MI274: Investing in Emerging Markets w/ Perth Tolle

0:00You're listening to TIP. On today's episode, I chat with Perth Toll, who is the founder of Life & Liberty Indexes and creator of the Freedom 100 EM Index. Prior to forming Life & Liberty Indexes, Perth was a private wealth advisor at Fidelity Investments. Perth is also a frequent speaker at investment industry events and provides commentary for various financial media, including Barron's, Bloomberg, Cheddar, CNBC, CNN, Fox Business, Market Watch, Morningstar, and even the Wall Street Journal. Perth was named one of the 10 to watch in 2020 by Wealth Management Magazine and one of the top 100 people transforming business by Business Insider in 2021.

0:43During this episode, Perth discusses the relationship between freedom and markets in emerging economies. With a background working in Beijing and Hong Kong, Perth shares her insights into the risks and challenges investors face when investing in authoritarian regimes and why she believes including freedom metrics in your investment process is important. Perth shares why she believes traditional emerging market ETFs are flawed and the concept behind her Freedom 100 EM index. Perth also elaborates on the four main types of autocracy risk for investors, which countries these risks are most prevalent in and provides examples of specific companies that were affected by these risks.

1:23She also touches on which emerging market companies she is most bullish on, such as Chile and Taiwan, as well as touches on some other risks top of mind for investors, such as the ongoing US-China tensions, why she thinks investors should avoid Chinese equities, her thoughts on the delisting risks, the China-Taiwan risk, as well as the biggest opportunities facing emergent markets in the coming years. And one quick housekeeping note before we dive into today's episode. For longtime listeners of the show, you may know who I am, whose voice this is. I am Robert Leonard, the original host of this podcast.

2:03For those who don't know me, I started the show back in August 2019 with TIP, and I hosted it for the first few years. And then I turned it over to Clay, who hosted it for about a year or so. And then he relatively recently turned it over to Rebecca. Going forward, I will be back behind the mic hosting the show for a while, at least until we bring in a new host, which we'll be hiring for very soon. So if you're interested, stay tuned for that announcement in the next few episodes. All right, that's it for housekeeping today. I'm excited to be back with you guys and be back behind the mic. Let's get into this episode with Perth Toll.

2:53educate and inspire the millennial generation.

3:04Welcome to the Millennial Investing Podcast. I am your host, Robert Leonard. And on today's show, I am joined by Perth Toll. Welcome to the show, Perth. Thanks for having me. I got interested in your work from reading your articles online. And I want to start today's show by talking about your background a little bit. I was hoping you could share a bit on how your experiences in Beijing and Hong Kong led you to explore the relationship between freedom and markets. Sure. Thank you. So I grew up in both China and the US. I was born in Beijing, lived there until I was about nine years old, and then moved to the US and traveled back and forth throughout my childhood.

3:41After college, I went and lived in Hong Kong for about a year, during which time I traveled to the mainland, to Beijing, Shanghai, and Shenzhen often. And that's when I first really opened my eyes to the impact of freedom in my life and also in the markets and these various places, US versus Hong Kong at the time versus the mainland. For example, I had a friend in Shanghai who we called Maggie. At this time, I was around 23 and 24. And she was the exact same age as me, just like all of my American friends in every way, except Maggie didn't exist on paper. She has no birth certificate, no school records, no social security benefits, just doesn't exist on paper.

4:20And that's because she was born the second child during the one child policy era, which defines the culture of my generation in China and also has led to now the worst demographics in the world and 30 million missing women in the country due to official Chinese think tank estimates and some have it as twice that. So Maggie's one of the lucky ones. She's not one of the missing women, but she doesn't exist on paper. So I realized, wow, that could have been me. And these policies and this governance in a country has a huge impact on the future of a society and its markets. So that's when I started to first explore the relationship between freedom and markets.

4:58And when I came back to the US, I worked at Fidelity as a financial advisor in the LA and Houston markets. And I had a lot of clients, like I had a Russian client who told me, hey, I don't want to invest in Russia because it would be like funding terrorism. And I felt the same way about China a lot. And so I wanted to create a way for investors who always have an emerging markets allocation to be able to fill that allocation without funding autocracies. I want to get into these freedom metrics a bit more. Talk a little bit more about what metrics you're looking at and how your indexes in total would differ from just investing in a total emerging markets index?

5:39Sure. So we are looking at freedom metrics that encompass both personal and economic freedoms. And we get our data from third-party think tanks that use quantitative variables. So we're using data from the Cato Institute and Frazier Institute. They have a human freedom index and data set, which has 83 variables across the spectrum of both personal, which is civil and political, and economic freedoms. So examples of civil freedom are things like terrorism, trafficking, torture, wars, whether it be invading other countries or internal organized conflict. Women's freedoms are part of this as well.

6:19And there's five proxies for women's freedom, such as women's freedom of movement, women's freedom to inherit, women's rights to children after a divorce, things like that. Political freedoms are things like freedom of expression, freedom of speech, media, religion, assembly, civil procedure, criminal procedure, judicial independence, and so forth. And economic freedoms are things we're more familiar with, like taxation, business regulations, freedom to trade internationally, the higher the free trade, the better, soundness of the money supply. And in areas of inflation, this is extremely important to bring down that inflation, that currency risk as well.

6:52So these are the things that we're looking at. We take the composite country score given to us by the Cato and the Fraser Institutes, and we derive our country weights based on those scores. So are there any countries then that just do not make the cut at all? Like they just don't make it into your index? And if so, which ones are they? The freedom weighting algorithm actually does naturally exclude the worst autocracy. So the worst scoring countries like China, Russia, Saudi Arabia, Egypt, Turkey, Qatar, UAE, those don't make it into the index at all. So we have zero allocation to China, Russia, Saudi Arabia, and so forth.

7:29And that's been the case since the inception of our strategy became publicly traded in 2019. So we were able to sidestep both the various crises in China over the last few years, and also the Russian invasion of Ukraine. So we've been fortunate in that in these very extreme kind of black swan events, which the emerging markets are full of, we've been able to come out unscathed, so to speak. Our investors have been able to kind of sidestep those risks. One of the big differences that came to mind is the weighting of Chinese equities and how that potentially impacts returns of the typical ETF or index compared to yours.

8:09We can get into how Chinese equities have outperformed and underperformed. We'll get into that a little bit later. But I'm wondering, how have your returns stacked up compared to just the total emerging market index? Yeah. So since inception, we have stark outperformance over the, let's say, the MSEI emerging markets index. I'll just look up the numbers here, but it's extremely, extremely stark right now. And we do seek to be the kind of a scorecard, a running scorecard for freedom in the emerging market space. So since inception, our strategy, the freer emerging markets strategy is up 27%. And EEM, which is based on the MSCI Emerging Markets Index, is up 7%.

8:52So this is since May of 2019. And if you look at the one year, the three year, and the year to date, it's telling the same story of the freer markets do tend to outperform. But I wouldn't expect that every year. So everyone that I share this with, I would want to emphasize, we had some very extreme events in the past several three and a half years or so. We had COVID. We had the China tech crackdown. We had founders being disappeared and that's still happening today. Just these kind of black swan events that really show the value of a freedom weighted strategy. But also I wouldn't expect to have these events every year.

9:28So now there's always something in emerging markets, but it is a very stark outperformance story right now. We'll get into the top countries in the freedom weighted metric in just a minute. But before we do, I want to touch on this article that you wrote on the four main elements of autocracy risk for investors in countries under authoritarian rule. So I was just hoping you could talk a little bit about these risks and how they can affect companies, investors in practice. Yeah. So the article that I did for Barron's does talk about these types of risks. And I wrote that article after COVID zero and then the protests happened.

10:07So it was extremely heartening and encouraging for me to see protests happen without immediate reports of a crackdown on the protesters when they were protesting against COVID zero in cities like Beijing, Shanghai, and a lot of other cities across China. I don't know if you remember this, but it only happened very briefly. Afterwards, there was a crackdown on the people that they could find who were present at the protests. And it was kind of set off by this fire that happened due to and due to COVID zero, people died because the firefighters couldn't get through to the properties. So when that happened, everyone was asking, hey, is this a sea change in China?

10:47And, you know, we how encouraged are you by this? And as an investor, it changed nothing for me as encouraged as it was for me to see that. And I think it was a flicker of hope in that time, but it didn't change any of the fundamental risks of investing in authoritarian countries. And one of those risks is misplaced priorities, which means companies in China, for example, and in other autocratic regimes have to put the state's interests before everyone else's interest. So before the interest of their shareholders, before the interest of their customers sometimes. So as an example of that, Tencent, who owns the WeChat app in China.

11:25WeChat has been used by the government to crack down on dissidents, on Uyghurs for a long time. And even in the latest Congress that we saw this weekend in China, data security was a big issue. And by data security, I mean the government wants access to all the data that these companies have. And that is used to often crack down on citizens who may disagree with the government. and Tencent has to hand over this data, whether it's in the best interest of their customers or not. And some of their customers will be detained, jailed, worse because they've handed over this data. But they have to do that because they have to put state interests above all others, whether it's in the best interest of their customers or their shareholders or not.

12:07There's also the capricious government interference risk where the government can come in overnight and say, oh, by the way, you're no longer allowed to participate in your core business activity. You are no longer allowed to raise capital overseas. You are no longer a for-profit company. Now you're a nonprofit. So this all happened in China in the last year and a half or so. Didi had to take their app down from the app store and say, you know, we can't accept any more new customers because they tried to have an IPO overseas and apparently didn't get approved and did it anyway. That did not turn out well for them.

12:43Education companies in China were told that they were nonprofits overnight. Friday night, stroke of a pen, your nonprofits now. That's not something that shareholders can recover from. So these types of things, right now, tech is still a main area of crackdown in China. You can see Baofan, the tech deal guy who is currently disappeared and detained for political purposes. And he had a hand in every big tech deal in China. So it's a very real risk of heavy-handed government interference in private market activity. But it's not just China. You You see also what happened with Russia, sanctions risk, right?

13:19If you invade another country, your market could be marked to zero due to all the ramifications of that. So all of these risks are still very present in China, despite the very short-lived protests that happened that kind of ended COVID zero, which is great. But as an investor, none of these risks have changed. Let's take a quick break and hear from today's sponsors. Even Einstein had blind spots. That's why modern science is built on the idea of peer review. Investing may be more art than science, but that doesn't make peer feedback any less valuable. The tricky thing is finding qualified people who are interested and willing to help vet your investment ideas.

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16:31And for a limited time, you can use code stocks15 for a 15 % discount at checkout. All right, back to the show. I want to touch on the risk of being nationalized. You mentioned that they could be, and a company could be restricted from their core activities, or I guess at the very extreme nationalized. How does that work? And maybe what's an example of a company that has been nationalized? So I'm going to use actually a non-China example for that. Very recently in Egypt, the biggest dairy company in Egypt, the government said, we want to nationalize this company. The founder said no and got thrown in jail.

17:08And his son also said no and was thrown in jail as well. So these are types of things that happen in the emerging markets space because the emerging market space is just so full of autocracies and companies just coming out of autocracies. In a situation like that, basically the government takes over ownership of the company and operations. Something similar that happened in China that I can point to is SMIC, the semiconductor company in Shanghai. This is a company that was founded by expat Americans who are actually from Taiwan. And they went back to China and founded this company. it's controversial and TSMC alleges that they stole a lot of the IP from them.

17:50And they did, SMIC did lose a lawsuit regarding that. And TSMC won that suit alleging the IP theft. But in the end, what happened with this company was it was basically taken over by state appointees and the founder has now been run out. And it's essentially now owned and operated by the government and its appointees. And so that causes a company to become a lot less efficiently run, in our opinion. We do exclude state-owned enterprises. Now, in certain of these countries like China or Egypt, a lot of non-state-owned enterprises are essentially state-run as well, like SMIC. So that's one of the tail risks when you're investing in these autocratic regimes.

18:31What happens to shareholders when that happens? What's the process like? Well, in that situation with SMIC, of course, their share price has declined drastically. They ended up kind of re-IPOing on the Starboard, which is the Chinese exchange. So they did have another IPO and it did pop on that IPO. IPOs on the Starboard tend to pop though on their initial trading because of state support. So a lot of these companies do depend on kind of government support to operate. And we just don't think that is the most efficient way to operate companies or to have sustainable growth. The freer markets tend to have more sustainable growth that's not state mandated or debt driven.

19:14They tend to recover faster from drawdowns as we saw in the recovery in 2020. And they tend to use their capital more efficiently because they're allocating that capital due to, according to the needs on the ground and providing the best value for their customers instead of whatever the government is telling them to do. So you saw the smart car revolution in China a couple of years ago that was driven by government kind of subsidies. Now there's ways to invest in that and participate in that without direct autocracy risk. One of those ways is invest in other emerging countries that have free trade.

19:47So Chile has a lot of free trade with China. Chilean companies such as SQM pivoted from mining copper mostly to mining lithium for the batteries in these electric vehicles. And so in that way, investors in Chilean companies were able to benefit from the unfree market in China and their demand for electric vehicles due to government subsidies without autocracy risk by investing in Chilean companies like SQM. So that's what we try to do as well. We try to capture growth in emerging markets without direct autocracy risk. Another risk you talk about in your article is the different accounting practices that many of these regimes use that lack international oversight.

20:30And because of that, the US has taken some measures over the last few years to crack down on this accounting inconsistencies, you could call them, to really try to protect investors from instances like Luckin Coffee, where accounting just isn't up to par or at worst, and maybe this case was fraudulent. So it's not necessarily happening right this second, but it's happened over the last couple of years. So it's still relatively recent. The SEC is cracking down on Chinese companies in particular. How do you see this affecting the future of investing in Chinese companies? Yeah. So Luckin is a very good example that actually was a while ago, but when it happened, it made a big splash because it was so fraudulent and so blatant.

21:12And I think the short sellers out there like Muddy Waters, for example, saw it coming a mile away, but nobody else did. And in fact, I had family and friends in Asia who were talking to me about it. They're like, oh, it's going to be the next Starbucks. And then after the fall, after the whole news came out that it was fraudulent and the stock crashed, there were still videos going around on Chinese internet where people were just making fun of Americans like, oh, look at these. Luckin's the greatest company in the world because, you know, and they literally said, stupid Americans, retirement money and gives free copy to Chinese people.

21:46I mean, it was, it's like a big running joke, right? And so I think that is a really good example of how we sometimes as investors in very free markets and being used to the rule of law, the investor protections, the IP protections, the stronger institutions that we enjoy here in whether it be New York or London or other places that have very strong institutions, very free capital movement and very high accounting standards, that we project that same standard and optimism onto companies that are in places that just don't have that. And so we are able to, we buy into these great growth stories and oh, it's the next Starbucks, but we don't account for the difference in accounting, the difference in governance in the place where that company operates.

22:35So when Luckin fell, the biggest holders in Luckin in funds were not the China funds. It was the emerging markets funds on an absolute basis, because emerging markets funds are so big. Funds like EEM, IEMG, and VWO took the biggest fall from that. And these are investors who are just trying to get a broad emerging markets allocation. They weren't trying to invest in Luckin. They weren't trying to invest in Chinese companies even. It was just for emerging markets allocations. So that's one of the things that we were able to avoid. But also, it's a really good example of just not being aware of these risks can really hurt you as a broad emerging markets investor.

23:16I'm glad you brought up those specific funds too, because I think most investors are pretty familiar with those ones in particular for emerging market exposure. Do you have any insights or updates on where all of that is now? Do you think that this risk is still very apparent and some companies could end up falling out or wiping out of these indexes? Yes, I do. I think that is a risk. And I think that the bipartisan support for measures like this is gaining momentum. It used to be that when we first launched the fund in 2019, we were the only ones saying this in the ETF space. Now the tide has turned and we no longer have to be as loud or as contradictory because everyone agrees that this is a problem, especially after Russia.

24:01So in those funds and other kind of China funds or other emerging market funds that have high China concentration, most of these funds have taken steps by now to kind of change to H shares of the same companies. So let's say you have a company that's listed in the US as an ADR, the funds are in process or have already changed to a Hong Kong listing. So yes, this actually does help Poncon listings a bit. But if you are an investor who is owning, say, one of these ADRs that's going to be delisted without being in a fund that's making these transitions, then yeah, that's something that is going to affect you and it could be very bad.

24:39So usually when a delisting happens, you can still sell, but the liquidity is going to be very narrow. There's not going to be a lot of liquidity. So you're probably going to sell at a very, very low price. So if you are an investor and you're currently investing in Chinese ADRs that are on the list to be delisted in the next three years, I would prepare yourself for that by either transitioning to a fund that's more diversified if you still want that exposure or selling while you can. Yeah, it's kind of crazy because big companies like Alibaba, they assured investors, they're like, we will comply and get everything right.

25:12But it could be pure panic. Then if something happens in the news where they're skeptical, like you said, the share price could crash and then investors won't have a big window to get out in time. You know, just everybody knows. So yeah, it's a big risk with companies like Alibaba. So that is a major tail risk that's coming for these stocks. Now, most people are already aware of this. So hopefully everyone is taking precaution. Now the fund houses, I know for a fact. So if you're in a fund, that shouldn't be a huge deal for you. It's more going to be a problem for these companies that are listed.