In early March, with the Dow at 6500 partly because most pundits were predicting an imminent plunge to 3000, I anticipated a fine contra-rally in this bear market. (Can You Hear the Bell Signaling a Bottom?” March 3). In “hindsight,” of course, everyone expected it; just ask them!) Then in April I began selling into the rally and was in 80% cash by month-end. Nothing has changed in my short-term outlook. I still believe the Dog Days of Summer will punish many a dog. But now is the time to begin looking over the valley to research possibilities and define what our strategy will be when it’s time to go long again.
Many investors, disappointed with the recent performance of U.S. markets, will be tempted to look to public companies in other nations. I was partly raised in Western Europe. I served as a defense attaché in Southeast Asia, deployed to the Middle East, and traveled to some 80 countries. I have a high comfort level investing overseas. But I also know that governance counts. As sloppily as America has governed its financial and securities markets these last few years of frat-boy partying, the US of A still has some of the more stringent corporate and political governance systems anywhere in the world – and likely to get tougher as a result of the shenanigans from bankers and brokers these last couple years.
This is especially true when comparing the U.S. with the the most popular nations whose siren call will beckon in the coming months -- Brazil, Russia, India and China, the best-known, most-recommended representatives of the emerging markets that, according to some, will surpass the United States in the next few years. To which I say, “Balderdash.” Governance counts. When reviewing any possible investment, I first ask myself, “Is the country in which this company is headquartered, or draws substantial revenue, or has substantial assets, subject to the rule of law or the capricious rule of men? Are their banks, utilities and transportation providers independent of the government or dependent on them? Are companies in key industries allowed to make decisions for the benefit of shareholders and the communities served or do they exist to prop up a corrupt government by creating jobs for workers otherwise unemployed or unemployable?”
Asking that simple question has allowed me to buy some stellar non-U.S. companies like Royal Dutch Shell (NYSE:RDS.A) (based in the Netherlands), Nestle (OTCPK:NSRGY) (Switzerland), Yara Intl. (OTCPK:YARIY) (Norway), and Toyota (NYSE:TM) (Japan.) It has also allowed me to avoid some otherwise fine firms because I predicted, correctly, that their hoped-for profits would evaporate in a fog of corruption, bribery, coups, revolutions, and the victim mentality that socialism engenders, fosters and perpetuates.
For an example of the crushing burden that corruption, and the socialist notion that resources exist to fund government programs, contrast Exxon Mobil (NYSE:XOM), the world’s largest publicly-traded oil company with Petroleos Mexicanos (PEMEX), one of the world’s mid-sized nationalized oil companies. Both are roughly equivalent in terms of production, with Exxon not too far under a billion barrels a year and PEMEX not all that far over.
XOM, governed by the laws of the United States and answerable primarily to its shareholders, regulators, Congress, etc., produces nearly the same amount of oil as PEMEX – but it does so with just 10% of the “workforce” PEMEX has. That’s right -- it takes ten times as many workers in feather-bedded, corrupt, low-social-mobility Mexico to produce a barrel of oil as it takes XOM. And 40% -- 40% -- of the Mexican government’s income comes from PEMEX, a wasteful firm drilling for wasting assets. Since Mexico refuses to allow foreign partnership with proprietary technologies in its nationalized oil company, it falls further behind in production every day. As this trend continues, and government revenues fall, unchecked population growth will collide with failure to provide basic services like food and water.
There are some democratic republics among emerging nations, where the rule of law supersedes the desires of leaders to feather their own nests, give jobs to their nephews, or buy votes by plundering future generations’ piggy-bank via massive socialist / populist wealth “redistribution" schemes. But they are few and far between. (Tomorrow, in Part II of this article, “The ABCs,” I’ll cite one of those, the "B" in ABC, as an example…)
Let’s take a look at Brazil, Russia, India, and China, which are often cited as exemplars of the emerging nations’ future dominance. Let’s see how they stack up in terms of corporate governance. I’m using, for the BRICs and the ABCs, the data from the most current CIA World Factbook, available in libraries or online. We’ll review them in order of BRICdom...
First comes Brazil, a giant, sprawling, pulsating magnificence, the largest (nearly the size of the U.S.) and most populous (200 million plus) nation in South America, with incomparable natural resources and a large and relatively well-educated population. (Literacy is 88% vs. 99% in the U.S.) This is a nation of great size (it borders every nation in South America but two), great diversity, great resources, and a great future. But, as Brazilians like to say, “Brazil is the country of the future -- and it always will be.”
Why this wry self-denigration from the residents of such a promising nation? What do these people see in their nation that far-away starry-eyed investors do not? There is no doubt that Brazil has a wealth of natural resources -- iron ore, cement, diamonds, gold, bumper crops of coffee, soybeans, rice, wheat and sugar cane for sugar and ethanol and, most significantly, what may be the latest elephant oil fields in the history of the world. And yet it struggles to keep its head above water. With all this going for it, why then do we see such poverty, inflation, crime and economic instability? If you have Brazilian friends, they can answer in one word: “Corruption."
As Jeffery Luke wrote in an article from Brazil, he was talking to a Brazilian friend who illustrated this point: “ ‘Let's say that we need a bigger bridge because of all of this traffic. The cost would be very high, say $10 million reals. Well, the government would collect taxes for two years, there would be big plans to construct this bridge, and then it would never be built. The money disappears, and no one knows where it went.’ A French expatriate who had lived in Brazil for several years told me that Brazil's problem is not corruption, but the inefficiency of its corruption. ‘Corruption is a part of every country, even successful ones like the U.S., Japan or Chilé,’ he said. ‘In these countries, you know who you need to go to with your money and what you have to pay to get what you want. Brazil is so disorganized and inefficient in its corruption, you might have to bribe one police officer and then another and still you have not reached the right guy,’ he said. ‘Or you pay off one corrupt judge, or a politician, and there's absolutely nothing done on your behalf. Sometimes you have to bribe someone once, and then bribe the same person again,’ he said.”
You may think corruption is not your problem as a foreign investor -- after all, Brazilian companies are still thriving in this environment so how bad could it be? But I would submit that qualities such as poor governance, corruption, bribery, over-regulation and a socialist world view all act as brakes on the ability of a company -- and thus your investment -- to succeed. Sooner or later, it will catch up to you and bite you somewhere painful. Why bother, when there are so many other good choices?
If Brazil’s major problem is corruption, Russia’s is both governance and corruption. In Russia, they simply don’t have any of the former. If Putin likes you, you get contracts and other people’s arms get twisted. If he doesn’t, you still have choices -- you can sign over everything you’ve worked for or you can get the shaft (sometimes literally, if stories of poison at the end of the umbrella are to be believed). The propensity to favor autocracy that has held Russia back for centuries appears to be in no danger of revision. The Russian people will endure much chicanery if only the state will hold together. They seek a strong central government to keep the nation from spinning out of control, even if that solution leads to unfair business practices, embezzlement, fraud, theft, extortion and the confiscation of holdings on a whim.
In terms of governance, there seems little change in Russia from the days of Maggie Thatcher’s observation that the then-Soviet Union was like “Upper Volta with nuclear weapons.” (Upper Volta was a country/basket case in west Africa now known as Burkina Faso.)
To poor governance and corruption, I would add lack of transparency and denial as reasons to eschew investment in Russian companies. Lack of transparency? This winter the Russian government opted to close all meetings to all members of the press, foreign or domestic. What are they hiding? As for denial, as recently as February 5, Prime Minister Putin said, “The measures taken by the government allowed the country to escape the shock of the crisis.” Wow. Could have fooled me and almost every Russian, kept alive only by massive oil exports. In the same speech, Putin recommended that the ruble become the world's reserve currency -- even though investors worldwide dumped the ruble fast, dropping it almost 40% since the economic crisis.
Moving on. India is a real and functioning democracy, though the outsider has to look closely to imagine how it works! This is the BRIC in which I have the most confidence in investing in -- just not right now.
As with Brazil and Russia, in India there is an endless bureaucracy to get anything done (albeit with a lower level of corruption than in Russia and Brazil), but it is still maddeningly inefficient. Beyond the bureaucracy and corruption, India faces some problems not faced by all the other BRICs, including higher levels of overpopulation, urban joblessness, environmental degradation, extensive poverty and less potable water. Annual monsoon rains bring good water but also contribute to deforestation and soil erosion. Further water problems result from pollution from raw sewage, agricultural pesticides and industrial effluents.
India is a young nation -- the better to combat Islamic growth rates in its neighbors and constant pressure from neighboring Pakistan. 31% of India’s population is under 14; all but 6% of the rest are under 65. But it is falling behind in educating these masses. Just 61% of the populace is literate -- and only 48% of women can read and write. That’s nearly 300 million women whose brain power India annually fails to tap. Who knows how many Robert Fultons or Albert Einsteins they deprive themselves of from among those 300 million?
India is a mix of old and new. Economically, just over half the work force is in agriculture but much of it is subsistence agriculture on small plots of land. Services of various types are the major source of real economic growth, accounting for over half of India's output but employing less than one third of its labor force. A holdover from its years of socialist economic principles, the privatization of government-owned industries is stalled. Keeping state bureaucrats in charge of these inefficient firms and doling out energy and fertilizer subsidies to keep the populace from voting the ins out of office has further hamstrung India. Still, increasing the level of foreign direct ownership, and dropping tariffs and trade barriers, has placed India in the forefront of the BRICs for me.
Finally, there is China. In China, the favorite of most proponents of buying the “emerging markets,” bureaucracy is more complex but, strangely, less pervasive than in the other BRICs. As a business owner, your choices are similar to those in Russia but the Chinese carry out the process much more deftly and quietly. No messy street assassinations, you just lose favor with the central bureaucracy and slowly die of neglect. As I’ve written previously, China must keep its people fed and employed or they risk revolution.
You could play this by buying Chinese soybean companies but I’d rather buy U.S. companies, subject to U.S. governance and regulations. Buying Deere & Co (NYSE:DE), for instance, is a lot safer, although less direct, way to play the insatiable Chinese appetite, literally and figuratively, for soybeans, wheat, rice and corn, than buying some Chinese company you’ve never heard of. It doesn’t matter if the economy is good or bad, people worldwide will continue to eat. They may eat less, they may not eat as high on the hog, but they will eat. The question is, how do you benefit from that fact? For me, my old U.S.-based favorites like Deere, Smithfield (NYSE:SFD), Seaboard (NYSEMKT:SEB), Archer Daniels (NYSE:ADM) -- now that the Andreas boys are gone, -- and many others fill the bill, as do the agricultural commodity ETFs like Powershares DB Agriculture Fund (NYSEARCA:DBA).
China faces environmental problems every bit as daunting as India’s. I’ve written previously of their severe potable water problems; there are some years where the fabled Yellow River doesn’t even reach the sea before it dries completely. In addition, in its headlong rush to take its place among the world’s economic powerhouses after decades of statist, centrist, socialist control, China has created air pollution on a world-wide scale; acid rain over much of the country; water pollution from untreated waste; and subsequent deforestation and desertification. Not a pretty picture.
As wite Russia, the government itself is the greatest problem. The socialist legacy continues to mislead the central leadership that they can somehow make decisions that are good for the entire nation, no matter the topography, climate, ethnicity or culture of the remote area. Add to this the Russian-like capacity for self-denial and an obsession with a total lack of transparency and you’ll never know if the numbers you are using on which to base critical decisions are real or made up. Finally, like Russia, China continues to cling to a number of state-run businesses they consider necessary for their “economic security.” Some are; but most are merely cash cows for party officials. If China ever made an honest attempt to separate these two, it would be a positive sign.
Until then, I’ll play China (and India, Russia and Brazil) via companies with something the BRICs need or want, but which are headquartered in areas of better governance. I’ll name names tomorrow, in Part II, when I discuss the “ABC”s.