FOREWORD

Know Where to Look

Humility is the first requirement of successful investing. We have to realize that we don’t know what is going on . . . and that we certainly can’t predict the future.

That means we have to find investment positions that work out even when they are based on absolute uncertainty and near complete ignorance.

Richard Russell tells us that in the film business they say that “nobody knows anything.” I guess they are always surprised in Hollywood by which films are box-office successes and which aren’t. Sometimes, they bet millions on a film with high expectations, only to see it flop at the box office. Then, they are surprised again when a film that they barely funded at all becomes a runaway success. Being an old hand in the movie business doesn’t mean you will pick a blockbuster every time, but at least you know where to look to find them. Then, all they can do is to take educated guesses, while recognizing that they will probably be surprised.

Karim can certainly take educated guesses, too. He’s been educated by roaming the world. He was born in Africa, studied in England and Canada, lives in Florida, and travels frequently. But there’s more to this book than a series of educated guesses. There’s also a very big idea. And the only thing that bothers me about the idea is that it is too obvious. Where’s the surprise, I ask myself?

The idea is simple. The developed world is growing slowly, if at all. The emerging world—which includes all sorts of countries in all sorts of different phases of economic development—is growing more quickly. Here’s a stark and simple illustration:

Figure F.1 shows what has happened over the past four years. There has been no real growth to speak of in the developed world. China is booming.

Figure F.1 GDP Growth

Source: Calculated from OECD Quarterly National Accounts and China Bureau of National Statistics, U.S. and China, 3Q 2007–3Q 2011, EU and Japan 2Q 2007–2Q 2011.

The big idea is that this process will continue. Grosso modo. It doesn’t mean that China has to continue growing at such a sizzling pace. Or that the developed countries will necessarily stay in their slump. But if the idea is right, the developed world will continue to outperform the undeveloped world for the foreseeable future.

Why might this idea be correct? One region is developed. The other is not. It seems more likely that the undeveloped region will play catch-up than that the developed region will sprint further ahead. Catch-up is easier. It doesn’t require learning any new tricks. The dogs in the undeveloped world just have to look at the dogs in the developed world and do what they do. Which is just what we’ve seen over the past 30 years.

The developed countries have heavy industry. So, the developing countries put up steel mills and auto plants. The developed world has shopping malls. So, they built them in the undeveloped world, too. Developed economies have highways, ports, container shipping, banks, McDonald’s—and all the rest of a modern economy’s infrastructure. The developing countries put them in place. The developed world appreciates the role of private property, and a court system to sort out problems, and markets to set prices and guide production. They now have those things in the developing world, too.

But the trend of faster growth in the developing countries isn’t just about imitation. There is something more profound going on.

Another way to look at the growth difference between the developed world and the emerging world is as an expression of the principle of “regression to the mean.” For approximately 99,700 years of human existence a man’s labor in India was about as rewarding as a man’s labor in Africa or Europe. It’s only in the last 300 years or less that wages in Europe and its Europeanized colonies raced ahead. But I imagine there is no inherent reason why, after all this time, that one human should be more productive than another. If this is so, you could expect the abnormality to be corrected, with the wages of humans in India and Indianapolis both regressing to a mean.

But how did they get so far apart? What, exactly, was going on . . . and why might it have come to an end now?

Much of the growth and prosperity of the developed world—if not all of it—can be traced to innovations and discoveries brought online in the eighteenth and nineteenth centuries. These were two: the discovery of America and the use of fossil fuel.

When Columbus crossed the Atlantic in 1492, he was only marginally richer, more productive, and more technologically advanced than other seafarers from centuries earlier. The Chinese apparently roamed large areas of ocean. So did the Phoenicians. And the Vikings. But America is much closer to Europe than to China, and the Europeans who followed Columbus were more ready, willing, and able to take advantage of his discovery. Europeans found an almost unbelievable amount of new resources. The Iberians—Spain and Portugal—focused on what is today Latin America. The French and English directed their energy to North America. At first, the Iberians seemed to get the best of the bargain. They found money—gold and silver—which gave their economies an immediate rush. But the effect was short-lived and harmful. What they got was the equivalent of today’s printing press money—an increase in the supply of money with no increase in the ability to produce things. The result was inflation and the impoverishment of the entire Iberian peninsula. To the north, the haul was similarly huge, but it was in a different form. The English and French discovered vast energy and resource wealth. They found things that they could use to create real wealth: timber for fuel, rivers that made communication easy, abundant minerals, and vast expanses of virgin farmland. It took time. It took work, saving, and investment, but the treasures of the North were ultimately transformed into much greater and much more enduring wealth. This was especially true after oil became widely used as the fuel of choice. America had a lot of it. Oil-fired machines soon increased output so greatly that the average person in America, Europe, and later in Japan, became much richer than his contemporaries in the undeveloped world.

Oil was essential. This is also why the Anglo-Saxon countries were able to hold onto their leading position for the past two centuries. They had oil. Their major challengers—Germany and Japan—did not.

But innovations are innovations. They produce growth but not eternally. You can understand why by looking quickly at the great innovations of human experience. Man is an animal. He fills the niche nature allows him. He probably lived on the African savannah for many thousands of years with no progress or growth of any kind. Then, the discovery of fire allowed him to extend his range. We imagine that there followed a growth spurt that brought him into the colder regions of Europe and Asia. He then discovered the bow and arrow, further increasing his available food supply and extending the range that nature permitted him. So, too, did the domestication of animals and the development of sedentary agriculture allow him to put more food on the table with less exertion, thereby permitting another growth spurt.

But once the new, wider niche is filled out, his progress and population growth level out and once again become stagnant. So, we have to wonder: Is the developed world at the end of its growth spurt?

In the early 1970s I recall driving from Maryland to New Mexico. For some reason, there was a price war being waged along Route 66. One station advertised gasoline at 28 cents a gallon. Another went down to 24 cents. And they washed your windshield, too.

Today, the typical person in the United States pays about 17 times as much for gasoline. Adjusted for changes in the Consumer Price Index, this individual pays about five or six times as much in real terms as he did 30 years ago. He pays much more of his income for gasoline, in other words. Why? Because the price of oil has gone up and his income hasn’t.

Perhaps in Europe, the United States, and Japan the use of fossil fuels has leveled off. The number of miles driven in the United States—which have risen steadily from the day Henry Ford built the first affordable “Tin Lizzie”—has begun to decline. And economic growth, as you can see in Figure F.1, has come to an end. It appears that oil has reached its point of declining marginal utility. Further increments of energy—at today’s prices—fail to produce enough additional output to justify the expense.

While the developed world’s use of energy is on the decline, the emerging world can’t get enough of it. The reason is self-evident. The emerging world has billions of people who don’t already own all of the energy-guzzling paraphernalia of modern life. And they are acquiring the means to afford it.

Figure F.2 tells the China story. There’s also Russia. Indonesia. Brazil. India. Turkey. And dozens of other high-growth emerging nations. I don’t necessarily believe that any of them will become the United States of the twenty-first century. But I take it for granted that they will use a lot more oil. At present, the per capita use of oil in the United States is 10 times what it is in China. But the trend is clear: Oil use in the emerging world is rising fast . . . as you’d expect.

Figure F.2 China’s Growing Energy Usage

Source: U.S. Energy Information Administration and U.S. Department of Energy.

Of course, the other thing that is rising fast in the emerging world is personal income. This is a crucial point. In the United States, the typical working person reached his peak earnings-per-hour in 1974. You can argue that he gets more in social services today, such as free cheese and free pills. But that seems like small comfort when he drives up to the gas pump.

You can see the adjusted wage cost of gasoline over the past 10 years by looking at Figure F.3. The typical U.S. citizen’s cost has gone up—because he isn’t earning more money. The Chinese buyer finds gasoline—as a percentage of his wages—has gone down, because his earnings have increased so substantially. Chinese wages are up 281 percent over the last decade.

Figure F.3 Change in Crude Oil Price Divided by Change in Disposable Income—China versus United States

Even with Chinese wages up so sharply, they are still far below U.S. levels. The average worker earns roughly one-tenth as much in China as in the United States.

So, there is plenty of room for more wage growth in China. That means there is also plenty of room for more purchases of gasoline.

Many people see parallels between the rapid growth of the U.S. economy at the start of the twentieth century and the rapid growth of the Chinese economy now. They are tempted to see this as the “Chinese Century” and imagine that China will be a powerhouse, like the United States, for the next 100 years.

Yes . . . maybe . . . but . . .

The U.S. economy was a powerhouse then because it was so unlike what it is today. It was a free-market economy back then. Willing buyers and sellers made capital allocation decisions. Sometimes they were right. Sometimes they were wrong. But the markets corrected mistakes—continually redirecting capital from weak hands to strong ones . . . and from failed projects to successful ones. Capitalism—not central planning—is how people get rich.

China is a “capitalistic” economy but with major guidance from the public sector. I don’t know exactly how important those bureaucratic inputs are. I don’t know if any Westerner fully grasps how it works. Even the Chinese I talk to are perplexed. But there is no question that central, regional, and local planners, by no means pure capitalists, direct vast amounts of investment capital.

As a result, there are perhaps trillions of dollars of misallocations of capital that are not readily or easily corrected. Shopping malls with no customers. Apartments with no buyers. Whole towns with no inhabitants. Many of these were built with debt. And much of that debt is bad debt.

It is impossible to predict how this will be resolved. Perhaps a blowup will be followed by a quick bounce back with reforms that allow for more sensible decision-making. Perhaps real growth is so strong that it overwhelms and smothers the mistakes. I don’t know.

But that’s why we need to invest as though we expect to be surprised. We surely will be.

Where the surprise will come from, I don’t know. But it looks as though people in the emerging world are bound to use more oil and earn more money. And emerging markets will be better places, generally, for capital investments than the developed world.

Karim will help you figure out where to look.

Bill Bonner