In the 1830s British investors spotted an attractive emerging market offering high returns with low risk. The United States was booming, thanks to industrialization in the Northeast, rapid settlement of the Midwest, and expansion of cotton production into new areas such as Arkansas and Texas. Merchants in New York and New Orleans controlled the lucrative shipment of cotton to London and Liverpool as well as return cargoes of European manufactures. The banking system was well-regulated by the Second Bank of the U.S., and the national balance sheet was pristine. In the 1830s the national debt (not just the budget deficit) was eliminated.
Despite these strong fundamentals U.S. bond yields were a lofty 5.3%, 60% higher than in England. So British capital poured into the U.S.. Net foreign inflows soared from $7 billion in 1832 to $59 billion in 1836, most of it invested in bonds issued by state governments to finance canal construction.
Bad timing. Andrew Jackson “killed” the Bank of the United States in 1836 and issued a “specie circular” stipulating that government land could only be purchased with gold and silver. A brief speculative bubble in 1837 was followed by a collapse in land prices, financial panic, and a depression stretching into the next decade. “During the early 1840s nine states defaulted, and several more came close,” writes NYU professor Richard Sylla. British capitalists abandoned the U.S. for more than a decade. As a smart Boston hedge fund manager once told me, “scared capital comes home.”
Crumbling BRICs
British investors’ misadventures in Jacksonian America are typical. It is hard enough to figure out what is going on in your own country (Federal Reserve economists missed the last three recessions), let alone someone else’s. Back in the late 1980s Americans believed that Japan would soon overtake the U.S. economy. Oops. Wall Street completely failed to anticipate the “Asian financial crisis” of 1997-98. In 2003 Jim O’Neil of Goldman Sachs dreamed up the brilliant acronym BRICs; he argued Brazil, Russia, India and China had embraced capitalism and would become globally dominant countries by 2050. We’ll have to wait another 37 years to learn if he was right, but recent developments are not encouraging and BRICs have dramatically underperformed the S&P 500 over the past five years (up 10% on average versus 98%). Here’s why:
- Brazil is beset by 6% inflation and anemic GDP growth of 1-3%.
- Russia has yet to embrace the rule of law and so is not a capitalist country. GDP growth slipped to around 1.7% in 2013 and remains highly vulnerable to any drop in oil prices.
- India’s economy is strangled by a corrupt and dysfunctional bureaucracy.
- How long can China grow 7%+ when the main driver is local government investment in dubious infrastructure projects? In the two and half years to June 2013, there was a 70% surge in local debt, much of which cannot readily be repaid.
High Risk in Emerging Markets . . .
As we have seen over the past seven years, the U.S. economy is frequently mismanaged, but it has the political, institutional, and intellectual infrastructure needed to get back on track. (The Tea Party attack on Obamanomics, resulting in the budget sequester that cut Federal discretionary spending, is a case in point.) The U.S. also enjoys the “inordinate privilege” of having a reserve currency, and its huge internal market makes it insensitive to exchange rate fluctuations. The U.S. economy is widely diversified across technology, aerospace, consumer products, tourism, energy, chemicals, healthcare, agriculture, financial services, etc. Emerging markets are far less diversified, have less robust capitalist institutions and face greater financial risk because many of them must borrow abroad. Mere mention by Bernanke that he would “taper” bond purchases sent a shudder through EM financial markets. Plus, you have to worry about the quality of corporate governance of individual firms.
. . . and How to Avoid Them While Still Participating in EM Growth
For all these reasons, emerging markets offer poor risk / reward. Yet Wall Street has a weird affinity for the EM game, partly from a desire for greater diversification. Look at the asset allocation advocated by a prominent Midwestern wealth manager — 45% in fixed income and 36% in Equity, including 6% in emerging markets. This allocation is conservative, with far more bonds than stocks, yet a sixth of the equity portion is in EM stocks.
That’s too risky for my taste. You don’t need to own EM stocks to get exposure to EM economies; U.S. multinationals are a safer method. As they modernize, emerging markets need and want what U.S. firms produce, be it Abbot medical supplies, Boeing aircraft, Monsanto seeds, YUM’s Kentucky Fried Chicken, PM’s Marlboros, or Schlumberger energy services. You can get plenty of EM exposure without worrying about India’s balance of payments, Brazil’s inflation rate, or Putin’s latest outrage.
The Fayez Formula
What EM exposure gives U.S. multinationals is not necessarily much faster growth in the near term, but long-term sustainability of fairly fast (7-12%) earnings growth. If you buy a stock for $20 per share with DPS of $0.60, the dividend yield is 3%. If the dividend grows 10% annually for 15 years it will become $3.34—a yield of 16.7% on your cost. In another five years that yield is 26.9%.
A rich and famous practitioner of this investment style is Houston money manager Fayez Sarofim, who was profiled in a recent Barron’s article. He owns top-quality multinationals for years and years. The Dreyfus Appreciation Fund, which Sarofim manages, has lagged the S&P 500 by about 1% percent per year over the past decade. That’s unimpressive but not a disaster considering the fund has a low-risk, tax efficient strategy. The top 10 holdings, accounting for 38% of market cap, are, in order, AAPL, PM, XOM, KO, CVX, JNJ, PG, Nestle, MCD, and OXY. Two other names mentioned by Barron’s are IBM and WMT. The median EPS CAGR of these 12 stocks, 2010-13, was only 7%, well behind 8.8% growth rate of S&P 500 EPS. To my mind, portfolio problems include:
- Too many big, lumbering staples stocks whose products are going out of style in developed markets (KO, MCD, WMT) or have poor execution (PG and, until recently, JNJ).
- Too many giant energy firms. Their production is growing slowly, they mostly missed the fracking revolution, and they need to cut deals with greedy foreign governments to secure new places to drill.
- Too few industrial companies, which are great plays on emerging markets where people are travelling more (BA planes, GE and UTX aircraft engines), living in modern apartment buildings (UTX), buying cars and trucks (CMI), eating better (DE, DD, MON) and need back-up electric power (CMI, CAT). Broadly diversified industrials such as ETN, PH, ITW, DHR and MMM are also well-positioned.
- Although AAPL was a great purchase, not enough new tech such as GOOG and QCOM.
To be fair to Fayez, when you run $30 billion and have fairly concentrated portfolios, it is hard to sell major holdings and easy to get stuck in slowing companies such as KO, PG, MCD and WMT. Which reminds us “average investors” that even a patient, buy-and-hold approach requires constant vigilance and a willingness to sell companies that slow down. Which is difficult to do correctly. For example, after years of mismanagement JNJ has revived thanks to a new CEO and a string of new drugs.
Copyright Thomas Doerflinger 2014. All Rights Reserved
