The Importance of Structure

In my research and investing I stress three things: people, structure and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below fair value if not outright cheap. 

This post is about structure and is the last of three main posts that provide insight into my research and investment process.  The two other posts are about people and valuation (see here and here).

Structure is the hardest to write about.  It is boring when compared to writing about people and is not easily quantifiable like valuation.  Nevertheless I think it is extremely important and something that investors don’t pay enough attention to. 

By mapping a business group’s structure investors can identify potential leakages, or situations where controlling shareholders can transfer something from the listed company to their privately owned vehicles.

It is also time consuming.  Mapping corporate structures of large business groups sometimes requires days or weeks of trolling through corporate filings, websites and news articles.  It took two weeks for me to map China’s two largest petrochemical conglomerates, CNPC and Sinopec, for my 2012 report on Chinese conglomerates.  And I could easily have spent more time on both. 

Business Groups

Business groups represent the ownership interests of an individual, family or government entity that controls two or more companies.  The group may or may not be legally defined.  It can be a formal holding company or just a loose collection of friends that co-invest in many projects together.  

They can account for a large role in national economic growth, especially in frontier and emerging economies where they control numerous businesses.  Many times they account for a large portion of economic activity.  In the early 1980s the Salim group’s revenue accounted for about 5% of Indonesia’s GDP (related book review is here). 

Business groups can be large and complex.  Below is partial map of Fosun, one of China’s largest privately-owned business groups, when I attempted to map it in 2014.  At that time the group had over 300 entities.  In one of the group’s more recent filings, it lists economic interests in about 500.  

Based on my experience I guesstimate that 20-40% of the value in most stock markets is controlled by a relatively small number of people – say 5 to 30 well-connected families and individuals.  Another 20-50% is controlled by the government through ministries, sovereign wealth funds or other government-linked companies and entities. The remainder are companies that have a distributed shareholder base, subsidiaries of MNCs or companies that are not part of the larger business groups. 

Taiwan is a good example.  One of the largest business groups in Taiwan is the Formosa Plastics Group which controls ten listed companies.  Together their value is over 10% of the entire value of all the companies trading on the Taiwan stock exchange. 

Governments are also the controlling shareholders of many large listed companies.  In a report I wrote on South East Asian business groups in 2011, I found that about 31% of the large companies listed in ASEAN were controlled by government-linked entities.  The largest was Singapore’s Temasek which controlled companies that accounted for almost 14% of the region’s total value of large investable companies.  In my 2012 book on China’s business groups, I found that the Chinese governments' proportion of control was even higher at about 60%. 

Group Structure Brings Additional Risks

The group structure brings risks to investors.  There is a large incentive for controlling shareholders to transfer assets, cash or something valuable from the entity they own only 51% of to that entity they own 100% of.  “Expropriation of minority shareholders” is the way financial types and corporate governance experts phrase it.  “Screwing over small shareholders”, is more succinct in my view. 

There are many ways for this to happen.  The beauty behind human ingenuity and imagination means that if there is proper incentive, someone will find a way around the existing rules and laws.  Investment bankers, lawyers, and corporate strategists are paid big bucks for devising such structures.

The remainder of this blog illustrates two schemes the controlling shareholder might deploy to take money away from minority shareholders: adverse related party transactions and something I like to call long term pump-and-dump. 

I. Adverse Related Party Transactions

Related party transactions are deals or transfers of some sort between two companies that are both controlled by the same person or group.  They are like moving money from one pocket to the other. It stays with the same person.  However if one of the company’s shares are listed, then moving money from one company to the other hurts small shareholders of the listed company. 

All related party transactions should be at ‘arm’s length’.  This means that the sale from one controlled entity to another is executed at the prevailing market price and that it would make no difference than buying or selling to or from a company inside or outside the group.  However determining market prices can be subjective and open to interpretation by the two companies involved.  The ‘market price’ can be set to benefit one entity at the detriment of the other. 

The following is a hypothetical example of how this works. 

Let’s call the very rich owner of a large business group BIG TYCOON.  BIG TYCOON is the eldest son of the conglomerate’s founder. His father invented and marketed what is now a very popular candy. To increase sales, BIG TYCOON’s father expanded from simple manufacturing into many other related businesses.  These include distribution and logistics (to get the candy to market), convenience stores (to sell the candy), and paper manufacturing (to make candy wrappers).   

Because he’s the eldest son, BIG TYCOON took ownership when his father passed away.  Unlike his father, BIG TYCOON enjoys the money and lifestyle of owning a successful business more than actually running it.  He’s not a bad guy in the sense that he beats his wife or children, but he’s simply not interested in the candy business or running a public company. 

The outline of BIG TYCOON’s conglomerate is shown below.  He owns 51% of Manufacturing Company and 51% of Convenience Store Company.  He also owns 100% of Distribution Company. As their names imply, the Manufacturing Company makes candy. Distribution Company distributes it and Convenience Store Company sells it.  

The Manufacturing Company and Convenience Store Company are both listed on the stock exchange.  The other 49% of both companies is owned by institutional and retail shareholders.  The latter two are called “minority shareholders’, since they own less than 50%. 

With 51% ownership in both public companies, BIG TYCOON has a firm grip on both Manufacturing Company and Convenience Store Company.  Even if all other shareholders get together, they won’t have enough votes to override BIG TYCOON’s decisions.

This structure gives BIG TYCOON near absolute control over all three companies despite owning a little more than half in two of them.  He can make decisions that may or may not be in the interest of the minority shareholders of the two listed companies.  

In fact there is a large incentive for BIG TYCOON to treat minority shareholders badly.  Why settle for 51% of the profits, when he can steer more to the company he owns 100% of?  This transfer can occur in many different ways.  One of the simplest ways is to lower the sales price of the candy produced by his 51% held Manufacturing Company.  

After the price change, BIG TYOON’s 100% owned Distribution Company pays a lower price for the candy, and its sales, margins, profits and cash flow increase.  The lower price causes the opposite at his 51%-owned Manufacturing Company.  Its sales, margins, profits and cash flow decrease. The end result is that minority shareholders suffer at the expense of the controlling shareholder, BIG TYCOON’s decision.

Manufacturing company’s minority shareholders are likely to complain about the poor results. BIG TYCOON has many ways to explain them - consultants telling him to lower prices to gain market share, rising competition, higher distribution prices by other logistics companies, etc.  

II. Long-term Pump-And-Dump

Another way for controlling shareholders to abuse minorities is through something that I call long-term pump-and-dump.  

A long-term pump-and-dump is another form of related party transaction.  In this case the owner transfers profits into the company that he wants to raise money for.  This makes that it appear to be healthier and more valuable than it actually is.  After the money is raised, the scheme is reversed. 

Let’s again use BIG TYCOON’s candy empire as a way to illustrate this scheme.   Let’s assume Big Tycoons’ empire now consists of two companies. He owns 100% of Wrapper Company and 51% of manufacturing company.  Most of these candy wrappers produced are sold to his Manufacturing Company.  

BIG TYCOON decides to monetize his stake in the Wrapper Company.  Instead of selling it outright, he wants to sell 49% through an IPO, collect the cash, and retain control with 51% shareholding.  This has worked well with the other two listed companies and he’s keen to do it again. 

However Wrapper Company is not growing and its future growth prospects do not look very good.  BIG TYCOON’s investment banker says that he can help Wrapper Company sell its shares and list on an exchange, but unless Candy Wrapper shows good growth, its valuation will not be very high. Who wants to invest in an old industry that’s not growing very quickly?

BIG TYCOON wants to get as much as he can for his stake and devises a strategy to make Wrapper Company more attractive to investors.  Firstly Wrapper will expand internationally.  They’ll sell at zero profit or even below cost to quickly ramp up sales in fast growing countries like China and India.  They don’t expect to make much profit out of this, and will likely incur costs as they need to get market share quickly.  This means undercutting their competition with lower prices.  

Secondly they decide that it will look good to have a new product.  They increase R&D spending and ‘invent’ a brand a new wrapper 'technology' that they claim is better and cheaper.  

To pay for all this BIG TYCOON decides to boost candy wrapper sales by increasing the price that Manufacturing pays for the new high-tech wrappers.  Increased revenues will cover the costs of international expansion and R&D.  

All is going according to plan and over the next two years Wrapper Company’s sales, margins and profits increase.  From the outside it appears that Wrapper Company's global expansion and new technology are accepted by the market.  However what is actually happening is that Wrapper Company’s growth comes at the cost of Manufacturing Company. 

BIG TYCOON meets with the investment banker and shows him Wrapper's progress.  The banker is very happy.  Instead of trying to find buyers for a slow growth, old-fashioned candy wrapper manufacturer he now has the technology-based, globally expanding Wrapper Company.  Its increasing sales, margins and profits are ‘proof’ that the global expansion and new technology are successful.  The banker is certain that Wrapper Company can be sold as a growth company at a high valuation. 

The skilled banker does a very good job marketing and selling Wrapper Company.  The IPO is a big hit, with the company valued at $1,050m.  Like his other listed companies, 49% of 
Wrapper Company is sold to minority shareholders who can now trade their shares through the local stock exchange.  

The 49% stake sold to the public raises $490m for the company and existing shareholders.  New shares account for half of this so the company gets cash of $245m.   The remainder are BIG TYCOON’s personal holdings so he pockets $245m.  The investment banker gets a 5% or $50m, fee for his efforts.

This leaves 51% – or a controlling stake – in the hands of BIG TYCOON.  BIG TYCOON retains control, has a lot of more cash, and another listed vehicle to potentially use as he did in our first example.  

The net effect of our fictitious story is that over time the value of Wrapper Company has been pumped-up by transferring profits out of Manufacturing Company.  Once the money is raised through the IPO, rights issue or other capital raising exercise, the whole process can be reversed. 

End Note

This lengthy blog has covered a lot of ground.  It not only introduces the concept of business groups, but it also makes an attempt to illustrate why it’s important to study their structure.  Two examples have been given to emphasize how controlling shareholders can take money from minorities. 

Along with researching key shareholders and valuing companies, structure is something I believe investors should spend considerable time researching.  As stated at the beginning of this blog, it’s not as fun as the other two but, if done properly, it’s essential to understanding the risk minorities take when investing in companies that are part of larger business groups.

Alibaba, Hong Kong and the US's Hot IPO Market

As this is being written Alibaba is in the middle of its roadshow to promote what is shaping up to be one of the world's largest ever IPOs. 2014 is turning into an investment banker's wet dream with IPO activity in the US expected to be the best since 2000 according to a recent report by Renaissance Capital.  

As most readers will remember the year 2000 was when the Nasdaq topped out at just above 5,000 before falling by almost 80% in the following 2.5 years.  The index is now close to that 5,000 level after 13 long years.

This recent history has stuck with me for a while.  As I wrote in a previous blog post my gut feeling is that a large number of IPOs tend to signal an expensive and overbought market.  

What is good for corporate capital raising and bankers is unlikely to be good for investors.

In that post I found that my hypothesis is not watertight, at least on a global scale. In several years an increase in IPO proceeds foreshadowed a good market the following year.  It seems that all the positive feedback from the hype surrounding IPOs as well as good post-IPO performance encouraged people to get into the market. 

What I did find was the opposite.  A widely-followed global index increased every year after capital raised via IPOs decreased.  In other words, investors were rewarded in the year after proceeds raised through IPOs decreased.


United States

Using similar data - this time from Renaissance Capital - it appears that there is a stronger relationship in the US between IPO capital raised and subsequent market performance. (Renaissance Capital's reports can be found here and here.)

As seen in the chart below, the S&P 500 index mostly moved in an opposite direction to the change in IPO proceeds in the previous year.  This happened in 10 out of the last 12 years as shown by the large number of red arrows.

When IPO proceeds increased in one year, the index was largely flat or declined in the following year.  And vice versa.  

The average rise in the S&P 500 index in the seven years after IPO proceeds decreased was 10.8%.  The average fall in the index in the five years after IPO proceeds increased was 0.5%. 

Readers should bear in mind that these are all rough numbers and based on a small sample. 

Hong Kong

Closer to home things get more interesting.  

In the last twelve years Hong Kong's IPO proceeds have given a much different signal. It appears that there is more of a momentum effect of IPO proceeds in Hong Kong.  High IPO proceeds in one year leads to a rising index in the subsequent year.  

In 6 out of the last 13 years the direction of the Hang Seng Index's rise or fall was the same the previous year’s change in IPO proceeds.  In other words, positive IPO issuance in one year tends to foreshadow an increase in the index the following year.

This was almost all during the go-go China boom years of the early and mid-2000s.  IPO proceeds increased some 14x from the 2001 low of HKD22b to the 2006 pre-GFC high of HKD332b.  

Since 2008 there has mostly been a negative correlation between the two.  (Again I need to emphasize the extremely low number of data points).

The average rise in the Hang Seng index in the 8 years after IPO proceeds decreased was just 2.3%.  The average rise in the index in the 5 years after IPO proceeds increased was 10.8%.

Hong Kong More Influenced by the US? 

But where it gets even more interesting is comparing the directional change in the main US and Hong Kong indices.  In almost every year since 2001 the direction of the Hang Seng index was the same as the S&P 500.   This is highlighted by the blue arrows between the last two columns in the chart below.  

From this quick and dirty analysis it appears that the US IPO market has been a better predictor of subsequent performance of the Hang Seng index than the local IPO market. 

This corresponds to my experience. When I was a sell-side equity analyst many of my portfolio manager clients in Hong Kong complained that they spent more time trying to figure out what the US market would do rather than analyze the situation in Hong Kong or China.  

Back to 'Baba

I do not know what direction the Hong Kong, US, or any other market will go next year.  It has been shown time-and-again that most predictions are useless.  In my opinion they are typically no better than one's astrology sign or Chinese zodiac.  

However with Alibaba's huge IPO, US equity indices reaching new highs and some believing that the US equity market is in bubble territory I'm feeling even more cautious than when I wrote the previous blog post last December (see John Hussman's market comment here).

But investors should bear in mind that I had the same feeling when Facebook went public in May 2012. Like Alibaba it was one of the largest IPOs ever. Upon listing it was the largest company to float with a market capitalisation of some USD100b.  It is now worth over USD200b, and is up slightly more 100% since its IPO price.  

Since Facebook's IPO, markets have also done well. The S&P500 and Nasdaq indices are up 41% and 50% respectively. The Hang Seng Index is up 19%. 

I was wrong about Facebook signaling a market top and lost out on considerable upside.  There are many reasons that I could be wrong again, but after this analysis I’m even more cautious on not just the US but Hong Kong as well. 

Book Review: The Money Game by Adam Smith

The Money Game is the second book by the late Adam Smith (aka George Goodman) I’ve read and reviewed.  Like Supermoney I was struck by how similar the investment world is today compared to 45 years ago, when it was published.  

The Money Game contains numerous quotes from John Maynard Keynes' work and it’s clear that the author is a fan.  Many times the author uses the Keynes' writings to reflect on the state of the investment world in the 1960s. 

Which - come to think of it - is basically what I’m doing in the remainder of this blog post.  “History doesn’t repeat itself, but it does rhyme”, Mark Twain is supposed to have written.

Shale Oil. Third Time Lucky?

“’Sir!’ said Sheldon the Kid.  ‘The Western United States is sitting on a pool of oil five times as big as all the known reserves in the world – (it is) shale oil.  Technology is coming along fast.  When it comes, Equity Oil can earn seven hundred and fifty dollars a share.  It’s selling at twenty-four dollars.  The first commercial underground nuclear test is coming up.  The possibilities are so big no one can comprehend them.’” 

 ‘The shale oil play,’ I said, dreaming.  ‘My old MG TC. A blond girl, tan from the summer sun, in the Hamptons, beer on the beach, ‘Unchained Melody,’ the little bar in the Village…’. 

‘See?  See? Said the Great Winfield.  ‘The flow of the seasons!  Life begins again! It’s marvelous’. 

Comment: The dialogue above describes a young analyst recommending a shale oil company to older Wall-Streeters who remember looking at shale oil as an investment when they were new to the investment industry.  This means that the current boom is the third time shale oil has attracted investors the last 70/80 years. FYI Jim Rogers has been pessimistic on shale as an investment (article here).

Behavioral Finance Is Not New

“Outside of New York there is an aggressive fund housed in pastoral surroundings, run by a man who won’t go into New York.  It is not only that he considers New York a sink, which he does, but that, ‘all those fellas ride into New York on the same train and read the same things and talk to each all the way in.’, This captain of money management doesn’t talk to anybody and doesn’t read anything. ‘All that is all in the price,” he says.  ‘Eighty percent of the market is psychology.  Investors whose actions are dominated by their emotions are most likely to get into trouble.’

The book references several psychology books including Dr. Gustav Le Bon’s “The Crowd: A Study of the Popular Mind”, Sigmund Freud’s “Group Psychology and the Analysis of the Ego”, Dr. W. McDougall’s “The Group Mind”.

Comment: What I thought was new – Behavioral Finance - is just more and better understanding of something that others had figured out before.  (But I still love Kahneman and Taleb.
Great video of them together is here.) 

Momentum Will Always Sell Funds

“Then the salesmen of mutual funds noticed that when they spread the literature from all the funds before prospective customers, a lot of the customers weren’t’ interested in nice, balanced, diversified funds any more.  They wanted the funds that had gone up the most, on the idea that those were the funds that would keep going up the most.”

Comment: Momentum investing is still popular.  In the last few weeks I’ve read and heard many suggesting that the US and Japanese equity markets will continue to be strong in 2014. They were amongst the best performing in 2013 so are easy for financial advisors to recommend – the trend is your friend.  (I personally think the US is showing many signs of being overvalued.  Buffett has commented that he can’t find much to invest in and Klarman has supposedly returned cash to shareholders.  “Tonight I’m goin’ party like it’s 1999”, sang Prince).

Information Overload

“All the players in the Game (i.e. investing) are getting rapidly more professional; the amount of sheer information poured out on what is going on has become almost too much to absorb”.

Comment: Even before the Internet, cable TV, personal computer, fax, and chumps-like-me-who-write blogs, there seemed to be too much information on the markets.

Insiders Make the Big Money

“Who really makes the big money? The inside stockholders of a company do, when the market capitalizes the earnings of that company”

Comment: Ultimately those who have control make the most money.  Not the outside and minority investors. The people that really win in an IPO are those that are selling equity.  Corporate executives manage and influence earnings to increase the value of their stock options.

Markets Reflect What is Happening in Society

“Markets are only a tiny facet of society, but being made by mass psychology, they are a good litmus paper for what is going on.”

Comments: The market tends to foreshadow economic trends.  Not the other way around. Investors spend too much time on macroeconomics. 

Is Investing Technology Really New?

Quoting ‘a professor at a one of the US’s leading university’, “…there are a couple of sophisticated funds that have computers like ours on the air.  Then it really gets fun.  Our computer scans the pattern of their other computer on the air, what its buying and selling programs seem to be.  Once we get its pattern, we can have all kinds of fun.  We can chase the stock away from it.  Or even better, we can determine where the other computer wants to buy.”

Comment: This sounds like it could be an article or marketing material for a CTA fund or high-frequency trader.

Socialism for the Rich

“One of our learned economists has described our economic system as “state socialism for the rich.  If socialism is the public ownership of the major institutions and industries of the nation, maybe we are just taking a unique way of getting there.”

Comment: Quantitative easing and its positive effect on bankers’ bonuses is now criticized as socialism for the rich.

  

Good Markets Underpinned by Good Leadership

“In the long run, the actions of all investors, individual and institutional, professional and nonprofessional, have to be based on the belief that leadership knows what it is doing and that rational men are handling the nation’s business rationally.  If that belief fades, then so do the markets.  They do not merely dive, they dive and then they disappear.  It happened here in the blight of the spirit from 1930 to 1933, and it has happened in other countries. “

Comment: Politics and leadership can be very influential in both the long and short term.  See previous post on the recent influence of election cycles on Asian markets here.

Governments Print Their Way Out of a Bind

“…the problem is universal.  It is that governments are now held responsible for the welfare of the people.  The aspirations for the people can outrun their ability to pay for them, and nobody has yet found a way to create answers to the aspirations out of thin air. What this means is that if governments have a choice between attempting full employment and defending their currencies, they will nearly always pick jobs over the worth of the currency.  Currencies do not vote.  In this country, the Full Employment Act of 1946 spells this out.  The government is committed to full employment, and if it must pump money into the economy to achieve this, and if there isn’t enough money, it creates the money.  Long-range inflation is the policy, articulate or not, of every country in the world. “

“Never in 5,000 years has there been a government that could resist debasing its currency. “

Comment: Except for the reference to the Full Employment Act, the above sounds very similar to what I’ve been reading for the last several years. 

Financiers as Government Skeptics

“’Skeptics, yes,’ said my friend the Gnome of Zurich.  ‘We stand for disbelief.  We are basically cynical about the ability of men to manage their affairs rationally for very long.  Particularly politicians.  Politicians promise things to the people for which they cannot pay.  So we Gnomes stand for Reality, or discipline, if you will.  Without us, the printing press of every government would simply print currency, there would be wild inflation, and in no time the world would be back to barter.’”

Comment: Sounds like something out of a hedge fund monthly letter.  Saving the world’s financial system, while betting on its demise, at 2/20.

More Good News From Greece

More good news from Greece.  This time it is from last week's New York Times article on the sentencing of former Greek defense minister and ex-leader of its Socialist Party Akis Tsochatzopoulos for money laundering.   During his trial the court was told that Akis pocketed close to US $75m in bribes when he was Greece's defense minister.   He received a 20-year prison sentence, on top of a previous 8-year sentence for concealing assets.

In addition, his wife, ex-wife, daughter and 16 others were also convicted and sentenced to 6-16 years for helping to launder the ill-gained loot (see a more detailed take on the sentencing in the Greek Reporter).

What is most significant is that Greek authorities are going after the well-connected and powerful.  As the New York Times article notes, "The conviction on Monday was unusual in a country where top state officials are rarely prosecuted.  But over the past year, the government of Prime Minister Antonis Samaras has intensified a crackdown on corruption."  

The article also noted that in early 2013 the mayor of Greece's second largest city, Thessaloniki, was sentenced to life imprisonment for embezzling some US$24m from the city.

As an investor, these are significant events that make me feel more positive about the country and its progress. Cracking down on corrupt officials and politicians is a significant change.  To me it is much more powerful and has more positive ramifications than Central Bank Band-Aids.

In all the emerging markets where I've analyzed companies there appears to be a circle of powerful business families, politicians, military leaders and other well-connected people that seem to look out for each other.  For an outsider like me, they seem to be above the law.   

Many times there are personal and family ties that bind these people together. The connections can also be school ties, club associations, business deals, co-investments, etc.  Money, licences, influence, and jobs seem to flow between those that are well-connected.  Typically the smaller the country the closer the ties between individuals.

For a smaller country like Greece with a seemingly long history of corruption, arresting and bringing charges against the powerful, rich and well-connected likely took courage, fortitude and persistence.

I suspect the country's dire economic situation is ultimately behind this change in attitude.  Several years into the Asian Financial Crisis, Indonesia implemented several significant reforms that ultimately helped the country to recover and move forward.

In a recent post I wrote about other reforms that should lead to a more stable and pro-business environment in Greece.  I suspect there is more to come.  "...virtually everybody I talked to said that the current system is not working and things had to change.   I also felt that many realised things were unusually good during the last decade or so and that the current status quo is unsustainable.", I wrote after my trip to Athens last summer.  

Hats off to the current administration for their efforts to shake things up.  I hope they do more.   I met a lot of smart, switched-on, hard-working people on that trip.  They deserve - and should work for - a better business and political infrastructure.

Bottom-Up Inflation

As mentioned in another post, I think inflation is high and likely higher than the official figures and economists' forecasts.  I recently read a well written report from a noted economist that is sticking to his long-term deflationary forecasts.   

He and others could be correct, but from my standpoint - mostly as a consumer - I see the opposite:  

Inflation is a big worry amongst Mainland Chinese with almost two-thirds citing it as their biggest concern according to a recent FT blog.
1. A friend put some numbers to my inkling that supermarket prices have increased.   After a few weeks away from HK she noticed that a jar of basic yogurt had increased from HK$19 to HK$24, or 26%.  This seems about right.  I've noticed that basic items such as bread, fruit, and vegetables seem to be significantly more expensive in the last several months.
2. The menu at my local Vietnamese restaurant has taped over prices with higher ones.  I've seen this in other restaurants. 
3. Hong Kong taxi fares will increase 7-9% in December 2013 (article is here)
4. Hong Kong's "10 Dollar Store” should now be referred to as the "12 Dollar Store".  Likely anticipating more price changes, the chain was renamed, "Living Plaza", from "Jusco $10 Plaza". (This actually happened a year ago as reported here).   Format of the store is similar to Japan’s 100-yen store.  Virtually everything the store is the same low price.   (A friend's wife - a Japanese speaker - noted that Japan’s 100-yen stores have NOT raised their prices in many years and that they have better quality products).

Forecast deflation may come to be.  Mainland growth is slowing.  HK retail sales appear to be down some 10-20% YOY.  Property prices seem to be softening.  

But from the ground level, I see more evidence of inflation. 

Why the US Does Not Have Business Groups

My favorite research projects are analyzing and writing about business conglomerates in Asia.  For me it is an easy way to quickly come-up to speed on a country's key people, capital allocation structure, and power chain.  After completing the reports I feel I know who is actually in control, their background and their relationships with important business and government personalities and entities.  I also get a sense of the who the good groups are and who the not-so-good groups are.  So far I've mostly been correct (see a case study type write-up here).


In the past several years I've been investing my own money using much of the same research methodology I used in writing the reports. The best example is my trip to Greece last year.  Other investments closer to home and based on recent reports have also done well.

So far I've been content doing my bottom-up research and have not really looked into why Asia and the rest of the world's corporations are organized differently than companies in the US and the UK.  The few US and UK companies I've looked at have a very flat corporate structure, and I've been told that neither country has business groups. 

However virtually all of my analysis and investment experience has been outside the US and UK, and the group structure is my base case when looking at companies.  Because of this, my research and investment methodology doesn't really fit with the US and UK's flat corporate structure.

I've always been a bit curious as to why the US and UK are different than the rest of the world.  But like a myopic-race-horse-with-blinders, I've accepted the structure for what it is and concentrated on trying to make good investments and recommendations.  

Thanks to to UC Berkeley PhD candidate Matthew Sargent for turning me onto the very well written, but long-titled, "How To Eliminate Pyramidal Business Groups - The Double Taxation of Inter-Corporate Dividends and Other Incisive Uses of Tax Policy". 

Written by Dr. Randall Morck in 2004, the paper states that a key reason that US corporations do not have the pyramidal business group structure is due to the 1935 imposition of inter-corporate taxes.

Apparently after the 1929 US stock market crash many business groups defaulted on their loans, and the public blamed the large conglomerates for causing the crash and subsequent depression. It sounds like this gave President Roosevelt's administration enough political capital to change how America's corporate sector is taxed and, by extension, organised.

The new tax regulations made dividend payments from a company to all the entities that owned it subject to taxes.  Each layer is subject to pay taxes on the dividends it receives from companies that it has a stake in.  If a conglomerate has many layers, each layer is subject to tax charges.  This makes each additional layer very expensive. This creates a  tax penalty on the pyramidal structure of business groups.  

America's utilities were given special attention.  The Public Utilities Holding Company Act (PUHCA), also passed in 1935, subjected utilities to US federal regulation and did not allow an owner with more than two corporate levels to hold any public utility.

After the two new rules were implemented, the group structure that was so prevalent in the US, was quickly broken up.  According to the paper, stock liquidations surged in 1936.   America has had a flat business structure ever since.

The paper attributes the UK's flat business structure to pressure from British institutional investors who were 'dismayed over corporate governance problems in business groups'.  As a result, the London Stock Exchange Takeover Rule was issued in 1968.  The rule said that any acquisition greater than 30% of a listco needed to be at least a 100% acquisition.  This forced the parent company of a listco to own all 100% of its subsidiaries or less than 30%. 

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What I found very interesting is that the pyramidal business group structure that I'm used to was very common in the United States.

They were so common, that in 1928 the US Federal Trade Commission wrote a report on the abusive nature of business groups.  The report found the same transgressions of business groups that I focus on when investigating corporate structures.  Morck notes that the 1928 report on US business groups said that US conglomerates had '...widespread instances of tunneling, poor governance, and monopolistic practices'.

Other government reports in the 1930s noted that many groups transferred profits between entities to avoid taxes.  "Listed companies in a business group could trade with, finance or insure each other at artificial prices, transferring taxable income from companies with few deductions to companies with many".

In other words, many business groups were ripping off the government as well as minority shareholders.  

This is very similar to what I've seen amongst many, but certainly not all, business conglomerates that I've researched. 

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This is a great paper, and I sincerely appreciate Matt for bringing it to my attention

But most of the thanks and appreciation goes to the author, Dr. Randall Morck, for researching and writing it.

A More Stable Pakistan

Seemingly lost in all the talk and turmoil of Syria and Egypt, the first full-term peaceful transfer of a democratically elected leader in Pakistan was reported yesterday: "Pakistani President Asif Ali Zardari has officially stepped down at the end of his five-year term, becoming the first democratically elected president in his country's history to complete his full tenure in office."  (I added the bold).

This is the best news I've heard for a long time.  To me this decreases political risk in Pakistan and the Indian sub-continent.

I liken democracy to investments.  The key take-away from my time in fund-of-funds was that good investors stick to their process.  Great investors seem to be more in love with their process and strategy than the companies they invest in.

I think this is similar to democracy.  Democracy to me is a process.  Sticking to the democratic process is more important than having a good leader at the helm. "People power", makes for good headlines - especially if the media's preferred party is being supported by the crowed.  But it is easy to overweight the loud protests in the capital's center.  What about those who live elsewhere in the country? 

Consider the US. George Bush had just about the lowest approval ratings of any US president during his last few years in power.  At the time I remember feeling that anybody would be better than him and that he should be replaced immediately. But the US stuck to its process. 

America was lucky. Its first leaders stepped down when their time was up. George Washington seemed to be one of the rare military and political leaders who willingly gave up power and retired. He set a precedent that has served the country well.  He is rightly called the Father of the country. 

I was among a handful of investment analysts covering the Indian sub-continent in the early 1990s.  Most of my time was spent in Karachi and Lahore as few institutions were able to navigate India's 'badla' system. 

In Pakistan I met many smart, switched-on people and managements.  Most business leaders and CFOs I met were very good and knew what they were doing.  Political instability seemed the biggest hindrance to growth. 

It has been about 20 years since I was last in Pakistan and I am very much out of touch with the place.  There could be more instability down the road, but a milestone seems to have been reached, a precedent set. 

The market seems to like this stability. The main Pakistan index - the Pakistan KSE 100 Share index - is up about 35% year-to-date and 3.3x since its January 2009 global financial crisis low. It is up almost 26x since its 1998 Asian financial crisis induced low. 

Bangkok - Changing and Staying the Same

Thailand is, and is not, changing.

That is my impression after a three-day trip to Bangkok to celebrate a friends 50th.  My first trip to Thailand was in 1986 and I've been going back every one-to-three years since.  This was my first time to Thailand in almost exactly two years when I was doing on-the-ground research for Inside Corporate ASEAN. My list of publications can be found here: http://michaelmcgaughy.blogspot.hk/2012/02/publication-list.html

Changing.  Bangkok for the first time feels like a real, first-world cosmopolitan city.  In the past it has always stuck me as a sprawling city in a developing country.  This time the night drive into the city from the airport yielded an urbane skyline, fast expressways and drivers that (mostly) stayed in their lanes. Later in the weekend a crowded BTS and fashionable shopping mall added to this feeling. Dinner, drinks and a terrace view of a concrete jungle reinforced it.

Staying the Same.  However in some ways Bangkok has not changed.

1. Traffic is still dreadful. It took 1.25 hours to go a few kilometers on a rainy Friday night.   
2. Politics remains rumour-driven.  My host informed me a few hours after I arrived that he received an SMS/Text stating that there will be a military coup in a few days. (another friend said this is not a rare message to receive)
3. Thais continue to start interesting consumer products. This is the country that gave us Red Bull.  

The last point is actually the purpose of this post.

The product is called G&G Body Deodorant.  It is for both underarms and feet. Basically a combination of Sure and Odor Eaters.

From a chemist's standpoint this combination may be very logical.  However from my consumer mindset it seems odd. Something that is meant to be spread on my feet does not seem like something that is also meant to spread on my armpits.

It was the only option at the supermarket so I gave it a try.  After a few days in a not-so-hot-Bangkok I found that it worked well.

At least for my upper body.  I still have not tried it on my feet.

The second picture is also from the trip.  It shows the King of Thailand getting haircut from his mother.  In Thailand virtually every retail business and office has a picture of the the king or other members of the royal family centrally displayed.  This was hanging at the Nonglingchee barber shop I tried. Very appropriate.