I’ve just finished reading Ruchir Sharma’s “Break Out Nations: In Pursuit of the Next Economic Miracles.” As head of emerging markets and a portfolio manager at Morgan Stanley, Sharma spends a lot of time travelling to developing countries. Having had a similar job myself, I know it can be a lot of fun. One of my favorite stories is about the time I took a helicopter over Lake Izukul on the first-ever investor trip to Kyrgyzstan, and the pilots got lost in the mountains while flying us back to Almaty.
Entertaining stories notwithstanding, I am skeptical of how much these “boots-on-the-ground” visits actually improve your investment returns. In my experience, interesting anecdotes and stays at the world’s Four Seasons hotels rarely lead to top investment performance.
Cracks in the BRIC Wall
Sharma’s fundamental argument is that the term “emerging markets” encompasses a widely diverse group of countries. As such, it makes little sense to lump them all together as a single asset class. Nor should we expect all of them to converge to the West. Over time, some countries will be winners and some will be losers. But only a handful of countries are destined to be successful over the long term.
On the one hand, this is just common sense. On the other, Sharma’s argument is a not-so-subtle critique of Goldman Sachs’ Jim O’Neill’s concept of the inevitable rise of BRICs — Brazil, Russia, India and China. In fact, the book’s first four chapters are dedicated to dismantling the myth that O’Neill has had such a key role in propagating.
I’ve written much about the problems the Chinese economy faces. When you include China’s local debt and shadow banking system, China’s real debt now exceeds 200% of gross domestic product (GDP). That amount would swallow up its much-vaunted $3 trillion stash of foreign reserves four times over. With growth slowing, China is headed for a crisis that will challenge the very fabric of its social structure.
Sharma cites my favorite metaphor for China’s dilemma:
“One commentator compares China’s possible fall below the recent growth rate of over 8 percent to the Hollywood thriller Speed, in which a bomb on a bus is set to detonate if the vehicle slows to below fifty miles an hour.”
Why is this my favorite metaphor? Because the “commentator” was me.
Truth be told, stock market investors have had their heads handed to them in China. The Chinese stock market today stands 40% below where it was five years ago before the onset of the global financial crisis. In contrast, the U.S. S&P has been essentially flat. That’s why your email inbox is no longer full of newsletters hawking the “China Miracle.”
Brazil is the mirror image of China. While Chinese policy makers are aware of their challenges, Brazil now suffers from hubris. The artificial sugar high of the commodities boom has made the Brazilian currency, the real, most overvalued currency in the world. Although Brazil’s former president declared that “God is Brazilian,” like Icarus heading too close to the sun, Brazil is headed for a fall.
Sharma’s native India is — much like Europe — a collection of disparate economies and cultures. Sadly, it’s also endemically corrupt, its economic development hamstrung by regional rivalries, and it is led by the reticent Manmohan Singh, a leader who is reluctant to push for unpopular, market-oriented economic reforms. Today, India remains a welfare state with a public debt-to-GDP ratio of 70%. High levels of debt, with no infrastructure to show for it, is a poor combination, indeed. Sharma gives India a 50-50 chance of becoming a “breakout nation.”
Russia is the kleptocracy you always knew it was. Despite the tailwind of a commodity boom and being the best-performing BRIC stock market over the past decade, the country’s corruption and business culture has it doomed to second-tier status.
“Show Me the Money”
The obvious investment strategy would be for Sharma to invest only in the countries with the best economic prospects. In his view, that means Poland, the Czech Republic, Turkey, Indonesia, the Philippines, South Korea, Sri Lanka and Nigeria. Yet, that that will never happen. These choices are both too small, and “off the wall.” To paraphrase Keynes, when you’re managing a mutual fund, “it’s better to fail conventionally than to succeed unconventionally.”
But I am skeptical of Sharma’s predictions for other reasons. As I write this, I am sitting on the banks of the Danube River in Budapest, Hungary. Twenty years ago, Hungary was the belle of the Eastern European investment ball — and both the Czech Republic and Poland seemed stodgy, boring and backward. Yet today, both the Czech Republic and Poland are among Sharma’s stars. You have to be a serious contrarian — like the Templeton Emerging Markets Debt Fund which holds a big chunk of Hungarian debt — to argue that Hungary’s economic prospects today are good. Yet, 20 years ago, Hungary’s current fall from grace is not something that anyone could have predicted. And there is no reason to think that today’s predictions are any more accurate than yesterday’s.
But the real elephant in the room is whether these insights can help you make money. And sadly, there is little evidence that they can. Under Sharma’s stewardship, Morgan Stanley’s own emerging market fund has underperformed its benchmark by more than 20% over the past five years.
As a former portfolio manager of an emerging markets fund, I know the institutional constraints on investing where you want to are huge. And the last five years have been a tough time to manage money. Last year, one the all-time best hedge fund managers, John Paulson, was down over 40% in some of his funds. George Soros was reportedly down by 15%. Although my own funds at Global Guru Capital did better than either of these greats, I wasn’t exactly laughing all the way to the bank in 2011 either. But Morgan Stanley’s under-performance does show the futility of trying to pick the winners and the losers.
This is not a critique of the Morgan Stanley team, per se. I was unable to find a single portfolio manager who actually outperformed the MSCI Emerging Markets Index over the past five years. And that includes emerging market specialists like Templeton.
That is why, in my “Ivy Plus” Investment Program, I invest in emerging markets by simply buying the lowest-possible-cost exchange traded fund (ETF) that tracks the MSCI Emerging Markets Index.
It’s terribly unsexy, I know. But that simple decision makes me one of the top emerging market managers in the world.
No trips to Kyrgyzstan are required…
Sincerely,
Nicholas A. Vardy
Editor, The Global Guru
P.S. Please join me for the Las Vegas Money Show, May 14-17, at Caesar’s Palace. To register, call 1-800/970-4355 and mention priority code 026655 or go to NicholasVardy.lasvegasmoneyshow.com. I also encourage you to sign up for my hedge fund seminar, Wednesday, May 16, 9 a.m. – 11 a.m.
