It's A Chaotic World. Profit From It

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 intrinsic levels if not outright cheap.

This post is mostly about people.  More specifically it is about investors and their desire for steady returns.  While I can understand the desire for predictability, it runs against my experience and philosophy.

Stability definitely has its place.  A stable political system, marriage and friendships are extremely good things.  And I’m about as far from an anarchist as possible.

But I feel differently about business and investments.  In fact I get scared when things are too stable and predictable.  The world is wonderfully chaotic and investors should embrace this rather than spending a lot of time, energy and money trying to smooth returns.  “Entropy is the only constant” is my favorite graffiti.  Closer to home friends say "變幻才是永恆"; "there is nothing permanent except change".  

Let me explain.

In the last few months I've been talking to people about my investment process and how I can help manage their funds.  It’s been going slow.  Most of the world is looking for steady, safe and predictable returns.  Asia’s moneyed class are looking for steady returns of 5-6% according to feedback from several in the financial community.

European investors must be even more scared.  Many are not only forgoing positive returns, but are paying governments for the privilege of holding their money.  Hence the negative government bond yields in many European countries. 

In contrast my investment strategy and process - which looks for out-of-favor quality companies in beaten down markets - are dependent on continued volatility.  Great bargains rarely appear in steady markets.  Great returns are also rare in steady markets. 

Be Afraid of Stability

Twenty-five years ago as a young analyst I loved analyzing companies that had steadily increasing sales, constant profit margins and growing profits. This made my financial projections easy. 

However experience has taught me not to trust steady returns and stability.  The business world is competitive and anything but stable.  I now believe that ‘stable’, ‘no risk’, and ‘guaranteed return’ are some of the most frightening words in business and investment.  

Consider the following:

• Bernie Madoff’s funds got big by seemingly delivering steady monthly returns in both up and down markets.   As we know now, it was all a fraud.
• Before it went bankrupt, Enron was well-liked by sell-side analysts and investors for meeting analyst estimates.  It steadily met expectations and was considered a stable and safe company.  But it was mostly smoke and mirrors before it became America’s largest bankruptcy. 
• The desire for, and fallacy of, steady growth is nothing new.  Adam Smith (aka George Goodman) wrote about the illusion of steady growth in his 1972 book SuperMoney. "Everywhere you looked, there was a company with a neat stepladder of growing earnings.  Some kept the stepladder right up to the day they filed for bankruptcy" (my review of the book is here).
• In his commentary on Dell being fined by the SEC for fraudulent accounting designed to smooth earnings, author and Darden School of Business professor Edward Hess notes that, "companies that grow for more than four consecutive years without resorting to earnings games are the exception, not the rule” (source document is here).

Growth and investments by definition are dependent on the future.  No one can predict the future so there is simply no way to fully guarantee their success or return.  Not every corporate expansion project works just as not every investment works (ask me about Ukraine. Link here).

At the end of the day, the world is not a stable or predictable place. And we don’t want it that way:

• If the world was stable over the last 100 years most of us would be plowing fields and playing cards instead of working in temperature-controlled offices and surfing 100 cable channels.
• Who would have predicted that a college dropout, hippy wannabe and a disheveled electronics geek would create Apple which changes the way we communicate, access information, and take pictures?
• I’m sure Kodak and many other companies would have preferred the stability of the pre-digital world.  Investors who embraced change did well, those that stuck with the old did not
• The biggest advertisement for positive effects of change is China.  Virtually the entire country has transformed in the last 30 years. Subsistence agriculture to export manufacturing to domestic consumption. Rural to urban migration. Collective agriculture to private property.  Etc, etc.

The world is wonderfully chaotic.  Live with it.  Embrace it.  Profit from it.

Valuation Matters. A Winning CAPE Strategy

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 intrinsic levels if not outright cheap.

This post is about value. I've written about the importance of people before (see here) and will at some point delve into the importance of structure.

A good way to minimize downside is to buy undervalued companies.  The hard part is valuing them.  There is no shortage of metrics and financial statement adjustments that analysts and investors use to determine if companies and markets are under or overvalued.

One my favorite ways of valuing listed companies is CAPE.  CAPE stands for Cyclically Adjusted Price-to-Earnings ratio.  It is like PE except that it compares the current price of a company to earnings averaged over a number of years.  PE or "Price to Earnings" ratio is a popular way to value companies, particularly those that are listed on stock markets.  It measures the value of a company in relation to one year's worth of earnings (more information can be found here).

CAPE was popularized by Robert Schiller who teaches Economics at Yale University. But it actually goes back to Benjamin Graham and it is through his writing I first became aware of it.

Benjamin Graham proposed valuing a company by looking at its average earnings over a business cycle - typically assumed to be 7-10 years.  Intuitively this makes sense.

Earnings can be volatile.  In a good year they can be high and in a bad year they can be low or negative.  Even good companies have some years when they lose money.  In those years they are not very popular and their share price usually falls as investors focus on the latest earnings rather than the company’s long-term strength and prospects.  This many times is a good time to buy.

CAPE May Predict Future Returns

There are many studies that have looked at CAPE.  One of my favorites is an easy-to-read academic paper named “Global Value: Building Trading Models with the 10 Year CAPE” written by Mebane Faber (available here).

This study notes that among the 39 countries it covers the 10-year CAPE does a good job at predicting subsequent returns.   Countries where the stock market was trading at low CAPEs subsequently had higher returns than countries that were trading at high CAPEs.

For countries trading at CAPEs below 10x the average real Compound Annual Growth Rate (CAGR) return was 12.3% over the next ten years.  This means that one could have doubled their money almost every 6 years through an passive investment in that country’s equity market if bought at a low CAPE value. This is five percentage points more than the US average long-term real return of 7% each year. Not bad.  (See reproduced table below)

The short term effects were also good.  One-year return for countries that trade below 15x CAPE was slightly above 24%.  Not bad again.

In contrast, buying at a high CAPE led to lower or even negative subsequent returns. A 10-year CAPE of 28x - which is where the US is now - translates into annual expected returns of some 4.4% over the next 10-years (CAPE calculation from Prof. Robert Schiller’s web page. Link is here).

Soon after the study was published CAPE became a bit more popular in the financial press.  2013 was a good year for the strategy and many took notice.  Among the countries followed by the study, the five countries with the lowest CAPE ratios had an average return of 20.7% in 2013.  The five countries with the highest CAPE ratios fell by an average of 17.8%.  This is a difference of close to 40 percentage points.  Massive for just one year.

However the strategy simply did not work in 2014. The five stocks markets with the lowest CAPE ratios fell by an average of 16.3%, while the countries with the highest ratios increased by 3.1%.  An investor in the low CAPE countries would have given up almost 20% in savings/returns.  The difference was not as big as the year before, but still was significant (Please see article here for a good summary of CAPE in 2013 and 2014.  For the last few paragraphs I took the numbers from the website here and added returns from the main index that tracks Jordanian stocks).

Much of the strategy’s poor performance last year was due to falling currency in the two countries with the lowest CAPE ratio - Greece and Russia. They were two of the world’s worst performing equity markets for USD investors with their ETFs falling by 36% and 42% respectively.  The falling Euro and Ruble were large components of this. They were down 12% and 59% respectively in 2014.

Getting 15% Without Much Work.  My Own Test

Not one to rely on others, and wanting to extend this into more countries, I did my own simple back test (actually it is ‘we’ as the very capable JC Ho did most of the heavy lifting).

The sample universe in my back test are 64 countries tradable through Instinet, an institution-focused broker (see here). 

Countries were ranked according to their weighted average CAPE ratio. The five countries with the lowest CAPE ratios were put into the ‘cheap’ basket, while the five countries with the highest were put into the ‘expensive’ basket.  We then calculated what the returns would have been if one had invested in each basket for a year, and then rebalanced the basket according to the next year’s ‘cheap’ and ‘expensive’ countries.  

The hypothesis was that over time ‘cheap’ will outperform ‘expensive’.

For returns we followed the most commonly used index of each country.  These are typically the ones that fly across the screen on Bloomberg TV and CNBC.  For example in Hong Kong we used the Hang Seng Index, and not the MSCI Hong Kong or MSCI China Index.

We adjusted all returns for USD. Currency movements can have a large impact when investing globally and I wanted to see what the returns are in the world’s ‘base’ currency.

Financials as defined by the database we used were excluded.  The reason being that I don’t enjoy analyzing banks and insurance companies and am not very good at doing so.  At the end of the day I’m looking for good investments and I might as well look where I think I can add value.

The test went back to 13 years covering the period from 2002 to 2014.  We were told by the folks at our super expensive data provider FactSet, that their data before 2002 are not as reliable as they were buying them from other vendors rather than entering the data by themselves.

Results

The findings support the hypnosis that ‘cheap’ outperforms ‘expensive’.

For the 13 years to 2014 investing in the 5 cheapest countries based on our simple CAPE screen resulted in a compound average USD return of 14.5% (CAGR).  Meanwhile investing in the 5 most expensive countries generated a return of 7.8%.

If one invested USD100 in this strategy at the beginning of 2002 it would have been worth over USD550 by the end of 2014 versus just over USD260 if one invested in the ‘expensive’ strategy.  Another way to look at is that the person who invested in ‘cheap’ countries would have more than twice as much over the test period.

An investment in the ‘expensive’ strategy would have done okay – a CAGR of close to 7.8% isn’t bad, but it leaves a lot of money on the table.  6.7 percentage points on average every year.  Instead of doubling one’s money every 5 years with the cheap strategy, it took a little over 9 years with the expensive strategy.

However both strategies did better than the S&P500. During the same time period the S&P500’s CAGR was 4.6% meaning that one could have made a butt-load more money by investing in cheap non-US countries.

Currency

Currency changes in aggregate were not as big as a factor as I expected.  But there were several years when currency played a large role.

Over the course of 13 years, currency changes of the cheapest five countries added a positive 0.5% per annum.  However this was volatile with the largest positive currency effect of 9.5% in 2006.  The greatest negative effect from currency was last year - 2014 - when the strong USD took away all the market gains and then some.  The 5 cheapest markets were up 7.9% on average when measured in their local currencies, but were down 9.9% in USD.

For the expensive countries the currency changes added more to the returns.  Currency changes added 2.1 percentage points on average to the returns of the expensive countries. Much of this occurred in 2002 and 2003 when currency changes added 10.6% and 12.1% respectively to the expensive markets’ return.

Dogs of the Dogs

One interesting aspect of the study was that cheap countries tend to stay cheap for a while.  Romania has been on the list of the five cheapest CAPE countries for six out of the last seven years and it shows up again in 2015.  In those six years the Bucharest Stock Exchange Trading Index has on average increased by 8.3%, with most of the negative returns occurring during the year of the global financial crisis.

Year	BET Index YoY % change (Calendar Year, USD)
2014	-4.6
2013	30.9
2012	17.7
2011	not in cheap 5
2010	4.3
2009	57.8
2008	-74.7
2007	27.0

Drawdown 

One drawback to this has been the fact that both strategies have not exceeded their 2007 peaks.  This means that they are both into their 8th year of drawdown.  The cheap strategy is a little closer being only 11% below its peak NAV. At the end of 2014, the expensive one remains 25% below its 2007 peak.

This is in contrast to the S&P500, which is 35% above its last peak in October 2007. “Don't fight the Fed” has been good advice since US quantitative easing/currency debasement/money printing was started in earnest at the end of 2008.

Research Alpha Could Help

I think these results can be improved on.  By sticking to high-quality companies in cheap markets I suspect one could do better than the 14/15% return above.  I add ‘alpha’ by only investing in companies that I think are controlled by high quality shareholders, have a simple structure and trade at cheap valuations (Research Alpha write-up is here).

This worked well for me in Greece and in many other of my investments elsewhere.  As of early February 2015, my six Greek stocks were up 156% in USD compared to the 3% increase for the US-listed Greek ETF (GREK).  This is not bad for 2.5 years in a volatile market.

What’s Cheap and Expensive in 2015?

Going into 2015 the list of five ‘cheap’ countries has not changed much as compared to the previous year.  Three of the five are the same (Slovak Republic, Romania, and Bahrain). In contrast none of the ‘expensive’ countries are the same in 2015 as they were in 2014.

If January is a good predictor of a year’s returns, ‘cheap' CAPE may not be a good strategy in 2015. Headline index returns of all five ‘cheap’ countries were negative in USD falling by an average of 4.6%.  ‘Cheap’ underperformed ‘expensive’ during this time period.

Things turned around in February and the 5 ‘cheap’ markets are now up an average of 2.1%, in the first two months of the year, having outperformed ‘expensive’ in February.

Note that the strategy is geographically concentrated with four of the five cheap countries neighboring each other (Slovak Republic, Romania, Czech Republic, and Hungary). The strategy’s performance in 2015 really depends on the strength or weakness of Central Europe’s equity markets.

“Cheap” 5 as of 1 Jan 2015

	Index	Return Jan 2015 (%, USD)	Return YTD Feb 2015 (%, USD)
Slovak Republic	Slovak Share Index	-4.6	7.4
Romania	Bucharest Stock Exchange Trading Index	-6.4	-5.5
Bahrain	Bahrain Bourse All Share	-0.2	3.3
Czech Republic	Prague Stock Exchange Index	-5.9	0.1
Hungary	Budapest Stock Index	-5.9	5.3
Average		-4.6	2.1

“Expensive” 5 as of 1 Jan 2015

	Index	Return Jan 2015 (%, USD)	Return YTD Feb 2015 (%, USD)
Jordan	Amman Stock Exchange General	0.0	1.2
Croatia	Zagreb Stock Exchange Crobex	-6.2	-8.0
Israel	Tel Aviv 100	-2.4	3.0
India	S&P BSE Sensex	8.2	8.3
Lithuania	OMX Vilnius	-4.4	-0.5
Average		-1.0	0.8

Caveats

This blog post should be taken with a grain of salt.  I think we've been pretty careful in our work, but there is likely a lot of biases and errors. Below are some. I suspect there are a lot more.

• Small sample set.  The most important caveat is the small sample set.  Thirteen years simply does not make for a robust test
• Poor/incomplete data. The database we use - FactSet - is pretty powerful but I've found several errors and omissions in their data especially in the lesser-followed markets.  And I suspect I've only found a small fraction of the errors
• Look-ahead bias.  This means that the sample data may contain information that became available to investors at a point in time, when in fact the information was not yet publicly available.  No matter what the database providers say, I think they backfill much more than they let on
• Investability. Many of the cheaper markets are smaller countries.  The perennially undervalued Romania has over 400 listed companies, but only 23 of them are worth more than USD100m.  The Slovak Republic only has 7. This means that the strategy is fine for a small fund or individual investors, but not something that’s attractive to larger intuitions

However there are two things that lend credence to this study.  Firstly, the simple intuition that one can minimize downside and maximize upside by paying a low price for an asset.  Secondly, the findings are in line with similar studies looking at CAPE as well as other valuation metrics.  Value works. 

Wrap Up

This blog hopefully enlightens readers on the importance of buying undervalued equities and introduced a lesser known ratio to calculate value. Close to 14.5% per annum isn't bad for a fairly simple strategy.

   

Intuition makes CAPE attractive in my opinion.  Valuing a productive asset over the business cycle makes common sense.  It's also fairly simple and straight forward to calculate. This can however make cheap companies difficult to find in a fast growing economy.  In my neck-of-the-woods, Mainland China’s listed companies are not that expensive on an 1-year PE basis, but it is hard to find more than a handful that are attractive on a 7- or 10-year CAPE basis. Either the country has found a way to stop the business cycle or stocks there are overvalued.  The same could be said for the US as well as India and most of Asia.

CAPE is one of the better valuation metrics to use in my opinion. There are many others. Using these ratios successfully many times comes down to how they're used and the investor's own self-discipline. Sticking to one's investment process overtime should lead to out-performance.  Valuation should be part of every investor's arsenal and CAPE may be one of its better tools.  

Book Review – Gordon Wu - The Man Who Turned the Lights On

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 article is about people.  One person in particular - Sir Gordon Wu Ying Sheung - who founded and built Hopewell Holdings into one of the largest companies in Hong Kong.

Gordon Wu – The Man Who Turned the Lights On by Rosemary Sayer is a good telling of his and the Hopewell story from an insider’s perspective.  

This is likely a ‘pay for play’ book meaning that the subject likely sponsored its writing or publishing in some shape or form.  As such, it should be read more like an autobiography than an objective biography.  I say this as it seems to gloss over many of the subject’s shortcomings, and likely avoids many others. 

While many criticize these books for not being objective, I personally like them as they many times pair a good writer with interesting people who would not write it themselves or realize someone could do a better job.

Even more so, these books provide an insider’s view on what was happening at the time.  This perspective is helpful.  As an analyst I’m outside and don’t really know what the management is thinking when they make important decisions.  Books like these help to better understand how the management and controlling shareholders make decisions.

During the early 80s and mid 90s, Hopewell was a key holding of many foreign investors in HK and virtually every brokerage and I-bank research department covered it.  Hopewell and Gordon Wu had a big profile as they were consistently in the press.

What I particularly like about biographies like this one is its insight into the entrepreneurs’ early years.  Gordon grew up in an upper middle-class family in Hong Kong.  His father founded and owned one of Hong Kong’s largest taxi companies that was built from the ground up in the aftermath of World War II. The family was wealthy enough to send eight of their nine children to college in the United States, where several eventually settled. Three earned places at top US universities including Gordon who studied at Princeton.

Living and studying in America made a big impression on him. The book notes that he made good friends there, and enjoyed the feeling that in the US everybody was created equal. Hopewell is named after the town in New Jersey that first inspired him to get into construction, and his eldest son, Thomas Jefferson Wu, is named after the third president of the United States.

Gordon Wu made one of the largest single gifts to any university – US$100m to his alma mater in 1995. Several years ago he hosted and paid for his entire graduating class and their spouses to come and see what he built in Hong Kong and China.  .

He was one of five Asian students studying at Princeton in 1958.  The book notes that Gordon actively circulated and made friends with his fellow students and did such classic American things such as attending Christmas and Thanksgiving dinners at friends’ and roommates’ houses.

Unlike many in his family who studied medical science, Gordon studied engineering. Also unlike many in his family, Gordon returned to Hong Kong.

Early Setback

The biggest takeaway from this book for me is that like many other successful entrepreneurs, he faced an early setback.

Hopewell Construction, the predecessor of the now Hong Kong listed Hopewell Holdings, was founded in 1963 with funding from his parents. Gordon was 28 years old at the time. One of its first projects was the Central Building in Wan Chai (now better known as the building that houses the Tai Yau Shopping Plaza). 

The setback occurred in the aftermath of Hong Kong’s 1965 property crash and mini bank run.  During this time one of Hong Kong’s largest, the Heng Seng Bank, suffered a major run and was quickly bought by HSBC where it remains today. 

Gordon quickly realized the extent of his problems and locked himself in his office to figure out a solution. Property prices fell to a level that made his land bank and existing projects unprofitable. Selling existing properties would not cover the losses.  The brief details of this episode imply that Hopewell Construction would likely go bankrupt.  Realizing this he “…wrote up a four-page summary with graphs and charts that were typical of his engineering style and went to visit his bankers…” at HSBC.  The plan impressed the bank officers and he received a loan.  Despite this, his family was mad at him for going into debt.  According to the book, he worked around the clock to keep the business afloat and meet his repayments to the bank.  By 1967 the property market started to improve and Gordon eventually formed a new company – Hopewell Holdings – that better separated his and his family’s interests.   

Many children of successful entrepreneurs are not very successful, or never get to the same level as the founder (see related blog post here).  Among the rare few who go on to do well, many go through early setbacks or ‘tests’ that likely provide life-long lessons.  Two similar circumstances come to mind.

Djarum’s Hartono brothers faced potential ruin in 1961 when their cigarette factory was destroyed in a fire about the same time that their father, who was also the company's founder, passed away. The brothers responded to the setback by building the first modern cigarette factory in Indonesia, and revamped and modernized Djarum’s management and corporate structure.  They are now the richest people in Indonesia according to Forbes (see here).

Saratoga Capital’s Edwin Soeryadjaya seemed next in line to take over Astra International, only to have the family lose control of the group as it needed to sell its stake to cover older brother Edward’s Bank Summa debts.  Founded during the Asian Financial Crisis, Saratoga is now one of the largest private equity groups in Indonesia, and Edwin is ranked number 26 on the Forbes list (see here).

Early In China

The second most interesting story is how Gordon organized a meeting with the most well-known and the wealthiest property developers in Hong Kong to build China’s first luxury hotel.  Participants in the May 1979 lunch included heads and representatives from Cheung Kong, New World, and Sun Hung Kai.  This was to be their first property project in China.  They would later become some of the some of the largest privately-held business groups in the world’s largest country with most of their wealth coming from property development.  Gordon was the one who organized the lunch and the project, and spent much of the next five years making the hotel project happen. He had the tenacity, vision and execution skills to get it done.

I won’t go into details here as the book provides good insight into doing business in early 1980s’ China.  For instance one problem in getting the new hotel approved was that it alone would use 2% of the electricity generated in Guangzhou at the time.  Tales of government officials’ naivety about the outside world, training staff on how to apply make-up and use modern washers and driers make one realize how much China has changed in the last 30 years.  Working and travelling between Hong Kong and Guangzhou gave him his next idea.

The third most impressionable story was how Hopewell designed and built the 122km Shenzhen to Guangzhou super highway, the first privately-owned toll road in modern China.  China now has the world’s most extensive highway and expressway system and the second largest number of cars in the world (see here).  Gordon Wu was an important catalyst in kick-starting it all and like the hotel project, he had to jump over many hurdles to get it all done.

But there’s a lot more in this book that is also interesting and others may find more interesting: building some of the first privately-owned power stations in China and the Philippines; insight into the long-term relationship with William Purves who eventually led the HSBC group; and trying his best to build a mass rapid transport system in Bangkok that was ultimately stopped by Thaksin Shinawatra.  

An interesting chapter sheds light on how he and Hopewell dealt with and survived the 1997/98 Asian financial crisis.  Hopewell’s projects in Thailand and Indonesia were going nowhere; the projects were leveraged and there were questions on whether contracts would be honored.  Hopewell’s stock price fell 87% in the 12 months to August 1998, and fell a further 25% over the next two years hitting a low around HK$2.  The press was vicious in criticizing him and Hopewell.  The chapter’s title “From Hero to Scapegoat”, sums up Gordon Wu’s experience in this trying time.  The company and stock have done well since the crisis.  Its shares have had fairly steady upward climb reaching an all-time high of HK$35 in Feb 2013.  A 16x increase 16 years, not including dividends.

There are also tales of Gordon Wu negotiating with Jiang Zemin to fix the Hong Kong / Shenzhen border crossing, being knighted by Prince Charles from the UK, being the first to float the idea of a bridge and tunnel linking Hong Kong and Macau (1978), and the support and tenacity of his wife during the early years and when the going got tough.

Gordon Wu and Hopewell are still around.  He’s turning 80 this year and is now Hopewell’s Chairman.  His eldest son, Thomas Jefferson Wu is managing director and Gordon’s wife Lady Wu Ivy Sau Ping Kwok is a non-executive director.

My main criticism of the book is the same as other books I’ve reviewed on this blog.  There's no index.  Gordon Wu and Hopewell broke a lot of ground in China and Asia.  Historians – as well as lonely analysts like myself – would benefit from an index.  

Gordon Wu is not your rags to riches businessmen.  He came from a well-to-do family and made the most of his education and background.  He thought big and had the balls to carry out his dream.  Like most successful business people he overcame setbacks and criticisms.  I suspect, but have no way of knowing, that there are likely some ghosts in the cupboard that are not covered in this book.  As Ir. Ciputra once told me in a short interview many years ago, "In property and construction, you have to get your hands dirty”.   

This book serves as a good reminder of the pioneering spirit and how one person can make a very large impact.  Being from the US, I mostly take highways, and other infrastructure for granted, much as I suspect the 20-somethings and below in China do now.  We don’t notice it when it’s working well, but complain when it’s not available or broken. 

I doubt many can think of the people or corporation that made it all happen.  Gordon Wu’s successful projects in China and Asia broke new ground and not only benefited the people who use Hopewell’s infrastructure, but by showing it could be done, he inspired many to copy him.

Here’s to the pioneers.