Why You Should Listen to Warren, Not Buffett

Mr.Warren Buffett is one of the US billionaires and chairman of the Berkshire Hathaway Inc. Ms.Elizabeth Warren is an attorney, Harvard law professor, and a United States Senate candidate.

I came across an interesting article with the same title as above by John DeFeo in TheStreet.com

The reason for Warren’s newfound Internet stardom is simple. She was able to articulate — in a few words — what the Democratic Party has been unable to communicate for years:

There is nobody in this country who got rich on his own. Nobody.

You built a factory out there? Good for you. But I want to be clear: you moved your goods to market on the roads the rest of us paid for; you hired workers the rest of us paid to educate; you were safe in your factory because of police forces and fire forces that the rest of us paid for. You didn’t have to worry that marauding bands would come and seize everything at your factory, and hire someone to protect against this, because of the work the rest of us did.

Now look, you built a factory and it turned into something terrific, or a great idea? God bless. Keep a big hunk of it. But part of the underlying social contract is you take a hunk of that and pay forward for the next kid who comes along.”

Whether or not you agree with Warren, she is worth listening to. (emphasis added)

The complete article can be found here.

Why Emerging Markets Are Attractive Relative To Developed Markets

In an increasingly globalized world, the dominance of the US over the global economy is declining. For example, in the past six years the U.S. share of total global market capitalization has fallen from an average of 57% in 2003 to 49% currently according to a report by Morgan Stanley. Much of this weight has swung to the BRIC countries which now account for about 7.6% of world market cap. These countries are on an almost equal footing with the might of France and Germany combined.

While emerging markets are growing faster and account for a larger portion of the global GDP, their market capitalization has not grown proportionately. Emerging countries contribute about 33% of the world’s total economic output (in nominal current terms), yet they account for just 14% of the world’s total market capitalization as measured by the MSCI All Country World (ACWI) index. The market cap of emerging markets will expand over time due to economic growth.

Significant disparities exist in the valuation of various emerging markets. The following chart shows the market cap to GDP of some emerging markets:

 

Source: Investment Management Journal, Volume 1, Issue 2, Morgan Stanley

The stock markets of Chile, Taiwan, Malaysia and South Africa are more mature and are valued higher than other countries due to large investments by foreign investors and domestic pension funds. In contrast the markets of Indonesia, Poland, Mexico and Turkey do not reflect their full economic size and have further room to grow.

The current crisis in the developed world is dragging down the emerging markets whose fundamentals are relatively strong. Hence investors can consider increasing their exposure to emerging markets.

Related ETFs:

iShares MSCI Emerging Markets Index (EEM)
Vanguard Emerging Markets ETF (VWO)
iShares MSCI South Africa Index Fund (EZA)
iShares MSCI Brazil Index (EWZ)

Disclosure: No Positions

Bloomberg Article: Emerging Equity Bears Buyers on BRIC Retreat

Standish: Emerging Markets Should Be Called ASTERISCS

The term “emerging markets” has lost its meaning over the years due to many reasons. Some countries categorized as emerging countries are actually well developed. For example, MSCI considers the developed countries of Taiwan and South Korea to be emerging countries for technical reasons. The political and economic systems of these countries are equal if not better than those in most Western countries. In addition, frontier markets are also sometimes added with emerging markets making the term “emerging markets” even more confusing for investors.

Recently I came across an interesting report titled “Emerging Markets as ASTERISCS” by Alexander V.Kozhemiakin of UK-based fixed income asset management firm Standish, a unit of BNY Mellon. The following are some of the key takeaways from the report:

  • The term “Emerging Markets” coined 30 years ago does not help to clearly differentiate between countries of different wealth, risk, and stages of development. Hence a new term called “ASsets Tied to Economies of RISky Countries,” or ASTERISCS can be used to define these countries.
  • Antoine van Agtmael, an economist at the International Financial Corporation coined the term “emerging markets” in the early 1908s as an attractive name for “third-world equities”. Since that time trillions of dollars have been poured into funds that have the term in their name.
  • As of June 30, 2011, the market capitalization of emerging market equities, as measured by the MSCI EM, is over four Trillion US dollars and is only about one third of that of the S&P 500. Hence there is potential for further growth in the financial markets of emerging markets.
  • A decade ago emerging markets such as Mexico, Brazil, Russia were considered as speculative based on credit ratings. However today many emerging markets (Brazil, Russia, India, China, Mexico, Malaysia, Poland, South Africa, Chile, etc.) are rated investment grade.
  • Country risk is an important factor to consider when investing abroad.For example, Greece is mired in fiscal problems and South Korea faces the threat of military aggression by the North. So when adding the world-class electronics maker Samsung Electronics to a portfolio, an investor must also put a mental asterisk next to it as a reminder that it is a South Korean company.
  • Developed markets can regress back to the status of emerging markets due to risk of debt defaults and implied credit worthiness. Defaults on public debt is a country risk since it can adversely impact the performance of all asset classes. For example, credit rating of Greece was cut several times in the past few years from investment grade to junk levels which led to the disastrous performance of the Greek equities.The chart below compares the returns of German and Greek equities. While German stocks rebounded swiftly since 2009 Greek stocks plunged to new depths.

Click to enlarge

  • Allocating assets to ASTERISCS poses an extra challenge as countries grouped as “emerging makets” differ widely in many charasterics. For example, though Chile and Pakistan are emerging countries, they are both literally and figuratively worlds apart.
  • Diversifying country exposures is not an easy task in emerging equities. Just eight countries comprise approximately 80% of the market capitalization of MSCI EM Index, with the top four (China, Brazil, South Korea, and Taiwan) accounting for more than a half.

 

 

 

 

 

 

 

 

 

 

 

 

  • One solution to the country diversification problem in emerging markets is to add frontier markets. However adding asset classes of all types in those markets is not easy. For example, the frontier market of Kazakhstan does not have a large equity market but offers relatively liquid US dollar-denominated bonds. Similarly, the emerging market of India offers a highly liquid equity market but the local debt market is closed to foreign investors.

Source: Emerging Markets as ASTERISCS, Standish

In conclusion, when selecting countries for investments one should not make decisions based on catchy names alone. Even the BRIC acronym that was coined by Goldman Sachs does not adequately do justice to group them together since all the four countries vary widely. Brazil is a democracy with plenty of natural resources the world needs, China is a communist state with a huge population and lack of significant natural resources, Russia is a dictatorship with large natural resources and a small population and India is the world’s largest democracy with a messy political system, a large educated population and lack of natural resources.

In 2005, Goldman created the term “N-11” (Next Eleven) to represent countries with the highest potential to become the next BRICs. This list is also comprised of countries which share nothing much in common. For example, Bangladesh – one of the world’s poorest countries – is grouped with South Korea and Turkey.

CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa) is another acronym that was added to investors’ vocabulary in 2009 by Robert Ward of the Economist Intelligence Unit (EIU). This group is believed to share many characteristics such a dynamic and diverse economy and a young growing population. However Egypt just recently experienced a dramatic revolution that toppled the previous regime and Turkey has been relatively stable democracy for many years now with a vibrant economy.

So instead of focusing on N-11, BRICs, CIVETS, “emerging markets”, “frontier markets” and other monikers investors have to evaluate each country individually and then make well-informed decisions.

Related ETFs:
SPDR S&P 500 ETF (SPY)
SPDR DJ Euro STOXX 50 ETF (FEZ)
iShares MSCI Emerging Markets ETF (EEM)
Vanguard Emerging Markets ETF (VWO)

Disclosure: No Positions

Goldman Sachs: Correlation Between US and European Banks Rising Dramatically

The US banking industry is still suffering from many fronts despite the billions of dollars in bailouts in the past few years. Accordingly investors are dumping bank stocks with no end in sight. Today Bank of America (BAC), one of the super-banks fighting for investors’ respect, reached a new low of $5.52. Like Citigroup (C), the bank may have to initiate a reverse stock-split should the stock price continue to decline.

The closely-watched  KBW Bank Index (BKX) lost about 4.80% today. The index is on a downtrend heading towards the lows reached in March 2009 or even lower.

5-year performance of the KBW Bank Index

Click to enlarge

 

Across the pond, European banks endured another beating today as well. While US banks were the focus of investors’ attention in the previous credit crisis, this time around many European banks are staring into the abyss. As European bank stocks fall on a daily basis US banks tend to follow. A report by Goldman Sachs last week noted that the correlation of US banks with European banks has increased dramatically in recent months.

Via: FT Alphaville

From the Goldman report:

Unlike in 2008, we believe this time it is not about capital, but about a weakening macro picture and a sovereign crisis in which no clear resolution appears in sight, which we think is why every single bank we cover has underperformed the broader markets. One would have thought the market would reward those with strong balance and robust capital positions, but it has not, which signals those are not the key issues this time. While we expect the market to eventually start rewarding banks for fundamental outperformance, correlations are likely to remain high at least until contagion fears in Europe are reduced and we have a better understanding of the macro backdrop in the US.

The key takeaway here is to avoid US bank stocks until the dust settles in Europe. The political drama played out on both sides of the Atlantic since the credit crisis suggests that it may take a few years for the industry to wipe the slate clean and get back to “normal”.

Related ETF:
SPDR KBW Bank ETF (KBE)

Disclosure: No Positions

Why Higher Taxes Are Not a Barrier to Economic Growth

The U.S. has one of the lowest individual income tax rates among the developed countries. For example, the top individual tax rate used to be 91% in 1960. For the 17 years from 1965-1981, the top individual marginal tax rate was 70%. However President Ronald Reagan reduced it drastically from 70% to 28%. Currently the top individual tax rate stands at just 35%. This is lower than the rate in most European countries especially in Scandinavian countries which have some of the highest tax rates in the world.

The very low tax regime in the US disproportionately benefits the wealthy. Hence it is not surprising to see that the majority of the Forbes The World’s Billionaires list are Americans. For example, Forbes puts the net worth of Bill Gates at $56 billion and Warren Buffet at $50 billion as of March 2011. Mr. Buffet famously stated  in 2006 that he paid an income tax of 15.5% on his income of $46 million while his secretary paid 30% as tax on her $60,000 income. Since then the situation has gotten worse with the nation’s wealth gushing up into the hands of these few elites rather than trickling down to the millions of working-class Americans. One side effect of this system has been the disastrous increase in deficits in the past few years.

Recently President Obama announced plans to reduce the bloated deficit. The congressional committee on deficit reduction ( also called as the “supercommittee”) is supposed to come up with a compromise before the Thanksgiving deadline. In a report released last week, Center on Budget and Policy Priorities states that the committee must consider revenue increases and spending cuts in order to produce a balanced plan. The authors of the report offer the following five reasons to justify their argument:

  • “Spending cuts alone can’t do the job.
  • The 2001-2003 tax cuts are a significant contributor to projected deficits.  Letting some or all of those tax cuts expire would make a significant contribution to reducing the deficit.
  • Higher-income people can and should share in the sacrifices needed to reduce long-term deficits.
  • Taxes are low both in historical terms and in comparison with other countries.
  • Higher taxes are not an inherent barrier to economic growth.”

Source: “Supercommittee” Should Develop Balanced Package of Tax Increases and Spending Cuts,
Center on Budget and Policy Priorities