Some of the best trades start with a disaster… when things are so bad they can’t get any worse. When the situation is so dire, it can only get better.
When investors have given up, prices fall. And at that point, it’s sometimes possible to find incredibly cheap assets.
But other times, a market is out of favour, and stays that way, for a reason. The general consensus is right… and contrarians get their fingers burned.
Michael Mauboussin: Here’s what active managers can do
Below I’m going to tell you about one of the world’s most hated markets and the potentially exciting investment opportunity that I came across a few years ago…
Big (potential) profits in a country few people have heard of
In December 2013, I visited Kazakhstan, in Central Asia in search of high-return investment ideas. Kazakhstan is bigger than all of Western Europe, but few people can find it on a map. It’s situated in a geographic blind spot south of Russia and west of China. And with a small population (just a little more than the city of Mumbai, India), few people give the country a second thought.
But Kazakhstan carries considerable heft. It’s the world’s largest producer of uranium… it has the 12th-largest oil reserves in the world… and it controls vast quantities of chromium, lead, zinc, copper, iron and gold.
And in 2013, there was one other thing Kazakhstan was a world leader in something that you don’t want to be the “best” in.
No. 1 in non-performing loans
In 2013, Kazakhstan had the highest level of non-performing loans (NPLs) of any banking sector in the world, as you can see in the graph below.
Investors use NPL levels like doctors use blood pressure readings… it’s a key barometer of the overall health of the banking system and, by extension, the economy. Kazakhstan’s NPL levels suggested the country’s banking sector and economy should have been dead.
Before the 2008-2009 global economic crisis, Kazakhstan’s banking sector was widely viewed as one of the best-regulated and strongest in all of Eastern Europe and Central Asia. It had strong growth, effective regulation and stability. International debt investors happily lent money to Kazakh banks, which in turn lent bales of cash to construction companies and real estate developers… some of whom held stakes in the lending banks.
Kazakh banking stocks went through the roof. International banks lined up to buy Kazakh banks at valuations that made sense only if Kazakhstan was going to start making diamonds out of ice.
Then came the 2008-2009 global economic crisis. If the global economy was knocked down in the crisis, the Kazakh banking sector was run over, stomped on and left for dead.
Banks that had lent to real estate developers – after a 400 percent run-up in real estate prices during the previous three years – found their collateral almost worthless when prices fell 30 to 50 percent. And repaying foreign currency debt obligations suddenly became a lot more difficult, when the Kazakh currency, the tenge, depreciated 25 percent, reducing its buying power relative to foreign currencies.
The country’s banking sector crashed hard. Levels of NPLs exploded. The entire banking system was paralysed.
Most investors saw that Kazakhstan had the highest level of NPLs in the world, and avoided away from the country’s banking sector like it was on fire. And that’s where the potential opportunity came in.
Sometimes, being hated is good
Markets that are widely disliked can generate huge returns. When pretty much everyone who wanted to sell, has sold, it doesn’t take much improvement in how investors view a market to lift prices sharply.
But there’s one thing worse than being hated: Being ignored.
And as I said earlier, Kazakhstan barely registered on the radars of even the most intrepid investors.
Of course, there were some good reasons that Kazakhstan was ignored.
For starters, Nursultan Nazarbayev had been the country’s president since 1990. He had never received less than 90 percent of the vote in any election – which was more a reflection of how Kazakh elections functioned, than his popularity.
The country’s TV stations and newspapers said what he wanted them to say. In the rare event that anyone dared to speak up, they felt the sharp end of a steel boot.
But even Nazarbayev couldn’t overturn the laws of nature… At the time, he was 73, where the life expectancy of the average man is 64. So many assumed he was living on borrowed time. (Nazarbayev is still president today, at the age of 77.)
Kazakhstan isn’t like other countries, where the vice president, or the head of parliament, steps in when the president dies, via a carefully crafted constitution. And Nazarbayev has been able to stay in power so long in part because he hasn’t let anyone position himself as a successor.
No one really knows if a succession plan exists. So in 2013 – and still today – a lot of people are worried about what would happen if he died. Some investors decided that the political uncertainty wasn’t worth the risk.
And with a president like Nazarbayev, it should come as no surprise that corruption was also a problem in Kazakhstan… even more so than most other emerging markets. In 2013, the country was ranked 140 (out of 177 countries surveyed) in the Transparency International Corruption Perceptions Index… well below the likes of India (94) and in the same ballpark as Nigeria (144).
With rampant corruption and being number one in NPLs, you can understand why investors weren’t interested in Kazakhstan.
But this type of setup is a contrarian investor’s dream. That’s why I found it interesting.
Are you sure?
Several years ago I worked for a global political risk-consulting firm, where I advised some of the world’s largest portfolio investors, and Fortune 100 companies, on different dimensions of political risk. One thing I learned was that when everyone – investors, diplomats, businesspeople and, yes, political risk analysts – is absolutely sure that a country is going to experience a cataclysmic political meltdown… it doesn’t happen. The reality winds up being something far less interesting. (It’s the political events that no one sees coming that really stir things up.)
The fact that there was such widespread concern meant that in late 2013, when I was kicking the tires in Kazakhstan, it was all “priced into the market.” In other words, investors were already assuming the worst. So anything but the worst would be good for Kazakhstan.
At the time, I felt that there was more of a succession plan in place in Kazakhstan than most people thought. Nazarbayev had carefully planned every step of his political life. He built an entire city – a grandiose monstrosity, or a work of architectural genius, depending on who you talk to, called Astana – as a memorial to himself. A guy like that will make sure his legacy of stability and prosperity won’t be erased the minute he passes away.
And the banking sector was a mess… but banking sector messes can’t last forever. And Kazakhstan seemed to have mapped a way out.
At this point, Kazakhstan’s economy was already growing fast. As I mentioned, the country is a massive minerals producer, sitting on the doorstep of China – one of the world’s most voracious minerals consumers. And after visiting the country and talking to the people there, I thought it was only a matter of time until Kazakhstan’s market bounced back.
In short, it seemed to me that Kazakhstan, and its banking sector, was a great setup for an out-of-favour investment.
Tomorrow I’ll tell you about the investment opportunity I found in Kazakhstan… and whether it was a triple-digit winner… or a terrible mistake