Five Questions for Arjun Divecha
Since 1993, Arjun Divecha has directed GMO's unusual approach to emerging markets investing. It is a computer-driven process that first searches for countries with the best outlook and lowest overall stock prices and then selects the most attractive stocks within those countries.
The computer models actually build two portfolios for each country: One, representing 70% of the holdings for each country, seeks stocks that are relatively cheap. The other, comprising 30%, is made up of stocks that have shown good recent price performance. It is possible, says Divecha, to be buying a stock in one portfolio while selling it out of the other. The two portfolios are "like wild animals that need to be kept in cages," he says. "If you let them out of their cages, they will intermarry and produce incredibly tame offspring."
This approach has proven successful for Boston-based GMO, which manages $121 billion in assets, primarily for institutions and wealthy investors. Divecha, who manages about $20 billion of that total, has produced annualized returns of 26% over the past five years through June 30, beating his benchmark, the SP/IFC Composite Index, by about three percentage points annually.
We visited with Berkeley, Cal.-based Divecha when he stopped in New York recently on his way to visit his daughter at Yale University.
KIPLINGER'S: Given that you begin your stock selection process by determining the most favorable countries, tell us which ones currently fit that description.
DIVECHA: The countries I like the most are Taiwan, Korea, Thailand and Brazil. The ones I like the least are Russia and India.
Taiwan is a relatively simple story. It's trading at about 12 times earnings and it yields about 4.5%. By any standards, that's pretty cheap, but especially for a tech-heavy market. It's about 70% tech. Why is it cheap? Number one is that politics in Taiwan have been pretty messy recently. There have been all kinds of moves to impeach the president. In the long run that doesn't matter; in the short run it does. Number two, the market is making a fundamental misjudgment that these tech companies are paying out all these dividends because they don't have anything better to do with their money. My view is that Taiwan has gone through a transition in the past five years from having a manufacturing base to being an intellectual-property base. So they've shifted most of their manufacturing to cheap Chinese companies. They no longer have the huge capital needs to build all these factories, so they can give that money back to the shareholders.
I like Korea because it's cheap. Korea is something I've liked for two or three years and have made a lot of money, but it's kind of on its way down.
In Thailand, the recent coup doesn't seem to have had any impact at all. I think what matters is the growth rate going forward. To the extent the coup creates uncertainty and people don't invest, that causes the growth rate to slow down and makes it less attractive. But in the short term, it doesn't affect us that much. Our judgment has gone from being slightly positive to neutral. We had been out of Thailand for a while, but in the past three months we've started buying it. It's primarily a value case.
Brazil is also a very simple story. Short-term interest rates are 15%. Inflation is at 4%. So you have an 11% real interest rate spread. It looks like inflation is going to stay low; therefore, they're going to bring interest rates down. You've got a market that's trading at seven times earnings, and real rates are going to come down. That sounds like a pretty good story. It doesn't really get much simpler than that.
Why are you down on Russia and India? Russia is a difficult one. Seventy percent of the market is oil based. To get Russia right you have to make a prediction on what's going to happen to oil prices. People ask me what's going to happen to oil prices and I tell them I'm a militant agnostic. I don't know and you don't either. But the likelihood is that oil prices will probably come down. So that makes it somewhat negative. The positive is that they're not squandering the oil money. The money is feeding through to the real economy in terms of consumer spending, for example. They've paid off all their debts, they're running a budget surplus and they're setting aside hundreds of millions of dollars. It's hard to see things going wrong. There's a lot of political risk in the long term, but in the short term there is not. Nobody's going to challenge [Russian President Vladimir] Putin in any serious way in the short term. You do have to worry about Russia in the longer term, but not economically. Economically, they are in fine shape.
We think India is expensive. Actually, I love the country. I am 50 years old and I've never been as optimistic about the country as I am today in terms of the fundamentals of what's going on. India's finally got it right. It's finally on a sustainable growth path. I have a feeling that there's a certain critical mass you need to get. As long as you don't reach the critical mass the government is really important because they have to keep doing things to make it happen. Once you reach the critical mass the government starts to become less and less important. I think India is now past that point. It doesn't matter what the government does because things have a momentum of their own. So I am very bullish from a long-term view. I just think from a valuation point of view for the next 12 months India is less attractive.
What about China? China has had massive overinvestment in a number of sectors for a long time. Too much capital has flooded in. Generally, the law of capitalism is you invest too much money and you get lower returns, and I think that is true of China. The likelihood is that you're going to get lower returns over the next few years. Does it necessarily cause a crisis? No, because the Chinese government has a lot of resources. If you really had a big crisis the government could pull out a checkbook and write a big check because the ratio of debt to gross domestic product in China is less than 10%, compared with 60% to 70% for most countries. And they've got a trillion dollars worth of foreign reserves. Yes, they have big problems, but their ability to deal with the problems is actually quite substantial. You could have a prolonged slowdown. But the likelihood of a crash is low. Certainly it is zero before the 2008 Olympics. The government will do anything -- I mean anything - to make sure there is no problem before 2008.
How are falling energy and commodity prices affecting emerging markets? If you look at the emerging markets index, about 30% to 35% is in energy- and commodity-related stocks, versus maybe 20% for the developed markets. So if you really do get a problem with commodities, emerging markets will in fact be hurt more. But it's not just one way. China is a big consumer, not a producer, so China will benefit from lower commodity and energy prices. India will benefit. Brazil will probably get hurt because it's an exporter. But it's also a big consumer, so it helps as well. So it's hard to say it will be unequivocally bad. It could be good for a number of countries. It would be good for Taiwan. It's a big energy importer. One of our cases for why we like Thailand is that it is very, very sensitive to energy prices.
GMO's seven-year outlook forecasts that emerging markets will be the best-performing stock category. Yes, relative to everything else. But in absolute terms, we don't like any of the equity markets. We see all asset classes right now as being relatively expensive. It's hard to make absolute money over the next few years. There's no place to hide. We just have to be resigned to getting lower returns. And one of our theories is, don't take a lot of risk. It's hard to make money, so there's a temptation to go out on the risk curve to make more money. We think it's a mistake to do that. Cash at a 5% return is not a bad place. If you think about it, emerging markets are the most attractive, and our forecast is a 3.8% real return. Add 2% inflation to that, and that's 5.8% for taking a lot of risk. You can get 5% for doing nothing. Seems like you should have a lot of money in cash.