BRICs, PITs, and PIGS: Go Ugly

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 blog is mostly about valuation and yet another example of how investing in beaten down, unpopular and ugly markets can lead to better returns. 

Usually valuations are low in markets that are not very attractive.   But who knows when the news can get even worse? Uncertainty and negative news flow keep most of us out of markets just when we should be buying. 

And it can take even greater will power to stay invested when nobody around you sees your point of view, friends and peers are calling you crazy, and well-educated, respected and slick investment bank analysts and traders are negative.    

It is psychologically easier to invest in markets when there is a lot of good news and the future looks very bright.  The problem is that these markets tend to be expensive and future returns tend not to be as good.

To contrast these two points let’s look at two acronyms that surfaced about the same time.

BRIC stands for Brazil, Russia, India and China. The acronym is attributed to Jim O’Neill in a paper he wrote for Goldman Sachs in November 2001 (found here).  In it he argued that these four countries should be included in high-level government groupings such as the “G7” because their size and growth would make them increasingly influential.

The acronym came out not long after the tech crash. Wall Street was ripe for a new story and over the next few years the term became more popular.  Goldman Sachs and many others launched BRIC funds and ETFs.  There are now over 200 of them according to a very expensive database.

The term took on a life of its own.  Leaders of the four appear to like the grouping.  Just a few months ago they and South Africa formally launched the BRICS Development Bank (link here).

About the same time BRICs was coined, traders and analysts who survived the late 1990s Asian financial crisis were referring to the ASEAN countries as PITs.  The term stood for Philippines, Indonesia and Thailand.  These were three of the hardest hit economies and markets.  Unlike BRICs I don’t think anybody has come forward to claim responsibility for it.  Calling your home market a degrading term soon after clients lost money would not likely make one popular.

Investing in the four BRIC countries when the phrase was coined until now would have generated decent returns.  The four countries' headline indexes are up an average of 302% since late 2001 for a CAGR of 10.5% (this and other return figures in this article are based on the average return of each country's headline index, in USD, dividends not included). 

In contrast, and despite the acronym’s negative connotation, one would have done considerably better by investing in the three PITs markets.  An equally weighted investment in the three grew by 675% over the same time period, which means the PITs investor would have made more than double the money of the BRIC investor.  Even the worst PIT outperformed the best BRIC.  Thailand, the worst performing PITs country, rose by 629%, a bit more than India, the best performing BRIC country, which increased by 611% from November 2001 to November 2015. 

In addition to being weary of investment fads, investors should also be skeptical of what the big banks are pushing. In July 2006 Goldman Sachs launched its BRIC fund.  From launch to close, the fund’s performance was just under 20%.  Over the same time period the three PITs indexes increased on average by 157%, meaning that one would have made almost eight times more money by investing in the markets that were unloved rather than the ones that the big banks were marketing.

Are PIGS Today’s PITs?

PIGS stands for Portugal, Italy, Greece, and Spain.  These are some the world’s worst performing economies and equity markets since the 2008 global financial crisis.  Like PITs it is not a flattering grouping and member countries have reportedly renounced the term (link here).

I suspect PIGS could be an up-to-date version of PITs.  The origins of both are the same and they describe markets that are having problems and are out of favor.  

Also like PITs the countries in the grouping are geographically close and have a lot in common in terms of economic integration, language, and culture. This is a stronger grouping than the BRICs. Except for the large country size, I don’t really see much that binds them like the PITs and PIGS.

Back to BRICs

Ironically now may be a good time to consider investing in BRIC equities. 

Russia has some of the world’s least expensive large companies and very impressive management.  Brazil is starting to look interesting with its currency down some 40% in the last two years.  There are some exciting and inexpensive companies in China and at 7x PE the Hang Seng China Enterprise Index does not seem very expensive. Weren’t US equities trading at the same level in the early 1980s just before that market’s long bull run?

There’s also a good contrarian signal.  Goldman Sachs recently closed the above mentioned BRIC fund.  Big banks have a habit of closing operations and products just when things start turning around. HSBC closed its South East Asian equity research offices in 2001 – just before those markets went on a multi-year bull run. Goldman’s closing of its BRIC’s fund may be a similar signal (more here). 

Go Ugly

This short piece is meant to show that going against the grain and doing what is uncomfortable and unconventional many times leads to higher returns.  The best place to find value is typically in ugly geographies and sectors.   

Are there other places that appear to be ugly and warrant catchy phrases such as PIGS?

How about “RUKs”, for Russia, Ukraine and Kazakhstan, three ex-Soviet countries whose currencies have fallen and have some of the highest interest rates in the world.   Or “PCB”, for Peru, Columbia and Brazil, three of the worst performing equity markets this year for US-dollar investors  Or “JOBQES”, for Jordan, Oman, Bahrain, Qatar, Egypt and Saudi Arabia which are among the world’s least expensive equity markets likely due Middle East uncertainty.  Or "GETOUt" for gold, energy, telcos, oil and utilities, five out-of-favor sectors that dominate my global value screens.

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Making Ugly Fun

"Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them", wrote Howard Marks in his very good book, The Most Important Thing.

Psychologically it is hard to put one's hard-earned money into unattractive and out-of-favor stocks and markets.   It's not easy or very enjoyable to try and catch a falling knife.  But buying quality companies at knock-down prices is likely a good way to limit downside and hopefully generate superior long-term returns. 

To help ease the way, I silently sing the chorus of a song from my youth.  Perhaps it will help you also.  It's sexist, corny and elementary, but with a catchy pop-hook its also very memorable, so make sure to click on the link below.  I've changed some lyrics in the second version to make it a little more investment specific.  

If you want to be happy for the rest of your life,

Never make a pretty woman your wife,

So from my personal point of view,

Get an ugly girl to marry you.

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If you want to be happy for the rest of your time,

Never make a pretty stock your life,

So from my personal point of view,
Get an ugly market to carry you.

"If You Want to Be Happy", by Jimmy Soul (link here), 

(Based on "Ugly Woman", by Roaring Lion (link here)  

Jamaican Twofer: Book Review and Notes

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 mostly about people and a bit about value. 

Let’s get value out of the way.  My interest in Jamaica was spurred close to two years ago when it came up on my screens as having some of the world’s least expensive listed companies.  Stocks were cheap, but what about their value?  To answer this question I started to research the country and its listed companies.  Most of what I learned seems positive for investors and 'cheap' quickly became 'value'. 

Part of that learning process included reading “Jamaican Entrepreneurship: A review of the characteristics, traits and ideas of some of the island’s most accomplished entrepreneurs”.  It is simply one of the best books I’ve read for a while and near perfect for my type of research and investing.

Positive Vibrations

Before reviewing the book, below are some interesting and lesser-known information about Jamaica that I came across.  Most of news flow has been positive in the short time I've been looking at the country.  Consider the following:

• Investors are bullish about Jamaica’s future. If stocks markets make indicators of future growth, the Jamaican economy should do well in the next few years. The JSE All Jamaican Composite recently hit its all time high this month and is up 72% so far this year in Jamaican dollars and 65% in US dollars. 
• Sovereign borrowing resumed.  Jamaica issued its first sovereign bond in three years in July 2014.  It was way oversubscribed (related article here). 
• SME support. According to the 2015 Doing Business Report by the World Bank, Jamaica has the best laws for small and medium-sized businesses in the Caribbean.  It ranks as the 58^th best place for small businesses in the world, jumping 27 places from last year (article here).
• Reinvigorated bauxite exports.  Despite the price of aluminum falling close to its 2009 low, bauxite production appears to be increasing with Russia’s Rusal expanding production.  Bauxite is an importance source of foreign exchange for Jamaica (article here). 
• Social openness.  Judging from the number of women in powerful positions and the racial smorgasbord of corporate directors’ names and pictures, Jamaicans appear to focus on ability rather than gender or color.   Women in powerful positions include Jamaica's prime minister, Portia Simpson-Miller and Kingston's mayor Angela Brown Burke. Almost 20% of Jamaica’s listed companies have female CEOs.  This includes Jamaica's largest bank (Scotiabank, headed by Jacqueline Sharp) and Jamaica's sole electricity supplier (JPS, headed by Kelly Tomlin) (article here).
• Expanding financial markets. Another female leader is the head of the Jamaican Stock Exchange, Marlene Street Forrest.  Since becoming General Manager, the exchange introduced online trading, and currency and bond markets.  She's also promoting the exchange as a place for companies to raise money as proudly proclaimed on its Facebook and Twitter feeds (article here).
• Urban redevelopment.  Jamaican conglomerate Grace Kennedy plans to move its headquarters to downtown Kingston’s waterfront thanks to the Urban Renewal Act.  The development may be available to investors through a REIT in the future (article here).
• Laws coming in-line with reality.  Along with many Western Hemisphere jurisdictions, Jamaica decriminalized medical marijuana in Apr 2015 (article here).   Just recently a Jamaican living in Canada has proposed investing US$100m in a marijuana growing initiative (article here). 

Book Review

 

“Jamaican Entrepreneurship” is my kinda book.  It is heavy on facts and very people-centric.  Its 239 well-organized and easy-to-read pages profile 15 Jamaican entrepreneurs from different segments of society, provides a short history of the island’s economy and business environment, and reviews policies that favor entrepreneurship.  

The profiles form the bulk of the book.  They include the entrepreneurs’ background, family connections, education level, and business accomplishments.  Most books such as this focus on the subjects' business backgrounds and typically provide just cursory background information.  Bravo to the author for including a full view.

Some of my favorite profiles are Audrey Marks, the founder and CEO of Paymaster Jamaica, the island’s first multi-payment agency; and Norman Wright, the Founder of Perishables Jamaica, who is helping to revitalize Jamaican farming by packaging, branding and exporting locally-grown herbal teas. Others are Rita Humphries-Lewin who founded and chairs the Barita Group of Companies, one of Jamaica’s largest investment banks; and high school dropout Gordon ‘Butch’ Stewart who started the Sandals hotel chain and revitalized tourism on the island.

Having written about many South East Asia-based Chinese business groups I found the profiles of Jamaican Chinese entrepreneurs to be the most interesting.  Many trace their roots to Fujian and Guangdong provinces – the same home provinces of many of the richest families in South East Asia.  Their stories parallel those of many South East Asian entrepreneurs such as Soedono Salim (blog post here).  Many started as traders before moving into manufacturing or services. The profile of Vincent Chang, who started a chain of fast food restaurants, is very similar to the history of some of South-East Asia's richest families. 

The book also includes a short and concise background to Jamaica’s history and economy.  Its ‘discovery’ by Columbus and the enslavement of indigenous people under the Spanish. The rise of, and dependence on sugar plantations based on imported slave labor. Independence in 1962 with a few good years before socialism, corporate nationalization and subsequent economic decline in the 1970s.  The 1990’s financial meltdown and the lost decade that began the new millennium.

Coming In From the Cold

It’s almost 20 years since the island’s financial crisis, and the country still has a lot of problems.  National debt is high at 132% GDP.  The book notes that interest on it accounted for about 50% of government expenditure in 2013.  There is a concern that this high debt level does not include that owed to China (article here).

Jamaica’s diaspora is a double-edged sword.  The book notes that it has the fifth highest rate of remittances in the world, which account for nearly 15% of GDP.  These are maintained by the high rate of migration with 85% of tertiary graduates leaving Jamaica – one of the highest rates in the world.  Every year 20% of Jamaica’s specialist nurses and 8% of its registered nurses leave the island. 

However Jamaica has a good shot at moving forward.  It can educate its citizens.  It has a young population.  Political transitions have been peaceful since independence.  Its financial infrastructure appears to be improving.  Laws and regulations are changing to support its business sector.

Jamaica punches far above its small size in a wide variety of fields.  Its citizens prove time and again they can compete with the best in the world.  With its progressive government, talented people, and a bit of hard work, there’s a real possibility that the next decade will see Jamaican businesses do as well at home as it’s citizens have abroad.

The book’s introduction logically points out that, “Jamaicans have already shown that they can have an impact on the world stage in areas such as sports, music, food and culture.  Now it’s time to make a mark on the global economy”.

My thanks to Dr. Laman for researching and writing such an insightful and easy to read guide to Jamaica’s other talent pool. It can be purchased at his website which is here.

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I'll end this blog with a link to one of my favorite Jamaican songs. George Faith's "To Be a Lover", remixed by Lee 'Scratch' Perry, can be found here.

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.

Why Equities Outperform

A week-long summer reunion got me thinking once again about how to best explain what I do to my more academically-inclined family.  “It sounds like you’re trying to figure out what will go up and what will go down. Don’t you get bored with that?” is the way my very wise mother summed up my profession/obsession with stocks.

Ultimately my goal is to help people invest wisely which means I first have to convince others that equities make sense.  A good place to start with is my skeptical family.

Like many, one of their biggest direct investments was a second property.  It did not work out well from what I remember.  

Property is often seen as a safer investment than stocks.  But is it a better investment? 

My example takes this post back to Asia - my home and center of attention for most of the last thirty years.

In the last 15 years property in Taiwan has been a very good investment with prices rising almost three times, according to one of the most followed property indexes in Taiwan, the Sinyi Taiwan Housing Price Index (link here).

The index is provided by Sinyi Reality Inc., one of Taiwan’s largest real estate brokers with an estimated 7.7% market share as of June 2015. [1] Sinyi was founded in 1987 and listed via IPO in Taiwan in 2001.

Since March 2001 Sinyi’s price has increased by 1209%.  It was a volatile ride as seen in the chart below, but investing in a company that provides real estate services was a better investment than real property [2].

Put another way, if one bought NTD1m (USD28,500) worth of Sinyi shares in March 2001 and held until end-June 2015, these would be worth NTD13.1m (USD424,000).  The equity investor turned NTD1m into NTD13.1m.  In contrast the average investor in physical property turned NTD1m into NTD2.9m.  The long term buy-and-hold investor in Sinyi’s equity made more than 4 times what the average property investor made.

Investing in bricks and mortar is fine, but trails the innovation, hard work, and intelligence of the 4,085 people that Sinyi employed at the end of 2014. [3]

However the return from the market overall was not so good.  Over the same period the Taiex, the main index followed in Taiwan, rose by only 69%.  Stock selection matters as I've written about before (see here).

Not Just Taiwan

Robert Shiller, a famous US economist and one of the few who warned that US property was expensive before the 2008 bubble burst, was also one of the first to compile long-term data on housing prices. 

He found that real housing prices in the US – i.e. after the effects of inflation –rose by 66% between 1890 and 2004, or a mere 0.4% per annum. [4]

I couldn’t find a direct comparison, however between 1900 and 2014 the real return from equities was 6.5% annualized. [5]

This includes reinvested dividends so the comparison is not apples-to-apples. Assuming dividends and their growth account for half that gain, the long-term return from US equities is almost 5 times more than that of US property.

People Power

Equities represent shares of a business.  When buying and selling stocks you're buying and selling a small part of that business.  Saying that equities are a better investment than property is another way of saying that investing in people is better than investing in land and the inanimate block of concrete, wood, and other building materials that sits on it.

And what are businesses?  Fundamentally they are a collection of people and things that do something to help other people.  Those other people buy the stuff or service that these companies make.  If the business is adding value it makes a profit.  If more people want to buy that stuff in the future the business will grow.  

Notice how often the word ‘people’ appears in the previous paragraph.  What I like about businesses – and why I believe equities outperform other asset classes – is that business is all about people.  And we humans are wonderfully complex, imaginative and progressive creatures. 

The stuff we do simply amazes me.  The diver that scores the perfect 10s. The invention of the Internet and integrated chips. The discovery of a new medicine that cures a disease that was once considered unbeatable. 

Think of how we live more interesting and efficient lives because of Apple’s innovations.  Think of how many people in the world have one or several integrated circuits in their cars, handbags and pockets that were made at TSMC or UMC's plants.  Think of the savings in time and convenience because of the MTR Corp.’s trains.  None of these companies were around when I was born.  They are now part of millions of people’s daily lives and are all multi-billion dollar companies.

It is totally big picture, but investing in companies is like investing in man/womankind’s incredible ability to innovate. Human beings are amazing and many listed companies are big and famous now because they provide a superior product or service. 

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[1] Prices have risen so fast that, according to the Global Property Guide, property in Taipei has some of world’s lowest rental yields. It is also one of the world’s least affordable places to buy with a price to income ratio of 8.4x, more than double than Japan which has a price to income ratio of 4x.  In short, Taiwan’s property rise may still have a way to go, but after such a good run, large future price increases are unlikely. 

[2] Note that we’ve left out stock dividends and property rentals from our calculations

[3] As per Sinyi Realty Inc annual report

[4] Irrational Exuberance; 2^nd Edition, Robert Shiller

[5] Credit Suisse Global Investment Returns Yearbook 2015

Summer Reading Book Review: One Summer - America 1927

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 mostly about people.   One Summer is full of great stories of a wide variety of people. The book was actually meant to be a guilty summer vacation read, but there is enough investment related material in it to warrant a post on the Minority Report blog.  Bill Bryson is one of my favourite authors and he does a great job with One Summer.  It is a very easy read with great insight into many characters that I’ve never heard of before.

For those who are not acquainted with him, Bill Bryson is an Iowa born and UK-based author who writes fact-filled, breezy and funny books.  I particularly like the way his books focus on lesser-known people and their backgrounds.  One of the key ingredients in my own investment research is people (link here) which is by far the most interesting element out of the three things I look at.

Bryson’s books are typically full of colorful and interesting souls many of whom have largely been forgotten, but nevertheless have many times helped shape the world we live in.  For more famous figures - particularly Charles Lindbergh in this book - he provides context, details and new findings that can be amazingly insightful, laugh-out-loud funny, and sometimes bewildering.

Cover - USA

As per its sub-title the book focuses on the summer of 1927, quite possibly the height of the roaring 20s in America.  The stockmarket was hitting new highs, jazz was a new and evil music, and Charles Lindbergh made the first non-stop airplane flight across the Atlantic.  It is Lindbergh's flight and his five-month tour around the US that begins, closes and provides the background for the book.

What I found most interesting is the author's observation that some time in the late 1920s Americans collectively realized that Europe was no longer the leader of most things.  "It is a little hard to imagine now, but Americans in the 1920s had grown up in a world in which most of the important things happened in Europe.   Now suddenly America was dominating in nearly every field - in popular culture, finance, and technology.  The centre of gravity of the planet was moving to the other side of the world and Charles Lindbergh's flight somehow became the culminating expression of that."

The vast majority of the book focuses on the more fun and interesting topics such as Babe Ruth, Lou Gehrig and why the 1927 Yankees were likely the world’s greatest ever baseball team; and Lindbergh’s incredible popularity and intense tour around the US after his groundbreaking flight.  

Although not mentioned in the book, 1927 was also a magnanimous year in investment history. In that year Benjamin Graham started teaching the now famous class called "Security Analysis", at Columbia University.  His class introduced a new method of analyzing securities that emphasized the difference between a company's true or intrinsic value and its stock price and how one can profit from this difference.  It would take another seven years till America's great depression, and his flirting with personal bankruptcy, that he and his colleague wrote "Security Analysis".  This book is as close to a financial bible, and is particularly liked by value investors.  His other classic, Intelligent Investor, was not published until 1949.

While more general in nature, One Summer has quite a few insights for investors.  I've copied several passages that I think investors and others in the financial community may find interesting. 

In re-reading many of the excerpts below, I kept thinking how similar America in the 1920s is to China today.  Stock markets are booming, funding costs are falling, more people were taking on credit, and corruption is not unknown.  Cohorts closer to other emerging markets can likely draw similar comparisons (Vietnam in the early 2000s, Indonesia, Thailand and Malaysia in the early 1990s, to name but a few).

Corruption is a good way to get rich. "...(then President) Coolidge kept a light hand on the tiller of state." "His treasury secretary, Andrew Mellon, spent much of his working life overseeing tax cuts that conveniently enhanced his own wealth.  According to historian Arthur M. Schlesinger, Jr., with a single piece of legislation Mellow gave himself a greater tax cut than that enjoyed by almost the entire population of Nebraska". "Mellon's personal net worth more than doubled to over $150m during his term of office, and the wealth of his family, which he oversaw, topped $2b.” 

"The total cost to the country of all the various acts of incompetence and malfeasance in the Harding administration has been put at $2b - a sum that goes way beyond the stupendous, particularly bearing in mind that Harding’s presidency lasted just twenty-nine months”. 

"Appointed to the role of head of the Veterans’ Bureau, (Charles) Forbes managed in two years to lose, steal, or misappropriate $200m.  …(he was) fined US$10,000 and given a two-year prison term”

Cheap finance and the carry trade did not work well in the end.  “Banks borrowed from the Federal Reserve at 4 or 5 per cent and lent it to brokers at 10 or 12 per cent.  They were, as one writer put it, ‘in the position of being handsomely paid simply for existing'.”

“As long as shares kept rising the system worked fine and for much of the 1920s that is exactly what shares did.  It was clear to anyone who cared to look, however that there was little correspondence between the prices of many shares and the values of the companies they supported.  While national output (as measured by GDP) rose by 60 per cent in the decade, stocks went up by 400 per cent.  Since most of these inflated prices had nothing to do with any underlying profits or productivity, all that kept them so giddily buoyant was the willingness of fresh buyers to bid prices up”.  

Prevalent share manipulation by the big boys.  "Many of the most respected business leaders in the country took part in syndicates in which share prices were shamelessly manipulated for the sake of a large, quick gain at the expense of innocent investors.  One such, reported by the financial writer John Brooks in his classic Once in Golconda, involved such luminaries as Walter J. Chrysler of the Chrysler Corporation; Percy Rockerfeller, nephew of John D. Rockerfeller; John Jakob Raskob, national chairman of the Democratic Party; and Lizette Sarnoff, wife of David Sarnoff, head of the Radio Corporation of America (RCA).  A broker working for them bought large blocks of RCA stock at selected intervals.  This had the effect of driving the price from 90 to 109.  The rise attracted other investors.  The broker than cashed the syndicate’s holding and the members shared a profit of nearly $5m for less than a month’s work.  With the syndicate’s money withdrawn, the shares sank back to 87, leaving other, uninformed investors nursing huge loses.  There was nothing to be proud of in any of this, but nothing illegal either.  Raskob made most of his fortune through such pools.  So, too, did Joseph Kennedy, father of President John F. Kennedy."

Rising stock markets make leaders popular.   “With markets constantly on the rise, he (President Coolidge) didn’t need to do anything except keep out of the way.  Under Coolidge's benign watch, Wall Street rose by more than two and a half times in value. The success of the economy not surprisingly did wonders for Coolidge's popularity."  

American consumers have almost always been important. "(In 1927) Americans were the most comfortable people in the world. American homes shone with sleek appliances and consumer durables…that would not become standard in other countries for at least a generation or more. Every year America added more new phones than Britain possessed in total. Kansas alone had more cars than France." 

Financial innovation (debt) made the American consumer. “Thanks to a brilliant new financial invention, Americans could suddenly have things that they had never expected to have - and they could have them right now.  It was called the installment plan, and it changed more than the way Americans shopped: it changed the way they thought.  Installment buying filled American homes with cars.  It made America the consumer paradise it has remained ever since. "

Great explanation of the gold standard.  "Under it, any paper money in circulation is supported by gold reserves.  When America was on the gold standard, a $10 bill could be exchanged for $10 of gold, and vice versa.  It was gold, in other words, that gave value to the otherwise worthless slips of paper known as money.  A gold standard had certain limitations - most obviously, the amount of gold that had been discovered - but it had many compensation attractions that endeared it to bankers.  It made inflation almost impossible since governments couldn’t just print money.  It kept the management of exchange rates out of the hands of politicians with their narrow, short-term interests.  It promoted price stability and, by and large, kept the heavy wheels of international trade turning.  Above all, a gold standard had a huge psychological importance.  It worked. It had worked for a long time.  It was what was known."

Federal reserve sows seeds of the great depression.  "The problem was (the gold standard) wasn’t working very well.  Half of all the gold in the world was in the United States, mostly behind a ninety-ton steel door in a five-story vault deep beneath the Federal Reserve Bank of New York in lower Manhattan.  This was not actually a terrifically good thing.  It might seem like a great idea to have all the gold, but in fact that would make it that other countries couldn’t buy any more of our products because they would not have gold of their own to pay for them.  In the interests of trade and a healthy global economy, gold should circulate.  Instead, it was accumulating - steadily, relentlessly, in a country that was already better off than all the countries of Europe put together." 

"...(the) Federal Reserve sets the stage for the 1929 market crash.  It was in America’s interest to keep international trade rolling along.  So (than NY Federal Reserve Head) Strong decreed that the Federal Reserve would cut its discount rate from 4 per cent to 3.5 per cent, to encourage holders of gold to move their savings to Europe where they would enjoy higher returns.  This in turn would bolster European reserves, help stabilize European currencies and boost trade overall.  Strong gambled that the American economy could absorb the stimulus of a small rate cut without going crazy.  It would prove to be a spectacular miscalculation.  …four of the reserve banks… refused to go along partly in petulance no doubt, but also in the legitimate belief that it was madness to encourage more borrowing with market values so high already”.  

“The cut in interest rates had an explosive effect - ‘the spark that lit the forest fire’, in the words of the writer and economist Liaquat Ahamed.  The result was the Great Market Bubble of 1928.  Over the next year, stocks would more than double from already irrational heights, and the volume of brokers’ loans to investors would rise by more than $1 billion to a tottering and unsound $4.5 billion - all fueled by the patently deluded belief that stocks could keep on rising forever. "

America was not so free in the past.  "America was in the grip of something known as the Great Red Scare.  In 1917 and 1918 Congress had enacted two startlingly restrictive laws, an Espionage Act and a Sedition Act.  Together these provided severe penalties for anyone found guilty of displaying almost any kind of disrespect to the American government, including its symbols - the flag, military uniforms, historic documents or anything close in which was deemed to repose the glory and dignity of the United States of America."

Like Madoff, Ponzi started out legit.  “…he concocted a scheme  - in itself perfectly legal - to make a profit by trading in international postal reply coupons.”   "The problem with Ponzi’s scheme was that individual coupons were worth only very small sums - 5 cents typically - so it would have been necessary to exchange monumental volumes to make a reasonable return.  Ponzi didn’t even try.  It was much simpler to pay off early investors with funds paid in by more recent ones." "Altogether, it is thought, Ponzi ended up some $10 million in the hole, equivalent to US$100 million today.  About 40,000 people invested with him. "

Fallacy of forecasts.  "When people imagined the future of long-distance transportation  it wasn’t always highways they thought of but airplanes and giant dirigibles cruising between city centers.” “…skyscrapers of the period began to sport pointed masts - so that airships could tie up to them”.  (MM's note - think of all the unused helipads in city centers). 

New music will bring down society - “Worst of all was jazz which was widely held to be a spring-board to drug-taking and promiscuity.  An editorial in the New York American called jazz ‘a pathological, nerve-irritating, sex-exciting music'”.  

Cover - UK/HK

High margin in illegal activities.  “Prohibition may be the greatest gift any government ever gave its citizens.  A barrel of beer costs $4 to make and sold for $55.” “By 1927, (Al) Capone’s organisation - which interestingly had no name - had estimated receipts of $105 million.  The scale of his operations unquestionably  makes him one of the most successful businessmen in American history.”


“Doctors could legally prescribe whisky for their patients and did so with such enthusiasm that by the late 1920s they were earning $40 million a year from the practice”. 

All that money led to a drawn out failure.  “Nearly everybody recognized that Prohibition was a colossal failure, and yet the nation persevered with it for thirteen more years”.  

“The national murder rate went up by about a third after Prohibition was introduced”.

American politicians break laws and oppose country. "During the war (WWI), Hoover illegally bought chemicals from Germany.  This was an exceedingly grave offence in wartime.  Remarkably he did so NOT because the chemicals were unavailable in Britain (where he lived at the time), but simply because the German ones were cheaper." 

America as an emerging market/economy.  "Nine tenths of all serious crime in America went unpunished... Only about one murder in a hundred resulted in an execution".