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The New Global ETF Investor - back to Contents >
Chapter 2:
A World of Opportunity Awaits You
The Case for Global Investing
Consider these facts:
- 95% of the world’s consumers live outside the United States.
- 75% of the world’s GDP comes from outside the United States.
- 75% of the world’s publicly traded companies are outside the United States.
- 53% of the world’s total market capitalization is outside the United States.
Furthermore,
- Over the past 10 years, the United States has never been the world’s best performing stock market.
- During both the 1970’s and the 1980’s, international markets outperformed the United States market.
- Economic growth in some international markets is oftentimes higher and in some cases more than twice that in the United States.
- Investors can oftentimes find better value in overseas markets. Sometimes much better value.
- Over the past 25 years, a blend of 60% U.S. (MSCI USA) and 40% international (MSCI EAFE) has been less volatile than the S&P 500.
- During the period 1950-2000, American stocks have had average annual returns of about 10% compared to 14% for overseas stocks and 18% for emerging countries.
- During 2002-2005, the MSCI Europe, Asia and Far East index was up 31% and the MSCI Emerging Market index was up 44%. The S&P 500 index was up 14%,
I hope this compelling list makes you pause and reflect. Here is the first question you might ask yourself: what is my portfolio’s allocation to international markets? According to study by Smith Barney, the average American investor’s allocation to non-US securities is about 6%? How could this be? What explains it?
There are four broad reasons why Americans have so little international exposure.
Perception of U.S. Dominance in the World Economy
It is difficult for Americans to invest in a world without boundaries. Part of the problem is that during the postwar period through the 1960’s, the United States did produce a majority of the world’s GDP. Now, it is about 20%. The United States was the leading manufacturing country, now we have more workers in state and local government than we do in manufacturing. The United States is still first among equals but not the only game in town as it was for so many years. This perception of former dominance by American investors stubbornly persists, closing off American minds to global opportunities.
Part of the perception problem is that during the 1990’s, US stocks did outperform international stocks by a substantial margin. But this was a historical anomaly caused by the slump in Japan and America’s high tech bubble. Looking at the last 20, 30 or 50 years and the performance numbers clearly indicate that international stocks as a whole have outperformed the US market.
Also think of the companies and products we use every day that come from international companies. Names like Toyota, Gerber, Bayer, Nestle, Nokia, Honda, USA Today, PaineWebber and Shell. Shop at Wal-Mart? It will import close to $15 billion of goods from China this year alone.
Seven of the ten largest insurance companies in the world, eight of the ten largest chemical, automobile and electronics companies in the world, and nine of the ten largest banks in the world are headquartered overseas. This brings up another common misperception of international investing, that by investing in US multinationals, Americans are gaining adequate exposure to international markets.
It is true that American multinationals derive a substantial amount of their sales from outside the US but the majority of their costs and capital are raised in the US. The result is that these companies look and to a great extent, act like a US stock. Studies show that multinational companies, no matter what their origin, perform more in line with their domestic market than with the global market.
The U.S. economy’s sustainable growth rate has also slowed down relative to its smaller and perhaps more nimble competitors. It appears that the US can grow at about a 4% clip without overheating whereas, China has been growing at a 9% pace for about a decade and, given the right market and growth-oriented policies, developing countries can grow as a whole at about a 6-7% rate or better.
Perception of Political and Currency Risk
Many Americans unfortunately equate international stocks with higher volatility and risk. While some international markets have been more volatile, we have already discussed how over the last 25 years a 60% U.S. and 40% international blend of stocks made a portfolio less volatile than one entirely made up of an S&P 500 index mutual fund.
The goal is not to avoid risk but to manage it effectively. You need to take an objective cold-eyed assessment of risk and weigh the odds and tradeoffs of taking a much more global approach. Rather than let fear immobilize you or greed cause you to overreach, set up a plan with your advisor that makes sense and that you are comfortable with. Even if you may be justifiably hesitant about emerging markets like South Africa or Taiwan which can move 30% or more up or down in a very short time, what about Switzerland, France, Australia, New Zealand and Singapore?
Uncertainty is an unavoidable fact of life and investing. Look at the sharp declines in U.S. markets during the recent 2001-2003 sell off with the S&P 500 down almost 40%, Nasdaq down 56% and some tech stocks down 90% and more. Putting all of your money in one country makes about as much sense as putting all your money in one company or industry. Doesn’t it make more sense to spread your risk all over the world?
Currency risk is another important issue. Americans are used to the U.S. dollar being the standard of value in the world but again does it make sense to have all of your assets tied to the dollar? Many economists see the U.S. dollar in a long-term secular decline. In the last two years, the dollar has lost 40% of its value relative to the Euro. The large and persistent US trade deficit is a major reason.
The U.S. needs almost $50 billion a month in foreign investments to offset the trade deficit. So far, foreign investors have been accommodating pouring over $1.5 billion a day into U.S. assets. The last time we had a monthly merchandise trade surplus – President Gerald Ford was in the oval office! Foreign investors have amassed $1.3 trillion in U.S. Treasury debt representing 36% of total outstanding Treasury debt.
In addition, total debt in America now exceeds $32 trillion; equal to three times its GDP. There is the risk that a perception of a steadily declining US dollar could lead to capital flight, higher US interest rates and pose a serious threat to US economic growth and therefore, US stock prices. Weighing all the factors, doesn’t it make sense for you to allocate a substantial portion of your portfolio to investments denominated in other currencies?
Lack of Corporate Governance and Financial Disclosure
This is an important issue that merits our close attention. The perception is that US companies are more highly regulated and have higher standards of financial disclosure than international companies. This is certainly true in comparison to countries such as India, China and Pakistan but all over the world, the regulatory gap is closing. Many countries are realizing the benefits of transparency and timely disclosure and are taking steps to improve standards.
You have to weigh the regulatory risk against the rewards of potentially much higher economic growth and capital appreciation opportunities many of these markets offer investors. Certainly you should limit your exposure to emerging market countries that are still sub par in this area. Keep in mind that in terms of market capitalization, most of the world such as Europe has standards equal to the US.
It is fair to say, however, that the US has room for improvement as well. As we all have learned from the corporate scandals of Tyco, Enron and Adelphia, as well as in the chicanery exposed at some of America’s leading mutual fund companies, mismanagement is not the province of any one nationality but is a recurring global problem.
Lack of Promotion of Global Markets by the US Investment Community
Has your investment advisor, financial planner or financial advisor ever talked to you much about global investing? Have you attended a seminar sponsored by a major investment firm extolling the benefits of international markets only to be baffled by the closing recommendation of allocating a maximum of 10% to international markets?
First, it is natural that most advisors are wary of talking about and recommending international markets because they don’t know much about them and have little experience in this area. They are fearful that they will look incompetent if they cannot handle a question or are unable to explain why a particular market is attractive or to be avoided. The vast majority of financial advisors has not lived overseas and have little international business experience.
Second, investment firms usually do not recommend substantial allocations to international markets because they fear being held liable if the investments do not meet expectations. International investing is also a red flag to investment firm’s compliance departments and therefore, advisors approach this area with disproportionate caution and reticence.
A Different Approach to Global Investing
Because we specialize in helping investors build global portfolios using ETFs as a core investment tool, we take an entirely different view of international investing. We take a decidedly global perspective. Our approach is to manage overall risk and weigh it against the potential rewards of a reasonable blend of US and international investments in your portfolio.
We look at your portfolio as being comprised of two parts. The first part is your core portfolio. Your core portfolio represents funds you want to preserve and grow for you and your family’s financial future. In short, your core portfolio is your safety net. Preservation is your primary consideration in your core portfolio. In this portfolio, we normally recommend no more than a 20% allocation to international equities plus some international bond funds. Let me emphasize that there is risk of capital loss in your core portfolio but an effort is made to limit potential loss through a value approach and a sizable allocation of bonds.
The second part of your investments we refer to is your growth portfolio. Your growth portfolio is your risk capital where your primary consideration is long–term growth. In this portfolio, occasional sharp declines can be expected but are seen as buying opportunities. For your growth portfolios, we recommend our “barbell strategy” whereby roughly 50% is allocated to international equities and bonds.
Our research and analysis leads us to the conclusion that international markets will outperform the US market over the next 20 years. We expect and hope that the US market does well but that international markets will do better, perhaps much better.
Before moving on, let’s take a closer look at investment opportunities in the Asian region.
The Case for an Asian Tilt
While Asian and emerging markets have risen sharply over the past few years, I believe that the international holdings in your growth portfolio should tilt towards Asia. Broadly speaking, here is our case for Asia:
- relatively open world trading system favors Asian emphasis on production and exports
- single-minded focus on production and growth
- taxes are low, capital inexpensive, incentives for exports
- savings rates of up to 50% of personal income leads to Asia generating a majority of the world's savings.
- currencies in the region largely tied to U.S. dollar and the Far East has 2/3 of the world’s foreign exchange reserves
- steady improvement in education with emphasis on science and engineering
- huge labor pool and low cost production base
Asia’s Demographic Edge
Another important reason to tilt to Asia is its attractive demographics and the resultant impact on potential economic growth.
There can be little doubt that a country’s or a region’s demographic profile can affect its economic growth and investment patterns. For example, many analysts point out that a major reason for the strong markets in the U.S. during the 1990’s was that the baby boomer generation was at its peak earning, buying and investing period.
An important competitive advantage that Asia (excepting Japan) has over the world is its youthful population. The average age in Asia is just over 28 compared with 36 in the U.S., 40 in Europe and 41 in Japan.
This is an advantage for three reasons. First, it means that there are more workers supporting retirees and this lessens budgetary pressures freeing up resources for other priorities. Secondly, as the youthful population matures, there is the potential for a bubble of saving, consumption and investing which feed on each other. Thirdly, this could set up the development of a key ingredient for economic and political success: a strong and vibrant middle class.
Demographics are only one ingredient of this virtuous cycle. Certainly a good educational system, openness to foreign investment and trade, and market-oriented policies are just as, if not more, important.
Let’s look a bit closer at the numbers. The average age is lowest for the Philippines (24), Malaysia (26) and Indonesia (27) with Singapore (34) and Hong Kong (35) at the other end and China (31) in the middle.
In terms of the percentage of population 50 years or older, again the Philippines, Malaysia and Indonesia are incredibly low at 12%, 13%, 14% respectively. This compares to 27% in the USA and a troubling 38% in Japan. China, Taiwan, Thailand and South Korea all have about 20% of their population age 50 or higher. Singapore and Hong Kong are at 24%.
And then there is India. Out of a population of just over 1 billion, 55% or 550 million are age 25 or less. This is the key to India’s future. If this group is better educated, can find jobs in the private sector, is more outward looking and less protectionist than the previous generation, prospects for sustained economic growth are encouraging indeed.
These numbers are but one of many reasons why investors should make some allocation to Asian markets with the goal of long-term capital appreciation.
The Asian Production Platform
In short, Asia has evolved into one huge and powerful assembly and manufacturing platform. In the 1980’s and most of the 1990’s the great majority of Asia’s exports went to the West but now more than 50% go to other Asian countries. During the last ten years, Asia’s trade with itself has grown almost 60% faster than its trade with the rest of the world.
These exports have grown at impressive rates. Since 1995, China’s exports have doubled, Malaysia’s and Taiwan’s are up 35%, the Philippines’ up 127% and Vietnam’s up more than 200%. This growth has played a large part in the emergence of a middle class, which is good news and critical in building a stable consumer base in the region.
As an example of this emerging Asian production platform, let’s examine the personal computer industry. According to research by J.P. Morgan and CSFB, the following is a list of the leading producers of the various components that go into computers sold in the U.S. under U.S. brand names:
| Hard Drive |
Singapore, China, Malaysia |
| Chipset |
USA, Taiwan |
| Dram |
Taiwan |
| Motherboard |
Taiwan, China, Thailand |
| Power Supply |
Taiwan, China, Thailand |
| LCD Panel |
Korea, Taiwan, Japan |
| Customer Support |
USA, India |
| Keyboard |
Taiwan, China |
| Casing |
China |
| Speakers |
Malaysia, Philippines |
| CD Drive |
Japan, Taiwan |
In addition, throughout Asia, with the exception of Japan, many countries share a demographic advantage. In Malaysia, the Philippines and Indonesia, only 13% of their population is 50 or older compared to 27% in the U.S. For China and Thailand the number is 18%. In addition, the migration of workers from rural to urban areas throughout the region bodes well for steadily increasing productivity if jobs can be found in manufacturing and service industries.
While the Chartwell Asian Opportunity Model Portfolio hopes to share in the growth of the region as a whole, China is attracting enormous attention through the media and investors.
From an investment point of view, China is today’s million dollar question. Is it poised to become a spectacular investment at par with Japan of the 1960s and 1970s? Will its financial structure, urban/rural pressures, and political upheaval lead to an implosion? Or will investors experience volatility and high returns with dips and twists along the way as China inevitably becomes a major world economic power?
For investors, China is definitely a speculative play with a high risk/reward ratio. Its potential, momentum and strengths must be carefully weighed against its risks and weaknesses.
There is no doubt that China is a force to be reckoned with. Its economic growth rate, around 9-10% for more than a decade, is impressive. Overtaking the U.S. in 2003 as the largest recipient of direct foreign investment (FDI) translates into an increasingly modern manufacturing and technological base. China still only represents about 3% of the world’s GDP but has been contributing 15% to world economic growth. Its political and diplomatic clout in Asia is increasing rapidly and it is paying close attention to improving relations with friends and foes alike. In some ways, it resembles the U.S. position in the early part of the 20th century.
China: The State Sector vs. Private Sector
The key issue and risk for investors is the struggle between the Chinese Government and state-owned enterprises (SOEs) versus the rapidly growing private sector. While private companies and foreign investment are clearly driving economic growth, SOEs are shrinking only slowly, are laden with debt and utilize a disproportionate amount of resources. State-owned banks are largely insolvent with non-performing loans estimated to be on average 30% of total loans. The allocation of resources in China is still largely state-controlled and the successful transition of China from a command to a market economy is difficult given China’s political system and huge pool of unemployed.
There have been some positive recent developments including the decision by China’s Central Bank to inject $45 billion into two of the country’s largest lenders. These steps are to alleviate investors’ concerns and to prepare the banking system for foreign banking competition slated for 2007. There is much more that needs to be done in the areas of risk controls, management practices and writing off non-performing loans but this is a step in the right direction.
China’s Entrepreneurial Drive and Economic Momentum
The awakening and transformation of China during the past two decades is unprecedented in economic history. China is estimated to have accounted for nearly a third of world GDP as late as 1820 but political upheaval, civil war, military conflict and ensuing communist revolution and rule left its economy in shambles.
Contrast this with today’s economic dynamism and momentum. 90% of urban Chinese own their home, nearly 300 million have cell phones, auto sales were up 75% last year, 180 million Chinese are on the Internet, there are 200 cities with populations of 1 million or more. You get the picture, the economy is cooking and China is on the move.
What could derail this economic locomotive with a full head of steam? We have already discussed some of them. It may be useful to look at the China question through a balance sheet analysis.
China’s Investor Balance Sheet
Assets
- Huge, almost limitless labor pool
- Low cost world class manufacturing base
- High personal savings rate (nearly 50% of disposable income)
- State-owned enterprises have shed 45 million jobs during the past five years.
- Private sector now accounts for 45% of national output and 80% of work force.
- National consensus on overriding goal of economic growth
- Large and growing foreign currency reserves of $450 billion
- Substantial flows of FDI and access to world capital markets
- Chinese currency tied to U.S. dollar
- More sophisticated, nimble and confident diplomacy and engagement with international community
- Central Committee membership increasingly college-educated and global-oriented
Liabilities
- Weak financial infrastructure, capital and currency controls and sharply increasing consumer debt.
- Total debt equal to 176% of GDP
- Unproductive and highly leveraged SOEs still represent substantial drain on economy.
- Largely insolvent state-owned banks and poor allocation of capital
- High potential for social and political instability due to high unemployment and urban/rural and east/west disparities. Rural population projected to grow to 800 million by 2020.
- Lack of due process and lack of transparency.
- Democracy taking hold only on a very limited basis. Question of whether Chinese culture can accept the concept of loyal opposition.
- Spending spree in capital investments in China may lead to bubble and over capacity in many industries
Soft or Hard Landing for China?
Pundits are having a field day debating whether China will be successful in trying to slow down growth a bit without crashing to a hard landing.
We don’t know of course but this fixation obscures the fact that China is a speculative long- term growth play. We fully expect ups and downs along the way you should think of it as investing in the America in the time of the “Wild West”. If you are very worried about the next year or two in China, you definitely have too much exposure and should ratchet back your allocation.
China is now enjoying an investment boom similar to what the US experienced in the early 1900’s. In 2003, capital investment as a share of GDP was 43%! Like a fast growing toddler getting his sea legs, expect China to fall down from time to time.
Russian and Chinese leaders consolidate power
We would avoid Russia and view it primarily as an oil play. President Putin’s power grab in the wake of terrorist attacks is both unsettling and counterproductive.
Mr. Putin has moved to dramatically increase central authority over Russia by eliminating the direct election of regional governors and weakening the democratic methods of choosing a parliament. Protests to these measures were tepid.
Our view is that this is exactly the opposite direction Russia needs to go. In our view, a top down approach for a country spanning eleven time zones and as ethnically diverse as Russia will just not work. Russia’s “state capitalism” will eventually fail because it will be run for the benefit of the Moscow elite, ignore the countryside, and fail to build a strong and vibrant middle class.
In China, President Hu Jintao replaced Jiang Zemin as the country’s military chief, consolidating his power as leader of the Chinese Communist Party, the Chinese State and the military. This is the first orderly succession of power in China in the history of the Chinese Communist Party.
At age 61, President Hu is unusually young for a top leader and is a product of the party machine. While he frequently refers to using “power for the people”, he has tightened media controls and recently proclaimed that western-style democracy is a “blind alley” for China.
Mr. Hu, however, does have a reform agenda including cracking down on corruption and wayward local officials as well as improving infrastructure.
My opinion is that China will probably evolve as a one party state with improved transparency and accountability of its leaders but little political power to its people.
Asia’s Thirst for Oil
Most global analysts bullish on the energy sector focus on the supply side. Their reasoning is that dwindling supplies of oil and natural gas will force prices and profitability up over the medium and long term.
This is a plausible argument but misses the other pincer, the demand side and, in particular, the probability of an explosion of demand from Asia.
Here is a key statistic. Currently, the U.S. and Canada representing about 300 million people consume about 22 million barrels of oil per day. The U.S. alone consumes about 19 million barrels a day of which 11 million is imported primarily from the Middle East.
All of Asia, representing about 3 billion people, consumes only 21 million barrels per day.
Oil is often referred to as “the blood of an industrial economy” and indeed it is. Hopes of China, India and more newly developing countries using cleaner and new fuel technologies for energy have been dashed. The main reason: they cost more.
Transportation accounts for about 75% of fuel consumption. As Asian economies grow faster than the West and more Asians acquire cars and trucks, demand will skyrocket.
China’s car market increased tenfold between 1990 and 2000. Currently, with a population of 1.3 billion, it has about six million autos and twelve million trucks and buses.
India, with a population of 1 billion, has about 5.5 million autos and 7.5 million commercial vehicles. That’s about 1 vehicle for every 195 people. In the U.S., the number is 1 vehicle for every 1.3 persons.
It seems to me that if China, India, and the rest of Asia even come close to expected growth targets, there will be an inevitable energy crunch. Barring an unexpected breakthrough in technology, the global oil market is too small to hold the added layer of massive demand from Asia.
India
Let’s discuss an Asian country that could present us with the next great bull market of the 21st century – an opportunity that has the potential of being a better investment than even China!
Like China, this country was stuck with a failed economic system for over 50 years. It was a bureaucratic, socialistic state that led to weak growth, and stymied entrepreneurship and initiative. Famines, lack of investment, and poverty were the result.
But In the early 1990’s, the country changed course and started to open up its economy to the world. The country’s personal marginal tax rates have fallen from 50% to less than 30%. Tariffs and import quotas have been slashed, exports are growing at a 20% annual rate, with America being its largest market. Only 10% of its economy is dependent on international trade, insulating it somewhat from external shocks. The banking system is much improved, and non-performing loans have dropped to less than 4% of total bank loans. It has quickly gone from a balance of payments deficit to accumulating $135 billion in foreign exchange reserves.
Unlike China, it is a functioning democracy with respect for property rights and the rule of law. Many of its citizens have English as their native language. It also has more advanced financial markets than China, and a stock market established in 1870 that has 6,000 publicly-traded companies.
It is a very youthful nation with 80% of its population under 45 and - this is amazing - 25% of all people 25 and under in the world live in this one country! Its Citizens are thrifty with money to spend with a 28% savings rate to support capital investment. Consumer finance is rapidly becoming available and fueling more consumption and retail sales totaled $180 billion last year.
Economic growth is already impressive with 8.2% last year and 7% projected for 2005. Per capita GDP adjusted for prices is higher than China and its GDP growth rate has averaged 6% during the past 10 years. Fifty percent of its output comes from services and it has world class IT, media advertising, entertainment and pharmaceutical expertise.
The country’s space program has launched 12 consecutive rockets without incident and it put the world’s first graphic mapping satellite into orbit earlier this year. It has become a close ally of the United States recently signing a defense pact and placing a huge order with Boeing while considering purchasing advanced F-16 and F-18 fighters. President Bush, not a big traveler, is planning to underscore the importance of strong bi-lateral ties by visiting this country by the end of this year.
You have probably guessed by now that the country we are discussing is India - the world’s largest democracy.
For sure India has its challenges: big infrastructure needs, frustrating red tape and a tendency for the government to hang on to large state-owned enterprises to mention a few. Still, compared to China, India does not get much attention except for the outsourcing issue and is – for now – largely under the radar screen of even many sophisticated investors. India’s 30 company Bombay Sensitive Index (Sensex) index is up 22% this year and broke the 8,000 barrier just last week. Much of the buying is being done by foreign institutional investors from the U.S., and more recently, Japan.
The challenge with investing in India right now is valuations of the leading companies and the limited investment options. Valuations may be getting a bit ahead of themselves with SENSEX companies trading at around 14-16 times next year’s earning projections versus 11 times for emerging markets as a whole.
The Morgan Stanley India Fund (IIF) is a closed-end fund that invests in India’s blue chips and is up 97% in the last 12 months and 39% so far this year. It is a bit pricey right now and trades at a 14% premium to net asset value so caution is recommended until this premium comes down to the historical average in the low single digits. There are only twelve Indian ADRs trading on U.S. exchanges and these are also expensive and trade at a price premium over the India market price. One exception may be Tata Motors (TTM) which is listed on the NYSE at a price of $11.50, has a dividend yield of 4% and trades around 13 times 2006 consensus earnings estimates.
Where to act right now? For the right investors, there are long-short funds that focus more on India’s small and mid-sized companies which tend to be much better values, have not participated in the recent run up of prices and are also more insulated from global capital flows. These funds can also hedge against companies with unsustainable valuations and cushion inevitable pullbacks in the market. Be patient - there no doubt will be great investment opportunities as well as new investment vehicles to take advantage of this great secular bull market.
India presents investors with the opportunity of a lifetime and its democratic government, stronger financial system, market-based interest rates and history of respecting property and intellectual rights may make it a better long-term play than China.
Japan
Japan also appears to be coming out of a deep slump and its market recovery signals renewed economic vigor. It appears to be finally addressing its banking problems and adapting to economic trends in Asia by accelerating the transfer of manufacturing to lower cost offshore countries in Asia. It is well positioned to adapt to this trend with its very sophisticated trading companies and knowledge of the region’s different cultures and business practices.
Japan's industrial exports to China are surging as fears of deflation have largely disappeared. The key issue is the revival of consumer and business spending. Signs are encouraging. Fixed asset investment has risen for five consecutive quarters and consumers are gradually opening their ample wallets.
Nevertheless, we would be careful right now for the following reasons. First, during the market’s 42% rise in 2005, foreign investors were doing all the investing. The Tokyo Stock Exchange reported recently that through November, overseas investors purchased a net $81 billion in Japanese shares. This is a record and more than they purchased at the top in 1999. A recent Merrill Lynch survey also indicated that 62% of US fund managers were overweight Japan. This is saying a lot since Japan represents about 25% of the benchmark MSCI EAFE index and 50% of Asian stock market capitalization. Therefore, what looks like a market weighting to many looks like too big a bet on the Japanese market to me. Even in our Asian Opportunity portfolio we have never gone beyond a 25% weighting for Japan.
Second, Japanese institutional investors have been net sellers of Japanese equities and individual investors, while active traders, have only nibbled at the market. For example, a recent Wall Street Journal article reported that in October individual net purchases were only $1 billion. All signs point to the Japanese being traders not long term investors with full faith in Japan’s economic recovery. One wonders whether the recent meltdown will make them more gun shy and trading oriented.
Third, an over reliance by foreign investors on the Japanese iShare that tracks the Nikkei 225 puts too much pressure on the vehicle as foreign investors head for the exits to lock in profits.
Fourth, the Japanese are classic momentum investors pushing values way beyond any reasonable values. Forget any fundamental analysis, if it goes up it attracts capital whether it is the Japanese, U.S. or Indian market.
In Japan, there is reality (honne) and appearance (tatemae). Most of the news accounts I read emphasize all the positive trends and downplay the risks. Perhaps the Japanese are too gun shy after many false hopes but perhaps they see the reality clearer than we do.
Japan is a massive restructuring play and there are a lot of good signs. Banks are in much better shape, real estate prices are turning positive for the first time in 14 years, 2% economic growth is welcome after many years of stagnation, exports are strong and the successful Koizumi led reform efforts may indicate substantial change is on the way.
But still, Japanese may be thinking twice because they know the reality. Many firms will do well but the high flying growth of the past is gone. Exports to China are strong but both China and South Korea are right on their heels in terms of technology. High budget deficits together with a rapidly aging population mean tax hikes. It faces a major demographic headwind as almost 40% of its citizens are 50 or older. Japan’s bureaucrats are resisting reforms tooth and nail and many of the old ways will be incredibly hard to change.
The market may very well bounce back as foreign and Japanese investors keep faith in the Japan restructure story. My bet is that they will both be more conservative and look for domestic-oriented companies where there is still good value and less downside risk.
My advice: keep an eye on the Japanese investors and follow their lead. The Japan recovery story is real but the timing is uncertain.
Japan’s Corporate Investment Comes Home
Over the past decade, Japan has like America been moving a substantial portion of its productive capacity offshore. The share of Japanese corporate owned productive capacity located offshore grew from 8% to 40% (it is 50% for the US).
Now, however, the trend is to invest in Japan. Canon, Toshiba, Daihatsu, Sharp, Nippon Steel and many other Japanese companies are all investing in substantial new manufacturing plants in Japan. The products range from digital cameras to DVDs to flat panel televisions.
Japanese labor and tax rates are roughly comparable to the U.S., so why the divergence?
Corporate Japan has come to the conclusion that the labor savings of moving production to China are many times offset by other factors. While labor rates in China are only 5% of Japanese labor rates, labor represents an increasingly smaller fraction of total costs.
More important issues are supply bottlenecks, transportation costs, employee turnover and quality issues, teamwork with headquarters, protecting intellectual capital and also the loyalty of employees.
Corporate Japan realizes that to stay a bit ahead of their nimble rivals is to constantly innovate, protect these innovations and shorten the rollout time for new products. You can accomplish this more readily when your people and supply lines aren’t thousands of miles apart.
Europe
Europe represents almost 30% of the market value of the world’s publicly traded companies and should be a part of any global or international portfolio. In almost every industry or sector, there are European multinationals competing successfully at the highest levels throughout the world. I thought the 40% rise in the Euro over the past two years relative to the U.S. dollar would dampen exports, earnings and economic growth.
But in 2005 the Euro was down 13% and at a two year low against the U.S. Dollar, European countries like Germany, the world’s largest exporting nation, is worth a good look. So is another country in Asia that has thriving exports in spite of a stronger currency.
The top line numbers from leading German industrial companies are rolling in with impressive numbers for an almost zero growth economy. Siemens quarterly sales rose 13% - the fastest since 2003. BMW’s sales rose by 11% in the third quarter although high raw material costs and pricing pressure resulted in weak net profits. A bright spot is Asia where BMW expects to sell 150,000 cars per year by 2008.
Overall, German exports are up for the third straight month and sales to countries outside of the European Union rose 18% annually from a year earlier. Clearly the Germans are good at making stuff and selling it to the world and the weaker Euro is helping spur growth. Germany’s DAX stock index is taking notice and is up 18% year to date.
Meanwhile U.S. exports are up a paltry 2% since 2000. Although exports to China are up 35% during this same period, Americans are now buying seven times more from China than we are selling to them. A good reason why according to research by Morgan Stanley’s Stephen Roach, is that consumer spending represents 71% of America’s GDP. The figure is 42% for China and 55% for Japan.
Speaking of Japan, the aftermath of the financial bubble has obscured the fact that it too remains an exporting powerhouse despite a currency that has risen more than 20% since 2002 and 13% this year alone. Just look at Japan’s current account surpluses over the past three years: $113 billion in 2002, $136 billion in 2003 and $172 billion in 2004. China is a major market and despite political difficulties, bilateral trade between China and Japan now exceeds trade between Japan and America.
A majority of Japan’s exports are manufactured goods and components. 50% of its exports to China in 2004 were electrical equipment and machinery and its top exports to the world include autos, electronic components, optical instruments, imaging equipment and computer parts.
Much is made over China’s huge trade imbalance with America which reached $126 billion in the first eight months of this year. No doubt a sizable share of Chinese exports to America are chock full of Japanese components. While some of these components were made in offshore facilities, many were made in Japan which has been able to hold onto its industrial base better than America.
How do they do it? First, the Japanese continually moving up the value-added curve and are careful to keep the R&D and manufacturing of sophisticated components close to home while outsourcing the low end to low wage countries.
Secondly, even though China’s wages are about 5% of Japan’s, factory automation has lessened the importance of labor costs. For advanced high tech products it accounts for only 10-15% of total costs. Having manufacturing closer to home also shortens new product lead times and increases cooperation between R&D and production teams leading to a crucial edge in staying ahead of its nimble competitors. Supply lines of 2,000 miles can be problematic.
Perhaps most importantly, there is the critical issue of protecting intellectual capital. Having research, development and production closer to headquarters better protects proprietary technologies.
Canon, Sharp Hitachi, NEC and Toyota (TM) are all good plays on Japan’s manufacturing edge while Sony will continue to lag until it boosts its R&D and catches up in product development. The Japan iShare (EWJ) exchange trade-fund is also an attractive option since it has about 50% exposure to Japan’s manufacturing sector with an annual fee of only 0.59%. The Germany iShare (EWG), up 36% during the past year is also loaded with the country’s top exporters and would be an excellent proxy for overall export growth.
Put these two aging but muscular manufacturing and trading giants in your portfolio.
But you cannot avoid thinking about Europe’s major problem: its moribund labor markets.
Our portfolios tend to favor the larger European multinationals because they are truly first rate global competitors and tend not to be overly tied to European markets and regulations. Europe as a whole faces two large hurdles in its effort to rejuvenate and revive its economy. The first is an overall tax burden approaching 50% of GDP versus 35% in the United States and lower in the rest of the world with the exception of Japan. The second is labor laws and regulations that impede economic growth and lack the flexibility needed to become globally competitive.
For example, let’s look at Germany. As the largest economy in Europe by a sizable margin, its struggle with the most modest labor reforms is not reassuring.
Chancellor Gerhard Schroeder’s left of center collation is facing stiff and vocal opposition to reforms scheduled to take effect in early 2005. Right now, unemployed workers receive long-term unemployment benefits equal to about 60% of their previous salary as long as they remain unemployed.
The reforms would keep these benefits in place for 12 months but would then reduce the payments to a more modest 345 Euros ($417) plus some extra money to pay for utilities and rent. In addition, the reforms would make it more difficult for Germans to turn down new job opportunities that are inconvenient or pay less than their previous job.
The jobless rate in western Germany is 10.5% and in eastern Germany 18.5%. About 39% of unemployed Germans have been out of work for more than one year.
The dilemma politically is that these changes will provide more incentives to work and lessen budgetary pressures but it will take some time for the reforms to have an impact on economic growth.
Any democracy has a tough time reducing labor benefits but it is hard to see how Germany and other advanced countries in Europe can generate robust economic growth without even more radical labor reforms.
Europe continues to grow at about one half the rate of the US and Japan. While the US has averaged 3% economic growth over the past ten years, Europe has grown 3% in only one year during the past ten years. On the other hand, its saving grace is that multiples are about 15 versus 18 in the US. Because of this valuation gap and the expectation of improved earnings, many analysts predict it will outperform the US over the next year.
Many of the leading nations of Europe face an aging population, high costs, budget deficits and high taxes but Europe is still a force to be reckoned with. A more unified Europe coupled with real market reform could lead us to reappraise our limited exposure in our model portfolios. There are still many fine European companies and they call out to look at stock valuation levels carefully.
Emerging Markets Show Strength and Value
Since 2000, emerging markets (26 countries in the MSCI emerging market index) have grown 250% as fast as developed countries. Many though certainly not all are running current account surpluses and smaller budget deficits than rich countries. The ratio of foreign debt to exports has also declined to 98%, an improvement from 170% in 1998.
45% of emerging market debt is now rated investment grade, up from 4% in 1994.
Asian export growth is showing definite signs of cooling off and many of these countries are too dependent on exports. No doubt these markets can be quite volatile but we still believe these markets are not overvalued.
Exchange-Traded Funds (ETFs) tracking emerging markets have had a remarkable run. In 2005, the South Korea (EWY) was been up 57%, Brazil (EWZ) up 56%, Mexico (EWW) up 49% and the Emerging Markets (EEM) up 34%. In the last 12 months, China (FXI) has shown some life up 26% and South Africa is up 32%.
The MSCI Emerging Market index is up 82% since mid-2004. In addition, lower risk countries like Singapore (EWS) have been up for four straight years and its Straits Times Index has risen by 85% since 2003.
I am getting a lot of call lately about what to do next. Should investors buy, hold or sell?
There are two arguments out there about the future of emerging markets at polar extremes from each other. BCA Research notes that despite the run up in prices over the past three years, trailing and forward price-earnings ratios are only 13 and 11 respectively. Both are far from being out of line from both a fundamental and a historical basis. Brazil is a good example with a market at about 10 times earnings.
Morgan Stanley took a different view in a research report published last week. It points to the shrinking of the sovereign risk premium for emerging markets as a sign of potential weakness. In other words, the degree of higher interest rates demanded from the market to offset the higher risk of emerging markets has shrunk sharply. In 2004 it was 3.5% and now it is about 0.50%. There can be little doubt that this shrinkage has fueled at least part of the rise in emerging markets.
The truth probably lies in the middle of these extremes. The world is filling in and emerging markets will very likely outperform more mature markets but don’t expect a straight line up. Near term there will be some pullbacks in specific countries depending on circumstances.
Be alert, get some good intelligence, and put in place some measures to control risk. Here are a few ideas.
First, follow our portfolio approach whereby we weigh each ETF in a portfolio to prevent getting carried away with too large a position in an emerging market ETF. It is a bit like dining out, you may like Thai food once in a while but do you want it every night?
Second, keep emerging market ETFs out of your core portfolio which should have the goal of preserving capital.
Third, use our trailing stop loss strategy that kicks out an ETF down 10% or so from its high.
Fourth, use put options to mitigate risk. When you buy the China ETF (FXI), consider buying a put option on this ETF out 18 months at the same time.
Fifth, if you have an emerging market ETF that has had a great run, why not take some money off the table? As old Joe Kennedy aptly put it: “only a fool holds out for top dollar”.
My view is that for the most part, emerging market countries are in far better shape today than in the 1990s and valuations are not way ahead of themselves. Also some of the lower risk countries like Singapore are appealing. In the early part of 1997 before prices crashes, the Singapore Straits index was at 24 times earnings. Now it is 15 and the broader market is at 12 times earning.
Keep in mind that 200 years ago India and China made up 50% of world GDP. We have a long way to go with this story but you need a smart strategy able to weather some turbulence now and then.
Eight Country Highlights
Now let’s take a look at eight specific countries that should be on your list of potential investments.
Switzerland: A Competitive Powerhouse
Do you think of Switzerland as a quaint, staid tourist country with great chocolate and fine watches? Or as another example of “Old Europe” with high taxes and big government which stifles economic growth? Think again.
While only 137 miles by 216 miles in size and a population of 7.2 million, Switzerland packs a punch and is a financial and multinational powerhouse.
Switzerland is an attractive place to invest for four broad reasons:
- Strong currency and fiscal responsibility
- Strong multinationals especially in areas of engineering, food, pharmaceuticals, and financial services
- Stable government and vibrant democracy
- Asset haven in times of stress and upheaval
Here are some more quick and interesting facts about Switzerland.
- The Swiss franc is backed by ample gold reserves
- It has no BOP problems and very little foreign debt
- It is outward looking with 40% of its GDP attributed to exports
- Switzerland is the third largest financial center in the world after New York and London
- It has a weak central government and its legislature meets for only two weeks four times a year
- It has the highest per capita income in the world ($37,000)
- Switzerland has had a functioning democracy for 500 years
- All men between 20 and 42 are required to serve in military training each summer resulting in army of 625,000 men.
- Swiss guards have protected the Vatican since 1506.
- Swiss voters actually voted down referendums for a shorter workweek and longer vacations
In short, Switzerland is a great place for tourists and investors. The Switzerland iShare is also up 24% during the past year.
Malaysia: A Good Proxy for Asian Growth
Malaysia is oftentimes overlooked by investors even though it has progressed quietly but remarkably from a relatively poor producer of raw materials to a bustling and broadly diversified middle income country.
Malaysia, positioned along the strategically important Straits of Malacca, should be on every investors radar screen for the following reasons:
- Its currency (ringgit) is tied to the U.S. dollar and it has little external debt and healthy foreign exchange reserves.
- Malaysia has a balanced economy with strong industrial and service sector, important natural resources and openness to foreign investment.
- It has a parliamentary system and divided powers between central government and 16 states and federal territories.
- Malaysia is well situated to benefit from growth in the region with key export and investment partners being Japan, China and the USA.
Here are some more quick and interesting facts about Malaysia.
- Malaysia was formed in 1963 through a federation of the former British colonies of Malaya and Singapore. Malaya received independence from the U.K. in 1957. Singapore seceded from the federation in 1965.
- Natural resources include tin, petroleum, natural gas, timber, copper, iron ore, bauxite. Small but consistent exporter of oil and natural gas.
- Ethnic groups include Malay (58%), Chinese (24%), Indian (8%), others (10%)
- Malaysia is home to a variety of religions such as Muslim, Buddhism, Hindu and Christian.
- It has a young and increasingly well educated population with a median age of 24 and a literacy rate of 90%.
- Malaysia’s per capita income is approaching $5,000. Solid middle income country with growing middle class
- Malaysia’s terrain is varied from coastal plains breaking into breathtaking hills and mountains. Only 5% of the land is arable. In area, it is slightly larger than New Mexico or 330,000 square km.
- Malaysia is well integrated into the global community with membership in APEC, World and Asian Bank, ASEAN and WTO.
- In 2003, its economy grew 4.9% despite the disruption of Iraq and SARS crisis.
- The Kuala Lumpur Stock Exchange, also known as Malaysia Bursa has over 800 companies listed.
Singapore: The Switzerland of Asia
Founded in 1819 as a British trading colony, the Republic of Singapore was founded in 1965 under the leadership of Mr. Lee’s father, Mr. Lee Kuan Yew. While it is only 3.5 times the size of Washington D.C., it is perhaps the one most strategically important global trading, finance and service nexus in Asia.
In many respects, Singapore is the Switzerland of Asia. Here are some bullets describing why Singapore is a great place to invest:
- While Hong Kong and Shanghai will argue about it, Singapore is the busiest port in Asia situated next to the vital trading channel, the Straits of Malacca.
- Singapore has a parliamentary form of government, an English common law judiciary system and is corruption and drug free.
- Unlike South Korea and Taiwan, which are heavily dependent on the cyclical electronics industry, Singapore has a well-diversified economy. 70% of its GDP is attributable to finance and services.
- Singapore’s accounting rules and regulations are amongst the most conservative in the world. For example, its rules on inventory accounting and the expensing of stock options are more conservative than those in the United States.
- Despite only 1.6% of its land being suitable for agricultural and having to import almost everything including water, Singapore manages to have a trade surplus.
- Singapore has a balanced budget, a stable currency and still manages to allocate 5% of GDP for military defense.
- It represents a multi-ethnic society with 77% Chinese, 14% Malay and 8% Indian.
- Singapore’s educational performance is legendary. The fact that it has twice as many Internet users as television sets is telling.
While Singapore’s critics have some legitimate complaints about restrictions on personal expression, you need to view these relative to the insecurity of the new nation and the ethnic tensions. Slowly but surely, free speech is improving with a Speaker’s Corner instituted in 2000 and the ability to express one’s views freely anywhere. The exception to this continues to be the sensitive topics of race and religion.
The Kingdom of Sweden
Sweden is an unusual blend of capitalist vigor and paternal socialism. It is a land of hardy and stubbornly independent people who live in a country the size of California with a sub artic northland.
Here are some interesting facts about Sweden.
- Sweden’s economy is on the mend and it has somewhat reined in spending and kept its edge in the areas of autos (Volvo), telecom (Ericsson), engineering and machinery, processed foods, and paper and pulp.
- Like Singapore and Switzerland, Sweden has very little arable land, (6%) but is somehow still able to eke out a trade surplus due to its prowess in engineering and skill at exporting.
- Sweden has been independent since 1523 (some say 1215) and is a hereditary monarchy with a representative parliament. King Carl XVI Gustaf has reigned since 1973.
- Swedes have a life expectancy of 80 years and a literacy rate of 99%, amongst the highest in the world.
- While all 18 year olds face compulsory military service and reserve commitments to age 47, Sweden has not participated in any war in almost 200 years.
- Sweden has a balanced budget but accumulated national debt represents just over 50% of GDP (about average for OECD countries)
- 50% of Sweden’s power needs are supplied by hydroelectric power.
- The United States is Sweden’s #1 export market but the US ranks #10 on the list of Sweden’s import partners. The same old story.
- In September 2003, Swedish voters overwhelmingly rejected joining the euro system. The Swedish Krona remains proud and independent.
- The Swedish stock market has been strong this year reflecting low interest rates, higher exports and stronger economic growth (3-4%) and an inflation target of 2%.
Provided that Sweden continues to show fiscal constraint and social spending does not erode its other attributes, it is a solid and prudent addition to any global portfolio.
Ireland: The Tiger of Europe
Ireland was always seen as on the fringe of Europe, its population of 4 million (UK is 15 times larger) was always lagging and seen as a bit quaint and backward. Into the 1960’s, parents still had to pay for secondary education and as late as 1987, Irish GDP was only 69% of the European Union (EU) average. The unemployment rate was a dismal 17%.
Suddenly, almost miraculously, its economy took off with average growth rates in the 1990’s of 6.9% and by 2003 Irish GDP was 136% of the EU average with an unemployment rate of 4%.
How can we account for this remarkable turnaround?
As usual, it is not due to one action but rather to a confluence of policies, timing and action.
Some point to generous EU subsidies and no doubt these helped build badly needed infrastructure and upgraded educational standards. But it was much more than that.
In the late 1980’s a grand deal was struck, labor would moderate its demands, freer trade was pursued, and corporate tax rates were brought down to ZERO for multinationals investing in Ireland. Education was also noticeably improved for its relatively youthful population, especially in the technology area.
Within a short time, Ireland became the low cost production base in Europe and the money flowed in. Foreign direct investment was the key and now 1,100 multinationals, many in the high tech sector, established manufacturing and R&D operations in Ireland. More than 25% of all American investment in Europe goes to Ireland. This, in turn, led to an export boom. The stronger economy also sharply increased labor participation including many more women.
The resultant rise of Dublin as a major city and financial hub also led to a tourist boom with more than 6 million annual visitors. Instead of talented citizens emigrating to the U.S. for opportunities, they were coming home in droves. Ireland also strived to keep its neutral status spending only about $600 million per year on defense.
You can see how every action spins off and helps build sustained growth and momentum. Every action led to another in a virtuous cycle but the key ingredient for success was undoubtedly massive inflows of capital. Capital from foreign direct investment, from EU subsidies, from the exports, from stronger domestic capital markets, and from migration. Good open pro-growth market policies together with sizable amounts of capital can lead to economic miracles.
The challenge for Ireland now is to maintain its competitiveness and momentum in the face of greater competition and higher costs. Congestion in Dublin, which represents 33% of the population and 40% of GDP, is a bottleneck on growth. There also appears to be a property bubble developing further driving up costs.
Our job is to identify the next Ireland and get you in early. Is it China? Brazil? Hungary? Indonesia?
Brazil’s Stronger Balance Sheet
Brazil’s booming stock market has caught foreign investor’s attention but the question still lurks in the background like an uninvited guest - is this just another leg in the typical boom and bust cycle?
For the answer, take a look at Brazil’s improving balance sheet. While America piles on the debt, Brazil is going the other way. It decided last December to pay off its remaining $15.5 billion debt with the International Monetary Fund (that must be a relief!) and announced just last week that it will retire all of its remaining $6.6 billion worth of Brady bonds issued during the early 1990’s financial crisis
Where is the money coming from? Brazil recorded trade surpluses in 2004 and 2005 with exports for the last twelve months hitting a record $120 billion. Exports of oil, soybeans, copper, steel, autos, sugar and coffee are surging even in the face of a strengthening currency. The Brazilian real is up 52% against the US dollar since May 2004 and up 22% during 2005. Brazil is almost energy independent and foreign exchange reserves are now $58 billion even after paying off the nettlesome IMF debt.
Behind all these positive numbers are substantial reforms begun by President Cardosa and continued by Luiz Inacio “Lula” da Silva. Payroll taxes and corporate taxes have been cut, the tax system simplified and last week Brazil announced that it would eliminate the income tax for foreigners that purchase public debt. Brazil’s strong currency will likely also lead to a loosening of foreign exchange restrictions.
A cynical friend of mine often comments that successful political leaders need to ignore their strongest supporters if they are to achieve real reform. If so, Lula is a good example since most expected him to reverse market reforms after taking power in 2002 while in fact he deepened them. Up for re-election in October, Lula has nevertheless delivered higher living standards and restored national pride. With 187 million people and an area only slightly smaller than the United States, this leading South American economic power together with Chile and Colombia are changing attitudes toward the region as a whole.
What’s the best way to bet on Brazil’s momentum and improving balance sheet. I had been recommending the Brazil iShare (EWZ) which is up 27% this year and 72% in the last 12 months. In June of last year I switched to the S&P Latin America 40 iShare (ILO) that gives you broader exposure with 50% exposure to Brazil, 38% to Mexico, 9% to Chile and 3% to Argentina. This ETF is up 18% this year and 69% over the last year.
How important is the October election to Brazil? Even with all the economic growth, lower debt, lower taxes, booming exports and strong currency, public sector debt is still 51% of GDP so continued progress is essential. Like the old saw goes, even if you are on the right track, if you’re not moving you could get run over.
Australia: Surf’s Up Down Under
The lucky country’s economy is on a record-breaking 14 year roll. The question is: will it continue?
Just imagine, from a few convicts dropped ashore in 1788 Australia has developed into a first class global economy. The reforms enacted by former Prime Minister Bob Hawke and Treasurer Paul Keating during the 1980’s set the stage for a remarkable run of prosperity. Specifically, they slashed import tariffs, floated the currency and reduced the power of big labor. The current Prime Minister, John Howard who has been elected for times, has continued and expanded these reforms riding a wave of economic growth – 14 years of uninterrupted 4-5% growth.
The national debt has virtually been eliminated, the currency strong, the government recently signed a free–trade pact with America and is starting to negotiate a pact with China. Australia received $42 billion in foreign direct investment in 2004.
This is all great news and our portfolio allocation to the Australia iShare (EWA) has done very well with a 105% gain over the past two years. The Australian iShare is up 15% so far this year and provides investors with exposure to about 60% of the total stock market.
The question is of course, what should we do now? When things are going this well for so long investors need to be skeptical and weigh the potential upside with the downside risk.
Despite all of Australia’s strengths, there are some areas of concern:
- there is a shortage of skilled and semi-skilled workers and relatively high labor costs (minimum $400 a week)
- complicated and rigid labor rules continue to hamper productivity growth which seems to be slowing
- the total tax take by the Australian federal government is 22% which is higher than the rest of Asian competitors and US (average of 16%)
- from 2000-2004 housing prices were up 100% and household debt is now 160% of disposable income
Australia is taking some measures to address these issues. It recently enacted a $17 billion cut in personal income taxes over three years and the independent central bank is raising rates. The leadership has also introduced a package of “radical” labor reforms which if enacted would also be a big plus. The aim is to give employers more flexibility and to bring labor negotiations down to the local level. The measures would increase probationary period for new employees from 3 to 6 months, exempt businesses with less than 100 employees from unfair dismissal laws and favor individual contracts over collective bargaining. All of these measures will be fought by the Labor Party and trade unions.
While much is made of Australia’s dependence on China and commodity exports, the Australian economy is well diversified with 5% of GDP attributed to mining, 5% to tourism and 80% to services. It also represents the third largest stock market in the region and a leading regional financial center.
After looking closely at the situation, I have decided to keep Australia in our portfolio but take some profits by halving our position. Here is my reasoning:
- the decline in housing prices has been incremental and has therefore not impacted banking, consumer and construction stocks as expected
- international fund managers are underweight Australia
- the market is not especially expensive – 12-month forward p/e ratio is about 15x, in line with average over past three years and below high of 18x. However, keep in mind that this low multiple is based on forward and aggressive forecasts of corporate profits.
- average dividend yield for Australian stocks is around 5%
One company to keep an eye on is BHP Billiton (BHP), the world's biggest mining group, which reported an 85% rise in net profit compared with a year ago, to $6.5 billion, for the year ending June 30th. The Anglo-Australian firm set a new Australian corporate profit record and after being up sharply in 2003 and 2004 has confounded skeptics by being up 26% so far this year. The company's good fortune, like that of other mining concerns, comes from rising demand in China. Another great Australian mining company is Rio Tinto which has a lower valuation because it doesn’t have oil & gas operations that contribute about 30% of BHP’s total revenue.
The center of gravity of the world’s economy is shifting to the Asia-Pacific region and Australia is in the sweet spot. Keep an eye on housing prices and corporate profit performance but for now keep some exposure to Australia in your global portfolio.
Hot Chile
Chile is about two times the size of Montana and has an incredible coastline of 2,650 miles. While only 3% of its land is arable, it has an amazing variety of climates and rich agricultural production. It gained its independence from Spain in 1810 and has 16 million citizens of which 90% are Catholic.
The Chile story is somewhat similar to Ireland before its economic takeoff. From 1978 to 1988, per capita income increased only $100 to reach $1,510.
Next, both a military government followed by democratically elected governments initiated market reforms and opened up the economy. Exports and foreign investment took off and debt levels came down. Foreign investors in Chile are treated the same as Chilean investors.
From 1991-1998 economic growth increased an average of 8% and per capita income on a purchasing power basis has grown to $10,700. Since then growth has moderated to a 4-5% range but public Chilean total public and foreign debt at 50% of GDP is very low relative to other Latin countries.
Trade is very important to Chile with exports accounting for 25% of GDP. It is rich in natural resources (copper, timber, fruit and fish) and has been busy signing free trade agreements. A Free Trade Agreement (FTA) with the US took effect in January 2004 and now 90% of Chile’s exports to the US enter duty free. After a similar trade pact with South Korea last year, exports rose 50%.
Current President Ricardo Lagos Escobar is under pressure to improve economic growth rates and bring down the stubbornly high 8% unemployment rate. On the positive side, inflation and interest rates are low at 2-3%. Chile has demonstrated fiscal discipline and enjoys both a trade surplus and a budget surplus.
There are no country- specific ETF’s for Chile but there is the Chile Fund (CH) which is a closed-end fund managed by Credit Suisse Asset Management. It is up 53% over the past year, trades at a 7.7% discount to its net asset value and sports a 4.6% yield. Keep in mind that 19% of the fund is invested in just one copper company Empresas Copec S.A. and the annual fee is high at 1.80%.
Another alternative would be the iShares Latin America 40 (ILF) which invests in Mexico, Brazil, Chile and Argentina. It is up an eye opening 67% over the past twelve months with an annual fee of only 0.55%. Currently, 49% of this exchange-traded fund is invested in Brazil, 38% in Mexico, 10% in Chile and 3% in Argentina.
Global Competitiveness Report
The World Economic Forum’s 2005 annual report and country rankings is helpful in giving us a broad picture of what countries are most competitive and, more importantly, which countries are improving their competitive position. The full report can be found on our website so we will hit only the highlights here.
The criteria for the country rankings cover three broad areas:
- overall macroeconomic environment and management including taxes, budgets, etc..
- strong, honest and transparent public institutions which leads to low levels of corruption and respect for property rights
- a robust private sector and, in particular, technology readiness
For the third straight year, Finland snagged the #1 position helped by strong showings in all three measurements. The US, dragged down by the macro economic criteria, came in #2. Next in order were Sweden, Taiwan, Denmark, Norway, Singapore, Switzerland, Japan and Iceland.
For the most part, most top country rankings were quite stable. The largest improvement in the rankings came from Norway which moved from 9th to 6th place, Japan moved up two slots and Chile moved from #28 to #22. No other country in Latin America comes close to Chile with its nearest rival Mexico, a full 26 spots behind.
On the down side, Bolivia, Dominican Republic, Philippines, Peru, Pakistan Poland all suffered declines. South Korea dropped 12 ranks at #35 and Vietnam also dropped sharply showing deterioration in all three criteria.
Perhaps a more useful ranking is the Business Competitiveness Index which attempts to measure how hospitable the environment is at the business operating level.
There are two criteria for this index:
- the sophistication of operating practices and strategies
- the quality of the business environment including access to capital, supplier networks and the like
In this index, America ranked #1 followed by Finland, Germany, Sweden, Switzerland, UK, Denmark, Japan, Netherlands, Singapore and Hong Kong.
Japan, Hong Kong and Norway all show strong improvement. India moved up 8 ranks and Indonesia moved up an incredible 18 ranks. On the negative side, Italy dropped nine ranks, Vietnam fell 23 places and Poland, Thailand and Mexico had significant drops as well.
Latin America appears to falling further behind Asia and emerging Central and Eastern European countries. If one looks at an overlay of both indexes, the following emerging market countries stand out as improving their competitiveness: Indonesia, Chile, Brazil, India and South Africa.
Bottom Line Investment Edge
Principle #2
Build your portfolio with a global perspective searching for value throughout the world. Target a reasonable blended international allocation in your core portfolio and consider for your growth portfolios a “barbell strategy” with roughly a 50% allocation to international markets. Tilt towards Asia in your growth portfolio.
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