors and Volatility,” Journal of Finance). Without a strong domestic institutional presence, there’s a weaker countervailing force to mitigate the volatility that stems from excessive momentum-driven retail trading. Overseas investors (including institutions) both passive and active (traditional mutual funds) who seek participation in EM growth, typically flock to more liquid bellwether stocks, only to see their fortunes rise and fall with retail investors, sometimes following the herds, and at other times leading the pack when overcome with geopolitical, currency, etc. concerns as recently witnessed in Turkey. This begs the question: can US institutional investors do better?
With growth as the central driving force attracting DM institutions to EM, it is important to remind ourselves that catalyzing growth takes a multitude of structural changes (e.g. reforms sweeping across economy, financial, capital markets, industries, etc.) that one cannot expect to materialize overnight, rendering baseless any investor reaction to short term-disappointment(s). Co-existing with growth are a host of inefficiencies which afford inefficiency premiums for private (alternative strategy) investors by either solving or exploiting a persisting problem (e.g. non-performing loans in China and now India) over a long term. By adopting a longer-term approach and committing to longer dated investment vehicles-for equity or debt- investors can also command illiquidity premiums in EM. This could arise from either contractually-bound return on capital as embedded in underlying private transactions or by providing liquidity in market dislocations caused by drying up of liquidity in public markets, a common occurrence in liquidity-constrained EM. To put in perspective, turnover velocity (value traded as a percentage of market capitalization), a measure of market liquidity, was pegged at 40% in EM vs. 54% in DM in early 2016 per WEF. Away from the public eye, private investors can be as entrepreneurial as they’d like in producing skill-based alpha not restricted to just stock-picking, valuation plays or sentiments-driven, multiples expansion in public markets. However, investing in private vehicles, would require investors to rethink the validity of public benchmarks for private investments which often presents apples to oranges comparison anyway. This would allow private investments to be evaluated against their stated objectives and investor expectations accounting for idiosyncratic risks along the way.
While enjoying the benefits of a long-term approach, EM investors can also escape regular spells of nerve-racking experiences. It would be a Turkish delight, if investors were not daily victims of forex fluctuations, investor outflows and fear of contagion spreading across global markets, negating the heterogeneity of EM in seconds. With geo-politics becoming a more dominant force in times forward, investors could be spared wild market gyrations. Domestic influences on markets-politics or government interferences (as quite prevalent in China to prop markets, etc.) would be less of a daily nuisance. Rather than plan/hedge for investor overreaction to daily news, managers would have the opportunity to navigate choppy waters by adopting both tested and innovative responses. Credit and steering committee deliberations would probably be closer to resolutions than proxy vote battles and activist-led dramas lately observed spreading to countries like South Korea, and Japan (not EM but still retail and now GPIF driven). In other words, a volatile roller-coaster ride could be avoided by allowing fundamentals to follow its own course, sparing (especially long-only) institutional investors the public flogging of investing in EM at the hands of the retail investors or governments, till such time EM public markets mature further with more domestic institutional participation, development of derivatives markets, regulatory reforms, etc.
Just because capital is tied up in private market vehicles for the long haul does not mean less reporting but in fact more quality and, purposeful reporting. However, here too the onus shifts to investors. Investors who have made informed decisions based on clinical due diligence of private market EM opportunities upfront, would be justified in asking for relevant curated information without restrictions because they would be cognizant of inherent risks and know what to look for/monitor. Managers would be expected to afford transparency to the extent sought to assure LPs that they are staying the course in pursuing and executing the strategy as laid out initially. However, expecting managers to provide generic data loads (with a traditional mind-set) in the name of transparency and standardization could overwhelm investors as well as managers.
In a nutshell, the entire gamut of EM opportunities across public equities, venture/growth/control private equity, private debt, infrastructure, real estate and commodities could be exploited better, insulated from public market volatility with a longer-term horizon in longer dated private vehicles. In fact, investing in liquid strategies like public bonds, and equities through longer lock-up fund structures also allows managers with more sticky capital to tap into situations with catalysts without having to worry about impulsive investor flows quarter to quarter. Relative value trading strategies aimed at exploiting short windows of opportunities that could be either hits or misses would also be judged with more patience over a longer track of success and failures. In a lower-for-longer market-trekking terrain, a private-for-longer might just be the road to EM.
ÊMA continues to remain responsive to investors’ ongoing search for growth and is conducting independent investment audit on EM private market strategies designed to capture GPs’ perceived opportunities without short-term market distractions/fallouts, to the benefit LPs’ portfolios. Stay tuned.
Kamal Suppal, CFA
Chief Investment Auditor
August 28, 2018
The above content is intended for sophisticated audiences as in institutional investors or family offices. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.