28 Sep 2018
The emerging markets storm buffeting investors increases the focus on quantitative analysis in portfolio management. There’s no silver bullet, but StarMine can offer critical insight at times of market volatility.
- Investors faced with the current emerging markets storm need data tools to help them avoid the temptation to “catch a falling knife”.
- StarMine Smart Estimate enables investors to better understand the chances of stocks beating or missing earnings expectations.
- Earnings Quality from StarMine tends to perform well in times of market volatility, helping investors tilt their portfolios towards stronger companies.
While investors in developed markets remain largely blessed with fair winds, the same is no longer true for emerging markets.
Significant stresses are appearing in many asset classes, including equities, currencies and bonds, as the United States unwinds quantitative easing and normalizes short-term interest rates.
Emerging markets storm
The challenges posed by this emerging markets storm are occurring at the same time as fundamental change in the way that investors operate.
Traveling across Asia Pacific, it is fascinating to observe the evolving nature of the investment process, with increasing sophistication in both security selection and portfolio construction.
A decade ago, the investment process relied on management meetings and fundamental analysis, whereas today a hybrid investment process (often shortened to ‘quantamental’) is now in the ascent.
Whether or not one agrees that “data is the new oil,” it is clear that increasing quantities of data support the investment decision maker.
StarMine Smart Estimate
We have long been a provider of content that supports buy-side equities and credit market decision making.
Two of our content sets are particularly relevant in periods of elevated volatility, such as the emerging markets storm impacting investors at the moment.
Across key metrics, our proprietary estimates place more weight on recent forecasts and better performing analysts, augmented with an algorithm that excludes estimates that predate significant new market information.
This new consensus makes it possible to understand stocks with a statistically significant chance of beating or missing earnings expectations (or revenue, cash flow, dividend, etc.).
The primary use case here is risk management, though this data can be used as a screening tool for long and short ideas.
Recent performance has highlighted the sharp downside moves that can occur where equities miss their earnings number, particularly equities where market expectations and valuations are elevated.
We recently highlighted the accuracy of the StarMine Smart Estimate in predicting negative surprises. The results were robust, with a 73 percent accuracy rate in predicting a negative surprise when our predicted surprise is >-2 percent.
Flight to earnings quality
According to Warren Buffett, “only when the tide goes out do you discover who has been swimming naked.”
As a bear market sets in for emerging markets, another means of assessing earnings risk is through an examination of the quality, or sustainability, of reported earnings.
StarMine offers an Earnings Quality model that assesses earnings sustainability based on accruals, cash flows and a Du Pont assessment of the operating efficiency of a company.
As we recently highlighted, Earnings Quality tends to perform extremely well as a factor in difficult market conditions and an examination of recent performance of the model bears this out.
Across the emerging markets universe, there is a 31 percent decile spread between the performance of the top and bottom deciles over the trailing 12 months.
Intuitively this makes perfect sense, as portfolio managers tilt their portfolios to companies with conservative accounting, strong cash flows and a strong operating model.
Notably, the performance of the top decile is actually positive; a significant accomplishment given that many emerging market indices are down significantly over a trailing 12-month time frame.
How to avoid a falling knife?
There is no silver bullet during periods of volatility and market dislocation.
However, there are models that can orientate portfolios towards safer companies likely to outperform, helping portfolio managers avoid the temptation to “catch a falling knife,” as the saying goes.
Every investment approach has drawbacks, and in this example, one may end up positioned defensively as the market sees a relief rally.
However, in an environment where U.S. interest rates continue to rise, trade tensions simmer and falling currencies add additional stresses to those firms with a revenue/debt mismatch, we can offer critical insight into security selection, whether driven by quantitative or fundamental investment processes.