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  • Stuart Fowler

Bull in a China shop


Following the money

The chances are you or your adviser will be following the money already flowing into China and the wider Asian area. Data collected by the Investment Management Association shows that through 2009 retail investors in the UK moved increasingly large sums into funds investing in emerging markets and Asia (ex Japan), to the extent of about one quarter of their net purchases of equities. For both sectors, these are record flows. The vast majority of the flows have been handled by intermediary firms, not self-directed investors. US retail investors have similarly shown record interest in China, India and smaller Asian markets.

Though the flows are enormous for the sectors, the stock of holdings is still relatively small. But that is the point about China and the other large economies playing catchup: India and Russia. They generate a sense of anxiety that personal portfolios ought to look more like the global size and importance of different economies. As if that was not enough, the idea of participating in much faster growth is even more compelling when investors see Western economies being held back in the growth stakes by the lasting loss of productive potential inflicted by the credit crisis. It is a good story but it is also a trap.

The growth trap

The growth trap is one that through history has caught out professional investors as well as retail investors. This suggests it is not as simple as professionals: smart, amateurs: dumb. It has to do with something that divides professional investors too: understanding the nitty gritty of business planning with financing costs allowed for. You can be smart by understanding how to analyse growth dynamics, whether for single companies or country equity markets as a whole. Or you can be smart by understanding the mistakes that others are making and exploiting them. In competitive fund management, good analysts often have to go with the flow, or momentum of markets, and hold positions much longer than fundamental value warrants, because of the need to keep up. Mistakes can be made even by smart investors, either in the analysis itself or in the gaming of other investors’ activity. Self-directed investors also get the analysis wrong but then usually compound that error by arriving late enough at the party to provide the sucker money that lets the smartest game players get out near the top.

In terms of its analytical roots, the growth trap is all about the difference between ‘top-line’ growth, say GDP for an economy or sales for a company, and ‘bottom-line’ growth, as in the cash flows and accounting profit underpinning each share owned by an investor. This difference between top and bottom line growth is largely explained by the irritant of having to finance growth. This is an irritant because there is almost always a gap between the opportunities for physical expansion (superior) and return on capital (average). This is because return on capital is determined by competition and scarcity which are largely independent of growth opportunities. Indeed, if anything, the more obvious the growth opportunities, the more likely competition will displace scarcity and push return on capital below the level required to finance growth without dilution.

Dilution is the effect on existing shareholders of issuing new shares to plug the gap between profit generation and capital investment. Dilution can be avoided by plugging the gap with debt, but only up to a point. And in any case the investor’s actual achieved return should then reflect the additional risk they are asked to bear.

Following the money

The chances are you or your adviser will be following the money already flowing into China and the wider Asian area. Data collected by the Investment Management Association shows that through 2009 retail investors in the UK moved increasingly large sums into funds investing in emerging markets and Asia (ex Japan), to the extent of about one quarter of their net purchases of equities. For both sectors, these are record flows. The vast majority of the flows have been handled by intermediary firms, not self-directed investors. US retail investors have similarly shown record interest in China, India and smaller Asian markets.

Though the flows are enormous for the sectors, the stock of holdings is still relatively small. But that is the point about China and the other large economies playing catchup: India and Russia. They generate a sense of anxiety that personal portfolios ought to look more like the global size and importance of different economies. As if that was not enough, the idea of participating in much faster growth is even more compelling when investors see Western economies being held back in the growth stakes by the lasting loss of productive potential inflicted by the credit crisis. It is a good story but it is also a trap.

The growth trap

The growth trap is one that through history has caught out professional investors as well as retail investors. This suggests it is not as simple as professionals: smart, amateurs: dumb. It has to do with something that divides professional investors too: understanding the nitty gritty of business planning with financing costs allowed for. You can be smart by understanding how to analyse growth dynamics, whether for single companies or country equity markets as a whole. Or you can be smart by understanding the mistakes that others are making and exploiting them. In competitive fund management, good analysts often have to go with the flow, or momentum of markets, and hold positions much longer than fundamental value warrants, because of the need to keep up. Mistakes can be made even by smart investors, either in the analysis itself or in the gaming of other investors’ activity. Self-directed investors also get the analysis wrong but then usually compound that error by arriving late enough at the party to provide the sucker money that lets the smartest game players get out near the top.

In terms of its analytical roots, the growth trap is all about the difference between ‘top-line’ growth, say GDP for an economy or sales for a company, and ‘bottom-line’ growth, as in the cash flows and accounting profit underpinning each share owned by an investor. This difference between top and bottom line growth is largely explained by the irritant of having to finance growth. This is an irritant because there is almost always a gap between the opportunities for physical expansion (superior) and return on capital (average). This is because return on capital is determined by competition and scarcity which are largely independent of growth opportunities. Indeed, if anything, the more obvious the growth opportunities, the more likely competition will displace scarcity and push return on capital below the level required to finance growth without dilution.

Dilution is the effect on existing shareholders of issuing new shares to plug the gap between profit generation and capital investment. Dilution can be avoided by plugging the gap with debt, but only up to a point. And in any case the investor’s actual achieved return should then reflect the additional risk they are asked to bear.

High growth economies

The dilution issue for companies scales up to whole economies. There is overwhelming evidence from achieved real returns from different markets that the return-generating process is essentially the same but neither return differences nor risk differences within this system are explained statistically by top-line growth differences. The world of investor returns is much flatter than naive observers would assume but that is consistent with profitability internationally being much flatter.

The evidence is in deflated equity indices for some 20 markets for much or all of the 20th century. In my book I also showed a chart of the fitted return trend for a Wilshire index of US shares from 1820 to 1999 and there was esentially no difference in the returns earned in the early period, when America was a fast-developing but already large economy, and the later period as a mature economy and stockmarket.

These general observations apply to the BRIC story even though the story appears to have particular explanations that are not typical in past data histories. The growth opportunity is seen as being a function of the gap between

  • the actual and projected size of the economy and its importance in a global context and

  • the total size of the stockmarket, being the value of the listed companies in the fast-growing economy.

For China, India and Russia the gap is seen as unusual in origin because long periods of more or less socialist systems, for up 80 years, destroyed productive capacity. Errors in economic management and perverse incentives continued only as long as they did because these countries could feed themselves, up to a point. That takes large populations and land mass including, to survive the worst or longest mismanagement, indigenous industrial raw materials.

Though Brazil is also put together with these to form ‘the BRICs’, its growth story is more to do with riding a commodity wave than having an obviously less well-developed and poorly capitalised group of publicly-traded companies. Though it is not the same sort of ‘corporate gap’ story, Brazil does share with India a long history of disappointment in realising its productive capacity, even with less state control of production than China and Russia.

The change in economic system that has the potential to realise the catchup possibility does not need to take the same form, as all modern systems are politically constrained rather than free markets. Indeed, though emerging capitalism is very different in China from the West, it is not dissimilar to the Japanese system, yet the equity return process in Japan throughout its peacetime history appears to be the same as in the West.

Our argument is not with the catch up story but with the implications for realised future investment returns. The naive assumption is that the gap will be filled by higher higher returns for the owners of the existing companies. This could not be more wrong. The gap will inevitably mostly be filled by new capital, whether for existing or as yet unformed businesses. It is in this respect no different from the growth trap in any growth economy. The financing problem does not go away just because these are large economies held back by bad government.

Valuation

If the return process is the same, it is the valuation at points of entry and exit that will mainly explain holding-period returns, not the sustainable return trend itself. But if typical investor assumptions about future returns are based on a mistake, it follows that there is a risk that valuations will be too high. This presents itself as an opportunity to game other investors over the short term but also as a risk of misallocation of personal capital over long holding periods.

We show below the real total return of the MSCI Emerging Market Index as an index (base 100 in December 1987), firstly as published in US dollar terms (orange) and secondly in real terms, deflated by US CPI (green). The second series is intended to correspond as closely as possible to our real return measures for developed markets. These follow the logic of a global model of real total returns in which the trend matters because of ‘mean reversion’ but the deviations from trend explain more of holding-period returns. If there were no net trend of either currency appreciation or depreciation over the period, differences in local-currency valuation would translate into future real returns to investors from other countries. In fact, holding-period real returns for international investors are also explained by differences between the actual exchange rate movements and changes in the ‘real exchange rate’, as derived from any gap between the two countries’ domestic inflation in the same period. Using US deflated returns for emerging markets is realistic from a global valuation perspective because the dollar is the key nominal and real exchange rate for emerging economies.

The real growth trend (broken line) is 6% pa which is almost exactly what we would expect from a developed economy’s stock market (even though this basket of markets across several geographical regions has shown higher volatility than an individual developed market).

The latest ratio to trend is 120%. It is not exceptionally high relative to previous deviations from trend but it needs to be seen in the context of much lower grow expectations for developed markets. The equivalent ratio of trend returns is currently 96% for the UK which is the most fully-valued of them all. The European ratio is 80% and the US 75%. Only Japan is priced for very low expectations, for reasons most investors will be familiar with, with a ratio as low as 44%. These detrended measures of value deviation since 2000 (the last peak of overvaluation) are shown below.

Our own measure of value is confirmed by a conventional fundamental measure that is very relevant if an investor accepts that the investor return world is relatively flat because corporate returns are relatively flat: price divided by the carrying value of equity capital in the balance sheet. Differences in price to book value ratios can only be rationalised by profitability differences.

Price to book value multiples of around 3-5 times in Chinese stocks (the range being between those available or not to foreigners), albeit lower than 6-7 times two years ago, are on a par with Japan at its 1989 peak. Even the banks, whose return on equity is surely not many multiples of banks in other economies, trade on ratios between 2 and 5 times book value. The MSCI India index ratio is 4 times. The MSCI BRIC index ended the year on 3.8 times book.

China fragility

If we had to pick candidates for major capital allocation errors of 2009, they will almost certainly appear somewhere in China’s economy. Though our argument here is not with the top-line growth, the signs of capital misallocation are enough to make a China blow-up plausible.

Any Japan analyst will surely be struck by the similarities with the way Japanese banks and companies misallocated capital throughout the 1980s and 90s, driving down marginal returns on capital even as high levels of capital investment continued. For households, the trap lay in both stockmarket speculation and rampant house prices. These too are echoed in China.

Any serious concern about the banking system in China will spring the valuation trap much quicker than if left to the typical cycle of equity momentum. There is always some risk in trying to be smart by gaming other investors, as people found out when the bubble burst in housing and credit markets in 2007 when levels of equity valuation were far from extreme.

The dilution issue for companies scales up to whole economies. There is overwhelming evidence from achieved real returns from different markets that the return-generating process is essentially the same but neither return differences nor risk differences within this system are explained statistically by top-line growth differences. The world of investor returns is much flatter than naive observers would assume but that is consistent with profitability internationally being much flatter.

The evidence is in deflated equity indices for some 20 markets for much or all of the 20th century. In my book I also showed a chart of the fitted return trend for a Wilshire index of US shares from 1820 to 1999 and there was essentially no difference in the returns earned in the early period, when America was a fast-developing but already large economy, and the later period as a mature economy and stockmarket.

These general observations apply to the BRIC story even though the story appears to have particular explanations that are not typical in past data histories. The growth opportunity is seen as being a function of the gap between

  • the actual and projected size of the economy and its importance in a global context and

  • the total size of the stockmarket, being the value of the listed companies in the fast-growing economy.

For China, India and Russia the gap is seen as unusual in origin because long periods of more or less socialist systems, for up 80 years, destroyed productive capacity. Errors in economic management and perverse incentives continued only as long as they did because these countries could feed themselves, up to a point. That takes large populations and land mass including, to survive the worst or longest mismanagement, indigenous industrial raw materials.

Though Brazil is also put together with these to form ‘the BRICs’, its growth story is more to do with riding a commodity wave than having an obviously less well-developed and poorly capitalised group of publicly-traded companies. Though it is not the same sort of ‘corporate gap’ story, Brazil does share with India a long history of disappointment in realising its productive capacity, even with less state control of production than China and Russia.

The change in economic system that has the potential to realise the catchup possibility does not need to take the same form, as all modern systems are politically constrained rather than free markets. Indeed, though emerging capitalism is very different in China from the West, it is not dissimilar to the Japanese system, yet the equity return process in Japan throughout its peacetime history appears to be the same as in the West.

Our argument is not with the catchup story but with the implications for realised future investment returns. The naive assumption is that the gap will be filled by higher higher returns for the owners of the existing companies. This could not be more wrong. The gap will inevitably mostly be filled by new capital, whether for existing or as yet unformed businesses. It is in this respect no different from the growth trap in any growth economy. The financing problem does not go away just because these are large economies held back by bad government.

Valuation

If the return process is the same, it is the valuation at points of entry and exit that will mainly explain holding-period returns, not the sustainable return trend itself. But if typical investor assumptions about future returns are based on a mistake, it follows that there is a risk that valuations will be too high. This presents itself as an opportunity to game other investors over the short term but also as a risk of misallocation of personal capital over long holding periods.

We show below the real total return of the MSCI Emerging Market Index as an index (base 100 in December 1987), firstly as published in US dollar terms (orange) and secondly in real terms, deflated by US CPI (green). The second series is intended to correspond as closely as possible to our real return measures for developed markets. These follow the logic of a global model of real total returns in which the trend matters because of ‘mean reversion’ but the deviations from trend explain more of holding-period returns. If there were no net trend of either currency appreciation or depreciation over the period, differences in local-currency valuation would translate into future real returns to investors from other countries. In fact, holding-period real returns for international investors are also explained by differences between the actual exchange rate movements and changes in the ‘real exchange rate’, as derived from any gap between the two countries’ domestic inflation in the same period. Using US deflated returns for emerging markets is realistic from a global valuation perspective because the dollar is the key nominal and real exchange rate for emerging economies.

The real growth trend (broken line) is 6% pa which is almost exactly what we would expect from a developed economy’s stock market (even though this basket of markets across several geographical regions has shown higher volatility than an individual developed market).

The latest ratio to trend is 120%. It is not exceptionally high relative to previous deviations from trend but it needs to be seen in the context of much lower grow expectations for developed markets. The equivalent ratio of trend returns is currently 96% for the UK which is the most fully-valued of them all. The European ratio is 80% and the US 75%. Only Japan is priced for very low expectations, for reasons most investors will be familiar with, with a ratio as low as 44%. These detrended measures of value deviation since 2000 (the last peak of overvaluation) are shown below.

Our own measure of value is confirmed by a conventional fundamental measure that is very relevant if an investor accepts that the investor return world is relatively flat because corporate returns are relatively flat: price divided by the carrying value of equity capital in the balance sheet. Differences in price to book value ratios can only be rationalised by profitability differences.

Price to book value multiples of around 3-5 times in Chinese stocks (the range being between those available or not to foreigners), albeit lower than 6-7 times two years ago, are on a par with Japan at its 1989 peak. Even the banks, whose return on equity is surely not many multiples of banks in other economies, trade on ratios between 2 and 5 times book value. The MSCI India index ratio is 4 times. The MSCI BRIC index ended the year on 3.8 times book.

China fragility

If we had to pick candidates for major capital allocation errors of 2009, they will almost certainly appear somewhere in China’s economy. Though our argument here is not with the top-line growth, the signs of capital misallocation are enough to make a China blow-up plausible.

Any Japan analyst will surely be struck by the similarities with the way Japanese banks and companies misallocated capital throughout the 1980s and 90s, driving down marginal returns on capital even as high levels of capital investment continued. For households, the trap lay in both stockmarket speculation and rampant house prices. These too are echoed in China.

Any serious concern about the banking system in China will spring the valuation trap much quicker than if left to the typical cycle of equity momentum. There is always some risk in trying to be smart by gaming other investors, as people found out when the bubble burst in housing and credit markets in 2007 when levels of equity valuation were far from extreme.

#brics #china #emergingmarkets #growth #valuation

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