Is Australia’s future written inside a fortune cookie?
On 3 March I shared my thoughts about the future of Australian companies that supply directly or indirectly, the Chinese building industry, or have more than 70% of their revenues or profits reliant on China with subscribers of Alan Kohler’s Eureka Report. Following are my insights…
Glancing over yet another set of numbers as reporting season draws to a close, my mind started to wander as I wade through forecasts for one, two and three years hence. I began to consider what might happen that could take the shine off these elaborate constructions and which companies are in the firing line. Consider Rio Tinto, which, in an effort to make itself “takeover proof” back in 2007, loaded itself up with debt up to acquire the Canadian aluminium company Alcan. It paid top-of-the-market multiples just 12 months before the biggest credit crunch in living memory forced it to sell assets, raise capital and destroy huge amounts of shareholder value. Do you think they saw that coming?
Before I elaborate on events that could unfold, allow me to indulge in a bit of history and take you back to the mid-1990s when I was in Malaysia and the Kuala Lumpur skyline was filled with cranes because of a credit-fuelled speculative boom. It was the same throughout the region.
A year or so after my visit, the Asian tiger economies were in trouble and the Asian currency crisis was in full flight. These are the returns that are produced by unjustified, credit-fuelled “investing” unsupported by demand fundamentals.
In December 2007, as I travelled to Miami, I experienced a distinct feeling of déjà vu as I once again witnessed residential and commercial property construction fuelled by low interest rates and easy credit, unsupported by any real demand.
These are not isolated incidences. Japan, Dubai, Malaysia, the US. Credit fuelled speculative property booms always end badly.
So what does this have to do with your Australian share portfolio? Australia’s economic good fortune lies in its proximity – and exports of coal and iron ore – to China. Much of those commodities go into the production of steel, one of the major inputs in the building industry.
In China today there is, presently under construction and in addition to the buildings that already exist, 30 billion square feet of residential and commercial space. That is the equivalent of 23 square feet for every single man, woman and child in China. This construction activity has been a key driver of Chinese capital spending and resource consumption.
About two years ago if you looked at all the buildings, the roads the office towers and apartments under construction the only thought to pop into your head would be to consider how much energy would be required to light and heat all those spaces.
But that won’t be necessary if they all remain empty. In the commercial sector, the vacancy rate stands at 20% and construction industry continues to build a bank of space that is more than required for a very, very long time.
Because of this I am more than a little concerned about any Australian company that sells the bulk of its output to the Chinese, to be used in construction. That means steel and iron ore, aluminium, glass, bricks, fibre cement … you name it.
Last year China imported 42% more iron ore than the year before, while the rest of the world fell in a heap. It consumes 40% of the world’s coal and the growth has increased Australia’s reliance on China; China buys almost three-quarters of Australia’s iron ore exports – 280 million of their 630 million tonne demand.
The key concern for investors is to examine the valuations of companies that sell the bulk of their output to China. Any company that is trading at a substantial premium to its valuation on the hope that it will be sustained by Chinese demand, without a speed hump, may be more risk than you care for your portfolio to endure.
The biggest risks are any companies that are selling more than 70% of their output to China but anything over 20% on the revenue line could have major consequences.
BHP generates about 20%, or $11 billion, of its $56 billion revenue from China; and Rio 24%, or $11 billion, from its $46 billion revenue. BHP’s adjusted net profit before tax was $19.8 billion last year and Rio’s was $8.7 billion.
While BHP’s profitability would be substantially impacted by any speed bumps that emerge from China, the effect on Rio Tinto would be far worse.
According to my method of valuation, Rio Tinto is worth no more than its current share price and while the debt associated with the $43 billion purchase of Alcan is declining, the dilutive capital raisings (so far avoided by BHP) have been disastrous for its shareholders.
As a result, return on equity is expected to fall from 45% to 16% for the next three years. Most importantly the massive growth in earnings for the next three years is driven by the ever-optimistic analysts who are relying on China’s growth to extend in a smooth upward trajectory.
Go through your portfolio: do you own any companies that supply directly or indirectly, the Chinese building industry, have more than 70% of their revenues or profits reliant on China and are trading at steep premiums to intrinsic value?
Make no mistake: Australia’s future is written inside a fortune cookie – some companies’ more than others.
Subscribe to Alan’s Eureka Report at www.eurekareport.com.au.
Posted by Roger Montgomery, 4 March 2010
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Gary
:
Hi Roger and thanks for your input into the world of investment!
Following the recent change to BHP’s iron ore pricing structure, we have analyst’s falling over themselves with earnings upgrades. How do you view it, is the general sentiment valid and will you be upgrading your own valuation of BHP accordingly?
admin
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Hi Gary,
As many visitors here know, I look at a range of valuations and ideally want to see share prices at discounts to the lower end of the valuation range. The upgrades are not surprising but longer term investors must understand what the likely average rates of return on equity will be, not just next year’s.
Mark
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Nice article Roger and good to keep thing’s in perspective as it is so easy to fall into the trap when the “China Will Save Us” story is rammed down your throat day in day out to believe it as fact.
carbonsink
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Roger, thanks for posting this a blog article and allowing people to comment.
My main concern is not that there will be an imminent crash in China, but that Australian policy makers (at the very highest level) are banking on very strong growth in China for the next 20 years.
According to this article Glenn Stevens, Ric Battellino and Warwick McKibbin are the “China bulls” on the RBA board, while Ken Henry is less sanguine.
Personally I find these extremely bullish views from the RBA quite alarming, especially when Wen Jiabao himself today described China’s economic growth path as “unbalanced, uncoordinated, and unsustainable.”
For anyone interested in the Chinese economy I strongly recommend reading Michael Pettis.
admin
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Hi Carbonsink,
Great stuff. Clearly very useful. In keeping with the tone of my site, would you mind using your first name in future messages? Thanks in advance.
Chris
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Interesting that Wen JiaBao described it like that….maybe the Chinese at the top are worried that if the economic locomotive does run off the rails due to too much speed, it could potentially lead to an uprising by the people and destabilise the system of Government (like East Germany). Remember, it takes just ONE event. If it did happen, they would lose all their toys and perks, but what would happen to the state-owned businesses ?
Hence, they are trying to publicly tap the brakes. I can see that they would like it to remain a Communist system, but with a few bits and pieces from capitalism as they see fit. The whole idea of “Socialism with Chinese characteristics”.
Surprising, because most times, when there is something controversial in the Western media that paints them in a bad light (e.g. fake products, censorship, Tibet etc.), it is like they sweep it under the carpet by shutting their eyes, smiling broadly and saying “Ha Ha, does not exist !”, but they have no problems coming out and telling the rest of the world that they are at fault on things that are really none of their business, e.g. President Obama wishing to meet the Dalai Lama is a personal matter between them and them alone.
Vishal
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A very fine analysis of the risks posed by speculative bubbles. I for one was getting very concerned by analyst after analyst apearing on TV talking about the “China story” and how they are going to need coal, iron ore, copper, natural gas etc for the next 20 or 30 years. While this might be true, these so-called “analysts” fail to take into account (or just ignore) the current market conditions and the history of markets being driven, in the short run at least, by the “voting machine” as Graham so clearly described.
admin
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Thanks Vishal,
You are absolutely correct. Nothing goes up in a straight line.
JohnC
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It’s a good piece on “big picture” risk. I too wondered about the present downside risks (the chance of losing present gains) and compared it with the upside risks (the chance of improving on present gains). I agree that China is a big factor, not just in the Australian story but also with greater Asia. On the other hand, discount rates are still low and I am not convinced that they will rise within two years especially if China experiences a slowdown in growth. Stocks remain my preferred option but I am reworking my portfolio appropriately.
I would also like to point out that with further relaxation of foreign investment rules in Australia, we have also gotten caught up in China’s speculative flurry to some extent. I’m no property bear but am mindful that today’s forecasts are not accounting for the presence of fickle impact of “hot money” in Australia.
Chris
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Absolutely JohnC, re: point 2. Take a look at the weekend AFR approximately 6 weeks ago. Page 14. The Chinese are paying well over the odds for real estate here, big block properties in quite prestigious suburbs like Burnside, SA, for their kids so that they have somewhere to study whilst here in Australia. Not an apartment – a house (!). It’s like money is not an object.
I also RE agencies taking REAs that speak Mandarin (not Malay, not Cantonese…specifically, they are after mainland Chinese).
There is a huge contrast between the wealth of some emerging markets when compared with others. The BRICs are not all as equal as each other as some people believe – China steals a lot of the focus. Just as an example, take a look at the general contrast between mainland Chinese students and Indian students here in Australia – a massive difference in their standard of living. Which one works to support themselves in takeaways, wait-staffing, cooking, cleaning, taxi driving, living 5-6 to a 3 bedroom house – while the other has very rich parents ?