Chapter Seven
You Don’t Need to Go Trekking with Dr. Livingston
There is value in some pretty
friendly countries.
ONCE MY PARTNERS AND I decided to invest globally, we had to give some thought to where in the world we were willing to invest our money. For many people, the words global investing conjures up images of Dr Livingston hacking through the jungles of Africa; Juan Valdez hauling coffee down from the mountains of Colombia on his trusty burro; or perhaps even the Russian Mob, their briefcases full of cash, while driving away in flashy cars with diamond-clad women. I confess to having the same fears.
Most people are predisposed to be somewhat provincial, Americans perhaps more so. The U.S. stock markets were big enough to accommodate our investing appetites, so Americans have traditionally not ventured abroad. We also have the Securities and Exchange Commission that regulates away many of the abuses of stock market manipulators though not all. The U.S. accounting standards also create a level playing field for research and analysis. (This may be less true today than when I started in this business, but that is a topic for another day.) Americans were skeptical of foreign accounting standards and complained that European and Japanese accounting rules were not sufficiently transparent; that is, we couldn’t figure them out. However, I took a different view. I figured if Hans, a portfolio manager in Zurich, could learn U.S. Generally Accepted Accounting Principles (GAAP) I should be able to learn Swiss accounting protocols. Fortunately, understanding annual reports for companies around the world has gotten a lot easier today as most companies use standardized international accounting principles.
When I started plowing through foreign annual reports, I found that European and Japanese accounting was not a minefield of deception—it was a treasure hunt. Many European companies, for a variety of reasons, were hiding assets and understating reported earnings. They did not like paying more taxes than they had to, and they did not want to raise shareholders’ expectations. One early example from 1990 was Roche Holdings, the big Swiss pharmaceutical company. A basic principle of accounting is that if you take a company’s net worth or book value at the beginning of the year and add to that the earnings for the ensuing year, and subtract what it paid out to shareholders in dividends, you should end up with the year-end’s net worth or book value. Not with Roche. In some years, book value increased more than the reported earnings after subtracting the dividend payments. As I dug deeper, I found that Roche had a habit of taking reserves for contingent liabilities, which had the result of reducing reported earnings. Why? Who knows? It just wanted to be conservative, especially in a particularly profitable year. Setting up reserves for potential liabilities is perfectly legitimate. Suppose the company gets sued for a faulty product or has entered into a money-losing contract, it can set up a reserve for the potential loss and deduct the loss from its earnings even if it has not yet had to pay. Banks do it all the time. They make loans hoping to get paid back, but know that a certain percentage of borrowers will default. So they set up a loan loss reserve as a percentage of total loans.
In the case of Roche, the reserves were fairly questionable. As a fictional example, it might set up a reserve along the lines of SF 150 million for the possibility of an earthquake destroying a factory in Zug, which has never had an earthquake. Since the chance of an earthquake in Zug was so remote, the Swiss tax authorities would not let them take the reserve against pretax earnings. So, poof, SF 150 million disappeared from their after tax earnings report. A few years later, Roche would reverse this questionable reserve. When an American company does this, the release of the reserve gets added back to earnings as it should. Not in Switzerland. Roche would merely add the reversed reserve to book value, net worth, without ever letting it show up as reported income. See what I mean by a treasure hunt?
Another example from about the same time was Lindt and Sprungli (L&S), a Swiss candy company. Lindt makes expensive chocolates and has a great brand name. It was and is highly profitable. When we ran across Lindt and Sprungli, it was selling for 10 times reported earnings. That was pretty cheap especially since U.S. companies had recently bought another Swiss candy company and one in Norway for more than 20 times earnings. L&S was cheap for two reasons. The Swiss stock market was down because inflation had risen to an unheard of rate of 3.5 percent. The Swiss are buggo on inflation, which may help explain why they have one of the strongest currencies in the world. And Herr Sprungli had recently divorced his wife and remarried a Scientologist follower of L. Ron Hubbard. This had spooked the Swiss stock market for fear that the new Frau Sprungli might be appointed to the board of the company. A Swiss banker friend of ours told us that the former Frau Sprungli and her children had more stock in the company than her former husband, and she had told him that if he put his new wife on the board of directors, she would fire him. The Swiss are very pragmatic.
As we pursued our due diligence of the company, we saw that in addition to selling at 10 times earnings, L&S was selling at only 3.5 times cash flow. Cash flow is pretax, pre-interest expense earnings plus noncash charges for depreciation of fixed assets like factories and machinery. This is the money a company throws off before the tax man takes his share. Something did not compute. This was too cheap. Companies are allowed to depreciate their investments in fixed assets like factories and machinery on the theory that they wear out and the company will have to build new factories and buy new machinery over time. The number of years you can use to depreciate factories and machinery is usually dictated by government tax authorities. Switzerland is different. The companies choose their depreciation schedule. By dividing the depreciation of L&S into its fixed assets, the value of its factories and machinery, it looked like its depreciation schedule was about 26 months. Now, Switzerland is not Burma. The factories are not built of bamboo. More likely, a Swiss factory could withstand anything short of a direct nuclear hit. When we asked about this, we were told that Herr Sprungli was a very conservative man. When we made an adjustment to the rate of depreciation, L&S was selling for only 7.5 times earnings. When similar companies were bought for 20 times earnings or more, L&S looked pretty cheap.
In my pursuit of global investment opportunities, I choose to invest principally in the developed countries of the world like Switzerland. I look for stable economies, as well as a reasonable form of government. The so-called emerging markets have a tendency to never quite emerge and remain unsafe and unstable places for investment. Although they can be the source of enormous speculative profits from time to time, they can also be the source of staggering, rapid losses. Look at Venezuela or Argentina. Investing in countries like this ignores the concept of having a margin of safety, and is a game I do not care to play.
For every emerging market success story, there has been a disaster of at least equal or greater proportions in these undeveloped markets. I have seen tremendous economic upheaval in places such as Russia after the collapse of the Soviet Union. The Russian markets had been a gold mine initially, and then hyperinflation hit. All the “smart guys” were buying Russian short-term notes with yields in excess of 50 percent. Seems too good to be true? It was. Russia eventually defaulted on the notes and left investors with nothing but memories of their money. By the time Russian debt was unfrozen after a 90-day trading and interest halt, the ensuing currency collapse had left Western speculators with devastating losses.
In the early 1990s, Mexico was the darling of the investing world. The Mexican market kept climbing to new highs. It appeared that Mexico had finally gained an understanding of capitalism and with its enormous store of natural resources was ready to take its rightful place among the strong economies of the world. The media proclaimed loudly that, at last, Mexico would be a first world nation. Then, a few political assassinations and a sudden currency devaluation later, we discovered that global money managers financed the entire run-up. The Mexican stock market imploded with disastrous results. Had Bill Clinton and the United States not stepped in with a generous stabilization aid package, the entire nation of Mexico might well have gone bankrupt. Needless to say, investors suffered enormous losses.
In the mid-1960s, My brother Will served in the Peace Corps in South America, where he got a lesson in Latin rule of law: Sometimes the laws work and sometimes they don’t. Argentina has gone from bust to being the darling of Latin America in the 1990s. Now it is bust again. And look at the most recent disasters in Venezuela and Bolivia. Elections have brought socialist leaders who are cozying up to Fidel Castro and nationalizing foreign company assets. Why bother to invest in countries that are this unstable?
Until the late 1990s, East Asia was the darling of the emerging markets investing world. Countries such as Malaysia, Singapore, and Thailand had experienced enormous economic growth with internal growth rates as high as 8 to12 percent. It was hailed wide and far as the Asian economic miracle. As it became evident that foreign investment, and not increased productivity, had financed all this growth, the balloon began to deflate. In 1997, with the taste of the Mexican crisis still in their mouths, investors began to flee the East Asian countries with disastrous results. In Thailand, the stock market fell over 75 percent. The Philippine market lost over one-third. In three days in October, the Hong Kong markets lost 23 percent and the government eventually spent billions to prop up local equity and currency markets. In Malaysia, the exchange lost over 50 percent. Singapore, considered one of the most stable of the East Asian tigers, dropped over 60 percent. These are not the risks that I consider to be consistent with a margin of safety.
There seems to be a boom-bust cycle in all the less developed markets. Early investors reap fast profits and then an excess flood of foreign investment and cash pushes the local economy to the point of a speculative bubble. It is a dangerous way to invest, as those left holding the bag will find the bag is empty.
As I write this, there is enormous investor interest in China. The world’s most populous nation seems to be waking up to the joys of capitalism. It is growing at a very rapid pace and has a huge population. Despite this, there may be significant dangers ahead. China is still a communist country. The government still owns or controls many of the listed and traded companies both on the Shanghai and Hong Kong exchanges. Investors are a silent partner with no recourse to protect them should the government decide to change policies. Again, the margin of safety appears to be missing.
Rather than tread the savannahs of the African interior, or the steppes of Siberia, or even the slopes of the Andes Mountains, more than sufficient profits are available if I mostly stick to stable economies with stable governments. This includes all of Western Europe, Japan, Canada, New Zealand, Australia, Singapore, and non-Chinese companies in Hong Kong. In these stable, mostly democratic, and capitalist nations, I continue to look for stocks that hold the same characteristics of value as do U.S. companies.
