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.

click image to enlarge

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.

click images to enlarge

Richard Shaw
QVM Group LLC