Chris Johns: Volatility in emerging markets offers investor opportunities

A quadrillion is the number 1 followed by 15 zeroes. Or, to put it another way, a thousand trillion. For anyone lucky enough to possess 175 quadrillion Zimbabwean dollars, the central bank has just announced it will swap them for five US dollars.

These are numbers that emerge when inflation reaches 500 billion per cent. Zimbabwe is giving up on its own currency and is, in recognition of what was happening anyway, adopting the US dollar as legal tender. The window of opportunity to get rid of your unwanted Zimbabwean dollars opens today and runs until the end of September.

While these sorts of stories might prompt potential investors in Zimbabwe to avert their gaze, it is worth pointing out that the currency exchange offer could be described as a moderately successful culmination of reforms that have seen inflation fall to minus 2.7 per cent.

It would, nevertheless, be the brave – and very contrarian – investor who now decided to put money to work in Zimbabwe.

In the often tortured nomenclature of global financial markets, Zimbabwe doesn’t qualify as an “emerging” market. The people who decide these things don’t even think of Zimbabwe as a “frontier” market, the group of countries that for one reason or another don’t make it to the lofty status of “emerging”.

But if the biggest investment opportunities arise with the greatest risks – as they often do – this is where intrepid (or perhaps just proper) investors should be looking.

It is sometimes tempting to think that the proper investor is becoming an endangered species.

Estimates vary, but it is reckoned that global institutional investors currently manage around $76 trillion (that’s 12 zeroes) of assets. Two powerful forces have combined to produce a potentially dangerous and destabilising set of affairs, something that is starting to concern the IMF among others.

First, an ever greater proportion of that cash is managed “passively”. The growth of index investing has led to many trillions of dollars being invested in the stocks and bonds of businesses simply because those firms happen to be the biggest.

Balance sheet

No consideration is ever given in this form of investing to whether or not such investments actually make sense.

The theory is that a company is big therefore it must be successful, and somebody else must have run the ruler over its balance sheet for it to have become big in the first place.

Second, and related, many asset managers just follow the herd – they buy what everyone else is buying.

This “momentum” style of investing has become increasingly popular and mathematical types can discern exploitable patterns of share price behaviour that prompt lots of them to jump on board. Nobody in this world ever bothers with scrutiny of a profit and loss statement.

A few short years ago any asset manager pitching for business with large savers would, without fail, know that the first question they were going to be asked was: “How big is your emerging market exposure?” Pouring money into these markets was flavour of the month and no amount of exposure was too large.

Anyone who answered that question with “it all depends on the prospective profitability and actual quality of the investment opportunity” was doomed to fail to win the business.

As night followed day, emerging markets investments performed poorly. It's almost always the same. Statistical studies of investment styles have looked at buying equities only in January, buying small company stocks, buying China because it is big, and a host of other smart ideas. Almost without exception, investing in this way will end up in disappointment. Things may work out for a while but the theme usually dies away or, in many cases, quickly reverses.

Today one of the themes of the moment seems to be to get out of emerging markets as quickly as possible. Investors are pulling out in a big way.

While Zimbabwe may be a contrarian idea too far, as the rush out of emerging markets gathers pace investment opportunities are going to arise.

Whether it’s Greece or a rise in US interest rates, there is a good chance that a rocky financial road lies ahead. Proper investors will know this means opportunity. All of the evidence is that few have the patience to avail of it.