by Clay Brethour, CFA and Dave Carlsen, CFA
“Spread your risk, maximize your opportunities.” It’s the most basic investment strategy there is, and it’s the principle that drives the entire mutual fund industry. Savvy investors diversify in a number of ways, dividing their investments among industries and sectors; among small caps, mid caps and large caps; and among various families of funds.
But if your portfolio is relying solely on the U.S. economy for growth, you may be missing the most important diversification opportunity of all.
Today’s financial/investment market is clearly a global market, driven by a global economy. As the current downturn makes clear, different nations’ economies react in different ways to global economic forces. A portfolio with international exposure may potentially provide a broad combination of diversification, safety and opportunity.
Growth opportunities are harder to come by these days, and no one knows that better than dentists. Having started their careers later in life than a traditional four-year business major, and often with significant educational loan debt to pay off, the prospect of saving sufficient retirement funds may seem daunting to dental practitioners. Taking advantage of the growth in emerging markets may be one way to make up for lost time.
One aspect of investing in emerging markets dentists may find particularly interesting: dental care is one of the first lifestyle upgrades adopted by newcomers to the middle class. Perhaps not so coincidentally, so do habits that require better dental care, such as consumption of sugary soft drinks and fast food.
From toothbrushes and toothpaste to Coca-Cola and KFC, the companies that are satisfying that growing demand are often those producing familiar American brands.
Why is that important?
Domestic investments can count on a certain level of political and social stability. The same holds true for the economies of the European Union and Japan. In some parts of the world, however, you never know when the rule of law might be suspended, an industry nationalized, or a revolution launched. Let’s face it: international investments can be scary things.
How, then, does one take advantage of the global opportunity?
One way is to focus on U.S.-based companies that derive a substantial percentage of their revenues from global operations — U.S. companies that are focused on penetrating foreign markets with their established brands. They present investment opportunities that offer a reasonable degree of safety and stability while offering the opportunity to potentially benefit from the growing economies of developing nations.
Why global markets?
We believe that growth opportunities will continue to be more abundant outside the U.S. over the next several years as developing and emerging countries continue to shape their economies. This process typically occurs in three stages.
First, triggered by pro-growth government policies and investments, a country needs to develop the infrastructure that would support external trade: a reliable power grid, transportation (roads, airports), telecommunications, reliable access to water and other natural resources. As factories move in, they need access to technology, business services and trained management.
During the second stage, as jobs are created, we usually see a migration of the rural populations to industrial or urban areas. This increases demand for housing, household and personal items, food, and other basic necessities.
Soon after comes the third stage: the emergence of the middle class, and accompanying discretionary spending on health care, financial services, and higher education.
We have watched regions of the world grow from “third world” status into economies capable of offering state of the art dental and medical care. Thanks to the global telecommunications grid, people in these regions know what first-world medical standards are, and they have become medical consumers with expectations at the level of U.S. patients.
That growth in demand is expressed across a wide spectrum of health care products, as citizens earn additional disposable income to spend on preventive and healthcare needs. These range from nutritional products (particularly infant) to dental work to treatments for chronic illnesses. That drove our investment in DENTSPLY (X-ray), for example, a company that provides basic dental supplies and consumables to dentists throughout the world. In improving healthcare environments, teeth often get addressed first.
With a prospering economy and more discretionary income comes demand for more medical treatment options. Varian Medical Systems, Inc. (VAR), another of our holdings, provides radiation therapy. Cancer is a global disease, and citizens of developing countries are demanding better treatment.
As a country develops, we consistently see higher incidences of preventive medicine and improving hygiene. Johnson & Johnson (JNJ), for example, provides the quality assurance of being a leading U.S. manufacturer, and is trusted for products ranging from dental floss to vaccinations.
As more countries move toward consumer-driven economies, medical product providers, as well as the providers of all consumer-driven products and services, should benefit. The best-run U.S. companies are moving quickly to exploit this opportunity with their established American brands — brands that are familiar and carry built-in demand, again thanks to the global platform provided by cell phones, cheap laptops and the Internet.
The growth of the global middle class has been explosive up until the recent downturn, and while it has slowed somewhat, its long-term prospects remain extremely strong. (The Brookings Institution forecasts that while total world population will grow 15 percent between 2008 and 2020, the global middle class will increase by 67 percent over the same time period.)
Serving multiple growth markets across the globe
We believe the best opportunities among these U.S.-based companies are those that are seeking to serve multiple growth markets spread across the globe, because different countries are at different stages of development at any given time. That way, upheaval in one region is generally buffered by sustained growth in others.
The U.S. is the most capitalistic society in the world, and capitalism has driven research and development, making U.S.-based companies the leading innovators of new technology and products. That is what drives demand for established U.S.-based brands in emerging markets.
What makes these companies particularly attractive is that they offer established brands that are instantly recognizable to millions who are adopting middle-class lifestyles for the first time. A generation ago, much of the consumer demand by an emerging middle class would be met by indigenous start-ups. Today, thanks to the global proliferation of communications technology, emerging middle-class consumers from Sao Paulo to Shanghai want the brands they recognize from their laptop and cell phone screens: American soft drinks and fast food, American personal care products such as toothbrushes and toothpaste, and American health care brands such as pharmaceuticals, for example. Local employment is far more likely to be generated by a branch of a multinational – a Coca-Cola (KO) bottling plant or a regional headquarters for KFC (YUM) – than an independent, homegrown start-up.
In the vast majority of cases, these companies will be recognizable, large cap names. To judge how successful a strategy this is, just measure the performance of a typical domestic large-cap fund or benchmark against the handful of boutique funds that follow the strategy of investing in companies that stand to benefit from international expansion and emerging markets growth.
Another factor to consider: many international investors jumped on the bandwagon for China’s industrial export sector while that was the short-term market darling. But today, a combination of quality-control issues and sharp reductions in overall U.S. consumer spending have hurt that sector. Meanwhile, companies serving China’s domestic market — including those producing established American brands as described above — are proving to be far more stable long-term investments.
The global recession appears to be easing, and many who have been hoarding cash are starting to look for ways to make wealth grow again. Population growth alone should generate significant growth in overall demand, with a focus on the basics such as food, clothing, shelter and health care.
Predicting the growth breakouts
The key to a successful investment strategy is to accurately predict where the growth breakouts will occur and be in position to benefit from them. While political, religious and social turmoil will continue to wrack the Middle East for the foreseeable future, other global regions are on tracks leading to a higher level of stability: China, Taiwan, Korea and Brazil are among that group.
Another key to a successful strategy is to focus on individual companies, not just sectors or countries. A company may be loaded with potential but if it doesn’t have a strong-enough balance sheet and cash flow to weather the current storm, it may not live long enough to realize that potential. That makes it far too risky for this approach.
That makes research vitally important to the long-term success of this strategy. Thorough research includes face-to-face meetings with company principals, on-site visits to their operations, in-depth analysis and forecasting. Thus, it makes sense to invest with a manager or fund that can do the work that results in a deep understanding of each company, and who can own enough holdings, in enough industries, serving various stages of development, to provide appropriate differentiation and risk dispersion.
In our opinion, American companies with global involvement remain an investment bargain, but the “buy low” window is starting to close. As a group they offer long-term growth potential and stand to bounce back in this nascent recovery. We believe these companies present a great way to spread your risk, and potentially maximize your opportunities.
Clay Brethour, CFA, and Dave Carlsen, CFA, are co-portfolio managers on the Buffalo Growth Fund, recently renamed from the USA Global Fund, which follows the strategy of investing as described in this article. Additional information on the fund can be requested at 1-800-49-BUFFALO. Both Brethour and Carlsen have more than 15 years of investment experience.
Mutual fund investing involves risk. Principal loss is possible. The Fund invests in U.S. based companies with substantial interests outside of the U.S. which may involve additional risk such as greater volatility and political, economic and/or currency risks.
As of 6/30/09, Buffalo Growth Fund had positions in the holdings mentioned in the article. The fund had 1.35% of its net asset value (NAV) invested in Coca-Cola, 2.02% of NAV in YUM Brands (KFC) 1.97% in Dentsply, 1.33% in Varian and 1.65% of NAV invested in Johnson & Johnson.
Fund holdings and sector allocations are subject to change at any time and should not be considered a recommendation to buy or sell any security.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
The Buffalo Funds are distributed by Quasar Distributors, LLC.