Emerging Economies: The Good, The Bad and The Ugly

In the partner article to this one, here, I noted,

Because the United States is one of the world’s most open societies with a vibrant and muckraking free press, most of our problems are known. This can overwhelm an investor at times, leading us to believe things are worse than they are.

That certainly seemed in evidence from some pretty starry-eyed comments made in response to that article, revolving around how great life must be in China. One blasted the preceding generations of Americans as having let him down and said he was learning Mandarin to be able to grow his earnings.

I would advise those inclined to agree with these commenters to move cautiously in that direction. I speak a few languages but, before I try Mandarin, I’ll be honing my English skills. English is the language of commerce, aviation and, in my experience, the most common second language taught around the world. It is the first language of Australia and Canada, two of the most per capita resource-rich and water-rich nations in the world, and of the world’s largest economy, largest manufacturer, and largest provider of services, as well as the first in many other leading nations.

Before anyone rushes to emigrate to some alleged People’s Paradise, they should know two things:

1. In any of these nations controlled by an unelected central national government, things may not be what they seem. The flow of information and the economic numbers may be manipulated either by the central authorities or by those at the bottom of the economic rubble who fear retribution if they report anything less than stellar results. In fairness, I am convinced that Wall Street, all of the time, and our own government, some of the time, are guilty of manipulating news, earnings, and economic reports, as well. The difference is, it is a temporary affliction here and the “revisions,” buried on page 12 three months hence, eventually come out. The Fourth Estate, augmented by bloggers and contributors like those on SA, are the guarantors of that willing or unwilling candor.
2. The pendulum swings. At least in a democracy. As a nation, we have done some bonehead stupid things. We pillaged our natural resources and our wilderness in the 1700s and 1800s with no regard to the consequences. We built factories as if they were temples, polluting the soil and streams all around. We allowed the untrammeled acquisition into a few stubby hands of virtually the entire means of production as recently as 1900. In each of these cases a wave of popular revulsion reclaimed middle ground. The pendulum swings.

Right now we have allowed far too much power to reside with banks and brokers on Wall Street. This is not nearly as concentrated, however, as the trusts at the turn of the 20^th century which were busted into smaller pieces (so that none was left that was “too big to fail.”) In each case we emerged stronger. If we tear down the cozy partnership / revolving door between Wall Street and Washington, we will again.

The Good

So – what’s good about the emerging nations that would make us want to entrust some portion of our net worth to their markets?

First of all, their populations are young. The graph below, from the current 2009 CIA Factbook, clearly demonstrates this. This “youth bulge” is interpreted by most analysts as a good thing, because it means that there are more strapping young workers and fewer non-working elderly for the rest of the population to support.

But it might also mean that they simply have lesser-quality medical care so the life expectancy is lower. That means that many people die while in their most productive working years at 40, 50, and 60.

The nations in which I invest in the developed world typically have a median age of 35 or greater: the USA, Canada, Australia, New Zealand, Scandinavia, the UK and the EU. In the countries touted by those embracing greater investment in emerging nations, only Russia and Central Europe are above 35, followed by China, with a median age of 33, and with all the rest having a median age of 14-30: India, Vietnam, Indonesia, Brazil, Mexico, the rest of Latin America except the Southern Cone, the Middle East and all 53 nations in Africa.

Second benefit, the growth rates are going to be greater in emerging nations. It is presumed that developed nations’ consumers will replace what they have, yielding a growth in demand of only 3% to 4 % annually. In emerging nations, however, there are roads, airports and rail terminals to be built; resources to be explored for and extracted; and factories, power plants, homes and schools to be constructed. Jobs are being created in this process so most emerging economies are expected to grow at a much higher 10% to 15%.

All true. But who benefits by the building of all these facilities? Do the emerging nations have their own heavy-equipment plants or do they buy from Caterpillar (CAT), Deere (DE), Komatsu (KMTUY.PK) and Konecranes (KNCRF.PK), all companies headquartered in and whose profits accrue to developed nations America, Japan and Finland.

Third, emerging nations have an incontestable advantage in lower labor costs. But, then, the sweatshops of Britain and the USA once held that same “edge.” Low labor costs last only so long as people are desperate for a job. This is an ephemeral advantage. Sooner or later, workers strike, or in People’s Paradises which do not allow such things, they riot for better working conditions (meaning higher costs), greater safety (higher costs) or better wages (higher costs.) This is a bit more complicated than the simplistic tout sheets that predict tipping the board wherever labor costs are lowest and expecting those nations to thrive. If that were the case, Zimbabwe and Congo would be the next big emerging nations.

The Bad

That brings us to the possibly less attractive aspects of emerging nations. These countries have their problems, too. Anyone who doesn’t understand this will be exhibiting the kind of linear thinking that creates bubbles and perpetuates declines.

First, the youth bulge is a double-edged sword. In most feudal societies and many in the Mideast, Africa, and Asia, there is a “third son” (and fourth and fifth, etc.) syndrome. If it is known that the first son will inherit the family farm or small business and the second son will be apprenticed to an uncle, what is left for children after that? This social dynamic alone serves as at least one plausible theory to help explain terrorism, social unrest, violent uprisings, and migration to surrogate families in the religious or political arena. Without stellar growth, the poverty, corruption and mass unemployment among young males can lead to unrest, disaffection and, at its worst, civil war and genocide in developing countries.

Second, I look at the mind-numbing, business-unfriendly, corruption-laden bureaucracy and political interventionism in most emerging nations. Exxon (XOM) and emerging nation Mexico’s nationalized oil company PEMEX both produce about the same amount of oil. But PEMEX needs ten times as many workers to produce a barrel of oil as it takes XOM. And since Mexico refuses to allow foreign partnership with proprietary technologies in its nationalized oil company, it falls further behind in production every day.

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, lack of social mobility and economic instability? If you have Brazilian friends, they can answer in one word: “Corruption." To get anything done in Brazil, you must grease the right palms, sometimes more than once.

In India, to start a business you have to visit 13 bureaucrats and wait 30 days. In China, it takes 14 different visits to bureaucrats and 40 days. In Brazil, as befits a nation where each bureaucrat has his hand out, it is a mind-numbing 18 procedures and 152 days. Doing Business compiles this and other data like investor protection, cross-border trading, enforcing contracts and so on and puts it all together in a best to worst “Ease of Doing Business Rank.” Of the countries I’ve mentioned in this article or preceding articles, Singapore ranks #1 in the world, New Zealand #2, the U.S. #3, Canada #8, Australia #9, Norway #10, Japan #12, and Israel #30. Of the more prominent emerging nations, China is number #83, Vietnam #92, Russia #120, India #122, Brazil #125, and Indonesia #129.

Third, and joined at the hip with corruption and bureaucracy, is the whole issue of corporate governance and transparency. In Russia, for instance, 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. Russia is the epitome of governmental and corporate unfair business practices, embezzlement, fraud, theft, extortion and the confiscation of holdings. Autocratic regimes decide what news gets printed and what doesn’t so the governance issues may seem less severe to the uninitiated – but only because of the lack of transparency. Worse – and not unlike our own right now, though ours are transient, theirs are chronic – governance rests in the hands of the few who make sweeping Stalin-esque or Mao-esque “grand plans” with no regard to differences in climate, topography, ethnicity or culture of the remote areas they are making decisions about, or the desires ofr the governed.

The Ugly

What if one government edict could take away not just your profits but your invested principal? That is happening in Venezuela today. It has happened to millions of small business owners and tens of thousands of foreign investors in other emerging areas, as well. What I refer to here are the basic rights we in this country take for granted: health rights, property rights, intellectual property rights, and basic human rights. If you ignore the repercussions of the failure to guarantee these rights, your naïveté will doom you to fail in your investments in emerging nations.

Take health rights. Linear thinking says “China is growing 10% a year, therefore in 20 years it will be the world’s largest economy.” Non-linear critical thinking, however, demands that we review the possible impediments to growth rather than merely accepting some tout’s linear compounded progression. For China to achieve all this, it will have to continue to divert zero funds for the massive environmental degradation they have created, zero funds to attempt to reverse the health disasters they have visited on their people in their rush to capitalize, no funds to reduce its air pollution to merely crippling rather than killing levels, and none to attempt to re-forest and re-create agricultural land that they have deforested and turned into deserts.

In addition, they’ll need to find new sources of water within their own borders or from their neighbors, risking regional wars to secure that water (China and India already fought to a stalemate once.) And they must continue to find markets of consumers at the same pace they have done to this point.

Ain’t gonna happen. I can’t predict exactly what will derail it, but as I said in my previous article, “while others are desperate to find ways to feed their people, between the US and Canada, we have what are probably the most abundant resources in agricultural land, food production and clean water of any two contiguous nations in the world.” No emerging nation can say that. I’m guessing China’s next war will be over food and water. I doubt they’ll keep a 10% growth rate if they’re fighting with the Russians over Siberian water flow. And I don’t think India or Russia will be quite so easy to conquer as Tibet (which brings China much of its water today.)

In addition to basic health / existence rights, most emerging nations have only rudimentary laws regarding physical and intellectual property rights, and typically a less than rudimentary regard for even their own laws. When government can shut down your business because it competes with the local strongman’s 3^rd cousin, there is no basis for sustained growth. If no one can trust the government not to do them ill, the entrepreneurial spirit withers and dies.

I have spent time in the Middle East where the culture is one of who you know rather than what you can do and where your life is pre-ordained by birth, religion, custom and tradition. I find it laughable that some of the leaders of nations that perpetuate this sense of hopelessness now trumpet their nations to foreigners who have never been there as being “the next China” or “the next Singapore.” Oil money buys a good PR firm but substantive changes are needed before the reality meets the illusion.

Of course, in many of the nations already discussed, the disdain for rights extends to basic human rights. I was a military attaché in Burma. I can assure you, while this Texas-sized “emerging nation” is blessed with abundant water, food, minerals, oil, gas and all manner of other resources including a hardened human work force, there is no way that under the statist kleptocrats who rule the country it will be anything but a giant gulag.

Where to Go

I can’t answer that for you. I can merely present “the other side” of the coin. For myself and our clients, I will play the higher growth rates in emerging nations almost exclusively via world-class global competitors based in the developed world. Even then, just because France’s Total (TOT) is in Burma doesn’t mean that I’ll buy Total. I’m quite certain they’ll spend their money then have their head handed to them as so many companies recently have in Venezuela. Wishing and hoping are no substitute for hard geopolitical analysis.

Instead, I’ll be buying companies that provide what the emerging nations need to keep up or, in the case of the lucky few, to join in the economic leadership of the world. That means oil, natural gas, coal, iron ore and other metals, food, grains, medical technology and health care, and modern equipment and technology that most frequently comes from the developed world. Examples include companies like Boeing (BA), Archer Daniels (ADM), CAT, Deere (DE), 3M (MMM), and Honeywell (HON) from the USA, Royal Dutch Shell (RDS.A) from The Netherlands, Israel Chemicals (ISCHY.PK) from Israel, Nestle (NSRGY.PK) and Roche (RHHBY.PK) from Switzerland, Yara Intl. (YARIY.PK) and Statoil (STO) from Norway, and Konecranes (KNCRF.PK) from Finland.

You get a good chunk of the emerging market growth story this way – without all the baggage that comes with it.

Full Disclosure: We own Konecranes and Honeywell, as well as beaucoup American and Canadian natural resource firms.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Also, past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless – especially so you are not over-impressed by the fact that our Investors Edge ® Growth and Value Portfolio has beaten the S&P 500 for 10 years running. What if this is the year we under-perform it?

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Comments

[Michael Clark:]

I agree. Obama should be getting out the surgeon's knife and begin dissecting the monsters into manageable units. No corporation should be big enough to endanger the country's or the globe's economy -- or to threaten America's democracy. Or to buy America's democracy. Small is beautiful I guess.

"Right now we have allowed far too much power to reside with banks and brokers on Wall Street. This is not nearly as concentrated, however, as the trusts at the turn of the 20th century which were busted into smaller pieces (so that none was left that was “too big to fail.”) In each case we emerged stronger. If we tear down the cozy partnership / revolving door between Wall Street and Washington, we will again."

Aug 25 03:54 AM

[Michael Clark:]

Nice article.

Aug 25 03:55 AM

[markfl:]

"Second benefit, the growth rates are going to be greater in emerging nations. It is presumed that developed nations’ consumers will replace what they have, yielding a growth in demand of only 3% to 4 % annually." The CBO forecasted that the United States would have only a 2.4 percent average annual GDP growth rate in 2015-2019. Nothing spectacular, especially if growth before then is sub-par or if another recession intervenes in that period. www.cbo.gov/ftpdocs/99...

Aug 25 04:25 AM

[Living4Divi...:]

Great article, JLS -

Russia is good example. Russia is staggeringly wealthy - chock loaded with oil, gas, alumina, nickel and diamonds.

Despite Russia's huge natural wealth - there are many problems: Kleptocracy is a big one: the rules of the game are changed on the fly, contracts are not honored, punitive taxes are enacted.
The second is that many quasi-SOE's are poorly run (such as GAZPROM) and way overstaffed and milked to meet the state's needs. It is like a prized dairy cow that is riddled with parasites. The parasites sap the vitality of the cow and the cow no longer produces enough milk. "There is many a slip between cup and lip"

Thirdly, many of these "plump dairy cows" have been leveraged to the hilt. Sure, the former SOE may have 300,000,000 worth of oil/gas in the ground, but it has also taken out 300,000,000 worth of loans. These loans were utter nonsense: Oil and gas are fairly cheap to extract and don't require tremendous amounts of capital. Pipelines are expensive, but they do not justify the loans taken out. Besides, most of the pipelines are paid for by the customers of the oil ang gas.

The justification for taking out these loans sounded very smart "we need to improve our infrastructure in order to extract more oil and gas." An analogy is when Americans took out loans of 450,000 on a 500,000 house. When the value of the house drops to 350,000 the house has negative equity and in essence is bankrupt.

In the end, it was a sham way to bleed equity out of the company.

Not all companies in Russia are kleptocracies. One has to examine the books very carefully and determine if the shareholders are being treated fairly.

Aug 25 06:49 AM

[Futurist:]

Joseph,
Thanks for an article that actually examines the risks of foriegn investing. Although you didn't examine the reward of such investing I understand your premise to be that there are very large risks out there that CNBC never mentions. I was awestruck when I visited China several years ago with their growth and modernization. I have made some investments in their medical field but am always wary that tomorrow the companies I invest in could be out of business by government edict or fraud or bad management.
Today everyone knows that China can never continue economic expansion without :
1) Water
2) Energy
3) Agricultural expansion

These all require government action and a direction and fortitude that is unparalleled in history. Can China really control water pollution and make clean recycled water or is it easier to attack Russia? Can China really produce renewable energy or will they need to take over the Vietnamese oil source? Will the Government reform the land ownership issues of the rural poor or continue down a road of underutilization of their agricultural land.

I believe that the Chinese government has a very long outlook on solving problems. The government doesn't respond in election cycles. Therefore, investors should have the same long term outlook.. But beware. In that long term horizon you might find governments, that are not democratic, take away your property before you get the gain.

Aug 25 08:11 AM

[MichaelJ007:]

I frequently reply to the diatribes of the US with "If you don't like it, move to China"... b/c despite how bad and unfair it may seem with things like TARP, Healthcare and our elected "socialist" officials, there is no better place on Earth where so many can enjoy such a high quality of life and such a variety of choices for expending such little effort. This article sums up the point wonderfully.

Aug 25 09:02 AM

[rrtzmd:]

...HAW!...ya' just gotta luv Joe!...May 7: "Uncharacteristically, about 80% in cash and top-quality bond index funds like SHY and BND, about 10% in high-yielding preferreds and convertibles, and about 10% in inverse, currency and gold ETFs like EUM, SH, SEF, GLD and CEW. Looking for banks that have run too, far, too fast, as short candidates."...June 7: "I am a fan of American ingenuity, not Wall Street dealsters. In the current U.S. markets, I am unable to find pockets of value. After we work through the next Alt-A, credit card, and other credit and housing crises – when many are despairing once more about the future of the country – we’ll be buying with both hands. Until then, we’re mostly in cash equivalents, short-term- bonds and bond funds, and a few well-selected short positions."...talking about apartment REIT's July 5: "We are not long any of these securities – yet. But we’re salivating at the prospect of buying them even cheaper."...July 22:
"We own short-term bond funds like SHY and TUZ and slightly longer-term (5-10 years) BND, AGG and TIP; and inverse ETFs like SKF, SRS, SBB, EUM, PSQ, SH, and DOG."...but NOW: "We own Konecranes and Honeywell, as well as beaucoup American and Canadian natural resource firms."...HAW, HAW, HAW!!...ya' just gotta luv him!!!...

Aug 25 10:57 AM

[Old Trader:]

Joe,

All of the (good) points that you mention in regard to investing in places like China, Russia, the Middle East, etc., fall under the general heading of "political risk", and has been a part of investing in EMs for as long as the term has existed, if not longer.

I think the bottom line is, if one agrees that diversification is important in constructing a portfolio, its doubly important, when investing in any of the EMs. Not just within a given market, but across the spectrum of EMs.

Aug 25 11:54 AM

[Tony Daltorio:]

Basically you have two choices as where to invest:

You can invest in the emerging markets that do have geo-political risk, but have large populations of hard-working people eager to move up the economic scale, fast economic growth, little debt and a high savings rate.

Or you can invest in the US which is controlled by an elite, with little hope for economic growth, the largest debts in history, and a population with no savings and the attitude of not working hard - getting something for nothing.

Sure I have some investments in the US, but overall it's no contest for me - most of my investments are outside the US.

Aug 25 02:41 PM

[Egbert Bloe...:]

Please revise your information about Brazil.

Two years ago we started the company ImoInvest Brazil, which took me no more then 15 working days and we had to grease no palm at all. The company is operating in the real estate development sector and experienced a very high level of professionalism. Corruption and bureaucracy is everywhere, but Brazil is probably no worse then other high developed countries.

Aug 25 03:33 PM

[Danny Newton:]

I think property rights are critical to any kind of development no matter how old people are. Is the government encouraging individual ownership and does the government support such ownership? A system of reasonable laws about foreign investment is also critical. This leaves Mexico down the list.

Aug 25 07:25 PM