Emerging Financial Markets 8: The Top-Down and Bottom-up Approaches

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Emerging Financial Markets 8 The Top-Down and
Bottom-up Approaches
Prof. J.P. Mei
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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

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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

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The Smith Barney ModelPut It Together

• What variables to use?
• How 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.

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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 Earnings revision and Price Change
• Question How do they translate rankings into
  weightings?

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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.

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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)

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How to Allocate Resources Among Stock Pickers
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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 High growth potential
• Overall portfolio balance

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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.

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Size/country-neutral Relative Strength Portfolios