Adventures Abroad Could Hurt U.S. Companies

Carson C. Block is the director of research for Muddy Waters, an investment firm.

Analysts across Wall Street are just beginning to warn investors about trouble brewing in emerging markets. The International Monetary Fund this month downgraded its global growth forecast for the rest of 2013 and next year, citing a big slowdown in emerging market economies because of higher interest rates, asset price volatility, weaker domestic activity and currency depreciation.

We have been outspoken about the risks in emerging markets for some time, most recently reflecting on Standard Chartered's large exposure to China, India and Southeast Asia, and the fact that credit-default swap pricing on the company was implying that lending to Standard Chartered was less risky than lending to JPMorgan Chase. While that imbalance has now corrected itself, we continue to see instability in Brazil, Egypt, Turkey and South Africa, and severe corrections in Latin American and Indian currencies.

Despite all the instability, it is astounding how little risk the markets are currently pricing into public companies that have poured shareholder money into emerging markets over the last several years through acquisitions and start-up projects. Artificially low interest rates in the United States have driven many management teams to make investments abroad based on higher expected returns without incorporating the local risks. In many cases, local divisions tend to be run on the ground and are subject to all the same local risks, including inflation, fraud, nationalization, political whims of the local governments (which often emerge as “taxes”) and legal issues.

These are countries that tend not to be the transparent democratic and capitalist systems that Western investors are used to.

We believe both the companies themselves and the analysts covering them have made overzealous assumptions about the safety and the expected earnings growth for these acquisitions. In the United States, too many analysts price growth at high multiples without thinking about where that growth is coming from. Many companies have made acquisitions that we think will ultimately generate returns lower than those of local market bond yields. In these situations, management would have actually created more value for shareholders by just buying local currency government bonds. What is more, many of these acquisitions were purchased by issuing debt in United States dollars and failing to hedge the currency exposure of the emerging market country â€" essentially doubling down on their bet.

Indeed, you do not have to look far to find American companies that underestimated the risks of investing in emerging markets. Caterpillar discovered this firsthand earlier this year when it found “deliberate, multiyear, coordinated accounting misconduct” at a Chinese company it had recently acquired. The company was forced to write-down its entire $500 million investment.

How did that happen, especially when the fraud could have been discovered by simply looking at the records the subsidiary filed with the Chinese government? A former Caterpillar board member told Reuters that the board was “distracted” at the time by a larger acquisition.

There are plenty of other examples. Wal-Mart Stores has faced bribery accusations in Mexico. Vodafone is fighting an egregious tax bill in India. Brookfield Asset Management was recently shown to have badly miscalculated the risks of investing in Brazil.

Calculating the risks of making an acquisition in an emerging market is often more art than science. Still, many American companies seem to plug overzealous growth assumptions into their models, and then assume a dangerously low weighted-average cost of capital that does not reflect the myriad emerging market risks, which not only put their growth projections at risk, but also can lead to total loss. We suspect such model antics will become more apparent and dangerous as the air continues to come out of emerging markets. Investors would be wise to understand the true exposure they have to emerging markets through their investments in American companies before it's too late.

As Warren E. Buffett has famously said: “Only when the tide goes out do you discover who's been swimming naked.”