Category Archives: economics

Shaping a portfolio for 2012 (III): China

January 6, 2012 By in China, economics, emerging markets, Foreign markets, Hong Kong, Portfolio management, Recent Market Action, Shaping a portfolio for 2012, Strategy Tags: , , , , , , , , , , , , Leave a comment

China

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.

 

 

importance of the cash flow statement: it’s like mushrooms

December 29, 2011 By in Accounting, cash flow, economics Tags: , , , , , , , Leave a comment

why project a cash flow statement?

While I was in graduate school, I spent a year in Germany studying at Eberhard Karls University in Tübingen.  Before school started I lived for a while with a German family.  Every Saturday morning we would roam the local woods in search of the mushrooms that would comprise one or two of our meals during the following week.  Since I had no clue what I was doing, my hosts would scrutinize any mushrooms I found very carefully to make sure they weren’t poisonous.

One type, the death cap–which I never stumbled across–still stands vividly in my mind.  According to my family and to public service announcements on tv, not only was this mushroom deadly, but the first symptoms of its effects only developed after the poisoning was too far advanced to be treated.

There’s an analog to this situation in the investment world.  These are cases where the financial results of past management actions narrow the scope of future possible outcomes to the point where one or two become highly probable–if not unavoidable. In these cases, management is never going to spell out the constraints it it working under.  Nevertheless, the current financial condition probably makes their future actions very highly predictable.

Projecting a cash flow statement for such a company is the way to uncover and evaluate.  (An analyst should do this for every company under coverage.  In my experience, most don’t.  In “mushroom” cases, however, the cash flow statement is crucial.)

examples

a toy company

In the early Nineties I was following–and for a while owned shares in–a small publicly owned toy company.  It earned, say, $10 million annually.  One year it had a surprisingly successful spring-driven flying toy doll for girls.  The following year it decided to make a similar toy for boys, with a martial theme and a stronger spring.  As I recall, the firm decided to spend $40 million on materials and labor for this toy (a real roll of the dice at 4x total corporate earnings).  It got the money through trade financing and borrowing from its bank.  The risk was especially high, since all the manufacturing had to be done at one time, in preparation for the yearend holiday selling season.  On the other hand, the prior year’s toy had been a smash hit; the firm really understood the boy market and felt this one would be, as well.

Soon after the toy was on the shelves of toy stores, the company began to get reports that the combination of a strong spring and curious young boys was resulting in severe eye injuries to users.  The government mandated a recall.  The $20 million in profits the company had envisioned was up in smoke.  The inventory that had cost $40 million to make was now worth close to zero.

Do the math.  At most $10 million in earnings from other toys vs. $40 million in short-term financing needing to be repaid = no way out.

the Mets

The New York Times published a recent article on the Mets’ finances, titled “For Mets, Vast Debt and Not a Lot of Time.”  There isn’t enough publicly available information to draw a firm conclusion, but if the figures in the article are correct, the Mets don’t have much wiggle room.  The current club drive to lower the total player salary bill may be the only real option it has.  Specifically,

Sources of funds:

The Mets lost $70 million (I’m presuming that this is a pre-tax figure, but this isn’t clear) last season, with a player payroll of about $150 million.  Let’s say the actual pre-tax cash outflow was $30 million.

If we make the (optimistic) assumption that ticket sales and concession revenue in 2012 is constant with 2011, then lowering payroll to $100 million will result in a pre-tax loss of $20 million for 2012.  Cash flow should be positive, at about $20 million.

2013 cash inflow = $40 million ?

2014 cash inflow = $50 million ?

Uses of funds:

repayment of $25 million to Major League Baseball, now overdue

repayment of $40 million Bank of America bridge loan

repayment of $430 million team loan in 2014.

If, again, the NYT figures are correct and the cash inflow numbers I’ve made up for 2012-14 are anywhere close, the Mets won’t be able to make much of a dent in the 2014 principal repayment requirement.  It seems to me that dealing with the $430 million that comes due in three years is the major management issue.

What I’ve written above is just the bare bones.  The Mets are attempting to find outside investors who are willing to accept having no say in the running of the organization.  Suit by the Madoff trustee is pending.  And, of course, there’s the tangled relationship between the Mets and SNY, the Wilpon-controlled cable network to which the club has sold broadcast rights.

others

Eastman Kodak has been supporting its ongoing turnaround through outside financing and asset sales.   Looking at the cash flow statement for the past couple of years and projecting it forward for the next few will be highly instructive.

Current market worries about Italy’s sovereign debt also have a cash flow basis.   The issue is the current high cost of refinancing maturing debt.  Unlike the previous corporate instances, Italy’s new government has much greater scope for initiating reforms that can change market perceptions quickly.  And perceptions, rather than the amount of outstanding debt (which is typically the corporate issue), are the main concern here.  Still, projecting sources and uses of funds forward for several years will give a much clearer grasp on the issues than simply watching current yields.

 

 

 

 

 

 

a final note on the Olympus scandal

December 26, 2011 By in Current Market Thoughts, Japanese development, Stock ideas, tobashi Tags: , , , , , , , , , , Leave a comment

a recap

During the summer, the newly appointed CEO of Olympus, Michael Woodford, followed up on an account in a Japanese magazine of severe financial irregularities at Olympus (TYO: 7733).  He discovered a number of failed M&A transactions involving gigantic payments to obscure companies that disappeared from existence soon after receiving the money.

He was fired for his pains.  He promptly left Japan, saying he feared for his personal safety.  Once in the UK, he disclosed everything to the world financial press.

An independent panel was appointed by the Olympus board of directors to investigate the situation.  The panel determined that Olympus had engaged in speculative “financial engineering (zaitech)“, presumably arranged for it by its investment bankers, starting in the late 1980s.  Like virtually everyone else who did this in Japan, Olympus lost its shirt.  It covered the losses up, again presumably using a service (tobashi) provided by its brokers.  This generated a cycle of progressively larger cover-ups and money-losing speculations that lasted over two decades.  The fake M&A was an attempt to get money to pay off creditors and end the cycle once and for all.

what’s new

Olympus has avoided delisting by providing the Tokyo Stock Exchange with accurate accounting statements by a mid-December deadline.  The “new” Olympus has book value of about a third of what it had previously claimed.

The stock lost about 60% of its value since the Woodford firing.

Two American funds managers appear to have held close to 10% of the company’s stock at the time the scandal broke.

The newest chairman of Olympus appears to me to be proposing that:

–the company’s board needs only a symbolic shakeup (where one or two members make a ritual expression of regret and resign), and

–Olympus should recapitalize by issuing stock to other members of the Fuji group, like Canon or Fuji Film.

my thoughts

Olympus is a typical Japanese technology-related company.  It’s torn between the need for constant innovation to keep up in  an increasingly complex and rapidly evolving world and its presence in a social/cultural environment where preserving the status quo is acknowledged as perhaps the highest goal.

Current management seems to be in the process of arranging a “traditional” solution to Olympus’s problems–one that doesn’t probe too deeply and where a new corporate direction launched by change of management is completely out of the question.  It sounds like other Fuji companies are willing to help this happen.

In other words, business as usual in Japan.

My guess is that this is the most likely outcome.  After all, except for what I think of as counter-culture companies run by younger Japanese, this has been standard operating procedure when companies get into trouble for the twenty-five years I’ve been watching the Japanese stock market.

Any signs that this time will be different should be studied carefully for potential to be a bellwether of change. (I’m not optimistic, though.)

I’m most curious about the foreign professional investors who  held large positions in Olympus.  Didn’t they know anything about Japan?  Did they really think that buying companies with low price to book or price to cash flow ratios would bring the same kind of success it does in the US?  Didn’t they see that this approach has failed time after time in Japan?

Apparently not.

“the emerging equity gap”: McKinsey (II)

December 21, 2011 By in Asian economic development, China, economics, emerging markets, Private equity, Strategy Tags: , , , , , , , , , , , , Leave a comment

Yesterday I outlined the McKinsey argument that a substantial “equity gap” will emerge in developing economies between the demand for stock financing for capital expansion and the money that investors are willing to make available to the firms that need it.

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 emerging equity gap”: McKinsey on financial markets in 2020 (I)

December 20, 2011 By in Dividend Discount Model, economics, emerging markets, Strategy Tags: , , , , , , , , , , Leave a comment

the McKinsey financial markets report

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.