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KDGF Asset Management Investment Strategy
February, 2014: Many readers of our letters have asked us to detail our investment philosophy and strategy to
better understand how we develop our market calls and our country, sector and stock selection process. Our
previous letters touched on our strategic framework, but this letter will go into this in more detail and hopefully
provide an understanding of how we arrive at our views and positions. We will then use examples to explain
how our Investment strategy led us to the positioning that we wrote about in earlier letters, specifically our
“Long Nigeria” position that we wrote about and entered into in January 2012, and our “China crisis” hedge that
we have repeatedly stressed is the most important building block of our portfolio. Finally, we will briefly touch
on recent critical events in Global Markets (QE “Tapering”) and in China.
In the coming weeks, we will launch our Global Emerging Markets fund, and due to regulatory constraints we
cannot go into detail about our expected positioning. However, hopefully this letter and our previous letters will
give readers a good understanding of how we analyze the markets and construct our portfolio.
Investment Philosophy & Strategy
The defining characteristic of Emerging Markets is that they tend to have strongly self-reinforcing
credit and liquidity feedback loops, and that capital flows and credit cycles tend to have exaggerated
impacts on asset prices. These dynamics typically drive Emerging Market bull markets higher, and
bear markets sharper and steeper than those in Developed Markets. This is what makes Emerging
Markets such an interesting investment opportunity. The opportunity is not that Emerging Markets
are “cheaper” than Developed Markets, or have better economic growth prospects – the opportunity
is that Emerging Market financial markets offer great opportunity on the upside and downside, and
that analysis of their underlying drivers can lead to strong returns throughout different market
cycles. Furthermore, these credit and capital flow cycles tend to recur over time, making this
investment strategy repeatable over the medium to long term.
Our investment strategy focuses on capital flows, liquidity and credit cycles, identifying markets where these
are at inflection points, investing in those markets that are on the right side of these cycles, and shorting or
hedging those markets (or the asset class as a whole) on the wrong side of these cycles, and those at risk of
sharp corrections or crises.
As these cycles develop, Emerging Markets are highly susceptible to credit booms that turn into bubbles, as the
self-reinforcing credit and liquidity feedback loops push asset values well beyond sustainable levels. Those
markets then become vulnerable to financial crises when credit or liquidity conditions change. It is crucial to
hedge out these risks when they appear. We currently see a high risk of such a scenario unfolding in China,
which has been the beneficiary of a historically large credit and liquidity bubble that is likely in its final stages.

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Market Selection Process
The following are some of the main factors that we analyze. In the interest of brevity, the list is not exhaustive
and the examples used are descriptive, not comprehensive.
Primary Importance
• Capital flows: Both to the asset class as a whole, and to individual markets: Are they increasing or
decreasing? Both external capital flows and internally generated capital are analyzed. While trade flows
are important as well and are incorporated into our analysis, Capital flows are often more impactful on
asset prices. Within the three broad categories of capital flows (Foreign Direct Investment, Bank Credit,
Portfolio flows), Bank Credit and Portfolio Flows are as a rule much more volatile than FDI, and lead
changes in overall flows.
• Credit cycles and interest rate/inflation dynamics: Falling inflation and declining real interest
rates in an economy with the potential for an expanding credit cycle (either due to cyclicality or because
of historically low credit penetration due to high inflation and interest rates) are very bullish. Increasing
inflation and rising real interest rates in markets in a mature credit cycle are bearish.
• Growth/Earnings prospects: We look for markets, sectors and companies with strong and
sustainable earnings growth. This is discussed in more detail below under “Stock Selection Process”.
Secondary importance
• Investor positioning – especially foreign investor positioning - within individual
markets: Low investor positioning is often bullish, and high investor positioning is often bearish. In
markets with low investor positioning, there are two broad categories: 1. either positioning has never
been significant (typical in Frontier markets such as Saudi, Myanmar, Iraq), or 2. it was significant at one
time but exited (typically due to crisis), and will likely return when conditions change (Nigeria, Vietnam).
Most investors are typically late identifying structural changes in markets, and wait to see confirmation
of trends before committing (or removing) capital to markets, and therefore miss the outsized gains
delivered by market turns.
• Valuations: Including P/E, P/B, EV/EBITDA, debt ratios and leverage, Dividend Yield. We are
especially interested when either low or high valuations are combined with extreme readings in the
other factors. So, for example, a market that has low foreign participation, where the credit/investment
cycle looks to be expanding, where we forecast increasing company earnings and where valuations are
attractive, is very interesting for a long investment. A market that has high foreign participation, has
had several years of high credit growth and is expensive, is interesting as a market to short/hedge. The
reason why Valuations are of secondary, rather than primary importance is because Emerging Markets
often undershoot or overshoot “fair value” as they move through market cycles. The primary factors
listed above – especially Capital Flows and Credit Cycles – are usually more impactful asset price drivers
than valuations are. Valuations are important, but they are often not the most important driver, and are
more important in combination with the other factors listed above than they are on their own.
We also believe that a relatively Concentrated investment approach is best, as the most attractive opportunities
exist in only a handful of markets at any given time. At the same time we are mindful of the need to balance

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between Concentration & Diversification for risk management purposes, and therefore have exposure limits to
individual markets, sectors and companies. Our typical portfolio consists of around 30 long or short positions in
companies from 5 to 8 markets at any given time, in addition to hedges against individual positions and against
the portfolio as a whole.
We also very strongly believe that it is necessary to have the flexibility to invest wherever the best opportunities
are in Emerging Markets, without having limiting geographic restrictions. History clearly shows that the best
(and worst) performing Emerging Markets vary in location from year to year, and that limiting the investment
universe to a geographic construct (Asia, or Latin America, or Eastern Europe/Middle East/Africa) is a mistake.
The conditions that we look for do not occur only in Asia, or only in Eastern Europe, or only the Middle East, or
Africa, or Latin America. They occur in different markets over different times, and they have a similar impact on
asset prices wherever they occur. In Emerging Markets investing, the key to delivering strong returns is not to
know more than anyone else about Russia, or China, or Mexico, or Indonesia, or Nigeria. Instead, the keys to
strong returns are:
1. Understanding how Emerging Market capital markets evolve and mature (and sometimes fall apart),
and how they respond to economic and financial inputs, both at the overall systemic level and at the
individual market level.
2. Having an investment strategy and process that identifies which individual markets and companies
are most and least attractive at any given time, underpinned by comprehensive bottom up analytical
procedures and thorough due diligence.
3. Robust risk management, at both the tactical level (position sizing, stop loss procedures) and at the
strategic level (hedging systemic risks).
The strength and key differentiating factor of our Investment strategy is that it combines these three aspects
into a process that is repeatable over time, scalable, and that works through the investment cycle.
Stock Selection Process
Once we identify the markets that we will invest in, we apply very extensive screening criteria to the companies
in those markets. We focus particularly on bigger, more liquid companies in sectors that are strongly impacted
by the improving credit and liquidity factors that attracted us to those markets in the first place, such as
Financials, Consumption, Infrastructure, and Real Estate. In general, we are looking for companies with strong
Returns on Invested Capital and sustainable growth prospects that are leaders in their market segments, with
good corporate governance practices, and management and ownership whose incentives are aligned with
minority shareholders. Our extensive and lengthy analytic procedures center around in-depth analysis of the
companies’ operations and financials to understand where their earnings are coming from, what their growth
prospects are, how scalable they are and where the risks are. This is critical in Emerging Markets where the
underlying reality of company financials is often different from surface appearances.

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Style Focus
Our overall style focus varies depending on the state of the industrial cycle, as empirical research shows that
different factors tend to impact stock returns at different stages of the cycle. For example, in early upturns, a
Value based approach tends to be best, while in more mature recoveries Value loses its primacy and
Momentum stocks typically outperform. In Downturns, Quality factors such as balance sheet strength and
market strength are important drivers, in addition to Value factors becoming prominent again. (And
conversely, in downturns, equities characterized as Low Quality and Low Value - i.e. expensive, with high debt –
tend to make the best shorting candidates)
Investment Examples
Perhaps the best way to explain our Investment Strategy is to give examples of how it has worked in practice,
and how we delivered strong outperformance over the last two years in our model GEM portfolio.
NIGERIA: The Nigerian equity market in 2012 is a good example of this strategy. Nigeria went through a painful
banking crisis in 2009 and foreign investors liquidated their positions in Nigerian equities. The bank sector then
went through an extensive restructuring process during which most of the banks were cleaned up. Throughout
2011, Nigerian fundamentals improved and the economy grew strongly again, driven by an ongoing
fundamental transformation in the economy and high oil prices. It was clear to us that the Global Financial
Crisis and Nigeria’s own banking crisis were just hiccups along its path of structural transformation and
growth. At the same time, equity valuations became severely depressed, as foreign investors still had negative
perceptions of the market due to its recent problems. Banks, which are always a key focus for us in Emerging
and Frontier markets, were trading at low valuations of less than book value, and as low as 0.5x Book Value,
even as sustainable Return on Equity was in the high teens and low 20’s. Foreigners, who had accounted for
more than 60% of the market in 2007, were less than 25% of the market at end 2011. Global Emerging Market
fund’s allocations to Nigeria went from 0.25% to 0.15% over the same time period. Domestic investors had also
liquidated their equity holdings, with domestic Nigerian institutional investors lowering their equity exposure to
single digits.
Thus, the Nigerian equity market was characterized by an ideal combination of early cycle improving
fundamentals, restructuring, low equity valuations and very low participation by foreign and domestic capital.
In addition, foreign capital had been very attracted to the market pre-crisis, and was likely to return to the
market once it become comfortable that the problems of the past had been dealt with. Our analysis determined
that the credit cycle was turning, that liquidity was increasing and that capital inflows would increase, making
this market an ideal candidate for asset price gains. Therefore, as we wrote in our January 2012 letter, we put
on a long position in Nigeria, with a focus on the banking sector. This was one of 7 markets that we were long.
(As a reminder, we take a concentrated approach to markets, as the specific characteristics we look for tend to
exist in only a handful of markets at any given time.) The biggest risk to this position in our view was that the oil

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price might fall, which would have a negative impact on Nigeria as oil exports are such a big part of its economy.
However, we hedged this risk with put options on crude oil, which have been cheap due to the relatively low
volatility of oil prices over the past few years. This turned out to be a very successful position as Nigerian
equities were among the best performing in the world in 2012 and 2013, massively outperforming the main
Emerging Market and Frontier Market indices.
CHINA: Our focus on analyzing Credit, Liquidity and Capital flows also led us to our view that China is
vulnerable to a financial crisis. As our readers are aware, this has been a concern of ours for the last several
years, and we have consistently written that China tail risk protection is the most important building block of
our portfolio. We have written very extensively about this in our previous investor letters and will not repeat
our arguments here (please contact us if you would like us to re-send our previous investor letters), but in short,
our analysis showed that China’s astonishing export and Foreign Direct Investment driven economic
transformation of the previous 20 years had rapidly transformed after 2008 into a fundamentally unstable asset
price bubble driven by extremely high credit growth, and unstable hot money inflows. When we first identified
these risks and began warning of them three years ago, our view was very much in the minority. Since then,
concerns over the risks that we identified have become more mainstream, but markets still believe – incorrectly,
in our view - that the risk of a financial crisis in China is extremely low.
Bullish Nigeria & Bearish China: Two sides of the same
“Capital & Credit Flows” Coin
Both of these calls – bullishness towards Nigeria in 2012/13 and caution towards China – were developed from
the same conceptual basis. Capital flows, Liquidity & Credit cycles drive everything. Early stage increasing
capital flows – such as in the Nigeria example above – are bullish, as they often result in big increases in asset
prices. (Note: Nigerian equities no longer offer as compelling a reward/risk ratio as they did, and are no longer
amongst our long positions) But late stage elevated capital flows – such as in China – often result in instability
and precede financial crises. These are classic “Minsky” patterns, and have proven repeatedly to drive both bull
and bear markets in EM.
It is also crucial to understand that Capital flows are non-linear, and can and do change dramatically, very
quickly, and with little warning. These changes always have far reaching impacts on asset values, and Emerging
Markets tend to be very susceptible to changes in these flows, and can be vulnerable to “sudden stops” in
Capital inflows. Our investment process seeks to identify and hedge markets that are vulnerable to these risks.

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Quantitative & Qualitative
Our investment process is a combination of Quantitative & Qualitative analysis. While Quantitative analysis
forms the foundation of our strategy, the Qualitative aspect is also critical. As we are forecasting how financial
markets will evolve in future quarters and years, we are making judgments about which markets and companies
are currently mispriced by the markets and that we expect to become more attractive, and which will become
less attractive. This “change” aspect is critical. Individual markets in EM are often cheap for a reason, as they
do not have the conditions necessary to attract increased Capital Flows. Quantitative analysis can identify
“cheap” markets, but many “cheap” markets stay cheap. Qualitative analysis is necessary to determine which of
these markets will stay cheap, and which of them are poised to experience rising earnings and asset prices.
This qualitative judgment also includes consideration of market Sentiment and Confidence towards the asset
class as a whole, and towards individual markets. These are especially important elements in Emerging Markets,
which as we noted above are highly sensitive to external capital flows, which in turn are influenced by Sentiment
and Confidence. In contrast, many traditional investment strategies in Emerging Markets make the mistake of
relying on a pure “value” approach. They risk investing in equities that are cheap for good reasons, and will stay
cheap over time. Just because something looks good on the quantitative side does not mean it is a good
investment. One of the keys to our investment strategy is to correctly analyze which market’s capital, liquidity
and credit cycles are turning, which will lead to increasing (or decreasing) earnings and higher (or lower) asset
prices, independent of absolute valuations. Just being cheap and unloved is not enough, as markets with
moribund fundamentals can stay that way for a long time.
The common characteristic of the above investment examples – initiating positions in Nigeria after most
investors had liquidated theirs, and hedging China risk while conventional wisdom believes that China is a one
way bet – is that they were based on our conclusions that existing trends were changing, and that therefore
an attractive risk/reward profile existed that was incorrectly priced by the markets.
This – correctly identifying when liquidity, investment and credit cycles change – is important. When these
cycles change in Emerging Markets, they tend to have a very powerful effect on asset values due to the self-
reinforcing credit and liquidity feedback loops that are particularly strong in Emerging Markets. The structure
of Emerging Market economies and financial markets are typically pro-cyclical, and respond strongly to even
moderate changes in economic dynamics. History shows clearly that asset values in Emerging Markets rise fast
and high in bull markets and collapse quickly in bear markets. That makes Emerging Market equities ideal from
an investment perspective, and argues very strongly for having the flexibility to be net long or net short as
conditions warrant. It also argues for an active, concentrated approach to stock selection as there tends to be
high dispersion in market returns, with a handful of markets greatly outperforming the overall indices.

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Another market characteristic during these transitions is that there are often highly asymmetric instruments
available at very attractive prices. Simply put, in out-of-favor markets like Nigeria in 2012, equities are often
very cheap and have much greater upside potential than downside risk. And in bubbles like the one China is in
now, inexpensive hedges are often available with massive upside potential in the event of a strong correction or
crisis. We look for both of these types of opportunities and seek to produce strong returns in both up and down
markets.
The Impact of the End of QE
With a reduction of Quantitative Easing in sight in the US (although not in Japan, which has a substantial impact
on global liquidity), we believe that Capital flows will play an even more important role in Emerging Market
financial markets in the near and medium term. These will drive both the EM asset class as a whole, and be one
of the dominant factors driving performance differentials amongst different Emerging Markets. The central
importance of Capital flows in our Investment Strategy should position us well in this environment.
China Outlook
The recent Third Plenum in China has received a lot of press about “bold new reform”, but the fundamental
underlying reality is that the risk of a financial crisis in China continues to grow, with key financial, debt and
economic variables continuing to deteriorate from already critical levels, and that China remains dependent on
foreign capital inflows to sustain its liquidity and credit bubble. The Third Plenum has not changed that reality,
and more critically, the seemingly intractable problem that reform requires powerful vested interests to give up
some of their wealth, influence, status and power, still stands in the way of any meaningful reform.
We have written extensively about this in earlier letters, so will not repeat those arguments here, but we will
reiterate the point that there are NO historical examples of an elite with the power and wealth that China’s
has, willingly giving up their privileged positions without a crisis forcing them to do so. That is precisely what
those who claim that China’s economy will successfully transform from its current structure into a more
consumption driven model are arguing. The China bulls all point to recent “anti-corruption” drives by the new
government as evidence that these entrenched vested interests can be overcome – that they will get the
message that they must change their ways and not stand in the way of reform. But we would point out that
there have been many anti-corruption drives in China before. In fact, 660,000 government officials have been
investigated for corruption in China in the last 5 years, and during Hu Jintao’s presidency (during which
corruption only got worse), 70 officials with a rank of “Deputy Minister” or higher were convicted of corruption
and purged. Simply put, “anti-corruption” drives have long been part of the landscape in China, and another
one is unlikely to prevent vested interests from fighting to retain their wealth and power. The potential riches
are simply too great.

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There are also NO historical examples of countries with comparable credit booms to the one China has had in
the last 5 years avoiding a subsequent financial crisis. Perhaps China will be the first to do this, but it is prudent
to hedge the risk that they will not. In addition, the fact that there are inexpensive hedges available against a
China crisis, with extremely high asymmetric payout profiles, offers investors the ability to hedge this risk. As
every Emerging Market would be – at least initially – very negatively impacted by a financial crisis in China,
investors with an unhedged approach to their Emerging Markets investments are essentially making the
judgment that China will be the first to successfully and smoothly make this transition, they are gambling that
“This Time is Different”…..