China is revamping its QFII program. That’s good news, and bad.

what QFII is

The acronym stands for Qualified Foreign Institutional Investor.  It’s the general name for any formal system for limiting foreigners’ access to domestic capital markets.

QFII arrangements are par for the course in emerging markets. They work as follows:

–A foreign investor applies to the government for permission to enter the market.  The application process itself can be complicated and time-consuming, and acts as a filter to weed out the less resolute.

–The foreigner must typically have a certain length of experience in the asset management business and a certain minimum amount of assets under management.

–A successful applicant is subject to a number of constraints.  Typically, he is given an investment quota,  a specified amount of money that must remain in the country.  Minimum holding periods for any securities purchases may be specified.  Certain industries may be off-limits.  Individual and aggregate maximum levels of foreign ownership of given enterprises may also be specified.

In China’s case, the QFII program has been in place for almost a decade.  QFIIs must have been in business for at least five years, have a clean regulatory record in the markets where they already operate, and have a minimum of $5 billion in assets under management. Foreigners can only buy equities.  In the aggregate can’t own more than 20% of a domestic company’s stock. Until this April, the maximum investment quota for any QFII was $30 billion.

why restrict foreign access to markets?

Every country in the world limits foreign access to capital markets in one way or another.  Control of companies thought vital to the national interest–transport, telecom and media are the usual suspects–is almost always legally barred to foreigners.

Bids in non-vital sectors are also often subject to government regulatory review. These cases often express the national ego rather than economic sense.   It isn’t that long ago, for example, that France disallowed Pepsi’s bid for Danone on the grounds that the yogurt company is a national treasure.  Mainland Chinese companies have extreme difficulty in getting government approval for purchases in the US.  In the early 1980s Washington rejected Fujitsu’s bid for Fairchild Semiconductor, on the grounds that a foreigner shouldn’t control a defense-related manufacturer–but then approved its sale to a French firm, Schlumberger (the purchase worked out very badly, by the way).

Emerging countries have more genuine worries.

–They fear that without ownership restrictions wealthy foreigners will buy the crown jewels of the local economy at bargain-basement prices.  Foreigners have more money.  And they may understand the long-term potential of companies better than locals.

–Emerging nations also have a vivid example of the risks in having open markets that occurred during the Asia financial crisis of the late 1990s. At that time, hedge funds tried to destroy the perfectly healthy Hong Kong economy through massive shorting of the currency and of the local stock market.   It took the deep pockets of mainland China plus the Hong Kong government’s purchase of a quarter of that market’s outstanding shares to see off the threat.

changes to the China system

In April, the individual QFII investment quota was raised from $30 billion to $80 billion.

This week, the China Securities Regulatory Commission has proposed further loosening of the rules:

–the minimum assets under management would be lowered from $5 billion to $500 million, thereby allowing many hedge funds to enter the market for the first time

–the cap on aggregate foreign ownership of companies would be raised from 20% to 30%, and

–in addition to equities, QFIIs would be allowed to buy bonds and stock index futures.

this is good news…

…because it represents another step in opening the capital markets of the world’s second-largest nation to economic forces, rather than simply local vested interests.

…and bad

Invariably, countries take measures like this when they feel the local market needs the inflow of funds that foreigners can provide.  It’s typically during weak economic times when the local government senses that domestic investors are much more likely to be sellers of local securities than buyers.

So while the moves by Beijing should be welcomed by long-term investors, they also seem to me to signal that tough sledding is ahead in the near term for holders of Chinese A shares.  For most of us, who are presently excluded from the market anyway, the relevant information is confirmation of what we have most likely already suspected– that corporate profit announcements from China over the next several months will likely be much poorer than the consensus is expecting.

private equity zombies–very hard to kill

what they are

The Wall Street Journal has been writing recently about private equity “zombie” funds.  These are funds that whose managers refuse to liquidate and return the proceeds to the original investors, even though the typical 8-10-year fund life has already passed.

A given private equity investment is supposed to last around five years.  That gives the managers time to make operating improvements and locate a buyer to sell the now-polished-up company to.  Add a year or so to that, so the managers to find enough good investments to use all the fund’s capital.  Add another, in case recession makes buyers temporarily wary.  That’s how you get to 8-10 years of life for the total fund.

In theory, private equity managers have no interest in keeping client money.  True, they get a recurring yearly management fee of around 1% of the assets under management (based, incidentally, on their own estimate of asset value–another bone of contention).  But their big payoff comes from their “carried interest,”  the 20% or so of the capital gains generated by each project that clients cede to them.  Private equity managers only collect this when the project is sold and proceeds returned to the clients.

The details, including the “sell by” date, are all spelled out in the private equity contracts.

How, then, can “zombies” arise?

The combination of two circumstances keeps them lurching around:

–failed investments, ones with no capital gains possibility, and

–clauses in the early private equity contracts that gave the managers (unlimited) extra time to find a buyer.  The intention was good–to not force the private equity managers to sell at a bad time.  In most cases, however, there was no other provision giving clients a course of action if they disagreed with the managers’ assessment.

The result is hundreds of failed private equity funds that refuse to liquidate, because managers want to continue collecting an annual fee.  They claim they’re looking for buyers, but…  The WSJ thinks that what we’re seeing now is just the tip of the iceberg.

two lessons

1.  Buy in haste, repent at leisure.  In the early days of any new investment fad, buyers rush headlong to be one of the first owners of the new thing.  They rarely look carefully.  If they are alerted about possible pitfalls, like no recourse if the private equity manager refuses to give back remaining money, they ignore the warnings.

2.  In desperate times, almost no one remains honest.  I’m an optimist.  I have great faith in human nature.  But in “zombie” circumstances, this is always a foolish bet.  At the very least, a professional with an obligation to protect clients’ assets shouldn’t rely on the kindness of strangers.

why not let sleeping dogs lie?

Institutional investors appear to be making a big push now to get their dud private equity investments resolved, even by selling them for half nothing (assuming they can find a buyer at all).


Two reasons:

–for taxable investors, an investment loss has an important tax value.  The present value of the loss deteriorates over time, so the sooner it’s used, the more it’s worth.

–keeping a dud investment on your balance sheet makes you look like an idiot.  Well, when you bought the thing, you were an idiot.  That’s the way it is.

But there’s invariably someone on your board of directors who will ask about it at every meeting.  Prospective clients may even make little gasping sounds if they recognize it on your list of holdings.  The black eye you’ve given yourself will only fully disappear when the investment is sold.  This is especially important if you see more of these coming down the track.


MSFT is making its own tablet …why?

the Surface tablet

Two days ago, in Los Angeles of all places, MSFT unveiled its new Surface tablet.  You can see pictures and get specifications at the company’s still-under-construction Surface website.

The tablet, slightly more oblong than the iPad but otherwise quite similar, will be available through MSFT’s bricks-and -mortar stores, as well as online.  There will be two versions, one driven by an ARM chip and a heavier-duty one driven by an INTC processor.

Although details are scanty, debut appears to be set for at least the lighter model late this year.

plusses vs. the iPad

There are some.  For instance,

–the iPad comes with a watered-down version of the Safari browser.  Ugh.  Surface will presumably let you use Chrome.

–there’s no easy way to type on an iPad.  I’m using the latest Logitech keyboard/cover on mine.  But even though reviewers say it’s the best yet, it’s still pretty clunky.  Surface has a lightweight keyboard/cover.

Of course, you can use the dictation feature on the iPad.  But try that in a library or on the train.

–you can’t create an Office document on an iPad, either.  Surface will come with special editions of Office, although whether the software will be available on Day 1 isn’t clear.

why have a Windows tablet?

Tablets are a great form factor–something MSFT knew when it pioneered the tablet almost a decade ago.  The company’s versions were just too big and clunky to be successful.

Thanks to AAPL, corporations now want to use tablets.  So do schools and colleges.  But the fact you can’t create usable documents or spreadsheets is a big drawback.  The longer this situation exists, the more pressure there is for tablet fans to create a non-MSFT solution to their productivity needs.

So the lack of a viable MSFT tablet is a continuing threat to one of MSFT’s core businesses.

why make one?

The first thing that comes to mind is that MSFT doesn’t think much of the tablet offerings by HPQ, DELL or their Asian competitors. That’s probably right.  You don’t see people camping out in front of Best Buy to be the first to own their latest models.

However, look at INTC.  To get the Ultrabook going, INTC created reference designs for the new product it wanted.  It gave the Ultrabook blueprints to manufacturers for free and promised them a lot of advertising support for any products that met its specifications.  Why didn’t MSFT follow suit?

Also, unlike the case with the X-box, manufacturing a tablet puts MSFT in direct competition with its main customers, the PC makers.  That can’t make the latter happy.

And, although MSFT has doubtless learned some tricks over the years, the company doesn’t have a stellar reputation as a device maker.  Think: the initial X-box or the Zune.

So why, then?

I think it’s to control the pricing.

Because of its high production volume, AAPL has a significant cost advantage over any maker of a competing tablet.  In addition, MSFT will likely have to price its offering at a discount to AAPL to induce buyers to give up the “cool” factor of the iPad and the convenience of the App Store.  There’s no room for a competitor to make much (read: any) money on a tablet, if it’s got to be better than the iPad and be priced lower.

In fact, my guess is that MSFT would count itself extremely fortunate to break even on the Surface in the first couple of years.  I think the company would sign on the dotted line in an instant if someone could guarantee MSFT would sell 10 million Surfaces in the first year, provided it priced the tablet at a $100/unit loss.

MSFT has done this before.  My view of Surface isn’t that far off from MSFT’s experience with the first-generation X-box.  Remember, too, that MSFT generates $1 billion in cash flow in less than two weeks.  Chump change isn’t an expression often linked to $1 billion, but it conveys the idea.

save me a Surface (the INTC one)

I’m not a particular MSFT fan.  But a successful tablet removes a perceived threat to MSFT’s core Office business, it makes the company more valuable.  In that sense, Surface is a potential big plus.  Personally, I’d prefer to buy a Surface when they come out.

Verizon (VZ) outperforming Apple (AAPL)? …what’s going on?


Yes, it’s true.  Over the past three months, VZ is up 10.7% while AAPL is flat and the S&P 500 is down 4.2%.  We should toss in another 50bp to VZ’s outperformance because it has a high dividend.

Maybe there’s nothing to this.  After all, the stock market is, even at its best, a two-steps-forward, one-step-back affair.  So VZ could be having one of its forward steps while AAPL is temporarily in reverse.  The period in question is very short.  The overall market is also down over the past quarter, the kind of environment that favors more defensive stocks.  And, of course, VZ and AAPL were neck and neck through the first half of last year before AAPL rocketed ahead and left VZ in the dust.

Still, there may be something a little more substantial going on.  I don;t mean to argue that AAPL will be an underperformer.  The surprise may be that VZ continues to be an outperformer.  I may be biased here, too.  I haven’t finished my research yet, but I have recently bought some VZ.

the argument for VZ

the US cellphone market is maturing

According to Nielson, 69% of current cellphone purchasers in the US are buying smartphones.  If we break that out by age, close to 80% of new phone purchases by Americans under 55 years of age are smartphones.  About half of those 55 or older are choosing smartphones, too.

Given that there will be some–mostly 65+–users who will never adopt new technology, can it get much better than this?  I don’t think so.

strategy shift in maturing markets

In a recurring subscription business, the winning tactic in any new market is usually to stake out as much territory for yourself as possible, without much regard for profitability.   You don’t care what anyone else is doing.  You just want to get as many clients in the door as you can.

As the market matures, however, two changes occur:

–growth comes from taking customers away from competitors, not from finding people who have never used the service before.  This is typically harder work and more expensive, so firms with scale end to have an advantage.

–profitability becomes more important.  Firms try to raise prices and to cut operating costs.

I think this is where we are in the US cellphone market.

sources of profit growth for VZ

1.  lowering phone subsidies.  To use round numbers, let’s say VZ pays AAPL $600 for an iPhone 4s.  It resells the phone, linked to a two-year contract, to a customer for $200.  VZ loses $400 on the transaction.

If the company can persuade that customer to choose an Android phone that it pays, say, $450 for, it loses $250 instead.  So it’s $150 better off.  That’s all incremental profit.

Better (for VZ) still, if the customer chooses a Nokia Lumia phone, the loss may be only  $200.

In Europe, phone companies are experimenting with using INTC reference designs to make house-branded phones.  Why bother?  INTC is only interested in selling chips, so it is ceding the entire wholesale markup to the carrier.  So it may cost the carrier $350 for a phone it can resell for $200–meaning a loss of $150.

Make this sort of marketing shift for enough customers and the savings become significant, even for a company of VZ’s large isze.

2.  raising prices.  In a sign that VZ thinks its market is maturing, it is fundamentally reworking its pricing.  Starting late this month, customers will get voice for free but begin to pay for data.  No more all-the-data-you-can-use plans, either.  Interestingly, VZ is going to eliminate a $20 per month charge for the ability to make your phone a mobile “hot spot” for internet access.  So you can tether your laptop or tablet to your phone for free, just by asking VZ politely.  Why?  Videos look a lot better on a tablet.  And they’re very data intensive.

all good things end, someday

At some point, possible profit-enhancing measures will run their course.  But that’s probably several years down the road.  In the meantime, VZ’s profit performance vs.Wall Street expectations may be surprisingly good.

In a perfect world (for the holder of VZ shares), the company would be able to spin off or otherwise shed its fixed line and FIOS money pits.  For stockholders, that would be like hitting the lottery.  It’s very highly unlikely to happen, in my opinion.  But, on the other hand, there’s nothing in the stock price for the possibility.

has Facebook (FB) bottomed?

I think it has–at least in relative performance terms.  But I also think that FB’s conduct during its IPO has created an enduring credibility problem for it.


The biggest factor depressing FB stock during its debut, in my view, was the joint, last minute, decision by the FB chief financial officer and the lead underwriter to expand the dollar amount of an already large offering by 40%.  That left no buying demand for the aftermarket.  If you think the underwriters didn’t know precisely what they were doing, there’s a bridge connecting Manhattan and Brooklyn you might be interested in buying.

However, it has only recently come out that the NASDAQ trading problems on the first day were much larger than I had originally appreciated.  CNBC has reported that investment bank UBS alone may have racked up FB-related losses of $350 million.  How so?

If you remember, NASDAQ’s computer systems weren’t able to handle FB orders at all for the first several hours of trading.  Some retail investors didn’t know for the better part of a week how much FB stock they had bought or sold.  It turns out, though, that institutional problems were a lot bigger.

CNBC says an unnamed UBS trader entered a buy order for 1,000,000 shares of FB.  He didn’t get a confirmation from NASDAQ.  So he entered the order again   …and again   …and again   …and again.  Then, apparently, confirmations for all the orders came at once.  It’s unclear whether the confirms came on Friday, or during the following week.

CNBC also says UBS only liquidated some of the stock at below $30 a share.  Do the math.  If we say the UBS trader bought the stock at an average of $40 and sold at $30, that’s a $10 loss on each share.  If so, he pressed the “buy” button 35x!!!, without thinking about the possible consequences  (Welcome to the world of trading.).  

Presumably the UBS trader wasn’t the only one doing this.

Notice, too, that the FB price didn’t dip below $30 a share until almost two weeks after the IPO.  So it took UBS at least that long to trade out of its unwanted position.  Throughout all that time, FB was under unnatural selling pressure.

I think that’s over.

prospectus disclosure

The IPO materials suggest that FB wants to portray itself as carrying out an ethically good social mission.  Mark Zuckerberg says as much when he leads off the IPO video.  Thereby, I presume, it hopes to gain investor trust and support–and a higher PE.

FB has just released correspondence between it and the SEC about the prospectus.  Media analysis of the documents indicates that FB withheld from the first version of the prospectus two items of information that I regard as the two most important facts about company operations.  They are:

–the regional breakout of subscriber growth and profitability, and

–the effect on profits of the switch to mobile use of FB.

(Note:  I haven’t looked at the correspondence, which is contained in SEC filings by FB.  But every major news source I read has reported the same story.)

You might say that in the rough and tumble of economic life, the most prudent course for a company is to disclose as little as possible to potential competitors.  You might also say that the initial draft of the prospectus is intended solely to stake out a negotiating position with the SEC.  In one sense, that’s right.  But if you do this, I don’t think you can pitch yourself as being socially responsible or try to cultivate potential investors as partners in the noble cause you’ve embarked on.

Think of it this way:

A married couple.  One partner likes to gamble but always loses.  One day, that partner comes home late from work, after losing $500 playing poker.  The other partner says, “I see that look on your face.  You’ve been gambling again.  How much did you lose this time.”  The reply:  “$5.”

Is this last statement true?  I don’t think so.

Yes, it is factually correct.

But it’s also incomplete.

If the two people were commercial adversaries, maybe the statement would be okay.  But in a relationship where the partners have assumed an obligation to be fully and completely truthful with the other, the reply is a lie.

No, the prospectus isn’t a marriage proposal.  On the other hand, I don’t think that FB can invite us to become partners on a socially uplifting journey while stamping caveat emptor on all its disclosure to us.  We can’t be both trusted allies and sheep ready to be fleeced.

The “like me, trust me” route does generate a higher PE multiple, in my experience.  But to the degree that investors perceive a double standard, I think the stock’s PE multiple will be lower than if it clearly chose one approach or the other.