The games that companies play: Tongda

Below is the 10-year stock price chart of Hong Kong-listed Tongda Group Holdings (698 HK). The company produces plastic components for consumer electronics, a hot industry given the explosive growth of smartphones in China in recent years.

Tongda

The red circles in the chart indicate two instances where the company has raised cash through secondary offerings.

Just before the January 2007 equity issue, the stock price went from HK$0.15 to HK$0.60, up 300% within a year.

Just before the March 2014 equity issue, the stock price went from HK$0.50 to HK$1.12, up 124% in just a few months.

Pretty good timing!

Now fast forward to 2015. The stock is up 72% YTD and volumes have started to pick up. How do they respond?

By yet another press release indicating plans to issue HK$880 million in convertible debt at a conversion price of HK$1.88 and an interest rate of 1.0%.

Tongda’s management is either very good at timing the market, or very good at drumming up interest for their stock at exactly the right time.

Exactly who will be buying these convertibles is a mystery. Barriers to entry in the industry are practically zero and competition from the likes of Foxconn is high. Free cash flow conversion rates are poor. And smartphone sales in China have started to contract after a few years of rapid growth.

For this you are paying 2.6x book and 16x earnings. Slower-growing competitor Ju Teng is trading at 0.7x book and 6x earnings.

I get the feeling that Tongda’s management will have the last laugh.

Fritz

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We may never fully understand Vipshop

Chinese ADRs are hard to get a grip on these days.

On the surface, Vipshop has a great story: secular tailwinds as a higher proportion of retail sales moves online, growth rates of almost 100% per year, a CEO that Jack Ma counts as one of his favorite businessmen and a shareholder register that includes investors such as Tiger Global and Passport Capital.

The story looks great… as long as we believe in the audited accounts. Should we?

In the past, short-sellers compared financials statements provided to China’s State Administration of Industry and Commerce (SAIC) with SEC filings to see whether a company may have misrepresented its true condition. When Beijing-based J Capital did this earlier this year, they claim to have found a discrepancy of 10x between their own consolidated version of Vipshop’s SAIC financials and SEC accounts. But in mid-May, Vipshop altered their SAIC filings such that such a large discrepancy no longer exists. In addition, regulatory changes from 1 March 2015 eliminated the requirements for Chinese companies to submit audited financial statements to SAIC. So this way of identifying frauds may soon no longer be available.

Screenshot_230

Altered SAIC financials for one of the subsidiaries

How about third party checks on Vipshop? According to iResearch, Vipshop had a market share of total China B2C e-commerce GMV of 2.9%. This works out to a GMV of about US$5.7 billion on an annualized basis. Given that most though not all of Vipshop sales is on a consignment basis (and therefore reported net), the SEC filing revenue figure of US$3.7 billion for 2014 could be true. The question is whether iResearch can really be trusted upon. First, the research is paid for by its clients so conflicts of interest are undeniable. iResearch also makes venture investments into Chinese Internet companies itself – hardly qualifies as an “independent provider” of research! NQ Mobile, Sinoforest, etc all used similar types of research institutes in their SEC filings, and they all turned out to be wrong. So here is another source: research institute CECRC (中国电商研究中心) claims that Vipshop has a market share of 2.8%, almost the same number as iResearch’s. It is not clear whether they relied upon management-supplied data for this ranking. Alexa, as flawed as it the website may be, shows a website ranking for vip.com of 1443 vs 985 for Dangdang, which sounds low considering that Dangdang has a market cap of US$845m vs US$13 billion for Vipshop. Counting website traffic from sites such as Baidu indicates falling traffic for Vipshop over the past year… but then again, it is undeniable that most of the growth in traffic comes from mobile these. So it is hard to draw any conclusions from either of these sources.

In April this year, further allegations about fake products were raised by competitor Jumei. Jumei claims that Vipshop copied parts of its website for brands that Jumei has an exclusive right to sell in China. If those allegations are true, Vipshop either 1) sells fake goods to its customers or 2) does not sell some of the goods it has on its website. You might think that customers should be furious when they hear this. But no, customers actually do not seem to care. There are countless stories of customers complaining about quality and wondering whether Vipshop products are fake. An equal amount of customers are bewildered of how cheap products on the website are. And also how much customers love buying goods that are heavily discounted from their MSRPs (loss aversion/anchoring or what behavioral economists call “positive transaction utility”). So maybe it is reasonable to expect high profitability when you are just selling poor-quality versions of reputed brand-name products?

Other questions raised by short-seller Mithra Forensic Research and J Capital:

  • Inventory is high, given that the vast majority of sales comes from goods on consignment. Has capitalization of assets (inventory) been used to keep COGS low and thus increase gross profit?
  • Why is days payable 125 days, compared with management’s goal of 45 days?
  • Failure to disclose 9 physical Vipshop retail stores
  • How can the company only have 4 logistics centers throughout the nation, compared to JD.com’s 97 warehouses for example?
  • The large discrepancies between the AIC and SEC filings that J Capital documented in its first report before the filings were allegedly altered

What is the truth?

It is hard to prove anything. But as investors we have to rely on probabilities:

  • What is the probability that a company in a commoditized industry goes from terrible performance pre-IPO to an ROE of 40%+? What has changed? Highly successful Chinese retailer JD.com still does not make any profit. Dangdang makes 14% and Jumei 18%.
  • What is the probability that a company that has had a cumulative cash build up of negative US$36 million (CFO-CFI) over the last three years is also a huge money making machine?
  • What is the probability that a company that lies about having physical stores and the authenticity of its products, is also truthful about its finances?
  • In general – what is the probability that a Chinese company listed in the US does not use the lack of rule of law to its advantage and rape foreign investors (convertible notes, anyone)?

The burden of proof should not be on short sellers. Long investors must also use their heads when they jump on to the next hot Chinese Internet story. And instead of questioning the legality of J Capital’s research methods and underlying motives, why did Vipshop not just release their SAIC filings directly to clear all doubts? Everything that comes out of the People’s Republic must be questioned. Yet we probably have to accept that we may never fully understand Chinese companies such as Vipshop.

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Liberty TripAdvisor – Judging the probability of a near-term acquisition

The Liberty TripAdvisor idea was a simple one: LTRPA is trading at a discount to its underlying TRIP shares, despite the fact that LTRPA has a voting right premium that is potentially very valuable.

The question is how and when value will be realized. In order for LTRPA to be worth as much as the underlying shares the company needs to avoid any tax consequences when the company is ultimately sold. If LTRPA sells its TRIP common shares on the open market it would be hit with huge capital gains tax where the tax basis of TRIP shares is only $400 million vs. a minimum value of $2.5 billion – an enormous tax bill. It would also lose its controlling stake in TRIP. It could sell both the common and the high-voting right TRIP shares to a third party, but then again same issue: would still be hit with high capital gains tax.

The only option and the reason why LTRPA was spun off in the first place, is a merger of LTRPA with a third party. Such a merger is tax free under US Internal Revenue Code section 355 as long as it is either a “Reverse Morris Trust” (LTRPA gains over 50% of capital in a merger immediately after the spin off), or if all of the following criteria are met:

1. Parent must “control” at least 80% of the vote of the SpinCo prior to distribution. LTRPA did not appear to satisfy this requirement but Malone managed to get past this requirement in the spin off process.

2. Parent and SpinCo must conduct at least one trade or business after the distribution and have been conducting such trade or business for at least five years prior to the distribution. I believe LTRPA’s smaller segment BuySeason was the reason LTRPA satisfied this requirement.

3. “Device Test”: the distribution must not be used to distribute the earnings and profits of a corporation. This may be tricky to prove for LTRPA.

4. Parent must distribute a minimum “control” of SpinCo.

5. The distribution must be motivated by one or more business purposes

Of course, since the spin off has already taken place the criteria have all been met. But the IRS ruling of LTRPA being a tax free spin off can be invalidated whenever one of the criteria ceases to be satisfied. Specifically, there is a presumption under the device test that if the spun off company is acquired within two years of the spin off date the tax authorities will consider the spin off fully taxable, paid by either the original shareholders or the parent. John Malone knows this and he will of course do everything in his power to avoid this from happening.

If IRS sees LTRPA breaching the device test, the company would have to make a “rebuttal”, a lengthy process where each party argues whether or not being acquired was part of the original plan when they spun off the company. In most cases, the company can successfully argue that the spin off was not a precursor to an acquisition if (the “Safe Harbor I Rule”):

(i) there was no agreement, understanding or arrangement or substantial negotiations concerning the acquisition during the first six months; and

(ii) the spin-off was motivated “in whole or substantial part by a corporate business purpose other than a business purpose to facilitate an acquisition

Greg Maffei has made it clear that is has not been in talks with any third party yet (although he has indicated that Alibaba and TripAdvisor itself could be potential buyers). He mentions it in the following interview from 15:30 to 19:00.

http://fora.tv/2014/10/09/Maximizing_Media_Returns_in_a_Time_of_Secular_Change

In the S-1, the reason for the spin off was not stated to be a potential acquisition of LTRPA but rather to demonstrate the underlying values in the Liberty Media portfolio in line with the success Malone’s tracking stock. It should be possible to argue that both of these conditions can be satisfied.

If history is any guide, then there has been plenty of acquisitions of subsidiaries recently spun off from their parent companies. In the below sample, all of Ralcorp, Motorola Mobility and Ticketmaster were acquired less than one year after the spin off date with no problem from the IRS.

All spin offs copy

There have been acquisitions of recently spun off companies within the John Malone sphere. Liberty Media International was merger with UnitedGlobalCom in exactly 1 year after the spin off date. Discovery Holdings was also merged with Advance/Newhouse Communications after the spin off of Ascent Media and that took only 9 months from the transaction until the close of the merger.

Malone spin offs copy

Conclusion: it is unclear whether an acquisition of LTRPA within two years after the spin off may cause the tax free status of the spin off to be invalidated. But there have been plenty of examples over the past decades of spun off companies being acquired much earlier than two years, so many that the “device test” might not be such of a big issue anyway. The most likely scenario is that LTRPA will enter into discussions with third parties after six months and that it will somehow be able to demonstrate that an acquisition was not part of the original plan.

I believe there is a fairly large likelihood of a realization of value before the two year period ends. Even if LTRPA is not acquired within two years, then the risk of a fully hedged long LTRPA short TRIP pair trade is so low that it might be worth accepting a lower return on the investment than in a normal long or short position.

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Pair trade idea – Liberty TripAdvisor vs TripAdvisor

Liberty TripAdvisor (LTRPA) was spun off from Liberty Media on 27 August 2014. The main asset is 22% of cash flow rights and 57% of voting rights in TripAdvisor (TRIP). The reason LTRPA was spun off was to seek a tax efficient way to realize the value of the TRIP shares owned by Liberty. The tax basis for those shares was ~$500 million for a company now worth $2.3 billion. A merger between LTRPA and a third party would be far more tax efficient. The block of shares that LTRPA owns is potentially very valuable as it is the only way for TRIP management to stave off hostile acquirers. Yet LTRPA shares are trading at a discount to equivalent TRIP shares. We see a hedged pair trade as the most attractive way to take advantage of this situation, providing decent returns with little to no market risk.

Background

TRIP was created as a spin-off from booking website Expedia. TripAdvisor itself is a travel website that offers user-generated reviews and information on hotels, restaurants, attractions and other travel-related information. Its revenues are based on ads and is thus more of an aggregator than the commission based revenue models of Expedia and Booking.com. It has 60 million members, 280 million unique visitors a year and 170 million reviews, which creates a strong network effect that makes it hard for incumbents to compete – similar to the moat that Amazon has through its product reviews. The business is growing and growing in clout. About 30% of TripAdvisor revenue comes from Expedia. The valuation of TRIP itself at 11x revenue is probably double of what it should be, given 10% top-line growth and no major economies of scale in its ad-based business model that justify a large increase from current 30% operating margins. Rather the margins are on a downward trend due to acquisitions.

Liberty Interactive, run by John Malone, had been acquiring TripAdvisor shares over a long time and now holds 57% of the voting rights. John Malone himself owns 40% of LTRPA voting rights, which makes him the controlling shareholder. You get 0.42 shares of TRIP for every share of LTRPA that you buy (31/74) – I am counting only the cash flow rights.

Cash flow rights

CEO Greg Maffei has said:

  • TRIP and LTRPA merger will likely not happen due to tax implications
  • Alibaba mentioned as a potential acquirer (with a $25 billion war chest)

The value of majority control

According to an Israeli study, the price of 1 percentage point of voting power was worth about 2% of the firm’s equity. Another study showed that the value of a control block in Brazil, Chile, France, Italy and Mexico showed that the value was at least 25% of the market capitalization. A third study in Anglo-Saxon countries revealed a value of less than 10%. A fourth study showed an average control value of 14% of market cap. Having said that, take-over premia tend to be lower in countries with strong law enforcement, good investor protection rules and pro-investor takeover rules. The United States would qualify. We should therefore err on the side of caution and exclude the developing country study from the sample. It is worth noting, that when Liberty Interactive acquired the shares of then TripAdvisor chairman Barry Diller, it paid a 63% premium to the market price of $38 for non-voting shares. Such is the value of a controlling block of voting shares. I believe more of this value will be captured by the Series B shares (ticker LTRPB) than Series A as the voting rights are 10x larger, but liquidity is non-existent. We apportion the take-over premium below to voting rights of Series A (71%) and Series B (29%).

Takeover premium

Valuation

By far the largest part of the value of LTRPA comes from the shares in TRIP. The total value of these shares at market value is $2.7 billion. If you add $1 billion in premium for the fact that Liberty TripAdvisor holds the majority of the voting rights, you get a total value of $3,7 billion. The rest of the businesses in LTRPA, primarily in e-commerce website conglomerate BuySeasons are negligible. It has had a cash burn of approximately $10 million a year. Assuming 5 years to fruition for LTRPA to be taken over, the cash burn will be approximately the same to corporate level cash of $50 million. I expect John Malone to terminate this business as he is rational allocator of capital. Deducting corporate level debt we get to a total value of LTRPA shares of $3.3 billion, a 44% premium to last day’s price of LTRPA.

Valuation

Conclusion

To gain control of TRIP, a potential acquirer needs to gain control of Liberty TripAdvisor as it holds 57% of the voting rights. To gain control of Liberty TripAdvisor, it is not enough to buy all Series B shares as they only provide 30% of the voting rights. John Malone also does not have character nor the track record of screwing minority shareholders in his holding companies. The most likely scenario is a full acquisition of LTRPA by a third party using shares as a currency as this would be the tax efficient option. In this case, I estimate a 40%+ upside to LTRPA shareholders with little or no risk given the opportunity to short equivalent TRIP shares at a very low cost (0.3% to borrow at Interactive Brokers). Liberty TripAdvisor is already in play, as has been indicated by Greg Maffei many times and a takeover offer is likely in the next year or two. It is hard to imagine a plausible downside scenario. Might Liberty TripAdvisor sell its TRIP shares on the open market (at a high tax basis)? Unlikely, given the track record of John Malone and Greg Maffei with regard to capital allocation.

Buy LTRPA and sell TRIP in the proportion 1:0.42 LTRPA:TRIP equivalent to 20% of the portfolio, as downside risk is deemed to be low.

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Short idea – VIP Shop

VIP Shop – Short Thesis

VIP Shop is one of China’s largest online discount retailer. The company sells branded items through “flash sales” on its vip.com website. Flash sales means that a particular product is offered at a discounted price on the website for a limited period of time. The company claims to have 49 million registered users and 12 million buyers and is selling 8700 types of brands. VIP Shop is a legitimate company with seemingly trustworthy accounting and OK presence in China.

The share price has skyrocketed in recent years due to what is perceived as strong underlying growth rates:

Share price

THE SHORT CASE

  1. If you believe in search index volumes and website rankings, the company’s growth has more or less stopped,. Below is the search volume on Baidu for VIP Shop in Chinese (唯品会). The number of Baidu searches for the company name has trended downwards since 2Q14 and continued to decline since then. Google Trends paints a similar story with search volume falling of a cliff in 2H14.

Baidu searches

  1. Part of the reason for the recent decline in popularity of vip.com is bad publicity amid the revelation that much of VIP Shops’ products are in fact counterfeit. From July to November, the government is running a campaign they target online transaction platforms and group-buying websites to seek out and punish companies that enable its customers to buy counterfeit goods. Newspaper stories that VIP Shop’s branded products were counterfeit spread like wildfire on discussion boards. Baidu search queries for “VIP Shop counterfeit goods” increased slowly in 2014 and shot up sharply in August 2014.

Fake goods

Examples of comments on online discussion boards (my translation):

“Even if the products are not fake they are useless. I bought three pairs of clothing, but the stitching and size was off [not symmetric]. I wanted to return but had to pay the transport fee so I couldn’t bother”

“A lot of VIP Shops clothing has its brand name tags glued onto the clothes” [indicates that they are fake]

“Last year I did not notice any fakes, but this year I got 3 fake pieces of clothing from VIP Shop. No way it was 100% cotton… disgusting”

“VIP Shop has fakes. My friend bought a Supor Rice Cooker [a famous Chinese brand] and it broke down after just a few days. I took it to the repair man and found that the insides were completely different from the real version.”

Etc, etc…

  1. VIP Shop has essentially no competitive edge, and industry barriers are few to none. This is reflected in the large number of copycat group-buying or discount retailer websites that has sprung up in recent years. Typical sources of “economic moats” that protect companies from competition such as switching costs, network effects, strong brand etc are not really present:
    • Websites such as online discount retailers offer close to zero switching costs for the customer, and barriers to entry for new entrants is close to zero. The sales channel is not perceived to be attractive for brand owners anyway.
    • Since VIP Shop does not have a strong distribution network and no production by themselves, it is hard to imagine any substantial economies of scale.
    • Unlike Taobao, which offers a platform for merchants to sell their products and thus benefits from a virtuous circle of lower prices and more customers, VIP Shop has no benefits from such network effects.
    • Anecdotes suggest that not many people in China have not heard of VIP Shop. This could be due to the strong presence in lower tier cities rather than larger cities such as Shanghai or Beijing, but regardless stands in contrast to e-commerce giant Groupon for example, which is valued at a much lower market capitalization.

There are also questions marks about the sustainability of the business model, even disregarding competitive forces. High end retailers usually don’t want their products sold through discount channels, so how can VIP Shop ensure large enough supply of genuine products?

In the past, VIP Shop relied on cheap clothing bought from textile firms after the huge inventory peak in 2012. Inventories are still high, but at some point textile firms will have less of a need to sell deeply discounted inventory to flash sales e-commerce sites to improve their balance sheets. (http://www.chinadaily.com.cn/business/2013-11/01/content_17074708.htm)

Products such as handbags are sold on the VIP Shop website, but brands such as Coach have not given their permission for sales of their products. Technically, this suggests either parallel imports (not allowed on the mainland) or fake products. Whatever may be the case, it does not bode well for VIP Shop.

The number of complaints from customers about VIP Shop is much larger than other online e-commerce websites. According to the 2012 survey on online discount retailers, 42% of shoppers at VIP Shop complained about the product.

Complaints

  1. The large amount of competitors that have sprung up testify that barriers to entry in the industry are sparse. Alexa website ranking puts VIP Shop at spot #126 in China and it is dominating in its niche. Flash sales operators like VIP Shop used to take 20-25% commission from vendors (a major source of their profits) but this commission has since dropped to 5% following pressure from Vancl and others.
  1. E-commerce sites in China evade sales taxes by not providing official invoices. This has been raised by shopping mall owners and bricks-and-mortar retailer as an unfair advantage of online retailers and the government considers it a loss of major tax revenue. The government is planning to roll out a nationwide e-invoice system in 2015 that will force online merchants to pay sales tax, which would then lead to higher prices (http://www.marketwatch.com/story/as-alibaba-ipo-looms-china-mulls-taxing-alibaba-users-2014-08-07)
  1. Certain claims by management seem too good to be true, or potentially false.
  • VIP Shop claims that 93% of its shoppers are repeat customers. But how can 93% of its shoppers be repeat customers than almost half of its customer complain about the service and the return rate is 15-20%?
  • Gross margins improved drastically from 9% to well over 20%, but management has failed to provide a good explanation other than “pricing power”. A plausible explanation is that the company increased the share of fake SKUs among total merchandise volume
  • The company claims monthly unique visitors of 25 million, yet data analytics website similarweb.com shows a number of just 4.5 million. This number is also not growing at any considerable pace.
  • VIP Shop has earlier claimed that it has no bricks-and-mortar stores. In an interview with the CEO earlier this year, he confessed however that the company did in fact have offline stores. It seems that VIP Shop regularly uses these offline shops to sell inventory that it cannot get rid of online.
  1. Valuation multiples are ridiculously high. The stock has become the object of speculation and somewhat of a favourite growth stock among institutional investors. For those that still entertain the idea that VIP Shop’s share price has been driven by revenue growth rather than any speculative excess, please look at the EV/Sales chart over the past few years:

Bloomberg

Not only has TTM sales increased at a rapid pace, but the EV/Sales figure has also shot up in a parabolic curve from EV/S of 0.5x to 4.5x currently. If VIP Shop achieves the same EBITDA margin as worldwide Group Buying website Group On has at 6.5%, VIP Shop would trade at 69x EBITDA. The shares are pricing a very long runway of growth.

PB

VIP Shops P/B at 32x is by far the highest of any major listed e-commerce company, and one must wonder: if the business is so easily replicable, why pay 32x book instead of starting a direct competitor at 1x book? It is either the world’s best money machine, or simply an overpriced stock. A telling sign is that VIP Shop’s Enterprise Value is 28 times larger than US competitor Overstock.com and 3 times larger than global group buying giant Groupon. The absolute number of US$12 billion in market cap is a large one indeed. The Chinese population is larger than the US, Groupon’s home market, but then again customer’s purchasing power is much less and the competition in the Chinese e-commerce industry is fierce.

Screen Shot 2014-09-21 at 09.17.45

In the more developed US market, the four largest “flash sales” retailers Zulily, Gilt, Rue La La and Haute Look have combined sales of roughly US$4 billion. Assuming a “reasonable” maturity EV/EBITDA of 10x and EBITDA margin of 6.5%, VIP Shop would have to have a 100% market share in a total market size of US$19 billion at that date. Given that China’s economy is still smaller than the US one, the numbers look implausible.

  1. Insiders are selling: other than a secondary placing in early 2014 of 1.3 million shares from insiders, Sequoia has also gradually been reducing its shareholding.
  1. The VIE structure of foreign listings of Chinese IT companies makes it hard to understand what the contractual rights of ADS unit holders actually are. Technically ADS holders have a right to the profits of the Chinese entity, but it is not yet clear whether Chinese courts would uphold these contracts. It is also unclear how ADS holders will be rewarded as all VIP Shop revenues are domestic and payment of dividend would require both withholding tax and a way to circumvent China’s closed capital account. VIP Shop does not pay any dividend and, judging from other Chinese VIE’s, it may never do so. It is not clear whether ADSs of Chinese VIEs should command premium valuations when both cash flow and voting rights are highly uncertain.

SUMMARY

VIP Shop is a reasonably successful e-commerce website with seemingly trustworthy accounting. Ultimately however it has a flawed business model where the company more or less deceives it customers by selling fake goods. If Baidu search queries is anything to go by, customer numbers have probably peaked already. This has been coupled with a speculative frenzy in the stock, driven by a promotional management, and where the stock has become the market darling among institutional investors. The valuation is now 32x book and close to 5x EV/EBIT, despite being in a low-margin, no barriers-to-entry business. Consensus expects revenues to grow 70%+ per year over the next 3 years with margins being constant. I challenge this view and believe that VIP Shop has already hit its peak due to problems with counterfeit goods, which was probably why the company managed to keep prices low and profitability high in the first place. I expect near-term issues from negative news reports amid a government crackdown on counterfeit goods. Even longer-term, I see few ways to justify its HK$12 billion valuation, even in a wildly bullish scenario of large market growth and additional market share gains.

Sell short at current price of US$209 using funds of 5% of total funds in the portfolio.

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Macro backdrop

Quick comment on each of the major asset classes, and their relative attractiveness vs. cash. I am agnostic about relative allocations and willing to go 100% cash if it is deemed to be the most attractive asset class.

Screen Shot 2014-08-23 at 13.46.23

Stocks

Stocks have benefited from lower interest rates the last 30 years and the excessive spending effect that comes from increasing debt/GDP. This is not only true for the US and Europe – global interest rates are the lowest they have been in 50 years.

Global interest rates

Assuming constant equity allocations and no increase in the number of shares outstanding, stock market prices cannot grow unless total money supply (money + credit) grows. Credit cannot grow forever as the total debt burden on economic participants becomes too high. The only way to keep up total money supply growth is then increase m0 (currency in circulation + reserves) substantially, either through printing currency in circulation or open market purchases funded by reserves. We have seen quantitative easing, whose effect is short term and not considerable on the money supply. But unless governments start physically printing money on a big scale, it is hard to imagine total supply of financial assets to grow at a very fast pace in advanced economies. Japan has already lived through this for many years – bullish for the currency but bearish on equity price increases.

Global debt

Investor equity allocations are elevated for most markets. They are especially high for developed markets in North America and Europe. Given high equity allocation figures for households in the US, equity prices must be high – especially considering that most bond instruments also look overvalued.

Household equity allocation

Valuation ratios for other countries in terms of market cap/GDP vs. historical levels

Country Total Market/GDP Ratio (%) Historical Min. (%) Historical Max. (%) Years of Data % of Peak
Belgium 229 80 229 4 100%
Mexico 42 12 46 23 91%
USA 123.7 35 149 44 83%
Sweden 125 63 159 13 79%
Canada 139 78 190 24 73%
Switzerland 287 84 431 24 67%
UK 132 47 205 42 64%
Korea 87 36 140 17 62%
Germany 49 22.7509 81.9083 24 60%
Australia 123 94 229 14 54%
India 78 41 165 17 47%
Indonesia 50 19 108 17 46%
Brazil 48 26 108 17 44%
France 78 54 183 24 43%
Netherlands 88 51 251.5 22 35%
Spain 81 50 235 21 34%
Singapore 141 92 418 27 34%
Japan 120 56 366 30 33%
Italy 14 9 45 14 31%
Russia 33 22 142 14 23%
China 44 41 662 24 7%

Peak valuations may never be reached again in some cases (Japan), so one should take the above figures with a grain of salt. Interest rate levels are also different for each country. But on an absolute level, market capitalisation rates in countries such as Italy, Russia and China are very low indeed, maybe for good reasons. Valuation levels are worryingly high for Western European, North American and selected emerging markets, especially for smaller capitalisation stocks.

The frothiness of the US IPO market is indicating a top. In 1999 around 83% of all companies that went public have never had a profit – today that number is 80%. This is a great source for short ideas.

US IPO

The AAII Sentiment Survey for the US points to neutral view on the market. Most investors are not even aware the equity prices have boomed. And fundamentals look OK for the US. The yield curve (although manipulated by the Fed) does not point to a recession.

2-10spredtorecession

Bonds

Interest rates have reached record lows in many countries, as mentioned below. But supply and demand for bonds speaks in favour for lower yields, which means that we may not see considerably higher rates for a long time.

Why should interest rates increase?

  • Supply: an increase in supply of credit would come from either 1) government 2) companies 3) households 4) foreign central banks. However, debt/GDP levels are very high in most developed countries, which means that the long term supply growth of credit will be limited absent any rise in taxation levels. 
  • Demand: We are seeing aging populations pretty much anywhere in the world except Africa, Middle East and South Asia, which means less spending, a secular trend toward lower inflation and higher demand for safe assets due to retirement needs. Deleveraging in the banking system in Europe and the US increases demand for high quality assets, which all fixed income securities are priced off.
  • Government intervention: manipulation of interbank lending rates or direct lending from central bank balance sheets would compress the whole yield curve if such actions persist. As growth is unlikely to pick up considerably, central banks have political incentives to keep rates low.

Higher risk bonds have rallied substantially in recent years, in line with increased risk taking by investors. Credit spreads are not as low as in 2007, but absolute junk bond yields are incredibly low.

Screen Shot 2014-08-23 at 13.05.20

High yield issuance in developed markets has been high in recent years. This means pressure on junk bond prices when these bonds will need to be refinanced. Developed market junk bonds may be a good source for ideas on the short side. The benefit of bond shorts is that upside-downside quantity ratios and recovery rates are easily quantified, so downside risks can be held at low levels (at a cost of negative carry).

High yield.jpg-large

Global default rates are not increasing yet, so it does not seem likely that the junk bond market will correct meaningfully. Junk bond default rates for US:

Default rates

Even though there is no compelling argument why interest rates should increase, credit spreads are mean reverting in cycles of 5-10 years. Default rates may be low in developed markets, but there are signs of stress in the banking system elsewhere, including in China, Indonesia, Russia, etc. In the US, the high supply of junk bond issuance over the past few years must have led to a deterioration in credit quality at a time when spreads have reached close to record lows.

Emerging market bonds, after last year’s emerging market bond rout are priced OK against US Treasuries. Current long term EMBI spreads are around 350bps, in line with the 10 year average. Currency risk may be underestimated, however.

JPM02-26chart2

Currencies

Currencies represent a claim on the productive abilities of individuals within a country where a currency has a monopoly through legal tender laws. The value of a currency increases with relative population growth and relative productivity improvements. The value of a currency also decreases with the supply of claims of citizens’ productive abilities.

If a currency (i.e. the local wage level in foreign currency terms) is undervalued, this will show by competitiveness of its exports and FDI flows. Competitive currencies thus tend to have current account surpluses and large FDI inflows. They should also have low debt/GDP ratios meaning base money is less over-collateralized.

Countries such as China, India, Brazil, Mexico and Indonesia score highly on long-term attractiveness for FDI flows.

Screen Shot 2014-08-23 at 15.23.50

Countries with current account surpluses to GDP include many commodity producing countries. Major investable Asian countries in red in the chart below. Interesting regions may include Singapore, Vietnam, Korea, Philippines, China and Hong Kong.

CA to GDP

Judging future productivity gains is harder, but a good start is looking at savings rate and R&D spending to GDP. China scores highly in this respect, as does Vietnam (relative to the size of its economy per capita) as well as India and South Korea. These are countries that are likely to have secular productivity gains relative to other economies in the next couple of decades.

R&D

Money supply growth may be negative for currencies speculators, depending on the shape of the futures curve, or interest rates levels for spot investments. For equities with strong pricing power thanks to strong economic moats, inflation is less of a worry. What I want to see is low money growth historically, but accelerating fast, as this may propel the economy to begin a new business cycle.

M0 worst

Inflation-wise, worst offenders such as South American and African countries are printing money at a fast pace, usually to finance budget deficits. Macao, Vietnam and Indonesia are also experiencing high inflation, making currency holdings at low interest rates less attractive. Best region for currency speculators in terms of low money supply growth include the Eurozone countries where deflation has taken hold.

Investor allocations for currency are usually driven by carry considerations, underestimating currency risk that may occur at turning points. Popular carry trades at the moment are borrowing in Hong Kong Dollar, Japanese Yen, US Dollar or Euro and investing in Chinese Renminbi and the Australian Dollar. Although the AUD and the CNY have started to correct, it seems like there is still a long way to go before these carry trades unwind.

AUD ownership

It is also worth avoiding currencies of commodity producing regions as the correlation between FX rates and commodity prices are high. Such currencies include the Australian Dollar, the Canadian Dollar and the Brazilian Real. Current account deficits are likely to continue falling.

The conclusion is: exposure to equities in countries with current account surpluses is generally a good idea. These include Vietnam, South Korea, China, India, Singapore and Hong Kong. Fixed income positions and spot currency positions are more attractive in low inflation regions such as the Eurozone. Short commodity producing country currencies such as the Australian Dollar, Canadian Dollar and the Brazilian Real. Also short currencies with massive capital inflows the last ten years including the Philippine peso, the Indonesian Rupiah and the Australian Dollar.

Commodities

More or less the only marginal buyer of commodities the last ten years has been China. The oil price has been driven higher by higher car penetration rates (boosted by car subsidies) and an increase in energy intensity due to construction activity. Still, the demand increase is driven by demand, thanks to oil consumption in volume terms growing more than 10% per year in China. Supply is now catching up, although very slowly. In real terms oil prices are still very high.

Real oil price

But the growth rate of China’s energy consumption is likely to slow down as it has to some extent been driven by a very large debt build up. The current building boom (infrastructure + real estate) started in 2003 and has led to energy consumption going up 2-3x since it started.

China energy consumtion 1990-2010_2_0

The increase in China’s debt/GDP is a scary chart, as very few countries in the past have increased debt at a pace of almost 80%+ in only five years. Spending levels in China has grown the fastest in the world over the last five years. The fact that China represents 45% of the global luxury market despite having only 15% of global GDP indicates the scale over overspending due to this debt feast.

China debt

Record speculative bets have held up the oil price for the last few years, but it is evident that insiders are increasingly bearish given by the amount of hedging activity.

Oil

The most important factor to watch in China – real estate prices – are on a downward trend, and have been accelerating their downward trend in recent months.

China real estate

Many other commodities are also trading at very high levels in terms of real prices compared to long-term averages. Iron ore and copper prices have seen increasing inventory levels and prices are in a downward trends.

A few other commodities such as US natural gas and sugar may be priced attractively, but only in relative terms. It is hard to be bullish on physical commodity prices given that the biggest growth driver may be losing steam in the short to medium term.

Property

Property is a function of household income + leverage applied. Falling interest rates have made it easier for buyers to gear up, which in many cases they really have. It has also benefited from favourable rules such as the deductability of interest expense when calculating taxable income for individuals in many countries. But these rules have been in place for a long time.

Best benchmarks include rental yields in absolute terms and vs. coutry opportunity cost as well as affordability ratios. Affordability ratios have at least double in most markets since interest rates started to decrease in most countries. Attractive rental yields vs. current long-term bond yields include Japan, Philippines, Ireland, Germany, Hungary and the United States. Attractive markets from a affordability perspective is again the United States, Germany, Japan, Ireland and Spain. The most expensive property markets in the world are mostly in Asia, including Hong Kong, Macau, China, Singapore and India. Selected markets such as Canada, Scandinavia, Australia are also showing bubble-like symptoms.

Conclusions:

  • Stock market valuations are generally high in most developed markets such as the US, Scandianvia and the UK as well as in favourite emerging market such as the Philippines, Indonesia and Mexico. Competition for high quality value stocks is very high. Good hunting grounds for “cheap” stocks are Russia, Vietnam and Hong Kong. The Japanese and South Korean markets may be attractive given high or accelerating money supply growth.
  • IPOs continue to be a great source for short equity ideas
  • Interest rates may continue to stay low for a long while
  • High yield bonds are pricing in very low currency risks and/or default risks. Credit spreads are close to record low levels, making shorting more attractive than it has been in years.
  • As interest rates are unusually low, long dated options (priced off the risk free rate) may be undervalued as well
  • Property is fundamentally a bet on interest rates. As interest rates are unlikely to shoot up in the near term, selected markets with good rental yield vs long rates and low interest rates may be attractive – including Japan, the United States and Ireland.
  • Cash is underowned and underappreciated, particularly US Dollar-denominated short-term instruments
  • Real estate and infrastructure investment levels in China are built on an unsustainable debt-build up, and the inevitable slowing of real estate construction will mean lower energy, metals and agricultural prices. Most commodities are expensive in terms of real prices vs. averages over the last century.
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Rules of the game

From 1 September 2014 this blog will be used to chronicle investment ideas and the portfolio composition at any given time of my personal account. I am an analyst for a Singapore-based investment firm engaging primarily in long-term stock investing.

Investments will be made in all of four asset classes: stocks, bonds, currencies and commodities. I will be using both direct ownership of assets and exposure to assets through derivatives. And investments will be made in various markets across the world through my various brokerage accounts.

Key building blocks of the investment philosophy with regards to equities:

  • My main focus is to invest in markets where equity is underallocated vs. other asset classes, where the currency is undervalued or long term competitive, where demographics are decent, and where reinvestment of capital is likely to lead to strong productivity growth. And in an ideal case, I want to invest just before money or credit growth is about to accelerate greatly, increasing the amount of funds that may potentially be invested in equity markets.
  • Franchise qualities of the company invested in is essential, to make sure the company has pricing power beyond what it is charging customers and its competitive position is strong. This to ensure strong returns on reinvested capital and also good cash flow generation.
  • Every investment thesis is focused on what will change in the company going forward, be it: new products, regional expansion, new regulation, an improving business cycle, competitor pressure subsiding, loss-making segments being closed down or general cost cutting programs.
  • Valuation is normally done on a P/owners earnings or EV/(EBITDA-MCX) basis, first forecasting future earnings and then applying a multiple at the end of the investment horizon for each case. Cash flow conversion rates need to be high.
  • For every investment, I aim to identify why it is cheap, and what is likely to happen to make this undervaluation disappear. Usually it concerns a misunderstanding of the prospects of the company, but it could also be technical reasons such as 1) asymmetric information where management knows more than investors, as evidenced by insider buying 2) capital flows, mutual fund redemptions or banking crisis leading to “forced” selling 3) technical reasons year end tax selling, post-reorganisation selling, failed merger arb situations, forced selling after spin-offs, dividend cancellations, or forced selling after rating downgrades.
  • I only invest in companies whose fundamentals are clearly improving or about to start improving. This goes hand in hand with a strong competitive position in the eyes of customers.

Focus is on upside probability vs. downside probability and how much I will make in each case. The largest positions are likely to be the safest situations where the downside is very limited. The focus will be on small capitalization stocks as it is normally easier to “know more than the rest of the world” about these stocks.

For bonds, most investments will be made in the high-yield arena, though at this point in time mostly on the short side. I will be taking bets on any variant perception I have on an issuer’s credit quality. For currencies, I will take highly contrarian positions, trying to identify inflexion points. Commodities will be also be invested in through derivatives, also in a contrarian fashion.

First post coming up soon!

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