(We are indebted to our good friend Jonathan Auerbach for the following, a fine summary of global investment opportunities from his colleague Mike Churchill.  Jonathan notes that “Mike in round numbers has outperformed the S&P by 50% over the past 5 years,” and that his firm’s current strategies resonate with those of Auerbach & Grayson. RA)

Over the past seven years I have done significantly better in emerging markets than in developed markets (i.e. commodity stocks). There is less intellectual competition in emerging markets so an investor is more likely to be rewarded for his work on individual stocks. Moreover,emerging markets lend themselves much better to supply-side top-down analysis. That’s partly because there are so many emerging markets and EM policymakers often make “big” moves that can be seen a mile away. One can always find at least one country that meets the necessary criteria and has attractive valuations. This year Pakistan and Japan (which I now consider an honorary emerging market) are among the most appealing places. In years past the fund has gone heavily into Turkey, Sri Lanka and Brazil. Pakistan now tops the list in terms of having the best combination of low P/E and high GDP growth in nominal US$, followed by Vietnam, Argentina (avoid-more later), Egypt, Russia, Ukraine, Sri Lanka, Thailand, Turkey, and Serbia.

Best growth/value combinations:  A big part of the appeal of Japan and Pakistan is that many companies in these countries are throwing off tons of cash. You wouldn’t normally think of Japan as a cheap market, but it is. This Japan call is reminiscent of the commodity call 10 years ago: Nobody is on the theme, nobody covers the stocks, the Nikkei is emerging from a 20-year bear market, stocks are super cheap and there is a macro tailwind. Japan now represents about 13% of the fund and that number could easily rise to 20%. There is an endless amount to do there and I’ve been crunching names as fast as possible. Japan has hundreds of the sort of cheap small-cap companies that the U.S. simply doesn’t have anymore. The language barrier is a problem but this is partly offset by the simplicity of the financials and the fact that managements are very good about providing earnings and sales guidance (available through Bloomberg).In the case of Pakistan, many blue-chip companies have 8%+ yields. The businesses are extremely easy to follow (they report financials as though it were still the 1950s). Banks are very cheap and are now moving nicely. I met with seven Pakistani companies at the Auerbach Grayson Pakistan/India/Sri Lanka conference last month and found much to like there. Lately I’ve been moving into the small-cap industrials, where one can find companies with solid track records and improving prospects trading at 4-6x earnings.

Vietnam ‘Fruitful’

Vietnam also may be a fruitful place for finding individual names. To this point the Vietnam call has been manifest only via ETFs. That has worked out wonderfully so far, but the ETFs own the big caps and these trade at PEs of 8-12x. In contrast, the small-caps trade at PEs of 4-7x. The Classical Insights fund is set up to trade individual stocks in Vietnam (which was an adventure in itself). The next step is to identify names that are attractive and buyable. Vietnam maintains caps on foreign ownership in the individual stocks and many names are capped out.

There isn’t much interesting to do in the U.S. anymore. Nearly everything has been picked over (or bought out). For the names that remain, there are 50 guys (or 500) analyzing every last stock. Sarbanes/Oxley played a big role in shrinking the market by discouraging new listings. In the years since its introduction, the names taken away by M&A have not been replenished by new listings. As a result, when one goes to peruse a sector today, it’s the same boring names that were there 10 years ago — minus those that were acquired — and everything trades at P/Es of 13-20. It’s just not interesting. That doesn’t mean U.S. stocks can’t work, but that stocks will be likely to respond much more to general liquidity flow (investor preference for equities as a class) than to company-specific news on which an investor can get an edge.

There’s not much to do in Latin America, either. Bizarrely, the three most expensive emerging markets in the world are now Colombia, Chile and Mexico. This is likely a function of two factors working in concert: Pension reform that has driven a lot of new local money into the equity market, and the continued relative unattractiveness of new IPO issuance. As such, an ever growing pile of money is chasing a fairly static selection of equities to buy. One Latin country that shows up as very cheap is Argentina. The country is wildly corrupt but some of these stocks may work anyway. The fund doesn’t own any Argentina at present, chiefly due to regulatory (i.e. corruption) risk. Another country that shows up as very cheap now is Egypt. In fact, Egypt hasn’t been this inexpensive in eons. Whether it’s truly an attractive place to invest I’m not sure. I am more comfortable with Pakistan, Japan and Sri Lanka.

Hong Kong, Oz: Not Enough Data

I have developed a bias against countries that report every six months: particularly Hong Kong and Australia. Six months is just too long to go without getting hard numbers on the performance of the business. The long delay between reports gives an advantage to locals who may have inside information. I may come back to the Hong Kong industrials because this is such a fruitful place to look for ideas. However, if I do, the focus would be on companies that provide material guidance between reporting periods.

Bottom line: This has been a frustrating period – but at the moment there is opportunity on every front. The average P/E on the cash-flowing portion of the portfolio is about 5.6x, which is extremely low. These companies nearly all are strong free cash flow generators too (i.e. FCF of 10-18%). The gold explorers in the portfolio are now trading at about $25 per eventual ounce in the ground on average, which also is extremely cheap. Potential catalysts that would get things moving would include: policy easing in China and/or more QE from the ECB and/or Bank of Japan.