MSCI and China’s A shares

A few days ago, MSCI, the premiere authority on the structuring of stock market indices around the world, declared that it had been carefully considering adding Chinese A shares to its Emerging Market indices–and concluded that it would not yet do so.

What is this all about?

MSCI

MSCI (Morgan Stanley Capital International) creates indices that investment management companies use to construct their products–both index and actively managed– and to benchmark their performance.

Having a certain stock, or a set of stocks, in an index is a big deal.   For passive investors, it means that they must hold either the stocks themselves or an appropriate derivative.  Either way, client money flows into the issues.

For active investors, they’re forced to at least research the names and keep them on their radar.  If they don’t hold a certain stock or group, they’re at least tacitly betting that the names in question will underperform.

 

If we measure economic size using Purchasing Power Parity, China is the largest in the world.  It seems odd that the country not be fully represented in at least Emerging Markets indices.

 

China

Beijing, in the final analysis, would like to have international investors studying A shares deeply and buying and selling them freely.

How so?

In many ways, the story of the growth of the Chinese economy over the past three decades has been one of slow replacement of the central planning attitude of large, stodgy state-owned enterprises with the dynamism of more market based rivals.  The heavy lifting has been done by constant political struggle against powerful entrenched, backward-facing, political interests that even today control some state-owned enterprises.  It would be nice for a change to have the market do some of the work–by bidding up the stocks of firms that increase profits and punishing those that simply waste national resources.

 

In addition, Beijing now seems to believe that freer flow of investment capital in and out of China can act as a safety valve to counteract the extreme boom/bust tendency that the country’s domestic stock markets have exhibited in the past.

 

the burning issue?

Foreign access to the A share market is still too limited.

Fir some years, China has had a cumbersome apparatus that allows large foreign institutions to deposit specified (large) sums of money inside China and use the funds to buy and sell stocks.  But becoming a so-called qualified foreign institutional investor and operating within government-set constraints is a pain in the neck.  It’s never been a popular route.

Recently, Beijing has begun to allow investment money to flow more freely between Hong Kong and Shanghai.  A HK-Shenzen link is apparently also in the offing.

In MSCI’s view, this isn’t enough free flow yet.  I think that’s the right conclusion.  Nevertheless, weaving A shares into MSCI indices is only a question of time.

my thoughts

As professional securities analysts from the US and elsewhere turn their minds to A shares, there stand to be both big winning stocks and equally large losers.  The big stumbling block will be getting reliable information to use in sorting the market out.

Shaping a portfolio for 2015: elaboratng on yesterday’s post

A reader had two questions about yesterday’s post, which I figured it would be easier to answer here than simply in a comment.

emerging markets

The big attractions of emerging economies to an equity investor are the possibility of very rapid economic growth for the country and of finding future titans of world industry as infants.  The two standard paths of gaining exposure to these markets are: to invest directly or to buy a developed-world multinational with significant presence in the economy in question.

Some emerging markets aren’t open to foreigners.  For those that are, the most important thing to realize, I think, is that there is typically little local support for stocks.  There are usually no pension funds or other local institutional investors (because there are no pensions and residents aren’t wealthy enough to afford financial products like insurance).  Local citizens don’t have enough money to be able to own stocks.  As a result, emerging market performance ends up being heavily dependent on foreign inflows and outflows.

Foreign flows can be very cyclical.  When developed market investors are feeling confident, inflows to emerging markets are typically very large.  When they’re scared, outflows are the order of the day.  Because there’s little local buying power, these outflows invariably cause sharp price declines.

Right now, oil-exporting emerging markets are being hurt very badly by the declining price of crude.  investors are also worried that emerging markets-based companies may have borrowed excessively, in US$, during the past few years of easy credit.  Such debts were a big factor in the crisis in emerging Asian markets that started in 1997.  In fact, today’s developments in Russia sound a lot like what happened in Malaysia in the late 1990s.

Yes, emerging market will eventually settle out.  I don’t think we’re anywhere close to that point, though.

rent vs. buy

Take Adobe.   Say you’re a web designer who wants to start a business on your own and that you want to use Adobe tools.

Buying a Creative Suite package to get started used to cost $2,500 – $3,000.  That’s a lot.

Many people would do one of two things:

–bite the bullet and buy, but never, ever upgrade; or

–find a bootleg copy on Craigslist for $200 or so.  Yes, it would probably stop working after six months, but it was cheaper than getting an “official” copy.

How many people took the second route?   I don’t know  …but probably a lot. I once heard Bill Gates estimate that 40% of the small business users of Office in the US were using counterfeit copies

Adobe has now gone over to a rental model.  $50 a month gets you access to the Creative Cloud version of all the Adobe tools.  The same sort of thing for photographers–$10 a month for Photoshop + Lightroom, vs. $600 to buy  (Amazon is selling the last disk version of Photoshop for $1500).

The plusses:

–the move from buy to rent changes a big one-time capital expenditure by a small business customer into an affordable monthly operating expense.  If users stay subscribers for at least five years, Adobe gets more money from rental than from a sale.

–Just as important, matching the tool expense more closely with customer cash flows is bringing a whole bunch of former illegals into the fold

–the company may also be attracting casual photography users who would never before have contemplated using Photoshop, but for whom $10 a month isn’t a big deal

–subscriber growth has continually exceeded consensus expectations.

The rental model isn’t exactly new.  It has been used for all sorts of equipment for years, from copiers to burglar alarms to colonoscopes.

What surprises me is that Wall Street has been so slow to figure out that the rental model works for software, too.  Yes, in the early days, the accounting looks ugly.  In fact, the faster the transition to rental goes, the uglier the income statement looks.  Development expenses remain the same, but instead of chunky sales revenue, the company only shows subscription payments for that month.  But professional analysts should be able to see past that.  My guess is that they miss completely the bootleg copy phenomenon.

 

 

 

 

 

Shaping a portfolio for 2015 (vi): the rest of the world

world GDP

A recent World Bank study ranks the largest countries in the world by 2013 GDP.  The biggest are:

1.   USA         $16.8 trillion

2.  China         $9.2 trillion

3.  Japan          $4.9 trillion

4.  Germany          $3.6 trillion.

The EU countries taken together are about equal in size to the US.

stock markets

From a stock market investor’s point of view, we can divide the world outside the US into four parts:  Europe, greater China, Japan and emerging markets.

Japan

In the 1990s, Japan choked off incipient economic recovery twice by tightening economic policy too soon–once by raising interest rates, once by increasing its tax on consumer goods.  It appears to have done the same thing again this year when it upped consumption tax in April.

More important, Tokyo appears to me to have made no substantive progress on eliminating structural industrial and bureaucratic impediments to growth.  As a result, and unfortunately for citizens of Japan, the current decade can easily turn out to be the third consecutive ten-year period of economic stagnation.

In US$ terms, Japan’s 2014 GDP will have shrunk considerably, due to yen depreciation.

If Abenomics is somehow ultimately successful, a surge in Japanese growth might be a pleasant surprise next year.  Realistically, though, Japan is now so small a factor in world terms that, absent a catastrophe, it no longer affects world economic prospects very much.

China

In the post-WWII era, successful emerging economies have by and large followed the Japanese model of keeping labor cheap and encouraging export-oriented manufacturing.  Eventually, however, everyone reaches a point where this formula no longer works.  How so?    …some combination of running out of workers, unacceptable levels of environmental damage or pressure from trading partners.  The growth path then becomes shifting to higher value-added manufacturing and a reorientation toward the domestic economy.  This is where China is now.

Historically, this transition is extremely difficult.  Resistance from those who have made fortunes the old way is invariably extremely high.  I read the current “anti-corruption” campaign as Beijing acting to remove this opposition.

I find the Chinese political situation very opaque.  Nevertheless, a few things stand out.  To my mind, China is not likely to go back to being the mammoth consumer of natural resources it was through most of the last decade.  My guess is that GDP growth in 2015 will come in at about the same +7%or so China will achieve this year.  In other words, China won’t provide either positive or negative surprises.

For most foreigners, the main way of getting exposure to the Chinese economy is through Hong Kong.  Personally, I own China Merchants and several of the Macau casinos.  The latter group looks very cheap to me but will likely only begin to perform when the Hong Kong market is convinced the anti-corruption campaign is nearing an end.

EU

In many ways, the EU resembles the Japan of, say, 20 years ago.  It, too, has an aging population, low growth and significant structural rigidity.  The major Continental countries also have, like Japan, strong cultural resistance to change.  These are long-term issues well-known to most investors.

For 2015, the EU stands to benefit economically from a 10% depreciation of the euro vs. the US$.  As well, it is a major beneficiary of the decline in crude oil prices.  My guess is that growth will be surprisingly good for the EU next year.  I think the main focus for equity investors should be EU multinationals with large exposure to the US.

emerging markets

I’m content to invest in China through Hong Kong.  I worry about other emerging Asian markets, as well as Latin America (ex Mexico) and Africa.  Foreigners from the developed world provide most of the liquidity in this “other” class.  If an improving economy in the US and higher yields on US fixed income cause a shift in investor preferences, foreigners will likely try to extract funds from many emerging market in order to reposition them.  That will probably prove surprisingly difficult.  Prices will have a very hard time not falling in such a situation.

 

linking the Hong Kong and Shanghai stock markets

restricting foreigners

Every country has restrictions on ownership of assets by foreigners.  Some of this is unofficial, like when France said yogurt maker Danone was a crown jewel that Pepsi couldn’t buy, or when New York blocked Mitsubishi Estate from buying a decrepit Rockefeller Center.  Other limits–notably restrictions on non-citizens owning media or transportation assets–are set down in law.

why?

It’s common that emerging countries restrict foreign ownership of all publicly traded locally owned corporations.  The same thing happened in Europe as it was rebuilding after WWII.  Two reasons:

–countries don’t want rich foreigners (translation:  Americans) to be able to scoop up valuable national assets for a song, thereby disenfranchising the country’s citizens and making locals into sort of tenant farmers, and

–they don’t want the potential disruption to economic activity (the currency and the money supply) caused by mad rushes in and out of local stocks by foreign portfolio investors.

two classes of stock

The most common method of controlling foreign ownership is for a country to establish two classes of stock, one to be held by locals, the other by foreigners.  The details vary widely country by country.  What makes China unusual is that, generally speaking, locals and foreigners trade shares in different venues–the letter in Hong Kong, the former on the mainland.

problems with the system

Whenever there are two different markets, and two different prices, for the same security, the party that gets the lower price is going to be unhappy.  Given that the supply of foreign portfolio capital is large and the number of foreign-designated shares is typically small, it’s almost always the local citizen who feels disadvantaged.

In addition, raising new equity capital can be awkward.  Foreigners may balk at having to pay, say, twice what a local does to buy a new share.

Invariably there’s unofficial arbitrage between the two classes.

In China’s case, it’s possible that Beijing wants inefficient state-owned enterprises to be more subject to the goad that can be provided by professional portfolio managers.

Shanghai/Hong Kong trading opened this week

This week, China opened limited foreign trading in Shanghai-listed stocks (not Shenzhen stocks, however, which make up about 40% of China’s market cap).  It is also permitting limited trading by mainland citizens in Hong Kong.  The control mechanism being used is daily limits on the cross-border flow of money in and out of both markets.  The system is called Stock Connect.

ho-hum, so far

The plan was announced a while ago–the result being that stocks identified as possible targets for fresh money in both Shanghai and Hong Kong were bid up in anticipation in recent weeks.  However, the volume of cross-border trading has been low and highly touted beneficiaries have been selling off.

For China, this initial indifference is probably the best possible outcome.  Still, this is another step in opening Chinese financial markets to the world.  And one day the ability for us to buy mainland stocks may be important.  It’s just not today.

 

 

October Macau gambling results

Just at midnight, New York time, the Macau Gaming Coordination and Inspection Bureau (DICJ) posted its report of aggregate casino win for the SAR during October.  The win, that is, the amount gamblers lost in the SAR, was MOP 28.0 billion (US$3.5 billion).  That’s up by 9.8% month-on-month, but down 23.2% year-on-year.

The result had been widely anticipated–and heavily publicized by the companies themselves, the government of the SAR and Hong Kong-based securities analysts.  Consensus estimates of the decline seem to me to have centered around -21% yoy.

The Hong Kong casino stocks were up a couple of percent in midday trading today when the DICJ report appeared.  Despite the wide publicity, the stocks immediately lost all their morning gains.  They drifted lower throughout the afternoon, ending down by around 3% for the day.

How could  stocks drop 5% on news that had arguably so fully anticipated?

I don’t think it’s that win was down 23% instead of 21%.  Both are equally weak.  More likely, in my view, is that short-term traders used the DICJ report to take profits after the stocks’ 15% gains in recent weeks.  It’s also possible that the market hadn’t grasped the current Macau casino situation as fully as I had thought.  It could be, as well, that the discounting mechanism for stocks nowadays in Hong Kong works more like the bond market in the US (reacting to strongly to current news as it hits the media) than the stock market.  (I doubt this last, but it has been a while since I devoted a serious chunk of my time to studying the Hong Kong market.)

my take

I’m not in a huge rush to buy, partly because I already have a pretty full weighting, both through the Hong Kong stocks and through WYNN and LVS.

My working hypothesis is that cyclical lows–10%+ below today’s close–have already been made.

Could the stocks drop another 5% from here–i.e., get halfway back to the lows of September?   …maybe, especially since the market upturn I anticipate will likely be in the spring or summer of 2015.  But it would take at least that much to get me interested again.  For now, I’m content to watch.