In previous articles, we have compared countries (and by partial implication country funds) in terms of:

• imports and exports
• transparency and corruption
• economic, banking, currency and political stability
• GDP growth rates
• inbound and outbound foreign direct investment.

In this article, we look at countries in terms of intellectual capital, expressed in terms of patent applications and granted patents. Certainly, there is more to intellectual capital than patents, but there is no more complete and comprehensive global measure of intellectual capital, of which we are aware, than patent applications and grants.

It seems to us that a country can gain economic advantage over other countries principally through,

1. natural resource exploitation,
2. low cost production of goods and services, or
3. innovation.

Patent applications and grants may be a reasonable indicator of the degree of innovation arising within a country.

Just imagine how powerful a country would be if it were a leader in all three dimensions.

The table below shows the ranking of countries by the number of international patent applications (not grants) originating from the 30 most prolific countries in 2007 as reported by the World Intellectual Property Organization (WIPO).

Dr. Kamil Idris, Director General of WIPO said in a February release, “The growth in patent filings by a number of countries in north east Asia and their share of overall patenting activity is impressive and confirms shifting patterns of innovation around the world.”

International patent applications from China grew 38.1% in 2007 over 2006, and applications grew 18.8% from South Korea.

Among the top 30 companies filing international patent applications, the U.S. was the leader with 12 companies; followed by Japan with 7 companies; Germany with 4; South Korea with 2; and China, Finland, Sweden, France, and the Netherlands each with 1.

Within the United States the ranking of the top 40 countries according to 2006 patent grants (not applications) is shown below.

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Make of it what you will. We think it is a good idea when investing in country funds to know how each country relates to the others in terms of competitive role and advantage. Intellectual capital is one dimension.

Richard Shaw
QVM Group LLC

BRIC (Brazil, Russia, India and China) are not leading the emerging markets so far this year.

Other than being performance leaders in the recent past, we really don’t see why investors would want to link them conceptually. They have quite different economies and resources and are subject to widely different economic, demographic, and geopolitical risk factors.

We continue to be impressed with the strength of Brazil in the face of weakness in India and China, and we are watching with interest the way the Middle East is developing as a frontier market.

Russia is doing better than India and China so far this year, but not as well as Brazil and the Middle East.

We like the apparent insulation of Brazil from the geopolitical turmoil that plaques so many parts of the world, including their historical avoidance of much of the impact of wars in the last century.

The larger Middle East is certainly a hot spot, but the fact is the U.A.E and some other area countries are stable beneficiaries of global petro-dollar money flows. They are booming and diversifying their economies as they grow wealthier. As frontier markets now covered by some public funds, they deserve watching and possible minor allocation.

Russia has risen from ashes in recent years due to its great oil wealth, but as we have pointed out in prior articles, is also an increasingly dangerous place for capital.

China and India simply seem to have been overdone and are giving some back now.

Richard Shaw
QVM Group LLC

We recommend selling any remaining positions of Russian funds and companies, even though the Russian market is already down considerably this year.

The Russian market could recover handsomely and make huge profits for those who buy in now, but it may also have significantly farther down to go.

The risk we refer to is not a fundamental risk of Russian national and corporate growth and profitability. In fact, we think the major Russian companies will continue to grow rapidly.

Our concern is that Russia has made a U-turn in its posture toward private capital and toward the West in general, and the United States in particular. That U-turn could be the harbinger of adverse political or even military events that could smash the value of Russian securities held by US and other non-Russian investors.

Whether by investors dumping and running from Russia in the event of conflict, or by Russia expropriating and nationalizing foreign assets, we see material event risk in Russia.

There are other exciting markets that do not pose the geopolitical risk that Russia poses. Investors would be better served by seeking opportunity in those places.

In June of 2007, we wrote about Russian expropriation of western oil company assets on trumped up charges. We wrote about naval tensions between Canada and Russia in July of 2007, when Russia claimed territorial and oil rights to the seabed under traditional Canadian artic waters. And in July 2007, we wrote about country corruption rankings in which Russia was ranked as more corrupt than all the other countries for which there are country funds available to US investors, except for Indonesia.

Russia first threatened and has now announced an arms race with the United States. Russia has threatened Europe with interruption of gas supplies in the middle of winter. The anti-west and anti-US rhetoric in the Russian media is strong and growing. This week Russia said that European and US recognition of Kosovo after its pending secession would create an “international emergency”.

Russian bombers recently buzzed a US aircraft carriers and were confronted by US fighter jets.

The recent declaration of independence by Kosovo has created a volatile and potentially explosive situation which could pit Russia as an ally of Serbia against NATO, who support KOSOVO, in a direct or proxy land war in the Balkans (the same place that ignited WWI).

CNN February 23 reported, “Russia — which has not recognized Kosovo’s sovereignty — said it has not ruled out using force to resolve the dispute over the territory if NATO forces breach the terms of their U.N. mandate.”  This is not a comforting investment development.

Do you want to be invested in a country in such a potentially hostile situation between Western Europe and the United States?  Do you think the Russian stock market would fare well in a conflict situation?  Do you have confidence that Russia would respect your property rights in their companies in the event of conflict? 

Do think Russia would treat your equity ownership rights better in time of conflict than the shabby way it treated the ownership interests of international oil companies in better recent geopolitical times?

These are not the signs of a fertile investment environment and indicate the potential for so much hostility that Russian markets could turn into a boneyard instead of a playground for investors.

Independent of any judgment about who is right and wrong about this or that matter, we are judging the prudence of US investors holding assets in a country that is in expanding geopolitical conflict with the US, and which is posturing about possible military conflict.

Minimizing risks and losses is an important part of managing investments. If you are a speculator and feel you have knowledge and agility, invest in Russia as you please. Otherwise, we think there are better places to seek high return with less risk.

If you ignore the brewing geopolitics, Russia doesn’t look so bad by some measures. For example, looking at BRIC through the RiskGrades.com site, we see these short-term risk (basically volatility) ratings relative to a global stocks basket:

• Brazil (EWZ) 219
• Russia (RSX) 93
• India (IFN) 271
• China (FXI) 303

For comparison, here are the risk grades for the US, developed non-US markets, and combined emerging markets (including Russia):

• US (SPY) 104
• Developed Non-US (EFA) 127
• Emerging (EEM) 185

From this perspective, Russia has been less risky than its fellow BRIC members (Brazil, India and China).

From a geopolitical perspective, however, Russia is in a completely different situation. Neither Brazil, India nor China are rattling sabers about an arms race (we don’t think the Taiwan issue is a hot one at this time). The direct commercial relationships between Brazil, India, China and the US create more interdependency than those between Russia and the US. Brazil, India and China are not expropriating foreign direct investment assets. They are not talking about international emergencies in the context of tensions with Europe and the US.

We could, of course, be wrong like the boy who said the sky is falling, but we would rather be safe than sorry.

The mortgage crisis gave adequate warnings before all Hell broke loose, but the markets did a “hear no evil, see no evil, say no evil” routine up to the bloody end. We think tensions like those surfacing between Russia and the democracies of the West may be the canary in the coal mine. Better to seek return elsewhere.

Charts below show 2008 YTD performance of two Russia funds (RSX and TRF) versus other countries.

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Richard Shaw
QVM Group LLC

We are frequently asked about emerging markets — are they a good opportunity? — are they a dangerous investment? — how much should be allocated to them?

YES, they are a good opportunity, based on past long-term gains and expected future growth.

YES, they are a potentially dangerous investment, depending on how you define danger; particularly if you get queezy with high volatility and the potential for a long and steep drawdown.

How much you should allocate to them is not possible to say without an individual analysis. What other classes do you have? How much do you have in each other class? What is your volatility tolerance? How long can you wait to recover from a potential period of decline? Can you sleep at night if things go badly for a while? What is your age, income and liquid net worth? What are your financial needs and obligations? ……

The Opportunity and Risk:

The best place to begin is at the beginning which we arbitrarily define as 1987 for practical purposes.

We would be remiss, however, not to note that the real beginning for emerging market stocks was actually 1602 with the formation of the Dutch East Indian Company (Holland) where the first stock market was created in 1606. Not long after in the early 1700’s, the Mississippi Company (France) and the South Sea Company (England) were sold to investors, also historic emerging market investments that made and lost investor fortunes.

Some important observations come out of that ancient history of emerging market stocks. First, they tend to create great interest and huge gains. Second, they can produce excess enthusiasm with subsequent periods of great losses. Third, some emerging markets make it beyond that stage to become developed markets — what is now the United States was once an emerging market, for example.

Emerging markets and public investors have been an investment phenomenon for about 400 years and are still a phenomenon today.

We define 1987 as the beginning here, because that is where our MSCI Barra data ends, and it’s also generally within the modern world economic timeframe.

The Last 20 Years:

The emerging markets from 1987 through 2007 handily outperformed the world markets, world market excluding the US and the US markets, as the chart below shows.

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• Emerging markets proxies: EEM and VWO
• US market proxies: VTI and IWV
• World excluding US market proxy: VEU

$1 invested in emerging markets on December 31, 1987 would have been worth $10.89 as of December 31, 2007. The same $1 would have grown to $5.69 invested in the US market, and only to $3.01 if invested in the entire world excluding the US.

Major Drawdown:

However, as the chart also shows, there was a long and deep drawdown from May 1996 through August 1998 (28 months) that reduced the value of emerging market stocks by 52.2%. That was probably enough to drive most emerging market investors to sell at a loss, before the emerging markets resumed their decline — and they probably didn’t get back in early for the subsequent rise if at all.

The US market has not been immune to major drawdowns in recent times either. There was a major draw down in the past 20 years, for example. Between March 2000 and September 2002 (30 months), the total US market declined 48%.

Two Emerging Markets Rising Periods on Each Side of Drawdown:

The first leg up brought a $1 investment at the end of 1987 to about $5 over 101 months. The second leg up after the gut wrenching drawdown brought a new $1 investment in September of 1998 to about $4.50 over 113 months.

It has been a long roller coaster ride that has paid off well. For those too new to investing to remember time before 1998, it seems like on long ride up and up and up, until 2008 when emerging markets are down about 8% - 9% YTD as of mid-February.

The Abyss Between Point A and Point B:

It’s not just the long drawdown from 1996 through 1998 that most investors must worry about. People can look a monthly historical charts such as the one above and make various assumptions about their ability to withstand the heat or to know when to get in and out — but could they really?

Life is full of wonderful ultimate opportunities, that present a deep crevasse between where you are and where you want to be. That may be true of exploring the Antarctic or funding a project with huge potential but early choking negative cash flows. Emerging markets pose a similar problem — very high volatility and potentially sleepless nights before taking the final gain.

Consider the chart of monthly volatility for the emerging markets and the US market.

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For emerging markets, 36 of the 240 months (about 1 in 6) experienced a 10% or greater swing in value. Of those, 16 (1 in 15; nearly every year on average) were to the downside. If your investment went down 10% in a single month every year of so, could you hold on?

For the US market, 3 of the 240 months (about 1+ in 100) experienced a 10% or greater swing in value. Of those, 2 (about 1 in 100; once each 8 years on average) were to the downside.

* * *

We like the emerging markets, but in moderation and as a well considered part of a larger asset allocation plan fit to your specific investor profile.

Richard Shaw
QVM Group LLC

Year-to-date, the recently popular frontier markets have outperformed the world markets as a whole, the emerging markets in the aggregate, and the markets of Europe, Japan and the US.

See our prior article identifying frontier market countries.

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