Download Global Bargain Hunting

Emerging Financial Markets
8: The Top-Down and Bottom-up Approaches
Prof. J.P. Mei
Active Asset Management
in Emerging Markets
 The
predictability of emerging market returns
 Market
over-reaction or excessive risk
premium required by investors
 Time-varying
expected return and risk require
a dynamic asset allocation model
 Objective:
Outperform the benchmark with
careful risk management
2
Sorting by One Variable
 PE
& DY: The HK experience
 The
BEHV Paper
– Sorting by Different Variables
– Form portfolios and track returns out of
sample
– Quarterly re-balancing
– High, Middle, and Low Portfolios and three
weighting schemes
3
The Future 10-Year Returns When Stocks are
Purchased at Different D/P in Hong Kong
30%
25%
20%
15%
10%
5%
0%
DY > 6
DY < 6
DY < 5
DY < 4
High Yield <--------------------------> Low Yield
DY < 3
5
The Future 10-Year Returns When Stocks are
Purchased at Different P/E in Hong Kong
30%
25%
20%
15%
10%
5%
0%
PE < 10
PE > 10
PE > 13
PE > 16
PE > 19
Low Multiple <--------------------------> High Multiple
5
Source: Malkiel and Mei (1998)
The Smith Barney Model:
Put It Together
 What
 How
variables to use?
do we group them?
 What
weight do we assign to each
group?
 What
weight do we assign to each
variables within each group?
 Good
modeling is similar to cooking.
The Smith Barney Model
(50%, 5%, 20%, 5%, 20%)
 Valuation:
P/E, P/E(Forecasted), P/B and
Earning Yield Gap
 Growth:
Earnings and GDP Growth for Next Year
 Risk:
Current account/GDP, Real exchange rate
over-valuation, Beta
 Interest
rate: Real Rate Change
 Momentum:
 Question:
Earnings revision and Price Change
How do they translate rankings into
weightings?
Strength and Weakness of
The Smith Barney Model

Strong marketing appeal: Intuitive and easy to
understand.

Flexibility: variables and weights used can be
adjusted to changing market conditions.

Timely information: the use of market information

Multi-colinearity: Similar Information

Failure to adjust for political and other risk
factors.

Transaction cost could be higher than indexing.
4
A Cautious Note for the Value Approach
 P/B
does not work in every countries
 P/Cash
flow does not work everywhere
 P/E
Trailing & Prospective does not
work everywhere
 Buy
on dip, sell on rally may not work
(Thai example)
5
THAILAND-DS M ARKET $ - PRICE INDEX
FROM 1-5-95 TO 2-28-00 WEEKLY
1200
1000
800
600
400
200
0
1995
1996
HIGH 1100.99
1997
1998
2-8-96 LOW 117.06
1999
2000
9-3-98
LAST
251.62
Sourc
e: D
ATASTREAM
How to Allocate Resources
Among Stock Pickers
The Bottom-Up Approach
 Company
Analysis and Stock Selection
 Applying
Valuation Models to Emerging
Market Stocks (Mariscal & Lee Model)
– A link between debt and equity market
– A framework to estimate country-risk adjusted PE
 Price/Book
Value (P/BV) and Price/Cash
Flow (P/CF) Ratios
 Industry Analysis:
 Overall
High growth potential
portfolio balance
3
The Momentum Trading Strategy
(Rowenhorst)






Sort all stocks by lagged returns into decile portfolios
Adjust for beta risk
Country neutral portfolio (sort by return in each
country)
Size neutral portfolio (sort by return in each size
decile)
Size/country neutral and risk adjustment
The Momentum Strategy (Chan, Hammed, and Tong)
-Most profits come from Emerging markets.
-Hardly any trading profits after transaction costs.
4
5
Size/country-neutral Relative
Strength Portfolios