Thursday, March 15, 2007

Investing in China

I need to start this post by noting that I wrote this several weeks ago while on a break in Munich. I didn't post it because I was looking for the slide to illustrate one of my points. In the interim, obviously, the markets have demonstrated some of the inherent risks in investing in the Chinese market, so my advice doesn't seem as precient, but they are my thoughts on the subject and the recent volatility does nothing to change them.

Investing in China

Recently, a close friend came to me and asked about investing in China. She was very excited about the opportunity, which, I have to say, I found quite surprising, since she is usually extremely risk-averse. What I came to realize from our discussion, however, is that she saw little risk in investing in China, because she viewed the macroeconomic climate so favourably. This got me thinking, first how important are macroeconomics in investing, and secondly, how favourable (from an investing point of view) are the macroeconomics of China.

Macroeconomics and Investing

The first question is one that I struggle with. Obviously, certain macroeconomic factors influence investing returns, sometimes quite substantially. For instance, tax policy impacts investing returns (high capital gains and/or income taxes on corporate or dividend income negatively influence returns, which have to be considered after-tax). Likewise, capital costs, particularly interest rates, have a significant impact on investing returns, because they affect one of the major strategic decisions that all investors and firms make: how to pay for assets (or what sort of capital structure a firm should to have). When interest rates are low, it can often make more sense to apply financial leverage, because all else being equal the assets acquired should produce cash in significant excess of the financing charges related to borrowing the money. On the other hand, in periods of high interest rates, fixed charges like interest may represent too much risk to a firm or investor, and therefore investing with equity may make sense. Of course, all else is rarely equal. What happens when cost of capital (in the form of interest rates) falls? Naturally, there are more people bidding up the prices of the assets, so while the cost of borrowing a dollar may decline, it may take many more dollars to acquire the asset then it would if one were purchasing in a period of tighter money. It is less clear to me that other macro factors that are often followed in the media, such as employment and even GDP growth, are really as significant for investing purposes. In specific cases, there may be cause for concern. For instance, if your investment is in an industry that is highly leveraged to economic growth or employment (say a temporary staffing agency), then these numbers could have major impact on your short term returns. Likewise, if you are in a business that focuses on consumer durables, the business cycle is likely to have significant impact on your investment. On the other hand, if you are investing over the long term, years or even decades, you have to expect that you will hold an investment through at least one business cycle, if not more. Thus, in purchasing an asset, you need to consider how that asset will perform over an anticipated business cycle. If you leverage to the hilt during favourable economic conditions, you may find yourself with negative cash flows (and insufficient liquidity) in a down cycle. This is why companies like home builders and auto makers tend to trade at very low multiples of earnings during the peak of the cycle, investors know that the business will also have down (potentially money-losing) years ahead, and so one must not pay too much for current earnings. These can be terrific investments, if market expectations for the businesses’ down cycles are particularly pessimistic and the worst fears do not come to pass. On the other hand, optimism can hurt you. Just ask Kirk Kerkorian about his General Motors investment. It is, however exactly this sort of optimism that has me highly concerned about investor behaviour in China. In this, I do not refer exclusively to retail investors like my friend, but even to corporate managements and other investors, who should, theoretically, have a shrewd and inside knowledge of their business and how it can make money.

The China Mystique

Before moving to a review of the macroeconomic conditions in China, I want to review some of the historical mystique around China, its products, its markets and what they suggest about the country’s prospects, particularly for Western firms. The history covers several hundred years, so it might seem a bit excessive, but another way to think about it is to consider how deeply rooted in Western culture the idea of penetrating China and its markets is.

The mystique of China dates at least to Marco Polo in the 13th Century. After meeting Kubla Khan, Polo returned to Venice in 1269, bringing with him porcelain (“China”), noodles and silks. Of course, silk had long been traded with the West across the Silk Road, and would continue to so be traded, but at tremendous cost. The products that Marco Polo brought with him were superior in every respect to those available in the West. As a result, the West spent the next five centuries fascinated with the Orient and what it could bring. For nearly two hundred years, however, very little progress was made. Crossing by land was impossible, and the Europeans (and everyone else, to be fair), lacked boats sufficiently seaworthy to make the trip by water. In the mid 1400s, King Henry the Navigator of Portugal financed the construction of far more sea-worthy boats. His advances led to farther exploration of Africa, and ultimately led (in 1498) to Europeans sailing around Africa for the first time. Portugal succeeded in setting up a series of “colonies” which were really trading posts and way stations for the boats making the trip to Asia. After 200 years of trying, Europeans still hadn’t reached the “Promised Land”, but they had made it to India, setting up a major trading post in Calcutta in 1503. The Portuguese finally made it in 1513 and by 1554 had set up a permanent trading post with China at Macau. This trading post primarily consisted of the Portuguese picking up goods in China and paying with hard currency from Spain (which was exporting it en masse from Latin America). Over time, the Dutch conquered most of Portugal’s outposts along the coast of Africa and India (the Dutch had developed even better boats), but Portugal, by its special position, held tiny Macau. (The Dutch went to Japan and formed a similar outpost at Nagasaki. They also colonized Indonesia, which is still the best thing that ever happened to the Dutch kitchen. Without curry, it would be nothing but pickled herring. But I digress).

Finally, along came the English. The English were relatively late to the colonization game, but were far more strategic. They also had another source of advantage – industrialization. Industrialization had started around 1750 in the U.K. and had rapidly come to signify not only higher productivity, but also higher quality. This is something that we often forget in modern times. Since nearly everything we purchase is manufactured, we tend to see hand-made goods as special and expensive (and therefore higher quality). While they are more expensive, the standardization that comes from using machines vastly improves the reliability of manufactured products. Thus, such goods were considered superior. The machine fabrication of metal and the precision that it allowed (think wrist-watches and other goods) meant that the English finally believed that they had the goods the Chinese would be after, and could begin some sort of barter. (The English wanted tea, of course, because it was seen as good medicine). So, in 1792 the English sent an envoy under Lord Macauley to Emperor Qi Lin. The entire voyage took over a year and can only be described as spectacularly unsuccessful. China was not interested in trading goods with the English, the Emperor explained, because it already had all of these things (which it certainly did not). The rest of the history is pretty short. The Chinese would accept only payment in silver for the tea that the English wanted. The English didn’t have enough silver to keep making purchases, so they had to find something to trade to the Chinese for which they could get the Chinese to pay in silver. This, of course, was opium. By the 1830s the Chinese were extremely concerned about the impact that the opium trade was having on the people, but at the same time, they continued to refuse to purchase goods from the West. The opium wars of 1840-41 resulted from the efforts of the Chinese to stop the importation of opium. The settlement, which was a stinging defeat for the Central Kingdom, was the continued importation of opium, and permanent ceding of the island of Hong Kong to the British Crown. The English did go on to discover that they could grow tea in other places, particularly in India, which helped ease the balance of payments, but that didn’t mean that they still didn’t want Chinese goods. Though China now knew that the West had superior technology, it was still reluctant to purchase that technology or its fruits. Thus, the opium kept coming, with later revolts. (The Boxer rebellion of 1898-99 resulted in the 99 year lease, at no cost, of the Kowloon Peninsula that now forms the main part of Hong Kong SAR).

China has continued to resist importation of foreign goods, even to this day, instead maintaining the mercantilist view that it should be self sufficient and export its products to other countries. After the disastrous efforts at self sufficiency and industrialization under the Great Leap Forward, followed by the slaughter of the educated in the Cultural Revolution, China decided to open itself to foreign capital. Thus, foreign products could be made in China, primarily for export to other countries. This meant that technical expertise, as well as capital, was imported to China, with one objective being the acquisition of the relevant skills to make the products at home, rather than import them.

The effects have been dramatic. China has lifted hundreds of millions out of abject poverty in one generation, with consistently high economic growth. Products are now produced in China, not only for export but for local consumption by a growing middle class. The institution of a one-child policy has left many more child-bearing-age women available to participate in the workforce, with the result that Chinese couples now enjoy significant periods as DINKs (Double Income No Kids) and can therefore save and consume. China’s two decades of growth at a compounded annual rate of 8% has positioned it as the third largest economy in absolute size, having now passed Japan, it is en route to surpass Germany. Of course, in relative terms, its population is still quite poor. Income inequality increases each year in China, with sea-coast dwellers making thousand of US$ per year and in land farmers subsisting on grains.

China’s Macroeconomic Situation

This brings us to our central question – is investing in China really a favourable exercise. I want to consider this from two perspectives – does it make sense to move production to China for the purposes of exporting the goods to mature markets in the West or other developing markets in Asia, and does it make sense to set up shop in China to pursue the Chinese market?

First let us consider the issue of using Chinese labor to manufacture goods. China’s labor pool can basically be divided into two groups: the vast number of unskilled laborers and the small number of skilled labor. Much has been made of the idea that China’s skilled labor pool is growing very rapidly, and will overtake the West soon. Evidence usually involves the number of people graduating from Chinese universities with degrees in Engineering, coupled with histrionics from folks like Lou Dobbs and his guests that soon the Chinese will do everything and there will be nothing left for Americans to do. This is posturing and grandstanding, and bears no resemblance to reality. In fact, Chinese engineers are of significantly lower quality than their Western counterparts. As the Economist recently noted in its special article “The War for Talent”, highly skilled workers are in significant demand. Secondly, unlike what the histrionics would suggest, relatively few companies are off-shoring jobs to East Asia. It is often assumed that manufacturing jobs that are lost in the West are lost to low-cost countries (thus the 2.2 million manufacturing jobs that have disappeared in the US since 1999 are assumed to have been moved to other countries). In fact, most of these jobs are lost to the same source that has undermined manufacturing employment since the 1960s – capital and automation. Robotics and other high tech tools mean that workers often find specific jobs on the line can be done without them. The remaining workers benefit from the higher productivity (which often lowers costs and prices, increasing unit sales and demand for the other jobs, at least until the increased volume justifies more capital and automation). Thus, what has really punished these workers is the cheap money produced by central banks in response to the various market shocks between 1999 and 2002. That capital made financing the assets needed to replace labor costs much cheaper, so the jobs were eliminated altogether, not moved.

Other research supports these findings – by 2011 as many as 2.2 million service jobs may have been off-shored to Asia, but this includes jobs sent to India. Compare that to the 4.7 million people who started jobs in the service sector with new employers in the month of March 2005 alone. The US economy creates as many jobs in a month as are off-shored in a year. Were off-shoring the no-brainer that the talking heads on TV suggest, there would be far more work being off-shored today. Coordinating off-shored work, particularly when it is central to a core business process is extremely risky and difficult, which is why it is so rarely done. In most cases, the labor is not there to do the work and ensuring quality control over the final result is exceptionally difficult. Few firms want to put their reputations at such risk. (Just to give a real life example, there is this from the Economist - when Robert Mugabe, President of Zimbabwe, formerly Rhodesia, was looking for his usual Boeing, he found that it was unavailable and was offered a Chinese made plane instead. He declined to make the trip because of concerns about the reliability and safety of the Chinese-made plane!)

But the China bulls, suggest, eventually that labor will catch up to Western standards. Here, they have a point, but in what time frame? China is actually up against something of a ticking clock. Because of the one-child policy and deep-seeded Chinese ethnocentrism, the population of China is fast reaching a peak. Now, many people, particularly those raised in the 1970s in the wake of Paul Ehrlich and “The Population Bomb,” which theorized that the Earth was reaching its “load factor” of people and that humanity would end in a Malthusian famine, may believe that this is a good thing. It may be. (Interesting, though, that children, who represented future production were the villains in the argument, while retirees, who represent nothing but consumption were vindicated. Perhaps the solution isn’t abortion but rather ice flows, but again, I digress). However, its impact on China’s future workforce is dramatic. It is estimated that the working population will peak around 2020, which is not that far away and is likely to be well before large numbers of highly educated workers can be trained in significant numbers. If it is anticipated that the shrinking workforce will be able to make all the goods that are projected, well, then we have to assume further productivity gains as outsized as those we have seen in the past. This is unlikely. As it approaches full industrialization, the country is likely to see productivity gains more in line with those in the west 1-2 percent per year, rather than the 3-4 percent it has been experiencing. In fact, what very well could happen is a labor shortage, even among the unskilled, such has occurred in the West. China might off-shore that work to Africa (in a sign that it sees this as an important labor market, it has become the largest source of Foreign Direct Investment, or FDI in Western Africa). This is not to say that businesses won’t make those decisions, but it is to say that profitable investments in Chinese production may be very hard to come by.

I will make one final note on prospects for profitable off-shoring to China. Growth in FDI in China is in the range of 25% per year. Fixed investment in China is growing at a similar rate, but economic growth is only growing at 8% per year. This suggests that the returns that those assets are generating are increasingly negative, or at best only marginally positive, since, if all assets were producing roughly the same return, an increase in fixed assets would produce a linear correlation in income growth. This trend is further exacerbated by issues with the security of China’s banks. China’s banks are not banks in the Western sense, with capital requirements and risk controls. Rather they resemble Japan’s banks in the 1980s, only with more political influence. Projects that have no hope of producing a financial return, but which help the local politicians in the hinterland bring jobs and pork to the rural poor, are often funded. It is estimated that the bad loans in China exceed $900 billion, though, in the absence of real credit assessment, it is difficult to tell for sure. This figure, were it accurate, would suggest that China would have to use all of its foreign reserves to recapitalize the banks. Essentially, what would happen is that the bad loans would be written off. This would represent a major charge to the banks equity, technically making them insolvent. The government, which owns and controls the banks, would then hand the banks new capital, in the form of the foreign reserves that the Bank of China holds, and tell them to get back to the business of lending. The problem is that in a Communist country the usual measure of success is production and not return on capital. In the absence of better risk management and credit scoring by the banks, the problem is likely to reoccur. If such controls were put in place, however, many projects that are contributing to GDP growth, and keeping unemployment in check, would cease. Obviously, the consequences would be catastrophic. They might even undermine the regime, leading to outright chaos or civil war. In such an environment there would be physical as well as political risk to any assets located in the country. On the other hand, an economy cannot just burn capital forever, particularly as the need for capital grows. Just ask the dotcommers about their burn rates and what happens when the capital markets stop supplying “free” money.

Which brings us, at last, to the question of whether or not one should invest in China in order to reach the local market? Clearly, the only way to reach the local market is through domestic production. The amount of production tends to outstrip local demand, however. This is ok, if exporting is a possibility (indeed it is probable), but it also means that price pressures can be very high. Do not forget that the population may begin to shrink. Even with higher output per worker, a declining population tends to lead to a declining demand for goods. In addition, the economic growth that is lifting the Chinese out of poverty may really turn out to have been a massive capital burning orgy (in many cases at least), which means that the local market may not develop as rapidly as people project. If we look at the chart of comparative growth rates, China, were it able to keep up its pace, would pass the US by 2038. But what if that does not happen? What if, instead, China went through a period of slow growth from a slower growing population, or from a banking crisis? What happened if the resulting disruption led to a Japan-like lost decade, with a short term decline in GDP growth of 8 or 10 percent? Such changes are common in developing countries. Would China, with its refusal to purchase anything without first making major commitments to investing there, still seem like a great idea? Clearly it would not.

That would be the time that I would think about buying in China.

New Blogger

So I have finally upgraded to the new blogger. This means that I can add labels to all of my posts which should make it much easier for you to search them. I now need to go back and relabel all of the existing posts as soon as I have time.

TRLG Update

I have always read that you should forget about stocks after you sell them. It is true that after you sell, you need to let a stock go (selling, I find is the hard part and the place where I am likely to get emotional, particularly if I have picked a winner. It can be like letting go of a good friend).
But occassionally, I cannot resist "checking in" to see if I made the right call. If you don't, how can you judge your analysis.

A while back, I decided to unload my TRLG stock. Generally, I had been impressed with the company's cash flows and balance sheet. But in 2006 they started changing their strategy. Their traditional strengths are brand and product development. The contracted all of the product production and eliminated all of the major capital investments that hamstring other manufacturers. Production involves large upfront capital costs. By comparison, unit costs are relatively small. This phenomenon, called operating leverage, tends to encourage producers to cut prices in order to amortize fixed costs over as large a production run as possible. As a premium manufacturer, TRLG needs to avoid those decisions. By ensuring that production is outsourced, the company has higher variable costs, but no operating leverage the company can hold prices high. If there is less demand, they simply order less product. (Operating leverage is different from financial leverage, which involves using debt instead of equity financing. It tends to have a similar effect, on business decisions, however. Debt payments mean that there are high fixed charges. The difference is that operating leverage involves depreciation whereas financial leverage involves actual cash payments).

So I was somewhat disappointed when I saw the company turn to retail operations to improve sales. As I mentioned in an earlier post, retail operations are difficult to manage profitably. Unlike the contract manufacturing business, retail has high fixed costs, including salaries, rent, electric and the like. Retail is a high operational leverage business. This is why stores tend to run clearance sales. Worse yet, the company has no specific competence or advantage in running retail outlets. That is not their core strength, which is marketing, branding and design. The worst negative side effect will be the impact on distributors and other retailers who must now seriously question the company's commitment to their success.

My concern was that the company feared lower revenue growth and had decided that the best way to achieve it was to open retail stores to capture the downstream revenue. I began to be concerned that revenue growth would not hold up. My fears appear to be validated.

Using a DCF model I developed, I valued the company at around $22.60 a share. At the time, the stock was trading at $22 so I put in a limit order at $22.60 which was filled that day (the day's high was $22.61). The stock subsequently rose to $24.61, so I missed out on several hundred dollars in further appreciation. Oh well, Nathan Mayer Rothschild, who founded the London branch of the eponymous bank, said that he always sold too soon.

TRLG released its earnings today and the numbers were less stellar than even my projections. Revenue increased only 35% and not the near 50% I projected. Worse, operating margins were even lower, so earnings for the year were only $24.4 million, not the $27.6 million I expected. Plugging these numbers in dropped the share price to just over $20. It gets worse, however, as I also assumed that these new lower operating margins are permanent. When I change the operating margin, the stock drops to $18. Then there is the revised growth rate. If the company is only growing earnings at 35% per year, and this includes downstream retail capture, I have to assume that volume growth is tailing off and therefore, I have to revised my future growth projections as well.

Taking all of this into account, it seems likely that a fair value of the stock is between $16 and $17.50, which is where it is trading today.

Fortunately, I got out at the right time

Tuesday, March 13, 2007

More Market Turmoil

The news coming out of the financial markets is bad, to say the least. While the economy continues to move along, creating jobs, but the four week moving average of intial jobless claims have climbed significantly to near 340,000, US GDP was revised lower and there is talk of recession from the likes of Alan Greenspan.

The big challenge now is the credit markets, which are starting to shape up pretty much the way the bears have suggested. As long-time readers know, I have been bearish, on pretty much everything, for some time. I have been bearish on commodities, on equities and especially on housing. Not that I am patting myself on the back, but a good friend and fellow investor (he, unlike me, has substantial real estate holdings) and I predicted in 2004 that 2007 would be a disasterous year in real estate. Our reasoning at the time was that the $1 trillion in ARMs due to reset in 2007 would lead to extremely high delinquencies. What I didn't expect was the degree to which credit standards would be relaxed. Morgtage "lenders" are now little more than brokers - they take the application, they make the loan, they collect the origination and application fees and then resell the mortgage as quickly as possible. In the last few years this has obviously been extremely profitable. However, as we approached the late stages of the bull market in housing, the need for fees meant that more and more low- and no-doc loans (affectionally called "liar loans" in the industry) were produced.

The banks who purchase and securitize the mortgage portfolios are not dummies. They knew this as well. As a result, they insisted on having more credit protection if things turned sour. "Lenders" like New Century Financial ("NEW") guaranteed the loans, and now the banks want their money back. Since NEW and others make their money from making loans, not from collecting interest, being forced to repurchase billions in loan portfolios means that the liquidity with which the companies make loans, dries up. Follow the yellow brick bankruptcy road: Repurchase means no liquidity, no liquidity means no new loans, no new loans means no new fees, no new fees means no income, no income means no offsets for the loan portfolio losses which means drops in stockholders equity, pretty soon you are out of statuory capital and the exchange is delisting you. New Century announced yesterday that they lacked the liqudity to continue operations. At this point, if they cannot get some new guarantees from their lenders, they will have to liquidate.

While NEW was an exceptional case (take a look at their financials, in 2006, facing major credit problems of which they claim to have been unaware - saying that they had lost track of deliquencies - they paid a massive dividend. But pay attention to something else, while they were paying this massive dividend, they were also floating huge amounts of new capital stock. In essence, they had become a massive Ponzi-scheme).

The issues at NEW are not isolated. Today, the Mortgage Bankers Association announced that deliquencies had increased sharply, to nearly 5% of mortgages, and that forclosures were at a record! Sub-prime mortgage deliquencies are at 13.33%. While their announcement suggested that underlying housing is fine - watch what happens when these houses are dumped on the market. Supply will be increased while demand is falling, a double whammy that will bring median prices sharply lower. Demand will remain far below the pace of the last few years, because tighter lending is taking large numbers of potential borrowers out of the market. Had this happened in 2004, when it was obvious that housing prices were far outstripping their historical link to rents, this might have been averted, but the Fed was busy printing money to prop up the administration.

The problems get worse, unfortunately, because of things called Collateralized Debt Obligations (CDOs). These are a derivative security based on the risk in a loan porfolio. Essentially, investors are able to purchase certain parts of the risk (potential losses) in a loan portfolio, rather than the actual loans themselves. As an example, say we have $100 million in loans that are sub-prime. It is likely that we will see defaults of around 9%. We don't know which loans will default, so if we purchase a portion of the portfolio we would expect to have 9% of the loans go bad. But, with financial engineering, we can structure this portfolio so that the first 15% of losses go to someone else. We purchase not the portfolio, but the risk. Now if there are 9% losses, we still get all of our principal back. Since the models suggest that there is statistically zero chance of having defaults in excess of 15% in the portfolio, our portion is AAA rated. Voila, we have made Tier 1 capital out of a junk bond. With such assets, the bank can now leverage 9 times and relend.

The problem is, we are getting dangerously close to that 15%, and when we cross it, big banks are going to start to take losses in their high quality assets. This is going to require that they deleverage, and they may be forced to liquidate as well in order to maintain capital requirements. This will be VERY VERY ugly.

At the same time, central banks are tightening because of the inflation that they have created and they will be hard pressed to lower interest rates significantly (though they will do so to prop up the banks if necessary). The problem is, banks are about to find that they cannot lend, because no one is sufficiently credit-worthy. As house prices fall, most homeowners will be too heavily leveraged. Those that can borrow (retirees, for instance) mostly will not want to.

Keep your eyes peeled and your powder dry - there will be values cropping up in the next several months. At last.