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Sydnee Gatewood
Sydnee Gatewood
Articles (2193) 

GMO Commentary: Top-Down Investing in Emerging Market Equities

By Sandeep Gandhi

April 23, 2020 | About:

Executive Summary

We believe that getting the country call right is the most important decision when investing in Emerging Market equities. Over the last 10 years, top-down (i.e., country and sector) Value has outperformed in these markets, even as bottom-up Value faced headwinds. Top-down modelling is more intricate than one would think. Over the past 25+ years we have studied many of the nuances inherent in building top-down models and honed our top-down process to bring it to today’s level of robustness.

In October 2019, just before the onset of the Covid-19 crisis, Rick Friedman, our Asset Allocation team colleague, published a paper that argued that long-horizon investors are being paid to bear the risks embedded in Emerging Market (EM) equities, especially EM Value equities.1 Since then, as the virus first appeared and then spread, global equity markets have taken a beating. As was true in October, however, EM equities – particularly those categorized as Value stocks – remain the most attractive asset class based on our current 7-Year Asset Class forecasts.

We have long maintained that getting the country calls right is the most important decision when investing in EM equities. That is just as true today as it was when we first launched the GMO Emerging Markets Strategy in 1993. In order to better capture this current opportunity in EM Value, we believe an investor must be willing to make top-down bets. In our opinion, using a traditional bottom-up-only process in EM leaves money on the table. A timely case in point is the wide dispersion in performance across countries within EM since the start of the Covid-19 crisis. For example, the difference in 2020 Q1 performance of the MSCI EM Value and Growth Indices was under 9%. Over the same period, the return spread between Brazil and China equity markets was about 40%, underscoring the opportunity that lies in making top-down bets within EM.

When we talk about “top-down” investing in EM, we are referring to making active country and sector allocation decisions within these markets. We do this using a systematic top-down process that, as with our bottom-up process, has valuation at its core.

We know that the performance of the MSCI EM Value Index over the past decade has been anything but inspiring. However, if we juxtapose the performance of GMO “top-down Value” in EM over the same period, it paints a very different picture as shown in Exhibit 1. Clearly, top-down Value outperformed in EM, even as bottom-up Value faced strong headwinds.


As of 12/31/19 | Source: GMO, MSCI

At our Client Conference in November 2019, we delved into some of the nuances of top-down investing and questions investors need to think about when attempting to capture this opportunity in EM equities. This paper captures some of the key points addressed at the conference.

The Opportunity with Top-Down Investing in EM

The fact that investing in the best-performing countries and sectors ex ante can add a lot of value to a portfolio’s performance should come as no surprise. Perhaps even the fact that this opportunity is larger in EM than in Developed Markets (DM) may not be that hard to wrap one’s head around, given EM are understood to be more inefficient than their DM counterparts.

Certainly, the historical performance strongly supports this: Exhibit 2 shows the average annualized 3-year rolling relative performance for the top- and bottom-performing countries in EM and DM.


Data from 1/20/00 - 12/20/19 | Source: GMO, MSCI

What is notable is just how big the spread between the top- and bottom-performing countries in EM is relative to those in DM. Of course, being able to pick the top- and bottom-performing countries with any respectable consistency would require a crystal ball of sorts – not something, unfortunately, we can claim to have at our disposal. But, if we believe the chart above, it tells us that even if an investor can, on average, call the fifth top- and bottom-performing countries with some consistency, the opportunity is sizable (and notably bigger in EM).

However, Top-Down Modelling Is Nuanced

Top-down modelling is more intricate than one would think, particularly in EM. Over the past 25+ years of building top-down EM models and implementing them in the real world, we believe we have learned a few things that may be of interest to investors. In the following pages, we highlight a few of the many nuances that apply to building top-down models.

Particularly for bottom-up-only investors, some of these top-down modeling decisions might seem rather simple at first glance. However, some of these seemingly simple decisions can lead to very different portfolios and outcomes. These decisions are therefore not as trivial as they might first appear.


A simple exercise of calculating aggregate valuations for a group of companies using a handful of different aggregation methodologies will make it obvious that the choice of aggregation methodology used can really change the top-down valuation estimate and, therefore, one’s view on a particular top-down group.

For example, as of September 2019, the aggregate Price-to-Earnings (P/E) multiple for South Korea was 11.2x using a market-capitalization-weighted aggregation, or 14.3x using a median aggregation. At the time, the average P/E for the MSCI EM Index fell between these two valuations at 13.2x. The aggregation methodology used made South Korea’s valuation look either cheap or expensive relative to EM overall (see Exhibit 3).


As of 9/1/19 | Source: GMO, MSCI

What makes this even more interesting is that a single company – Samsung Electronics – made up about 34% of the market capitalization of South Korea as of September 2019.

Depending on whether the P/E of Samsung were 5x or 20x (it was 10x as of September 2019), the corresponding market-capitalization-weighted aggregate P/E for South Korea would vary from 8x (i.e., very cheap) to about 14x (i.e., mildly expensive).

By contrast, the impact of Samsung’s P/E on the median aggregate P/E of South Korea would have been relatively muted.

There are other aggregation methodologies one can consider, of course: equal-weighted averages, square-root-market-capitalization-weighted averages, capped-weight-aggregates, capped-contribution-aggregates…the list goes on.

So, which is the “best” aggregation methodology to use? After extensively studying several such aggregation methodologies, our view is that every methodology has its merits and its biases. No one methodology is, therefore, the “best” in our opinion.

Philosophically, to use a real estate analogy, we are hoping to capture the valuation multiple that is representative of the “neighborhood” (i.e., country or sector) within which we are looking to buy a “house” (i.e., company). Given that motivation, we prefer models that are not driven heavily by the valuation of a single house in the neighborhood.

Practically speaking, we have found having a few different lenses into the valuation of a group to be most promising. Our highest-conviction bets come about when a country or sector is attractive based on a variety of lenses.

Continue reading here.

About the author:

Sydnee Gatewood
I am the editorial director at GuruFocus. I have a BA in journalism and a MA in mass communications from Texas Tech University. I have lived in Texas most of my life, but also have roots in New Mexico and Colorado. Follow me on Twitter! @gurusydneerg

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