More deals tied to emerging markets suggest the switch to value may be real, contrarian says

By Emma Trincal

New York, Sept. 27 – Several issuers have recently priced larger deals tied to emerging markets, a sign that the asset class may be making a comeback after having inflicted either pain or frustration on investors amid the trade war and a rising dollar, a value-oriented contrarian portfolio manager said.

“Maybe investors are becoming a little bit more interested in value investing. We’ve seen a switch recently,” said Steven Jon Kaplan, founder of TrueContrarian Investments.

Bigger sizes

In the beginning of September, Toronto-Dominion Bank priced $55.91 million of five-year leveraged notes linked to the iShares MSCI Emerging Markets ETF.

The upside leverage is 1.513 times with no cap. Investors will be fully exposed to any loss.

Another block trade priced two weeks later. Wells Fargo Finance LLC’s $40.3 million of two-year leveraged notes on the same ETF offer 150% on the upside capped at 21.525%. The 15% geared buffer has a 1.1765 multiple.

RBC deal

Royal Bank of Canada was set to price on Friday another leveraged note with a geared buffer due Oct. 2, 2023 and linked to the iShares Core MSCI Emerging Markets ETF. The payout is 1.3 to 1.35 times leverage on the upside with no cap and a 20% geared buffer on the downside with a 1.25 multiple. If the ETF falls by up to 20%, the payout will be par. Otherwise, investors will lose 1.25% for every 1% ETF decline beyond 20%.

Bargain trade

“People look back at how bad emerging markets did last year and they don’t want to go to back there,” Kaplan said.

“But emerging markets have been doing better than the U.S. very recently.”

Kaplan’s focus is to look for value, something he said can be found in emerging markets.

“People all around the world have been crowding into U.S. assets avoiding emerging markets,” he said.

“Tariffs, political uncertainty were major concerns. The stronger dollar was another major one.

“But there is also growing uncertainty here, including political risk. Slowly people have come to realize that U.S. stocks are becoming pricey and therefore risky.”

Several analysts have noticed a that a rotation from growth to value is underway after value stocks underperformed growth and momentum assets for over a decade.

“There’s definitely a switch, a rebalancing taking place,” he said.

“Price-to-earnings, price-to-book are beginning to mean something again for investors.

“When you compare emerging markets with the U.S. it’s clear that the U.S. is way overvalued. Prices on some of the popular, high-flying names are beginning to lose their appeal.

“Emerging markets have never been so undervalued compared to the U.S. You have terrific bargains. People may begin to notice.”

Four years

Kaplan said he liked the notes for their structure and duration.

“Four years is good. It allows for a partial recovery from a recession,” he said.

“Five years would have been better. Five years from now is an election year and U.S. markets tend to reach highs during those times.”

Academic studies have demonstrated that investing in the early part of an election year has been profitable, he noted.

As a market observer Kaplan pays attention to historical patterns. Some trends, he said, have generated specific performance results in a consistent way, he said.

Cheap in October

“Just like I would prefer to see a five-year, even a four-and-a-half year rather than a four-year because of the elections pattern, I would rather not have a note maturing in October,” he said.

“There are seasonal patterns, which have been confirmed by academic studies. It’s better to sell earlier in the year than later.

It’s the popular “sell in May and go away” and there is truth to it, he said

“The pattern goes back a hundred years.”

Smart maturities

Kaplan said he understood why issuers of structured notes would use round numbers with maturity dates designed to fit a specific duration as is the case with bonds. But with bonds linked to equity derivatives, perhaps the tenors should be stretched or shortened to accommodate market views or patterns.

“You don’t want your note to mature in the middle of a recession. It may be a good idea to be a little bit more flexible with maturity dates,” he said.

Another reason to “be a little bit more flexible” could be tax considerations.

“Long-term options always expire in January. That’s because you don’t have to pay the taxes until the next year.”

The most positive thing for this portfolio manager remained the relatively longer-dated term of the notes.

“Two years would have been a very bad thing. It’s very possible that the U.S. markets may have peaked on July 26.”

The date marks the all-time high of the S&P 500 index at 3,027.98.

“If we have a recession in the next two years, it will have a global impact, especially on emerging markets. So, you need time.”

Over the long term, emerging markets perform well due to the growth of their economies.

All-sizes portfolio

Kaplan said he also liked the iShares Core MSCI Emerging Markets ETF used in the notes because it includes all market capitalization, including small-cap stocks unlike the more common iShares MSCI Emerging Markets, which only tracks large- and mid-cap equity.

“I think it’s a good choice because small-caps tend to grow faster. They also have better value than mid-caps or large-caps,” he said.

Scary asset class

Finding bargains and tolerating risks associated with more volatile assets is an important requirement for contrarian investing, he noted.

Investors in the underlying fund endured a 15% decline last year. In 2017, the fund rallied 37.7%, but that was in the heels of a 14% negative performance in 2016. Over the past five years, the average total return of the iShares Core MSCI Emerging Markets has been a meager 1.92% gain, according to Morningstar.

The fund is up 6.2% for the year, underperforming the S&P 500 by 12 percentage points.

“Those ups and downs and losses had a psychological impact,” he said.

“People have a limited tolerance for pain. That’s why they’re all crowding in the U.S. markets right now even though they’re overbought. They should be buying assets at a bargain. But fear usually prevails.”

Among the “fear” factors is the risk associated with global trade tensions with China, which makes 30% of the iShares Core MSCI Emerging Markets, he said.

Good structure

The note however offers some protection without penalizing truly bullish investors, he said.

“The 20% protection is good. It’s always better to have a buffer than a barrier, even with the gearing,” he said.

“It’s also a very positive thing to have no cap.”

End of the bad times

Kaplan noticed more flows going into emerging markets. To him, the trade remains contrarian and prices are still compelling. But things could change.

The recent block trades and perhaps more to come suggest that a bullish play on emerging markets may not be as contrarian as it was a little while ago.

“If we see a lot of notes pricing on emerging markets it’s something to pay attention to,” he said.

“It’s interesting. It probably means that value is back. People are starting to realize that there isn’t much value left in the U.S. markets. All the hype about momentum investing may soon be over.”

RBC Capital Markets, LLC is the agent.

The notes (Cusip: 78015KDS0) will price on Sept. 27.

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