When you invest for a living, it is hard to escape your profession, even during vacation. When my wife and I landed in Lima, Peru just before Christmas, I couldn’t help but notice the Scotiabank branch across the street from our hotel. When we turned on the television, we found that service was provided by DirecTV, a stock we started to buy in November. And of course, everywhere we went, people were talking on their Apple phones, using technology from Qualcomm and network equipment supplied by Cisco. When I needed to buy medication at a pharmacy in remote southern Peru, I found generic drugs from Teva. All of these are companies in which we have invested. The world has become one very large market, and investors are naturally interested in being a part of it.
‘Over the past decade or so, many investors have become involved in direct investment in emerging markets. Whether through mutual funds or Exchange Traded Funds (ETFs), we have watched money flowing into well-marketed themes: The BRIC (Brazil, Russia, India and China) countries; the Asian tigers (Indonesia, Malaysia, and Thailand) and so on. This week the Economist Magazine discussed the emerging middle class TIM economies (Turkey, Indonesia and Mexico). We have resisted the urge to follow this trend for a number of reasons. Here are some of them:
• The rule of law is tenuous in many emerging economies. Russia appears to be run by a well organized criminal class. China is, even after liberalization, still a Communist totalitarian state given to the imprisonment and even execution of business people it doesn’t like. This week Turkey purged several hundred police officers engaged in investigating government corruption. Direct investment in companies in these countries carries the risk of government expropriation, unfair taxes and unequal application of laws. Canadian companies have over the past few years faced sudden, unexpected and disastrous changes in government policy in such diverse locations as Chile, Kazakhstan, Mongolia, Venezuela and Bolivia.
• Accounting standards and financial reporting are uneven, uncertain and unreliable. Investors in the late forestry company Sino-Forest learned this lesson to their acute discomfort. Restatement of financial results is commonplace. In our view, if one cannot rely on financial statements, it is impossible to invest wisely.
• Currency risk becomes a large factor in investing success or failure. Even if one picks the right companies, if the local currency moves the wrong way, the stock price movement can be swallowed up by currency depreciation. Each of the Brazilian Real, the Turkish Lira and the Argentine Peso are down about 20% against the US dollar in the past eight to ten months, and these are among the largest and most stable of the emerging economies. You have to be a pretty good stock picker to make up for that.
• The taxation of dividends from foreign entities is tax ineffective. Countries with which Canada does not have treaties may withhold up to 25% of dividends for taxes; and of course, such dividends do not receive the benefit of the Canadian dividend tax credit.
So what is an investor to do? Should we ignore the often more robust growth prospects outside of the highly developed economies of North America and Europe? Or should we instead, find a way to do indirectly, what we fear to do directly? The second route is our preferred course of action. Brand power has gone international. Many U.S. based multinational companies, including giants such as Johnson and Johnson, Kraft and Proctor and Gamble, now make 50% or more of their profits outside of their home country. These companies have, in a real way, become transnational. While the head office might be in the U.S., assets, employees, sales and profits are spread worldwide, and companies which we routinely view as American, Canadian or British may in fact be significant participants in emerging economies. By investing in these companies, which have more transparent accounting and which are subject to laws and rules with which we are comfortable, we can become global investors without many of the worries noted above.
Over the past two years, we have added a significant number of non-Canadian stocks to our portfolios. Many are the shares of major international players such as Apple, Microsoft and General Motors. This is a theme we intend to continue, particularly as we see a more robust recovery in Europe and the continuance of growth in regions such as Latin America and south Asia. Our portfolios will incrementally become more globally focused, and may well reap the benefits of international diversification without many of the attendant risks.
Disclosure: The author and/or household family members owns shares in Apple, BNS, Cisco, Microsoft and Teva
Clients of Baskin Financial owns shares in all securities mentioned above.