Wednesday, November 7, 2012

Invest for Kids Conference 2012


    I had the privilege of attending the “Invest for Kids 2012” conference today, where a dozen of the most talented hedge fund managers and financial analysts discussed their macro views and their favorite investments.  My thoughts in italics.

Frank Brosens of Taconic Capital Advisors
  Favorite Investment: GM.  Sales are up 40% over the last 2 years, with stock price stagnant.  With the election out of the way, the treasury will now sell their 32% stake, at which point management will pay out $20 billion of stale cash to shareholders.  Fantastic new management recently took the reigns.  Next year is the peak of the "refresh" cycle with many new products coming to market, which boosts sales and margins.  And, they're introducing many new trucks, which are particularly high margin.  There's general pent up demand for autos, with the average car age now at 11 years, vs 9 in 2008.  Even with valuation at current low levels, the stock price could rise 200% based purely on growing revenues, higher margins, and better cash allocation.
   Last year Marc Lasry pitched GM at the Invest for Kids conference; I was interested but skeptical and didn't pull the trigger.  Now I'm convinced.  I like the near-term catalysts and GM's sales in the last year are very supportive of a higher valuation.

Nelson Peltz of Trian Fund
  Focus on the income statement - if you find $1 on the balance sheet, it's worth $1, but that same $1 on the income statement is recurring so it's worth $10+.  
  Favorite Investment: Danone.  Food companies are currently trading at a 15% premium to the S&P 500 instead of their traditional 30%.  Danone is a health and wellness food company with most of its revenue from yogurt, water, and infant nutrition.  50% of revenue from emerging markets.  Free cash flow yield of 7%.  Trading at 9x forward looking.  Forecast 50% stock price appreciation over 2 years.  

Kyle Bass of Hayman Capital Management
   The US is monetizing our entire fiscal deficit every year.  Japan is monetizing 2/3 of theirs.  It's kind of a joke listening to central bankers talk monetary policy.  They're monetizing all the debt, plain and simple.
   Favorite Thesis:  Japan is on the brink of collapse.  We've passed the Rubicon. They sell more adult diapers than children's diapers.  The ultra rich are starting to pull their money out.  Starting to see net redemptions from Japanese pensions.  The currency will collapse.
   I fully believe in this thesis, but timing has always been the issue.  I think we've likely crossed the tipping point and collapse is likely any time now, but it's unlikely to take more than 3 years.

Ari Levy of Lakeview Investment Group
  Favorite short:  IOC interoil company is a fraud.  They've somehow gained an enterprise value of $3 billion through an incredible marketing effort, despite having basically nothing of value.  They own land in Papua New Guinea that probably does not produce meaningful oil or gas.  They routinely lie to investors about those assets.  6 companies have explored and given up on the exact same land.  
  This is a good short in theory, but the short interest is 23%.  That's a recipe for a short squeeze.
Steven Romick of First Pacific Advisors
  Real GDP growth has been collapsing for 40 years.  It was 5.5% in the 1940s, 3.5% in the 80s, and now it's 2%, and to get the shrinking growth, we're having to use more and more debt.  
   Favorite Pick:  Renault - cyclical exposure to unpopular Europe, but 50% of sales outside of western europe.  Buy Renault and sell Nissan and Volvo against it and you're getting a free stub.  Renault could sell off its assets and buy back all its stock and you'd be getting the core operating business for free.

Alex Klabin of Senator Investment Group
   Favorite pick: Rayonier.  It's a big timber player in the US and also makes high end fiber products.  They produce 35% of the global supply of certain fiber products; great margins.  Because of growth, the company will soon have to end their REIT structure for regulatory reasons, which will likely entail spinning off the fiber business.  The whole business is being priced as commodity timber with a low valuation, so spinoff should unlock value.  He expected EBITDA will go up 50% over 2 years.  Sees 30-60% stock upside over that time period.

Steve Mandel of Lone Pine Capital
  Favorite Pick:  Verisign (VRSN).  Registry operator.  Gets paid $8 per domain name.  6% annual growth in domain names.  They sign a contract with ICANN that gets confirmed by the department of commerce that dictates the prices they can charge.  Likely to continue being able to hike prices by 40% every 6 years.  Trading cheap given the certainty of cash flows.

Sam Zell, Real Estate Mogul
  Must be a contrarian, and the confidence to do that comes from finding deep value with bottom up analysis.  
   Current macro environment is terrible and uncertain.  Doesn't see value in equities or real estate.
  Volatility is underpriced.  Bet on black swan events.

Kelly Cardwell of Central Square Management
   Favorite Pick:  NXST - broadcaster pure play.  Being unfairly lumped together with newspapers.  They're a major content creator with good asset allocation.  They've cleaned up their balance sheet in the last 2 years and are prepared to make accretive acquisitions.

Jim Grant author of Grant's Interest Rate Observer
   Interest rates are cyclical, and despite the 31 year bull market, it won't last forever.  
   Favorite Picks:  Buy gold.  It's a moratorium on the market's faith in central bankers and fiat money.  Buy Metlife insurance equity.  Smart management (hedged against the falling interest rate yields), trading below tangible book value, powerful brand, diversified sales.


Friday, October 5, 2012

Whatever it takes


   We remain in a central bank dominated market.  The German Bundesbank has given the go ahead to the European Central Bank (ECB) to buy up as many peripheral bonds as they want, and the ECB has loudly announced they stand ready to do whatever it takes to keep the European Union from falling apart.  In practice that means the ECB stands ready to buy as many Italian and Spanish bonds as investors want to sell.
   The US Federal Reserve announced similar intentions.  The Fed initiated a mortgage buying plan that entails purchasing $40 billion a month in mortgage backed securities (MBS).  About 90% of all mortgages in the US are turned into MBS and new issuance totals about $150 billion a month, although a good chunk of that is naturally amortized each month.  MBS analysts estimate this will have the Fed buying about 70% of all new US mortgages, in addition to their purchases of about 100% of all 30-year bond issuance.  

   This means that discussion of the fiscal deficit or debt to GDP ratio becomes almost silly.  The treasury issues new bonds to pay for government spending, which are then quickly bought by the Fed.  There's no legal limit to how much the Fed can buy, and now it appears there's no clear political limit either.  The point is that as much as at any time in the last few years, a bet on any asset is primarily a bet on the Fed.  If the Fed doesn't want the S&P 500 falling below 1400, they can buy up whatever assets are necessary to prop up equities.  The importance of the debt is almost entirely political.  We have a looming $600 billion "fiscal cliff" at year end, when spending cuts and tax hikes will automatically take effect without congressional action.  This leads into the need for another debt ceiling hike by April of next year; the exact timing is questionable since the treasury has some accounting slight of hand they can use to push the debt ceiling a couple months forward.  

    Many of the smartest investors I follow believe the deflationary and deleveraging pressures of the credit crisis fallout will continue to outweigh the inflationary pressure of the Fed's printing press for the foreseeable future - in other words, they think the Fed's money printing won't result in significant inflation in the next 2 years.    Additionally, the next political phase in the US is one of fiscal austerity, which is naturally deflationary.  This leaves investors in a tough spot.  It's hard to love shorting any asset when the Fed stands ready to buy with an infinite bankroll, but the fundamentals are bearish.  My positioning is unchanged with long commodity-related equity exposure and short equities in general.

   Finally, I'll leave you with some random insight from the best value investor you've never heard of.  Li Lu is a hedge fund manager and Warren Buffet's pick for one of the top 3 investors alive.  In 1989 he was a student leader of the Tiananmen Square protests in China before studying at Columbia.  Here is an interview he gave and here are notes from a lecture he gave at Columbia.  Lu makes use of traditional value investor metrics like price to earnings and price to book, but describes his role more as a journalist with insatiable curiosity who, on rare occasion, stumbles across an interesting story.  Before investing, he wants to understand the business behind the stock as thoroughly as though he owned 100% of it.  He suggests gaining a similar depth of understanding of the company's industry.  

Thursday, June 7, 2012

Europe faces reality


   Last week, many headlines blared: "Europe finally faces reality."  There is now consensus that either the Eurozone will dissolve or Europe will finally form a true fiscal union.  Just about everyone agrees the latter is preferable, but Germany insists it will not back eurobonds or deposit insurance unless countries cede control of their budgets to a central European authority.  Most other eurozone countries (including France most importantly) are refusing to give up sovereignty.  Investors are optimistic that Eurozone leaders will quickly lay out a plan and the ECB will plug any gaps in the mean time.  To make it clear just how dire things are in Europe - both Italy and Spain will begin defaulting on debt within 4 months without additional aid.  This week, Spanish ministers began openly begging the ECB for aid for its banks, announcing that the market is refusing to finance Spanish debt. 
    I can't handicap this game and I think Europe's problems are probably fairly priced in the market.  If Eurozone leaders get their act together in time, equities will pop, otherwise they'll plummet.  There's probably no value in us betting on the outcome at this point.  I covered the last of my short euro position.
    While the world watches Europe, my concern remains the US.  Most data out of the US last week was dismal, ranging from increasing unemployment to worsening PMI indexes.  I remain very concerned that early in the next president's term we'll get fiscal tightening and the austerity will have dire effects.  Additionally, the market is now pricing in some form of additional quantitative easing, but I expect that a basic extension of "operation twist" and even large mortgage purchases will be met with an equity sell off.  Without something more aggressive, investors will rightly wonder what difference another 30 basis points in lower yields will make when 10-year notes are already at 1.6% and 30-year mortgages are at 3.8%.  Anything short of outright money printing is just "pushing on a string." 
     Back in 2008, I was convinced by my study of economic history that the collapse would likely come in two waves.  First we had a very sharp collapse followed by a sharp rebound.  Then I expected a second wave down after which equities would simply sit near their lows for an extended period, probably several years.  The first rebound happened sooner and was sharper than I expected because of the unprecedented quantitative easing.  I don't expect to time the second wave any better, but I remain confident in the general pattern.  So, I'm in no rush to get long equities in general.  Don't worry about repeating 2009's mistakes and missing the rebound.  Still, I'm a value investor, and I'm always on the lookout for specific value opportunities.  Today that means I want to find the most hated stocks so I'm looking in Europe, and in the beaten down energy sector.  My schedule as a trader and MBA student keeps me busy and makes value hunting difficult, so if anyone has any specific picks in these sectors, I welcome suggestions.  One last point - given the strong rally in treasuries and sell off in risk assets and the constant talk of Europe, it feels like the risk is for a continuation of the trend - more bad news, deflation, and "risk off."  The opposite is true.  Anyone with more than a 6 month time horizon should be far more concerned about inflation.  The market is already pricing in global recession with some small chance of global depression.  That's why investors are accepting yields of below 0% on short-term Bunds, and below 2% on 10-year Japanese, German, and US bonds.  To sleep soundly at night, we should be confident that our portfolios will withstand the surge in inflation that is very likely to start sometime in the next 5 years.    


Wednesday, May 16, 2012

Economic Commentary: A political and possibly a monetary turning point


   The big news of the last few weeks has been out of Europe.   For the past 4 years we've had loose monetary and fiscal policy in the US and relatively tight monetary and fiscal policy in Europe.  I believe that is about to switch.  Now is a good time to identify attractive European equities and European assets that will benefit from increased spending in the near future.
- France just elected the Socialist Francois Hollande; I think he's a moderate at heart but will reverse the relatively extreme austerity that Sarkozy was championing.
- In the past week, Greece roiled markets as voters gave support to parties that are declaring all debt agreements void.
- The unsustainable debt and unemployment situations in Spain and Italy have led to increasing bond yields and growing concern, highlighted by a major bank bailout in Spain announced last week.
- Germany's bundesbank may finally be throwing in the towel on inflation and we may get another major money printing operation from the ECB soon.

  First on Hollande - the markets view him as a big question mark. He's advocating "growth" policies as opposed to Sarkozy's austerity, but no one knows the specifics.  My own take is that Hollande is really a moderate and will not make any radical changes.  Analysts are suggesting that his election and that of Greece mark a political turning point.  Voters are rejecting austerity programs that are ostensibly in the service of foreign debt holders.  However, France has no printing press.  Hollande can increase government spending, but I doubt this will have much of an impact.  French banks have little in the way of excess reserves, so just about every euro that Hollande spends will effectively cause a decrease in private sector spending of a similar amount since banks will have to buy the additional sovereign debt instead of lending; in contrast, banks in the US have lots of cash sitting under the mattress so an increase in government spending would likely increase total consumption.  Hollande might want to be profligate, but in the short-term it won't matter since France's total consumption will change little.  The key is the pressure Hollande is likely to put on the ECB to print Euros.  More on this shortly.
    I don't know what will happen with Greece, but at this point if they leave the Eurozone or default on the bulk of their debt it will be neither shocking nor particularly important to global markets.  Greece's stock market is down 90% from its highs and much of their sovereign debt has already been written off by investors.  The focus is rightly on Spain.
    Last week the Bank of Spain announced a partial nationalization of the large institution "Bankia."  The announcement included a rough outline for a plan requiring all Spanish banks to set aside more reserves, which will further reduce lending to the private sector.  I've said it before and I'll say it again - austerity has never succeeded in getting a country out of a deflationary recession in the history of the world.  Spain will either slide into crisis, or the EU will have to embark on a radical change in direction with a money printing scheme.  With Spanish youth unemployment at 55%, I'll be surprised if we don't see major social turmoil in the next year. 
    The ECB created a trillion euros as part of the ongoing peripheral Eurozone bailout...and it's clear that was no where near enough.  Spain needs more money ASAP and France will likely be demanding easing soon.  Murmurings from Germany's bundesbank suggest they will soon give in and allow further monetization of the sovereign debt.  Back in 2008, the US Federal Reserve doubled the money supply and yet deflationary forces were stronger than the money printing.  I don't know which force will prevail in the coming year in Europe, but the looser monetary policy will likely generate a bid in real assets.  I continue to favor energy commodities and related equities.  

    My positions are unchanged - very small short euro position, short yen, I'm continuing to gradually ease into a long-term short treasury note position, and I'm long energy related equities.  With the exception of the small euro positions, I'm viewing these positions on a 3-10 year time frame.  I want to increase my energy equity investments so if you have any particular ideas or analysis, I'd love to see it.  I also want to invest in European assets - they're incredibly unpopular and the wave of fiscal and monetary easing will provide a tailwind - and would appreciate suggestions.


Wednesday, March 14, 2012

A Global Bond Bubble - Alpha


Within the US, UK, and Europe, there is likely a bond bubble going on currently with artificially low yields due to central bank intervention and asset purchases in bond markets. A sluggish economic environment combined with further quantitative easing and uncertainty surrounding the European debt crisis will most likely weigh on long-term yields. With unemployment high and inflation low, the Federal Reserve is likely to continue to maintain extreme monetary policies, thus depressing US Treasury yields. I expect long-duration bonds will fare the worst, while sectors of the fixed income market with credit risk outperform as risk appetite returns. Only professionals who can go long and short bonds with duration and derivative instruments (PIMCO, Doubleline, etc.) can play in the bond space today.

My general advice to passive investors: AVOID ALL BONDS TODAY. Or stick to low maturity cash-like options from countries like Canada and Australia.

But if you have to invest in bonds, the most effective ways to access bonds are through active or passively managed ETFs (lowest transaction costs plus good diversification). I prefer to take some credit risk to seek yield but I generally want shorter maturities and duration with high cash flow yields. Hence high yield corporate bonds issues, through an ETF, is our preferred space. To the extent that spreads compress further and yields stay low, I would prefer cash or other liquid measures over any fixed income.

10-Year Bond Yields are at Multi-Decade Lows and Are Close to 1940s and 1950s Lows


I am underweight fixed income relative to previous allocations because I am concerned about its near-term performance outlook. A further fall in 1-year UST yields seem extremely improbable, while a rise over 12-24 months seems likely. Our rationale for this concern is (i) fixed income is currently trading at a premium on a historical basis and appears overvalued; (ii) benchmark UST yields are near 50-year lows in the US and gilt yields are near 300-year lows in the UK; and (iii) there is limited upside potential for principal appreciation.

I expect that over 10-years the purchasing power of the USD and fixed income securities will be significantly lowered due to:
i) high and volatile inflation as economic growth picks up and the velocity of money increases (I think inflation will be 100-300bps higher than the current ~2.5% breakeven level implies);
ii) continued financial repression (negative real yields in many core instruments), as detailed in the Reinhart paper “The Liquidation of Government Debt”;
iii) Further quantitative and qualitative easing asset purchases, after which the Fed won't be able to contract its balance sheet, leading to classic monetary inflation in 2-4 years.

Breakeven Inflation Rates are Too Low Due to Fed Purchases and an Exploding Fed Balance Sheet

Finally, mortgage bonds also seem unattractive due to extreme Fed intervention through Fannie and Freddie to support mortgage bond markets. I would like to note that the 30-year conventional mortgage rate is significantly below its 40 year low. Hence any upside in mortgage bonds is superseded by the downside risks.

Mortgage Yields are at Multi-Decade Lows - The Biggest Owner of Agencies is the Fed

Most investment-grade bonds look unattractive due to 50-year low yields last seen in the 1960s. Yet investment grade spreads and high yield spreads over USTs look decent compared to last ten years. I think this is deceptive due to the artificially low UST yields due to monetary and quantitative easing.

Investment Grade Bond Yields are at Multi-Decade Absolute Lows, Though Spreads seem OK

If forced to invest in bonds, high-yield bonds are the best of a bad lot because they have low duration (due to a higher coupon) and decent cash flow yields. Yet high yield bond spreads are not necessarily cheap/low either. Spreads at 750bps above USTs are interesting and 900bps above are attractive. Current spreads in the 600bps range are merely acceptable, given our low allocation. Our preferred vehicles for high-yield bonds are ETFs like JNK, HYG, and PHB. Our strategy here is to hold a shorter duration index and clip the coupons – the risk behind this is if rates rise quickly, an investor can get hurt fast. Finally, structured finance vehicles like CMBS are too new and have high product risk – it’s hard to get exposure there and so for now I would like no allocation to them.

High Yield Bonds with Low Duration are the Best Offering of a Bad Lot

Wednesday, February 29, 2012

Economic Commentary: Long Natural Gas Equities - Ari

There's "blood in the streets" as one Natural Gas investor recently told me. Nat Gas is trading below production costs for most drillers and has been so cheap for the last couple of years that many companies in the natural gas industry are near bankruptcy. I smell opportunity.

First, let's look at why Nat Gas prices have fallen so much and why I expect them to be significantly higher in 5 and 10 years. Prices have fallen precipitously because of a dramatic increase in production from new technology. A decade ago, the bulk of US production came from the gulf region and was prone to disruption from summer hurricanes. In the last few years, tremendous amounts of new production have come online in places like Pennsylvania and New York via shale extraction. This is a true game changer and means we're unlikely to see the spikes of $15 natural gas during hurricane season again anytime soon However, the current price of $2.60 is unsustainable. These low prices are persisting because at many sites, drilling produces profitable crude oil and throws off natural gas as a byproduct. No matter how low natural gas prices go, it will still be produced at these sites.

While supply will gradually fall at current prices, the bigger change will come from demand. Historically, a barrel of crude oil has traded at between 6x and 10x the price of an mmbtu of natural gas. The low end, 6x, represents thermal parity, and the high end reflects the logistical advantages of crude over natural gas. This suggests a "fair" price of natural gas between $10 and $16. A tremendous price disparity can and probably will be maintained as long as our energy infrastructure continues to strongly favor crude. Currently, it would be much cheaper to run a car off of natural gas, but we don't have many cars capable of burning nat gas, nor do we have the fill station infrastructure ready. Alternatively, we may move to electric cars that run off the energy grid, necessitating far more nat gas burning power plants. Additionally, its clearly in our national interest to shift demand to natural gas; if we could replace 50% of our crude oil imports with natural gas that we produce domestically, this would dramatically reduce our dependence on "problematic" countries in the Middle East and South America as well as reducing our trade deficit by more than a quarter.

The bigger short-term catalyst for price appreciation will likely be the export of liquified natural gas (LNG). Currently, natural gas is basically a continental market. It's very expensive and logistically difficult to transport natural gas from the US to Europe or from the Middle East to Asia. A lot of money has been flowing into creating the necessary infrastructure recently and the Japanese nuclear disaster was the necessary catalyst for demand. Japan's imports of liquified natural gas have been surging, and the global demand for natural gas has followed suit as countries like Germany reduce their reliance on nuclear energy.

So why not just buy natural gas futures? Why bother with equities? Because I view this is a 5-20+ year secular trend, equities will likely produce a significantly higher return. For example, if you buy nat gas futures and they triple in value over 10 years, you've earned about 11.5% a year, not bad, but we can probably find companies that will produce returns on capital of greater than 30% a year in the same scenario. We're likely to benefit from both the accrued corporate profits as well as a higher valuation multiple. In other words, profitable companies churn out profits every year and they benefit from the higher earnings multiple that comes with higher natural gas prices. For bets of under 2 years, I generally prefer to stick with commodity futures, but for 5+ years, equities are usually preferable. Additionally, investing in equities lets us earn additional returns from our skill in individual stock picking.

While I have growing confidence in my ability as a stock picker, small natural gas companies are tough to value without industry expertise. So, I turned to my friend Josh Young, portfolio manager of Young Capital Management, and asked for his advice. Josh recommended 2 specific energy producers that he believes are very cheap relative to their peers: Gastar Exploration (GST) and Sonde Resources (SOQ) and I have a small amount of money in each. Josh thinks these are good buys even if nat gas prices remain weak and suggested that these are not the ideal picks if we specifically want to bet on nat gas prices rising dramatically. I like these stocks as a happy middle ground to profit even if nat gas doesn't strongly rebound while giving us significant upside if it does. I expect to periodically look for additional stock picks in the energy sector over the next five years with a particular focus on companies that provide upside to natural gas prices as well as companies that will profit from investment in natural gas infrastructure.

As an aside, I recently had the pleasure of moderating a panel at the University of Chicago. Jeff Yass, the founder and managing director of Susquehanna International Group (SIG), explained how he thinks about markets and was then joined by prominent finance professors George Constantinides and Ralph Koijen. One of Yass' interesting points was that in a high volatility environment, the median of a stock's distribution will be quite a bit below the mean; since stock's have unlimited upside, the most likely future value must be below the current price since the likely loss must be balanced against the small chance of unlimited upside gain. As a result, a 50% or even 80% fall in prices is not evidence of market inefficiency.


Monday, January 23, 2012

Economic Commentary: Shorting Japan - Ari


First I'll offer a quick update on the global markets and economy and then zero in on my next big bet: shorting Japanese Yen and government bonds.

The last two months have been relatively quiet for the global markets despite plenty of scary headlines. Iran threatened to close the strait of Hormuz and crude oil rallied moderately. US equities started strong on the back of better than expected employment and consumption data and were then further buoyed by good news out of Europe - Spain and Italy were more successful in their debt auctions then expected and Greece may be nearing a resolution with debt-holders for an orderly restructuring. The Euro has gradually sold off and I covered almost all of my short Euro position. I'm generally too early in covering my winning bets, but with record short interest in the Euro, the downtrend may have run its course for a while. A good line about the Euro comes from Jim Rogers; Rogers has been bearish on the Eurozone for a decade but is long the Euro at the moment because he believes that while the Eurozone will eventually collapse, it won't be this year or next.

I've talked before about Japan's coming crisis, but was reluctant to pull the trigger on a major bet because I didn't feel like I understood the timing well enough. I still don't have a clear picture of how the crisis will unfold but I believe I can structure a bet with excellent reward for the risk despite the uncertainty. I'm shorting both Japanese Yen and Japanese government bonds.
Why short Japan? First the basics - Japanese debt to GDP is around 230%, far higher than any country has ever been able to sustain in the history of the world. Social security alone accounts for 52% of the government budget. Japan has gotten away with this debt load primarily because almost all their debt is owned domestically (about 95%); the Japanese people keep buying debt that yields almost 0% for cultural reasons and because the government requires them to do so (many institutions are required to have huge holdings of government bonds). The demographic situation in Japan is rapidly worsening. The percentage of elderly Japanese is rising from 17.4% in 2000 to 25% in 2014 (versus 12.8% in the USA.) Now throw in stagnant growth in tax revenues and the fact that 25%* of tax revenues go to pay interest on the debt. This is debt that yields close to 0%! It's easy to see that if Japanese debt sells off even moderately and yields climb just slightly, the country will almost immediately have to choose between defaulting and monetizing its debt.

What could trigger yields to rise? While Japan's fundamentals have been worsening for a decade, their bonds were supported by increases in savings. The rate of savings has been gradually falling but nominal savings were increasing. The savings rate has is now on track to hit 0% and turn negative in the next few years. Another specific catalyst is that the latest data from the Japanese government suggests that Japan just experienced its first trade gap since 1963! As Japan's current account surplus vanishes, that means there's less excess capital to buy Yen denominated bonds.
So how does this crisis play out? A lot of the demand for Japanese bonds exists because the Japanese have had more than a decade of deflation. A 0.5% yield is tolerable under these conditions. Once yields start ticking higher and headlines of "Monetize or default?" start flooding Japan, at least some of the bond holders will start to sell. With every tick up in yields, the situation becomes exponentially more vicious. Even a 1% increase in long-term yields would produce an immediate cash flow crisis. Most likely, the central bank will start to purchase the bonds to keep yields down. This monetization will produce the threat of inflation, causing more bond selling, forcing more central bank purchases leading to a rapid and large devaluation of the Yen. The Japanese government would likely sell holdings of US securities to partially finance these purchases so we might see brief but sharp upward pressure on the Yen for this repatriation of government assets. Any scenario I try to envision of Japanese bond yields rising seems farfetched to me because it would be suicidal for Japan, but I'll be shorting Japanese bonds in case they choose not to monetize. In case I'm completely wrong and Japan starts to finally experience growth, this may also lead to higher bond yields so the short JGB helps to reduce the risk exposure with, I believe, a positive expectancy hedge. With long-term yields near 0, I'm getting a very cheap option on higher yields.

I should also note that a crisis in Japan will surprise many investors with its contagion effect. We rarely think of Japan as a key driver of the global economy, but Japan is the third largest economy in the world (just slightly behind China) and represents almost 9% of global GDP. Japan is also the second largest holder of US treasuries and US dollars in the world. In a crisis, they will likely become aggressive sellers to raise money.

Friday, January 6, 2012

Backpacking Through China: An Investor's Perspective - Ari


For the past two weeks I backpacked along the southern and eastern coast of China and found a very different country than I expected, simultaneously more modern and more authoritarian and culturally isolated. My tour included the wealthier and more modern areas of Guilin and Yangshuo in Guanxi, Shanghai and nearby Nanjing and Suzhou, and Beijing. I focused on trying to understand modern China from a business and investment perspective. The basic themes prevalent at every level of society and business were cultural isolation, materialism, and exploiting the outside world by any means necessary. I'm more confident than ever that China's domestic demand will grow exponentially and the Chinese people will quickly gain managerial, marketing, and engineering expertise...but this will not necessarily translate into returns to foreigners. The Chinese Communist Party (CCP) and People's Liberation Army (PLA) play a deeper role in commerce and the public markets than many suspect. The government is pursuing policies to exploit western commerce while remaining economically and culturally isolated in critical ways. China is a dazzlingly large and complex place; with 1/4 of the world's population and the largest economy within a generation, we have every reason to try to understand it.

Infrastructure and Travel Limitations
My first surprise was both the success and authoritarian nature of China's investment in infrastructure. China's highways, airports, long-distance buses, and high speed trains all put the US to shame. Shanghai's subway system was second only to Tokyo among the cities I've visited, and the regional airports and train stations were highly efficient. The authoritarian counterpoint was that China has extreme restrictions on travel for domestic citizens under the Hukou (household registration) system. ID cards and intense security are employed for all inter-city travel. Poor Chinese are basically forbidden from traveling to major cities. For much of the trip, I traveled with my friend, Alpha; he's spent a great deal of time in India and contrasted Shanghai with cities like Mumbai or Delhi where beggars fill the streets. Throughout my travels in China I encountered virtually zero begging and almost no homelessness. This reflects the travel restrictions, and quick action of the police to relocate the beggars away from prosperous areas. Putting aside the question of morality, this has helped attract foreign capital and modernize cities like Shanghai with remarkable speed.

The epitome of China's recent construction is Pudong, the new financial district in east Shanghai. Twenty years ago, Pudong was literally boggy farmland. Now it hosts a modern financial center (likely to become Asia's predominant center of finance within a decade) and some of the most impressive architecture in the world. The eastern part of Pudong consists of residential compounds for the very wealthy. I briefly stayed with my friend's family in this area and was surprised by the isolation. Within these new gated communities sits mansion after mansion with a surrounding tiny 0.5 acre yard, live-in help and paid driver; in front of many houses were two or three ultra luxury European cars. The mansions are occupied by a mix of rich Hong Kongkese, Communist Party bigwigs, foreign executives, and a few rich mainlanders. While the mansions all look gorgeous, they are poorly constructed and epitomize a theme of Chinese production; shoddy craftsmanship is considered the rule, even for luxury goods. I should note that Shanghai's gleaming modern skyline was constructed mostly by state owned companies; the holy grail of Chinese modernization is more like Singapore on steroids than western style capitalism.

Cultural Isolation and Chinese Youth
While most Chinese study English in school, the young Chinese told me that they felt it was perfunctory; the government actually discouraged serious attempts at fluency. Western English media is either censored or strongly discouraged, and most Chinese feel like English is unlikely to be useful for them. This made communication difficult; my attempts at speaking a handful of Mandarin words from my guidebook were mostly met with blank stares, probably because of my poor use of tones and the limited experience of the Chinese at hearing their language mangled by foreigners. The lack of English language is likely to be a persistent obstacle to China's international economic growth. English has become firmly entrenched as the international language of business, and China has among the lowest English fluency of any country in the world, (maybe excepting countries with mastery of other imperial languages, like Angola).

Economic inequality in China is a cliche, but I was surprised to find a stark three tier system of both income inequality and economic freedom. First are the rural (and semi-industrial) poor. The poorest farmers (more than 1/4 of the country) use primarily 18th century technology to farm small plots of land in a lifestyle that is probably not all that different from two thousand years ago. Bridging the gap to modernity are the temporary factory workers; young women in particular move to factory towns (and live in factory dorms and eat factory cafeteria food) for a few years and then return home with their saved money. These people are restricted in their movements and live in under the thumb of CCP authoritarian rule. The second tier are the educated "middle class." Generally young, well educated, ambitious, and materialistic, these people live primarily along the coast. I believe one of China's biggest problems is the perceived ceiling at the top of this class. I spoke to a twenty-something accountant working for Deloitte in Shanghai. He said that if he works hard and does a good job he can achieve a comfortable middle class lifestyle, but without family connections in the Communist Party he will hit a wall. Because of this, he and many other people like him feel that the best opportunities are outside of China; he wants to move to the US, New Zealand, or Australia. As an aside, he said that middle class Chinese don't want to move to Europe because they view it as a "sunset society." The middle class is carefully monitored but generally enjoy free movement and can easily evade authoritarian limitations like the Great Firewall and capital controls (more on this later). The third tier, a tiny proportion of the population, probably less than 0.10%, is composed of the very rich. These are Hong Kongkese, foreigners, top Party Officials, and Red Guard elite; they are functionally exempt from all authoritarian controls as long as they avoid displeasing any political leaders. At this level, political connections and wealth are easily converted from one to the other. Political "entrepreneurs" have purchased the title of provincial party secretary for as much as $500,000; the few cases we learn about are of entrepreneurs who were later convicted for corruption, usually taking several million dollars in bribes within a few years of gaining their new post.

Young Chinese care little for politics. They share a general pessimism about the structure of Chinese society and view the Party as monolithic and unbeatable in the medium-term. In the words of one Chinese professor, "[The youth] may risk their lives to steal money, but they will not do it to attend a political demonstration." The Chinese twenty-somethings I spoke with all shrugged when asked about the long-term prospects for reform. Their focus is on advancing their own position and that means cozying up to the party or leaving China. One young Chinese professional told me that in college, talk of politics was discouraged and students were generally uninterested. The Chinese youth are conservative in other ways as well; pre-marital sex is uncommon, drug use is unheard of, and alcohol and tobacco play a very minor role. When asked about China's economy, they were optimistic, but less so than most westerners. They think a significant portion of China's recent growth has come from unsustainable government spending on infrastructure.

I ran into the "Great Firewall", China's method of controlling the internet, when I attempted to purchase a book about China for my Kindle from Amazon while in staying in Beijing. The internet connection timed out for 2 minutes. The exact rules of China's firewall are constantly changing and opaque. Basically, it slows down all internet access of sites outside China and prevents access to "distasteful" materials like pornography and any news or commentary critical of the CCP. It can be easily and legally circumvented with a proxy or virtual private network (VPN). So why does China bother if it's so easy to ignore? While anyone can easily circumvent the firewall, it plays a powerful role in controlling the media that most Chinese consume. A Chinese woman can do a search on Baidu with servers located within China and get lightning quick responses, or she can access a slow and censored google, or buy a VPN to access uncensored google. For most Chinese, they simply don't bother using anything but Baidu, because they have no reason to. It never occurs to them to do an internet search for "CCP official embezzlement" because they're never confronted with those kinds of stories in the first place. As Americans, we're frequently confronted with stories that are distasteful to the government, like say Abu Ghraib torture, without having to do a specific search for it. The Great Firewall lets the elites access whatever they want, while the vast majority of the country is content to consume the media approved by the CCP. Another effect of the slowing of external sites is that all media companies that want to produce for the Chinese market must locate their servers in China, which places them under the power of the CCP. The result is primarily self-censorship with the occasional arrest of a dissident blogger or raiding of an internet server center. A random aside, Baidu not only censors on behalf of the CCP, it sells Chinese companies the right to hide negative search results.

Party Rule and the People's Liberation Army
China is a blend of a benevolent Singaporean style autocracy, a capitalist development state like Japan, and robber-baron socialism like Russia. For national matters the Party enjoys complete central control. China is run by 9 people, the Party's "Standing Committee." These are selected from the 25 person politburo who are selected from the roughly 370 person "central committee." The People's Congress (about 2200 people) periodically rubber stamp these rulers. The Chinese state firmly retains a Leninist structure - mirroring the state at every level is the parallel but superior Party. Hu Jintao is the state president, but more powerfully he is the party secretary. The key to the CCP's control is the power to appoint and remove personnel. The CEO of every large company, the president of every major university, the chief of every police bureau, and every provincial governor serve at the pleasure of the CCP and are appointed by the completely secretive "Organization Department." The result is that all the major commercial and political organs serve state interests when so ordered. In 2009 while western governments were imploring big banks to lend, the CCP ordered Chinese banks to do so. In the west, bank lending shrunk; in China it surged 50%. “As an organization, the Party sits outside, and above the law. It should have a legal identity, in other words a person to sue, but it is not even registered as an organization.” – He Weifang, law professor.

It's critical for investors to understand that the western style boards of large Chinese companies are a facade. A party committee oversees all major strategic decisions of these companies and has final say. One striking example was in 2004 when the CEOs of China's largest 3 telecom companies were "shuffled" with no prior warning. One of the CEOs was on a roadtrip in the UK to pitch investors on an upcoming share sale when he was abruptly informed by the CCP that he was to immediately resign his current post and take control of his primary competition. It was as though the CEOs of ATT and Sprint suddenly announced they were switching places. In 2009 the exercise was repeated with 3 major airlines. Similarly, western investors need to understand that there is no independent judicial system. Judges are completely under the thumb of the CCP.
It's worth noting that the centralization of power is complete only for national matters. Provincial governments and townships enjoy tremendous freedom, largely because Beijing lacks the power to enforce their authority far beyond the city limits. In my readings, I found numerous examples of local leaders ignoring Beijing edicts from the Cultural Revolution to the present day. In general, the recalcitrant officials are not openly rebellious, rather they pay lip service to Beijing and just substantively ignore the CCP orders. On rare occasion CCP leadership will make a show of jailing or executing these leaders, usually under unrelated corruption charges. While the most egregious cases of corruption are prosecuted (e.g. Li Gang and Ma De), for the most part local officials are allowed to be corrupt as long as they stay under the radar and support the Party. Additionally, on very rare occasions there are obvious rifts within the power structure of the CCP, as when Jiang battled Hu over Shanghai corruption in 2006.

The People's Liberation Army (PLA) has one purpose - to keep the CCP in power. Another way of phrasing the same proposition is that the CCP relies on the PLA to maintain its power. The recent state and Party leaders Jiang and Hu spent an inordinate amount of time visiting military installations to maintain this support. While details are unclear, it appears that in the Tienanmen square uprising in 1989 a significant percentage of soldiers and commanders were reluctant to attack their fellow citizens (aka the treasonous protesters). The party responded by strengthening its oversight and integration with the military. The PLA has always been involved in the economy. Sometimes recruited to work on industrial projects, they have also invested in companies and stated businesses to boost their meager budget. In the 90s, the CCP ordered the PLA to divest most of its economic interests, but PLA leadership remain among the wealthiest Chinese with tendrils that reach into every industry. One American businessman who spent years working with Chinese factories told me that many of the factories he dealt with were secretly run by a single PLA gang; he learned this when investigating why factories that should have been competing with one another were instead acting as a cartel.

Contrary to this picture of a reactionary and unchanging leadership, both the Party and PLA are rapidly modernizing in their own way. The Party has started eagerly recruiting the brightest students from college and inviting star entrepreneurs to join their ranks. The PLA has become much more merit based and is working to become a modern military. In this way, the leadership has created a social safety valve by offering the ambitious but unconnected a way up the ladder, while simultaneously improving the skills of the ruling class.

It's worth taking a slight historical detour here. There are some themes that recur throughout China's 3000 year past that I believe are still in play. First, modern China sees itself as the descendant of Imperial dynasties that ruled the Han people (representing 92% of modern Chinese). While China actually spent about half of its history in more of a federalist system and much of its time under foreign (i.e. non-Han) rule, it's the imperial dynasties that consistently wrote China's history books and today form its political lineage. From around 50 BC, these dynasties employed a complex meritocratic system of staffing the bureaucracy. The theme of centralized power rippling outward through talented bureaucrats remains in vogue today. Second, China has never been particularly interested in international trade. In the BC era, China routinely turned away foreign trading missions, asking for only pledges of sovereignty and tribute in the form of silver. Even when it briefly ruled in the oceans around 1350 AD, China's fleets made a few trips to other countries to demand allegiance and then abandoned the routes out of a lack of interest in the resulting trade. In 1793, a British trading mission was famously told by Emperor Qianlong that China had no interest in British manufactured goods. The opium wars 50 years later were partly an attempt by Britain to eliminate the massive trade surplus China enjoyed as they exported tea and silk and imported mostly silver. I think today's economic policy reflects a similar sentiment but with a twist - whatever foreigners make that the Chinese want, they are determined to learn to produce themselves. This is of particular importance for western companies that hope to sell in China, a topic I'll delve into further in the next section.

Another theme from Chinese history is historical revisionism necessitated by the power of ideas. Most imperial dynasties burned older histories, executed the authors of non-favorable histories for treason, and ritually revised the past to make their own authority look like an obvious extension of the past. In the past century, China underwent several such revisions. For example, Mao disdained Confucius and cited the early Qin dynasty as exemplary. Today's communist party is reemphasizing Confucianism and disdains the Qin period as too authoritarian. In the mid 1800s, a group of nationalist Christians led the Taiping rebellion that resulted in a staggering 20 million dead. Mao's Great Leap forward led to a similar number of lives lost from famine. Ideas in China are powerful and the government correctly views ideas as weapons. This explains their aggressive censorship of seemingly benign intellectuals and religious leaders.

International Trade and Materialism
Alpha and I paid special attention to China's brands. So far, China has produced few brands that can compete internationally (Lenovo is a rare exception). Chinese companies have excelled at cheap manufacturing, but can they move up the value creation chain and produce a Nestle or General Motors? While we saw many examples of weak Chinese branding and amateurish advertising, we also saw some examples that should make western brands concerned. China has knockoffs of Starbucks, KFC, Nike, and just about every other major international brand that appeared well executed to my untrained eye. Ultimately though, I think it matters little. Chinese demand is likely to rise so quickly that China doesn't need to find a foreign market for its brands, at least not in the next decade. It has 1/4 of the world at home. That's a lot of feet to wear Li-Ning (the local brand equivalent of Nike).

The problem facing western brands trying to access China is one of regulation and price. On one popular shopping street in Suzhou, I saw a Nike store, Li-Ning, and then a tout selling fake Nike. The real Nike shoes cost about $160, Li-Ning was $60, and the fake Nikes (of lower quality) were $20. Most western luxury brands actually cost much more in China than in the US and Europe, despite being manufactured in China. One common reason is that the companies have export-only licenses so the goods must be exported out of China and then re-imported back in and face tariffs. Alternatively, KFC is omnipresent in China and faces no premium since there's no export involved. As investors, we need to distinguish between western brands that effectively do business locally (like KFC), and western brands that must import some element of the business (like Coach). At best the latter group will face an uneven playing field and at worse they could be forbidden from selling in China at any time. Foreign companies need a license to sell within China and this license is viewed as a privilege and can be revoked on a whim.
China has adopted a policy of requiring foreign corporations to form local partnerships. I spoke to a senior executive at Ford who explained that lately the Chinese have been demanding not only partnership in the ownership structure, but also in the high-skilled labor; Ford is required to locate a major engineering office in China if they want to continue to do business there. Unabashedly (and I'd argue very intelligently), China is aggressively studying the technological and managerial expertise of the companies that do business there. The Chinese government understands the idea of "smiley curve." In a product's life cycle, there is a lot of value created in the design and engineering phase, only a little during manufacturing, and a lot during marketing and retail. For example, of a $30 pair of headphones sold in the US, only about $3 stays in China. China wants a bigger piece and has the policies in place to get it. What does that mean for Ford? While I think that Chinese demand will grow fast enough to provide plenty of sales to both Ford and local brands, it ultimately depends on what line the Chinese government chooses to pursue. If they decide it's in China's interest, the government will not hesitate to withdraw the permits that currently allow foreign brands to sell within China.

The Chinese clearly intend to exploit western companies for profit, expertise, and as corporate police. One example of the latter comes from Macau (also spelled Macao), a small island south of China that was originally a Portuguese colony and is now a special economic zone of China. Macau has been a crime ridden center of gambling, organized crime, prostitution, and money laundering for much of the last century. One man, Stanley Ho, had a legal monopoly on casinos. Recently, the Macau government (with Chinese encouragement) invited a half dozen US casinos to establish operations in Macau. These casinos, including Wynn resorts, have their global operations scrutinized by the Nevada gaming board. They have to play by the same rules in Macau as they do in the US. As a result, they have a clear incentive to report unfair and illegal activity of their local competitors to the authorities and to establish infrastructure that rewards a clean gaming economy.

A key question concerning China's future is if they can generate the domestic demand to reduce their reliance on exports. I find it impossible to understand how anyone who has visited China could doubt that the answer is a resounding Yes. The Chinese are arguably the most materialistic people in the world today. The middle class Chinese are incredibly aspirational and consumption driven. They desperately want to improve their quality of life and understand that education and hard work are the way to get there. Contrary to the communalism imposed by the government, individual Chinese are entrepreneurial spirited. Everyone I spoke to supported the idea that most people in China are looking to improve their economic status quickly, either from temporary factory worker to skilled labor, or from mid-level auditor to investment fund manager. In Shanghai, conspicuous consumption abounded from knockoff Rolexes to genuine European luxury cars. The religious practices in China support this materialism. In the words of one young Chinese professional, the Chinese Buddhists are not really religious but just come to temple on rare occasion to pray for wealth or good test scores. This was in line with my observations at the Buddhist temples; the "prayers" available for purchase (ribbons or wood carvings with text) were for wealth, good test scores, a job promotion, or having a male child. While some books suggest that as many as 80% of Chinese are a member of one religion or another, the Chinese people I spoke with thought the real number was a small fraction of that. In China's early history Confucianism may have been an obstacle to economic growth since Confucius disdained merchants and trade. The Confucianism of China today ignores these tenets and emphasizes the ideals of a harmonious society and respect for authority.

The Environment and New Construction
I was apprehensive about traveling to Beijing after reading stories of air so polluted that it made breathing difficult. In 2006, blue skies were a distant memory and on most days, you couldn't see more than a few hundred yards because of the thick smog. Remarkably, Beijing is less polluted today despite a doubling of cars on the road. In the government's 11th five year plan, released in 2007, the Chinese government fully acknowledged their environmental catastrophe. They publicly accepted that the pollution was reducing GDP by as much as 3% a year, killing tens of thousands of people a year, and reducing the expected lifespan of the general population. As a result, the government enacted some of the most vigorous environmental controls in the world. These included car emission regulations that are more restrictive than in the US and regulations and subsidies to put modern pollution scrubbing technology on factories and power plants. It's hard to overemphasize this point. The Chinese environment is still a mess, but they are devoting tremendous resources to cleaning up; China builds about 50% of the world's solar and wind plants and is investing $1 trillion over the next decade in renewable energy. The environment is a national priority at every level, from the top of the CCP to the average entrepreneur. Local officials are now judged on both environmental and economic metrics. While Beijing air remains significantly more polluted than Manhattan, the results were clear. On my last day in China, I was able to enjoy Beijing with clear blue skies. An obvious place to look for investment opportunities in China is in companies that produce "green technology."

My friend Alpha and I debated whether China will face a hard landing in the next 4 years (I think so, Alpha disagrees). I'd need another few pages to delve into the macroeconomics, but one turning point for China is clear. At least the current wave of real estate and construction spending is over. The Chinese government recognizes this and recently announced the construction of 30 million low income homes in the next five years. Critics argue that the "home" in question is sometimes as small as 150 square feet and little more than a berth for temporary laborers. Also, provinces are counting projects already underway as part of the new home construction figure, but it's still a massive undertaking. The goal is to support the construction and real estate markets while providing political cover for the CCP in case unemployment rises and GDP growth slows. Investors need to keep a close eye on such projects. The initial boom in infrastructure was largely productive; China needed highways and high speed rail. The next round may consist mostly of bad loans for "bridges to nowhere."

Learning about China will be a lifelong endeavor as I chase a quickly evolving target. I don't pretend to understand China, but this trip and the associated conversations and readings have given me a rough sketch. First, China may claim to be the oldest surviving civilization, but it is a young and materialistic economy; it will continue the process of industrialization, urbanization, and especially, rapid growth in consumption. Second, China is authoritarian and savvy; the government is using their power to exploit western technology, expertise, and capital; success in China (or selling to China) requires dealing with the CCP. Third, the Chinese are incredibly aspirational and will work hard to advance in life; I believe they will likely reshape the nepotistic CCP structure around them (especially if the USA keeps stupidly denying visas to their best and brightest). China will continue its expansion as a global economic power. They will inevitably grow from the manufactures of the world to also challenge the west as engineers, designers, and marketers. The key question is: will they choose to isolate themselves or will they gradually integrate? Will the government focus on import replacement and continue to "protect" the population from foreign goods and media, or will they globalize?

The advantages of investing in a company like Ford that is based outside China, is that they have much stronger corporate governance and are subject to western laws. The string of recent Chinese accounting frauds is just the tip of the iceberg; investors in Chinese companies will be in for a bumpy ride for the next generation or longer as they find no legal system to protect them and few sympathetic ears in government. However, China may continue to block imports by restricting permits, employing tariffs, and giving home grown companies special advantages; if so, foreign companies that are attempting to sell to China may end up as poor investments. I haven't come to a satisfying conclusion yet, but I think the answer lies in carefully investing alongside mainland Chinese. For example, as the majority investor in the mezzanine debt in a state owned company, you are likely to find yourself defrauded. If you own 2% of the senior debt or equity of the same company, you are investing alongside the Chinese and the company's management will have a tough time singling out your investment for "special" treatment. If this analysis seems too paranoid, it's worth looking at other historical precedents. Large US companies routinely defrauded British investors in the 19th century through dilution of equity and subordination of debt among even less subtle methods.
China's booming economy and sheer size will offer tremendous opportunities for investment over the next generation. With some smart decisions and a careful approach, we can profit from what may end up being the single most important secular trend of our lifetimes - the rise of China.


Aside from my own observations and discussions with Chinese locals and expert foreigners, I am indebted to three books. "The Party" by Richard MicGregor is a phenomenal look at the modern Chinese political structure. "China: A History" by John Keay is a great overview of ancient China. "Postcards From Tomorrow Square" by James Fallows is a short collection of essays with some revealing anecdotes about Chinese culture.