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Beware ridiculous investment cases

 

"With no Soviet threat, the US has found it exceedingly difficult to define its ‘national interest'. Foreign policy in a Republican administration should refocus the country on key priorities: building a military ready to ensure American Power, coping with rogue regimes and managing Beijing and Moscow. Above all, the next president must be comfortable with the US's special role as the world's leader."

In February 2000, a professor of political science at Stanford University gave a speech entitled ‘Promoting the National Interest'. Among other things the speech included a big chapter on ‘Dealing with the Powerful' which focused on the need "… to find the right balance in our policy towards Russia and China. Both are equally important to the future of international peace".

The speaker was also a senior fellow at the Hoover Institute and foreign policy adviser to Republican presidential candidate George W Bush - her name was Condoleezza Rice. She was trying to do a number of things with these speeches: provide a sharp break with what she regarded as the failure of the Clinton regime in the foreign policy arena (there was an election campaign going on); produce an intellectual framework for decision making; signal that America would be a strong supporter of democracy around the world - in this regard she felt the large democracies of India and Brazil would be very important. The one thing she was not trying to do was give investment advice.

A year after this speech, Goldman Sachs started its much-cited series of papers on BRIC, which pointed out that Brazil, Russia, China and India were likely to become very economically important by 2050 if they continued to grow faster than the rest of world. This is pretty obvious - take any number and grow it twice as fast as another number for 50 years and it becomes relatively more important - but the implication seemed to be that investors should be focusing on these emerging equity markets.

The authors of the BRIC reports did show some caution however. In 2003 the executive summary of ‘Dreaming with BRICS' says: "The key assumption underlying our projections is that the BRICs maintain policies and develop institutions that are supportive of growth. Each of the BRICs faces significant challenges in keeping development on track. This means that there is a good chance that our projections are not met."

But in their words "…being invested in and involved in the right markets - particularly the right emerging markets - may become an increasingly important strategic choice". In other words "this may or may not happen but if it does you may make money out of it" not exactly the hardest sell in the world.

Undeterred by the authors' caution, heads of marketing at fund management houses scented an opportunity, the BRIC Fund concept was born and so far these vehicles have generated very good returns for investors. Looking back, it seems ridiculous that a series of speeches, meant to identify the US's foreign policy priorities in the post Soviet era, should end up as a fund management marketing pitch.

If this sounds like some sort of joke do not laugh - some of these guys probably brought you Latin American funds in 1994 just before the Tequila crisis hit, Asian Tiger (remember them?) funds in 1997 just before Thailand collapsed and technology funds in 1999. The track-record of fashionable, marketing-driven investment concepts in fund management is questionable to say the least.

 

n order to better understand what you are buying when you buy equity funds investing in BRIC, it is worth considering them from a so called ‘top down' point of view, a sector perspective and, most importantly, from the point of view of the quality and valuations of companies that will actually be spending your money.

Starting off at the broadest level,
only two of the four BRIC Fund constituents are countries where democracy is firmly rooted - Brazil and India. This is important because democracies are usually bolstered by notions of equality before the law which tends to mean better protections for minority shareholders of listed companies.

China shows little sign of moving towards democracy and the fortunes of companies in which you will be invested will often be totally dependent upon arbitrary government decisions. While democratic elections do take place in Russia, decades of party dictatorship have stopped a basic spirit of legality from developing in the country and the current government shows less and less inclination to build one.

In China, your money is likely to be invested in companies which depend on powerful politicians for their survival. Always remember that your money will carry very little weight in Russia because it is simply not needed by a commodity-rich country with oil at around $75 (€59.7) per barrel. In both Russia and China the risk of your companies being plundered by the state will be both very real and extremely difficult to quantify.

A second and important thing to know is that buying BRIC will mean you will be buying commodities after several years of strong performance. This is because nearly 50% of the BRIC universe is in either energy or material companies and this is a much higher weighting than for the broader emerging markets or Asian universes. Although high commodity prices may well persist for a few more years BRIC investing is in effect doubling up on the commodity bet. The profits of half the companies you will have your money in are very commodity dependent, but so is the health (and therefore riskiness) of the Russian and Brazilian economies.

A consequence of BRIC markets' high resource weighting is that they may often provide a much lower diversification benefit than might be expected as large resource companies are now significant constituents of developed world markets also. Russia and Brazil which are the commodity-heavy markets, in the BRIC universe have tended to move more and more with the world markets of late (chart 1) and also with each other (chart 2). The dominance of the resource sectors in the BRIC universe echoes the dominance of the technology sector in emerging and Asian stock markets during the boom at the end of the 1990s.

The assessment of a company's quality is certainly a subjective ‘grey area', but we regard it as the most important determinant of a company's long-term share price performance. Ultimately the best economy in the world will not generate good returns for shareholders if companies are run by incompetent or dishonest managements, or if they are run for the benefit of interests other than shareholders.

We therefore look for companies where managements and controlling shareholders are aligned with us as minority investors and where they have strong long-term records. We also prefer businesses to have some ability to set prices rather than be dictated to by sometimes unfriendly markets.

Within BRIC (and perhaps not surprisingly given earlier comments on democracy) we find both India and to some extent, Brazil, to have many well-run shareholder friendly companies. Unfortunately, at the moment valuations of most of these high quality companies often prohibit us from investing on a long-term basis. They are simply too popular right now.

 

n China, we find fewer good quality businesses and many are still too young to have decent tested track records - valuations are acceptable in most cases. Finally, Russia offers very few investible companies from the quality view point and we only have a small exposure here. Overall from the company point of view the case for quality investing in BRICs is mixed at best. The outcome for investors who buy into BRIC funds right now is by no means clear while the investment case rests largely on the maintenance of high commodity prices and political stability.

There will always be companies within BRIC that are good long-term investments and these are likely to be run by well aligned and high quality business people - most of these are highly valued right now.

While the history of BRIC can be traced from foreign policy thinking to investment banking and ultimately fund management marketing departments, this investment theme is only a few years old and has yet to be really tested under market adverse conditions.

Until proven, it seems to make little sense for investors to confine their emerging market exposure to four potentially volatile stock markets only when there are a significant number of interesting companies in other emerging economies. Places such as Mexico, South Africa, South Korea, Taiwan and Turkey may well merit attention too.

Disclaimer - the views expressed in this article are those of the author and do not necessarily reflect the views of First State International or the Asia Pacific and Emerging Markets Team.

Jonathan Asante is joint deputy head of global emerging market equities, at First State Investments

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