Over the past year, investors have become excessively cautious about emerging markets. To compensate for the additional uncertainty, many underestimate the upside potential. Paradoxically, to get a better handle on the risks, we believe they should assume the worst. By using this “pre-mortem” approach, not only do they have a better chance of avoiding disaster, but they can also more accurately quantify the rewards.
Emerging markets have had a less-than-stellar 2013. Investors, it seems, have remembered why emerging-market stocks are more volatile than their developed-market counterparts: they’re more susceptible to risk. For the technically minded, volatility is embedded in their beta.
Rear-View Mirror Is Misleading
But looking at emerging-market stocks that way is tantamount to steering forwards by looking backwards. While investors may have been guilty of over-optimism before, many now seem to be assuming that past volatility will continue in the future. Yet, as we all know, the past is no guide to future performance. Businesses, and the environment in which they operate, can change rapidly, making history a blunt instrument for predicting what’s to come.
Unfortunately, this rear-view mentality is not the only problem that bedevils traditional methods of assessing future risk. Behavioral biases are a big obstacle to forecasting outcomes effectively. Traditional methods usually involve variations of the question “What could possibly go wrong?”
The problem with this approach is that any proposal to invest in a stock almost always involves a high level of emotional and reputational investment from those making it. Looking for loopholes inevitably entails implicit criticism of fellow workers or more senior colleagues. As a result, any risk assessment exercise can itself become fraught. At the very least, a critic willing to put their head above the parapet may suffer embarrassment; at worst their actions could be career limiting. This probably explains why so many investments (and other projects) fail to reach their potential despite flaws that, with hindsight, seem obvious.
Removing Emotion from Critical Thinking
We believe a pre-mortem gets round these issues by reframing the question in a way that removes the emotion. By assuming that the project has already failed and then asking why, criticism becomes a much more constructive exercise. Instead of being seen as Jeremiahs, those coming up with the best reasons for failure are more likely to earn kudos.
Of course, the premortem is not new: American academics proposed the idea of “prospective hindsight” nearly 25 years ago.* We have simply taken their theories as subsequently refined by others, applied them to investment analysis and added a quantitative element.
How to Conduct a Pre-mortem Analysis
First, we think of plausible reasons why a stock has failed to reach our price target, grouping them under four general headings: compliance, financial, operational and strategic. Then we quantify their importance by looking at their likely impact on a stock’s future beta. The resulting score takes account of both the likelihood and size of any effect. This can then be used to calculate the company’s true cost of equity and hence a risk-adjusted internal rate of return for an investment.
This approach can, we believe, take much of the emotion out of forecasting and thereby provide a more accurate view of a stock’s potential. And in emerging markets, where research coverage is thin, the financial and economic background is volatile and the political situation can change overnight, we think that should give investors a powerful edge over the competition.
*“Back to the Future: Temporal Perspective in the Explanation of Events,” Deborah J. Mitchell, J. Edward Russo and Nancy Pennington, Journal of Behavioral Decision Making, vol. 2, 25-38 (1989)
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.