The Interview was conducted and originally published on June 7th, 2011 by Mark Wallace on the blog site of Capitalist Exploits.
Last week we spoke with Carlos Andres, a guy I consider a true frontier capitalist and a friend. Carlos and I had dinner last night in Punta Del Este, Uruguay. The setting was an empty but upscale restaurant frequented by Brazilian tourists and Argentine businessmen. The wine was flowing and the conversation quickly turned, as it usually does, to emerging and frontier markets. Our discussion covered economics, politics, the business environment and particular investment themes playing out in these countries.
As capitalists, all of these things are important when assessing the best place to put our limited and hard-earned capital to work. This is true whether it’s a developed welfare/warfare state in decline or a little-known frontier market on the rise.
Carlos, Chris and I all agree that there is significant opportunity for gains substantially above average in often overlooked emerging and frontier markets. Risk in the “mature” economies is increasing due to over regulation, corrupt political systems, military adventurism, encroaching nanny states, monetary and budgetary insanity and ever-growing tax burdens. Meanwhile many “third world” countries are rapidly stabilizing, modernizing, privatizing, liberalizing trade, lowering taxes and encouraging capital to enter their markets.
In our last post we finished with a mention of natural resource companies and the tremendous opportunities Carlos sees in that sector in particular. We’ll pick up where we left off…
MW: Carlos, in our last post you teased us by mentioning the tremendous opportunity you see in targeting overlooked and undervalued natural resource companies in emerging and frontier markets. You spoke of the commodity super-cycle and you mentioned specific countries you’re focusing on. Can you go into a bit more detail on how this super-cycle might play out, and how it will specifically impact the emerging and frontier countries you keep an eye on?
CA: Sure. I believe I left off by saying that natural resource demand, primarily out of Asia, is expanding rapidly and reshaping global supply dynamics. Asians are saying goodbye to the countryside in waves and moving to the big city in search of higher wages, more opportunity and a better standard of living. They want their shot at the dream and who can blame them.
This dynamic is on powerful display in China in particular, a country of 1.3 billion people or roughly 20% of the planets population. The Chinese government has done its part to encourage the trend. They helped kick-start the process by pursuing a unique hybrid model of government, featuring communist leadership along with a type of free-market business-friendly economy. The jury is still out on how it all ends, but for now it has created an economic juggernaut with no historical equal.
They also have redirected a large portion of their massive foreign exchange reserves (derived from an equally massive export industry) towards infrastructure projects and business lending to promote their internal economy. It had the desired effect. China was open for business. All they needed now was a cheap source of labor, and the rural peasants were happy to oblige. The migration taking place from the rural countryside to the big city is dramatic in scope and historic in scale.
It doesn’t take a lot of imagination to visualize the strain this process has placed on the world’s natural resources. As an example, China uses more steel, concrete, and copper than any other country and not just by a little bit. Most people may not realize the scale here. Off the top of my head, they use 4 times more copper than the US. Steel is 6 times more than the US and concrete is on the order of 10 times more than the US. By way of comparison, the US is the 3rd largest country in the world by population with 312 million people or 4.5%.
On the oil front, China is the 2nd largest user, somewhere in the neighborhood of 9 million barrels per day. This is well behind the US at 18 million but well ahead of 3rd place Japan at 5 million. However, Chinese consumption is rising sharply whereas US demand has plateaued. And here is a stat that I think will shock many: The Chinese are now the world’s largest motor vehicle producer by far. In fact Chinese production is greater than the US and Japan combined. I’ll wait for you to pick your jaw up off the floor.
On the electricity front, China uses only 10% more electricity than the US but they’re just getting started. They are only using about 400 watts per person whereas the gadget oriented US uses 1,400. The Chinese are adding electrical capacity at an astonishing rate, with 22 nuclear reactors under construction and 33 planned. This is the most aggressive nuclear program of any country by a large margin.
Finally, I can’t help but mention gold, an important area of focus for me. India is the biggest buyer of gold by far, but China has recently become the largest gold producer in the world. However, gold demand is also rising dramatically in China, rising over 5 times in 2010 from 2009 levels. Not only are they the world’s largest producer, but they imported 25% of the rest of the world’s production in 2010. If they keep this up, they will catch India in the very near future. The Chinese government is aggressively buying gold and encouraging its citizens to do likewise.
You get the idea. The world has never had to meet demand like this before, and this is a relatively recent phenomenon, beginning in about 1995 but really accelerating over the last 5 to 10 years.
The whole point of this lengthy discussion was to highlight what is driving global natural resource demand and to illustrate that this represents a permanent structural change to global demand. Not that current demand will always stay at these levels, but the fresh new demand coming from gigantic new urban class is here to stay. Thus the global supply structure is being transformed to address a new demand profile. It’s that simple.
The commodity index is up over 200% since 2000, as compared to the under-performing Dow, S&P and NASDAQ. Asian demand has a lot to do with this. By comparison, the Dow is up about 18% over the same time period with the S&P and NASDAQ in negative territory.
This of course spells opportunity for countries with rich natural resource endowments, and it just so happens that the universe of emerging and frontier markets is full of such places.
In the, so called, emerging markets of Brazil and Russia, it is common knowledge how their rich natural resource endowments have restored some of Russia’s former glory and established Brazil as an economic powerhouse. In frontier markets, the likes of Colombia, Ghana, Chile and Peru are thriving economically on the back of the natural resource boom. In fact, all of these countries are experiencing growth rates ranging between 4% and 9% with Peru leading the pack.
That was a longwinded answer but hey…you asked.
MW: Clearly there is a lot of opportunity in identifying the benefactors of this resource super-cycle. Last night at dinner we talked more about what you call the arbitrage between “actual risk” and “perceived risk”. Can you expand on this a bit and tell us how we can use it to our advantage as investors?
CA: Certainly. This simply refers to the idea that “actual risk” in carefully researched emerging or frontier market countries is often much less than “perceived risk”. Uninformed investors and analysts typically attribute very high risk to these markets based on non-existent, incomplete or skewed information. A lack of expertise in evaluating information and a lack of discernment cultivated by experience also plays a role. As a result, the investing herd shuns these countries and the promising companies that are operating in them.
The end result is that good opportunities in developing countries are typically overlooked and their valuations on the stock market reflect this. So, observant and alert investors are able to buy these opportunities at steep discounts. Being very selective, this steep discount can set the stage for significant profits which we hope to realize when “perceived risk” ultimately converges with “actual risk”. We equate our profits to the difference between the two at the time we make our investment.
Of course, there is a little more to it than this. There are other factors we look for as well that help to reduce our risk and boost our returns.
MW: So let’s take the top down approach here. Once you identify a country and make your assessment of whether the risks are real or perceived, what’s the logical next step? In other words, how do you find the companies within that country that are set to benefit the most?
CA: It’s not rocket surgery. That’s a joke by the way. I identify an industry where the supply and demand dynamics are out balance and where this imbalance is likely to persist for a lengthy period of time. I then begin to identify the companies that operate in the selected industry. It should be pretty evident by now that I’m focused on the natural resource space, mining in particular. This includes oil and gas.
There is no one best way to identify companies. There are many approaches, including extensive reading on a topic, filtering stock exchange information, reviewing company listings that are publicly available from regulatory bodies, newsletter subscriptions, Google searches, etc. That’s the easy part. Once there is an extensive list of players, I begin sifting them to identify the cream of the crop. I’m part spreadsheet jockey and part evil scientist, so I disappear into my “laboratory” and emerge after a few hours (or days) with the golden shortlist.
In simple terms, I look for growth stories where the company has critical milestones in the near-term future. Achieving these growth milestones tends to add shareholder value. Share prices tend to move when good news is released to the investing public indicating that the company is achieving its growth goals. I rely on expertise and experience to handicap the likelihood that the company will achieve its goals and then buy the shares long before the news starts rolling in. This is my strategic advantage.
MW: Ok, let’s now assume you’ve found a promising country, quantified the political, economic and business risks, identified a promising sector and found a company that you believe can be successful. How do you allocate your capital?
CA: I like to think that by taking the approach described above I’m not engaged in high-risk investing. But the bottom line is that natural resource investing in frontier markets is heady, high-risk high-return stuff. It is not for the faint of heart. Expertise and experience does reduce some of the risk. Nevertheless, this type of investing is for speculative capital only. Capital I can afford to lose. It is a small part of my portfolio, but it’s the part of my portfolio that I enjoy most and expect the biggest returns from.
In addition, I am ruthless about taking capital off the table the moment I achieve substantial gains; say 50% to 100%. If there is significant upside remaining in the growth story, I will typically take back my original principal for redeployment elsewhere and leave the rest. That way, I’m playing with house money the rest of the way. If it winds up in money heaven, I don’t feel so bad. If the investment goes on to bigger gains my overall return just improves and I feel wicked smart. If the growth story is over, I move on to the next opportunity. This works well for me and preserves my capital.
MW: Once you’ve made your investment the fun really begins, right? Now you have to stay on top of what’s happening. Emerging and frontier markets can change on a dime, and often do. How do you mitigate the risks to your capital after you allocate it?
CA: By being on the lookout for warning signs both on a company level and at the political level. I am constantly reviewing company news, calling management, and reviewing political and legislative developments. Experience and instincts also play a big role here. Sometimes the information alone doesn’t spell trouble but the story just doesn’t hang together right. I don’t sell on a hunch, but when I have a hunch I start digging.
Thanks Carlos! That was a great discussion and hopefully gives us all some insight and ideas we can use in our own investing. We’re not done yet however. Remember that dinner I mentioned to you last night? Well, it went on for almost 4 hours, and it just got more and more interesting. Coups, dictators, scoundrels and mistresses… intrigue of the highest order!
Thursday we’ll discuss emerging and frontier market politics and the implications it has on our investing using a real-time example. When you are living in and dealing with these places the political and even military risk, is very real. A proper understanding of the factors at play can help you preserve and grow your capital and give you a decided edge! [
See you Thursday… [link to the Thursday Interview]
“I’m not a dictator. It’s just that I have a grumpy face.”
- Augusto Pinochet (Installed himself as President of Chile after a successful coup in 1973)