Sunday, March 25, 2012

Emerging Markets, China and US Market Structure


Last week’s blog was about reading the tea leaves in terms of the future. This week’s crop of comments is, on balance, more favorable. Combining the old slogans of Goldman Sachs and Merrill Lynch under prior managements, I come out very long-term bullish on investing globally; recognizing there will be problems which equal opportunities. I have grouped this week’s inputs into emerging markets, China, and US market structure.

Emerging markets

These elements were published in an article by Simon Kuper in Saturday’s
Financial Times: The comments in italics are mine:

  • Life expectancy in the less developed countries has gone from 46.6 years to 67.6 years over the last fifty years. While this does mean there are more mouths to feed, it also means more workers, some requiring in-depth training. Perhaps the most important positive is that a more mature population can lead to more mature thinking about leadership.

  • A smaller % of people are living below the global poverty line, particularly in Africa, which is no longer viewed pejoratively as the “hopeless continent.” Some in the investment world are already using this recognition to raise money for investing in the continent.

  • There is an increasing number of countries being guided by the rule of law. This is not our law or our concepts of justice. Nevertheless, rulers are being constrained to act or seem to act within the limitations of local law. This is making it safer for investors, particularly if commercial disputes will be governed by agreement in arbitration conducted within the U.K.

  • Long Term Military Occupation and annexation is slowing. There is recognition that military adventures are expensive and now largely unproductive. We can conquer through consumer goods movements much easier.

  • Fertility Rates have been declining, both in the developing and developed world. This is taking some of the pressure off of societies to find food and jobs for their growing populations. These trends may be going too far in the developed world and China in the long run. The US could be following “Old Europe,” if it does not intelligently manage its immigration policies.


China is a mixture of developing, developed (the second largest) economy, a resurging leading empire, and a controlled governmental experiment. Because of the size of its needs and its dominance of vital imports, China will have an increasing input to the rest of the world. Many of the economic developments within China are based on governmental edicts; progress will be faster than in less controlled and more competitive societies. Because of the speed of development and less marketplace discipline, accidents and mistakes will occur. The central political powers recognize this as an almost certainty and have some plans to alleviate the problems on the first level, there will be quick reactions as shown below:

  • The regulators in the Mainland are discussing with Hong Kong-based financial institutions, their investing Yuan pools into China. These pools are being raised from the Hong Kong market. (The sources of this capital do not seem to matter, but in essence, it was originally sourced within the country and then transferred into the free marketplace in Hong Kong. The key point here is that at this time, China is seeking development capital.)

  • In a parallel move, in a matter of hours it was reported that Chinese authorities delivered permissions to foreign investment advisors to increase, and in some cases double, their investment within the country.

  • Another example of this opening up of the indigenous market was the approval of JP Morgan’s purchase of 19% interest in a local trust company. The majority owner is an arm of the central government.

  • China is changing much faster than the general perception, e.g., food inflation is much more a political concern in terms of the “vegetable basket” for city dwellers than the “rice bowl” for those in the country. In addition, one of the main drivers in residential construction was the increase in per capita living space, from 13 square meters in 1990 to 32 square meters in 2011. Some minor further increase, to perhaps 35 square meters is expected. (This change will not only increase spending, but will also shift but will fill up the new homes with appliances and other goods. Whirlpool* has just cut a deal with a large chain of appliance stores to get favored placement.)

*For many years I have owned shares in Whirlpool. Sales into Asia represent an estimated 4% of their total sales with most of the units are being shipped in from Brazil. This is not a recommendation to buy the stock.

The US market structure

Two very different factoids:
  • Money Supply is growing faster than GDP in the US. The lesson from history is that in time, if this trend continues, as seems probable, the rate of inflation will increase. The American Institute for Economic Research has released a report that the inflation rate could reach 15% by 2014 and that in December M2 grew year over year 10%, and the economy 2.8%. These projections seem alarmist to me, but in institutional accounts I have increased the share of TIPS. (Individuals need to be concerned that they will pay current taxes on TIPS income even though they won’t receive it for many years.)

  • The second factoid is that the Wilshire 5000 is currently only tracking 3,675 stocks. When originally constructed, this stock index was covering just about all of the US traded stocks. Over time through acquisitions, bankruptcies, and going private transactions the field of available stocks has shrunk. One could argue that that has left an adverse selection of securities as the better companies were acquired (often at substantial premiums over current price) and that controlling shareholders believed that their companies were worth more than market prices. The reduction in the number of tradable entities has not hurt, up till now, the performance of small-capitalization funds which for a number of years outperformed their larger “cousins.”** But at some point the actual adverse selection factor could retard the managers’ selection skills. (Unfortunately, we may never know, as it is expected that the “Jobs Act,” (Jumpstart our Business Startups Act) is expected to be passed by final congressional votes, and will significantly loosen the regulations on small companies. There will be good and bad, perhaps fraudulent, small companies going public under these relaxed rules. I am not concerned about individual losses created by these poorly supervised small companies, what I am concerned about is that the losses will be so large in media headlines that people will withdraw from investing in all small companies. This in turn will have, as usual with legislation, created the opposite effect. After the losses become well known availability of capital will be curtailed and thus there will be fewer new jobs created.

**A number of our accounts have positions in small-cap funds.

What are you worried about? Please let me know.

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Sunday, March 18, 2012

Misunderstanding Mutual Funds, Spain and Goldman Sachs

As an analyst for more than fifty years, I have learned that I will never have enough information to be completely secure in my investment judgments. On average, I receive over one hundred business or investment related emails daily, and in addition, I read numerous trade and general circulation publications. I must admit one of these publications is the New York Times which every now and then gets something right, and almost always has impact on some investors.

The mutual fund myth

Many people, including some who would call themselves sophisticated, knowledgeable investors have an image that the bulk of mutual fund investors are na├»ve and will buy any fund that has good performance and then jump to the next fund that has better performance. In the Sunday Business section of the New York Times, a statistical table of the fifteen largest mutual funds is published. I find this data particularly instructive, compared to the often exaggerated image of mutual fund buyers as “Ma and Pa Kettle.” First, none of the fifteen largest funds has total expense ratios over 1%, thus a large number of investors own some of the least expensive funds. In the long run, the low expenses provide a performance advantage over the average fund. What is even more instructive is the fund management families that make up the roster of the fifteen largest. Seven are managed by the American Funds group that relies on salespersons to raise assets. The next largest group is the four Vanguard funds, followed by two from Dodge & Cox and one each from Franklin Resource and Fidelity. Six of the funds have no sales charges and two have share classes that have different sales charges. I believe that at least half of the combined assets of these funds are from institutional investors and probably over half represent retirement money. For the most part, the shareholders in these funds maintain their ownership for longer than average holding periods (even though a number of these large funds have not produced “top of the charts” performance for many years). Yet, they fill the needs of their holders. In many cases they have normal redemption rates, as voluntary or involuntary retirements and health issues require funding. New sales are now probably largely sourced from various retirement plans. For some time, more dollars have been leaving than arriving in these coffers. This imbalance may be about to change.

In February, my old firm, Lipper Inc., estimated that $1 billion came into Large-Capitalization Growth funds, and another $700 million came into Multi-Cap Growth funds. (Multi-Cap is a classification for a fund that has assets in different levels of market capitalization. Often Large-Cap is the largest commitment, but not the dominant market-cap.) During February the more speculative group of investors often including hedge funds, put $6.9 billion in Sector Exchange Traded Funds (ETFs) and $5.1 billion in World Equity ETFs. If these speculators prove to be correct, I expect it will ignite the interest in Large-Cap funds.

A survey of international asset managers compared expectations for the US market in January compared to their expectations in December. In January, 62 managers expected a rise versus 53 in December. Only nine were looking for a decline.

Disclosures: Both my private financial services fund and I personally own shares in most mutual fund management company stocks, including one mentioned above. We own a large number of these management company stocks within the US, Canada and the UK as a way to understand our primary investments for clients in their underlying funds. A number of the funds in the largest funds table are owned in our client accounts. I have been annually advising one of these funds as to the appropriateness of the advisory fees since the late 1970s. I believe my multiple involvements with mutual funds and their managers make me a more informed and better analyst. The prices of mutual fund management stocks are leveraged to the market’s expectation as to their growth in assets, which normally leads to increased profit margins.

Other tea leaves

JP Morgan Private Bank has noted that the US Consumer Spending is the largest source of consumer sales in the world by region. However, the US is behind both Europe and Asia in terms of the level of gross investment, and is the only major region that is a net importer. Brazil, Japan and other countries are fighting what they see as competitive devaluations through QE or other interest rate repressions. Until the fears of induced inflation increase and the exhaustion of the excess corporate capital hoard occurs, we are not likely to see meaningfully higher interest rates. As US taxpayers, we should hope that rates remain low for the next ten years as the US is facing the largest single refinancing need of any country or region.

Sam Eisenstadt, the long-time statistical genius behind Value Line is once again expressing a precise bullish view as to the market into August, where he believes the S&P 500 will reach 1520. Market Hulbert translates this in MarketWatch to a DJIA of 14360.

Spain, and its somewhat kissing cousin California, are in deeper trouble than they appear to be on the surface. Both have more complex conditions than are initially apparent. Officially, Spanish sovereign debt is listed as $732 billion and 68.5% of GDP. However, if you add in the bank and other guaranteed debt plus the regional government debt, the total indebtedness rises to $1.1 trillion or 103 % of GDP. What makes this difficult to swallow on the part of the task masters in Germany, is that it is too similar to Ireland, where the biggest part of its debt was the Irish government’s assuming the local banks' real estate debt. The Spanish banks' commercial real estate loans are larger than similarly combined loans in Germany and the UK. (Just as we went to Asia to get a better understanding of China earlier this year, we are trying to plan a visit to Spain to get a view on the ground.)

The connection with California (which has a long tradition of Spanish investment) is that as the EU was being formed, I was urged to invest in Spain as it was ironically touted as the “New California,” providing low cost labor for Europe’s manufacturing needs. Spain would be home for a real estate explosion as the Europeans from less favorable climates would want to vacation and retire there. For awhile it worked, until the production of debts rose faster than income, similar to, you guessed it, California. To bring the parallel up to date, in the annual period ending in February 2012, California tax revenue fell 22.5% due to sharp declines in retail sales as well as use taxes and personal income taxes. A sunny climate is not sufficient to produce prosperity.

Goldman Sachs

Last week was “The Week that Was” for the firm. Too much has been written about the reactions to a disgruntled employee. Much of this verbiage is in the so-called “popular press,” as distinct from the professional or trade press. I do not want to add to the collection other than to make two points. First, many amateurs do not understand the concept of agency where an agent is working exclusively at the time for a client. On the other hand, a principal is involved on the opposite side of the trade. A couple of generations ago there were separate brokers (agents) and dealers. Over time, driven by economics, these two functions were combined in the same firm. Most of the time people, (whether they recognize it or not) deal with Goldman as a dealer not as an agent. Clearly both some clients and a small number of employees of the firm do not appreciate the distinction. The popular press does not. The second point I feel compelled to disclose is that we are no longer clearing through an affiliate of the firm, as we did not provide sufficient revenue to them, but this has no effect as to our long-term holding of Goldman Sachs.

Investment conclusion

Read as many tea leaves as you can. Look for deeper implications from factoids because they are often visible before the full picture becomes clear. As many of these thoughts are not without controversy I would like to hear from you.

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Sunday, March 11, 2012

Is the Market Afraid of Secular Change?

Are you as tired as I am of hearing that the stock market is cheap based on history? That is like saying that if I pay attention to my rear view mirror, or in some cases rear view camera, I won’t have an accident, except if I drive into something or someone ahead of me. Why are the potential buyers not jumping into these “relatively” cheap prices? Perhaps, the buyers remain un-invested because they sense that prices do not reflect enough of a discount to future values. Compared with historical precedents, future prices won’t be as high as expected. Or, perhaps they are saying to themselves that they are uncertain as to what future prices will be.

Playing the cycle

Normally after a period of economic decline or slowdown, market prices accelerate in an upward trend. The appropriate way to play this game is to invest with managers who find that current prices do not reflect current values, and in more extreme cases, there are deep value managers that believe that stocks are priced below their current acquisition values for knowledgeable strategic buyers. Often their portfolios contain ways to play industrials and/or industrial commodities and materials. These kinds of strategies have worked well since the bottom of the current major upsurge some four years ago. As an analyst of the mutual fund business as well as a portfolio manager of portfolios of funds and other financial services investments, my judgment is that the performance is good, but not good enough. Not good enough to get massive flows into these funds. I wonder why? This lack of enthusiasm has lasted long enough for me to begin to believe that there is an analytical underpinning, and not that every long term fund investor has been seduced into buying an exchange traded fund (ETF).

The long-term

Historically, managers’ of pools of capital, (their own or for other people and organizations) make current decisions with the belief that they can make quasi-permanent investments that won’t have to be changed. In other words, they hope they can see the future clearly enough to be considered sound and perhaps wise investors. They believe not only that the current price is appropriate for today’s conditions, but it is at a significant discount to future prices. Their beliefs are based on the visibility of long-term secular trends. The absence of these trends may be what is holding them back, with all of their potential equity capital.

In John Mauldin's March 5th blog (free subscription required), a very thoughtful piece by Niall Ferguson is published which outlines the advantages that Western Europe and (therefore the US) had over the rest of the world, starting about 1500, just as China was turning inward and losing its position as the most advanced and richest society. Briefly the six advantages he lists are:

  • Competition makes people and groups focused and stronger.

  • Scientific revolution with its breakthroughs in mathematics, astronomy, physics, chemistry, and biology, generated Nobel Prize winners benefitting the countries they came from.

  • The rule of law and representative government are essential requirements to keep the competitive or animalistic tendencies honest.

  • Modern Medicine gave us more productive lives.

  • The Consumer Society demanded more, better and cheaper goods. I would add safer products and services.

  • Work Ethic combines more extensive and intensive labor with higher savings rates, thus sustaining capital accumulation.

These attributes, characteristic in the last generation, are now being found elsewhere, largely in Asia. Japan, in its own way developed solutions to become, for awhile, the second largest economy and a generator of technological consumer goods, including cars that were in demand throughout the world. Looking at the above listed factors, there are two major concerns for those who are looking to jump on board the secular trends that led to American Exceptionalism. First, in almost every case we are losing or have already lost our leadership position with possible greater relative losses coming. For example, students in both Singapore and Shanghai score higher on math tests than those in the US. Koreans have a 220 day school year vs. the theoretical 180 day teaching schedule in the US.

My second concern is that the speed of advance on what were considered unassailable positions is dramatically accelerating. The following is a list of collapses largely due to internal pressure and economic, often deficit spending, problems:

  • The Roman Empire suffered losses and deterioration over a thousand years, however the real collapse occurred in one generation.

  • Though advanced in many areas, the Ming Dynasty collapsed in a short period of years. The current government is very conscious of this history.

  • The Soviet Union fell apart due to its attempt to keep military and space spending up to the levels of the US.

  • In the “Arab Spring,” three Northern African regimes fell in a matter of months.

These kinds of unexpected changes suggest investors not use long periods to develop their valuation processes. We all know that an 8% compound growth rate will create a doubling in nine years. But what if you don’t believe that you can see eight or more years into the future? Around the world, 2012 is the year of elections and other changes in government leadership. Facing all investors is the guess as to whether the next government, if it is a continuation of the present regime, will have major differences in policies than ones present today. Under these circumstances one can understand that investors are reducing the length of future discount periods. Even if one thought that earnings, net cash flows, or dividends would rise 20% in the next twelve months, it would produce a lower return than the doubling over nine years. On that basis, a lower than historically normal price/earnings ratio seems warranted. This calculation explains the lower valuation that is present in today’s market and thus for the non-buyers, the market is not cheap!

Are there positive secular changes?

For something to be a secular change that can be relied on, it will have to be long lasting, easy to recognize and cause tectonic shifts in the global economy. Allow me to suggest three major changes that can be described under three classifications: wear out, dine out, and dry out.

Wear Out

As an urban society we have become dependent upon the use of housing, transportation, power and household appliances. In the US, China and much of the English-speaking world, we built more living quarters than immediately needed. Many of these stand vacant for lots of reasons, including the fact that their construction techniques are leading to faster “wear out” phases. As we have been creating family units faster than new homes being constructed, we will see a pickup in the reduction of the overhead supply and there will be some additional houses built. This turnaround appears to be occurring ahead of a major economic turnaround because of another “wear out” set of factors. Young people want their independence and their parents want their own freedom. Both sets are wearing out their welcome. Both may contribute to the departure of the younger generation. The second set of “wear out” drivers is the physical and technological obsolescence of electrical power systems, and the need to replace cars and appliances that are too expensive to repair. While the manufacturers have long calculated scrap page rates, the need on an individual level comes as a surprise. (This week, we had to replace our refrigerator and a washer and dryer with foreign brands.) Regardless of economic conditions, these “essentials” will need to be replaced when no longer serviceable.

Eat out

Both China and India already have larger middle classes than the US. One of the characteristics of urban populations is that they can no longer gather their food from local agriculture and must rely on stores and some form of restaurant to provide their meals. (A recent Wall Street Journal article about a mining town in Russia that is having economic pressure, has two McDonald’s in it.) One impact of the change in location to cities is that people’s diets on average now use some 3420 calories per day, compared to the 2630 calories when they were living rurally. For speed and energy needs, the diet uses more meat/chicken protein. This growth is requiring China and others to import grains to feed to their animals. Only from Argentina, Australia, Russia, and the US can they get the quantity and quality what they need.

From an investment standpoint, long term portfolios may need to have farm land as an alternative. For those of us who choose a secondary approach, buying into companies or local banks that supply goods and services (including capital) to farmers, could be attractive. There is still another way to benefit from this trend, which is to get into the transaction stream of agricultural futures. My preference, which I have done, is through a provider of agricultural future funds.

Dry Out

China has approximately 20% of the world’s population, with an obvious need to feed its people. Unfortunately, it has only 6% of the world’s fresh water, which has not been well managed for years. While I do not know of any funds that specialize in water-related equipment and services stocks, there are numerous companies and parts of companies working in this area.

Investment Conclusions

I suggest that a wise investor might look at today’s lack of future visibility and thus a low valuation period, as an opportunity. Instead of being fearful of oncoming secular changes, be opportunistic and focus on one or more favorable secular trends.

Please let me know if you believe I am all wet.

Did you miss Mike Lipper’s Blog last week? Click here to read.

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Sunday, March 4, 2012

Guessing the Impact of China on Investments

I am neutral as to what China means to the world of investing. However, I am certain that changes within China will have an enormous impact on how we invest and more importantly, how successful investments will be in the long run. I once thought the term “Chinese Puzzle” referred to a children’s game. Now, I believe it refers to the number one challenge facing the world.

Since we have returned from Asia, I am much more conscious of the huge amount of information that we can receive both from China and various groups active in China. Over the last several weeks, in almost every investment (and in many cases, political) discussion I had, the impact of China comes into the conversation. There is much to learn and I am learning.


There are two critical elections occurring in China. The whole idea of elections (and even more surprising, competitive elections) is new in this controlled society. The first real popular election of any kind was the one this past weekend in Wukan, a village of some 13,000 (out of a nation of 1.3 billion), to replace a local government that was overthrown by an armed population after corrupt politicians paid too little for the ceased land that they then sold to developers. That the central government did not brutally repress the revolt is truly remarkable. The provincial leader who decided on this new course of action is himself a candidate for a seat on the nine member Politburo Standing Committee, which runs the party and the country. He is opposed by another rising provincial leader who is espousing the singing of politically correct party songs and other throwbacks to the Mao era.

These elections will say a lot as to China’s future.

Chinese commercial law

This past week I attended a seminar, “Doing Business in China: What Investors Need to Know About Dispute Resolution in China.” The program was put on by Debevoise & Plimpton, based on efforts from their Hong Kong office, and Fangda Partners, from the experiences of their three Chinese offices. The illuminating talks described the current trend to increasingly rely on internal courts as distinct from offshore jurisdictions. For me, there were two surprises. The first was that there is no penalty for lying in a civil case. Further there is no discovery demand in these cases. Second, and some might like this within the US, there are no damages assessed. Proven losses will have to be repaid. These two factors suggest that you want to resolve disputes before they get into the courts. Fangda Partners quoted “The Art of War,” by Sun Tzu, “The best victory is to defeat your enemy BEFORE the fight.” What these elements suggest to me is that new entrants into China should be counseled by “old Chinese hands” before they enter the game. On this basis, I would be cautious on counting on new entrants.

Adam Smith Plays a Role

In discussing investing with a very smart US Portfolio manager, he felt that much of the gain from using Chinese labor has already been achieved. In 1776, Adam Smith informed the world that certain countries have specific advantages. In the case of the Chinese, until recently their advantages were, at least in the coastal locations, a highly productive, hard-working labor force with low wages. As I have noted in earlier blogs, it is the policy of the Chinese government to raise wages as part of its attempts to reduce social disruptions. Combining this drive with the apparent peaking-out of the size of the work force, the low wage advantage will shrink in terms of China. In this portfolio manager’s view, that for a number of multi-nationals (both in the manufacturing and intellectual property businesses), gross margins from China are likely to decline as they have in the US for these same companies. There are two investment implications if you accept this view. First, watch what is happening to gross margins of those companies that are doing a lot of work in China for the export market. The second implication, which is already happening, is to see whether the shift of production to India, Vietnam, Thailand, Malaysia, Philippines, and perhaps selected countries in Latin America and Eastern Europe, continues. India, which is currently going through its own problems with politics and corruption, is of particular interest with the size of its young English speaking population, and the announced drive to create hundreds of new universities.

A broader thought and danger

A further investment implication of these trends is that we live in a dynamic world where the length of our visibility into the future is becoming shorter. If we have fewer years of reasonable certainty, in theory, the product of our discount methodology of future value will decline. Our investment strategies may have a shorter life span than the buildings we are creating. Under this type of thinking, overall valuations are likely to decline as measured by price/earnings ratios.

Some Chinese fortune cookies

In reading all that I can about China, I am amassing a large number of nuggets. Some of these may be tasty in the future; others may turn out to be quite sour. (I would be happy to discuss these items with any member of this blog community.)

  • There are concrete plans to construct the Pan Asian Railway with over 81,000 kilometer of track connecting China (and its products) to 17 nations; including markets in South East Asia, Central Asia and Germany. (Historically the Mongols did a similar thing.)

  • On March 9th, hard data on industrial production and fixed asset investment in 2012 will be revealed.

  • One factory in Japan produces 10% of all the 42-inch television sets in the world. Some claim that there are only 15 workers in the plant. Is this a possible future model not only for China, but for the rest of the world? (At some point will manufacturing not be human labor intensive? This, in and of itself, would materially change our economies.)

  • The February Purchasing Managers Index (PMI) in China was 51, showing some expansion.

  • Chinese home prices declined, continuing their 19 month descent. The Chinese government is playing a major role in the control of permits and the availability of credits through the banks that are owned by the government. As an outgrowth of the housing slowdown, Chinese banks are trading at record lows relative to their stated net asset value. (I suspect that this is somewhat common around the world. However, I take a different point of view; that the markets do not believe the stated book value of banks and perhaps other companies. Thus, when this period is over, we may find that some are selling at several multiplies of book value. I would rather put my analytical faith in the markets over the work product of the accountants and their corporate clients.)

  • The wave of Chinese companies entering the US and Hong Kong markets appears to be reversing, as numerous companies are going private (at prices I believe to be well below their IPO levels).

  • Bloomberg carried an item that bears researching: the net worth of the Chinese political leaders is believed to $89.8 billion, compared with the aggregate wealth of the US President, Supreme Court and Congress of $7.5 billion. There appears to be a great amount of wealth from China that wants to invest beyond its borders.

  • I am always fearful, particularly in rising markets, so any indication of rising speculation of the “animal instincts” makes me nervous. I believe from my discussions with both professional investors and other so-called sophisticated investors there is a great deal of interest in buying Exchange Traded Funds (ETFs). The nature of these people is that they are much more short-term oriented than the average mutual fund buyer. Thus, when the firm I previously owned, now known as Lipper Inc., estimated that the net purchases of equity ETFs was $7.5 billion in the week, while equity mutual funds had an outflow of $260 million, I get more nervous.

Please share your thoughts with me.
Did you miss Mike Lipper’s Blog last week? Click here to read.

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