Small-Cap Stocks in China and India

Nov 10th, 2006 | By Christopher Hancock | Category: International, Macroeconomics

If there be any among us who wish to believe the Federal Reserve’s recent pause signaled something greater, something almost provident, a beacon if you will, an unmistakable signal calling for blue skies ahead, those persons should be the ones who pause. Those persons should think again.

Right now, the only entity more broke than the American consumer is the American government itself.

Both parties sit behind the wheel in a speeding car heading the wrong way down a one-way street.

It’s only a matter of time. Fortunately for our representatives in Washington, they have a way out. Their balance sheet maintains the greatest long-term asset of them all: The power to tax. They still assume the right to practice charity with wealth they did not create; they still embrace the power to allocate goods they did not produce.

Shareholders of America’s largest oil companies pay particular attention: Arbitrary taxing to pay government debts has a long history in this country.

Between 1775 and 1779, Congress orchestrated the worst inflation in U.S. history. The government issued paper bills known as “Continentals” to finance the War of Independence. To pay these debts, Alexander Hamilton insisted Congress impose an excise tax on whiskey. Congress agreed. It quickly imposed an arbitrary tax conveniently inflicting Western distillers with little cash, and more importantly, little say in government affairs. This tax led to the Whisky Rebellion.

Unfortunately, American consumers, deep in debt with little savings, have no similar revenue-producing means at their immediate disposal.

Most middle-income Americans, the ones driving our buy-now, pay-later economy, have spent well beyond their means. Americans currently perpetuate a negative savings rate. The average U.S. household has about $8,000 in savings.

Cheap oil and cheap credit have fueled this era of consumption…this gilded age of instant gratification.

But the days of ultra-cheap oil are firmly behind us. The U.S. Department of Energy recently scrapped its predictions that oil prices would drop to around $30 a barrel by 2025, saying that costs will persist near or above $50 a barrel for years.

The days of cheap credit look to be waning as well. Americans can’t live off the bottle of home equity forever. A continued setback for the housing and mortgage market would be devastating to many American consumers.

So comments reported in a recent Wall Street Journal article by Angelo Mozilo, chief executive of Countrywide Financial Corp. (the U.S.’s largest home-mortgage lender), mean much more for the long-term health of the consumer-driven side of the financial markets than the most recent remarks from the Federal Reserve.

“I’ve never seen a soft landing in 53 years,” Mr. Mozilo said.

That’s good to know.

Many homeowners and investors alike fell prey to hype in the housing market. No one mentioned the risks. Headlines only glorified the gains.

All market manias have something in common: They snowball from the group think mentality.

It’s no wonder.

Peer influence shapes our decisions each and every day… We cherish the bandwagon…the herd mentality. It’s only human nature.

How many people outside the city walls of New York do you think called themselves “Yankee fans” before the likes of Joe Torre and Derek Jeter came to town? I doubt very many. But today, when the Bronx Bombers come to Baltimore, you’ll find more fans sporting navy blue and white than the hometown Orioles’ orange and black.

Peer influence makes the already popular even more popular. And the stock market or the housing market is certainly not immune to this phenomenon. Bubbles come and bubbles go. The technical term is “irrational market exuberance.”

In the long run, all bubbles eventually come to an end. There’s no telling what triggers the retraction. Some average investor wakes up one day and realizes that he’ll probably not recoup his investment on a company with an earnings multiple well above 200x. It’s really common sense.

But in the short term, as Benjamin Graham points out, “Markets are voting machines.”

Right now, the combination of sustained high oil prices and low interest rates will lead to higher prices in all areas of the American economy. As former Fed chair Paul Volker cleverly noted, “There’s no inflation unless you have to buy something.”

Americans are finding themselves with nothing left to spend. Goods subject to hedonic adjustments can’t hide the era of silent inflation forever.

The endgame: Americans will be forced to consume less and less.

In the meantime, the emerging economies aren’t really emerging any longer. Their debut was a smash…now everyone around the ballroom wants the first dance.

Last year alone, these economies accounted for more than half of world GDP. They now churn out 43% of the world’s exports and hold 70% of the world’s foreign exchange reserves.

Most lay the blame on China and India. Those two seem to be the whipping post for all the global woes these days. Whether they’re selfishly sucking up the world’s excess supply of excess oil or brazenly expanding their militaries without our parental blessing, the Dragon and Tiger rest in our proverbial crosshairs of suspicion and doubt.

China and India symbolize a greater global trend. They’re not lone gunman. In fact, these two countries combined for less than one-quarter of emerging economies GDP last year alone.

The real hangover for many in the West will begin when the export-driven countries of Southeast Asia start actually consuming what they produce…and those days aren’t far off.

While real wages in the developed West are either flat or even falling, wages among the up and coming Eastern nations continue growing.

By 2040, the shift in global economic power will have completed this dramatic shift. The five largest economies by GDP will include India and Mexico in place of the outmoded Western nations Britain and Germany:

Source: IMF, Goldman Sachs

This trend will open great opportunities for small-cap stocks from emerging economies throughout the globe…the companies fighting to be the next industrial titans known the world over. Finding those companies now, while they’re still in the growth stages, would be like finding General Electric and Microsoft, long before the likes of Welch and Gates became household names.

But dare not, dear reader, mistake the superficial for the essence. One must practice the emotional restraint of an English butler before heading into international waters. Beware of the population trap… Growth projections founded on demographics alone won’t guarantee superior returns…no matter how stylish Company X may be dressed.

Remember, most investors view their stocks not as they truly are, but as they would like them to be.

And always remember, you’re buying the business, not buying the stock.

Good Investing,
Christopher Hancock
November 10, 2006

Christopher Hancock

Christopher Hancock lives and breathes emerging markets. He travels extensively and utilizes his contacts across the globe to recommend the best international investments in the world. After working with Citigroup in Hong Kong on the challenges and opportunities associated with the forthcoming RBM flotation reform, Christopher left many of his friends behind and decided to return to the States to pursue a career in equity research.

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