After the New York close last Wednesday, LVS reported results for 1Q12.  Revenues came in at $2.77 billion, up 30.8% year on year.  Adjusted Earnings Before Interest Taxes and Depreciation/Amortization (EBITDA) was $1.07 billion, up 42% yoy.  Adjusted EPS were $.70.  That was a gain of 89.2% over results in the year-ago quarter.  The figure also came in $.01/share above the highest Wall Street estimate, and $.07/share ahead of the consensus.

the details

EBITDA breaks out into:

$456.4 million in Macau, up 20.6% yoy

$472.5 million in Singapore, up 66.1% yoy

$115.8 million in Las Vegas, up 77.9% yoy

$27.5 million in Bethlehem, Pa., up 24.4% yoy.

three unusual items (all in Macau)

The ” adjusted” figures exclude two of the items:

–$51.5 million in pre-opening expenses for the Sands Cotai Central which opened earlier this month, and

–a $42.9 million writeoff of costs linked to the closing of the Zaia show at the Venetian Macau.

Results did, however, include $13 million of costs associated with retailing–management declined to provide any detail.

market reaction

1928 and LVS have dropped about 5% each on the results announcement, despite the obvious strength in the numbers.  I don’t see why.

True, there are some nits to pick, namely:

–LVS is currently keeping 3¢ of every dollar high rollers are betting in Singapore and in Macau.  History says that should be more like 2.85¢, or 5% less.  at some point the company will have a sub-par quarter or two to make up for the current largesse.  But that’s the nature of the casino business.

–There is the mystery $13 million loss in Macau.  But that’s more like a rounding error than a serious dent in operating income.

–EBITDA margins fell qoq in Macau in March.

On the other hand,

–management wasn’t much more incoherent than usual on the conference call that accompanied the announcement

–US operations are much healthier than they were a year ago

–1928 appears to be gaining market share in Macau, even before the new casino opening. Revenues were up 9% qoq, in a basically flat market.

–the mysterious $13 million shortfall in Macau seems to explain all the EBITDA margin deterioration in the SAR vs. 4Q11.  If management is correct in its diagnosis, this is a non-recurring item.  In addition,

LVS is deleveraging   …fast

At December 31, 2010, LVS had $10.1 billion in debt on its balance sheet plus $710.7 million in preferred stock.  Against that, the company had $3.04 billion in unrestricted cash.

As of March 31st, 2012, LVS has accumulated an extra $1 billion in cash.  All the preferred stock has been redeemed and debt is $200 million lower.

That’s about a $2 billion shrinkage in net borrowings.  At the current level of $1 billion in cash generation from operations per quarter, LVS could be completely debt free by June 2013.  (LVS points out that it could be completely debt free today, if it wanted to be, by selling a chunk of its retail space in Macau.)

next stop Spain?

LVS confirmed that it is deep in negotiations with Madrid and Barcelona to develop a huge casino/resort complex in Spain over a decade.  No details as yet.  I wrote about the possible Spanish expansion a little over a year ago.

investment arithmetic

I think that LVS will earn about $3 a share this year.  So at Friday’s closing price, LVS is trading at 18.6x this year’s earnings and yielding 1.7%.

That’s not the right way to value the company, however, in my opinion.  I prefer sum-of-the-parts.

Based on its current market cap in Hong Kong, LVS’s share of 1928 is worth roughly $22.5 billion.  If we think the Marina Bay Sands in Singapore should trade at 80% of 1928′s EBITDA multiple, then it’s worth about $25 billion ($31 billion if MBS were to trade at parity with 1928).

LVS’s market cap (even though it’s up over 30% ytd) is $41 billion.  Therefore, LVS’s US operations are still trading at a value of negative $6.5 billion.

What should the value of Las Vegas + Bethlehem be?

There are, of course, two parts to US profits for LVS–casino operations and management fees collected from Asia.  For simplicity’s sake, lump them together.  Say they’ll generate $600 million in cash from operations this year.  Let’s cut that down to $400 million after taxes.  Now, let’s assume this business never recovers and should be evaluated as if it were a junk bond.  If we assume a that the cash represents a yield of 7.5%, then the principal value of the “bond” should be $5.3 billion.  Subtract $2 billion in debt (that may be excessive, but…) and we’re left with $3.3 billion.

Fair value for LVS, then, should be $3.3 billion + $22.5 billion + $25 billion  =  $50.8 billion, or 24% higher than where the stock is currently trading.

WYNN may be the highest quality casino company, but this analysis means for me that LVS is the most attractive casino stock (remember, I own both LVS and WYNN–more WYNN than LVS, though).

The reason I see for the recent strength in the shares of both Wynn Macau and its parent Wynn Resorts is a press report that 1128 will receive government approval this coming Monday for its proposed new casino in the Cotai section of the SAR.  The news was first published in the Portuguese-language newspaper Jornal Tribuna de Macau and subsequently in Macau Business.

According to MB, the contract signing ceremony will take place while Steve Wynn is in Macau next week, but the official announcement will not come until the contract is published in the Official Gazette in mid-May.

oops!!

Twice before during the past several months, parties associated with WYNN have, prematurely, announced that the company had received approval for the project.  These breaches of protocol appear to have offended the Macau government and resulted in further delay each time.  In the current case, it appears to me that the leak must have come from the government itself, so the article shouldn’t matter.  When questioned about it, Mr. Wynn said nothing, just that he was hopeful of approval but that the decision was up to Macau.

The Wynn Cotai project, whose design was complete over a year ago, will include hotels, casino(s), restaurants, retail and convention/meeting space.  The size of the casino floorspace isn’t clear, although we know the Macau government is eager to see new projects contain a greater percentage of area devoted to non-gambling activities than has been the case to date.  The project will probably end up costing close to US$3 billion.  Opening could be in early 2016.

The Cotai casino would be good for WYNN and 1128…

Cotai, Sheldon Adelson’s idea for recreating the Ls Vegas Strip in Asia, is becoming the hot new gaming location in Macau.  Also, it’s increasingly evident that both Wynn and Encore in Macau are closing in on the limits of their capacity.  So the new project will provide a concrete (no pun intended) path for future earnings growth–both for 1128 and, by implication, for its parent WYNN.

…and for the SAR as well

After all, Steve Wynn is the premier casino designer in the world.  And his company is a master at catering to high roller gamblers.  It would make no sense for the SAR to deprive itself of his expertise.

approval for another firm coming later this year

The government’s overall idea is to continue to expand its tourism business, but at a controlled rate.  It has announced that this means approving two new projects in 2012.

The two prominent other applicants for permission to build a new Cotai casino complex are MGM China and SJM.  If they’re the two finalists, as they probably are, this presents an interesting–and possibly revealing– decision for the SAR.  SJM, the former monopoly casino operator when Macau was a Portuguese colony, which continues to control about a third of the market, is owned by the Ho family.  Pansy Ho also continues to have significant influence over MGM China, where she has about a 20% equity interest.  Declaration of the winner may give some insight into the direction of government gambling policy.

After the close of New York trading yesterday, AAPL reported results for its second fiscal quarter (the company’s fiscal year ends in October).

It was–contrary to highly publicized negative analyst expectations–another litany of record performances.

Revenue was $39.2 billion, up 58.7% year on year.

Net income was $11.6 billion, up 93.3%.

EPS was $12.30, a 92% yoy gain.  Of 42 analyst estimates for the quarter, the lowest was $8.46, the highest $11.80, the median $9.81.  So, once again, AAPL blew away the consensus.

details

The company sold 35.1 million iPhones during the quarter, up 88%.  This compares with 46% growth in the overall smartphone market.

iPad sales were 11.8 million, a 151% yoy increase.

4 million Macs went out the door, up 7% yoy (in a PC market that was up 2%).

iPod unit volume was 7.7 million units, down by 15%.  The music player–which was once half the company–now represents only 3% of sales, however.

what caught my eye

AAPL continues to be capacity constrained with the new iPad.  The huge tablet sales gain this quarter appears to have been driven by demand–especially from schools–for iPad2, once AAPL dropped the price to $399.  I don’t see any reason to think that this new-found new source of tablet demand will go away any time soon.  And it could turn out to be very big.

Greater China was the geographical star.  Sales in the region, which made up 20% of the AAPL total for the quarter, tripled yoy.  iPhone sales were 5x the year-ago level.

Mac sales barely outpaced the market for the quarter.  But that’s comparing a newly refreshed product line a year ago with the same lineup today–now a little long in the tooth.  So I don’t think the weaker than usual comparison means anything.

Management gave its usual song and dance to “justify” its low-ball earnings estimate for the June quarter–$8.68/ share.  The company did make two reasonable points, though.  It expects to sell a lot of iPads, which carry lower margins than other AAPL products.  Also, 2+ million of the iPhones sold to telephone companies during the period went to replenish store inventories depleted during the holiday season.  This extra demand won’t be present in the current quarter.  Neither is that significant, in my opinion.  Together, they may just mean that yoy gains in 3Q12 won’t be quite as impressive as in 2Q12.

pre-announcement analyst panic

AAPL sold off by about 15% in the days before the earnings release.

I was struck by the number of analysts who rushed to publicly validate the price decline by offering negative assessments (now proven to have been wildly incorrect) of the company’s 2Q12 prospects.  One can only imagine what they were saying in private meetings with institutional clients.  I was also struck by the dearth of AAPL defenders–although it’s possible their comments were edited out.

For instance,:

–one analyst I read predicted Mac sales would be down, year on year, in the quarter–without mentioning either how difficult the comparison was or that Macs only make up a bit more than 10% of AAPL’s business.

–another said in a recent TV interview that he was lowering his forecast of iPhone sales from 33 million to 30 million–and intimated he thought that figure might still be too high.

I have four observations:

1.  I think the analysts in question extrapolated from what they knew about the US and Europe to the rest of the world.  When you think about it, that seems kind of loony.  Why would you think China, which is growing at 7%+ and where people are just starting to buy smartphones, would look like the US?

2.  More generally, the incident says something about the quality of research on Wall Street.  APPL isn’t the only case.  Analysts did the same sort of extrapolation with INTC last year.

3.  It says something admirable about AAPL that they don’t have one standard of information dissemination for ordinary people like you and me, and another one for Wall Street analysts.

4.  This shows how a rumor-driven market works.  Once a story starts, information sources rush to repeat and amplify the rumors, mostly because they’re worried that otherwise they’ll be thought to be out of touch.

AAPL’s stock?  It still looks cheap to me.

Thailand

I was just getting acquainted with Thailand when the Ms. Chamoy Thipyaso chit fund scandal broke.  “Mae” (=Mother) Chamoy, the wife of a Thai Air Force officer, appeared to be running a very large chit fund investment operation that was stringing together a sequence of startlingly high investment returns.  She had agents throughout Thailand collecting new money for her.  Money was pouring in.

The fund turned out to be a gigantic Ponzi scheme, however.

The scheme sustained itself for an unusually long time.  It continued to operate even after it had become so large (US$100 million+) it was implausible to think Mae could find enough lucrative “secret” microfinancing opportunities in Thailand.  Several reasons for this:

–people wanted to believe.

–the fund appeared to have the backing of the military, the ultimate source of political and business leadership in Thailand.  This gave an implied assurance that the investment results were real.  Prominent high-ranking Air Force officers invested with Mae, and forcefully urged their subordinates to do so as well.

–investors who thought about withdrawing some of their “profits” were pressured not to do so, with the threat that if they took money out they would be blacklisted and not allowed to invest in the fund thereafter.

Interestingly, large investors in the Chamoy fund continued to urge their friends and work subordinates to plow money into the fund even after they realized it was a Ponzi scheme.  Their rationale?   …it bought them more time.  That extra time allowed them to continue to enjoy a lifestyle they knew was going to end when the fraud was discovered.  And it allowed them to arrange their financial affairs in a way that would minimize the negative impact on them personally.  To followers of the Bernie Madoff case in the US, this must certainly sound familiar.

my thoughts

In my reading about microfinance, it seems that Ponzi schemes have been a constant problem wherever third-party chit funds–not the ones where friends and neighbors lend to one another–operate.  That means virtually everyplace in South Asia and Africa.  There seems to be an especially large amount of study done of the industry in India, which I have no practical experience with (because the stock market isn’t easily open to foreigners–and I think the political environment is particularly unfriendly toward equity investors.)

Personally, I’d worry more about Ponzi schemes in the US springing up among the firms that the JOBS Act will allow to raise equity.  These are the entities that won’t have adequate financial controls or accounting statements for shareholders.

My chief p2p banking concern is a more prosaic one–that the present very low loan loss rates will prove to be more a function of the industry’s newness rather than of the creditworthiness of borrowers.  Time will tell.  And, unlike fraud, this is a risk we can take precautions for.

Taiwan

There was a unique twist to the Taiwanese chit fund industry that I encountered in the mid-1980s.   Chit fund loans were secured by post-dated checks issued to the borrowers by the lenders.  In Taiwan at that time, “bouncing” a check–having insufficient funds in the account to cover payment–was a felony, punishable by the check writer serving time in prison.

The threat of jail time was thought to be sufficient incentive to ensure repayment.  So no one worried too much about the creditworthiness of the borrowers, which–as it turned out–included large publicly-traded companies.  American accountants I met, who’d been sent to Taiwan to break into the auditing business there, told me that they could see the fact of unaccounted-for money sloshing around in potential client companies.  They just couldn’t see how much.  Because of this, they were reluctant to take any engagements.  And they were continually undercut by local accounting firms who charged virtually nothing for “audits.”   American bank lending officers told me the same thing.

The chit fund business received a major shock, during a mild economic downturn, some large companies had made hundreds of millions of dollars in chit fund loans–all unrecorded in the financial accounts–that they couldn’t repay.  Bankruptcies resulted.

my thoughts

This is another potential problem for equity holders in firms crowdfunded under the JOBS Act.  Without audited financials, it’s impossible for an outside investor to determine what the capital structure of a company is.

I also think, à la Taiwan, a legitimate auditor will simply walk away from a suspect company rather than make a public outcry.  Non-disclosure agreements may force it to do no more.  A less fastidious auditor, one nobody ever heard of, might take the business and issue a clean opinion.  After all, Bernie Madoff got one for years, didn’t he?

I began to look at smaller Asian markets as an investor in 1985.  It was there that I encountered the informal self-help savings and lending associations that are typical in developing economies.  My introduction came through chit funds in Thailand and Taiwan, but these structures exist throughout the developing world.

what they are

the simplest

In their simplest form, the associations are groups of friends of neighbors who contribute a specified amount of money to a pool on a regular basis.  The funds pooled each time the group meet are lent to a single participant, determined either by the implied interest rate bid or on a rotating basis.

more complex

At a higher level of organization, groups come to a designated place at a specific time–like by having a meal at a certain restaurant on Saturday–and offer to third parties the money they’re willing to lend.  They may signal their intent simply by piling their money in the center of their table.  Prospective borrowers move from table to table to negotiate loan terms.

the pinnacle

For the largest such chit funds, agents for the fund do the collection and forward the money to the fund’s central headquarters.  Lenders don’t have any direct contact with the borrowers.

why chit funds?

There are a number of motivations, normally all based on the idea that the formal banking system doesn’t function well. For instance:

1.  There may not be any local banks.

2.  Banks may offer very low interest rates to depositors.

3.  Banks may decide to lend only to large companies.

4.  Potential depositors may worry about bank solvency–the possibility that they’ll lose their money in a bankruptcy or nationalization.

5.  People may not want to reveal the extent of their wealth, or the extent of their taxable income.

the US equivalent

Interestingly enough, this emerging world form of microfinancing is beginning to make a strong showing in the US.  It’s taking two forms:

–Congress recently passed the JOBS (Jumpstart Our Business) Act.  JOBS greatly simplifies the procedures for a small company to make an offering of equity.  For companies with less that $1 billion in annual sales, JOBS does away with the requirement that they present audited financials to potential investors (not a stellar idea, in my opinion).  JOBS also defines the maximum amount that low-income investors can put into a given offering.  By so doing, it legitimizes the efforts at equity crowdfunding (see my post) now underway in the US.

–John Mack, former head of Morgan Stanley, recently joined the Lending Club, a P2P (peer to peer) lender.  P2P lending is chit funds come back to life, but on the internet instead of in your local restaurant.  You can go to the websites of P2P firms like Prosper and Lending Club and select the borrowers you wish to lend to by yourself.  Or you can hire a financial advisor to do this for you.

why now?

To start with the obvious, the technology needed to run P2P or equity crowdfunding is readily available.

Interest rates have been low for a long enough period of time–with little relief in sight–that more conventional means for savers to obtain high returns have been exhausted.  Not only that, but getting a return above 2% in Treasury bonds requires committing money for a very long time, exposing the lender to the risk of loss as/when rates eventually begin to rise.

I see the JOBS ACT as an attack (maybe as the first step in a prolonged attack) by Washington on the current IPO practices of Wall Street investment banks.  Conventional IPO costs in the US are very high by world standards, and a private individual stands about the same chance of getting an IPO allocation as a snowball in northern hemisphere July.

The naming of the JOBS Act suggests that Washington wants to be seen as doing something to create jobs.  What a commentary if this is the best they can do.

My first reaction to P2P is that it may be a true innovation, like money market funds and junk bonds were in their day.  P2P could end up being a very big business–unlike JOBS, which I see, in its present form, as gimmicky and filled with opportunities for fraud.

That’s it for today.  Tomorrow:  historic problems with P2P lending, including a word on Bernie Madoff.

On Monday April 2, the Macau Gaming Inspection and Coordination Bureau published on its website monthly results for March in the SAR.  Here they are:

Source: Macau DICJ (Gaming Inspection and Coordination Bureau)

what they say to me

Yes, it’s the strongest non-holiday month ever in Macau.  Only last October (with Golden Week) and this January (New Year) had higher monthly win for the casino industry.

On the other hand, we don’t see anything like the almost manic surge in the size of the market that we experienced throughout 2011.  We may see some upward bounce in the April and May figures, as the new Las Vegas Sands casino on Cotai opens this month.

There isn’t enough evidence yet to draw firm conclusions.  However, if the right way to read the current figures is that the market is plateauing for the moment around the MOP 25 billion level (this is my guess), year on year growth comparisons should begin to narrow as the second half starts.

Although, again, there’s no clear evidence, I’m reading this potential growth slowdown to be the result of economic slowdown on the mainland.  If so, as the current expansionary measures Beijing is enacting bear fruit, I’d expect the growth rate to begin to expand again.  Timing is the only question.

It’s possible, though, that the plateauing I see is being induced by the leading casinos having reached full capacity–in which case, second-choice casinos should enjoy their day in the sun over the coming months.  And the Macau government should accelerate the pace of its approval of new casino permits.

One other point:  prior to the mammoth overcapacity the Las Vegas casinos by aggressive new construction during the past five years, only about half of that industry’s profits came from gambling.  The rest was food, lodging and entertainment.  One would expect that at least the American-owned casinos would follow the same development model in Macau–a move the Macau government is strongly encouraging.

Over the next five years, then, one could expect the gambling market to grow by at least the rate of Chinese GDP, or by close to 50%, and the industry’s profits to expand by a minimum of another 50%–and maybe much more–as non-gambling businesses expand.

Over the next five months, on the other hand it’s less clear how much there will be to cheer about.  I don’t see any need to sell the stocks;  I just don’t think they’ll run away to the upside.

No company ever goes into a foreign country expecting a level playing field.  There are always going to be rules–written and unwritten–that favor the home team.  This is the flip side of the belief that you’re always going to have at least a slight advantage over a foreign company in your domestic market.

One exception–if you’re hoping that the foreigner will buy your domestic business.  Chances are he’d be willing to pay over the odds.  But it’s equally likely the government will force a sale to a domestic competitor.  Around the world, that’s just the way it is.

in sports

We see this all the time in sports.

Olympic judging.

Your favorite baseball team plays an away game.  You can be sure the field will be manicured to minimize the home team’s weaknesses and your strengths. The visitor’s dugout in San Francisco is, unusually, on the first-base side of the field?  Why?  It faces right into the frigid wind off the bay.

The home town timekeeper will make the game clock in basketball or hockey run fast or slow, as the home team requires.

Even the referees will exhibit a home-town bias, perhaps influenced by crowd noise.

what’s not cricket

Some actions are beyond the pale, however.  One such appears to be happening right now in India.

In 2004, when Vodafone was still intent on ruling the world, it entered the Indian cellphone market by buying an interest in an existing player from Hutchison Whampoa.  Aware that if the transaction were done in India it would trigger a capital gains tax of around $2.9 billion, the parties did the deal offshore.

The Indian Tax Department ruled that the tax was still due.  Vodafone refused to pay and lengthy litigation ensued.

Two months ago, the Indian Supreme Court ruled in Vodafone’s favor–that no tax was due.

proposed retroactive tax law change

On Saturday, the Financial Times reported that in its annual budget the Indian government proposes to change the tax law, retroactive to April 1962, to make offshore transactions involving multinationals and Indian subsidiaries subject to domestic capital gains tax.

Although the proposed change, if implemented, will have much wider implications than for Vodafone alone, it is being widely seen as aimed directly at the UK telecoms company.

The issue of course, is that Vodafone has played on the home field and won–but the losing side is trying to change the basic ground rules five years after the fact, in a way that turns victory into defeat.

I think it’s ironic that this situation is arising just as the Indian government has decided to try to woo foreign portfolio investors for the first time.  If the budget documents are not just bluster and parliament makes the retroactive tax law change, that would seem to me to dim substantially the appeal to foreign investors of India’s large domestic population.  The negative effect could last for many years.  For emerging markets investors, then, I think the Vodafone situation bears close watching.

In assessing China, I think it’s important to distinguish carefully between the course of the mainland Chinese economy and the fortunes of China-related stocks.

the economy

background

The foremost goal of the Beijing government is to keep the ruling Communist Party in power.  This translates into the economic objective of avoiding possible social unrest by keeping employment high and unemployment low.  That’s quite a trick when you’re managing the transition from a rural, agriculture-based society to a more urban and manufacturing-oriented one.

In addition, China dedicated itself to creating a Western-style market-based economy in the late 1970s when it realized the country was too complex for central planning to work.  Again, hard to do when three-quarters of your industrial base was zombie-like state-owned corporations, when being a businessman was a felony and where citizens preferred to bury chuk kam gold trinkets in the back yard rather than use banks.

Complicating the situation further is the fact that high corporate or local/national government officials are Party officials whose chances for personal promotion are directly related to aggressively growing the areas they control, whether doing so makes long-term economic sense or not.

results

At the same time, all the mid-level national economic officials I’ve met–who actually implement policy–have been highly sophisticated, well-trained (mostly from the US or UK), competent and dedicated to creating healthy and balanced growth.

Given the large size of the Chinese economy and the paucity of tools to make economic policy, the best they’ve been able to do is to lurch between two extremes, overheating and stalling (the latter meaning unemployment is rising–a combination of new entrants to the labor force and layoffs)–and gradually lessen the amplitude of the cyclical swings.

where we are now

When the developed world appeared to be coming apart at the seams in 2008, China allowed a particularly strong domestic lurch to the upside.  For the past two years or so, Beijing has been trying to force an economic slowdown to rein in that expansionary impulse.

Policymakers have most recently been signalling their belief that slowdown has gone far enough and it’s time for faster expansion again.

China stocks

By and large, non-citizens can’t buy or sell stocks in the domestic market.  I’m not sure it makes much economic difference whether the local bourses go up or down.

Hong Kong is the natural market where the best and brightest of the mainland list their shares.

Over the past six months, Hong Kong stocks have sold off much more heavily than, say, the S&P 500, in response to worries about the Eurozone and potential global economic slowdown.  Since bottoming in early October, they’ve only rallied back in line with the S&P.  As I see it, so far there’s no anticipation of a better mainland economy this year in Hong Kong stock prices.  Many stocks there look cheap to me.

what to do

Personally, I think it’s important for all but the most risk-averse investors to have some exposure to the Chinese economy.

The most conservative way to do so is to hold companies listed in the US or Europe that have significant businesses in China.  Luxury goods retailers like LVMH, Tiffany or Coach are possibilities.  Casino companies like Wynn and Las Vegas Sands make all their money in Asia.

Discount brokers like Fidelity offer international trading services that allow foreigners to buy stocks in Hong Kong directly and cheaply.  Most investors will likely find it easier not to do research themselves, however, and buy an ETF or an actively managed mutual fund that specializes in Hong Kong or Greater China.

Price action in December and early January is often hard to read because of tax-related selling–losers in December, winners in early January.  Still, I’ve been a bit surprised that Hong Kong stocks haven’t done better than they have, given that the most recent economic news out of China, the EU and the US has virtually all been positive.

I don’t think this means that the positive case for the Chinese economy and for Hong Kong stocks is incorrect.  It may just take more time for negative emotion–from investors located in Europe, I think–to exhaust itself.  I’ve always thought that “buy on weakness” is pretty lame advice.  But it’s probably the right approach in this case.

I believe the qualitative story

To recap:  The qualitative argument the consultant makes starts with the idea (which I think is correct) that stock markets in almost all emerging nations are hazardous to investors’ wealth.  The companies listed may be the politically connected dregs of the local economy, not the stars.  Financial statements may not be reliable.  Corporate management may not have shareholder welfare as a primary goal.  The regulatory playing field is probably heavily tilted toward insiders.  It’s ugly out there.

Firms may not find it easy to raise money under these conditions.  Foreigners are unlikely to help, either, since in the developed world an aging investor base isn’t likely to have risk assets to spare.

Therefore, emerging economies will only fill the potential we all believe they have if their governments make substantial changes in their stock markets.  Otherwise, companies in these countries will come up $12.3 trillion short of their equity funding needs by 2020.

This is a problem, not only for these countries but also for any investors who have bought emerging markets index funds or ETFs banking on emerging economies to flower fully.

I agree.

…the quantitative?

It’s the quantitative stuff that I have problems with.  Specifically,

1.  starting with a quibble…

McKinsey projects that global financial assets will be worth $371 trillion in 2020.  It’s not $370 trillion.  It isn’t $372 trillion, either.  The precision of the figures implies that McKinsey can forecast the state of financial markets almost a decade ahead with an accuracy of +/- .25%.  All the empirical evidence is that no one can forecast with this degree of accuracy even one year ahead.  Stock market participants know the limitations of forecasts, because the real world beats them over the head with their misses every day.  Why isn’t McKinsey aware?

…or maybe not

The “equity gap” McKinsey forecasts amounts to $12.3 trillion (not $12.2 trillion…).  That’s 3.3% of projected financial assets in 2020.  How much of the “gap” would remain if McKinsey didn’t stick with overly precise point forecasts?

2. using local GDP to forecast corporate profits

McKinsey assumes that the profits of publicly listed companies in a given country will rise in line with nominal GDP.  Three reasons why I think this is a mistake:

–many parts of the local economy may not be represented in the stock market.  On Wall Street, for example, autos, housing and real estate–all pretty sick sectors at the moment–have virtually no stock market representation

–in the US and UK, at least, publicly listed firms tend to represent the best and the brightest of the local economy.  Private equity and trade acquisitions winnow the elderly and the infirm from the herd.

–in the developed world, foreign sales and profits make up a considerable portion of the stock market’s total.  In the UK, for instance, maybe 75% of the earnings of the FTSE 100 come from outside that country–explaining its dominant stock market size in the EU, despite not being the largest economy.  In the US, the best guess of S&P is that foreign earnings make up about half the total.  The figure is rising.

My conclusion(s):  the method McKinsey uses will understate corporate profits, and thereby the size of future equity market.  This is not new news.  Wall Street has been actively discussing the increasingly non-US nature of S&P profits for the past two decades.  In other markets, it’s been a key subject for much longer.

3.  we live in a post-internet world

It isn’t just the internet, either.  Other key factors as well have conspired over the past couple of decades to substantially decrease the capital intensity of business. 

–development of sophisticated supply chain control software, combined with internet communication and the rise of specialized logistics/transport firms, means everyone holds smaller inventories

–for many industries, today’s capital spending = servers and software, not machine tools and buildings.  The rise of technology rental, software-as-a-service, for example, means decreasing capital intensity

–e-commerce has vastly decreased the requirement for repeated expensive advertising campaigns and ownership of physical retail outlets as tools to make potential customers aware of a product or service. 

–the separation of design and manufacture that the internet allows means that companies use less capital intensive processes to make products in low labor-cost countries

in developing economies, too

There’s no doubt that emerging nations will still need a lot of development in capital intensive areas, like power generation, chemicals, water, roads, ports and related infrastructure.  But there’s no reason to believe that these economies won’t also avail themselves of the same capital-saving devices in other areas that developed nations now do.  For instance, eastern China is already outsourcing some manufacturing operations to lower labor-cost countries.

My point:  in projecting the future capital needs of publicly trade firms the McKinsey assumption that companies will be as capital intensive as they have been in the past is the simplest one.   I don’t think it’s right, though.  In fact, the more I think about it, the odder it sounds.

A final thought on this subject:  as prices change, behavior adjusts.  If the cost of equity capital were to begin to rise, companies will rethink their spending plans and economize/substitute.

The McKinsey Global Institute just published a research paper titled: “The emerging equity gap:  Growth and stability in the new investor landscape.”

The paper is the product of research by McKinsey consultants, in conjunction with “distinguished experts” from the academic world, government and private financial companies.  No actual bond or equity market investors appear to have been asked to help with the work, with the possible exception of the head of index products for a UK insurer.

its conclusion

The study’s conclusion:  by the end of this decade there could be a shortfall of $12.3 trillion between the amount of equity capital global firms will need to fund their operations and the amount that global investors will be willing to offer on current terms.  To put this figure in perspective, total world financial assets are projected by McKinsey to be $371 trillion.

If this is correct, companies may:

–borrow more, thereby increasing their vulnerability to cyclical economic downturns ( a company always has to service its debt, but can reduce or omit dividends without triggering a default)

–issue equity on less favorable terms to the firms,

–use capital more efficiently, or

–expand more slowly.

I’m going to write about the McKinsey study in two posts.  Today’s will outline the McKinsey argument.  Tomorrow’s will have my thoughts.

the McKinsey argument

1. qualitative

Throughout its analysis, McKinsey divides world financial markets into those in the developed world (the US, Europe and Japan) and in the emerging.

the developed world

aging

A key starting point for McKinsey is the demographic fact that the US and Europe are old–and aging.  This list of median ages (from the CIA) illustrates this point.  Starting with Monaco, the Florida of Europe, median ages by country range as follows:

Monaco     49 years old

Germany     45

Japan     45

Italy     44

Sweden     43

UK     40

Spain     40

US     37

China     36

world median     28

Indonesia     28

India     26

Many African and Middle Eastern countries fall in the late teens or early twenties.

Why is this important?

As people become older they gradually shift from wanting to increase their assets to being happy to preserve the wealth they already have.   This increasing risk aversion means they are less willing to buy equities.

pension plan shifts intensify this trend

In the US, corporations have pretty much completed the process of transferring the risk of paying for retirement from themselves to their employees.  They’ve done this by substituting defined contribution pension plans for defined benefit ones  This shift is now under way in Europe.  Individuals tend to put a smaller proportion of their retirement assets into equities than the defined benefit mangers would have.  In addition, corporations tend to shift the assets in their residual defined benefit plans into bonds to limit their risk exposure.

the emerging world

Although emerging economies will provide most of the growth in the world over the next decade, and have relatively young populations, they are unlikely to generate widespread–and increasing–domestic interest in equities.  Two reasons McKinsey thinks so:

–most citizens are too poor to want to take the risk of holding equities, and

–most emerging markets have low standards of financial disclosure, are badly regulated and exclude foreigners.  So they’re not places you’d really want to put your money.

2.  quantitative

In the report, McKinsey attempts to estimate, on a country by country basis:

–how much equity money corporations will need through 2020, and

–the amount that investors are likely to allocate to equities over that period.

equity needs

McKinsey addresses the first task by trying to project what the total market capitalization would be for each country, based on the assumption that each can obtain all the equity funding it requires to fuel growth.

It assumes that aggregate assets and earnings will grow in line with nominal GDP.  It applies a valuation multiple to them that’s derived from a two-stage present value model.  McKinsey then adds the results of IPO stock issuance, which it extrapolates from past relationships between IPOs and GDP.

investor allocations

This is a complex process that McKinsey only describes in outline, even it the appendix to the report.

Basically, the consulting firm projects, country by country, future disposable income.  It assumes that in the emerging world that individuals continue to put the same fraction of their disposable income into investments and that their allocation between stocks and fixed income remains constant.  For the US and Europe, on the other hand, it shrinks the equity portion progressively–citing age as the rationale.

the results?

McKinsey estimates that investor demand for equities will grow by $25.1 trillion between now and 2020.  However, worldwide corporate demand for equity financing will rise by $37.4 trillion, creating a $12.3 trillion “equity gap.”

According to the analysis, the US will have a slight funding surplus, despite a gradually waning interest in equities by Americans.  Europe will face a funding deficit of $3.1 trillion.

The real potential problem is in emerging markets.  China is in the worst shape, facing a potential financing deficit of $3.2 trillion.  Other emerging markets face a total funding deficit of $7.0 trillion.

That’s it for today.  My thoughts tomorrow.