More thoughts on growth in Asian consumer trends

Here's an excellent little story from an all time great stockmarket guru, Richard Russell, the editor-publisher for www.dowtheoryletters.com. I think his point illustrates my views exactly re: rise of the Asian consumer...

Richard Russell
A story: I'll never forget this item -- and it's a true story. An American executive was flying overseas, and he happened to be sitting next to a well-dressed Chinese gentlemen. They talked, and their conversation got around to the rather unique talents or abilities of various nations. They agreed that the talent of Americans was innovation and creative thinking. The Italians, they agreed, tended to be outstanding artisans. The French were born arguers, thinkers, and highly individualistic. "And what about you Chinese?" asked the American. "What is your outstanding talent?" The Chinese gentleman immediately answered, "We Chinese are obsessive learners."

I never forgot that remark, and I'm convinced that it's true. For instance, one of the constant complaints about the Chinese economy is about their rotten, inefficient, messy banking system, a system floating on bad debts and concealed losses.

So what are we reading about now? The Chinese are allowing the great American banks and investment companies to buy into their banking system. Morgan Stanley, JP Morgan, Goldman Sachs, Citigroup, Wells Fargo -- almost every month we hear of another great US outfit buying a multi-billion dollar percentage of a Chinese bank. And in the process the US banks are "fixing" the Chinese banks, showing the Chinese "how to do it." So when I read of these transactions I think of what the Chinese gentleman said. Yes, the Chinese are obsessive learners. And they're even eager to learn English. The Chinese government has instituted a crash program in the Chinese schools to teach English to hundreds of thousands of Chinese children. And as they rush into the global, capitalist world, the Chinese are now graduating hundreds of thousands of engineers and scientists.

As an aside, Business Week (Feb. 6, 2006) has a feature article entitled, "To Get Rich Is Glorious," which was a statement made by Chinese Chairman Deng Xiaoping. What the article is about is that China has become a hot bed for luxury goods. There are now 300,000 millionaires in China, and they are buying Prada shoes, Versace jackets, Piaget watches, gold bars and lots of diamonds. The great untalked-about fact -- there is a huge amount of cash sloshing around in China today. And a lot of it is being spent on luxuries.

Nuff said...Come on the Asian consumer!

The New Year rallies - but when is it time to sell?

YTD, best performing market in Asia is the Thai SET (+6.8%), followed by Hang Seng (+5.9% YTD) and Jakarta SE (+5.8%). The early strong performance for the SET should not be a surprise, if we look at the average performance for the Thai market over the new year over the past 15 years, 13 year of those have registered positive performance (the traditional New Year rally!) averaging around 14% if taken from beginning of Dec to end of January.

However, this is not a Thai only phenomenon, in fact looking at the average performance for all the Asian markets over the similar periods, there has certainly been more ups than downs for all the markets during this time. The question to ask then is when to sell?

This is a trickier issue to handle and over the past years has ranged from anywhere in mid Jan to almost May (which inevitably tends to be the month to start taking some money off the table), or for some markets never! Even best performers of yesteryear may not necessarily indicate worst performer of this year. For e.g. see Mumbai, which was one of the top performing markets for last year, up 61% YoY, of which 5.8% comes from YTD, putting it very close behind Jakarta YTD. However, Korea, which was up almost 50% at the end of last year, is only up 0.4% YTD, one of the worse performing Asian markets YTD.

So where are fund managers looking to put their money this year (always a good indication of sustainability in the rallies). Most are now looking to increase their weighting in Thailand, after almost 2 years of disappointing performance, citing cheap valuations vis a vis the region (indicating that there may still be some legs in the rally in Thailand). Most are still bullish Korea and Hong Kong/China, citing strong growth prospects at reasonable (if not still cheap for Korea) valuations. Sectorwise, investors are focusing on technology, banking on another reasonable year for growth globally, whilst banking sector, given the strong growing economies in the region, is likely to also see positive benefits from rising loan growth and deleveraged balance sheet of corporates in Asia over past few years.

So time to sell? Not necessarily. Valuations in short term still does not look overstretched and growth prospects still look strong. With tech demand still remaining strong, OEM manufacturers likely to be positing some strong earnings growth (as well as strong textile sector demand given settling of quota woes) in 1H06. Longer term, I still feel quite strongly over the rise of the Asian consumer and still feel that this theme has lots of legs. Asian economies are in general viewed as export driven econonomies and the rise of the more discerning Asian consumer remains underplayed. However, how this long term trend will pan out in the short term remains to be seen. In meantime, ride on!

On the other hand, I don't necessarily like to follow the crowd, and will be digging deep into the Thai, Singaporean, Indonesian and Taiwanese economies for some deep value picks. We continue to feel particularly strongly about the consumer growth stories in these economies and have identified quite a few interesting small caps which offer strong growth prospects but at very reasonable prices. More later.

The mystery of capital, (and why economies contract)

Just finished an interesting book (The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, by Hernando de Soto) on why the wealth gap between Western countries and Emerging markets will continue to widen. He makes a very good argument on the fact that the lack of capital creation capabilities (largely due to large percentage of extralegal businesses, which has arisen from the absence of practical and economically sound legal framework) cripples the ability for the enterpreneur to raise capital and therefore fund the growth for his business. Based on Hernando's estimates, the 'wealth of the poor' in these markets are larger than several times the size of market capitalisation, deposits and certainly wealth of the rich of these countries but the inability of the poor to use these assets to raise capital (largely because a squatter living in his home is unlikely to be able to go to get a mortgage from the bank against his home to raise capital to startup or boost his business) means they remain stuck in a vicious cycle.

The most interesting point, in my view, was that because lawyers tend to uphold the law (whether it is perhaps economically the right thing for the country or not) means that the legal system tends to act against, rather than recognise these extralegal rights, resulting in the inability for the country (and the majority of its population) to pull itself out of the poverty cycle. When a couple of professors did some research into this fact, they noticed that data from 52 countries showed that for every 0.5-1% increase in size of labour force of lawyers, the rate of GDP growth tended to contract by 3.7-4.7%. Now isn't that proof enough...

Thai PM sale of family business comes under fire

Unfortunately for Thaksin, it's probably a no win situation either way. If he continues to hold Advanced Info Services (AIS), a mobile operator that has a 50-60% market share of the mobile telephone subcribers in Thailand, he will be criticised for having conflicts of interest given his position as Prime Minister of Thailand. By selling it to Temasek, effectively the Singaporean government, he comes under fire for selling out a 'national asset' to foreigners and which could raise security concerns. Die if you do, die if you don't. The fact is that no one in Thailand could afford to buy AIS in any event, so his only choice was to look abroad. Singtel, which is 63% owned by Temasek, already owns 19% stake in AIS, so either Singtel or Temasek was probably the most natural choice for a buyer.

One can cite many examples of policy corruption in the sale of the PM's families' stakes to Temasek (the latest being the amendment of the telecom act increasing the foreign ownership levels from 25% to 49% which came into effect 20th Jan 2006 - a few days before the official announcement of the sale!), but the biggest issue for minorities in telecom co's must be the increased risk both industry-wise and politically. 3G reform which was agressively being pursued by the SHIN group has been put on hold and although there is another public hearing by the NTC in Feb, it is quite clear that 3G is actually not needed in Thailand and the opposition will surely point out that it is purely a means to convert existing concessions which will expire in 7-13 yrs time and will benefit foreigned owned telcos and damage the TOT and CAT, national assets. Because of the the concession fees, Thailand is probably one of the few countries in the world where spending on a new 3G network probably makes more economical sense than investing more on the existing network purely because under the 3G network, the operator stops paying revenue sharing to the Telephone Organisation of Thailand (TOT), the concessionaire holder for the current mobile licenses.

Existing (local) shareholders' appetite for putting in a 3G network seems however less than enthusiastic. Interestingly, the family controlling the second largest mobile player, TAC, had also decided to sell their stake in the holding company, UCOM, to Telenor group, which currently holds 30% of TAC, which means that the only remaining locally controlled mobile player is TA-Orange, who has in any event, been on the lookout for a foreign investor since Orange sold out. This may be partly driven by the uncertainty of the actual 3G licenses itself but having gone through the upheavals of the previous capex cycle (2G) in the mobile sector, who is to blame them for wanting to get out!

In any event, I do not believe that Temasek (nor Telenor, for that matter) has received any assurances from sellers nor are they able to and as we move closer to the end of the concessions, the PV of the FCF during the concesssion declines and terminal value rises. At some point, the TOT and CAT will offer to buy out the listed concessionaires at the PV of FCF during the concessions, but not probably before serious investment into the new 3G networks are underway. Either way, my views would be the same, investing in a stock at the beginning of a capex investment cycle is probably a bit early (given uncertainties of new technologies and cost overruns)...better to wait to reap the rewards when the infrastructure has already been laid down and proven...probably also why I don't really like looking at new tech startups...(that's another story)

Finally, Thaksin has been accused of avoiding taxes by selling Shin rather than AIS direct. Really, some people just can't be satisfied! Who would want to pay a US$550m tax bill if they could avoid it! The fact is that the businesses, or other investments in Shin group does not even come close to US$0.6bn. Temasek got, what I would refer to as the 'MacDonald Value Meal' proposition. When you buy a Big Mac Meal, you get the fries and the Coke whether you want it or not. It's cheaper than buying the Mac and the Coke separately...Take it or leave it. The Ucom family sold its assets back to the family, however, I doubt Thaksin would be looking to buy ITV and Sattel back, otherwise no point selling AIS in first place. On the other hand, who is to say someone else might not be interested in these companies...(not us for sure!).

To be diversifed or not, that is the question

After a series of visits to tech OEM manufacturers across Asia, I came away with several impressions. Several years of oversupply has resulted in continuing consolidation in this sector. Acquire aggressively or be acquired is the general theme, especially in the smaller mid size players. There seemed to be two major types of players in this sector.
1) The highly concentrated specialist - whose top 3 clients probably makes up the majority, or over 60% of the company's revenue, or
2) The diversified player - who has clients which are no more than 10-15% of the revenue at any one time.

The growth rates are generally faster at the former, especially if its clients hits the jackpot (for e.g. Motorola RAZR phones, IPOD parts etc), however, interestingly, these companies are also the most vulnerable to a takeover (easier to understand their expertise, acquired for their client base etc, more uncertainty of future business). Anecdotal evidence seem to also suggest that this group also has the highest failure rates, as a client shifts its manufacturing to a lower cost producer or is closed down, it loses an irrecoverable amount of business, resulting in bankruptcy.

The interesting question, therefore is, is it better to be a diversified player or not? This question is a highly relevant question, and one that is close to my heart. As manager for the NTAsian Discovery Fund, we tend to run a highly concentrated portfolio, focusing on (hopefully) not more than 20-30 names across the region of some of our best ideas. Undoubtedly, for larger returns, a more focused approach is better. However, portfolio theory hardly recommends this approach for fund management, on the other hand, Warren Buffett is not exactly known for his diversified investments and he doesn't seem to have done too badly for himself.

Interestingly, surveys of top 50 richest people in the world often shows that there were more single equity investors in the top 50 than any other category (Microsoft, Walmart etc). Another interesting point to note though is that if you looked at this list perhaps 5 or 10 years ago, the biggest changes in wealth also came from this category, including the biggest category of individuals who drop out of the top 50 richest list. Easy come easy go (easy for some at any rate...). Point being, if your wealth is tied to one thing, it's a faster path to richness, on the other hand, it will also drag you down just as quick!

I digress, the quickest way to rapid returns is undoubtedly through focusing your investments in your best ideas. On the other hand, if you want to keep those returns, you better have the ability to switch to your investments to your next best ideas, or you could be liable to go back down with your investment (large shareholders tend to have difficulties selling out at top!). Hence one of the prime reasons for our fund's philosophy to run a concentrated portfolio (focus the approach but not too much that we are stuck with our investments all the way up and all the way back down).

Going back to the IT sector. Most of the smaller players try to land the big fast growing account, to ride the coattails of a hot product, generate the cash to expand and finally to try and diversify and catch the next big customer. A faster way to do this is to buy an existing player to diversify your own portfolio (to reduce reliance on one customer). This latter is often more feasible, largely due to the short lifespan of consumer electronics products, it just doesn't give a manufacturer time to diversify its customer base through organic growth to reduce reliance on a single customer/product. Diversify (before your product cycle runs out) or die. Fact of life for an OEM manufacturer in Asia.

Although this does it make it somewhat difficult for our fund, which focuses on long term investments of at least 2-3 years, to invest in non diversified OEM manufacturers (will it still be around in 2-3 years time?), it nevertheless throws up the interesting idea of arbitrage by buying any manufacturer that are trading at below their book value, especially if they have modern manufacturing facilities and have a heavy reliance on large customers. Having made this argument, would it be hypocritical then for our fund to invest in a diversified OEM manufacturer given our fund focuses on running a concentrated portfolio? By investing in a company with diversified customer base, does this mean that we are in fact indirectly diversifying our investments? Should we put our money behind the fast growing player to ride the high returns?

In my view, if a diversified OEM manufacturer is trading at deep valuations especially as the market is focusing on the fast growing IC packagers, for e.g., we should be looking at the former, not the latter. Our focus is to generate high returns by investing in companies trading at deep valuations from underresearched or out of favour companies. In essence, buying something that is worth $1.3-1.50 for $1 rather than buying something that is worth $1.3 for $1.4 and hoping that it would grow enough to be worth $2 next year. Or even better buying something that is worth $1.3 for $1 but that will growth to be worth $1.5 in a year's time. After all, a bird in hand is better than two in the bush. Happy hunting!

Malaysian investors looks outwards

Although the Malaysian market has been effectively underweighted by foreign investors for over two years, it looks like this status quo could as locals start to look outwards for regional investment ideas. Recent legislation has allowed more freedom for local investors to invest overseas with the results that the focus over the past 6-12 months and going forwards have been careful dipping of toes into regional markets. Whilst the absolute amounts raised over the last 6-12 months remain relatively small in the grand scheme of things (estimated at US$500m), the level of interest and foreign investment is escalating.

This development is hardly surprising as the longer the Malaysian market languishes in absence of positive news flow or catalysts, the appetite for foreign exposure will continue to grow. Functionally, it is unlikely that any fund is fully invested to the maximum 30% levels permitted at this point. However, we already are seeing recent fund launches focusing on regional markets and that is expected to continue. The baptism of domestic fund managers into regional markets will mean an initial conservative approach but expect that to change as they move up the learning curve.

Value and yield wrapped by a focused strategy seems to be a common theme and this is unsurprising. In view of this, the Malaysian market overall is likely to suffer, especially small caps, which are predominantly focused on by domestic investors. In our filters, there are interesting ideas and value emerging, however, it remains too early, in my view to trawl through the Malaysia market looking for bargains. The broadening investible horizon would suggest the lofty valuations previously seen would unlikely to be reached again barring company specific factors.

Thai Beverage listing

I don't know why, but the protests against the listing of Thai Beverage on the SET really perplexes me. Am I just a total capitalist with no moral fibre or are people right to protest against the listing of one of its largest liquor manufacturer in the country. Of course the fact that predominantly Buddhist Thailand has one of the highest rate of consumption of liquor in Asia and the fact that even if Thai Beverage doesn't list in Thailand but instead lists in Singapore with little hiccup to its financing requirements are probably minor points. Still, I feel that it is hypocritical to a large extent, especially if these energies are better spent protesting against the government and corruption rather than against a somewhat questionable cause. Quite rightly, the SET President, Khun Kittirat, has vowed to resign if Thai Beverage lists in Singapore before Thailand.

China's growth

China, in my view, will drive growth in Asia for the next decade. To fight head on (on cost basis) with China is madness, to ignore it is just as foolish. Opportunities for the entrepreneur in China is immense, with the growth creating a whole new segment of middle class consumers eager to experience the Western lifestyle. Having recently met with quite a few corporates currently expanding their retail operations in China, it is not a surprise to see meteoric growth rates coming through. Franchises especially, in my view, are thriving. With little experience in consumer products, the chinese entrepreneur is hungrily grabbing any half decent franchise he/she can lay their hands on. Companies with strong brand names and products with good potential in China are getting hundreds of enquries from potential franchisees looking to invest in China. Huge investments are being ploughed into China, however, interesting to note that the majority is actually coming from outside of US/Europe.

Many people have asked me what I think of China. Some of the growth rates coming out of China seems to defy gravity, and when we look at China sitting from another country, I can see why it is difficult to dismiss the growth as unsustainable. However, when we look at the size of each province (each the size of a developing country), it's not difficult to see how when we put lots of these together, all looking to grow rapidly, that astronomical growth rates are being seen.

However, the important question to ask is how sustainable this growth is, but rather, at what cost, this growth is being achieved? China currently consumes 12 percent of global energy, 25 percent of aluminum, 28 percent of steel and 42 percent of cement but yet only still accounts for less than 4.5% of total global economic output. The huge inefficiencies in the system is likely to put a strain on its banking system, especially the state run banks, which are potentially loaded with up to 50% of their assets in bad debts. Shuffling assets into asset management companies or selling some stakes in banks to foreigners is a small mitigating force, that in my view only delays the inevitable, the cost of sorting out the millions of $ of bad assets. From my experience from the Asian crisis, easy money is like heroine. The more you get, the more addictive it is. You can't go without it, and when it's time to go cold turkey, it's going to hurt. Banking crises rarely happen overnight, but it's going to be more like a burst dam. First, it starts leaking (and this stage can take a long time) before it starts gushing.

To conclude, high growth by itself does not necessarily equal health. Unfortunately, with the inefficiencies in the system, the faster the growth, the more unhealthy the Chinese economy could become (sort of like eating too fast causing indigestion). It would be interesting to see how the government can implement measures to ensure a healthy Chinese economy, measures that would ensure that the economy lives according to traditional Chinese medicine philosophy "take everything in moderation".