Thursday, September 26, 2013

Asia's More Stable. Play the Instability

Asia is more politically stable than ever before. A key reason for this is that virtually all Asian countries have functioning and predictable leadership transitions. Most with stock markets have an increasingly entrenched and open democracy.

In the long run this creates stability.  Democracy can seem like a messy and chaotic process, but as long as the process is adhered to and respected it seems to create long-term stability.  And equity markets like this consistency.

Leadership changes create uncertainty, something markets don't like. They typically trade at lower valuations when investors’ and speculators’ collective unconscious deems that uncertainty has increased.

There have been several studies looking into the link between political change and stock market performance in the West.  If I remember correctly they seem to show that valuations are highest during the third year of a four-year US presidential cycle. 

In the third year, the uncertainties associated with a new administration are no longer uncertain. Management has made their capital allocation decisions based on the new government’s policy initiatives. Investors have incorporated this new information into their strategy. Analysts increase target stock prices as forecasts are extended based on the new perceived stability.

I've also read that a potentially good time to invest is when a candidate from the US Democratic Party is polling high before the election.  The market likely trades down as the Fox News labeled far-left, tree-hugging hippie is perceived as being anti-business and the American Way.  After investors and speculators realize the new guy is not so bad – and is going to keep his banking and business buddies happy - the market eventually rebounds.

Recent history bears this out.  Between the beginning of October 2008 and now (7 weeks before Obama was elected to his first term, and five years later) the S&P500 index rose by 43%.  Between the beginning of October 1992 to the beginning of October 1997  (7 weeks before Clinton was elected to his first term, and five years later) the S&P500 rose by 130%.    During the same time period under George W. Bush the S&P500 fell by 15% (early October 2000 to early October 2005).


Closer to home, I don’t think many investors are factoring political transitions into their investment process. Or at least I've not seen much written about it.

In my opinion Asia’s political transitions should actually have more influence on large cap equity prices and the headline indexes than in the West. 

The reason for this is that Asian governments control a significant number of the region’s large listed companies.  According to calculations done a few years ago, Malaysia and China have the highest percent of central government controlled companies at about 50% of market cap.  It was about 40% in Thailand, 35% in Singapore, and 30% in Indonesia.

An example of how this works occurred when I was researching a report on China's corporations.  While researching and writing the book, news started to filter out that Xi Jinping and Li Keqiang would be the next leaders in China.  Not long after there was a leadership change at the SOE oil companies and later the state-owned banks. A few analysts wrote that capex plans had been put on hold while waiting for leadership and policy changes.  


There have been several articles written about what caused the recent sell-off in emerging markets. I wonder how much of this may be due to the uncertainty surrounding upcoming elections.

Eyeballing the table below - which lists countries by the date of the next general election - one gets the sense that the markets that are recently the most volatile, are also the ones where there is an expected leadership change in the next few years.

Amongst the two hardest hit were Indonesia and India. It could just be a coincidence that both are expected to hold elections next year, but I sense some causation. We don’t know who will be governing Indonesia twelve months from now, and India has to hold a general election by May next year. 

Peak-to-trough Indonesia fell by 27% in the 2nd and 3rd quarter this year.  Its currency is down some 15% since the beginning of April.  Between the two, USD investors were down some 40% by mid-August. 

The Indian market did not fall much compared to others – down some 14% peak to trough - but its currency is now down some 22% since the beginning of April.  For USD investors this was a 36% decrease in a relatively short time.

Most of the Asian markets that fell the most were also the most expensive.  According to several long-term valuation metrics I track, Indonesia, the Philippines and Thailand were some of the world’s most expensive markets going into the 2nd quarter. They were also at a phase in the election cycle that made them politically more stable than they had been for several years.  Red and yellow shirts have been peaceful in Bangkok; Aquino is proving to be the best leader of the Philippines since Ramos; and for the last 9 years SBY has provided the first real political stability in Indonesia since Suharto’s 1998 resignation.  I suspect his stability helped the markets to increase to the rich valuations they still trade at.

The change in Asia’s political landscape has been very impressive since I first came to Hong Kong as an exchange student in the mid-80s.  Taiwan was still under martial law. PRC politics were shrouded in mystery. Marcos was still in power.  Suharto, Mahathir and Lee were SE Asia’s strongmen. We came to accept that military coups were the normal way leaders were replaced in Thailand.

More impressively the transition to a more open political change came about relatively peacefully.  Compare what is happening in the Middle East to Asia ex-Japan over the last three decades. 

The changes have made each country – and Asia as a whole - more stable.  Increased FDI flows to the regions are a reflection of this. 

I don't see any reason that Asian markets won't react similarly to the market psychology that seems to accompany the US election process.  "People Are People" sang Depeche Mode in their 1984 hit. 

Monday, September 16, 2013

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%. 


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. 


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.

Wednesday, September 11, 2013

US Version of Research Alpha

My research and investment methodology focuses on people, structure and valuation. I call it Research Alpha because it emphasizes factors that most analysts do not pay much attention to.

It can be lonely doing this as my methodology is not popular.  There are not many people to compare notes with.  Many investors don't believe or understand it. The majority of investors likely never thought about it.  

So it is nice to read an article that does a good job of articulating an investment focus that is close to mine.  It was written by Kristina Salen who is an ex-Fidelity/Oppenheimer/Merrill Lynch analyst.

According to the article, the author left finance and is now CFO of an interesting web-based business called  The article looks at her previous investment role from the perspective of someone who is now on the other side of the fence.

The article I'm referring to was posted on the author's Linked-In website recently.  I became aware of it through the very good Quartz daily email.

The article seems like a US-centric version of my strategy.  In it, she notes three things that she learned about investing: strategy is important, people are important, and that forecasting quarterly earnings is mostly a waste of time.

The three factors she writes about are not one-for-one with my focus on people, structure and valuation; but they seem close enough to my past writings on Research Alpha and the importance of people to warrant a blog posting.

We agree on people.  Business is about people. They make all capital allocation and management decisions.  Understanding their background, their relationships and their past decisions can help investors determine if they are good or bad at allocating capital and managing a company.

We also agree that spending time on quarterly earnings is not very important.  I think of short-term earnings forecasts and what goes into them as Research Beta. There are many analysts making forecasts and these are quickly reflected in stock prices.  Trying to guesstimate next quarter's earnings feeds our emotional need for short-term results, but real wealth rarely comes quickly.

Where we differ is strategy.  Strategy is important, but to me structure is more important in emerging markets.  

By analyzing a conglomerate's structure one can identify the scope for leakages from a listed company into an unlisted entity owned by the same controlling shareholder(s). Minority shareholders get shafted if earnings, funds and management time and focus are transferred to other group owned companies.   

Strategy is likely more important in developed countries. In emerging markets the focus is on catching-up and transplanting business models, products and services that have already been successful. 

This brings up what I believe is the biggest difference of investing in the US and the rest of the world.  The difference is ownership structure.  In the US companies are primarily a single entity that has a distributed shareholding base.  They are typically not part of a conglomerate or 'group' as is the case in most of the rest of the world.  

Most investors don't look at the entire conglomerate and don't spend enough time looking at who owns and runs the entire business group.  I think this is a mistake. 

I've never heard of Kristina before I read the Quartz email.  Her article is insightful, well written and I'd encourage readers of this blog post to also read it.  

I'd also like to thank her for writing it.  My work is a little less lonely knowing that others look at the world somewhat similar to myself.  

Tuesday, September 10, 2013

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. 

Monday, September 9, 2013

Green Shoots in Greece

Some green shoots in Greece were reported yesterday.  The most significant is that the Greek economy shrank by 3.8% in the second quarter of 2013 compared to the year before.  This is not good, but better than the 4.6% that was initially expected.

As pointed out in the article, one of the reasons for the less-than-expected decline was an increase in tourism.  Revenue from tourism increased by 39% in the first five months of 2013 compared to last year.  A big factor here may not even have been Greece itself, but the unrest in Egypt.  But I suspect it is as much a change in the perception of Greece.

Typically most forecasts overshoot on the way up as well as on the way down.  This is prevalent in both macroeconomic as well as earnings forecasts.  I don't see why Greece would not fit this general trend and I suspect we will likely have more upward economic revisions in the future.

For me another statistic I think is much more important : Greece's ranking in the World Bank's Doing Business 2013 report.  This reports ranks countries on the ease of setting-up and keeping a small and medium business running.  Greece moved up 11 places from a rank of 89 to 78 - the largest increase of any developed market.

As several of my readers know I'm a big fan of Greece.  Especially its equity market, which despite its good performance, is still one of the least expensive in the world on some long-term valuation measures.

Please note that I'm biased.  One of the best weeks of my life was spent learning about the country, its stock market, and its listed companies.  The people I met in Athens last year are smart, switched-on and, from my very limited number of contacts, genuinely feel things need to change.  My write-up is here.

Sunday, September 1, 2013

One Of Global Capital Market's Most Powerful People Lost His Position

China’s central government news agency, Xinhua, yesterday announced that the head of SASAC, Jiang Jiemin, is under investigation for ‘serious discipline violations’.  Typically just being under investigation is enough for a high-ranking official to lose his/her position.  This seems to be the case, as references to Jiang on  SASAC's website have been removed. 

For those that don’t know, SASAC stands for the State-Owned Assets and Administration Commission of the State Council.  It supervises and manages non-finance state-owned assets owned by China’s central government.

On paper, the head of SASAC is one of the most powerful people in global capital markets.  Companies under SASAC and its finance company equivalent, Huijin, control more listed equity by value than any other organization in the world. By my calculations these and other SOEs directly under the Ministry of Finance, typically account for 4-5% of global equity.  

Here is the breakdown.  The three stock markets in China (HK, Shanghai, Shenzhen), account for some 9-10% of global market capitalization.  About half of these consists of Chinese Central Government controlled companies.  This means at any given time about 4-5% of global market cap is owned and controlled by the Chinese Central Government. The bulk of this come under SASAC (see table below). 

SASAC’s function is repeated at the provincial and local level, which increases its influence on global capital markets a bit more.

Take it all with a grain of salt.  SASAC does not appear to be as powerful as one would expect given its responsibility and the fact that some of the world’s most valuable companies are – on paper – under its domain. 

The reason for this has to do with the government’s structure and hierarchy.

The head of SASAC is at the Vice-Minister level.  This is the same level as the SOE heads.  Thus, the head of SASAC has little sway over the SOE bosses, as they are both at the same level.  This is like one employee at the same level as his colleague telling the other what to do, instead of a boss telling his/her employees what to do.

Secondly Jiang Jiemin has only been at SASAC for 6 months having been shifted there from the head of CNPC/PetroChina this March.  I’ve not heard or read of any changes he has suggested or instituted in his short time leading the organization.

The big question going forward is the structure of the government’s ownership and control of its SOEs.   China’s SOEs are criticized for getting the majority of bank loans and crowding out privately-owned SMEs.  The bosses of the largest SOEs are seen to be more powerful than many politicians.  In every SOE I researched for my book on China's corporations, all were involved in scandals.  Many times these scandals went on for several years before the accused was finally investigated.

My general feeling is that there will be little reform of the SOEs in China in the near term.  There are likely high-powered vested interests and ghosts in the cupboards that will resist any change.  I suspect it will be a longer, drawn out-process more similar to Taiwan's privatisation.  There are many similarities between Taiwan some 20-25 years ago and China now; and I think Taiwan's development and reform may be a good road map for things to come.  

Politics however is impossible to predict, and the news that Jiang Jiemin and other senior officials at CNPC/Petrochina are under investigation is surprising. 

Hope springs eternal however.  Xi Jinping took over the central military command much sooner than his predecessors.  Recent investigations into high ranking party, government and SOE leaders could signal that he has more power and leverage than many pundits originally thought.   I am halfway through his biography which indicates that despite spending most of his career outside of Beijing, he is very well connected with senior military, business and political leaders.

The Third Party Plenum is due to take place in November this year and there could be more interesting investigations and personnel changes over the next few months.  

* Notes to graph above.  The last time I updated these numbers was in Fall 2012 so the slide is out of date. I've updated my numbers several times however the overall percentages do not change much.