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Emerging Markets? No, Thank You! (Part 2 of 4)

|Includes:Berkshire Hathaway Inc (BRK.A), BRK.B, BYDDF, BYDDY, WSC

In the first blog post of this series of four posts, I discussed why investors who decide to stay home are behaving in a perfectly rational manner because of the bounds of their knowledge.  Herein I start to dig into the investment experience of US investors during the last century and what that means for emerging markets ("EM") common stock investors today.

A Quick Look at the World's Greatest Emerging Market

An investment in a common stock is usually an investment in a business and a business operates in one or more "ecosystems".  The United States enjoyed an incredible growth rate during the last century.  What is often overlooked is how unimpressive the first half-century's common stock investments performed.  From urban expansion, to automotive distribution, to electricity and radio adoption, to retailing chains to the dawn of the nuclear age, those 50 years are amazing.  In contrast, investors holding a portfolio reflecting the Dow Jones Industrial Average index didn't do as well (perhaps a later blogpost will exhibit the numbers though a logarithmic chart is easily attained online).  In addition, the index doesn't reflect all the investment frauds common in the period.  Indeed, John Pierpont Morgan was constantly fearing Europeans investing in the US would get weary of their losses and the constant setbacks and take their capital home shrinking his business.  Nearly every decade had a financial meltdown in the US since the Civil War.  Every promising industry such as rubber and electricity had numerous frauds and insolvencies.  Debtors' prison existing in some form through the 19th century.  The courts favored locals over "foreigners" where that word got to apply as much to US nationals from different states as those from abroad.  This was the ecosystem of the world's then-biggest emerging market.

Time passed and the US took shape in more ways than geographically.  Its economic ecosystem of fairer securities markets and courts, more diverse and stronger industries, uniform rules and laws, and a stronger national identity despite adopting many peoples from around the world and having them settle about in a continent-wide nation.  I believe it took this sort of half-century foundation to create the greater wealth yielded during the second 50 years.  Investors were then amply rewarded but only after that foundation was set.

Emerging markets like Brazil, China, India, Mexico and even Nigeria are today being compared to the US 100 years ago.  What's going unnoticed is how poor the investment experience of Western companies in these and other EMs have been save the last decade.  I've noted here how difficult it has been recently for Western banks in China ( and the Economist further shows such underperformance is not limited to the financial sector (  If multinationals with decades of experience operating around the world cannot properly call the shots in these markets, what are the chances of Mr. Jones, portfolio manager in New York who goes to Beijing twice a year, getting it right?  I would place his odds less than HSBC's (founded as "The Hongkong Shangai Banking Corp.") CEO's.

Another matter that goes unnoticed is how much capital is required for EM companies to reach their expected growth and the dilution impact on common stock investors.  If we did so much as running a lemonade stand in our youth, we learned that for a business to grow its working capital must as well--we needed to buy fruit, sugar and water before we made the first sale and had to buy greater amounts of the same to increase sales the next day.  That reinvested capital can only come from three sources:  retained earnings, credit or increasing equity investment (i.e. dilution).  Retained earnings can provide part of the capital but it's usually not enough to fund maintenance and growth capital expenditures; dividends, if any; and working capital growth.  Credit, both trade and financial, is fickle since it is often short term in EM and the "surprised" setbacks noted above amongst others adverse events don't support debt-heavy balance sheets.  That leaves by default raising equity capial which spells dilution to preexisting investors.  It's one of the reasons investors in the US had returns less than their economic growth would suggest.  Indeed, corporate finance-focused banks were springing up like weeds before the 1929 crash to funnel capital into these companies.  While such capital formations sound good for an economy, the phenomenon was bad for common stock investors.  Emerging markets investors will almost certainly experience the same in some markets.

In the next blog post, I'll discuss why even a small allocation to EM is not worth the effort.

Disclosure: The author owns no common shares in any of the aforementioned companies.