New Threat for Emerging Markets Investors

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  • Posted on April 15, 2011


    By JAMES B. STEWART Getty Images

    Brazil mining giant Vale boasts a record that most chief executives can only dream of: year-over-year revenue growth of 127%; earnings growth of 269.5%; a return on assets of 13% and an operating profit margin of nearly 50%. Shareholders should be thrilled: The stock price has tripled since the depths of the financial crisis. So what has been Vale chief executive Roger Agnelli’s reward?

    He was basically fired. After years of intrigue, Vale announced this month that Agnelli will be replaced by Murilo Ferreira, a former Vale executive.

    For Vale shareholders — and that includes just about everybody who owns an emerging-market mutual fund or exchange-traded fund — this may only be a shot across the bow. No one has suggested Agnelli was removed for incompetence. On the contrary, his very success appears to have made Vale an even more tempting target for political interference.

    Vale is the second largest metals and mining company in the world (after Australia’s BHP Billiton) and the largest producer of iron ore. With a market capitalization of nearly $170 billion, it’s also one of the 30 largest publicly traded companies. Vale is currently the fifth largest holding in the $38.2 billion iShares MSCI Emerging Markets Index fund and the second largest (after Petrobras) in the $13.2 billion iShares MSCI Brazil Index fund.

    Despite his famous Italian name, Agnelli is no relation to the Fiat family. He’s a native of Sao Paulo who grew up in modest circumstances before joining Bradesco, one of Brazil’s largest private banks, in 1981. He was named Vale’s chief executive in 2001. Since then the dashing, youthful-looking executive has shown a shrewd eye for international acquisitions, including Canada’s Inco in 2006, and has steered Vale through a global boom in commodities fueled by Chinese demand. Vale stock has increased more than 10-fold during Agnelli’s tenure. Shares currently trade at $32.

    Vale, in its investor fact sheet, states emphatically that its “main goal is to maximize shareholder value” and stresses the company’s “competitive advantages,” which include “long life and low cost assets” in minerals and mining and “discipline in capital allocation.”

    Vale also has an ownership structure unusual among public companies, though not among former government-owned companies in developing countries. According to Vale, 53.3% of its common shares are owned by Valepar, a holding company, and 6.8% are owned directly by the Brazilian government. Brazil’s national development bank owns a stake in Valepar, as do various Brazilian pension funds, and it is widely perceived as heavily influenced, if not controlled, by the Brazilian government. Though the government denies interfering in Vale’s affairs, it has been widely reported that Brazilian president Dilma Rousseff and her top ministers orchestrated Agnelli’s ouster.

    One of many points of contention between Agnelli and Rousseff appears to be the government’s interest in boosting employment and investment in Brazil by having Vale expand from its historic roots in mining into labor-intensive steel making. Does this make any sense? ArcelorMittal, the world’s largest steel producer by far, has a profit margin of just 3.7% and return on assets of 2.7%. And ArcelorMittal enjoys massive economies of scale and globally diversified operations. What competitive advantages in steel making does Vale offer?

    So much for maximizing shareholder interests and discipline in capital allocation. Agnelli was right to stand firm, and should depart with his head held high.

    What does this mean for investors? If I was a Vale shareholder, I’d sell now. There are ways to invest in the commodities boom, starting with Vale rivals BHP (whose shares I own and have recommended) and Rio Tinto, which is based in the U.K. and Australia, two countries that inspire far more shareholder confidence.

    Government interference, especially to advance social and political goals that have nothing to do with shareholder interests, seems paradoxical when the government is one of the largest shareholders. Yet the pattern seems all too common in many, if not most, countries. This is a pervasive risk in emerging markets with high level of government ownership in publicly traded companies. It’s one reason why price/earnings ratios in emerging markets are and should be lower than in the United States.

    I don’t see any reason to cut exposure to emerging market funds simply because of one incident in Brazil, but such funds have done very well since the financial crisis and it might be time for some prudent rebalancing. Now that a global economic recovery is well underway, investors should be alert: Agnelli’s ouster may not turn out to be an isolated instance of government meddling, in which case investors’ romance with Brazil and other emerging markets will quickly fade.

    The Wall Street Journal/AC



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