When speaking to clients, our investment team is frequently asked whether the market's extraordinary run is due to come to an end. It's a question many in the market are currently grappling with, and it pays to look back into history to provide a guide.

History repeating itself

In 2009, we saw only 5 drawdowns greater than 5% over the 18 months following the market's low on 6 March 2009. Surprisingly the average drawdown was just above 4%, with each drawdown lasting on average just 7 trading days.[1]

Despite seeming counter-intuitive given apparent risks, it isn't unusual for markets to recover in this fashion after a large shock. History repeated following the recent COVID-induced drawdown, with only 2 drawdowns greater than 5% since the market bottomed on 23 March 2020, and each drawdown averaging only 3 trading days.[2]

Today we find ourselves 15 months past the pandemic bottom in markets, with the ASX300 Accumulation Index having risen in 14 months out of the 15, and up a total of 67.8%.[3] The market is 7.1% above its all-time high, and continues to climb higher.

Watching the signs

We remain positive on the market over the next 6 weeks as we head into a strong reporting season. However, a number of potential issues are accumulating as we enter the seasonally weaker period into September, with bond markets, options markets and the Chinese economy all attracting our attention.

Bond markets

The US Federal Reserve is committed to keeping its foot firmly on the accelerator until either employment numbers fall dramatically, or inflation accelerates to uncomfortable levels.

US headline inflation numbers released this week unexpectedly accelerated to 5.4% year on year in June, the biggest rise since 2008. One data point certainly does not make a trend; but three data points in a row is hard to dismiss, particularly when price pressures were so broad-based. Yet inflation is still transitory according to central bankers, and any acknowledgement otherwise is still months away.

Increasing inflation fears continue to spook investors that central banks may move sooner rather than later to lift interest rates, which saw the US 10-year bond yield rise from 0.50% in August 2020 to 1.74% in March 2021. But the yield has since retraced to 1.47% as the bond market warns of a potential economic slowdown. After experiencing a sell-off, since the middle of May investors have rotated once again into the tech sector, fuelled by the bond yield fall. Market breadth is narrowing (rarely a sign of market health), with mega-cap tech shares in the US increasingly taking leadership.

Options markets

The options market offers interesting insights, with positioning suggesting nearly everyone in the market is bullish. Implied volatility remains subdued, with the current put:call ratio extremely low - reflecting a heavy skew towards upside participation with little downside protection. 'Who cares about protection' seems to be the belief of the times. When the deck is stacked heavily towards upside participation, investors can aggressively move en masse to downside protection when markets do fall - leading to an even sharper reversal.

China

Meanwhile, the Chinese economy is at an interesting juncture. Having led the world out of the COVID-induced economic downturn, several indicators suggest risks are rising. Total social financing, which is a broad measure of credit and liquidity in the economy, has been falling after the Chinese government embarked on a process of deleveraging, allowing the economy to move forward with less stimulus support.

The Chinese approach is in contrast to that of the US, which continues to provide significant monetary and fiscal stimulus. Other Chinese data has also been weak recently, including the Caixin composite PMI which fell from 53.8 in May to 50.6 in June (the lowest reading since April 2020). New orders are at a 14-month low. The People's Bank of China has recently cut the Required Reserve Ratio (RRR) by 50bp, releasing an estimated RMB 1 trillion in base money liquidity and reducing bank funding costs by RMB 13b per annum. This should assist bank liquidity; however, we do not believe it represents a change in monetary policy by the Chinese authorities, with tighter prudential regulations and a continued slowdown in credit growth likely.

Alan Greenspan famously said in 1973: "It's very rare that you can be as unqualifiedly bullish as you can now." These words were spoken just before two of the worst years for the US economy and the stock market. Could the Australian market be heading for a similar comeuppance?

Funds operated by this manager: 

Premium Asia Fund, Premium Asia Income Fund, Premium China Fund

Founders have changed the world and will continue as long as capitalism exists. Our system motivates bright individuals to pursue dreams and build companies that improve human lives, just as trees in a canopy compete vertically for sunlight. For us investors, we need not miss out on these game changers. We can participate in the rise of these companies alongside their founders, and if analytical judgement is cast correctly, stand to benefit immensely from their journey.

Are all founder-led companies start ups?

Investing in founder-led companies does not mean venture capital investing - there are over 2,000 listed founder-led companies globally, varying in age, size and industry. Not all founders work on new and shiny products, only a small proportion are start ups. In fact there are many blue chip founder-led companies that are not in the technology sector, and these global household giants should resonate with many of my readers: Marriott, Morningstar, Hermes, Walmart and Nike.

What are the risks of founder-led companies?

The pros of investing in founder-led companies are well documented by academics and practitioners alike - Credit Suisse and Bain have quantified a +7% outperformance since 2006. Other studies show multi-decade alpha. In business, skin in the game matters and that is why founders make great business owners and operators.

But not all founders are great. Not all founder-led companies turn out to be the next Amazon. Hence everything in moderation, and why diversification is needed to dampen the volatility of owning just one company. This is where a clear portfolio construction recipe comes in.

I have previously likened portfolios to making a cake in this publication. We select our best ingredients and apply them in the right proportions before baking in an oven at the right temperature. What generates returns is not what has happened, but what will happen. And proportions are crucial.

Instead of baking one cake with all our cake mix and hoping it turns out well, we should divide the cake mix to make many cakes. With each cake we make, risk is reduced. That is the key to a well-balanced portfolio of founder-led companies. The sum of the parts is always greater than the whole, especially when it comes to risk management.

There is an optimal way to diversify and the framework for this process is tied with the concept of vintages.

How to diversify a portfolio of founder-led companies

The least volatile founder-led companies are also usually the oldest. Think Walmart, Hermes and Nike, who have each existed for decades. The advantage of these generational companies is stability of growth and predictability of dividends. They move like ocean liners, their brands carry an inertia that spins off free cash flow consistently. You can rely on these founder-led companies to deliver slow and steady growth to your portfolio. The advantages are not without risk though. Older generational companies can become complacent. Their founders may have already reaped the rewards of their lifetime of efforts and become content with sitting back and relaxing. Their succession planning may not be smooth. The companies themselves may not be built the right way to adapt to changing environments. Ocean liners have a huge turning circle; it becomes impossible to navigate fast-changing conditions when they have only been built to travel in straight lines.

This is why portfolios should be built to capture the full spectrum of founders from different vintages. You want both ocean liners and speedboats. Younger founders are hungry and motivated. They are free of the shackles imposed by legacy constraints. In this day and age, issues caused by use of outdated technology can prove significant for incumbents - you can observe how difficult it is for banks to transform their systems. It is easier and faster to build from scratch than it is to modify, much like how building a new house is faster than renovating an old building. When the pace of change increases, newcomers have the advantage.

Take for example a company my fund is invested in. It's a Dutch company called Adyen in the global payments market. They've been built with technology from the ground up that allows them to outcompete incumbents. As a result, they have been able to win significant market share in a very short period of time and capture the accelerating change in consumer payment behaviour.

When it comes to founder-led companies, there are pros and cons to both old and young. Having all your eggs in either one or the other would be unwise. Spread your portfolio across founders from all vintages. You want to build a fleet that encompasses the ocean liners, giving stability and reliability, and mix them with speedboats who can navigate changing environments and adapt with the times. This is what can truly mitigate risk.

Skin in the game - when theory meets practice

A final question and thought for my readers: which of these investment opportunities is inherently riskier over the long-term:

1)    Multinational blue chip where the board has employed a salaried CEO on a 5-year contract; or

2)    A mid cap company where the founder retains majority ownership, is the CEO and Chair.

The multinational blue chip has existed for much longer, so its share price is more predictable, less volatile. The mid cap founder-led company has a much more volatile share price - analysts have a wide variety of opinions regarding its prospects.

But which one is riskier over the long-term? Which company would you rather invest in?

The answer depends on your understanding of the difference between risk and volatility. One investment is more volatile, but is actually less risky over the long-term.

Happy compounding. 

About the author

Lawrence Lam is the Managing Director & Founder of Lumenary Investment Management, a firm that invests in the best founder-led companies in the world. We scour the world looking for unique, overlooked companies in markets and industries on the edge of greatness. We are a different type of global fund.

Disclaimer: The material in this article is general information only and does not consider any individual's investment objectives. All stocks mentioned have been used for illustrative purposes only and do not represent any buy or sell recommendations. Ownership of this publication belongs to Lumenary Investment Management. Use of this material is permitted on the condition Lumenary is acknowledged as the author.

Click here for Part I of this series

In this second part we will consider the current standing of the larger EM countries and then review long term performance of the various indices and, and in the process demonstrate that active management is very effective in less efficient markets.

Let's turn now to the state of the larger EM countries. It is surprising to many just how big the largest emerging markets are already.  China and India together are already bigger than the US or Europe.  

The main emerging market powerhouses are China and India.

• Together, these two countries are home to over 35% of the world's labour force and population.
• In 2018, their combined gross domestic product (about US$28.1 trillion) was greater than that of either [1]:
  • the European Union ($18.8 trillion) or the
  • United States ($20.5 trillion).

In any discussion of emerging markets, the powerful influence of these two super-giants must be kept in mind.

Whilst countries like India and China are still in the EM index, it is worth looking at the next table which compares them to the framework introduced earlier and considers just how emerging they still are.  Putting aside the geopolitical and trade factors which can cloud the conversation it is, we believe, reasonable to view a few of the EM countries as no longer emerging, or at least getting close to that stage of their journey as a nation.

If we take a historical and visual look at Emerging markets and Asia ex-Japan we can see  in the image below how Asia ex-Japan used to be a niche subset of Emerging markets, compared to Developing markets (DM)

That, in our view, is no longer the case.  Almost unnoticed, Asia ex-Japan has become the dominant (80%) part of EM.

Where we are starting from today - and are heading very quickly - is shown in the following images where we recategorise Developed markets as The Western economies (including Japan) and separate Asia ex-Japan and the Frontier markets/commodity countries.

This contention carries compelling investment implications.    The underpinning of these changes in large part is a theme that will have at least a full decade of strong growth as the poor of Asia climb into middle class.   

Strategic allocations and portfolio construction need to catch up and to rethink the use of emerging market funds.  As a minimum we suggest that advisers take 80% of EM into an Asia ex-Japan specialist and add to that a Global resource/commodity specialist. 

The obvious question following our contention is; "what do the numbers say?"  The chart below, whilst busy, tells a compelling story.  Note: Saudi Arabia is not included as it does not have a long enough history but over five years its story is consistent with our contention.

Some key observation to assist in understanding the implications of this chart:

• At the bottom is MSCI Brazil.
• The second from bottom is MSCI Emerging Market index excluding Asia.  This index provides long term support for a contention from Part One that the non-Asia components of EM indices are performance detractors.
• Moving up you can see a quite well-correlated South Africa and Russia.
• Next there is the MSCI full EM index.
• Above that - as would be expected given the underperforming countries - is the Asia ex-Japan Index.
• The top line shows the value of a specialist active manager in a less efficient market.

In summary, investing in an Emerging Markets Fund is primarily an investment in Asia ex-Japan, and the remaining approximately 20% has detracted from long term performance by comparison.  We therefore contend that it is a better outcome for clients to use a specialist Asia ex-Japan that has a strong China capability and if the commodity exposure from EM funds is desired we argue a specialist in either Global Resources and/or Commodities is more effective.

[1] Source: Emerging Market Countries and their 5 Defining Characteristics; Kimberley Adao www.thebalance.com; Aug 2020

Often cited as the densest year of technological innovation of all time, 1995 stands out for several reasons; The launch of the world's first internet enabled marketplaces (Craigslist and eBay), the start of online dating (Match.com), the first fully digital, animated feature film (Pixar's Toy Story) and of course, a humble "bookseller" was born (Amazon.com). While lesser known, 1995 was also the year the greatest internet startup in antipodean history was founded, REA Group.

Just like the great tech tales of Silicon Valley, our Aussie protagonist (REA Group) was started in a garage (1995), IPO'd just before the dotcom bust (1999) and lost ~90% of its value shortly thereafter (2001).

However just before complete failure, it was dealt a dose of good fortune, with Rupert Murdoch and his global media empire, News Corporation stepping in and providing a much-needed capital injection. News Corp. took 44% of REA Group (realestate.com.au at the time) in exchange for A$2 million in cash plus A$8 million worth TV and print advertising, giving REA Group a total equity valuation of A$23 million.

Fast forward twenty years to today and News Corp. owns 61% of REA Group which has a market capitalization of A$21 billion, or 910 times the valuation Murdoch paid in 2001. For comparison, a purchase of Amazon stock at its low point after the dotcom bust would have returned 510 times the initial investment today, or less than two-thirds what REA Group delivered (excluding dividends), which earns it a place among the greatest internet start-ups of all time.

Aside from being a multi-decade compounder for shareholders REA Group holds one of the most privileged positions in real-estate of any company in the world. Real-estate markets tend to be highly localized, with the comparable property radius only extending to surrounding neighborhoods, creating fragmented, non-uniform supply dynamics, which are highly supportive for an online marketplace like REA Group which can aggregate that supply more uniformly.

In addition to this, the Australian market is unique, in that it is impossible to function as a real-estate agent (or broker) without a subscription to REA Group's professional tools and access to its property listing portal, which as we will discuss, is entrenched with buyers and renters in the Australian market.

Through its flagship portal (realestate.com.au) REA Group has become "the destination" for real estate in the Australian market with ~65% of Australia's adult population (12 million people) checking property listings, real estate news, and home prices on the site every month.

Additionally, REA Group continues to increase its lead over the number two player (Domain Holdings), reaching 6 million more Australians and attracting over three times the monthly visitators of its peer, a gap which continues to widen.

REA Group is Australia's #1 Property Portal

Source: REA Group

Adjacent to its privileged position with Australian real-estate customers, REA Group also has an indispensable relationship with real-estate agents. To effectively operate in the Australia market a real-estate agent has very few choices outside of subscribing to REA Group's agent administration tools to find clients, build an online profile and market their listings, this has translated into extremely strong and durable pricing power for REA Group.

While the official strategy is to support agents and remain in their servitude forevermore, one cannot help but observe the increasingly potent value-added services it offers property buyers, sellers and renters, slowly disintermediating agents in the value chain, which is the natural progression of a genuine two-sided marketplace like the one REA Group oversees.

As REA Group continues to reduce friction costs of buying, selling, and renting properties for customers, it is likely to capture a larger share of transaction economics over time.

In Part-II of this series will discuss some of the powerful levers REA Group has at its disposal to increase its share of Australian real-estate industry economics and the numerous other valuable real options it holds within its portfolio. We are very grateful for the trust you have placed in Montaka Global to protect and grow your wealth, alongside our own wealth, and believe REA Group will continue to be a wonderful investment over the long-term.

Click here for Part II of this series

Our contention is that use by date of Emerging Market  (EM) funds has passed and that this has quietly happened over the last decade without much notice.   In Part One of this discussion we will look at the make up of EM Indices and their comparison to Asia ex-Japan funds.

What we will outline is that a decision to invest in an EM fund is already mainly a decision to invest in Greater China and the rest of Asia ex-Japan.  What is leftover in EM are countries that are speculative commodity countries largely with questionable or poor governance.  We contend that there are better ways of accessing resources and commodities than via a generalist manager.  Specialists for both are the better way to improve investment outcomes.   

As well it is reasonable to think that some of the emerging markets - particularly Greater China have in fact emerged. What that means for investing is a rethink about asset allocations.

Let's start our discussion with a quick look at Emerging markets.  Following is a framework for assessing emerging market status[1]:
 

1. Lower-Than-Average Per Capita Income
   
   The World Bank defines developing countries as those with per capita income of $3,995 or less.
    
2. Brisk Economic Growth
3. High Volatility
4. Currency Swings
5. Potential For Growth - successful, rapid growth can also lead to the fifth characteristic, which is the higher-than-average return for investors.  That's because many of these countries focus on an export-driven strategy. They don't have the demand at home, so they produce lower-cost consumer goods and commodities for export to developed markets[1].
    

In China, Taiwan and Korea, and to some extent India, however you can already see a clear shift to consumer led economies vs export led.

Let's start by breaking down the Emerging markets.  If you consider the table below - Emerging Market Breakdown using the MSCI - what you can clearly see is that 75% of the index is made up of four Asian countries: China, Taiwan, Korea and India.  Some EM indices also include Hong Kong which would further increase the dominant Asia exposure.

Looking into the smaller weights, we then come to a group of four which represent the next 14% of the index.  Brazil, South Africa, Russia and Saudi Arabia.  These countries have two things in common in our view:

1. They are all commodity countries which we contend are best invested in through a global resource or commodity specialist manager.
    
2. For different reasons, they also have questionable governance or corruption concerns, further increasing the need for specialist understanding, if not on the ground presence.
    

The final cohort of 19 countries in total represent only 11% of the index and individually and together are largely rounding errors, without also considering the Social and Governance challenges some face.

Emerging Market Breakdown (per MSCI 31.3.2021)
Note:  8 other countries are included in some EM indices - e.g., Hong Kong & Vietnam

Let's now dive a little deeper and look at the next chart which shows that an EM investment is effectively already an Asia ex-Japan investment with a dominant exposure to Greater China.

EM and Asia ex-Japan deeper dive

These charts show that investing in Emerging Markets IS already an Asia ex-Japan investment, but:

• With the addition of volatile and mostly detractor countries, and
• Missing what is arguably the strongest global thematic of all - an historic and enormous rise of middle class out of poverty.

So, to us this reinforces our contention that specialists are a better approach to investing in emerging markets.  Use of an Asia ex-Japan specialist with a deep China understanding combined with a Global resources or Commodities specialist makes more sense than an allocation to a generalist EM fund.

[1] Source: Emerging Market Countries and their 5 Defining Characteristics; Kimberley Adao www.thebalance.com; Aug 2020