Chapter 5. A New Landscape for Investors

Since the world began to recover from the extreme stress of the financial crisis, it has become increasingly important that investors in search of the highest long-term returns over the coming years distinguish from among the world’s thousands of publicly traded companies some of the more attractive opportunities. Without a structure or framework to draw on, this could prove a difficult, if not daunting, task. On the other hand, depending on your perspective, there are tens of thousands of stocks to choose from in the world’s markets, so the possibilities are numerous.

If all investors have come to recognize one phenomenon (and, if not, this chapter may help), that phenomenon is the entrance of several new players onto the global stage of capitalism during the past 30 years. We must use the word capitalism in a broader sense, because few countries seem to apply the exact same regimen of the term from top to bottom. However, we can acknowledge that an unprecedented number of people are now competing in the global marketplace for goods and services. Perhaps this is the most important element of globalization as it relates to investing—which nations are becoming increasingly competitive, and what markets, businesses, and investments stand to benefit from this competition. Most importantly, the centerpiece of this phenomenon lies in the one word: competition.

During the twentieth century, the world bore witness to a wide dichotomy in the argument over how best to eliminate poverty and create prosperity. Among the many approaches were ideologies embraced by fascists, communists, and freedom-seeking capitalists, who were all vying for the top position in the world’s rank of prosperous societies. These ideologies clashed with each other in economic wars, military wars, and cold wars, but in the end, only one system was left standing in a form close to resembling its original design. The United States, and its institutional bias toward promoting freedom across all aspects of its society, ultimately triumphed in these battles. It empirically displayed from top to bottom the most prosperous civilization the world has ever seen. This display coincided with the dissolution of many competing ideologies, because ultimately they could not compete in the war waged on the commercial battlefield. Without question, the standard of living progressed in the United States at rates, and to levels, that few could have imagined in the ages leading up to the creation of this country. One of the most striking periods of this rise in economic productivity and the standard of living occurred in the decades following the end of World War II. This stretch of time defined by rising productivity lasted until the standard of living became temporarily derailed during the heavy onset of regulation and low growth of the 1970s. From the late 1940s until the early 1970s, productivity per worker increased at a rate of approximately 3% per year. Although this sounds modest, it means that productivity and the standard of living per worker were doubling at a rate just under every 25 years. In other words, if you were a child during this period, you could reasonably expect to have a standard of living twice that of your parents by the time you reached adulthood. Of course, there were conditions. To achieve this goal, an individual was expected to enter the workforce and compete for a good salary or wage, and save their money to store and build wealth for retirement. This practice can be distilled even further: Work hard and save your money. In the true free-market capitalist system, these two components must be successfully combined for an individual or society to continually advance.

While Americans were working hard, saving, and prospering during the post-war boom of the twentieth century, many other countries in the world remained under the grip of oppressive regimes. Far from prospering, the citizens of these countries routinely dealt with hunger, famine, low wages, and corrupt rulers. One of the biggest problems these regimes faced in their ability to create prosperity was that their economies never reached anything close to their full potential. These countries were routinely guided by ruling factions who actively steered resources. Just as managing a large company can become too complex for any one CEO or small group of executives, directing an entire country’s economic resources is a hopeless endeavor. One of the key reasons the citizens of these countries could never prosper under these governments was because resources were routinely misallocated, assets hardly ever received reinvestment, and innovation atrophied. That is about the only way to explain a country with the wheat production of Russia lacking enough bread to go around, as was the case by the early 1990s, when the wheels were coming off the Soviet Union. As these countries began their transition away from their closed-market, centrally planned economies, they transferred state-owned assets into private hands, even if incompletely. This helped unleash some of the human potential that had been lying dormant for decades. More specifically, governments in countries like China, Russia, India, and Brazil, while all starting from different relative positions and all going at their own pace, began to step out of their people’s way. They let their citizens compete in the global markets for producing manufactured goods, services, energy, information technology, and commodities.

Arguably, over this time period beginning in the 1980s, no country has unleashed so much raw human potential through institutional guidance toward greater commercial competition than China. The effects of this Chinese policy are clear if we examine the country’s GDP per head taken on a purchasing power parity basis over that time horizon. It is readily apparent that over the past three decades, or since its de facto ruler Deng Xiaoping was rumored to say, “To get rich is glorious,” the Chinese have been improving their standard of living at a breakneck pace of 12% per year. Forget doubling your standard of living every generation; in China, the pace has been every six years or so (see Figure 5.1). Naturally, this rate of growth also has a lot to do with starting from a low base; nevertheless, the phenomenon is real.

Figure 5.1. China per capita GDP (purchasing power parity)

Source: World Bank

It would be easy to look at these figures and discount their meaning due to their low base. But if we examine this growth alongside the country’s institutional reforms, illustrated by the continual opening of its economy, we can see that this phenomenon is being driven by a fundamental change in the economy. Quite simply, the government, although still authoritarian, has been allowing its people to compete and fulfill their hopes for a better life. For example, if we examine China’s rank over time in the Global Competitiveness Index, shown in Figure 5.2, this dynamic becomes more evident. From just the year 2000 through the 2009 rankings, China raced from the bottom 30% of the ranking in 2000 to the top 20% of the ranking for the 2009–2010 publication. More succinctly, in just nine years, China went from having one of the world’s least competitive economies to one of the most.

Figure 5.2. China’s decile ranking in the Global Competitiveness Index, 2000 to 2009

Source: World Economic Forum

Entrepreneurialism Is Thriving in Many Key Emerging Markets

Competition leads to innovation, innovation leads to progress, and progress leads to wealth. We should hasten to acknowledge that wealth can be measured in numerous forms, extending beyond the financial manifestations. Heavy competition, innovation, and progress are the key ingredients of the Chinese economic miracle, not the cheap labor that some pundits cite. Cheap labor can take a nation only so far before it ceases to step forward any further. The truth is that China’s adoption of freer market principles unleashed a wave of competition as its people took advantage of the opportunity to improve their lives after decades of oppression. The country is teeming with entrepreneurs (see Figure 5.3). China ranks among the top five countries in the world for its percentage of entrepreneurs who are all actively engaged in a constant state of competition with each other. It also has multinationals who have set up shop in China, seeking to participate in the new wealth that is being created. Clearly, succeeding at this level of competition, where local businesses are hungry for the opportunity to become wealthy, and the most successful multinational companies in the world have ventured into your backyard, requires a great deal more than cheap labor to thrive.

Figure 5.3. Overall entrepreneurial activity ages 18 to 64

Source: Global Entrepreneurial Monitor

In addition to the large presence of entrepreneurs in China, the prospects for more entrepreneurs to enter the workforce and compete remain strong. Based on polls conducted by Gallup in China during 2006,¹ the Chinese actually rank starting and owning a business as the most desired vocation. This was well ahead of the old regimen of joining the ranks of the government or working for a state-owned enterprise. In fact, the poll found that just under 30% of respondents desired to start and own a business, versus a modest 8% who sought employment in a government or state-owned enterprise.

The Chinese drive toward entrepreneurialism is backed by a general dissatisfaction with their standard of living and their career, as shown in Table 5.1. As it turns out, many Chinese citizens are dissatisfied with their current state and see launching a business and taking control of their own prospects as the best solution. This disposition among the Chinese makes for a deep and broad pool of competitive businesses across the economy, which in turn spurs progress.

Table 5.1. Satisfaction with Aspects of Life

The way China competes is simple: It is a nation of savers who expend the majority of their energy trying to excel in business. Since the opening of the economy in the 1980s, a great many Chinese have competed in the highly competitive export market for global goods and services. The United States did the same during its industrial boom that spanned the twentieth century, as Japan did as it emerged from World War II and took the world by storm in the 1980s, and as South Korea did as it emerged from the shambles of the Korean War to culminate its rapid ascent into the OECD. Therefore, China and its fellow emerging markets have joined a commercial environment that now includes an unprecedented number of competitors from across the globe. This had not been the case over the course of the twentieth century. In other words, China entered a highly competitive environment that requires its best efforts to succeed. Aside from top-down surveys, further evidence exists of China’s ascent into the highest competitive stratospheres of the global business landscape. Bottoms-up surveys also provide empirical backing to China’s competitive drive and its dividends as Chinese companies have begun to appear in the widely read business rankings published by Forbes and BusinessWeek.

Beginning with the Forbes Global 2000, perhaps the most simplistic ranking of the top 2,000 companies in the world, measured by a composite ranking of size based on sales, assets, profits, and market value, China’s rapid advance into this group is notable. In 2003, the country contributed only 13 businesses to the entire 2,000-member ranking. By the publishing of the 2009 ranking, however, China’s list of companies joining this group had risen sevenfold to 91, as shown in Figure 5.4. This advance provides increasing evidence of the country’s commitment to competing among the best companies in the world, and its relative success as its businesses expand their operations and gain market share.

Figure 5.4. Chinese countries in the Forbes Global 2000

Not only have Chinese companies grown to the point of penetrating a greater portion of the largest 2,000 companies in the world over the past six years, but they also have been successful in penetrating the upper reaches of the ranking. For example, in the 2003 ranking, not a single Chinese company was among the top 50 in the world. But by 2009, five were in the top 50, and three had actually climbed into the top 25. Table 5.2 shows the number of Chinese companies placed by quartile in the top 100 companies on the list.

Table 5.2. Chinese Companies in the Top Quartiles of the Forbes 2000

This evidence of China’s increasing competitiveness in the global business world is fortified by the increased recognition of its companies’ ability to innovate on its path to financial success. As you know, innovation comes from competition, so China’s increasing innovation is the direct result of its intensely competitive base. Let’s return to the Global Competitiveness Ranking, published by the World Economic Forum (see Table 5.3). If we examine the subindexes, one of which ranks innovation, we can see that China’s level of innovation has risen with its increasing competition in the world’s markets. In 2006, the country ranked just 57th among the most innovative countries in the index, but by 2009 this ranking had leapfrogged almost 30 spots to number 29.

Table 5.3. Global Competitiveness Ranking: Innovation Subindex

Coinciding with this advance in innovation chronicled in the Global Competitiveness Ranking is some bottoms-up evidence of the same phenomenon. Using the annual BusinessWeek ranking of the top 50 most innovative businesses in the world, a Chinese computer manufacturer, Lenovo, cracked this elite company in 2009. As we compare the rankings from 2009 to the 2007 rankings, it is clear that, only two years ago, this list was confined to a group of iconic household-name developed-market companies (see Table 5.4). Since then, however, four emerging-market companies have cracked this enclave of innovative firms—Lenovo and three Indian companies: Tata Group, Reliance Industries, and Infosys.

Table 5.4. BusinessWeek’s 50 Most Innovative Companies for 2009 and 2007

Emerging nations, including China, India, Brazil, and several others, have already examined and successfully implemented the key factors that lead to successful competition in the capitalist system of commerce. Much proof already exists that these countries have developed key institutional biases toward free-market competition, as well as sound fiscal policies. Most importantly, as we place these factors of increasing competitiveness and sound fiscal policies into the context of the recent financial crisis, it seems probable that businesses from these countries will actually see their competitiveness accelerate over the coming five to ten years as they benefit from the crisis.

Crisis Is an Opportunity for Those in a Position to Seize the Opportunity

Simply put, firms from these countries were already competitive heading into the financial crisis. As the world economy recovers, these firms have a clear opportunity to emerge from the wreckage as even stronger entities.

China is far from alone in its emergence onto the global business stage due to its embrace of global competition. An old, if unfortunate, joke states that “Brazil is the country of the future, and it always will be.” Ironically for this country with blessed resources, and now an enviable fiscal scorecard, the future may be now. In the past, the country was prone to widely swinging cycles of boom and bust that were both punctuated and accentuated by its sloppy finances. To place its economic history into context, a quick review of its annual rate of inflation judged by its year-over-year percentage increase provides an ample illustration of its constant financial turmoil. Brazil’s heavy use of debt and loose monetary policy had taken inflation into the sphere of hyperinflation, or an outward manifestation of financial imprudence, that had reached an artistic level. During the course of the 1980s and 1990s, hyperinflation spiraled into growth rates approaching 3,000%, as shown in Figure 5.5. At these levels of inflation, consumers would have been wise to buy groceries as soon as a store opened in the morning rather than waiting until the afternoon.

Figure 5.5. Brazil’s annual year-over-year percentage change in inflation

Source: IMF

Still, the country eventually repaired its finances and inflation abated, eventually into the low single-digit rates seen during the past several years. Having gone from the emerging market’s largest debtor nation to a creditor nation, Brazil received notable upgrades in its debt ratings, including an increase to investment grade by Standard & Poor’s in 2008. Brazil successfully executed a strategy that would open its economy and stabilize its longtime Achilles heel of weak finances. The result has been that Brazil can also count itself among the nations that have an opportunity to improve their competitive positioning in the wake of the financial crisis. The clearest illustration of the country’s newfound financial strength is its becoming a creditor to the International Monetary Fund through the purchase of IMF bonds. This represents a sharp reversal from its traditional position as the heaviest borrower of IMF resources during its various crises. More importantly, this shows that the country is attempting to take its financial strength and translate it into additional clout in world affairs. This reversal has not gone unnoticed by observers. Following a poll among business economists conducted by the World Economic Forum, Brazil received the highest ranking in the world among countries expected to benefit from the crisis and recession. All told, only five countries received a ranking that predicted an improved forecast following the recession, including, in order, Brazil, India, China, Australia, and Canada. One large reason for this confidence in Brazil’s prospects comes from its diligent reversal of its prior financial weakness. Brazil, which had accumulated over $200 billion in reserves during the boom preceding the crisis, was able to implement a number of fiscal and monetary measures in response to the financial crisis without weakening its financial position in the process. In the meantime, Western developed nations, such as the United States, had to push their fiscal balances and public debt levels into nearly uncharted territory in their attempts to counteract the financial crisis. Moreover, Brazil had also entered the crisis less dependent on Western developed nations for its exports. It had actually diversified its export base substantially into fellow emerging-market countries such as China. This offset some of the worst possible exposures to the initial shock. It also meant that exports would stand on stronger future footing, because many of Brazil’s key trade partners were not left financially hobbled by the crisis and their risk-laden responses. One case in point comes from Brazil’s deeper relationship with China as a key trading partner. For instance, in 2005 only 6% of Brazil’s exports went to China, but more recently China became a larger partner than the United States, accounting for nearly 14% of Brazil’s exports. There can be no question that the financial crisis at least temporarily negatively affected Brazil. But its financial prudence leading up to the crisis, in addition to its further diversification of its trading partners to more creditworthy nations, has provided a tremendous advantage to the country as it emerges from the financial crisis.

The New Landscape

In sum, we have discussed an ongoing paradigm that could have residual effects in the years to come, following the financial crisis and recession. This paradigm is simple because several of these developed countries that we have already mentioned did not expose themselves to the heavy use of borrowing and credit extension that ensnared developed markets, such as the United States and many in Europe. Therefore, for these fiscally sound economies, the global recession is a cyclical phenomenon whose effects will pass. On the other hand, the debtor nations encompassing the developed world must deal with the lasting consequences of substantial public and private debt loads, and the possible risks introduced by the institutional responses from their governments. This ultimately increases the financial burdens of all stakeholders of the indebted economies, because taxpayers must redress these imbalances over time. We cannot be sure how long it will take the United States and other developed markets to repair their balance sheets. But no matter the time period, it seems probable that a secular trend of saving and paying down debt balances will come at the expense of historic levels of consumer spending that occurred in the years leading up to the crisis. Likewise, any ill effects from the government response of a massively expanded monetary base, unprecedented budget deficits, and increased regulation implies that the United States economy has introduced possible further distractions from uneventfully resuming a solid rate of growth. We have seen so far that a new investment landscape is separated by a clear divide between countries, economies, businesses, and consumers who lie on the financially sound side of the chasm. Those that remain must traverse the divide from their current land of debt burdens, impaired financial systems, impending regulations, and risky sovereign finances. It is likely that the latter side will cross the divide in time and rejoin the former side in financial health. Until then, investors will find better growth among those inhabiting the healthy land.

With that said, investors looking ahead need to consider the long-term attractiveness of companies operating in these increasingly open and competitive nations. Just as important, investors need to consider the various methods through which they can participate in this growth, ranging from natural resources such as oil to consumer goods. More than 80% of the world’s population lives in the emerging markets that are in the process of constructing a middle class of consumers. The remainder of this book discusses several investment themes that should capture this potential growth and reward investors who have the patience of long-term focus. Furthermore, because these themes surround long-term phenomena, they should afford lasting opportunities that can be taken advantage of at future points of maximum pessimism.

Endnote

¹ William J. McEwen, Ph.D. “The Chinese: a New Wave of Entrepreneurs?” http://www.gallup.com, December 26, 2007.