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 Etsy.com.  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.  

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. 

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.

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.

US Economy Improving : Random Thoughts From San Diego Vacation

I spent last week in San Diego getting together with family.  Random notes below. 

• Deflation?  Many economists are worried about deflation.  However I did not see any signs of this.  It has been 7+ years since I was last in California (albeit San Francisco). Gas prices are now higher.  Quoted prices are US$3.50 to US$4.50 range per gallon when it was US$2.++ range before.  Most things seemed to be more expensive than when I lived there before including.  A trip to the outlet mall was particularly depressing, as I did not see as much value as I was expecting. Air tickets are also more expensive (see last bullet point).

• Economy seems to be recovering.  Hotel salesperson at San Diego's Sheraton hotel said that bookings and reservations are up compared to last year.  He thought that things had finally turned the corner after several bad years since 2008. 

• However parking lots at tourist attractions were not crowded.  Legoland and USS Midway parking lots and theme park/battleship were not as crowded as expected.  It was the height of the tourist season and I thought things would be totally full.  I gauged that parking lots were at best half-full.  Waits for rides were short.

• Chinese tourists.  My Shanghai-via-Beijing-native-and-15-year-San Diego-resident-friend said that he's never heard so much Mandarin spoken at San Diego tourists spots.  He also noted that Mainland Chinese were buying lots of real estate in San Diego.  I also noticed a lot of Mandarin.

•  Homeland security myth.  My software engineer brother-in-law had a particularly depressing story.  Not for himself, but for the country.  He found it difficult to get a job in the Washington DC area as he does not have security clearance to work in the still expanding intelligence service and consulting business.  Getting this seems to be an expensive endeavor.  Instead, companies vastly prefer to only hire those that already have clearance. This clearance system does not seem to have stopped leakages (i.e. Snowden).  It does likely produce a good stream of income for the numerous ‘consulting’ firms living off government largeness.  This is a shame as my brother-in-law is a US military buff and would have made a great asset to a homeland security or intelligence firm.  Restricting hiring to already cleared candidates decreases potential candidates and will lower available talent and quality.  It is also depressing to know that the US government continues to expand its eavesdropping service and spying service.  Americans should not feel secure by this practise.  Instead my brother-in-law is now doing something much more productive.  He has moved to Iowa and is developing systems to improve agricultural yields.

• Dreadful airlines.  Had an awful experience on United Airlines.  In addition to the surly air crew, crap food and odd boarding practice; I spent 8 hours in the San Francisco airport due to a missed connection.  My first plane was 2 hours late taking off.  It was a very old plane and it sounded like maintenance was the reason for the delay.  Thus I spent 1 out of my 7 days wandering around the San Francisco airport in a jetlagged daze. This is despite paying an extra hundred or more for the short connection time.  This is the second time I've missed planes due to missing a connection on United.  I suspect United purposefully puts in short connection times for marketing purposes.  Their is a very high chance that the connection will be missed, but the low connection time lures buyers.  A fellow delayed traveler said the other US airlines are pretty much the same. 

• I suspect bad service from US airlines is likely to continue. This is because that, according to Morgan Creek's Second Quarter 2013 Market Outlook, the US airline industry is an effective oligopoly with the top three carriers accounting for 84% of US volume.   As per textbook oligopoly economics, prices are noticeably higher and quality lower.  What's that about deflation? 

More Positve On China. Guo Shuqing Back in the News. Shandong as Financial Canary in a Coal Mine?

When researching and writing my 'group reports' I come across individuals that I like tracking as a general gauge of how an economy is doing.  Business and government are ultimately made up of people and I figure that if good people are moving up the ladder then things are likely going in the right direction.

These are people that appear to be doing-the-right-thing instinctively, rather than doing it for a particular gain.  They lead the curve rather than follow it.  

Sheila Blair in the US is one such person.  She seemed to be a lone voice of reason and common sense in US financial service regulation during the George Bush-era.

Pak Sugiharto, ex- Minister of SOEs in Indonesia is also someone I have a lot of respect for. His appointment to that ministry was shortened because his reforms were too effective and too many powerful people complained.  He is now President-Commission of Indonesian oil giant Pertamina and seems to have done a good job in reforming what had been an extremely corrupt organization.  He recently speculated that some of Pertamina's subsidiaries may be floated. 

Guo Shuqing is another such individual. I came to know him when I was researching my 2011 book, Inside China's Corporations.  At that time, he was the chairman and executive director of China Construction Bank (CCB), one of China big-four state-owned banks. He is a reformer and is a behind a number of China’s large financial institutions including the State Administration for Foreign Exchange (SAFE - one of the biggest pools of capital in the world.  It manages China’s vast foreign exchange reserves).  He later helped create and lead Central Huijin Investment Limited, which holds the government's equity stakes in its SOE banks and financial institutions. He became governor of Shandong province in March 2013 after a short stint at China Securities Regulatory Commission (CSRC) China’s version of the US SEC.

Guo Shuqing was back in the news today.  An article in today’s SCMP noted that Shandong has released financial sector reform plans.  These include "setting up private banks and leasing firms, carrying out trials for issuing local government debt, and developing asset securitization".  The article also speculated that Qingdao could be come a regional financial centre to promote free trade between China, Korea and Japan.

An academic quoted in the article goes on to say that Shandong may be used as a testing ground for financial reforms.  This would be in line with past government efforts to try things on a local level before making a change at the national level.  The most notable example of this is the mid-1980’s special economic zones.   

As governor of Shandong, Guo Shuqing reportedly amended the guidelines to make them more market oriented.  His background and connection to the central government likely give more credence and strength to these reforms. This could also be a sign that this Fall's CCP Third Party Plenum will be reform oriented.

These all sound good, but is to be taken with a large grain of salt. The best laid plans anywhere go awry and there are likely large vested interests in Shandong that are against any change.  Politics is impossible to predict.

What I like about this is that somebody who appears to be doing the right thing is moving up.  This is good and makes me feel more positive on China, its economy, and its markets.  

More on Guo Shuqing

Guo Shuging studied law at the prestigious Chinese Academy of Social Sciences, worked in two economic-reform government bodies and was a visiting scholar at Oxford. He helped establish, and was one of the first directors, of SAFE.  He later became the Chairman of the newly created Huijin.  He has political leadership experience having been the vice-governor of Guizhou province between 1998 and 2001.

He was brought into as CCB's Chairman in 2005 following the former chairman's resignation amid bribery charges.  He was unique amongst the big-four bank managers as he was the only one to sincerely make use of its foreign joint-venture partner.

While others paid lip service to using their foreign partners' technology, experience and people, my research pointed to Guo Shuqing personally engaging and integrating Bank of America's more advanced card and other products’ processes and technology.   CCB's share price did well, and I regularly see it recommended as a favorite among foreign sell-side research banking analysts.  Between November 2006 (when ICBC became the third large SOE bank listed) and November 2011 (about the time Guo Shuqing left CCB), CCB’s share price increased by 23ppt to 52ppt more than the other two listed banks.

After CCB he was moved to head the CSRC, which is analogous to the US SEC or HK's SFC.  In line with his reformist background, he rolled up his sleeves and started to institute long-term reforms at the agency.  He did not see many of these through as he was only there for 17 months.  Feedback from my Hong Kong buy-side friends said that he was set on reforming the organization even more, but met too much resistance from vested interests.  

He was appointed to the governor of Shandong province in March 2013 (article here).

Shandong

For those who don't know, Shandong is one of the largest and richer provinces in China.  It has 94m residents and accounts for almost a tenth of China's GDP.  It is famous as the birthplace of Confucius.

Situated halfway between Shanghai and Beijing it tends to get overlooked by the other two regions.  

I used to go there often in the mid-1990s when I was looking at a possible private-equity investment. At the time, Shandong reminded me of Ohio, a very important US state that gets overshadowed by more famous American cities and places.  If one thought of a 'heartland' in China, I would put Shandong at or near the top of the list. 

Walter White is Chump Change. William Jardine is the Real Deal.

Breaking Bad's first episode hooked me, and I've been a fan since. Great script, acting, story-line, cinematography, etc.  I never thought I'd be so enamored by such a depressing subject.  The series last episodes are currently airing in the US and I'm looking forward to them.

Breaking Bad is a US cable television series of a mild-mannered high school chemistry teacher's transformation into a regional drug kingpin.  The protagonists Walter White has a teenage son with cerebral palsy, a daughter on the way, and is diagnosed with cancer.  He starts 'cooking meth' to pay for his cancer treatments. Many twists and turns later, Walter White by luck and skill eventually becomes the largest crystal meth producer and dealer in the South Western USA.

But Walter White is chump change, a small fry, and a petty thief compared to the real-life William Jardine.

As far as I can tell William Jardine, and the company he co-founded, Jardine Matheson, was the largest and most organized drug dealer the world has ever seen.  His drive to expand the opium trade up the China coast and his active lobbying for what is now called the Opium Wars, eventually led to an estimated 70% of adult males in China becoming users or addicts.

At least this is the conclusion I came to when researching the origins and history of the Jardine Group for an investment bank report.  Called Inside Corporate ASEAN, the report looked at the largest conglomerates and controlling shareholder groupings in South-East Asia.  Much of the salacious stuff about Jardine's early history was edited of rough drafts I submitted to the bank. But the stories remain with me.

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The two men had similar upbringings.  Like Breaking Bad's main character Walter White, William Jardine came from a humble, yet educated background.  A graduate of University of Edinburgh's medical school, he learned about the opium trade as a ship's doctor in the East India Company.

Like Walter White, William Jardine was a hard working and 'honest' man.  William Jardine had a Calvinist upbringing, was described as hating idleness, and not fond of rest or recreation. Both men did not use their own products, and looked down on those who take narcotics.

However, unlike the Breaking Bad protagonist, William Jardine was not a devoted family man.  He met his eventual business partner, James Matheson at a Macao brothel and never married.  The two were in the drug trade not to provide for their families or to pay for medical bills, but simply to make money.  "Both men were committed to making a fortune as quickly as possible, the future credo of the opium trade generally", wrote Thomoas Dormandy in his fantastic book, Opium.

In fact, William Jardine was more akin to Walter White's nemesis, Gustavo Fring.  Both innovated product distribution and thought big.   Instead of only selling in Southern China, which was already fairly saturated when he arrived in the 1820s, William sailed up the China coast opening new markets as far North as Tianjin.  His innovation and hard work paid off and by the mid-1830's Jardine Matheson was largest opium trader in China, and likely the world.

But this was not enough. Toward his retirement, William Jardine returned to England and helped persuade the British government to send troops to  southern China to defend free trade there.  He advised the British naval forces on the best strategies to use along the coast and Yangtze River.

His prewar efforts partially led to the Opium Wars and the 1842 China Treaty of Nanking. The treaty ceded Hong Kong Island to the British, opened several ports to foreign trade, and had the Chinese government pay for the war.  A key reason for England's quick and easy victories during the first and subsequent was that many Chinese soldiers were opium users and not prepared or disciplined to fight the more mechanized British troops. 

William Jardine died in 1843 in England.  His company Jardine Matheson soon left the opium trade having diversified into other businesses.  

However opium use kept expanding. "In 1888 The London Times estimated that 70% of the adult males in China were habituated or addicted.  Two years later, exhausted by futile protests, the fifteen-year-old emperor, under the thumb of his great-aunt, the Dowager Empress Cixi, former prostitute, imperial concubine, serial murderess and lifelong (opium) addict, revoked all laws against cultivation, trading and consumption.  The laws had been so widely ignored that their revocation barely made a ripple."(also from Opium, by Thomas Dormandy).

Let's see Walter White top that in the remaining episodes...

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Jardine is now one of the largest non-government controlled conglomerates in SE Asia by market value.  In Fall 2011, when the report was published, it accounted for 11% of large company market capitalization of the six ASEAN markets.  It is the second largest  business group in Singapore as well as Indonesia, and by far the largest non-government owned one in the entire region. Jardine controlled companies accounted for 16% the Straits Times Index, Singapore's most quoted and benched marked equity index.

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