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Saturday, September 25, 2010

My message to Managers in March 2008: Profitable opportunities for US investors in 2008 – China & India

Profitable opportunities for US investors in 2008 – China & India

As per Jim Rogers, China and India in 2007 are what England was in 1807 and New York was in 1907. He has been right about the fact that we entered commodities bull market in 1999. Since last decade China has outperformed in the BRIC category and since last few years, India has shown tremendous potential opportunities for growth. My main message here to US investors is how they can increase their returns by investing in the Asian markets. Recently, times have been very tough in the US equity market, so “US equity long only” strategy is not proving to be a profitable one. So how can investors stay inside their circle of competence and still do new things which they haven’t done before and generate good returns.

Confidence of US investors is quite shaken in the present market scenario and they are bit skeptical about the future market risks as well. In these conditions, it can be very hard for them to trust in countries they have never visited, forget about investing.  In that case, one should look at smart investors like Jim Rogers who is long Asian markets and profiting from their unprecedented growth since last one decade. Legendary investor like Warren Buffett for many years is investing in companies which have huge exposure to Asian market (for example ISCAR, Petro China, Coke)

The present statistics of the US equity market is indicating that stock market has not given the kind of return which shareholders were looking for. Especially in the last one year, all the major sectors have got severely hit and still there are no signs of improvement in the coming few years. There are growing economic concerns over increase in US trade deficits, falling dollar value, decline in housing value, severe credit crunch, and high commodity prices leading to all time high inflation. Financial sector has lost almost half of its value compared to last year, this is unprecedented as never was a time when the entire finance sector was so heavily leveraged. Now when the housing bubble burst is in its early innings, the impact can be seen all over the place, not leaving any sector intact. All the major hedge funds, mutual funds, asset management companies have seen severe haircuts in their portfolio gains, reason being they are heavily allocated towards the US equity and not towards the commodity and emerging markets. Yes, they own little bit here and there but not sufficient enough to cover up for the losses made by US equity group. In my opinion, there is an urgent need to change the portfolio allocation and apply few new investing strategies, while staying inside our circle of competence.  

Following the footsteps of legends like Warren Buffett and Jim Rogers, I can see new ways in which US investors can safely benefit from the Asia’s growth story. Since decades, Warren is concerned over the rising trade deficit of US, which will eventually devaluate its currency. At age 72, for the first time, to hedge for future currency losses, he went short over dollar. Later on finding Petro China cheap on valuation basis, he bought half billion dollar worth of the stock and made seven fold returns in three years. Berkshire has a majority stake in Coke and Warren likes its Asian market more than that of the US. The main reason being the number of middle class consumers in Asia is now comparable to that here in US. It is well evident, that the per capita consumption of consumer good items is going to increase in Asia at a much fast rate than in the US. Due to Warren’s ability to look a decade ahead, makes the Berkshire Hathaway stock a safety net. Now looking at Jim Rogers, he is heavily bullish over Asia and is invested their through stocks and commodities since a long time. He understands the need to go long over commodities as the entire Asian countries need it to fuel their economic growth.  So the lessons which we can take from these two legendary investors are to focus on Asian stock market and going long over commodities. Initially these two combined can be a small part of the portfolio and based on the experience, one can vary his allocation.  In the US equity part of the portfolio, one needs to be long on companies, who are heavily exposed to countries outside the US, so that they can hedge against the dollar decline.

In the next page, I will do a small case study on chances and effects of US going into recession.

Case study: Chances of US going into a recession and what it means for the US investors

Case 1: US economy escapes a recession. In July 2008 GDP shows a marginal growth over past 2 quarters & mortgage crisis is over and all the consumer indexes show an uptrend. 

Probability of Case 1 happening – 10%.

If this happens, then there is no need for investors to change their portfolio allocation and they can continue with their present strategies.

Case 2: US economy enters a mild recession i.e. of close to 1.5 years and we see GDP growth in July 2009 and all other problems get over.

Probability of Case 2 happening – 30%.

In this case, investors have to change their strategy and portfolio allocation by 15%, it means they have to look for opportunities outside US and look for other strategies other than US equity long only, like short dollar, short financials to name a few.

Case 3: US economy enters a medium term recession for 2.5 years and economy recovers by July 2010 and by then the mortgage crisis is over, consumer is back, spending.

Probability of Case 3 happening – 50%.

In this case, investors have to really take a closer look at their portfolio and change their allocation by at least 25% and get exposed to Asian market, ETF, currency, real estate, commodities. If there is a good return, then they can increase their portfolio allocation. Rest of the 75% of portfolio needs to be only in companies which are present around the globe, to be hedged against any major risk in US economy.

Case 4: US economy enters a severe recession by not showing any improvement till July 2011

Probability of Case 4 happening – 10%.

If this happens then the ideal thing will be to change the portfolio considerably & look for deep value in the US equity market, buy stocks with long term potential at a great margin of safety.
In the current scenario, if the US economy goes into recession, then it will not spare the economic growth around the globe. Decoupling theory is proving to be wrong as cracks in the global market is clearly evident. Still the fact remains that 2.5 billion people live in China and India and most of them are productive and contribute daily towards the growth of their nation. Also the scope of growth is immense, as at present, basic infrastructure is not present in these two countries. Pretty soon when the well educated human capital will start delivering in every possible sector, then one cannot ignore the positive outcome. In those circumstances, the growth will be phenomenal, creating a cycle of more development, more jobs, high income, leading to higher living standards, meaning more spending, more demand and hence more supply. So now is the time to understand the Asian economic cycle to reap the fruits of future growth. One has to go beyond the low cost labor and think in terms of “wealth at the bottom of the pyramid”. Once the middle class of both the nations rises, then the consumption cycle will lead to massive growth. China has prowess in manufacturing and India is advanced in the service sector. Going forward there is going to be a great symbiosis in between China and India in terms of business relationships and that will accelerate their economic development. The US companies who are located there will enjoy massive growth few years down the line. Major profit share will go to the local companies who understand its consumer’s lot better than their US counterparts. So to get the real growth one needs to look at the future prospects of these local companies and include in their research. Investors can focus on the kind of companies they invest in US market and look for similar companies in the Asian market and look for value. In this way they will stay inside their circle of competence and will be able to increase their returns.

For investors, fund managers, my suggestion is to modify their portfolio allocation, look for high quality emerging market stocks, ETF’s, essential commodities and focus on companies with high exposure to Asia.  By changing their strategies slightly they can reap immensely going forward and hedge against any major slowdown in the US economy.

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