WHY WE SHOULD WORRY THAT MRS MERKEL DOES NOT UNDERSTAND GERMANY’S ECONOMIC HISTORY

Normally my blogs take the form of commentary on what I have been up to and where I have been going in my global quest for value on behalf of investors in the funds we manage at CIM and Santa Lucia.  

Of course the analytic and portfolio management process is not just a function of what we find on the road.  It is an aggregation of many inputs including reading reports on companies and putting all the research, desktop and field, into context.  The contextual part of the process requires us to  detour into a certain amount of economic and political commentary hence providing the pleasure of reading a lot of well written and carefully thought out work from some of the most intelligent people on the planet.  We sieve through that and hopefully synthesize those elements that are most relevant.  I am sure we miss a lot of gems but there is a fair amount of dross to discard on the way and triage is important.  My law degree is probably the most useful part of my education as 99% of the stuff that appears in legal judgements is irrelevant.  The greatest skill is to identify the 1% that matters.  It is a skill that fewer and fewer judges seem to possess with unfortunate consequences as is regularly evidenced by the stupidity of judgements coming out of courts such as the European Court of Human rights, and sadly elsewhere as the rule of law deteriorates in too many countries.

This is a preamble to a blog that will consist primarily of an extract written by the brilliant Michael Pettis, a Beijing based economist who was asked to review a book called The Leaderless Economy by Peter Temin and David Vines.  Pettis has a truly global understanding of the interrelationship of trade flows and capital flows around the world.  I think the insight that follows is supremely important because it explains to a large extent why Europe is in such a mess.  Regardless of the appalling behaviour of some Greeks particularly the political elite including multiple frauds, constant and deep corruption, and dysfunctional institutions that inflict great damage on their own country as well as on others, the sad fact is it is Germany’s failure to behave properly that is at the heart of the problems facing Europe right now and indeed to some extent it is German policy that is adversely affecting the world economy at large.  Over to Mr Pettis.

“If China runs a capital account deficit and the US a capital account surplus, and these are roughly equal to net purchases by the PBoC and other Chinese government entities of US government bonds and US assets, China will run a current account surplus exactly equal to its capital account deficit.  The US will run a current account deficit exactly equal to its capital account surplus.

This may show up in the form of corresponding bilateral trade surpluses and deficits between the two countries, but it is not necessary, and in fact extremely unlikely, that it would. While we cannot say just from looking at the numbers whether low US savings relative to investment forced the Chinese into saving more than they invest, or whether high Chinese savings relative to investment forced the Americans into saving less than they invest, but the savings rate in one of the countries was determined in large part by distortions in the other.

The main point is that if you want to understand the causal relationship between Chinese surpluses and US deficits, or between German surpluses before 2009 and peripheral European deficits, you have to look at the direction of net capital flows, and not at bilateral trade. I will return to this, but to get back to The Leaderless Economy, this book is underpinned by the same deep familiarity with financial history that Peter Temin brings to all his work, and perhaps this is why the book should leave everyone terribly frustrated on two counts. First, the authors show that while the 2007-08 global crisis and its aftermath were unquestionably large and complex affairs, there was nothing about the crisis that was unprecedented – we have experienced similar events before – and we understand far more about what might or might not have worked than subsequent policymaking might suggest.

The authors show for example that anyone who had a reasonable understanding of the current and capital account pressures of the 1920s whose inconsistencies doomed Germany should have been able to understand why downward pressure on German wage growth, in the several years before the global crisis was set off in 2007 by the US subprime crisis, would ultimately force huge internal imbalances onto Europe during that time. More importantly, this understanding should have been enough to convince European policymakers that unless Germany responded to the crisis by reflating domestic demand sufficiently to generate large current account deficits, it would be all but impossible to prevent a decade of anemic growth and extraordinarily high unemployment in peripheral Europe.

It’s not that Germany in the 1920s was anything like Germany in the 2000s, or even that Germany suffered in the 1920s from the kinds of pressures it forced onto peripheral Europe in the 2000s (although this is closer to the truth). The problem was that Germany in the 1920s was required to export large amounts of capital, because of extremely high reparations demands, while its ability to run current account surpluses was constrained by European post-war policies.

No country can run a capital account deficit unless it runs a current account surplus, and these enormous countervailing pressures forced Germany, among other things, into an unsustainable borrowing path. Similarly since 2008-09 peripheral Europe has been under pressure to run capital account deficits (it must repay substantial borrowings and fund flight capital, but it has trouble borrowing without implicit ECB guarantees). Its ability to run countervailing current account surpluses, however, is constrained within Europe by Berlin’s refusal to allow a reflation of domestic demand and it is constrained outside Europe by Germany’s enormous current account surplus, which prevents a currency adjustment. This forces peripheral Europe into both rising debt and high unemployment, and it is only because Europe as a whole has forced the problem of weak German demand onto the rest of the world that conditions in Europe are not even worse.”     

Unhappy together, Happier apart?  Where is Fiona Shackleton when you need her?

In summary unless Germany changes its ways the present EU structure and the Euro in particular are at risk.  Meanwhile what Greece does or does not do is almost irrelevant.  Anything they do, even a default, will not solve the critical contradiction at the heart of Europe.  The peripheral countries cannot consume enough, and Germany will not.  The peripheral countries cannot afford to pay for what they do consume while Germany can but chooses not to consume what it can afford.  Over to you Mrs Merkel.  

False Dawn or Light at the End of the Indonesian Tunnel?

My latest voyage was to check on some of our investments in Indonesia.  The situation as of June 2015 is not the one we had hoped to see, or indeed expected to encounter, as at year end 2014.  One should never hold up hopes too high for Indonesia, a country that continues to promise, but never ever fully delivers.  Still the potential remains as exciting as always and one day the place will blossom as it should.

The challenge here, as in many other countries, is a well-entrenched bureaucracy that is both corrupt and incompetent; a legacy of the days of Presidential/Military rule.  Since the arrival of democracy post the Asian melt down of the late 1990s there has been progress, but not enough.  The Anti-Corruption Commission has collected some notable scalps and is very popular but of late has been fighting off attacks from the police where as you would expect corruption is a particularly bad problem.

When Jokowi came to power after huge success as Mayor of Solo, and having had a real impact as Mayor of Jakarta, there were unrealistic expectations as to what he could achieve as President : unrealistic because he has no real power base except the people; and they only get to vote once every five years so can be safely ignored for the remaining 4½.  His own party is controlled by someone else and as of now in Parliament he does not have a majority.  Still chaos among his opponents enables him to assemble support for popular measures, and the President can force through quite a lot of change, especially administrative, without consulting the Parliamentary snake pit.

We should not ignore his accomplishments.  There has been real progress in pushing along infrastructure, with several high profile projects having broken ground including a badly needed port.  Several important toll roads are now moving along faster; but more, in fact much more, is required.  The multiplier effect in Indonesia of infrastructure investment is massive, and the country needs more of everything - now.

Part of the problem is that the government does not seem to know what it is doing.  Proposals are introduced, dropped, reintroduced, modified and then many vanish without trace while others end up enshrined into law.  Yet there is no clear pattern.  It seems like a lottery.  The process and outcome are impossible to predict.  This makes life difficult for investors.  Worse ministers in the cabinet contradict each other.  One says foreigners can now buy freehold apartments, another says they cannot.  One department is pushing a major land reclamation project along the sea shore of Jakarta, another is attempting to block it; Jokowi does not seem in control even of his own team.  Indecisiveness is bad for investment and companies cannot make long term commitments if there is too much change.  

Not surprising then that investors are having second thoughts, especially international institutions.  FDI remains a bright spot, especially from Japanese firms who are staking out a lot of strategically placed real estate; but funds flow both in bonds and equities has turned negative causing both the rupiah and the stock market to drift south. 

The good news, and there is some good news, is that much more of this and the Indonesian market will re-enter undervalued territory.  On a purchasing power priority basis the currency is already cheap – of course it can always get cheaper.  Funds flows have nothing to do with value but they do set prices.  The multiples of Jakarta listed companies, with a few glaring exceptions such as the local subsidiary of Unilever, are starting to look more sensible.  Then there are some sectors that are already bombed out, where a value investor can start to do analysis now.  Picking the bottom is always tricky especially when factors affecting the category are global : as they are with the areas of the Indonesia economy that have been hit especially hard.  These are of course the commodity linked complex of which coal is the most important, followed by palm oil, gas products, with a supporting role played by a chorus including coffee and rubber.

Coal is key.  The price has been heading lower for some time.  There is oversupply especially of the relatively lower quality, lower calorie content thermal coal where Indonesia is the world number one exporter.  As China cuts back and stacks the deck in favour of its own less efficient producers there had been hopes that India under Modi might take up the slack; but it was not to be.  Astonishingly one of the world’s worst run companies Coal of India has summoned up a new burst of energy from somewhere and is ramping up domestic production more rapidly than expected.  Less astonishingly the power industry in India remains a mess with new capacity behind schedule and massive bad debts affecting the whole energy chain.  Reform needs to start with getting people to pay their bills.  By some estimates between 30-40% of customers do not believe they should pay for electricity in India and most of these do not.  So no relief from there for Indonesian coal producers.

The obvious answer is Mine Mouth Power Plants.  Indonesia desperately needs more output.  There is widespread support for these projects even in Parliament where of course there are plenty of interested parties sizing up how much of the potential profit could end up in their pockets.  Some units are getting started, but implementation is likely to be patchy.  Still with coal shares beaten up – in some cases down over 80% - the market remains sceptical and has yet to attribute much, if any, value to early stage plans.  Yet MMPPs could add very significant value to several listed companies as early as 2017 and deserve close attention.  It is perhaps too early to dive in now.  The trick will be to decide just how far ahead investors will be prepared to look in a country with, to be polite, a patchy record.  1H 2016 perhaps?  This may not be music to the ears of the climate change green lobby, but Indonesia is too poor to turn up its nose at the one cheap source of fuel it has in abundance; so more coal fired stations are coming and the local economics are such that enough of these could turn the country into one of the low cost power locations in S.E.Asia.

Palm oil has also been hit hard; but lower prices appear to be luring buyers back.  Again China and India are the big customers.  In the short run Malaysian inventories are too high and will continue to be an overhang for the next couple of quarters.  The El Nino effect is usually a plus for plantation companies.  That phenomenon is in process though it is too soon to say whether its impact this time round will be serious or trivial.  The planters are also beneficiaries of a weak rupiah.  So far plantation stocks, while some have corrected, are not bargains, though there might be value in picking one name from this space for a diversified portfolio.

There are bargains on offer even today in the area of energy and related services.  This sector too is a major beneficiary of a weak rupiah.  Primary producers have seen share prices slump even when they produce more gas than oil; and even when gas prices have continued to edge up as the bbl equivalent equation still favours gas with oil at $60.  The market does not seem to be able to distinguish between the two so anyone who cares to dig deeper could uncover a pleasant surprise especially when focusing on cashflow rather than accounting profit. 

Support services are experiencing knock on price pressure.  Not all of that has worked its way through the system.  Offshore supply vessel providers and rig operators face demands for 20-30% discounts while capital projects are getting slashed and/or delayed especially in deep water.  This is not a pleasant environment.  The profit of some players has evaporated; but again the cashflow has not so debt is also going down and balance sheets in general are getting better, while the Enterprise Value shrinks into attractive EV/EVBITDA territory.  Time to nibble at least.  In theory these companies provide an almost seamless currency hedge.

Yet here too it is arguably too early to get fully involved, even if it is time to start a watching brief.  The moment to plunge in and bottom fish could come soon than most expect with the worst affected counters already off 80%.  The arrival of Swire on the shareholder register of the largest inter-island coal carrier hints of possible M&A.  Cabotage has not done the oil service companies much good but the local shipping market at least is getting some relief.  These are the sorts of bombed out businesses where a value investor should be sniffing around.  Last year growth was on offer in Indonesia.  The balance is beginning to tilt back to value.     

   

Back Home to the Musical City of Singapore

After what has been the best part of six weeks on the road, it is an indulgent luxury to get back to find there are no painful bills waiting to be paid – or at least none that are overdue with threats attached.  That can happen in Singapore because for some reason while almost everything works really well there are a few exceptions.  One of those is snail mail.  Perhaps no one cares any more.  Still on those occasions, thankfully rare, when a bill is sent from London, it can take anything up to 10 business days to get here : occasionally even longer.

No sooner touched down than I find myself at the Esplanade to see the Singapore Symphony Orchestra who were back to their best.  The biggest problem with Strauss’s Also Sprach Zarathustra is that the most enjoyable moments all come in the first three minutes and the remaining twenty-seven are a bit of a let-down.  They seem to have the score back to front.  Perhaps some orchestra one day should try to play it in reverse.

You could almost say the same about Holst’s the Planets since Mars is the most rambunctious and full on, as you would expect from the Bringer of War.  Yet that is unfair to the other planets, all of which come with their own charms.  This piece is a triumph.  All sections of the orchestra get a full workout including some instruments that rarely get a look in.  

I suspect if you ask seven different people which planet they prefer you would get seven different answers.  For me it is a toss-up between Jupiter and Saturn even though they are very different.  Uranus also has wonderful moments.  Actually they are all great except perhaps Neptune the last one in the series which for me is the weakest.  What is it about composers who want to end low?  Have they not heard about crescendos?

One highlight of my week, albeit brief, was getting a chance to catch up with the Lord Mayor of London, Alan Yarrow, to whom I am related : specifically his father and my mother were first cousins and also very close friends.  Alan is the perfect man for this position.  He is charming and gregarious without being insincere.  He also understands the city and financial markets as well as anyone, around and has a long and distinguished history of genuine involvement in charitable activities.  The only blot on his resume is that he went to Harrow; but then he did not have a choice.  One branch of the family went to Harrow, while the other went to Eton.  Just as Alan is the perfect ambassador, his wife, Gilly, complements him in every way.  She is outstanding at mingling in a reception while making everyone she talks to feel comfortable.  They are a great pair.  

Their visit to this corner of the world was particularly well received in part because of the long history they both have here; they have lived in Sri Lanka and Singapore, and in Alan’s case, he was born in Johor Bahru; so a lot of links and a great deal of history.  We think the first family member landed in Singapore in 1836.  You will still find quite a few Yarrow legacies around Malaysia and Singapore, along with Griffith- Jones and Guthrie, the other strands of the family.  My great aunt was a particularly prominent pioneer in education in both countries setting up the Tanglin School, and also opening a school in the Cameron Highlands.

The reception was at the British High Commission, a wonderful piece of old style colonial architecture.  Sadly there are far too few of these buildings left standing in Singapore.  Perhaps they are not practical, but I fear the real problem is the relative value of a block of new apartments compared to one old house.  While not as comfortable as a modern residence, the BHC does have charm and character that mark it out from many other official residences.  

Sorry to criticise the home country but they need to do something about the quality of wine served on these occasions.  This is the second event I have attended there.  It is a sad state of affairs when someone who prefers a glass of wine under most circumstances finds beer a better bet.  The eats were fine but the wine was not up to snuff.  There is plenty of perfectly decent wine available at reasonable prices (of course no wine in Singapore is cheap), so no excuse for serving rubbish, especially when you are trying to generate goodwill and promote bilateral trade and investment.  You do not want to give the impression that either your guests are not important enough to merit a good glass, or that Britain is too cheap or perhaps worse too budget constrained, to provide one.  You want to put people in a receptive frame of mind so they depart full of goodwill towards the hosts.  A small saving here is definitely penny wise and pound foolish, and a false economy.         

Samsung is Korea: Or is Korea Samsung?

After Chengdu I headed north to Seoul to attend the Samsung Global Investors Conference, courtesy of Samsung Securities.  A stopover at Hefei gave me a brief taste of possibly the most efficient airport I have ever passed through.

My last visit to Seoul was in March 2009.  Not much seemed to have changed.  The crane index appeared higher than six years ago, though not by enough to change the economic index.

The conference was held at the Hotel Shilla, a happy coincidence as it is my favourite hotel in Seoul.  The location is not the most convenient, but a manicured garden and excellent facilities more than make up for that.  In the Shilla, you know you are in Korea.  This is not yet another Four Seasons or Marriott.  Still fusion décor has taken over since my last stay.  The rooms have been refurbished and are now more convenient for the business traveller, but they have lost some character in the process.  I suppose that does count as progress.

I like the Shilla, but it is not cheap; and if your room rate does not include breakfast you may want to give that meal a miss.  There is an extensive buffet but at $55 it should be better.  I expect to be ripped off at breakfast, but this is the biggest bill I think I have ever had : should have drunk an extra orange juice.  The other point of interest about the Shilla is that it is the location for possibly the most extensive range of duty free luxury brands anywhere.   Even without tax that is not the place to voyage for value, but others might disagree.  The line-up is impressive.

There were nearly 90 corporates presenting so selecting who to see was a challenge.  Of course Samsung has clout.  Chaebol rivalries apart they can corral more or less whoever they want.  Would you ignore a call from Samsung if you are a serious company in Korea?   

Korea is an interesting economy.  The country has produced a surprising number of world class companies for a relatively small population.  Samsung of course is one of the most recognised names in the world, its brand ranked as the seventh most important globally by Forbes; and it deserves to be.  Posco is arguably the most efficient steel producer.  They are home to world class car companies, perhaps the best ship builders, and some of the most efficient construction companies with skill sets that run the gamut from desalination to nuclear.

Sadly corporate governance remains the weak link.  The half a dozen families who control much of corporate Korea have shown little interest in minority shareholders.  The recent ‘nut’ rage incident perhaps reveals what they really think, but they try not to let the mask slip too often.  Korea is one of the only financial markets where corporate governance has gone backwards over the past decade.  The focus of the families is firmly on succession planning, inheritance issues and tax avoidance.  In cleaning up complex corporate structures with cross holdings and way too many related party transactions, there will be winners and losers; but this will not be decided in a rational value based process.  Unless you understand family dynamics, these groups are almost uninvestable.  The contempt some of these families have for their outside shareholders was conclusively demonstrated last year by Hyundai, indulging in one of the worst examples of value destruction in recent listed company history, spending a small fortune on a vanity HQ that sends a message about priorities that is all wrong.  The payback period on this project is probably about 50 years, though it will be great for the egos of the family and senior executives.

Hyundai:  Design Proposal for New Headquarters

That said, and in part because of this, Korea is one of the cheapest markets in the world right now.  A value investor has to look and see if it is possible to sidestep the value traps and buy a good business at a decent discount.  My guide in this exercise is Ju Kim, truly one of the few brokers still on the sell side who really cares about whether his clients do well or not.  I have been working with him for over twelve years.  He has never steered me wrong.  If you are investing in Korea or thinking about it, you should track him down in New York where he is based.  He also knows a great place go for Korean barbeque when you are in Seoul.

And it came to pass that I did find one gem (I hope) among the dross.  That topic is deferred for another day.  In addition I got to see Posco and had an interesting discussion about trends in the auto industry.  LG Display is clearly one of the best in that business and will be a leading OLED player, and perhaps a pioneer in AMOLED too.  There is a lot going on.  LG is likely to remain a key player, but so much change makes it harder to identify which horse to back, if any.  This industry does not have a distinguished history of generating return on investment; rather it is a capital hog.

Korean construction companies have been among the world’s most active MNCs with a global footprint, boldly going where many competitors fear to tread.  The Gulf has not always been kind to them, or indeed to anyone in this business since 1978, but on the whole they are good at what they do.  I find the risk/reward profile less than it should be much of the time, but there comes a point in every cycle where the sector can provide a decent ride.  As the domestic housing market comes out of the doldrums this might be such a moment.           

Then there is Naver, the King of Search in Korea and owner of Line, the leading messaging service in Japan, Indonesia and Thailand.  Naver is hard to analyse, a task not made any easier by the reluctance of the company to disclose data that would be useful to investors.  I understand the point about competition, but there is a balance and as a public company Naver has not got that right.  I suspect there is an interesting Sum of the Parts case to be made.

There are a couple of changes in the environment that could prove helpful to equity investors.  First the current government has been very vocal about the need for Korean companies to pay more dividends; and they should because they can.  At the start of the last decade yields in Korea were decent.  Now they are pitiful, the lowest in Asia.  Some companies have not raised the absolute amount in ten years.  Payout ratios have plunged.  Even Japan seems ahead of Korea in understanding this rather basic point.  Share with your shareholders.  The campaign appears to be having some effect, and in an era of invisible interest rates, dividends can be a critical driver of share price performance, so if companies do fall into line that could cause the whole market to rerate positively.

Second the National Pension Plan is lining up to increase its allocation to equities following the example of its counterpart in Japan.  Korea like Japan is an aging society and the current rate of return at the NPP will not suffice to meet its future expected liabilities.  A move to more equities is being forced on it, but key to making the move pay off will be higher dividends.  When the NPP talks, managers at many Korean companies will listen; or at least they will have to listen, and appear to take their suggestions seriously  and perhaps even act.  The NPP has a lot more clout than foreign institutions when it comes to asking for  higher dividends.  So there are two reasons to hope corporate Korea will become more responsive to the concept of Total Shareholder Return.

No country visit is complete without a comment on the airport.  Incheon should be a star.  It looks great; but is struggling.  It took me nearly thirty minutes to get through immigration and security.  That is just too long for a serious airport.  Based on the number of passengers sprinting through the terminal and rushing up escalators it is something they need to fix; more channels and perhaps more people too, at least at peak periods.  Getting in on arrival was also slow.  When flying out of Seoul my advice is to leave extra time.  I also have to add that the food selection in the Singapore Air Lounge is the worst I have encountered anywhere.  To end on a nicer note, they do have plenty of small trolleys in the terminal.  This issue is my personal pet peeve, and for me the key indicator to rate whether the operator cares about passengers.