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<\/b> (not just the budget deficit) was eliminated.<\/p>\n
Despite these strong fundamentals U.S. bond yields were a lofty 5.3%, 60% higher than in England.\u00a0 So British capital poured into the U.S.. \u00a0Net 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.<\/p>\n
Bad timing.\u00a0 Andrew Jackson \u201ckilled\u201d the Bank of the United States in 1836 and issued a \u201cspecie circular\u201d stipulating that government land could only be purchased with gold and silver.\u00a0 A brief speculative bubble in 1837 was followed by a collapse in land prices, financial panic, and a depression stretching into the next decade. \u201cDuring the early 1840s nine states defaulted, and several more came close,\u201d writes NYU professor Richard Sylla.\u00a0 British capitalists abandoned the U.S. for more than a decade.\u00a0 As a smart Boston hedge fund manager once told me, \u201cscared capital comes home.\u201d<\/p>\n
Crumbling BRICs<\/b><\/p>\n
British investors\u2019 misadventures in Jacksonian America are typical<\/b>.\u00a0 It is hard enough to figure out what is going on in your own country<\/b> (Federal Reserve economists missed the last three recessions), let alone someone else\u2019s. Back in the late 1980s Americans believed that Japan would soon overtake the U.S. economy. Oops.\u00a0 Wall Street completely failed to anticipate the \u201cAsian financial crisis\u201d of 1997-98.\u00a0 In 2003 Jim O\u2019Neil 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.\u00a0 We\u2019ll 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%).\u00a0 Here\u2019s why:<\/p>\n High Risk in Emerging Markets . . . <\/b><\/p>\n 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.\u00a0 (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 \u201cinordinate privilege\u201d 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.\u00a0 Emerging markets are far less diversified, have less robust capitalist institutions and face greater financial risk because many of them must borrow abroad.\u00a0 Mere mention by Bernanke that he would \u201ctaper\u201d bond purchases sent a shudder through EM financial markets.\u00a0 Plus, you have to worry about the quality of corporate governance of individual firms.<\/p>\n . . . and How to Avoid Them While Still Participating in EM Growth<\/b><\/p>\n For all these reasons, emerging markets offer poor\u00a0risk \/ reward.\u00a0 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.\u00a0 This allocation is conservative, with far more bonds than stocks, yet a sixth of the equity portion is in EM stocks.<\/p>\n That\u2019s too risky for my taste. You don\u2019t need to own EM stocks to get exposure to EM economies<\/b>; U.S. multinationals are a safer method.\u00a0 As they modernize, emerging markets need and want what U.S. firms produce, be it Abbot medical supplies, Boeing aircraft, Monsanto seeds, YUM\u2019s Kentucky Fried Chicken, PM\u2019s Marlboros, or Schlumberger energy services.\u00a0 You can get plenty of EM exposure without worrying about India\u2019s balance of payments, Brazil\u2019s inflation rate, or Putin\u2019s latest outrage.<\/p>\n The Fayez Formula<\/b><\/p>\n 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<\/b>.\u00a0 If you buy a stock for $20 per share with DPS of $0.60, the dividend yield is 3%.\u00a0 If the dividend grows 10% annually for 15 years it will become $3.34\u2014a yield of 16.7% on your cost.\u00a0 In another five years that yield is 26.9%.<\/p>\n A rich and famous practitioner of this investment style is Houston money manager Fayez Sarofim, who was profiled in a recent Barron\u2019s<\/b> article.\u00a0 He owns top-quality multinationals for years and years.\u00a0 The Dreyfus Appreciation Fund, which Sarofim manages, has lagged the S&P 500 by about 1% percent per year over the past decade. That\u2019s unimpressive but not a disaster considering the fund has a low-risk, tax efficient strategy.\u00a0 The top 10 holdings, accounting for 38% of market cap, are, in order, AAPL, PM, XOM, KO, CVX, JNJ, PG, Nestle, MCD, and OXY.\u00a0 Two other names mentioned by Barron\u2019s<\/b> are IBM and WMT.\u00a0 The median EPS CAGR of these 12 stocks, 2010-13, was only 7%, well behind 8.8% growth rate of S&P 500 EPS.\u00a0 To my mind, portfolio problems include:<\/p>\n 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.\u00a0 Which reminds us \u201caverage investors\u201d that even a patient, buy-and-hold approach requires constant vigilance and a willingness to sell companies that slow down.\u00a0 Which is difficult to do correctly.\u00a0 For example, after years of mismanagement JNJ has revived thanks to a new CEO and a string of new drugs.<\/p>\n Copyright Thomas Doerflinger 2014.\u00a0 All Rights Reserved<\/p>\n","protected":false},"excerpt":{"rendered":" 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 … Continue reading \n
\n