Ever since the dawn of attention to investment performance, the smart guys figured the way to outperform was to invest outside the general experience of others. Often this technique worked initially until too many others copied the strategy. As with life in general, the unexpected happened and the exits became crowded and were blocked for the late movers. This is a repeat performance of a movie I have seen before.
I am a Believer
I am a believer in investing internationally. As a trainee in my first job after my education in the US Marine Corps, I had a tour of duty within a bank’s vault to count the actual foreign stock certificates that backed up the bank’s issuance of American Depositary Receipts (ADRs). More than 15 years later, when I could start to invest for my own account, I began investing outside of the US. Over the years I have invested in Latin American and Asian closed-end funds, individual equities in Canada, Australia, the United Kingdom, Netherlands, Finland and Japan as well as private equities in the UK and France. In addition, at the time of my sale of the operating assets of Lipper Analytical to Reuters PLC, we had foreign clients buying non US-data from our offices in London and Hong Kong. Thus, I believe I have won my stars as an international investor. So why am I raising the yellow flag of caution now? Simply because it is getting crowded out there.
On Thursday of this last week Petróleo Brasileiro S.A. or Petrobras, sold over $70 billion worth of common stock. This was the world’s largest initial public offering (IPO). According to the Wall Street Journal, options will be available which will expand the common stock offering by 25%, including an undisclosed amount of preferred stock. (It is true that some $43 billion was an exchange with the Brazilian government for the drilling privileges to a potentially huge offshore series of sites. Nevertheless, an enormous amount of cash was invested into Petrobras.)
First Warning Flag
The sheer size of the enthusiasm for this transaction should be enough of a warning to a practiced investor, but there are other danger signs. Petrobras has been a favorite of many well-known global investors. A number of them felt that the terms of this offering were not in favor of the existing outside shareholders but were to the benefit of the government. Among those who are rumored to have sold out are George Soros and the good people at Templeton. One of the risks in any investment is that the government may turn less friendly. (This risk is valid in the US as well.) Based on my experience, foreign investors typically don’t really own foreign securities permanently. They rent them.
The Second Warning Flag
One of the better international money managers that I had the pleasure of knowing taught me the importance of the flows of money into a security. In the 1970’s, he focused on foreign money coming into the Japanese markets. He believed that the “weight of money” would lift Japanese stock prices that were clearly not bargains. He focused a good bit of his attention on mutual fund data and that was why he contacted me. His clue to exit an overpriced market was when there was a slow down in the gusher of money coming into the market.
As is commonly acknowledged, mutual fund redemptions have been larger than the rather lackluster sales of US Equity mutual funds. As of the end of August, according to my old firm now called Lipper, total net assets are approximately $4.7 trillion dollars, with only $3 trillion devoted to US diversified investing. The fifth largest collection of assets is in Emerging Market Equity funds ($253 billion). This excludes $112 billion of the more narrowly focused funds that invest outside of the US and Europe. The two collections together have total net assets of $365 billion as of the end of August, which is somewhat larger than the money invested in S&P 500 Index funds. Clearly, emerging markets are not undiscovered territory. The cautionary flags go up with US Diversified Equity funds shedding $ 10 billion in August, with $2.3 billion going in one month to Emerging Market funds. This shows a significant shift in investors’ opinion. A more dramatic indication is that in the same month $3.8 billion went into Emerging Market exchange traded funds (ETFs). I believe this latter inflow is much more speculative in nature. If you will, they are more like daily renters than annual leasers.
The growth in demand of ETFs is particularly ominous. Money can flow in and out of these funds on a daily basis. When the money moves, the managers must transact as nearly as possible to mirror an individual stock’s proportional ownership in the index. If some negative news event causes a redemption run on an ETF, they will have to sell some of each position. The history of international investing, particularly in small markets, is that when we come in we buy from the locals who feel that our valuations are wrong. When we sell under duress they understand that any price is a good price from the pressured seller’s point of view. The losses can be dramatic under those circumstances.
To put the ETF risk in perspective, each week I look at the twenty-five largest SEC registered open-end funds. On that list are five ETFs, two of which invest in emerging markets. On a combined basis these two funds have $70 billion in assets. They promise their large shareholders instant liquidity during US trading hours.
The Third Warning Flag
The next set of concerns is one of personal exposure. Over the last two weeks I have had three discussions about emerging markets. The first was with a marketing executive of a major broad line fund group who was commenting that its International/Emerging Market funds were selling very well. The second conversation was with a retired international investor who was being pitched to go back in business, focusing on the frontier markets which are exciting many people. I am hearing a great deal about investing in Nigeria and Ghana. (Memories of the “South Sea Bubble” of the 18th Century come to mind.) The final conversation was with a fund president who has been away from the market for some time and is being asked to develop a country-specific infrastructure fund as well as other frontier investments. (The Nineteenth and early Twentieth century investments by the Scottish trusts and Barings also come to mind.)
Despite HSBC’s ten point pitch to invest in the emerging markets and Western Asset’s belief in the attractiveness of the debt side of the emerging markets, I would be particularly careful now. If you are lucky enough to have been there already, cap your exposure at sometime. If you are not invested in emerging markets directly, you can gain some exposure through US companies that export or have operations in the area. As a contrarian bet I would look to large US Growth funds, they have lots of attractive companies in their portfolios at reasonable prices. They should do well enough on a relative basis over the next four years.
What do you think?
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