July 2006 Market Commentary

“Yet Another Fad Exposed” pdf version

In the 17 years we have been writing the Market Commentary there is one recurring theme — the penchant for investors to pursue the latest investment fads. Tech stocks, biotech, precious metals, oil, hedge funds, real estate, international stocks, you name it, the list is almost endless. Invariably each of these fads ends badly for those who climb on the bandwagon late in the cycle.

What propels investment fads? There seem to be three major factors. One is that people want to do what other people are doing. If everyone likes a certain type of investment, it must be good. A second is the tendency to buy yesterday’s performance. People forget that investing is buying future and not past performance. The third is the desire for quick and easy profits, the magic bullet approach to investing.

With the collapse of the so-called emerging markets in the last two months we have witnessed another wonderful example of how to lose money jumping onto an investment bandwagon in its late stages. It is also a classic example of what can go wrong with investment fads.

There is no question there has been tremendous growth in the so-called emerging economies and particularly in the BRICs (Brazil, Russia, India, and China). The economies in these countries are growing by leaps and bounds with huge amounts of foreign capital pouring in as they pursue capitalism. It would not be hard to argue that the economies in these countries will grow much faster than those in the developed countries and particularly the United States.

However, most people forget the significant risks to investing in these markets. The first is to distinguish between exposure to rapidly growing economies and exposure to the stock markets of rapidly growing economies. If you are seeking exposure to businesses which operate in rapidly growing economies you need look no further than many U.S. multinational companies which are obtaining substantial growth in their earnings because of business produced outside the U.S. Caterpillar, Intel, Citigroup, etc. all get a significant share of their revenues and profits outside the U.S.

If you invest in non-U.S. stock markets you certainly get exposure to non-U.S. economies but you also get a few other things which may not be so desirable. Those include regulatory risks, liquidity risks, and currency risks.

The most transparent stock markets in the world are in the United States. Whatever the complaints about the SEC and other parts of the U.S. regulatory apparatus, we have the best policed, most honest and most transparent markets in the world. In contrast, regulation of securities trading in the emerging markets is spotty at best, not to mention concerns about political stability and power of the legal system to protect property rights.

As important as the regulatory framework is the liquidity of U.S. markets. Large, well-capitalized companies with millions of shares changing hands daily are much easier to get into and out of with relatively little movement in price. We think the recent debacle in emerging markets resulted in part from too many people following the herd instinct and wildly throwing too much money at very thin markets and eventually overloading the circuits in those markets. Just as the prices were driven up by the flood of capital, they went down as some of that capital which got in for the wrong reasons tried to run for the exits at the same time and the bonanza turned into a fire sale.

Finally there are currency risks. Figuring out which industries and companies will prosper is no easy task. This challenge is compounded in the emerging markets where a number of external factors can cause local currencies to fluctuate in value thus adding or subtracting from the value of an investment. Even if you have all of the industry and company specific fundamentals right, your profits can be obliterated by changes in currency values.

As we have pointed out in discussing other “great” investment ideas, there are two very important rules to remember when investing. One is that by the time most people hear about a new idea, the easy money has already been made. The second is a basic law of investing. The more money which pours into an investment the lower the returns will inevitably become.

July, 2006