Intro

Patrick: [00:01:24] My guest this week is Harvey Sawikin, a co-founder and lead portfolio manager at Firebird Management, which manages funds dedicated to investing in emerging market equities. Emerging markets are often a blind spot for investors of all types. Most of us have never traveled to the far East or Eastern Europe, where many of the thousands of emerging market public equities operate. I've been very lucky to travel quite a bit in Asia and the Middle East, but never to Eastern Europe, which is where Firebird focuses its investments.

Evaluating Emerging Markets

Harvey and I discuss his 24 years of experience evaluating emerging and frontier market countries, industries, and individual stocks. We discuss his experience buying privatization vouchers in Russia, banks in the Baltics and how today's emerging market opportunity-set compares to the past. Like so many of these conversations with investors who have earned significant excess returns, it's clear investing opportunities in emerging markets are often disguised. Finding them requires risk, hard work, discipline, and a dose of luck and timing. Please enjoy my conversation with Harvey on emerging market opportunities.

What is your single most memorable travel experience since the beginning of Firebird?

Harvey: [00:02:31] Wow, that's a really tough question. I'd have to say my first trip to Russia in January of 1994, because it was like stepping into a John Le Carré novel, it was just grim, gray, dirty, smelly. And I went right in the dark of winter and I stayed at the Moskva Hotel, which is now the Four Seasons - at the time it was just disgusting. And I went out, they had a cafe, I couldn't eat, I couldn't find anything to eat in the cafe. The food was inedible. There was some sort of thing, some sort of jellied thing that looked - it was all inedible.

I said, "Okay, there's got to be some restaurants around here." I started walking and I couldn't find, in the freezing cold, I couldn't find any store with any food. The stores that were open had no food and there was nothing else open. I said, "I'm going to starve now." I turned a corner and there was a McDonald's. It was only the second McDonald's in Russia. I think the only time I was so happy to go to a McDonald's was when I was probably seven years old and they opened the first McDonald's in New York, up on the upper West side, I went with my mom. So, God bless McDonald's for the first few times I went to Russia. And then I discovered there were some other restaurants. I just didn't know where they were.

On that same trip, we went to the voucher auction to buy privatization vouchers, which was held in an old Lennon post office, which had been turned into an exchange where they were trading metals in the morning and then in the afternoon, they were trading privatization vouchers. It was unheated, guys were running around with fur hats, exchanging these packs of vouchers. I recall it like it was yesterday and it had the smell of opportunity. People say to me sometimes, "When you started out in Russia, it was so risky. You took such a big risk. Why did you do that?" And I would say, "No, you don't understand. I was absolutely sure I was going to get rich. I had no doubt. I was so confident. I couldn't wait to buy Russian stocks. I was so sure of it."

Patrick: [00:04:44] How did the settlement process work? What was the actual logistics of buying these things?

Harvey: [00:04:49] Well, the vouchers were complicated because basically they were only supposed to be owned by Russians. You would pay a Russian broker to do it on your behalf. They would tender the vouchers and then they would receive the shares with a pre-agreement to transfer the shares to you when they received them. So you were taking, yes, you were taking some risk. This is why the Templetons of this world couldn't have done it, since you were essentially out of pocket, and were trusting of a broker. We found a broker very early on that we trusted. Pretty soon, Credit Suisse got in there, CSFB, and they became like the main trader in the vouchers and they made a lot of money for themselves doing that, and for their clients.

Patrick: [00:05:42] Maybe you could begin by describing how you got interested, in the mid-nineties, in emerging markets investing and in Eastern Europe and Russia specifically. How did you approach the markets? Obviously, we're staring at a huge map of a lot of the emerging markets behind you. There's a massive world, a lot of countries out there, a lot of different governance structures and political structures. How did you begin to approach that problem?

Harvey: [00:06:02] My original co-founder, Dan Cloud, he had a very brilliant insight, which I think is something remains true today about emerging markets investing. His insight was that he saw lots of people making fortunes on emerging markets, but the emerging market funds never seemed to do very well. Fidelity and Templeton, even Mark Mobius - his fund, his returns were never that impressive. And Dan said, "The reason is, the guys who make a lot of money, they're doing it in their PA (personal accounts). These are guys who are sitting on trading desks buying Thailand when it's at penny's. They set up accounts at local brokerages and they get in when the insiders are buying. The Templetons and Fidelitys of the world only get in once there's already custody and even GDRs and whatever. And by then, it's up 10 times already. And the insiders are already looking to lighten up." He said, "We should do a fund where we do what the traders do on the desk, our fund is the PA. We won't have a PA, this is the PA."

That was the insight. I think even today, I still think in those terms. So we started with looking for markets that were really baby markets without custody, where we had to go in and figure things out, set up custody with local brokers and so on. And after a couple of false starts at the end of '93, the Russian voucher privatizations began. Dan knew something about Eastern Europe. He had traded Poland very successfully when it started. And he said, "We've got to get over to Russia to check this out. This looks like it could be something big."

And Ian Hague, who is another co-founder, who is still my partner now, was a Russian expert. They spent many, many hours talking about Russian history and culture and language and approached it from every angle. I was looking at it from a legal point of view, from a tax point of view. So we looked at it from every angle and we said, this is doable. This is not nearly as bad as people think. The approach was, we're going to do something here that's complicated, that is not set up for you easily. We'll be the first foreigners in there doing this, and we're going to buy things.

Oh, and then, I sort of buried the lead. The most important thing was that when we looked at the valuations and the voucher privatizations, we realized that companies were being auctioned off at 1% of the value of Western comparables. The first auction we participated in was for an oil company, which had as much oil as Mobil. Mobil at the time at a $40 billion market cap and this company had a $40 million market cap - we understood that it would, in the voucher auction, have a $40 million market cap. So we said, look, this company does not have to become as good as Mobil. It only has to become only 95% worse than Mobil, and we'll make five times our money. And sure enough, and we participated in that voucher auction, sure enough at the peak, I think that company traded at maybe a 60% discount to Mobil or to Exxon. So essentially it went up, I don't know, 40 times to the peak.

The most important thing was that when we looked at the valuations and the voucher privatizations, we realized that companies were being auctioned off at 1% of the value of Western comparables.

So it was extreme valuations, it was not accessible to most investors, investing alongside of Russians who were scooping up shares - the smart Russians were scooping up shares while your average Russian didn't understand the value of what they had been given in the voucher privatization. So they sold it. They sold their voucher for a bottle of vodka. They never had any belief that it could be worth anything, but there were a lot of Russians who understood what it could be worth. And many of them are now billionaires.

Patrick: [00:10:01] Fast forwarding to today, this theme comes up over and over again in these conversations. That the best returns come with a lot of the characteristics you described. Very hard, no custody, something that's happening for the first time, differentiated expertise, whether it's legal, tax, regional, whatever. Fast forwarding to today, how would you segment out the emerging markets in terms of the regions or the types of opportunities, and maybe comparing the opportunity set today? Because you see a lot, just statistically, that emerging markets look very cheap relative to developed international markets. What does it look like in comparison to the early days when 1/100th is a good discount? It's not like that today. So how do you think about the landscape now?

Harvey: [00:10:40] The truth is there are things today that are, if not 1/100th, they're 90% discounted. Obviously, they tend to be the countries with the biggest hair on them, such as Ukraine right now in my region. And actually, in my region, we have in our fund mandate, probably 35 countries. We're only active in nine. Some of those other ones are countries that are, even after 25 years of freedom from the Soviet Union, they're still not ready. They developed down the wrong path or whatever, but catching one when it changes is very important. And over the years, we've caught a bunch of them because Russia was our first. But then we caught the Baltics, we got in early in Estonia on Hansabank in December '94, made 75X until we were taken out by Swedbank in 2004, I believe.

Then we did Romania and Bulgaria. Then we did Kazakhstan. Then we did Georgia in 2004. Even today, we're always looking to see - I've been to Ukraine, actually, the whole team has been to Ukraine over the last year, just to see. Unfortunately, we keep trying and we keep seeing it's not ready. So I think that anywhere in the world you go right now, you're going to find a next big thing. Usually, it's one that people are not looking at. There's always a next big thing that people agree on. I always get the feeling that it's never going to...

Patrick: [00:12:10] Work?

Harvey: [00:12:10] Like Cuba. Cuba has been the next big thing literally since 1994. For various reasons, I always thought no one's ever going to make any money in Cuba. Vietnam was the next big thing for 20 years. It actually started to do well in recent years. But you had a long, long wait before it did anything.

Patrick: [00:12:29] What do you think, of the countries that are the consensus next big thing, what are the common variables that make people arrive at that consensus? And maybe why do you think they tend not to pan out? Or is it just a valuation story?

Harvey: [00:12:40] Yeah, I think it's more like they're focusing on maybe not exactly the right things. They're looking at a country that's big, like Iran. Iran has been talked about in the last couple of years as a next big thing. I know several people who've been trying to invest in Iran because it's a big economy and it has a lot of potential, but it's not a country that is set up for outsiders to make money. I don't know a lot about it, but what I do know is that the revolutionary guard has a lot of control over all the levers of power, including the financial markets and listed companies. So you have to ask yourself, is this a game where I can play?

Now, there are some markets that never worked as emerging markets as stock markets, but people did quite well in private equity. I would say Latvia is an example. We had a couple of things in Latvia. We never really made any money there. People did quite well in private equity, especially in real estate. One of the questions you have to ask is, is this going to be a stock market? Is there a place for a foreigner in this stock market or is it all sewn up by insiders? Is there anything to buy that's any good? Those are some of the factors. And also the political - another one of Firebird's original insights was that emerging market investors probably focused 80% on valuation and economics, and maybe 20% on politics, when it really should it be more like 50/50.

For example, a big part of our decision to go into Russia was analysis of the political situation. Subsequently, in all the markets we've gone into, politics is a big deal. And any time you think in emerging markets that politics has ceased to be a big deal, you can get blown out of the water, which is what happened to people in Egypt. Nobody saw that coming. All the gem funds were in Egypt and they all got blown out of the water when Mubarak was taken down. Recently, more recently in Poland, where they went to a very populist government that shook things up in a negative way in Hungary. So central Europe politically became much, much tougher over the last few years and the performance of their stock markets has been affected by that.

Patrick: [00:15:04] How do you think about, maybe you have a specific checklist, but the economic landscape, the political landscape and the market - capital markets' infrastructure? So are there minimum conditions that you look to meet before you even consider doing deeper work on a country, maybe starting with the economic situation?

Harvey: [00:15:23] I don't think we have any hard and fast rules that a country has to have X inflation and X GDP growth or whatever. Each country presents its own factors. We balance them all and we'll be a little bit more generous in terms of going into a country where, let's say, the politics is a little dicier if the valuations more than compensate you for it. For example, even in Ukraine, which we still don't believe in from a macro point of view and political point of view, there are a couple of stocks that we own just because they're compelling. And you can look at them and say, okay, in all the likely bad things that are going to happen in this country, how will this company fare? For example, if they devalue the currency, is this a problem for this company or not?

It can be a fairly subtle analysis, but then when you have a country where the politics and everything is ticking over perfectly, and that happens too. I would say, for example, the Baltic states recently, they have it all going just as it should be. There we'll pay a little bit more for the equities. You're not going to find these dirt cheap bargains but you'll find things that are still 40% to 50% discounted to Western Europe. That for me is good value and to blend it together.

Also, to go back to one of your earlier questions, what do we do now? We started as essentially frontier investors because that's where we got attention. But as we've matured as a company, over 20 years, we have a lot more of the more developed emerging markets and we apply a different investment approach to the more developed emerging markets than to frontier markets, which require a different approach. When we come to a frontier situation, we have to put on our different hats and different glasses and say, okay, what are we looking for here? What's the play?

Patrick: [00:17:32] How would you distinguish between frontier and emerging? So obviously there's MSCI-type classifications, but as you think about it, what is the dividing line between those two ideas?

Harvey: [00:17:41] Well, for example, countries that already have normal custody where anybody can go in and the institutions can go in. Certainly, if their currencies are either pegged to the dollar or the Euro, or they're in the Euro, those are the indicia. There are countries we call post-political, which means that they can have elections, different parties come to power, but it doesn't really change anything. For example, in Estonia or Lithuania, they've had all these different governments in the last few years, but the path is already set in stone. They are moving more and more to EU convergence, that's it. But then you have countries where elections are still absolutely critical. That's really more of a frontier market where you're facing the prospect of a big loss if the wrong party gets elected, or if they shake things up in a bad way for the market.

Getting Access to Emerging Markets

Patrick: [00:18:37] How do you think about the access points that we'll say just generic Western investors have into emerging markets, things like ETFs, indexes? I'm always interested where there's places that the index methodology might be very flawed. One thing to talk about here would be for example, state-owned enterprises, how you think about SOEs and their role in the benchmarks against which you evaluated.

Harvey: [00:18:57] I think index funds are even less - I buy them in the US somewhat hesitantly - but they're even less appropriate for emerging markets because of what you said. The largest cap companies are often the ones that don't build any shareholder value. So if you look at the Russian index, one of the reasons it was only up 5% last year, and we were up over 20%, was because it was being dragged down by a few big SOEs that were not building value. Now, I would put a caveat in there. There are times when you need to be a stock picker, and there are times when the index is going to outperform everybody else. We've had some periods where you could have just thrown a dart in our region or in Russia and done just as well as we did.

I think we haven't had one of those periods for about 10 years, but it could happen. I am prepared to underperform and my investors by now, they've been with us for so long, we have such a long track record, that they're willing to give us the benefit of the doubt when we're underperforming. And I say, look, it's becoming a bubble. All the crap is going up. I'm not going to buy bad stocks just to keep up with the market because they become the liquidity play. We can get away with that. I think it's harder for a younger fund to do that because people will say, "Oh, they lost it. They don't know what they're doing. They haven't had time to prove themselves through different cycles."

Patrick: [00:20:35] When that happens, how much of that is just a macroeconomic play, whether it's oil pushing up state owned enterprises, what are the drivers of those periods where you expect underperformance?

Harvey: [00:20:44] It's a moment of a bull market. I've been through bull and bear markets. I can say humbly, I've been through one of the worst bear markets and one of the greatest bull markets of the last 50 years. Because I was in the Russian bull market and I was in the bear markets of 2008 and 2009. And I would say that one of the key tasks, probably the first piece of advice that we were ever given as emerging markets managers by a very smart guy, who is still an investor of ours, named George Robinson, who runs a very famous EM fund out of London, was, "Your job as an emerging markets manager is to know whether you're in a bull market or a bear market and act accordingly."

"Your job as an emerging markets manager is to know whether you're in a bull market or a bear market and act accordingly."

It requires thinking about a lot. It means that if you're in a bull market, you need to go with the flow. You need to understand that valuations can go to levels that you're not comfortable with but certain stocks will emerge as the leaders of the bull market. You got to ride them, and don't get too fancy and too complicated. I believe we're in a bull market right now. It's amazing that no one has used this word in emerging markets, even though they've been going almost straight up for two years. And my market, like my Russia fund has been up like 23 out of the last 25 months or something, and yet we're not being inundated with new money. People don't seem to realize that we're two years into this fantastic bull market.

That's what it feels like to me. And because I think I'm in that type of market, I'm taking a slightly different approach. I'm letting the winners run. The leaders that are emerging, the stocks that everybody wants. Like Sberbank, let's take an example, in Russia. This is a stock that has gone from $3.50, the GDR a couple of years ago, to $19 today. And somebody who's ridden it from, let's say you got in at $3.50 and you've ridden it to $19, it's very tempting to say, okay, I don't want to be a pig. I want to cash in. But is it over? No, I think it's half way. By the way, Sberbank's valuation is still attractive. It trades at something like 1.2 times book with a bank that is generating 20% return on equity in a market that feels like a bull market driven by rising oil prices.

So I think that you have to put on a different hat, and a bear market is a different hat. This is very tough to do. One of my weaknesses as a manager, in a bear market you have to, as they say, "Go out back and kill all your darlings." You just got to shoot them all. Even stocks you love and you think in the long-term are great companies, you got to sell them. I think the single hardest thing for a fund manager to do is to sell a long-term buy because it's going do badly in the next couple of years.

Patrick: [00:23:47] When it comes to portfolio construction, how do you think about risk exposures? So we've talked about politics and economic conditions, things like that. Do you care at all what the broad universe or benchmark looks like in terms of its weight to different countries? How do you think about that side of things?

Harvey: [00:24:03] I think that anybody who has a benchmark and then says that they're benchmark unaware is just being stupid because investors are not benchmark unaware. Even the word benchmark agnostic is a little strong. I would say that I'm...

Anybody who has a benchmark and then says that they're benchmark unaware is just being stupid because investors are not benchmark unaware. Even the word benchmark agnostic is a little strong.

Patrick: [00:24:19] Self-denying.

Harvey: [00:24:19] ... I'm benchmark afraid. I'm afraid of the benchmark beating me and beating me badly and for a long time. I can underperform the benchmark for a little while but I do have an eye on the benchmark. Some of the things that we have in our fund right now are some of the things that are big weightings in the index. For example, I don't shun SOEs. Just because they're SOEs, it doesn't mean they're bad. In fact, I would say, three of the best Russian companies are state-owned enterprises and we own all three of them, actually four now that I think about it. They all happen to be index components.

So if you can enjoy a stock that's in the index and weight it at the index level or close to it and feel good about it, that's not a terrible thing because you might be wrong. It could be that the stock emerges as one of the great leaders of the market and you don't want to be forced to be in a position where you - and I see some of my peers in Russia, and this is probably true in other markets too, they just have a philosophical hatred of a particular company because it screwed them in the past or whatever, bought out a subsidiary at an unfair price or whatever, and they swear it off forever. Even if the company completely transforms. I try not to hold those kinds of grudges for a long time because people change, companies change and it's dangerous to be rigid in this business because you could get left behind.

Patrick: [00:25:56] Can we talk about the actual, the bottom-up part of the process? I think originally there's a top-down component. You mentioned 35 countries. You're only in nine of them. There are certain conditions or a story that needs to emerge. And ideally, it's something that, it's not Cuba, and everyone's not looking at it. When it comes to the actual companies and industries that you're interested in, maybe walk us through that process. What you're looking for, whether or not there are industries that you focus on, something specific to emerging markets, and then how you think about that.

Harvey: [00:26:23] Well, in a frontier market, the first question you have to ask, you look at all the stocks in the stock market. If it's a new stock market, it depends on how they did privatization, if there could be a lot or only a few. And you need to identify what the country's comparative advantage is, what does this country have to offer? When we went to Russia, we saw, okay, this country is going to be one of the oil giants of the world. So oil stocks, you want to own oil stocks, for sure. And weirdly, when I think back to 1994, those were not considered to be the blue chips. The Russians themselves, they were very interested in buying shares in GUM Department Store and in Red October Chocolate Factory, because these were things they knew, they shopped at GUM. Now you could buy it. They had eaten Red October Chocolates, they could buy that share now. But they didn't see the oil companies, that wasn't a tangible thing that they had interacted with. So they didn't think that those were the things to buy.

In a frontier market, the first question you have to ask is...what is the country's comparative advantage, what does this country have to offer?

Incidentally, when Lloyd Benson, who was secretary of the Treasury at the time, he visited Russia and Yeltsin gave him a share of GUM Department Store and of Red October Chocolate Factory, and I think Benson should be very angry because if he had given him Lukoil, it would have gone up 100 times and those stocks were dogs forever. So I think you have to ask, what is the key sector? Is it a retail, is it going to be a consumer-oriented economy where you want to own things in banking, retail? Or you take Kazakhstan, it's another frontier market we've invested in. It's only under 20 million people so there are limitations on what a retailer can do, but they are huge oil exporter, they have metals - so you'd look at that.

In a more developed market, by then you already see what sectors have emerged, and there are certain sectors that are just not investible for foreigners. Anything related to defense usually is very difficult. But sectors that have emerged and companies that look like public companies, once you're talking about a more developed emerging market, those are the ones.

The metrics we use, again, it depends on whether it's a frontier market or whether it's a developed market. In a frontier market, where the companies don't really have, let's say, great earnings yet, you're looking for market share. You use comparables a lot. Like if this was a Western telecom, what would it be worth? What's their market share? Those kinds of questions. In a more developed emerging market, you can go on to price to book and P/E and all the normal things.

But I would say that there's been a big transition in emerging markets in the last 10 years, and particularly in the last five years, away from headline numbers and to fundamental value creation, which is now what really separates the winners from the losers in the stock market. So if you look at, there are companies in my market in Russia, that look very cheap on a headline basis because let's say they have a three P/E but the free cashflow is nonexistent because the CapEx is inefficient and a lot of stealing and nothing ever winds up going. And the only way they can pay dividends is by borrowing and paying dividends. But then you have companies that generate tremendous amount of free cash flow and share it with investors through dividends and buybacks. Those are the companies that are outperforming, that have helped us a lot in the last few years to outperform.

I think that this is a result of lots of emerging market company managers having, it's a new generation of people who were trained in Western business schools, or at least they're familiar with Western practices. And globalization has had this effect on these countries - the mantra of value creation is much more widely accepted. At least in my region, I can't speak so much to the rest of the world, but I believe that in most of Asia ex China, that's the mantra. China, I think, is a different animal. I think people who invest there need to be experts.

Patrick: [00:31:05] How do you think about dividends? Do you care about that cashflow stream? You mentioned borrowing to pay dividends. Maybe that's a bad thing. How do you think about return of cash directly to shareholders?

Harvey: [00:31:14] We're dividend hungry. We love it. At the same time, if a company has worthy investment projects, more than happy for them to invest in them. It's the same thing that Warren Buffet always says, "I don't want the dividends. I don't want the cash back. I want you to invest it." That's easy for him to say in the United States where the investments are smart. Well, let's put it this way, his companies tend to make smart investments. In our part of the world, a lot of that money was stolen so shareholders like to see the cash on the barrelhead because it means this is real profits. I can touch it.

But in my last meetings, I was in Russia 10 days ago and I had some meetings, and they were speaking my language. They were saying, "Look, the board has come up with a new policy." I met with a Russian steel company. This was amazing. They were the first company to institute a quarterly dividend. They have a new dividend policy. They're going to dividend out their entire free cash flow up to 0.3 times debt to EBITDA. And if debt is below 0.3 times EBITDA, they'll pay above 100% of free cash flow to get it to that level. And then they complained to me that other Russian steel companies, that are public, were copying their dividend policy and doing the same thing. And when I left, I said, "Oh my God, can it be that Russian steel companies are competing to see who has the best corporate governance?" Considering where it was 20 years ago, where they would shoot you for even asking where did the money go. So I think they're speaking my language, but I do love dividends.

The market has, MSCI Eastern Europe right now has a 4% dividend yield, which tells me that we're not toppy. That's a sign. It's never the P/E, the market P/E is 10. I've seen it at 10 before, but not with a 4% dividend yield. I think it was probably at 10, let's say, go back to 2005, 2006, it was probably 10, but the dividend yield was probably 2% if that. So it's a whole different ball game in my part of the world. And I would imagine it is the same everywhere in emerging markets. Again, ex China because China's a different story.

Comparing Emerging Markets to the US

Patrick: [00:33:35] On the way in I was reading, I can't remember the name of the book, but there was an Orwell quote in the book, something to the effect of whatever has the momentum now seems invincible. And the S&P 500 has been invincible here in the US, it's on a trailing 10-year basis crushed just about every other major investible index. You also, I think Firebird manages some equities, US value equities. How do you think about the opportunity comparison between US equities, maybe US value equities, and emerging markets today?

Harvey: [00:34:04] I think they have one thing in common, which makes me positive on both. Which is that equities still offer a much more attractive return than the relevant fixed income instrument. For example, in the United States, let's say that the S&P is trading at 23, whatever it is. So your earnings yield is over 4%. The 10 year is 2.7%. Even after that move, it's 2.7%. And people are getting excited, look at the dividend yield. People forget that this is only a recent phenomenon, that the earnings yield...

Patrick: [00:34:45] Could be higher.

Harvey: [00:34:46] ... basically was higher than the bond yield. When I started investing in 1992, I read The Intelligent Investor. And Graham says in there that, "You know that the US market is a good buy when the earnings yield is at least two times the bond yield. And if it isn't, you should just put like 25% into equities."

So I said, okay. I put 25% of my money into equities. And I said, okay, I'll wait until Graham's conditions are in place and then I'll get fully invested. It didn't happen until 2009. That's when it finally was. In fact, at that time, it was three times the earnings yield. I think by 2010, the earnings yield was three times the bond yield. And I said, boy, I should be buying US equities. I did, I only wish I had gone fully invested like I should have, but anyway, it's not as attractive now. But it's still attractive. Of course, I'm having these arguments with people all the time when I say that the US market is still good. And they say, "Well, that's only because the treasuries are too cheap." And I say, "If you're going to argue that you know the fair value of the 10-year and no one else does, that's a loser's argument."

There are a lot of reasons why the 10-year trades where it does. And I asked a friend of mine who's an expert on fixed income, "What do you think, is it being pushed up by the Fed?" He said, "Of course, it is." If the Fed was not involved in the bond market, yields would be much higher, but they are. And they will be for a long, long, long time. There's like a 10-year process of getting the fed out. So where's the problem? Obviously, if the ten-year does keep going up, the yield keeps going up. At some point, it does start to look like US equities are now facing very steep competition. It's going to be a factor and I'll adjust my portfolio accordingly.

Patrick: [00:36:52] You mentioned that you try to run this place like it's your PA, which I think is what everyone would want out of their asset manager. Back to that question, so US equities relative to fixed income, I understand the argument. What about equities relative to emerging market equities versus that same differential across your 20 plus year history?

Harvey: [00:37:09] I would say that we're now in a period where EM equities should outperform developed market equities after 10 years of the opposite. To use a cliche, what's becoming a cliché, we have coordinated global growth for the first time since 2007.

Patrick: [00:37:25] Can you say more about what you mean by that? By coordinated global growth?

Harvey: [00:37:28] Well, I mean, the US is growing, Europe is growing, even more than the US GDP-wise, China's growing. And not only is China growing, but after carrying much of the global economy on their backs for a few years, now they're growing more on the basis of exports again, because Europe is their biggest export market and it's growing again and people are buying stuff. When I saw that car sales in Europe last year were the highest they'd been in 10 years, that's not fake. That's not fake news. That's a real factor that affects everything. And emerging markets are growing, the others outside of China, everybody's growing.

That reminds me of the period from 2003 until 2007, when 4% global growth was happening. And it was a great time to be in cyclicals and resource stocks and emerging market equities. Then we went into a period of very serious retrenchment with a couple of false starts and then sank down again. So you had 10 years, and during a period like that, obviously developed markets are going to perform better, and tech and FAANG and all that. People are not leveraged to global growth quite as much, but I think the leadership has switched again. And I think that money has barely even started to flow into emerging markets yet. I was talking to a fund to funds manager, who's setting up an emerging market fund to funds. And I asked him, "When do you think we'll start to see some inflows?"

And he said, "One year after the EMs start outperforming the US, people start looking at them, then it'll take another year for them to figure out what they want to do. So two years after, that's when money will start to flow in." They started outperforming probably about a year ago. So we're only a year into it. We need another year. Then I would say, first quarter of 2019, we'll start to see more significant inflows to the asset class. So we haven't really seen much in the way of inflows to my funds, despite two years of extremely good performance.

Patrick: [00:39:37] Can you talk a bit about the investor types that allocate to emerging markets? You mentioned a lot of your investors have been with you a long time. I always think about it from the basic individual that makes their own decisions all the way up to the very slow to move, massive sovereign wealth funds or something like this. When you think about potential LP investors in your strategies, how do you segment them? And do you believe that everyone's just kind of performance-based investing or are there others that look to emerging markets to fill some other specific need in their portfolio?

Harvey: [00:40:08] It's a combination. Our largest investor is a quasi sovereign wealth fund. It's a very large asset manager and we fill a need. They have a huge portfolio, and they were looking for a particular type of emerging market equity investor. We fit the bill and we have them. We have some other institutional types, but I would say that the more typical investor for us is a high net worth individual, somebody with a million dollars or two million dollars, who feels uncomfortable, as they should, sticking that into an ETF. Or looks at Templeton, Fidelity and doesn't like what they see in terms of performance and track record and says, there's got to be something better and I'm willing to pay higher fees for expertise. That's the kind of investor we have. It's interesting because it's come full circle, when we started out in the nineties, our investor base was exactly like that. It was high net worth individuals and then some very sophisticated institutional investors who we filled a need.

Then for five years, we went through this amazing boom in fund of funds, which transformed the whole hedge fund industry and created unbelievable bubbles all over the place. Everything, a lot of that was pushed up by these fund of funds, and most of them are gone. So we're back to the same type of marketing we did in the nineties again. And for me, my dream investor is an older, slightly stubborn person who's made money, either investing or with a business and is very skeptical, doesn't get fooled by slick sales pitches and invests for the long-term. That's the kind of person who, when you're down, they will add more. If they're convinced that your strategy is right and you know what you're doing, they'll add more and not run for the hills the minute there is a twinge.

My dream investor is an older, slightly stubborn person who's made money, either investing or with a business and is very skeptical, doesn't get fooled by slick sales pitches and invests for the long-term. That's the kind of person who, when you're down, they will add more.

Those are my favorite investors. And I've had some of them, people like that for 20 years. Unfortunately, the funds are starting to outlive some of our favorite investors, and that's another interesting thing, is to see whether the next generation has been adequately prepared, what to do and how to invest. Sadly, I find that the answer is usually no.

Patrick: [00:42:36] Can you talk about the value of travel in the process itself? You mentioned that you were just in Russia, it sounds like someone from the team is basically traveling at all times. Maybe tell a story or two about why you do that and why that's valuable versus just looking at financial statements and information.

Harvey: [00:42:51] First of all, I enjoy it. For me, going on the road is still extremely fun. Here in New York, I'm an obscure nobody. When I go to Russia or Georgia, I'm a hero and everybody wants to wine and dine me and so on. But it's not an ego boost, I just enjoy it, and it's interesting. I was in Georgia a couple months ago, visiting with Bank of Georgia, one of our big investments, and they have a subsidiary that's building the first hospital and clinic chain in Georgia. It was amazing. They showed us this one hospital. They said, "This is the first neonatal clinic in Georgia. This is the first sophisticated CT machine in Tbilisi." And I really felt like we were part of something. Then we went to a hydro power plant that they're building.

You see and touch what it is you're participating in. It makes you feel good. And of course, I feel like because I've been doing this so long, I have a fairly good gut for management if I see really good management. Last summer, I met with Lukoil, which is an oil company in Russia, and it was a new IR (Investor Relations) guy they had hired. He was really impressive. Lukoil always had some difficulties with investor relations, never had the right person. And I said, okay, this guy is awesome. I loved what he was telling me. He told me some things that, while not inside information, were very insightful as to some things that were going to happen with Lukoil that have happened, like the decision to institute a buyback. So I felt like it increased dramatically my confidence in that position that we held and we added to it.

So you get these insights meeting with people. And the opposite too. Like you visit a company, I was just in Russia, I visited a few retailers. I visited a retailer called Magnit. I first visited their stores two years ago. This was the market darling two years ago. On paper, it looked really good. But if you actually visited the stores, you saw that they were letting them go to pot. They were dirty. There was inventory sitting all over the selling space. And then I went to their competitor, X5, which was introducing a sparkling new store format and was only a little bit more expensive. And I said, X5 is going to eat Magnit for lunch. We sold our Magnit, which had a huge gain on, and at that time was, I think it was the third largest holding in the ETF, and switched into X5. And sure enough, X5 has outperformed by a couple hundred percent.

Then I went just recently, but they said, "No, Magnit, it's still good. They've just reformatted their stores. They're going to be just as good as X5s." This is the story that the analysts are telling while presumably they're still trying to offload Magnit shares onto people. I went to the Magnit store last week, and it was still, even the refurbished store, was still no good. It was dirty. There were empty shelves because they have this just-in-time logistical strategy, which is not working. There's empty shelves and there was still inventory sitting all over the floor and carts. Then I went to a couple of other stores that were sparkling and new and filled with goods. And they just can't compete.

These are the things you see when you go. Even in the more developed emerging markets that have plenty of research coverage, you have to see with your own eyes sometimes. Frontier markets, without a question, you have to go. You can't develop an opinion about a frontier market unless you spend some time there, get to know the people, the business culture, get a feeling for what's going on there. And even then, you don't always get it right. We've had some huge mistakes over the years, thinking that a country was going to be great. And then it went in different direction. Sometimes you have to adapt to that.

Mistakes in Emerging Markets

Patrick: [00:47:02] What do you think the biggest mistakes are that emerging markets investors make? And you can interpret that two ways. One would be your direct competition, other active managers in emerging markets, but also just allocators to the asset class.

Harvey: [00:47:15] The managers that I've seen over the years fail, usually fail for a couple of reasons. One is that they get arrogant and they forget that they're outsiders. They try to do things that are too funky or get involved in - I saw one asset manager of a portfolio equity fund put almost his whole fund into a private company. He got screwed and wound up losing the fund. I've seen a lot of people just get suckered into very large illiquid things. I learned a lesson myself in 2008 about matching liquidity to the terms of your fund and style drift, I would say, is a big risk in emerging markets because people think that they can do anything. They think, just because they had some good early returns in an emerging market, that they now master that market. They can do private equity there, they can do derivatives, they can do shorting, and become very overconfident. I think that's one of the biggest mistakes.

Style drift, I would say, is a big risk in emerging markets because people think that they can do anything. They think, just because they had some good early returns in an emerging market, that they now master that market. They can do private equity there, they can do derivatives, they can do shorting, and become very overconfident.

Liquidity mismatching, and just lack of patience. Literally, I was in a almost 10-year bear market in emerging markets. Then it turned bullish about two years ago, but I had to go from 2008 to 2016 underwater, no performance fees, investors not particularly thrilled. And we survived in that environment by very, very disciplined, bottom-up stock picking, investing for dividends. We were able to do okay relative to the markets, but we knew that in that environment, we just going to have to wait until things got good again. Emerging markets is very streaky. You have to be around when the good times happen.

In terms of investors, they make the same mistake in emerging markets they make everywhere else, which is buy at the top, sell at the bottom. I am begging, I have a few investors who either put a toehold in my fund and they said they'll give you more later, or they're looking at it and looking at it and looking at it. I am thinking, please, don't wait until we're 20% from the top of the next bull market and then give me all the money. Don't be like that, please. And most people, that's what they're going to do. For me, if that's the way it plays out, for us, the goal is going to be how to handle, what do you do with inflows when you're not confident about the valuations and you feel you're near the top and sell at the bottom?

I had a couple of big investors, I would say several of my biggest investors pulled the rip cord at the exact worse time at the end of 2015, just as oil was getting ready to bottom out, just as the global economy was turning, just as Europe was starting to grow again, they just gave up and sold at the bottom of that particular cycle. So patience, long-term, and I would say, look for managers. Another thing is, this is self-serving, but I believe that emerging markets investing is a very specialized skill, much like distressed debt investing. I've been doing it for 23, 24 years. I think I learned something over that time.

When I invest with other fund managers, if I invest in distressed debt, I wouldn't buy a distressed debt mutual fund or ETF. I find the best manager and give them money. I'm more than happy to pay them 2 and 20, if they'll have me. Because a lot of times they're closed and I have to ask, please. But with emerging markets, everybody's attitude is like, "Oh, I can just buy the ETF." Well, good luck because look at the historical performance of not only the ETFs, but the mutual funds against the top ranked EM managers, the hedge fund managers, net of the performance fees and what they've delivered. So I think we're more like distressed debt than we are like say, US equities, but that's self-serving, of course.

Patrick: [00:51:32] You mentioned the smell of opportunity in Russia in the mid nineties, what comes closest in today's market to give you that same sense?

Harvey: [00:51:38] There's nothing that jumps out at me right at the moment that I feel like is a screaming buy, that I would be so excited to just be able to buy some. I think the whole thing looks pretty good. Reminds me of where we were in about 2005, when we were only a couple of years into that bull market. I hope this one progresses in a more measured way and it doesn't turn crazy. I think it will because people were burned last time. I don't really see anything in the public equities that I think is an absolute screaming buy. I do some things outside of my funds with my personal money that I think are interesting. I invested in a ride sharing service called Via here in New York, I think it's quite interesting. I think that's a model that could be very big around the world.

Patrick: [00:52:36] What makes that distinct from the Ubers and Lyfts of the world?

Harvey: [00:52:40] Via is a private company that runs these vans in big cities. They're in New York and a few other cities. It's really an alternative to public transportation. They're an alternative to buses and they have this incredibly sophisticated algorithm that matches people up on routes. They even use some sort of AI to make sure that the route that it takes is also psychologically attractive to you. For example, they pick up people in a line all over the upper West side and then they take them to their offices, but they don't take you out of the way, even if it would be shorter. Because they know that you're going to believe that they took you out of the way and it made it longer, even if it made it shorter. So it's an unbelievably brilliant algorithm developed by these two former Israeli military guys. I was lucky enough to be able to put some money into that, in a round along with Mercedes, which took half the round. So little things like that. I bought some gold coins recently.

Patrick: [00:53:42] Interesting. What was the thinking there?

Harvey: [00:53:44] I think that gold, I don't want to get involved in a discussion on cryptocurrencies, but let's put it this way. I don't think...

Patrick: [00:53:51] You're talking to the wrong guy.

Harvey: [00:53:52] I don't think they're going to replace gold. I saw Cameron Winklevoss on TV claiming that cryptocurrencies were the new gold. I told you, I spent a lot of time analyzing people to see their level of truthfulness. And I saw in his eyes that I don't think he really believed what he was saying himself. They're not going to replace gold. Gold has been around, an ounce of gold buys you the same amount of wheat now as it did in Moses' time. I don't know if you will be able to say the same thing about bitcoin, but whatever. My point is not that cryptocurrencies went up, it's that gold went down partially because of them. So while I'm not a gold bug, I felt that having some gold coins, plus I used to be a coin collector when I was kid, so I liked the idea of buying some incredibly cool coins, which also had its investment value. And that was just a little personal diversification.

Patrick: [00:54:51] What was your all-time favorite coin in your collection?

Harvey: [00:54:53] I don't know. Probably some, I remember buying a mint set of Kennedy half dollars in the sixties when I was a little kid and Kennedy was - I remember exactly what it looked like. It had these real shiny Kennedy half dollars and then the rest of the US coins. But that started me as a fund manager. I think that if you scratch a lot of the top fund managers, you'll find a coin collector, a stamp collector, a collector. Because it's the same impulse, isn't it? We all love to consume, but there are some of us that our favorite kind of consumption is consumption that also feels like investment.

When you buy coins as a kid, you're buying something with your money, but it's something you know is going to have value or you believe is going to have value over time. And I was one of those kids, there are other kids who spend all their money on cotton candy and this and that. I was always the other kind of kid. And I would say that this is also why so many fund managers are art collectors, like I am, because I don't get any particular pleasure in spending a lot of money on particular kinds of travel or this or that. But when I buy art, I have this feeling of both consuming and investing at the same time. I think most fund managers who are good, they have that gene for long-term cumulation of wealth by acquiring stuff.

Patrick: [00:56:32] Sounds like a good interview question for people. Did you have a stamp collection as a kid?

Harvey: [00:56:34] Yeah. Ask them. You'd be surprised. I bet you. Why are so many fund managers art collectors? I think these are probably the kids who had baseball card collections and coins and stamps and everything else.

Patrick: [00:56:49] So I have two closing questions for you quickly. The first is, if you were to choose one country, you could only travel to one of the various countries you spend time in, purely for enjoyment. And that could be investment enjoyment, it could be pure travel. What country would that be?

Harvey: [00:57:02] I would say that right now, of the places I invest in, the place I would recommend going to the most is Moscow because the city has really transformed in the last five years. The hotels are great, there are a lot of great Russian food, Russian cuisine but with a contemporary spin on it.

Patrick: [00:57:25] Not jellies?

Harvey: [00:57:26] No, just amazing farm to table Russian food all over the city. The city looks good. There's Uber and Yandex.Taxi you can get around. Everything works and it's fascinating. There are a lot of museums to see. So it's just a fascinating place to visit, tack on St. Petersburg and I think that's a fantastic vacation.

Patrick: [00:57:51] My closing question for everybody is to ask what the kindest thing that anyone's ever done for you is.

Harvey: [00:57:56] Other than a family member, I don't know. I think that I would give a shout out to my old law firm, Wachtell Lipton. They worked me very hard, but they always treated their associates like real important people and they compensated us fairly. And then when I left, they were extremely nice to me. I then went on to write a novel, which was published in 1995, which was about of a law firm that some said was like Wachtell Lipton. And it wasn't a particularly favorable portrayal of the legal profession, I have to say. Marty Lipton wrote me a note saying how much he liked the novel. And I thought that was just a class move. He's really somebody who stands out to me as class act.

Patrick: [00:58:47] Fantastic. Well, this has been a really, really interesting conversation. Thank you so much for your time.

Harvey: [00:58:55] Thank you.

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