E327: $7B CIO: The Right Way to Invest in Emerging Markets

0:00Robert, you're a founder and CIO of a$7 billion fund focused on emerging markets. Everybody that I've ever met tells me emerging markets is a trap. Why is emerging markets not a trap? Look, I think that's a great question. And I think people perceive it to be a trap because of the way that they've approached the asset class. And what I mean by that is I think most investors have thought of emerging markets more of an afterthought and more of a yes, no digital, should I do it or should I not do it as opposed to how I should do it. So what do they end up doing? and they end up kind of buying the wrong thing at the wrong time.

0:30They stick with it for too long. They capitulate and they blame it on the asset class. But that's not necessarily how they invest in developed markets. In developed markets, they think about, where do I want to be? Do I want to be in fixed income? Do I want to be in equity? Do I want to be in growth? Do I want to be in value? But in EM, it just seems to be yes, no. Or they'll go and do one investment in one country, doesn't work out, and they say the entire asset class makes no sense to them. I invest in Indonesia, emerging markets doesn't work. I mean, there's been times where, you know, some will say, give an example of somewhere you're working right now and say, oh, well, we're working in Turkey right now.

1:01Turkey would never invest there. I was like, well, let me guess. You did one private equity investment. The currency was at 1.5. Today it's at 43. The company's in great shape, but you're not. I said, exactly. I said, well, that's about how to do the asset class, not if to do the asset class. Because at the same time, you probably could have gone in and done a private credit, structured loan in US dollar, gotten collateral, uncorrelated collateral, and not needed some sort of super monetization event to get your capital back. So look, I just think it's all about how people do it. And they tend to come in late cycle and they come in with very low conviction.

1:33And when does low conviction ever work out? It's absurd if somebody did that to the US, they would invest into some factory in Ohio and then they would say the United States doesn't work. People do that for emerging markets. When we last chatted, you said that emerging market indices have done more harm to emerging markets than almost anything. Why is that? Let's continue on the last concept, which is now someone's made up their mind to go into the market. And quite frankly, they're usually chasing last year's returns when they do it. And they look at an index and then they buy some sort of index tracker, right?

2:04So they've made their decision probably later than they should have. And by definition, when you go into an index, you're going into low conviction, right? You're buying what somebody else told you to buy. In our case, in emerging market debt, it's JP Morgan, right? So they create the JP Morgan Emerging Market Bond Index. and it does some really bad things to investors, right? So when I started Gramercy back in 1998, 99, Argentina was 18 % of the index. We were already writing research about the coming default in Argentina. Why the heck is it safe to be market neutral or benchmark neutral Argentina at eight, nine or whatever?

2:35And you can say that was a long time ago, but in 22, the same index forced you to own Russia and Ukraine just as Russia was invading Ukraine. The issue is that these indices are just completely passive? What's the issue exactly? By definition, when you buy an index, you don't buy what you've necessarily decided you want to buy. You've decided what someone else should tell you that you should know. But then, look, I get the whole ETF effect in developed markets. I don't get it in emerging markets. And what I mean by that is, if you look at the last five years in emerging markets debt, the blended index has maybe done an average of eight or 9 % total return over that period.

3:14Over that five years, the dispersion of outcomes within that index have been down 95 % and plus 200%. So to me, that seems like an environment that at a bare minimum is target rich for active management, or another way of saying it, you're somewhere between negligent and grossly negligent to take that approach as opposed to a high conviction approach. What's the right way to approach emerging markets and what has worked? I'll start with the notion of high conviction. And the emerging market story over the past 20, 25 years, if you were Rip Van Winkle, actually came true, right? Which is you've got these upwardly mobile economies, populations, GDP growth, and you've had better returns than the U.S.

3:52comparable risk elsewhere. The challenge has been is that people haven't been Rip Van Winkle. They have been trapped by the cycles that have occurred within emerging markets. And each of these cycles has had a name, right? So dislocation events. One was called the tequila crisis. Then we had the Asian debt crisis. Then we had the vodka crisis. Then we had the Campanina crisis. Then we had the Tango crisis in Argentina. Then we had the global financial crisis. You would think that a monkey could figure out how to allocate and trade into this market. There's very identifiable cycles that have occurred.

4:18But people have done this strange dance between fear and fear of missing out. So last year was a great year for emerging market debt and quite frankly, for local markets and emerging markets. What do people want to buy this year? Local emerging market debt. The FOMO has kicked back in. And what will happen is people will allocate to the wrong thing. There'll be a gap. They'll capitulate and they'll blame it on the asset class. So how should you do this? Take a high conviction approach, try and capture the return that's embedded in the asset class, but avoid the downside that has become embedded in people's mind, the behavioral mistakes that people have made.

4:52So take a top down and bottoms up approach. I call it like a barbell, anchor the barbell in high conviction yield. So once you have high conviction yield that comes from your single best ideas, underwrite everything you own, underwrite everything you don't own, and what you don't own is equally important. And then when you have high yield, the opportunity cost to move away and make the other mistakes that people have made, which is people tend to buy distressed when it's not distressed and opportunistic when it's not opportunistic in special situations where they're not special. And David, that's because they don't really have the conviction on the other side of the barbell.

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6:36From company filings and brokerage research to news, trade journals, and more than 240 ,000 expert call transcripts. That context turns raw signal into conviction. The first to see wins, the rest follow. Check it out for yourself at alpha-cents.com slash how I invest. This rooted thesis that I talk a lot about, which is everybody wants to know when to buy an asset. They never want to know the thesis. And the reason that's a problem, best example of this is Bitcoin. If I had come to you in 2011, told you to buy it for$40, it went up to$100, then it went up to$200 and you sold. Great. You would have gone to 5x if you didn't have a fundamental thesis.

7:17But if you had held it, if you had a fundamental thesis, you'd be up 1 ,000, 2 ,000. A lot of people don't think about the second order effects of having a rooted thesis. It's not only keeps you from selling when the asset goes down, it also keeps you from selling when the asset goes up. You just have a fundamental view on asset. I couldn't believe more. I mean, we call that something different here. We call that planning the trade and training the plan, right? And so when you underwrite something, you say, this is where I want to buy it. This is where I think there's value. And because of the thesis, this is where I think I should exit it.

7:48So what do people typically do? As it approaches their target, they talk themselves out of it because volatility has made them rethink it. And when it's well below their actual target, they tend to sell too early. So we like to do what I call the happy trade, not the grumpy trade. Plan three levels on the way in and plan three levels on the way out. So what does that mean? I want to own the thing at X. Well, I should give myself some room to own it at Y and Z because there's all sorts of reasons. I'm not smart enough to pick the bottom. But what a lot of investors do is they wait for X, X doesn't come, and they miss the trade.

8:22Right? So for us, it's plan the trade. buy it in three levels. If I buy it after the first level and it keeps going down, I'm happy. But if it rips, I'm happy as well. The worst thing is the grumpy trade where you did nothing. And I think that's a derivation of what you're talking about, which is people took all the risk. They said, I think it's worth X and I should get out at Z, but they changed their mind at Y. Not because any information changed, their psychology changed. You have the job of deploying$7 billion dollars into emerging markets. How do you go about investing that? And tell me about your first principles.

8:56This is an asset class where you should come in with high conviction. We like to think about this asset class less about beta and more about how you get returns. It's a place to go and get returns. It's a lonely place. I think people put too much emphasis on liquidity in this market. So the idea that the safe way to emerging markets is through liquid emerging market debt, liquid fixed income. It's like the gateway drug to emerging markets. And then everybody buys it and what do they find out? One, they didn't really need the liquidity because a lot of allocators, pension funds that have been on your show, what have you, they make a decision.

9:27It's strategic, right? We're going to be two, three, 4 % for a long time. And if we change our mind, it'll take two years, but they park all their money in T plus one, right? So number one is the liquidity is not there when you want it, but the opportunity cost for parking and liquidity when you don't need it is too high. And what do I mean by that? Where we see a lot better return potential is in structured private credit and emerging markets, two, three-year duration paper, not one year, but you can get a thousand basis points over what liquid's getting you. And you get more return, you get less risk, and you explicitly give up some liquidity, not a lot, and you get handsomely paid for it.

9:59I think that to us is what is one of the most interesting opportunities in emerging markets today. Give me an example of this kind of investment. If you were buying the index, you would buy Mexico. And one of the things you would buy in Mexico is a company called Pemex, which is the quasi-sovereign oil and gas company of Mexico. And over the past few years, if you had purchased short duration bonds in Pemex, you'd get about 5%, 6 % yield. But what do you get and what do you not get? So when you buy a bond, how is it baked? So the way a bond's underwritten in our market is JP Morgan or some bank calls you at 815.

10:39They say, we're doing a billion dollar deal for Pemex. It's 10 times oversubscribed. How much do you want? So there's no opportunity to get your DNA on the establishment of that credit at all. And by the way, it comes with a bond trustee, which isn't really there for bondholders. They're there for themselves. And it has a collective action clause. So what does that mean? You don't bake the credit and you don't have the opportunity to work it out because of the collective action clause. You get forced into what others want. And for all that, you get five or 6 % and it's liquid, except for when you need liquidity in these dislocations that I talked about before.

11:07An alternative would be we lend to suppliers of Pemex, people who lay the pipes or build the platforms or whatever it may be. We get correlated collateral, which is a receivable from Pemex itself. And then we get uncorrelated collateral, things that have nothing to do with the business, shopping malls, real estate, whatever the family groups may have. And we're coming in at like a thousand basis points over that, like 16, 17%. This is 12 to 18 month paper. We're not talking about 10-year infrastructure paper or what have you. It's amortizing. It's not PIC. It's cash pay, et cetera. So give up 12 to 18 months of liquidity, pick up 1 ,000 basis points, pick up collateral, and pick up uncorrelated collateral.

11:45I think that's a trade-off we're supposed to do all day long. Tell me about your philosophy on currency risk. Do you always hedge it out? Is there sometimes times to take it on? I'll say that generally that we look at currencies and emerging markets as nothing more than opportunistic. From time to time, there's distress. Now, we run a lot of different return streams. We have fixed income, private credit, special situations, whatever it may be. So if I think about it from a private credit, which we just talked about, the Pemex loan, we're going to lend in U.S. dollars. If not in U.S. dollars, it's going to be pesos hedge back to dollars.

12:18If one's getting mid-teens returns in dollars and you can mitigate that currency risk, why take it? It just adds another layer of risk that's unnecessary. Another layer of risk that's unnecessary. And to your point, what's the thesis? What's the target return? And what's the safest path to that target return? So if target returns mid-teens and you can get that in dollars and get collateral, uncorrelated collateral, the currency just becomes noise. And let's talk about private equity in emerging markets. And that's kind of the Turkish example I gave you a moment ago. When you buy private equity in emerging markets, you commit to something for 10 years and you have currency headwind in your face the entire time.

13:00And over 10 years, why take that risk when you can lend in dollars, get private equity type returns? Like a private equity manager will say, well, I got you a Moik. They like to talk Moik, two, three times Moik. Well, you give me money for 10 years, I'll get you Moik too, right? But if you look at their IRRs, right? The IRRs that we're putting up, the yields that we're getting in private credit in short duration, and then turning it over and over again, well, just take our number for 10 years, it's more than three times, right? Why take that extra risk? People talk about assets as if they're priced, but there's always supply and demand dynamics.

13:31Once some asset gets really out of favor, the price goes to a price where it's very favorable to come in. You were talking about people do the exact opposite. They ride momentums versus trying to go in for value. Is that why this trade exists in that there's not many investors that want to own suppliers to Pemex? A couple of things. I think private credit emerging markets today, like we've talked about in the case of Pemex, you're typically, you want to be solving for market failure and you want to be getting paid for market failure. And I think that's what developed market private credit was doing in the US in 2009 and 2010.

14:05The market failure was the sucking sound of capital that left the banks, the proprietary capital that was no longer available to be lent out. Well, we've seen that in places like Mexico and Turkey and whatever it may be, which is, If you go to a place like Mexico and Pemex, the bond investors are buying bonds. Banks are being told that they have to lend senior secured locally, and they don't really have the capacity for the supplier credits. They're lending directly. They use up their entire line on Pemex direct, not on the Pemex suppliers. There's nobody left to lend, despite the collateral that's there.

14:38If I go to Turkey 2018, we were getting high teens returns in dollars, LTVs of 33%, gas stations, shopping malls, land at the new airport as our collateral. And why were we getting that? Because Turkey was in the midst of a financial crisis and banks were being told they could no longer lend. And we were able to find borrowers that had great assets. They had mismatches between those assets and the liabilities that they had created for themselves. And we had one borrower, they were a supplier. They would take post-dated checks for their product. We call it post-dated checks. They call that commercial paper, January, February, March, April.

15:14And then they would take all those checks and they would go to a bank and they would factor them. Well, in the midst of a financial crisis, the bank stopped funding. So all of a sudden, they've got these liabilities and they can no longer turn their assets into cash. So we're able to turn the assets into cash and rely upon the value of the assets. Started the conversation talking about how absurd it is to group all emerging markets as one trade, Turkey, Indonesia, and other countries. but at the same token, aren't each of these markets very specialized, have specific relationship networks, specific diligence?

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17:27You get more privacy, more guidance, and more free resources to grow the right way. Northwest has been helping founders and entrepreneurs for nearly 30 years. They're the largest registered agent LLC service in the US with over 1500 corporate guides, real people who know your local laws and help you every step of the way. What I love is how fast you can build your business identity with their free resources. You can access thousands of forms, step-by-step guides, and even lawyer drafted operating agreements and bylaws without even creating an account. Northwest makes life easy for business owners.

17:58They don't just help you from your company. They give you the tools you need after you form it. And with Northwest, privacy is automatic. They never sell your data because privacy by default is their pledge. Don't pay hundreds or thousands of dollars for what you could get from Northwest for free. Visit northwestregisteredagent.com slash invest free and start using free resources to build something amazing. Get more with Northwest Registered Agent at northwestregisteredagent.com slash invest free. When you want more, you start your business with Northwest Registered Agent. They give you access to thousands of free guides, tools, and legal forms to help you launch and protect your business all in one place.

18:36With Northwest, you're not just forming an LLC, you're building your complete business identity from what customers see to what they don't see, like operating agreements, meeting minutes, and compliance paperwork. You get more privacy, more guidance, and more free resources to grow the right way. Northwest has been helping founders and entrepreneurs for nearly 30 years. They're the largest registered agent LLC service in the US with over 1500 corporate guides, real people who know your local laws and help you every step of the way. What I love is how fast you can build your business identity with their free resources.

19:07You can access thousands of forms, step-by-step guides, and even lawyer drafted operating agreements and bylaws without even creating an account. Northwest makes life easy for business owners. They don't just help you from your company. They give you the tools you need after you form it. And with Northwest, privacy is automatic. They never sell your data because privacy by default is their pledge. Don't pay hundreds or thousands of dollars for what you could get from Northwest for free. Visit northwestregisteredagent.com slash invest free and start using free resources to build something amazing.

19:39Get more with Northwest Registered Agent at northwestregisteredagent.com slash invest free. You have to be able to approach the asset class both top down and bottoms up. And the bottoms up for us, which is missing in that question is we have local teams throughout emerging markets. So when I talk about a private credit, a loan to Pemex, we have a partner in Mexico who's dedicated to us, who has nearly a hundred employees on the ground, engineers and what have you that are focused on the supplier credits that we're dealing in Mexico. Now we don't give them the investment decision, nor do we simply pay them to source credit.

20:13We require that they co-invest alongside with us. So we have lending platforms in places like Mexico, Brazil, Peru, Turkey, Africa, et cetera. And the cool thing about lending platforms and local presence is information in emerging markets doesn't know if it's long only or alternative in nature. It's just information. So one needs to be properly set up to capture that information. So go back to Pemex example, when COVID hit and oil went to negative 30 or 40 or whatever it was, well, the bonds at Pemex that I told you about that were issued at five, 6%, the longer duration bonds in Mexico went from par to like 50 cents.

20:50At the same time, our suppliers were paying us. So we knew that Pemex was paying our suppliers and our suppliers were paying us. So this wasn't a fundamental issue. There was something technical going on in the market. Now our private credit team could just sit on that, but of course we have an open architecture to capture this information. They're like, Hey, by the way, we're getting paid on our credits. There's, there's, there's not a fundamental issue in the oil sector in Mexico in 2020. We're getting paid. Well, that's informative to people who are doing other business elsewhere on the platform to understand that what they're seeing in New York is very different than what's happening in Mexico City.

21:23Tell me about your team. Are you focused on a couple of countries and how do you deal with the cyclicality of emerging markets? How do you strategically place your team and your relationships? First of all, we have four major teams. So we have four different return streams and four teams. And that's different than some alternative credit shops. We made a decision nearly a decade ago to go from a founder-led firm with all the investment process and people around the founder to classic CIO PM construct, align the investment teams with the success of their product, the performance of their product and what have you.

21:58So within our business, we have four individual strategy groups and four individual businesses. And the cool thing is they tend to be very uncorrelated to each other. So what's going on in public credit can be very different than private credit and special situations are kind of uncorrelated to both. So So each one of those teams will have portfolio managers internally, analysts internally, lawyers internally. I mean, this is very legal intensive business. But then we also have our platform partners. I mentioned close to 100 in Mexico, 35 in Turkey, another 20 in Peru, whatever it may be, that are essential.