Vietnam – The Birth of Capitalism

Life is tough at the bottom, especially if you are the world’s lowest cost producer. A claim that will last until the next country undercuts you. And there is no shortage of countries lining up to do so. Over the last few years, China had been widely touted as the lowest cost producer in the world. I remember seeing several broker reports, including one titled, “What if China was the lowest cost producer of everything?” That claim didn’t last too long though. As the number of factories in a certain location within China rose, labour shortages and high turnover rate inflated wages quickly. This was compounded by China’s strict (but necessary) domestic migration policies (to stop half its population potentially descending into cities and industrialized zones).

However, let’s not forget that although Vietnam has a sizable population (around 86m people at last count), it is still only the size of a large province in China. There are still significant hurdles to overcome in Vietnam, not in the least of which will be infrastructure bottlenecks, which are already starting to appear, at this early stage of its development. Having said that, Vietnam also has some potentially unique opportunities, not only because of the rapid pace of liberalization that it is undergoing but also because of the demographics of the population, which even by Asian standards, is extremely skewed towards the younger age. I noted that in the evenings, everywhere you looked, there were wedding dinners. So, when I think Singapore, I think private bankers haven. Perhaps for Vietnam, it will be wedding planners heaven.

This potentially amazing macro story does not seem to have been missed by the markets and the astounding amount of money chasing the limited ways to play Vietnam has resulted in an even more astounding performance in the stockmarket, which was up 146% in 2006 and 40% for January alone!

With a market capitalization of only US$15bn, the Vietnamese stockmarket may not necessarily be the best way to play the rapidly growing economy, especially as the average local investor has little understanding of valuations. My meetings with local brokers, including one that transacts more than 60% of the foreign volume in the Vietnamese stockmarket, yielded little beyond “more buyers than sellers” and the fact that investors are willing to pay higher prices even now.

Still, share ownership levels are impressive, with already close to 150,000 accounts (compared to Thailand’s 100,000 accounts but of which less than half are active), largely driven by the government’s privatization push, which is putting share ownership into the workers’ hands (aka Maggie Thatcher style) and creating awareness of the stockmarket (albeit in a potentially risky and dangerous manner given little education on valuing companies) at an early stage. However, some of the larger privatizations remain tricky, with limited domestic liquidity and foreign participation, and consequently may be more restricted, compared to what we have seen recently over the past twelve months. “Blue chips” (a definition that is loosely applied given less than a couple of years of track record for some of the larger companies) are trading at heady valuations, with the largest private commercial bank, recently listed, trading at 36x FY07 PER and 8.4x PBV. Although net profit is forecast to grow at 73% over next two years, EPS will be shrinking at an almost frightening rate of -19% over the same period due to increasing capital required to fund the growth.

Credit quality, albeit furthest from anyone’s mind currently, over the longer term is likely to become a huge potential issue. Recent moves by some banks to allow credit approval authority to be extended to branch managers, in order to promote stronger loan growth, is not necessarily a risky move, assuming the right controls and credit approval processes are in place. However, when it comes on the back of certain “stories” we hear, such as bank managers taking a commission of up to 10% of loans extended, we can’t help but feel some déjà vu, some nostalgia from Thai banks’ pre-crisis lending practices. Investors chasing after growth (especially if it is associated with Vietnam, or even China for that matter) are so willing to pay a premium for that growth that all risks are discounted to an almost non-existent level. (Does that remind you of the dot com boom anyone?) The perennial assumption that the one or two steps back is not going to matter much in the five steps forward scenario. Looking at the stockmarket though, it seems like most investors there are factoring in the ten steps forward scenario with no steps back…

Growth is only one aspect of the Vietnam story. How to continue to grow at the neck breaking pace is another potentially more important question, one not focused on much by investors. One thing I noticed was that there all roads were basically two lane or four lane roads at most. Given the rapid industrialization going on, there’s no doubt in my mind that the traffic is only going to get worse. The picture below for a two lane road going in and out of Ho Chi Minh is a frequent scene. Guess what will happen when the locals start having enough money to buy cars. The first thing I would recommend is for them to put some traffic lights into all their crossroads. I thought driving in China would be a nightmare, but that was until I sat in a car in Ho Chi Minh.

The bottleneck at the ports could get even worse. Demand is estimated to rise from 2.5m TEU currently to 6m TEU within the next five years. However, with estimated capacity of only around 1.5m TEU currently, demand already exceeds capacity. Current excess demand is being handled by the military/Navy port but that’s only a temporary solution. Part of the problem is that required infrastructure spending over the next few years is estimated to amount to close to US$145bn with Vietnamese government looking to fund less than 1% of that. This means huge opportunities for private sector funded projects, and also part of the reason for the huge privatization drive that we are now seeing throughout Vietnam, some of which is trickling through in the stockmarket.

The government not only realizes that it will require enormous private funding to build some of these infrastructure projects (meaning a myriad of direct investment opportunities) but will also require private sector help in providing jobs for the 1.5m people enter the job market every year. With each job provided by the state sector costing US$20,000 versus US$1,000 in the private sector, the Vietnamese government cannot afford not to privatize. Other bottlenecks that will surely crop up include the capacity of the existing airport, roads and expressways not only to ports but also within the city itself, some form of mass transport system and probably most importantly, the legal system.

One of the most impressive aspects of capitalism as driven by social principles is the evolution of the agricultural sector. Vietnam is currently one of few countries in Asia which is a net exporter of food. In a period of less than 10-15 years, Vietnam has become one of the largest producers in the world of rice, cashew nuts, pepper, coffee and in the future, potentially rubber.

Part of the reason for this is that a substantial portion of crop planting in a particular area is initially government designated. Once an area is designated for certain crops, the government divide and allocate plots of lands within that area to different farmers, who in effect ‘manage’ their designated plot with a profit sharing arrangement with the government (in effect paying ‘rent’ for the land). As such, what we see is an unprecedented scale of coordinated farming set by socialistic needs but driven by capitalistic principles (farmers are incentivised to maximize yield for their particular plot given profit sharing arrangement).

The above combination of factors does indeed provide a unique set of investment opportunities, particularly in direct investments given the lack of public funding for the majority of the designated infrastructure spending that is desperately needed. The stockmarket remains the easiest channel for most investors to play this growth opportunity, and given the lack of depth (and education in the finer points of valuations for local investors), pricing for most investable stocks remain lofty. Although we will continue to explore investment opportunities in Vietnam, helped somewhat by our proximity, our investment criteria (as with China stocks) is likely to screen out most investable stocks in the market. We are in the process of opening an account in Vietnam and obtaining our identification code to trade in the stockmarket but frankly, at this juncture, we’ll probably be watching from the sidelines for a while longer.

Thailand, despite many missteps, mismanagement and just general incompetence (largely due to political antics) has always been able to meander through its problems, partly because geographically, Thailand is well positioned as a hub (which is why Thai Airways continues to scrape through despite being one of the most poorly managed airlines around) and partly because it really is not a bad place to go to for your holidays. However, if Thailand doesn’t watch out, it might just start seeing a serious challenger in its next door neighbour.

Biggest supporters of US$ starting to lose faith?
On a separate note, the Malaysian government recently announced that it was starting to diversify some of its US$80bn foreign reserves away from US$. Asian central banks have never been particularly adventurous with their cash piles of US$ (excepting Singapore) but this recent move comes on the back of murmurings from other Asian Central Bankers, particularly the Chinese and Japanese, both of whom have denied any intention to seriously consider diversifying their investments. Still, with continuing weakness of the US$ expected, the pain tolerance for the slower accumulators of foreign exchange reserves (particularly the ASEAN countries) are likely to be lower and consequently, may be the first group to look to diversify. Given that our portfolio is positioned largely to benefit from weaker US$, we would be unlocking the bolt if we could, but the Thai government just doesn’t seem to be playing ball. Still, wouldn’t want to be standing in front of the door when the rush does start.

Skyhigh Exuberance

Euphoria remains high
As Asian markets ended the year with a bang (some more lethal than others, see Thailand) with some markets posting all time highs, and with strategists and analysts from the sell side generally being bullish about 2007, I can’t help but feel cautious about exuberance in the markets. Part of the reason is perhaps the fact that I’m based mainly in Bangkok, which is not exactly the centre of booming Asia at this point in time, and that sort of brings one back to reality. Just open up the Asian Wall Street Journal’s Year-End Review of Markets and Finance and the headline says it all “Can the party get even better?”, which is under a picture showing Investment Bankers ready to have a feast in 2007.

Having been on the sell side for more than a decade, I have had the axiom pounded into my brain “Bullish Brokers get the Business”. A self evident truth upon which other knowledge must rest, and from which other knowledge is built up. With an estimated more than 90% of funds invested in Asia being long only (of which the remainder has the ability to short but is probably long biased), the inability to short (more than probably at best a quarter of the stocks in less than half the markets in Asia) and it’s not difficult to see why it just doesn’t pay to be a bear in Asia (on the sell side at any rate). Richard Russell succinctly puts it, “Conventional market wisdom tells us that "the higher the rise, the bigger the fall." Well, the markets have been on the up-escalator ever since October, 2002, and nothing bad has happened yet. Furthermore, the universal opinion of the experts is that nothing bad is going to happen in 2007. In fact, from what I gather, the experts believe that nothing bad is ever going to happen -- at least not in this lifetime.” He was talking about the US stock market, but then, he could be talking about a few other markets in Asia from what I can see. Investors tend to forget…fast.

For a value fund, it’s a tough time to be picking stocks, for we are the “turtles” of any race and it’s tough to see the way when the “hares” are rushing past. Still I’m an optimist and the good thing is when the “hare” is rushing past, inevitably, it will not find the diamonds hidden in the rough. As such, we will continue to search far and wide in 2007 for similar types of gems to those we dug up in 2006.

I thought it would be appropriate to round up some of my thoughts for markets in Asia and what we could expect to see in 2007 and what we are likely to be focusing on in 2007.

ASEAN markets
I believe the ASEAN markets remains undervalued relative to other emerging markets, despite the fact that Indonesia, Vietnam and Philippines have been probably three of the top five best performing markets in Asia in 2006. However, I would not be focusing on the blue chip stocks in ASEAN as I believe they are not only expensive but are also over-owned. For larger funds to get exposure to these smaller markets, they tend to focus on the top few stocks, which mean average valuations for these stocks tend to be higher than what you would pay if you went for ‘second tier’ stocks. Given analyst resources in these markets (which tend to be a lot less than the larger markets in Asia), it’s not surprising that only the top quartile of the number of companies listed in these markets are covered, providing significant opportunity for those willing to do some deeper digging.

Despite the relative resilience of the fund to events in Thailand so far, we are a little wary of recent events in Thailand. It just goes to show even the more stable countries can ‘blow up’ in a short period of time, and I suppose that’s why risk premiums for these markets tend to be higher than more developed markets. For 2007, we will probably look to switch rather than continue to increase our exposure to both Thailand and Indonesia in order to reduce country risk for the portfolio. I believe there is more room to invest into Malaysia and Philippines and will be doing more digging there. We have already established some initial headway into Vietnam and will be sniffing around there in 2007. For the latter, I believe there is currently too much money chasing after a very small pie (the Vietnamese stock market) and that risk premiums are not being reflected if we compare the valuations being paid for in Vietnam versus the rest of ASEAN. Still there is no harm looking, but the better valued investments are probably private, and that will take a lot more work.

As for Thailand, after a series of mishaps (although unrelated - as far as I know anyway), investors are beginning to have doubts about Thailand as a laggard play (relative to rest of Asia, having been the worse performer now for almost two years running). I myself continue to believe the long term potentials of the Thai market, it’s just a shame that it’s been run by a small group of greedy, power hungry individuals (no names) with more interest in lining their own pockets than to further the development of the country. This issue unfortunately does not have a short term solution because the pro democracy advocates (generally Bangkokians), who are so keen to see everyone get their right to vote, also happens to be the ones who are most unhappy at seeing who gets voted in and will happily support a non democratic removal of such parties, for which the age old adage for Thai democracy still stands true, “The provinces votes into power a Prime Minister which Bangkok will inevitably kick out”.

Until more investment is put into education, this will not change and is also the fundamental issue that the Junta is facing in drafting a new constitution that will both satisfy Democracy advocates and those that want to see less corrupt politicians in power. The fact is that the previous constitution was perfectly workable except that it did not factor in the ability of someone who was rich enough to bypass its’ controls (in other words, it was not written with someone like Thaksin in mind). Consequently, the only other option is to appoint a Prime Minister and Cabinet, something which would not only make the Junta look no better than the previous government but would also probably cause some major dissent amongst the populous. On the other hand, if you polled voters even now, one of the more admired and desirable Prime Ministers from the past is probably still Anand Panyarachun, whom, as it happens, was an appointed Prime Minister. Damned if you do, damned if you don’t.

It will be interesting to see how the Junta will try to meander from promising full Democratic elections at the end of 2007 to promising a non (or perhaps less?) corrupt appointed Prime Minister and Cabinet. Although the current appointed Cabinet was actually quite well respected to start with, the recent misstep over Capital controls from the BOT (for which no one has yet resigned to take responsibility), the lack of activity (due mainly to the lack of experience in dealing with government matters from new appointees) and the rapid appointments of soldiers to boards and positions of power has somewhat toned down initial euphoria and support for the coup and the Junta. At any rate, further violence, disruptions and shuffles cannot be ruled out as both Junta and pro-Thaksin camps manoeuvre to negotiate a ‘settlement’, with both sides flexing their muscles to improve their leverage. In meantime, it’s probably not going to be too pretty for the Thai stock market.


Korea – Derating to continue?
Korea is another seemingly darling turned nightmare market for foreign investors with recent rulings over Lone Star’s Investment in Korea Exchange Bank (004940 KS) signaling potentially a more nationalistic and patriotic stance from the government. Foreigners have been exiting this market faster than you can say, well, Korea Exchange Bank. In fact, since the beginning of the year, foreign investors have net sold close to US$12bn worth of stock, the only stock market (in Asia) to see net outflow in 2006. Nevertheless, from my visits, Korean companies are, in my opinion, on the leading edge of manufacturing in Asia, and are difficult to ignore for pure absolute value. It’s just a shame that corporate governance and minority shareholder treatment is probably still one of the weakest in Asia. Still, I believe we will probably be doing a lot more work in Korea in 2007. I always find that the best value is quite often in places where investors are exiting (especially in a rush), not where they are heading to.

HK/China (and India) – Irrational exuberance?
As I had indicated from my previous memoirs, China and India are difficult markets to ignore given the enormous growth potential for both markets. In fact, our main gripe with China and Indian stocks are not the growth prospects but the valuations. In order to get exposure, we have to pay prices which will take 2-3 years to bring into reasonable levels, assuming current growth rate is sustained, something which is not only against the fund’s investment strategy but would also probably keep me awake at night. Still, that won’t keep us from digging, but don’t hold your breath.

Taiwan – Best Value in Asia?
Taiwan, at this juncture, given average PER valuations of 13x FY07 earnings against average EPS growth of 20% and dividend yield of 4.2% (vs 3.2% for Asia), is probably one of the best value markets in Asia. The only problem is that political risk for Taiwan remains high and a large proportion of the listed companies are technology related. Still, that’s not enough to put us off, and we’re probably going to be all over Taiwan in 2007.

I believe as we see a strong ASEAN growth story pan out, earnings momentum and revisions are likely to follow, together with more M&As, which should bode well for our portfolio, given our close to 87% exposure to the ASEAN market. However, 2007 will be a challenging year in my opinion and given where markets are now relative to 2006, it would not be a surprise to see a couple of repeats of May 2006 performances for Asian markets in 2007.

With close to 270 companies visited in 2006, we had great coverage over the past year and were able to unearth some real gems. Despite the strong performances in Asian markets so far, I continue to remain optimistic on our prospects for uncovering more under-researched gems as the rush for beta to play the momentum will leave a lot of ‘value’ stocks untouched, largely because liquidity is generally lower, market capitalization is smaller or purely because growth is not as sexy as the higher rate (but much more expensive) growth stocks.

I would like to leave you with a summary of our “stock recommendation sheet” (back by popular demand). I always like to think of the fund as an investment holding company, which incidentally, holds not only some of the most well known brands in Asia, but also globally. NTAsian provides an investor with unparalleled exposure to rising affluence and domestic consumption in Asia. At 9x FY07 and 7.8x FY08 earnings, NTAsian (NTASIAN KY Equity) is not only trading at close to a 40% discount to average Asian market PER valuations but is also growing close to 3-4x faster versus the Asian markets, in terms of EPS growth. You can’t find better value than that!

Another Global Warming Plug
With reports coming in now that China will probably exceed originally forecast emissions within half the time that was originally targeted (or potentially equal US emissions within the next 10 years), and that most countries, even those that signed the Kyoto Treaty, are unlikely to meet their emission targets, it is a constant reminder that there is a price to growth that is not purely monetary. For us, being on the frontier of investing in Asia, we feel strongly that we have a social responsibility to ensure that the companies we are investing in are fully compliant or working towards these goals and in 2007, will be working hard with our investments to meet these goals.

If you were one of our fund subscribers, you should have received the book, “An Inconvenient Truth” from us. We hope you enjoy it. It’s not totally accurate or scientific (after all, it’s authored by a politician!), but it’s an excellent introduction to one of the greatest problems that we are potentially facing as the human race. For those whose interests have been piqued and would like to learn more, I highly recommend “The Weather Makers: How Man Is Changing the Climate and What It Means for Life on Earth” by Tim Flannery. This is a little more technical but a superb book highlighting this issue and why this is a matter that will impact our generation. In the end, a point the author makes is most prescient, if you thought you had a disease which may or may not be fatal, but the doctor recommended you to take some medicine anyway as insurance, you probably wouldn’t think twice about doing something about it. Scientists may never fully be able to prove of the link between human caused emissions and global warming until it is too late, but why should we not take prudent steps now to avoid it, rather than finding out that they were right only when it is too late to do something about it.

Until next month. Happy New Year everyone!

No China No Grow

China part deux
As I wrote last month, it is tough to ignore China’s growth potential. So having come back dissatisfied from my previous trip to China, I went back to Shanghai to dig deeper. Delving further into the China story, we realize that China, is not like any other country in Asia. 138 major cities with populations ranging anywhere from under 1m to 20m people per city, we are literally talking about a “Continent”, not just another country. Case in point, the number of credit cards in China grew from practically zero to nearly 20m cards within a period of less than 2 years and is now growing at 1-2m cards/month. Even if credit cards in circulation were to grow at 100% p.a. for the next 3 years, it would still account for less than 20% of total debit cards currently in circulation. Interestingly, 99% of owners of the 900m debit cards in circulation use it only to withdraw money and not to buy goods. When you throw these kind of numbers around, no wonder credit card companies are plunging headlong into China.

Still, the key question remains how to invest profitably in this kind of climate. Property is always a good key indicator of wealth creation, and in Shanghai, property prices have been increasing on average 30% per year since 2002, and was up almost 200% in the past two years. However, recent attempts by the government to cool the property sector are starting to take some effect. How serious could things get? Very serious, according to Credit Suisse First Boston's Dong Tao, chief economist for Asia ex-Japan in Hong Kong. He reckons mortgages account for 40% to 50% of all bank lending in Shanghai and that Shanghai property lending accounts for a fifth of all mortgages countrywide. A Shanghai crash could slam China's already shaky banks. Property generated about one-quarter of Shanghai's 14.3% growth in gross domestic product last year. Moreover, while Shanghai accounts for just 5.4% of China's GDP, a crash could have a ripple effect. "It affects demand for materials and electronics, insurance and mortgages. It's the source of fiscal revenues and consumer confidence," Dong says. "If we see a major dip in Shanghai it will be a substantial risk to the national economy and the global commodity market."

Still that doesn’t seem to be stopping some investors. The Carlyle Group, one of the largest private equity investors in the world, just dropped US$120m for 110 villas in Shanghai. With rents in Puxi going for close to US$23.6/sqm/mth, average rental yields for these villas could come to 10% based on prices Carlyle Group paid for them. Still, that’s not quite the going price for prime Shanghai property for the ‘average’ millionaire on the street.

If you want a pad in the heart of Shanghai in one of the most exclusive developments in Shanghai, it’s going to set you back a cool US$6m, which works out to US$10k/sqm (fully furnished), or almost 3.5 times what Carlyle Group paid for their villas. Still there doesn’t seem to be a shortage of demand as all 15 units were sold out in the development I looked at…

Suffice to say, we will not be hurried into investing purely due to the strength of the market there so far but will continue to search for a direct China play which meets our investment criteria.

Vietnam is sizzling, but is it burnt?
On another note, another hot investment destination on everyone’s minds (and lips) is Vietnam, the second fastest growing country in Asia, after China. To put everything into perspective, the current market capitalization of the Vietnamese stock market is US$5bn and this is expected to increase substantially by 2010 (target: US$40-50bn, according to one of the largest funds invested in Vietnam). Valuations accordingly are not cheap. Based on consensus forecasts, the Vietnamese stock exchange is trading on an average PER of 15x FY07 earnings, against expected EPS growth of 11-12%. With the amount of money chasing limited investment opportunities in Vietnam, the market is already up around 100% YTD.

I personally prefer Indonesia
On the other hand, I want to highlight a less sexy but potentially more interesting and better valued alternative. For slightly cheaper valuations, investors can buy into Indonesia at 13x FY07 PER, and whilst Indonesia is trading in line with Asian FY07 PER (based on average PER valuations from our brokers), EPS is expected to grow by an average of 20% p.a. for the next two years, which is almost twice the average Asian EPS growth rate and almost twice Vietnam expected EPS growth rate for the next two years.

Although Indonesia is not expected to grow as fast as China or Vietnam in terms of GDP growth, note that in absolute terms, Indonesia will grow its GDP by US$20bn, which will be almost six times more than Vietnam’s expected +US$3.5bn for FY06. In the meantime, GDP per capita for Vietnam is still less than half of Indonesia. Based on similar principles, China will generate additional GDP of US$160bn for FY06, which is 8 times more than Indonesia’s GDP growth this year.

Looking at it in another way, as a corporation looking to target domestic consumers, their primary focus will not be so much on GDP growth but more on how much disposable income each consumer has in his/her pocket. If the average GDP per capita for a Vietnamese citizen is only US$633, a growth of 8% will only generate additional capita of US$50. On the other hand, if the average capita per Indonesian is US$1,263, a 6% growth will generate additional capita of US$76, theoretically a more attractive proposition given a population size that is also almost 4 times larger than Vietnam. In addition, I can’t imagine the cost of living for a low end worker to be substantially different in Indonesia versus Vietnam. So it is no wonder international consumer companies are drooling over the thought of the developing Chinese consumer, because GDP per capita there is expected to grow by US$138/person, and with a population size 4 times larger than Indonesia and who have GDP/capita of $1,728, almost 37% more than the average Indonesian.

Interest rates in Indonesia are falling the fastest of any Asian country, down almost 200bp since the beginning of the year to 10.25% with expectations for another 200bp by the end of 2007. With improving outlook, I expect signs of FDI to start picking up and as a result, together with a buoyant stock market, we can potentially see falling rates and a strengthening currency scenario, a bullish outlook for not only domestic demand, but also the stock market.

Given that we are a bottom up focussed fund, we didn’t waste anymore time in China (or Vietnam for that matter) and our second trip to Indonesia in the past couple of months yielded the latest addition to our fund, Arwana Citramulia (ARNA IJ). At 5.7x our FY07 forecast against expected EPS growth of 43.5% for FY07 and 30% EPS growth for FY08, our disappointment at not finding any suitable investment opportunities in China were more than compensated by our latest investment. Arwana, a low to mid end floor tile manufacturer serving the domestic market, the only one with multiple factories around Indonesia is a perfect play on rising consumer spending power in Indonesia. Transportation costs account for a large proportion of costs and having factories near customers is a key success factor for the company. Part of the reason for Indonesia’s slower than average GDP growth has been the fact that a lot of investments have centred around Jakarta. However, with the capital city accounting for only around 6% of the total population of the country, this was not going to be a sustainable growth proposition. Increasing investments into infrastructure to other parts of Indonesia will mean it’s only a matter of time before FDI follows, and more people in other parts of Indonesia can afford to tile their floors…