Is the bubble bursting?
In 2010 here at the Insights Blog I wrote:
“a bubble guaranteed to burst is debt fuelled asset inflation; buyers debt fund most or all of the purchase price of an asset whose cash flows are unable to support the interest and debt obligations. Equity speculation alone is different to a bubble that an investor can short sell with high confidence of making money.
The bubbles to short are those where monthly repayments have to be made. While this is NOT the case in the acquisitions and sales being made in the coal space right now, it IS the case in the macroeconomic environment that is the justification for the purchases in the coal space.
China.
If you are not already aware, China runs its economy a little differently to us. They set themselves a GDP target – say 8% or 9%, and then they determine to reach it and as proved last week, exceed it. They do it with a range of incentives and central or command planning of infrastructure spending.
Fixed asset investment (infrastructure) amounts to more than 55% of GDP in China and is projected to hit 60%. Compare this to the spending in developed economies, which typically amounts to circa 15%. The money is going into roads, shopping malls and even entire towns. Check out the city of Ordos in Mongolia – an entire town or suburb has been constructed, fully complete down to the last detail. But it’s empty. Not a single person lives there. And this is not an isolated example. Skyscrapers and shopping malls lie idle and roads have been built for journeys that nobody takes.
The ‘world’s economic growth engine’ has been putting our resources into projects for which a rational economic argument cannot be made.
Historically, one is able to observe two phases of growth in a country’s development. The first phase is the early growth and command economies such as China have been very good at this – arguably better than western economies, simply because they are able to marshal resources perhaps using techniques that democracies are loath to employ. China’s employment of capital, its education and migration policies reflect this early phase growth. This early phase of growth is characterised by expansion of inputs. The next stage however only occurs when people start to work smarter and innovate, becoming more productive. Think Germany or Japan. This is growth fuelled by outputs and China has not yet reached this stage.
China’s economic growth is thus based on the expansion of inputs rather than the growth of outputs, and as Paul Krugman wrote in his 1994 essay ‘The Myth of Asia’s Miracle’, such growth is subject to diminishing returns.
So how sustainable is it? The short answer; it is not.
Overlay the input-driven economic growth of China with a debt-fuelled property mania, and you have sown the seeds of a correction in the resource stocks of the West that the earnings per share projections of resource analysts simply cannot factor in.
In the last year and a half, property speculation has reached epic proportions in China and much like Australia in the early part of this decade, the most popular shows on TV are related to property investing and speculation. I was told that a program about the hardships the property bubble has provoked was the single most popular, but has been pulled.
Middle and upper middle class people are buying two, three and four apartments at a time. And unlike Australia, these investments are not tenanted. The culture in China is to keep them new. I saw this first hand when I traveled to China a while back. Row upon row of apartment block. Empty. Zero return and purchased on nothing other than the hope that prices will continue to climb.
It was John Kenneth Galbraith who, in his book The Great Crash, wrote that it is when all aspects of asset ownership such as income, future value and enjoyment of its use are thrown out the window and replaced with the base expectation that prices will rise next week and next month, as they did last week and last month, that the final stage of a bubble is reached.
On top of that, there is, as I have written previously, 30 billion square feet of commercial real estate under debt-funded construction, on top of what already exists. To put that into perspective, that’s 23 square feet of office space for every man, woman and child in China. Commercial vacancy rates are already at 20% and there’s another 30 billion square feet to be supplied! Additionally, 2009 has already seen rents fall 26% in Shanghai and 22% in Beijing.
Everywhere you turn, China’s miracle is based on investing in assets that cannot be justified on economic grounds. As James Chanos referred to the situation; ‘zombie towns and zombie buildings’. Backing it all – the six largest banks increased their loan book by 50% in 2009. ‘Zombie banks’.
Conventional wisdom amongst my peers in funds management and the analyst fraternity is that China’s foreign currency reserves are an indication of how rich it is and will smooth over any short term hiccups. This confidence is also fuelled by economic hubris eminating from China as the western world stumbles. But pride does indeed always come before a fall. Conventional wisdom also says that China’s problems and bubbles are limited to real estate, not the wider economy. It seems the flat earth society is alive and well! As I observed in Malaysia in 1996, Japan almost a decade before that, Dubai and Florida more recently, never have the problems been contained to one sector. Drop a pebble in a pond and its ripples eventually impact the entire pond.
The problem is that China’s banking system is subject to growing bad and doubtful debts as returns diminish from investments made at increasing prices in assets that produce no income. These bad debts may overwhelm the foreign currency reserves China now has.”
I now wonder whether we are seeing the bubble slip over the precipice? Falling property prices (10 per cent of the Chinese economy) leads to lower construction activity, leads to declining demand for Australian commodities, leads to falling commodity prices, leads to bigs drops in margins for a sizeable portion of the market index…
Watch this video and decide for yourself.
Posted by Roger Montgomery, Value.able author and Fund Manager, 8 December 2011.
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.
Mark Thompson
:
Hi Roger
Please find attached article in West Australian Newspaper on Saturday 7th January 2012.
Something to pontificate, hypothecate , repeatedly a number of times you have discussed rationality , however this article (weblink) if ever approved will knock out the capital city of Western Australia (Perth) and turn it into a quarry if somehow this is approved , which it wont be I am sure .
Regards Mark
http://au.news.yahoo.com/thewest/a/-/breaking/12522071/chinese-miner-eyes-suburbs/
mark
:
Can someone answer me why or how do housing prices keep rising if no one can afford to buy them? The only thing conclusion i can come to is that the cost of building houses increases but no one can afford to buy them. In china it seems the rich are buying them but dont need to sell them & if they did maybe the real price will be reached. Me thinks not a good investment
Roger Montgomery
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Me agrees.
Steve F
:
A chinese born colleague at work recently returned from a trip to China. He said the cost of living is becoming very expensive in China and that he was amazed at the increases in prices over the last few years, particularly housing. Average wages haven’t increased and it’s a minority who are making all the money out of the economic boom.
My parents also have a vacant house next to them, owned by a wealthy chinese investor. The house has deliberately been untennanted for about ten years and the owner has probably missed out on $300-$400K in rent. Recently the owner knocked the house down, built a brand new one. I’m not sure what the plans are for the new house yet but I won’t be suprised to see it unoccupied. If they sell it, the returns would be poor to average without the reantal income even with rising land values.
This isn’t something I can understand as in Australia, a rental property has a purpose – to provide somebody with a roof over their head in return for a rental yield. It seems to me that the weathy Chinese owner of the untennanted property owns it as a status symbol and a store of wealth. This might be what’s behind the Chinese property bubble – a heap of people just speculating on the price rising and not worrying about fundamentals like rental yields and tennants. Plus boasting about how many properties they own.
Roger Montgomery
:
And here’s another comment from a highly regarded commentator/analyst at ZHedge:
“Chinese market courtesy of secondary industrial metals, notably steel: “The investment landscape for industrial metals is becoming increasingly more difficult to navigate. As highlighted in last month’s letter, we are continuing to see a rapid deceleration of growth in China, specifically within the cyclical industries. A recent trip to visit steel companies outside Beijing underlined the impact of extremely tight liquidity and continued restrictive policy in the Chinese housing market. Steel capacity cuts – through idling or accelerated maintenance outages – are now commonplace and the speed of these cuts has certainly surprised the market. Construction is the principal end-market blamed for this weakness; given the very large inventory overhang and the continued lack of liquidity, this is not surprising. In our equity universe, we have also seen numerous companies expressing concerns regarding China construction demand. Zoomlion, China’s second largest construction machinery company, recently said, “Demand for construction machinery has shrunken drastically and growth will no doubt continue to slow next year.” Within the context of declining housing starts, plummeting transaction volumes and the beginning of a meaningful move down in housing prices, these shifts in the steel market have been an interesting harbinger of more substantial problems in the Chinese economy. Our principal concern is the extension of housing weakness into the banking system through the mechanism of both failing developers as well as the opaque and informal lending. We are concerned that the recent strength in iron ore, steel and copper has been misinterpreted by the market. In our view, any suggestion that the Chinese market is undergoing a substantial restock is misplaced.” Today, we get a confirmation of just this warning courtesy of Citigroup which has charted weekly Iron Ore China port inventories and of broad steel inventories. Needless to say, domestic steelmakers, who better than anyone know the state of domestic end product demand, have seen the writing on the wall, and have one message for the world: short Brazil and Australia.”
Terry
:
This is from a site that I subscribe to and specifically mentions the China real Estate problems, well worth a read
For a few decades now, the Communist Party in China has had an implicit social and political contract with the Chinese populous for decades, which goes something like:
“We will deliver economic growth and improvements in your material living standards. You will meekly do as you are told, refrain from dissent, work hard, save a huge percentage of your money, and ignore obvious corruption.”
While nearly everyone in China has benefited to some degree under this current “system,” the wheels are definitely starting to come off. Official GDP numbers are now slowing, real estate prices are falling, and inflation is quickening.
Now, I’ve made no secret that I’m decidedly bearish on China’s medium-term prospects. After my trip there back in June to conduct some good old-fashioned “boots on the ground” research, I wrote extensively about the massive overbuilding of apartments, office blocks, and all manner of infrastructure on an almost unimaginable scale.
Put simply, every year since 2005, more than 50% of China’s GDP has consisted of construction-related spending. The law of diminishing marginal returns says this simply cannot continue.
It represents a misallocation of the household sector’s hard-earned savings on a colossal scale, and I believe it will end badly. Not a day goes by that there aren’t riots and protests somewhere in China (including cyberspace) as the downtrodden man in the street reaches his froggy boiling point.
Increasingly in China, though, those who see the writing on the wall can see that the days of system stability are numbered. And they’re not hanging around.
For a number of years, mainland Chinese buyers have accounted for nearly all new apartment sales in Melbourne and Sydney. On numbers I’ve seen, they have been investing between A$2 billion and $3 billion a year.
An increasing number of mainland Chinese are establishing permanent residency and sending their child(ren) to school and university in Australia.
They all want to have their options open when China’s economy and political system hits turbulence.
Judging by the poor economic numbers coming out of China, this day of reckoning is drawing ever closer. One alarming indicator is that the Chinese renminbi has traded down to the lower limit of its strictly controlled trading band for SEVEN TRADING SESSIONS IN A ROW.
This suggests that there is more money leaving China than being earned from overseas trade or invested there. The exchange rate may be only one simple indicator, but it’s a great barometer for what is going on: China is not going to be the savior of the global economy, but rather another casualty.
ben
:
Interestingly enough, China has a massive shadow banking system.. so government efforts of raising up reserve ratios maybe futile since most of the banks can still pump out funds via the ‘backdoor’… alot of the you read about it could be ‘iceberg’ effect in that the shadowbanking system isn’t accounted for by the statistics.. and no one really knows how big it is. Alot of these loans won’t be on the balance sheets either.
So what we *POTENTIALLY* have is a whole bunch of non performing loans which are leveraged up by the securitisation.. sound familiar?
Roger Montgomery
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Thanks Ben
Martin R
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Hi Roger
I have lived in Beijing for the last ten years, and I will share a few of my personal feelings about China for what it’s worth, not specifically about the housing bubble, but more generally speaking.
1. The notion that there may be some sort of uprising or revolution by the population inspired by a desire for freedom and democracy is utter nonsense and simply will not happen. Any such attempts would be ruthlessly crushed as we saw in Tibet recently. There may be extremely incremental progress however this will occur over the space of decades, not after some “arab spring” type event. Politically speaking the country is backsliding towards greater protectionism, control and censorship, not less. I thought this a decade ago when I first arrived and have seen no progression since. The Olympics was a perfect example of this.
2. Despite all the logical evidence, I seriously doubt there will be a massive burst of the alleged property bubble. I’m not certain of what the chinese govt would do to minimise or prevent it, but prevent it they will. They have come too far to allow what would be a massive loss of face internationally aside from any perceived backlash from within. And loss of face is everything in this culture. Let’s not forget, they can basically do anything they think is necessary without fear of losing an election, union trouble or any of the multitude of issues that have dragged the progress of western democracies into the indecisive quagmires they now find themselves in. I feel RIO & BHP are banking on this based on their multi billion dollar expansions on various projects. They could be wrong but I seriously doubt it.
3. There are many things in China that cannot be justified on conventional logic. However, they continue to surge ahead in leaps and bounds at a rate far greater than any other country. In the last decade and a bit in Beijing alone, they have built or are currently building 11 complete underground subway lines, 4 completely circular ring roads, an airport to dwarf most others (with another one in planning), and that’s just the tip of the iceberg and just Beijing. Never mind a space program, entire cities, high speed trains, tens of millions of apartments etc etc. It makes the snail’s pace “progress” in Melbourne look a laughing stock by comparison. There, they cannot even manage one ring complete ring road, nor one complete new railway line in over four decades. As far as figures I have seen stating there are 64 million empty apartments in China, there are far more people than that to potentially fill them who still live in squalor. At some point these things will even themselves out somehow.
My point is, they get things done, quickly and more cheaply, and I don’t believe there will be any sort of catastrophic event either in housing or socially. A natural disaster such as an earthquake is the only likely one to happen. It’s just the gut feeling I have from having spent many years living here. And let me say, while it has many challenges and problems, it has been in many ways a great place to live. In a snapshot comparison with Melbourne daily life, much more freedom, much much less violence and social decay, and generally far less restrictions than in our great Nanny State of Australia. One really must spend time here to fully understand the dynamics of the place.
Roger Montgomery
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Great counterpoints Martin. Thanks for sharing the benefit of your experience here.
Geoff
:
A number of years ago a friend who is a successful fund manager invited me to visit him in Shanghai, he was born there and he and his family have lived in a western country for periods of time. It was a great privilege to do this and he showed me around Shanghai and other cities in the general area, i.e. Nanjing. We compared investing philosophies and he impressed me in regard to his disciplined and intellectually rigorous approach. At the time an apartment in Shanghai was reasonable in price compared to say Australian standards, but almost unaffordable to many Chinese. Since then prices have increase about 2-3 times. There was a frantic amount of construction going on and many infrastructure projects were underway.
At the time I had investments in different commodity related assets and could see that prices would increase in the medium term, but my visit and information my friend provided about use of different commodities, i.e. copper, significantly checked my enthusiasm.
Since this time my friend has sold most of his property in Shanghai and moved to live in another country, not Australia, and is waiting for things to correct. This is a significant move and course of action for him, he is or was a substantial investor in businesses in China. Given this example of a lack of confidence in China at present, we ought to seriously re-evaluate our own thinking about China as Roger has highlighted in his article. There will be a time to invest in China again, but only when value is present again.
Roger Montgomery
:
Thanks for sharing that personal insight and experience.
Rici Rici
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Personally i am using the high AU$ to diversify internationally.
There are a number of high quality US stocks that screen well on a ROE basis and have secular earnings growth.
I have even taken a bit of a plunge and purchased shares in a listed company on the Greek stock exchange (screens exceptionally well, no debt, great ROE, great relationship between book value and ROE, large barriers to entry). Enough hints lol.
If this risk with China comes to fruition, then at least i am spreading my risk
Roger Montgomery
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Indeed, the US looks a whole lot cheaper than Aus.
Chris
:
Agreed.
However, I have personally neither the time nor will to try holding and following international stocks….not being ‘near’ the action, I don’t know and won’t pretend to, so my holdings are in ETFs through a very well known provider (enough said !).
I believe that most active fund managers probably cannot beat the index (over the longer term and after fees and CGT) in their own currency when sat in their Melbourne / Sydney offices, let alone another layer of complexity on top (USD vs AUD) and being so far away from the action just compounds this.
I seem to remember the words of Buffett in 2007 when he was asked about index funds, that if individual investors don’t have any idea about what they are doing, they are probably better off buying the index and will outperform most money managers over the longer term.
However, getting people to admit that to themselves is the hard bit. Most people think they are more competent than they really are and comparatively better than others at doing something (Illusory superiority – driving is a favourite one)
Matthew Smith
:
I am quite sure that Jim Chanos will make some money on his China shorts – that said he also has long positions in China as well
Roger Montgomery
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Yes, its all about alpha.
Rici Rici
:
This was picked up extensively on cnbc. Interesting one commentator suggested that the retail crowd could implement a similar strategy though using Proshares FTSE China 25 Ultrashort (Ticker: FXP).
Yet when i looked at google finance for the 1 year share price movement of FXP it didnt correlate anything to the degree of the movement in the Shanghai Composite Index.
And therein lies the problem with alot of these ‘short products’, they are really only effective for day traders, the underlying derivatives used in the products are balanced day to day meaning that the longer term movements in the ‘shorts’ dont necessarily mean that one makes money on a longer term ‘short view’.
By the way, if China is going so well, why is its equity market consistently going down. Not necessarily a direct correlation link (for example whats the underlying ‘value’ of the Chinese market vs market price, i dont have the answer to this). Still something to reflect upon.
I am not going near anything that is a derivative of China at this point in time and that includes Australian resource equities.
Roger Montgomery
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Dont forget counter party risk and hypothecation
Rob S
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His long exposure is to Macau Casinos – Run by western companies like MGM, he’s less doubtful of the accounts of these companies compared to anything on the mainland. He summarises his position as short construction, long corruption!
John Wilkinson
:
Once again very interesting and thought provoking piece Roger.
My early morning starts have me listening to ABC regional radio with a regular contribution from Westpac economists in Europe and America.
Normally upbeat commentators who sound just exhausted and wrung out with the situations they are observing. Now China too?
Phillip Adams (Radio National) thinks it is the beginning of the end of capitalism.
What are you like at growing vegetables Roger? We may be back to the barter system for a while!
Thoughts for a new book…. “Veget.able” to cope with the coming crisis!. Can help co-author
Roger Montgomery
:
Dear John,
Tomat.able, Corgett.able, Cactus.able….You gave us all a real laugh here at headquarters. Thank you.
gabe
:
China – When I traveled there 30 years ago it was a adventure
When I left I remember a conversation with a American school teacher – I stated these people are the greatest capitalists I have ever seen all they need is a little freedom and use their skills – He
said I don”t see how they haven”t done anything in hundreds of years. Ha Ha wonder what he has to say now ??
However I wish their government was more honest and open about finances and the dealings will other nations this would go a
long way in the area of trust and friendship. Roger I have heard this story and others and it is a real worry and if it does tip over
the edge you wont want to be in property or equities so if you got
a job hang on to it and SFS pensioners like me will be after yours.
Gabe
Roger Montgomery
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Thanks Gabe. COmbined with the fact we can only find a small smattering of value, we believe the other side of risk is opportunity.
Jordan
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Hi Roger,
It is my understanding that value investors traditionally refrain from focusing their energies towards the understanding of broader macro-economic issues, particualraly those of other nations. Rather, they dedicate their intellect towards locating and purchasing – at a discount – outstanding companies whose intrinsic values will increase over time; through good times and through bad (i.e. even a collapse of the Chinese economy). One only has to look as far as one of your favourtie stocks, JBH, to see that a great company can double their EPS through the worst of times (the GFC)! This leads me to question why you, as a self-proclaimed value investor, have dedicated a post to deciphering issues that are naturally beyond the scope of value investing strategy?
Regards
Jordan
Roger Montgomery
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Hi Jordan,
Fortunately, we have the bottom up value investing process running smoothly. So I post what ever I like on the blog. The blog is not the investment process. While our brand of value investing doesn’t have a macro overlay, I know many value investors that do both here in Oz and in the US. I hope there are some followers here who appreciated the heads up…because we are always on the outlook for events that may produce opportunities…we are ready.
Rici Rici
:
To Jordon:
Sometimes that macro overlay has a very relevant impact on the POTENTIAL future intrinsic value of an underlying stock.
Take BHP and RIO, from a value perspective and taken just in isolation of their current financial metrics, they would look a screaming buy.
Yet what is the biggest influence on their future profitability: China.
If China has a significant slow down, then hard commodity prices will have a significant slow down. Suddenly those best of bread resource companies wont look like such value plays anymore (earnings sensitivity to commodity prices).
Harley G
:
Hi Jordan and Roger,
I have followed the blog since pretty much the beginning and I have read many times now of commenters being critical or questioning Roger for posting or commenting about ‘macro’ issues or topics deemed outside the ‘value investors realm.’ I think that is complete nonsense. For starters, when you look at an individual company and try to determine its future prospects you are forced to take a more holistic view of the industry, the economy, etc.
The original value investing method involved buying stocks that traded below what their assets were worth. It didn’t involve looking at the business because it simply didn’t matter. That is not what Roger practices, at least from my view and apologies Roger if I am wrong. What I have learnt from Roger is to find companies that yes are cheap but more importantly are going to increase in value well into the future – you cannot accurately forecast a company’s future prospects without looking at its industry, where it is located, will demand for its product hold up, etc and having a well constructed ‘macro’ view helps to put all of these things into place.
All the success stories from this blog have been the result of finding cheap companies in industries that are set to do well (Vocus with the ‘macro’ view of growing demand for internet, Forge with the view of long term commodity demand, Matrix with the view that ever declining oil reserves will lead to deep sea exploration becoming more economical) and in order to identify which industries are set up well for growth you MUST take a ‘macro’ view. It doesn’t mean you have to figure out how the market is going to react after the 18th emergency euro summit or if the AUD is going to hold up over the next few months. But to completely ignore vital components to successful investing like demographic trends, technological trends, world capital flows, and the like puts you at risk of missing out on the big investment winners and perhaps catching a few losers – or ‘value traps’.
Jordon, in your post you say we should be looking for companies that increase in value in good times and bad “even during a collapse of the Chinese economy.” I agree with you entirely but I have to say that in my view you are looking at it the wrong way. If the Chinese economy were to truly ‘collapse’ very very few Australian companies will increase in value during that time and most if not all of the share prices will become much much cheaper. But that will be a fantastic opportunity to buy companies that will continue to grow as China recovers. There are a number of risks that exist at the moment that one should at least have an general understanding of. If an investor were to take your approach, he or she would likely begin to become heavily invested in mining services/resource/etc companies as they are currently cheap and over the long term have strong prospects. But I think what Roger is trying to hint to us is that in his view, while some of these companies are cheap, stepping back and taking a look from the top down will give strong indications that a much greater opportunity to invest may be approaching. Having watched Roger on TV/radio and seeing his views on technical analysis and market timing, I think this is the closest we will come to hearing Roger trying to give us some insight on ‘timing the market’ :P
Roger Montgomery
:
Thank you Harley,
I appreciate you taking the time to clarify. I think you are right. I have two additional motivators; 1) to inform and educate and 2) to consider what a sustainable ROE might be.
Jordan
:
To Harley and Roger,
Thank you for your responses. Firstly, I do understand that Roger’s strategy not only involves purchasing companies with a sufficient margin of safety, but also looking for those businesses that will have substantial increases in intrinsic value over time. Nonetheless, I disagree with you on a number of points, particularly your statement that:
“…you cannot accurately forecast a company’s future prospects without looking at its industry, where it is located, will demand for its product hold up, etc and having a well constructed ‘macro’ view helps to put all of these things into place.”
As Roger says, one must be concerned with what a sustainable ROE might be. This in my opinion does not result through an understanding of the broader macro-economic environment, but rather through a detailed bottom-up analysis of the company’s business model and other characteristics that indicate the strength of the company’s underlying competitive advantage.
Roger, your approach, as I understand it, is similar to Buffet’s in that he also focuses on purchasing with a margin of safety; but only those companies that have excellent growth prospects over a long period of time (in other words, a sustainable ROE). I believe that this second element of Buffet’s strategy is derived from his appreciation of Phillip Fisher’s investing strategy. Buffet is often quoted as being 85% Graham and 15% Fisher. Buffet, like Fisher, has been very successful at identifying those companies that have fantastic growth potential, not by virtue of his understanding of broader economic trends and the “macro view”, but through analysis of a business from the bottom-up; looking for characteristics which highlight the strength of its competitive advantage. For example, expenditure on research and innovation, marketing expenditure, large profit margins, integrity of management, strong employee relations etc… Fisher outlined a fantastic 15 point checklist in his book that can help reveal companies, from the bottom-up, NOT the top-down, whose intrinsic values will grow over time. Neither of these investing greats considers macro-economic issues, such as the Chinese housing market, when making intelligent investment decisions. Such macro-analysis is therefore in my opinion a waste of one’s energy and time.
Harley, you mention MCE as an example of the benefits of looking at the macro picture. I also believe MCE is a fantastic company, but from a purely bottom-up analysis, not the top-down. Coming to your conclusion based on the notion of ever declining oil reserves is in my opinion a dangerous reason to invest in the company. You’re ultimately making assumptions about future energy sources, technology and international relations – all of which are broader trends, both macro and environmental, which one simply cannot predict, but of course could potentially affect the earnings of MCE. I believe it is a much safer strategy and potentially more fruitful to undertake a bottom-up analysis of the company to decipher its intrinsic value growth potential.
Secondly, in response to your statement:
“If the Chinese economy were to truly ‘collapse’ very very few Australian companies will increase in value during that time and most if not all of the share prices will become much much cheaper. But that will be a fantastic opportunity to buy companies that will continue to grow as China recovers.”
I agree that a Chinese collapse would offer outstanding bargain prices, but ultimately such a statement indicates that you are attempting to predict future stock prices. The fundamental no no of value investing!!! Once you start making assumptions about future prices, you are no longer investing, but speculating. If such a Chinese collapse did occur, of course you would want to be prepared to take advantage of the bargain prices. This is a fundamental reason why we as investors should always have cash on hand in case such events do occur. However, that does NOT then infer that we should spend our time attempting to predict future collapses and market corrections (based on the macro-view) in order to capitalise on the resultant bargain prices.
Once again, I have to reiterate my example of JBH – a company that increased its intrinsic value throughout the GFC; one of the very very few companies as you say. But ultimately, these are in fact the very companies that we should be looking for as intelligent investors; namely the very very few outstanding companies in the ASX that will afford above average long term returns through good times and in bad. In summary, attempting to understand macro economic and environmental trends is not in my mind fundamental business analysis and will ultimately lead to speculative rather than intelligent investment decisions.
I apologise for the length of this response, but still hope you find my opinions worth reading.
Regards
Jordan
James
:
Hi Harley,
Interesting you see Vocus and Matrix as success stories. I know there are a lot of us that lost big money on those stocks. It would appear that they were bubbles that have burst. If only I had bought TLS and WES I would be doing much better.
Roger Montgomery
:
When the facts change, so must your conclusions and positions.
Mully
:
I agree Roger but that phrase is just as easily used as a cop out for when one simply gets it wrong. From what I can see, nothing has changed fundamentally for Vocus since its capital raising except it’s share price. I quite like Vocus’s medium to long term outlook and view it as a potential takeover target at some point in time but, despite the hype on the blog, have never considered it a bargain not even at its current price.
As for Matrix, their negative cash flow goes back to 2009 and has simply deteriorated since then. I could never understand how this company had an A1 rating but then that’s just me.
Roger Montgomery
:
A couple of quick points. Modelling some expectations had shown cash flow turning positive, but it didn’t transpire. Change position when facts change. I too like Vocus medium term outlook too.
Chris
:
Roger, I would say to James that it is not so much choosing the “best stocks” (we all want to do that), it is as much as avoiding the worst stocks and deducing from the remaining list “which ones are worth looking at”.
Some people who win at online FPS games don’t necessarily beat the most opponents, they just die the least, so their k/d ratios shine. In sports, some teams goal difference is because they defended extremely well, not because they scored lots of goals.
If you discover a dog stock after scratching the surface of a hot tip, it may just have saved you making an investment into it. Your own IRR is huge, because how long does it take for you to save $1k or $10k ? $100k ?
The fact that something is wrong is just as valuable as knowing that something is right. The amount of people who backed a stock because it had a trendy name or it was a popular stock – only to watch it crash – is amazing.
Roger Montgomery
:
Another excellent insight and perspective.
Harley G
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Hi James,
All bubbles begin on some sound basis of economic reasoning. I still think those stocks would have done well if Roger had not mentioned them, but agree it played a role in pushing them to the prices they went to. It depends on where you bought in. Vocus has been expensive for a long time, still now its around 3x book value and I don’t believe its cheap. Yes, I agree things have changed with Matrix, and management has not been overly impressive but to be fair they have been hit by things out of their control.
But you are right I should of used other examples – Forge, Decmil perhaps.
Roger Montgomery
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Feel free to use any examples you like Harley. Don’t forget SIlver Lake et al.
Ric Jay
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A nice, thoughtful piece on China Roger. Picking through the many and varied China ‘experts’ I read, I tend to agree with your thinking.
One of the first asset bubbles on our side of the pond that will be pricked when the Chinese pebble is dropped is Western Australia property, particularly highly-geared apartments in Perth and the ridiculously over-priced boom towns.
If I had any of this, I would be selling now … and concentrating on the little, green bubbles of your excellent Skaffold machine.
Ric Jay.
Roger Montgomery
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Thanks Ric-Jay
Brad
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China will, almost certainly grow at 6 – 10% pa for at least the next 20 years.
But as the Chinese get richer, they will probably want more freedom – this will be their greatest challenge.
I agree with you, Roger, it won’t be a smooth ride.
Andrew
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“The problem is that China’s banking system is subject to growing bad and doubtful debts as returns diminish from investments made at increasing prices in assets that produce no income.”
Can an asset that produces no income be called an asset at all?
This is a very good post Roger, and one that has got me thinking. My wife and i were discussing China recently and how they seem to be rather progressive when it comes to investing in renewable resource technology etc and how that might set them up to be the major superpower in the world for a while.
if what you say is true about their property than it is not hard to see the outcome. Dubai was the same. If suopply of housing exceeds demand than the prices will have to come down. If entire towns have been constructed with no-one than i say prices will come down quite a bit. This will have a huge ripple for Australia as we have well and truly in a typical laid back aussie “she’ll be right” kind of way have an economy which appears to be dominated by shipping expensive rocks mainly to china.
Thanks for this post Roger, it is a good reminder as to why this blog is so valueable and such a good resource.
Roger Montgomery
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Delighted you enjoyed it Andrew.
Ray H
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>Can an asset that produces no income be called an asset at all?
Gold comes to mind.
Harley G
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I find it interesting that so many of the guys on CNBC and the like claim the biggest downside to gold is it does not produce an income. But ironically, assets like bonds, loans, etc pay interest to offset the counterparty risk you take on. When you hold physical gold their is no counterparty, it is a closed transaction and you have full ownership. When fear is low, there is no need for a counterparty-risk-free asset but when fear is high and major broker dealers are going bankrupt, banking liquidity freezes up and investors dont know which government in Europe could be the next to show signs of stress, assets with no counterparty risk become much more attractive.
Roger Montgomery
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Hi Harley,
I agree. The only observation I will make is that many (including me) have owned gold using derivatives, such as futures. Novation -available on futures exchange traded derivatives – is thought to break the nexus between buyer and seller and reduce counterparty risk. I for example have owned gold through futures contracts and as the events surrounding MFG have shown those who used that firm globally – there can be counterparty risk.
Brad
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Australia GDP per person: $60k
US GDP per person: $55k
Taiwan GDP per person: $20k
China GDP per person: $4k
They have a long way to go……….
Roger Montgomery
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Becomes an interesting discussion if you look at either the global and local economic and population growth that has delivered $4k per person or if you consider the natural resources (inputs) required to get it higher…a cessation of deflation with subsequent prices rises could also improve the number without a change in volumes…
Ilya
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China’s low GDP per capita is kept artificially low by Yuan’s peg to the $US. If Chinese drop the peg and let their currently appreciate the gap would narrow rapidly.
Roger Montgomery
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Yes.
Matty
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Chinese drop the peg, what happens to their exports….this is all built on sand (supported on a deck of cards full of jokers). We will buy your debt if you buy our products.
The economist magazine from Nov 12th had a great article on state capitalism in China. The article highlighted the lengths that the “most powerful entity you never heard of” goes to support state aims. There is a great chart (would be coloured deep scarlet in Skaffold), with state assets quadrupling over 6 years and profits flat-lining – ending up at about 3% of assets in 2010. A statement in there that if a market interest rate were paid, their profits would be wiped out. Just makes you aware of the tenuous links to reality and sustainability. Then you look at the demographic change coming and wonder when you will see a silver lining again. Or is that gold?
Roger, when you write (above) that you are “Ready” What % cash are you talking about? If this leg of the economy were to fall over now when everything else is such a mess…it doesn’t bear thinking about. Can you remember the time in your investing life when you didn’t have this China hype? This for me is the real Black Swan out there, even though it has been talked about alot for some time, I just don’t think it is being factored in. Maybe other people out there are more prepared?
Roger Montgomery
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Great stuff Matty. The recent rally saw several holdings reach intrinsic value or surge well beyond producing a low expected IRR. Those holdings have been liquidated.
Harley G
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Matty: I completely agree with your statement – I think what the market is pricing in is low(er) commodity prices but far from pricing in a true Chinese slowdown or property crash.
I have spent a great deal of time trying to understand what is going on in China and the more you find out the more concerned you become. Firstly, I should state that I have read nothing that suggests to me that China’s long term growth will be sacrificed. But my view on the short to medium term is not so positive.
Firstly, I know some investors here are happy to buy companies leveraged to China because they believe in the long term growth. But I would really advise people to try to understand what is going on in the property and banking sectors over there and how interrelated and dependent on one another they have become.
I have already posted a few comments here so I won’t fill up too much more of Roger’s blog. But I hope that those investors who are shrugging off the China slow down in the belief that they are taking a long term view know what they are doing and have really looked closely at what is essentially the system that has single handedly supported our economy since 2008. It is not just a problem amongst the banks and some wealthy property investors. Through shadow banking systems, provincial pooling of money amongst the average Chinese, bank ‘trust funds’ that funnel money into property and record the spread as fee income (helping to mask NPLs) a property collapse would spread through the entire economy. I am not advising people to invest one way or another – I am just saying that make sure that any investment you make you fully understand what the prospects for your investment are based on and unfortunately for many companies on the ASX their performance in recent times has been almost entirely thanks to China, and thus in my view it warrants a detailed look.
Roger Montgomery
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Well done Harley. Ties in with Ben’s observations too.
Ilya
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OK. Here is the deal. At the moment Chinese keep their own currency artificially low so that they can export to US etc. in exchange for paper. US get goods while Chinese get paper. Does that sound like a good deal?
If Chinese were to de-peg the Yuan from $US, their currency would appreciate and the value of their wages will rise. All over sudden Chinese citizens will be able to purchase the fruits of their labour themselves instead of shipping them to US etc. in exchange for the currency that is being printed to oblivion.
I think this is a much better deal for Chinese than what they have now. Sure they will be some losers. Some exporters will go out of business others will have to retool for internal demand. But overall Chinese will be much better off.
At the moment Chinese are transferring their purchasing power to the US citizens. What’s so good about that? If they let Yuan raise, and they will, they will keep the purchasing power for themselves. In the end we want jobs so we can buy things, we want exports to pay for imports. Or as Peter Schiff says: “What good are jobs without stuff? This is called slavery…”
Roger Montgomery
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Thanks Ilya.
Harley G
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Hi Ilya,
I agree in part with what you are saying but I think you are taking an oversimplified and US view of ‘China should stop manipulating their currency as that is the key to both China and US’s problems.’ (Feel free to prove me wrong of course, happy to debate it)
I don’t think its that easy. Firstly if China were to announce tomorrow they are removing the peg, do you think the reaction would be an appreciation? I do not. I think there is a lot of money in China waiting to get out, far more than is willing to invest at the moment – particularly in this environment, and their trade surplus may turn into a deficit in coming quarters. The property bubble is a direct consequence of the currency peg. To let it go immediately or even relatively quickly would be akin to outright popping the bubble, in my opinion. It would be a ‘first out the door’ event I believe. One of the only things keeping the bubble from popping now is the fact that even if they sold, where would they put the money? Negative rates in banks, stock market not looking promising, commodity stock piling and speculation has already occurred. (Just as a side note I believe that the Chinese authorities will keep a tight grip on the property market, and while it will be painful, the end result will be a bottom in the Shanghai Stock Market, a more lenient approach to the currency peg, a DEPRECIATION of their currency, sparking a pick up in exports, and also marking the bottom in our own market. I do however, think this occurs over a year or two and after a (perhaps substantial) decline in our market.)
So in my view that rules out an immediate de-peg. The next option is to gradually loosen the peg, as they are currently doing. But to do this they have to sell US assets (mostly gov paper of course) and then buy something else. What will they buy? Euros? That seems like a risky bet at the moment. Say they do buy euros in some substantial amount, the ECB (lead by Germany) will then see their exports threatened and step in to depreciate their own currency, and will have to buy dollars, thereby negating the actions of the Chinese.
Finally, you mention the process of appreciating the yuan would ‘transfer purchasing power’ to the Chinese people. But what would that do to the $3trn in reserves the Central Government holds? Any increase for consumers would be balanced out by a loss in value of the gov’s reserves. The government does not ‘own’ the reserves, they are deposited with them through the banking system, so if the government appreciates the yuan (depreciates the USD) the true ‘owners’ of those reserve dollars would lose an equal amount of purchasing power.
But like I said I agree with your post in general. My view as to how things play out is the Chinese, who by all accounts are savvy traders/investors (ex traders working in the central bank) know that a substantial appreciation in the USD is approaching either through recession, euro crisis or their own property bubble. I believe they will see the yuan falling and will not try to stop it. As the USD appreciates and a mad rush for USD begins they will offload their USD assets using the spike as an opportunity. When the calm returns we will probably see news stories like ‘China offloads largest holdings of treasuries in years’ or the like. They of course will have, at that point, a spike high in their USD holdings, a low euro (my view is the euro survives) as well as other currencies, and gold likely well below where we see it today. And I believe at that point our market will be a fantastic opportunity. If it plays out as I think it will then both Jim Rogers and Jim Chanos would ultimately be right!
Ilya
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Hi Harley,
Obviously I am oversimplifying things. I always take a long-term view and if one takes a long-term perspective it is easier to debate in broad/simple terms. Besides, economics, just like investing, is really simple and does not require explanations from the “we know best” boffins at RBA or Fed. Anyone with a shred of common sense can immediately grasp that a country that saves and produces has much better long-term prospects than one that borrows and spends. Somehow only those with very expensive education and even Nobel Prizes in economics tend not to grasp that. Reminds me of William Buckley’s famous quote that he would rather be governed by the fist 100 names in the Boston phone directory than the entire faculty of Harvard.
I agree with you that de-pegging Yuan overnight wouldn’t be a great idea given the large imbalances accumulated and amplified through ongoing global currency manipulation.
Long-term I cannot see any other way forward for China than to de-peg the Yuan. It is not wise for Chinese to follow US in the ultimate race to the bottom and destroy their currency all the way with LBJ.
Roger Montgomery
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And the best time to do that in their minds is when they achieve…stronger domestic consumer demand or x% of GDP or…?
Ilya
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I am not sure, Roger. My guess their hand will be forced by the events. Inflation is a very tricky beast. Historically it tends to start imperceptibly gentle and then suddenly spin out of control. I think whatever Chinese tactics are right now, the reality hasn’t set in yet. Once it is clear to everyone what is going on, everyone will rush for the exit.
Roger Montgomery
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Sometimes I think of the 1930s. The economics were terrible for the decade but by 1932 the stockmarket had already factored in the worst and it began its ascent.
Ash Little
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But we are not cheap like that yet in my view
Gady Manor
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Hi Brad it’s not the quantity of the GDP it’s the quality! China is trying to grow too fast to meet GDP targets. There are many families in china that can’t afford a house, their combined salary is $800-$900 a month when houses are $300,000+, property in china will crush eventually to meet that demand.