Pee Dee's  Instablog

In this third of a series of four blog posts, I further develop why investing in emerging markets ("EM") common stocks is a greater challenge than many foresee,  what Benjamin Graham had to say on the subject and how that applies today.

Why a Small Allocation is Still not Worth It

Pension and other institutional fund consultants scoffing at the idea that EM is not the place to be invested will say that they never recommended investors place a whole portfolio into EM.  Instead they should allocate a small portion to "optimize" the portfolio.  If it's true that time is money, Western investors should consider whether it's worth having any investment in distance EMs.  Why?  Beyond the inherent economic, financial and social volatility of these locales, the cost of knowledge is relatively expensive and entry and exit costs can be exorbitant.

Because many of these markets don't have free presses and uncensored media, the time it takes to gain useful and accurate information can be extremely long and / or expensive.  One speculator, for example, has made note of how China's reported GDP growth rate comes in like clockwork at about 9% or 10% with hardly a reversal.  He further notes that its government can forecast GDP growth 12 months in advance down to the basis point.  A zoologist can give the broad path and direction migrating birds take but couldn't predict where a flock will be at a certain hour.  How a government could predict with such accuracy and little revision for a nation of 1.3bn persons leaves one scratching his head as to the composition of such figures.  Getting better figures will be extremely costly.

Something happens when publicly traded investments go from popular in the media to ignored:  liquidity vanishes as does information.  For those who have lived through the '90s various boom-busts cylcles in EMs, you know what it's like to have investments go from bid-ask spreads of, say, three percent to 10% or more and traded volume for your promising stock go from $1mn / day to $50k / day while the stock is declining.  Meanwhile, the company still has equity financing plans that it wants to execute because of trade commitments--meaning more dilution than expected.  It's a thrill only a deer in headlights can appreciate.  For those rushing into EMs for the first time, that should note that thrill can be very expensive.

Benjamin Graham Had it Right 40 Years Ago

In Ben Graham’s last edition (1971) of “The Intelligent Investor” he posits on what is today emerging markets bonds that “For many years past we have questioned the attractiveness of such investments from the standpoint of the buyer.”  If only buyers of Icelandic, Uzbek or Kazakh bank bonds did the same in 2007.  Without numbers, I speculate that the survivorship bias of EM indices is greater than reported.  Many indices created today exhibiting some theoretical historical performance reflect companies that exist today but ignore those, once prominent or important, that fell by the wayside.  The US domestic automobile industry is left with three companies.  Few investors today are aware of the hundreds that went bankrupt or became irrelevant prior.  The consumers benefited while the investors were hapless.  The Dot-Com era experience is a perfect recent example.

In the next and last blog post, I review the experience of one fund manager who returned 185x, without using leverage, to his mutual fund investors over 30 years and what his actions say about his dedication now to investing in China.


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

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 (seekingalpha.com/instablog/234616-pee-de...) and the Economist further shows such underperformance is not limited to the financial sector (economist.com/node/17046627). ; 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.

With many of the major economies around the world on the ropes, emerging markets ("EM") have been garnering a good amount of attention and investors' monies.  With growing economies, an ongoing shift in global trade trends with more emerging countries engaging in commerce amongst themselves and the internet instantaneously diffusing technology and knowledge at little cost around the globe, these markets are almost assured to grow more important.  Does that mean Western investors should invest in these markets?  Probably not.

Academic research, in simplified form, suggests that investors find a great number of investment opportunities and, to ensure they don't correlate with each other, have them be as disparate as possible.  This premise leads academics and investment promoters, amongst others, to suggest that investors allocate a portion of their portfolios to emerging markets (and recently also to the latest fad, "frontier markets" or those not in the MSCI EM Index).  Failure to do so is derisively called "home bias" which implicitly suggests that investors are being affected by a psychological maladie.  In this four-part blog post I'll explain why this is not the case and why staying close to home is often better than venturing afar.

Home is Where the Money is

Herbert A. Simon, a Nobel Prize winning economist, psychologist, educator, computer scientist, pioneer in artificial intelligence and all-around renaissance man, coined "bounded rationality" as a phrase describing how we humans pragmatically make decisions.  In essence, we make decisions based on what we know, not on what we could optimally know, to make the "best" decision (en.wikipedia.org/wiki/Bounded_rationalit...; Hence what seems "irrational" to one is fully rational to another because of the latter's knowledge bounds.  While this oversimplification seems too obvious to win a Nobel Prize, it nonetheless gets ignored by investors and economists nearly everyday.  Think about "optimal capital structure", "optimal portfolio allocation", or "optimized decision making" for examples. Long Term Capital Management ultimately failed while attempting to make "optimal" portfolios.

For a professional investor in the mutual fund capital of Boston to know what is happening in China's political capital Beijing, there is much she needs to appreciate, even if she were born there but spent the last 10+ years getting immersed in Western education and culture.  Her bounds of knowledge of China may be wider than a native Westerner who goes for one or two business trips a year but it almost certainly will be narrower than her local counterpart.  Simon's Travel Theorem also applies here (he posits that "Anything that can be learned by a normal American adult on a trip to a foreign country (of less than one year’s duration) can be learned more quickly, cheaply, and easily by visiting the San Diego Public Library."  This was even before the internet.).

In addition, there is the social dynamics of EM that investors usually are either not cognizant of or too heavily discount partly because of its complexity.  In many of these markets, a small ethnic minority often dominates the nation either politically or economically and in extreme cases both.  This almost always leads to quietly harbored resentment and then oftentimes to violence or policies with poor consequences or both.  There are unfortunately too many recent examples of this such as Indonesia's and Russia's ethnic pogroms and persecutions against certain minorities; and Zimbabwe's and South Africa's appropriations or "redistributions" to their majorities.  In accord with the Travel Theorem, while these unfortunate events simmer before they boil, the New York Times may report it but analyst research reports or management meetings in an office tower or plant or a few days trip in a nation seldom yields such insights.  Hence when the boil comes investors are "surprised" though they need not be.

Staying "home", you know the score before the first pitch.  It usually gives an investor that knowledge advantage that another local has in his own market.  It's no wonder why VCs and other professional investors focused on management in startups almost alwyas restrict their investments to local firms even going so far as to limit which states they invest in.  Common stock investors should consider the insight of these investors perfectly rational.

In the next blogpost, I'll explain why staying close to home leads to a better investment experience than sending capital to exotic locales better known to most on Thomas Cooke brochures.

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