Bizarre Price Behavior amidst Painful Losses, Revenue Declines, Margin Pressures, Recessionary Markets
Persistently Serious Questions about Liquidity & Solvency
“There’s somethin’ happenin’ here
What it is ain’t exactly clear
There’s a man with a gun over there
Tellin’ me, I got to beware
I think it’s time we stop, children, what’s that sound?
Everybody look what’s going down
There’s battle lines being drawn
Nobody’s right if everybody’s wrong
Young people speakin’ their minds
Gettin’ so much resistance from behind
I think it’s time we stop, hey, what’s that sound?
Everybody look what’s going down
What a field day for the heat
(Hmm, hmm, hmm)
A thousand people in the street
(Hmm, hmm, hmm)
Singing songs and carrying signs
(Hmm, hmm, hmm)
Mostly say, hooray for our side
(Hmm, hmm, hmm)
It’s time we stop, hey, what’s that sound?
Everybody look what’s going down…”
- From the song ‘For What It’s Worth’ by Buffalo Springfield
Every once in a while a trade comes along that defies all macro-economic logic, market fundamentals, valuation metrics, technical analyses, and good old common sense.
Every thing you ever held sacred, sensible, and proper about – admittedly somewhat “inefficient” markets – is left thoroughly violated.
The third-largest French bank by market capitalization, Credit Agricole Group (EPA: ACA) (PINK: CRARY) is just such a study where laws of financial gravity don’t seem to matter.
Could Credit Agricole be an extraordinarily profitable “Short” trade?
You decide based on the facts discussed below:
Context: Treating a cocaine habit with more cocaine
Over the last few years, while their US and British counter-parts have continued to undertake drastic measures to restructure their operational and financial foot-prints, Eurozone banks have levered up even further by buying hundreds of billions of Eurozone periphery sovereign, corporate and consumer debt. This disastrous move actually gathered momentum in late 2011 on the back of the 1 trillion+ Euro LTRO facility offered by the ECB to these very Eurozone banks who, by Q4, 2011, had lost credibility in international money markets and were asphyxiating from a lack of dollar funding. Like all government interventions, what LTRO injections generated as an unintended consequence was it discouraged the technically insolvent Eurozone banks from de-leveraging their balance sheets off the hundreds of billions in bad assets that should have been sold, restructured, written down, or written off several years ago. Cut to the present, an already untenable situation of bank illiquidity has definitively (and perhaps irreversibly) morphed into an insolvency problem for banks feeding on their own region’s debt.
To quote an Octo 3, 2012 Bloomberg article on French banks:
“The investment-banking units of BNP Paribas SA (BNP), Societe Generale SA, Credit Agricole SA (ACA) and Natixis (KN) SA have 2.05 trillion euros ($2.64 trillion) in trading assets, including bonds, equities and derivatives, data compiled from the banks show. That’s a 21 percent jump in the 12 months to June and a two-year high, just shy of France’s $2.77 trillion gross domestic product.
Trading in derivatives for BNP Paribas increased 48 percent to 446.1 billion euros in the 12 months through the end of June. For Societe Generale, it rose 38 percent to 242.8 billion euros.”
Through the LTRO (Long-term Refinancing Operations: a real liquidity injection program) and now OMT ((Outright Monetary Transactions: essentially, a liquidity injection announcement to buy unlimited sovereign periphery bonds), what ECB has done is take in a cocaine addict into rehab and provided the patient with even higher doses of cocaine so it doesn’t go into withdrawals.
While the remedy for this patient was a combination of medicines that were bitter and painful and would have included:
a) restructuring irredeemable sovereign and corporate debt by letting errant financial institutions take the losses, i.e. debt forgiveness;
b) consolidating, closing and re-capitalizing insolvent financial intermediaries;
c) bring about gradual but strict fiscal discipline including change in policies as well as governance;
d) reforming inflexible labor markets to boost competitiveness;
e) privatizing inefficient and high-potential government assets,
f) and most importantly, letting the debtor nations exit the Eurozone to regain competitiveness through issuance of their own currencies.
By doubling down, however, a patient who could’ve been rehabilitated by Eurozone governments and the ECB is now terminally ill — and is about to die from off-the-charts toxicity levels (debt) that kept the patient even more high on cocaine than it was before coming into rehab.
Because it was politically unpalatable to let the Eurozone banks pay for their sins. The banks waved their considerable clout by pulling out the “systemically important” card.
And the troika (IMF, European Commission, and ECB) buckled.
Now, against this back-drop, let’s drill down to Credit Agricole’s health.
Fundamentals & Valuation: Heavy Things Don’t (and Shouldn’t) Defy Gravity
First, there’s the minor issue of solvency and leverage.
Despite being a heavily leveraged, highly unprofitable banking enterprise with subsidiaries and strategic investments in the choicest, most “eventful” of high-risk Eurozone markets such as Greece (Emporiki Bank), Spain (Bankinter), Italy (Intesa SanPaolo), and of course its home territory of France, this retail banking-focused group’s stock price has perversely undertaken a parabolic rise – up 80% since the lows of this year and 66% in the past six months alone.
Credit Agricole belongs to that rarefied top layer of a huge pyramid (oops, did I just say, pyramid…scheme) of financial services sector “Eurozone sinners,” i.e. French banks, that together account for the largest private sector balance sheet exposure to the so-called “Club Med” European periphery sovereign, public and private sector debt.
As early as the spring of 2010, The Economist estimated that French and German banks owned as much as 40% of all Eurozone peripheral debt that is estimated to run between 2 to 3 trillion Euro.
As per the 2011 Eurozone bank stress tests, exposures to just Greek debt among four French banks were:
- 1.7 billion Euro for BPCE,
- 6.6 billion Euro for Societe Generale,
- 8.5 billion Euro for BNP Paribas, and
- 27 billion Euro for Credit Agricole (roughly 150% of the other three French banks combined).
To quote Bloomberg on French banks’ total exposure to Greece vis-a-vis its German and British counterparts:
“French banks held $40.1 billion in Greek public and private debt at the end of June, or 55 percent of all foreign claims, according to data compiled by the Bank for International Settlements. German lenders had $5.5 billion in Greek debt holdings while U.K. banks held $5.6 billion, BIS data show.”
Putting the extent of French banks’ precarious situation in context, should the $40.1 billion of Greek debt be written off in an entirely realistic scenario were Greece to default in the coming months, such an “event” will wipe out at least 40% of the market capitalizations of France’s three biggest banking groups (BNP Paribas; Societe Generale, and Credit Agricole).
How much of that Greek debt’s been sold in the secondary market yet, and at what kind of write-downs is anybody’s guess today?
Coming down to balance sheet risk, Credit Agricole holds an eye-watering 136 times in assets (1.9 trillion Euro) vis-a-vis its equity value (13.9 billion Euro).
To quote Jonathan Weil, Bloomberg View columnist:
“Total assets at Credit Agricole were 1.9 trillion euros as of Sept. 30. Risk-weighted assets, however, were a mere 298.3 billion euros. In essence, we’re supposed to believe that 84 percent of Credit Agricole’s assets were riskless, even though that obviously is impossible.
For a more realistic capital ratio, take tangible shareholder equity (which excludes intangible assets such as goodwill) and divide it by tangible assets. At Credit Agricole, the figure was 1.4 percent as of Sept. 30, which translates into leverage of about 73-to-1.”
To make a mockery of Basel III compliance, Credit Agricole refused to provide visibility on its current core Tier 1 capital levels (as a reminder, Tier 1 capital ratio principally comprises of common stock and earnings v/s risk-weighted assets).
To quote FT:
“Mr Chifflet (Chief Executive) said the whole Crédit Agricole Group – the quoted entity and the regional banks – were on track to reach a core tier one ratio of 10 per cent by the end of next year (2013). The key measure of balance sheet strength is set at a minimum of 9 per cent under the incoming Basel III rules. The bank would not disclose a figure for the end of September.”
Credit Agricole’s latest press release on Credit Agricole’s website states that the banking group’s core tier capital ratio is 11.3 per cent at 30 September, 2012.
However, the Credit Agricole release goes on to say:
“The Group also reaffirmed its target of a fully loaded Basel 3 Common Equity Tier 1 ratio of over 10% by the end of 2013, above regulatory requirements, integrating the necessary buffer to be constituted as global systemically important bank (1%).”
So, the loaded question (pun intended) is, what does Credit Agricole Group consider as “fully loaded” Basel 3 Tier 1 ratio where the banking group is falling short right now?
How is this “fully loaded” calculation different and more conservative from the 11.3% reported by the banking group that the management is not even willing to disclose the group’s current standing on this metric?
Such efforts by management to deliberately obstruct and obfuscate the true state of the bank’s health is alarming, unhealthy, and frankly, can be construed as arrogant.
After all, last time I checked, French capital markets reside within an advanced economy where management is accountable to public scrutiny — be it from depositors, investors, regulators, media, or citizenry.
Moving on to impact on Credit Agricole’s earnings from its Greek unit:
Since 2008, Credit Agricole’s Greek unit Emporiki Bank has generated losses to the tune of 4.42 billion Euro, and another 1.28 billion loss in the first six months of 2012.
In the quarter ended September, 2012, Credit Agricole took a 2 billion Euro charge in order to let go off its disastrous foray into Greek banking through its subsidiary: Emporiki Bank. The Greek subsidiary was recently sold to Alpha Bank for the princely sum of 1 Euro, and the transaction is expected to close by end of 2012 (until its not). The deal could easily unravel if “Grexit” happens. In the event of a Greek sovereign default, Credit Agricole is expected to be on the hook for a number of contingent liabilities of Emporiki Bank (which would very likely go belly-up if “Grexit” comes to pass). In addition, to wash its hands off this cash-hemorrhaging misadventure, Credit Agricole has committed to a capital injection of 550 million Euro and convertible bonds worth 150 million towards the combined entity’s equity — which incidentally would be less than worthless because all of Alpha Bank’s equity owners (including Credit Agricole) would be on the hook for billions of Euro in additional liabilities should the combined entity come under stress or go under during the next Greek restructuring or outright default.
For all the rhetoric surrounding the banking group’s “adjustment plan” to de-leverage the entity off its massive balance sheet relative to its equity, let me quote Credit Agricole’s most recent press release about its enormous Q3, 2012 loss:
“The Regional Banks registered a 3.9% increase in revenues in the third quarter of 2012, while continuing to improve their loan-to-deposit ratio, which contracted to 126% from 127% at 30 June 2012 and 129% at 31 December 2011.”
A 300 basis point change over 3 quarters for a crucial chunk of the group’s business is hardly an “improvement.” Its the proverbial management fiddling away while Rome (or shall we say, Paris) is burning.
The press release is available here: http://www.credit-agricole.com/en/News/Press-releases/Financial-press-releases/Third-quarter-and-first-nine-months-of-2012
Quoting Bloomberg’s article on the bank’s most recently quarterly loss:
“Credit Agricole recorded a 572 million-euro writedown mostly on its Italian consumer-credit business, a 181 million- euro loss linked to its sale of CA Cheuvreux, and a 193 million- euro accounting charge on its stake in Spain’s Bankinter SA. Credit Agricole is selling Athens-based Emporiki for a token price of 1 euro to Alpha Bank, it said Oct. 17. The French bank will inject more funds into Emporiki, bringing the total capital boost since July to 2.85 billion euros, and buy 150 million euros of convertible bonds issued by Alpha Bank. Credit Agricole’s corporate and investment bank had a 302 million-euro net loss in the quarter, hurt by own-debt charges and the cost of selling CA Cheuvreux. Excluding one-time items, the division’s like-for-like profit fell 15 percent to 325 million euros, the bank said.”
The pattern that emerges from all of these exits is that these transactions are large, multi-hundred million Euro write-downs attributable to a de-leveraging process that can be described as nothing less than a “fire-sale”. It begs the question: When does a business let go off assets at such deep discounts to book value?
It is when the entity’s finances are so depleted that it is fighting for its life, i.e. solvency.
Then, there is the even more pedestrian issue of profitability.
To quote Financial Times:
“The French bank, which had prepared the market last month for bad news, reported a result that was about €1bn worse than expectations of a net €1.8bn-€1.9bn loss in the three months to the end of September, marking a sharp fall from the net profit in the same quarter last year of €258m. Revenues of €3.4bn were 32 per cent down on the third quarter of last year.”
Between Fiscal Year 2010 and 2011, Net Profits declined a staggering 72.4% from 4.09 billion Euro to 1.12 billion Euro. With 3 months to go in the current fiscal year (2012), Credit Agricole has recorded a net loss of 2.48 billion Euro thus far — and the full year numbers are likely to fall further for reasons discussed in this note.
Fire-sale of assets can be expected to continue as part of the bank’s “adjustment plan” — so more losses can be expected in the coming quarters. There’s no way out to profitability for the short-to-medium term.
Yet, what can only be described as an affront to the markets, the company is still contemplating whether it will pay out a dividend this year or not. You can’t make this stuff up.
To further quote Bloomberg on Credit Agricole’s investment banking activities:
Credit Agricole is also shutting its riskiest investment- banking businesses. The bank has stopped most of its equity derivatives and it has no proprietary trading activity, according to a Sept. 26 presentation. The lender is selling its brokerage CLSA to China’s Citic Securities Co. in a transaction valued at $1.25 billion.”
Of course, the worst is yet to come.
As the French economic indicators deteriorate (including 10% unemployment levels at a 13-year high), consumer and small business lending (Credit Agricole’s forte) will fall further in the coming quarters — which will in turn impact net interest income and margins. With deep and wide provincial exposure through its regional banks, Credit Agricole’s retail banking loan provisions are expected to rise significantly — much like their Spanish local lending counterparts or “Caixas”. So, one can expect both a top-line and a bottom-line contraction in the coming quarters for Credit Agricole as well as for its peers. Crucially, Credit Agricole is expected to be impacted much more than its other two large French banking peers since the other two (BNP Paribas and Societe Generale) do have more income diversification through investment banking and trading lines of business while Credit Agricole is well on its way to exiting.
To add fuel to fire, Francois Hollande, President of the French Republic wants to bring about a radical transformation of French banking sector with a view to ring-fencing riskier investment banking and trading activities from the more staid, low margin retail and commercial banking businesses. While the objective is admirable, the impact of greater (and no doubt more onerous) regulation and fragmentation of the French banking sector will raise the cost of doing business for French banks precisely at the worst time — thus putting liquidity, margin, and ultimately, solvency pressure on full service banks like the French triumvirate.
Speaking of margins:
Among its large banking peers around the globe, the bank’s lack of profitability (Net Margins) at -4.0% can only be matched by industry laggards like Lloyds Banking Group (-4.1%), UBS (-1.2%) and Morgan Stanley (-0.8%). These are, might I add, the most dilapidated homes in a bad neighborhood where several other troubled Eurozone peers are generating double digit profits. For example, Banco Santander (17.4%), BBVA (14.2%), Natixis (13.0%), BNP Paribas (11.5%), and Commerzbank (11.6%). Along that sliding scale, even other large European players are eking out single-digit net profits: Deutsche Bank (9.2%), Banco Popular (8.7%), Caixabank (5.5%), ING (4.1%), Societe Generale (3.3%), and Credit Suisse (3.3%).
Furthermore, at -5.2% Return-on-Equity, Credit Agricole is in the august company of “fallen angels” like Lloyds Banking Group (-2.2%), Royal Bank of Scotland (-6.9%), and Bank of Ireland (-9.1%) — each of whom required a full or partial government bailout wiping out much of existing shareholders’ equity.
Macro-economic Maelstrom: Tale of Five Fat Tails
The breathtaking disconnect between Credit Agricole’s stock value and ground reality is particularly accentuated by what is happening right at this moment on just the macro-economic front (without even getting into the Middle Eastern and Asia-Pac geo-political escalations):
S&P has recently downgraded French banks and put Credit Agricole on a “negative” watch.
Meanwhile, as the German and French economies enter discernible slowdowns of their own, how much political capital do the leaders have left to thrust on their citizens any more bailout guarantees (de-facto wealth transfers) from creditor Eurozone members to a growing list of debtor nations with yawning deficits just to keep the current face of the Eurozone intact?
France’s Southern European neighbor is dragging its feet on an ECB intervention through the OMT program while the Spanish provinces threaten secession as a bargaining chip to change the fiscal balance-of-power between the federal and state governments. At the same time, the Spanish continue to lose precious time as state government bailout aid fund is all but spoken for and more requests are on the way. Bad loan provisions at banks continue to rise, unemployment is hitting Franco-era heights, yields are artificially in control (on the OMT promise and CDS bans), and the socio-political climate is about to explode (with suicides and evictions tearing at the core of this already strained society).
The island’s banks are practically insolvent and this tiny Eurozone member is expected to seek a bailout of 20 to 30 billion Euro of its own — mostly to keep, what else, the country’s banks afloat and their rich Russian oligarch depositors liquid. While the bailout requirements are a small amount relative to the kinds of guarantees and disbursements already made by Eurozone members towards the likes of Greece, Ireland and Portugal, yet Cyprus might just end up beating Greece to the tape in the first full-fledged default of a Eurozone sovereign triggering an avalanche of bank-runs and defaults elsewhere in the Eurozone.
4. United States:
The 2012 sequel of the fiscal cliff-hanger starring President Obama and Speaker John Boehner has officially been released post-US elections. Regardless of the outcome, much drama is most assuredly going to unfold.
Of course, the big elephant in the room is Greece tip-toeing again to the brink of another restructuring cliff (pardon the mixed metaphor). This time involving OSI (Official Sector Involvement) aka hard restructuring or debt forgiveness, and possibly, another round of PSI (Private Sector Involvement) who have already been arm-twisted to taking hair-cuts before. Wonder, what their hairdo will look like before the Greek saga comes to its long-winded end. Credit Agricole will be one of the lenders most impacted by any further restructuring, re-profiling, and the like. To state the obvious: the huge and real social pain being exacted by the downward debt-deflation austerity measures is reaching boiling point.
The beginning of the end of the Eurozone (at least as we know it) is very near.
Any of the above risks may very well be the trigger for a downward re-pricing of most capital markets that leading economist and fund manager Marc Faber mentions as the impending 20% correction. Which is just as well, because the current gap between the financial and real economies is getting to breaking point.
Given the above tail-risks very much on the near-term horizon, does any responsible fiduciary, hedge fund manager or asset manager believe that Credit Agricole (or for that matter any other major Eurozone bank) needs to trade at or near its 52-week highs.
Strange Price Behavior: Good News is Good News; Bad News is Better
I do dozens of equity trades a month. Given my ‘Short’ position in Credit Agricole being my largest (long or short) in the portfolio, I have paid particular and real-time attention to its deteriorating fundamentals and its strange stock price behavior — particularly over the last two “eventful” months since the Draghi OMT announcement.
Having reflected on Credit Agricole’s price behavior, I can plainly state that the stock price is tone-deaf, impervious and idiosyncratic (in a not so healthy way) to the banking group’s astonishingly ugly and quickly deteriorating fundamentals — let alone — to the broader macro-economic and geo-political tail risks of a somewhat orderly Greek exit and subsequent disorderly Eurozone contagion; the rapidly contracting French economy and softening of the rest of the Eurozone core (Germany, Finland, The Netherlands, Belgium and Austria); the rising tensions in the Middle Eastern and Sino-Japanese conflict and of course; the forthcoming hairy, painstaking negotiations surrounding the US fiscal cliff.
Management’s lack of transparency regarding the entity’s current core Tier 1 capital ratio, and absence of a fair and conservative assessment of its risk-weighted assets, is further exacerbated by the fact that stock has recently been trading at or near its 52-week highs — almost in spite of the “short sellers” who have been trying to wake the markets up from their QE and OMT-induced stupor.
Upon touching a 52-week low of 2.88 Euro, the stock traded below 3 Euro for much of the summer 2012. Then, it started its somewhat inexplicably steep climb well before the ECB President Mario Draghi’s so-called “game-changer” announcement of OMT aimed at bringing peripheral Eurozone bond yields down to more manageable levels. Of course, it’s another story that a single shot is yet to be fired from Mr. Draghi’s OMT bazooka since the early September, 2012 announcement of buying “unlimited” peripheral Eurozone sovereign bonds against “strict conditionality”.
After the OMT and QE-Infinity announcements, the stock went off like a rocket comfortably piercing its previous 52-week high of 6.29 Euro and setting a new 52-week high of 6.55 Euro. Arguably, part of the near vertical stock price climb could be explained by a “short squeeze” of investors who bet heavily during the summer that the long-anticipated break-up of the Eurozone was around the corner.
Then, of course, came along the (un)expected wider-than-expected quarterly loss ending September, 2012 of 2.85 billion Euro for the group. The loss was merely greater by 1 billion Euro than the consensus estimate. Clearly, certain “recreational/medical” substances that were recently put to ballot in the US are already freely available and extensively used among the analyst community tracking this stock.
Guess what the stock did on this “earth-shattering” earnings announcement:
The young guns manning supposedly sophisticated artificially “intelligent” algorithmic trading machines initially had the audacity to fly off the handle (as is customary on most days), and take the stock higher than its opening price before reality began to sink in that, maybe just maybe in the face of this mind-numbingly large quarterly loss, this day was not a good day for such blatant exuberance toward the stock price — lest regulators get alarmed and other market participants feverishly start “raisin’ cane” about the issue. Ultimately, on the day of this spectacular loss in earnings, the stock traversed a downward trajectory of 11% of rather vigorous trading activity through the day, and then within minutes very large blocks of shares pulled the stock right back up erasing half the losses. Such moves don’t pass the smell test.
Is it a case of putting lipstick on a pig with exposure to the PIIGS?
On most other days, the stock defies gravity. There have been instances where the bank’s “high beta” price behavior puts Silicon Valley small cap tech and bio-tech stocks to shame — rising (and a few times falling) as much as 5 to 8% on an intra-day basis.
There seems to be significant amount of doubt and trepidation in the markets about the true and “fair” value of the stock.
Then, there are days when the stock’s high correlation breaks down vis-a-vis its two larger, better-capitalized, and profitable French banking peers: BNP Paribas (EPA: BNP) and Societe Generale (EPA: GLE). Predictably, more often than not Credit Agricole rises more than twice its two French peers or falls less than half vis-a-vis the other two. Such price action can mean one of two things: Either the market is placing greater value and confidence in Credit Agricole compared with its other two French rivals (hard to imagine). The other conclusion, obviously is, something smells fishy here. Imagination would come in handy as to who and why is behind such odd price behavior.
Yet another example, on Nov 7, 2012, the Bid price (5.90 Euro) was higher by 2.1 cents than the Ask Price (5.921) for a good 5 minutes between 3.25 pm and 3.30 pm GMT, while the algos were busy “blindly” buying trying to prop up the stock price. Such dissonance has become a regular occurrence with this stock.
Are those who are trying to prop the price of this stock over-playing their hand through their not-so-intelligent algos?
Could it just be that certain vested interests are working hard to deploy cheaply accessed capital towards bolstering shareholders’ equity — in the process boosting the bank’s Tier-1 capital ratio and magically transforming an otherwise insolvent and illiquid bank seem solvent, liquid, and even attractive?
Or is it that some large, powerful pools of capital are angling to gain from this speculative, high-beta play with a view that the French government will succumb to the “too-big-to-fail” card and back-stop the insolvency scenario for Credit Agricole?
Wouldn’t Mario Draghi, President – European Central Bank, be pleased to know that his LTRO-injected liquidity is being put to good productive use to prop up equity values of otherwise failed banks?
Surely, Joseph Schumpeter’s soul would be utterly amused that “creative destruction” of capitalism is being frustrated and obstructed right in his homeland: Europe.
In the face of all the performance issues, market challenges, and macro-economic risks, in whose vested interest is it to keep Credit Agricole’s equity price propped up at such a patently (un)fair value?
Conclusion: Welcome to The Twilight Zone!
Looking at Credit Agricole’s long list of cardinal sins that it is yet to seek recompense for, it still appears that management of balance sheet/solvency risk, liquidity risk, and event risks seems like a novelty for lesser, more conservative, and faint-hearted banking cousins at the lower tier of the Eurozone banking pyramid (scheme), and not for this historic French banking champion.
Its long list of “accomplishments” in banking over-reach and over-leverage can only be explained by the belief in certain investment management industry quarters that the banking group is systemic to the French economy, and therefore, it enjoys an implicit back-stop guarantee from the French republic. What such investors fail to appreciate (fully at least) is that such a back-stop would come with onerous costs. Nationalization and State intervention is a French tradition. Should the bank fail, current shareholders will get severely diluted or entirely wiped out. Junior bond-holders might follow close behind.
Quoting an October 25, 2012 Bloomberg article on France’s 60 billion Euro (thus far) assistance to its banking sector:
“PSA Peugeot Citroen SA (UG)’s troubled finance arm brings the state’s backing for the nation’s banks to more than 60 billion euros ($78 billion).
The government yesterday said it will guarantee 7 billion euros in new bonds by Banque PSA Finance, the consumer-finance unit of Europe’s second-largest carmaker. The aid comes on top of support for Dexia SA (DEXB), the French-Belgian municipal lender, and for home-loans company Credit Immobilier de France.
The French government is also providing a guarantee of about 28 billion euros to bolster Paris-based mortgage bank Credit Immobilier de France, or CIF, as it’s known.
France is already backstopping 36.5 percent of 73.5 billion euros of outstanding state guarantees on the debt of Brussels- based Dexia, which was the first victim of the sovereign debt crisis at the core of Europe. Belgium wants it to do more.”
These guarantees and capital injections cannot be generously dispensed ad infinitum without ramifications for France’s own credit rating. So, as the French fiscal situation becomes increasingly vulnerable, the spigots are to be turned off fairly shortly.
Investors beware. As leading Harvard and Stanford historian Niall Ferguson points out about empires, and I para-phrase: Collapses are never linear. Initially, they are slow and gradual and then they are swift and precipitous.
Against the above discussed macro-economic and micro-economic backdrops, to see Credit Agricole go nearly vertical in the last few months, no one will blame you if you thought you were in the yesteryears’ TV show: The Twilight Zone — where everything was topsy-turvy; everything was bizarre.
Ultimately, certain laws of financial gravity are inviolable:
1. We are the market.
2. Market forces are irrepressible.
3. All mis-priced assets have their day of reckoning; mean reversion is a reality.
Profit from this one.
“This is the end
This is the end
My only friend, the end
Of our elaborate plans, the end
Of everything that stands, the end
No safety or surprise, the end.”
- From the Song: The End by The Doors
Sources: BBC, Bloomberg, CNBC, Credit Agricole Group, The Economist, Financial Times, Google Finance, Marketwatch, Reuters, Seeking Alpha, S&P, Wall Street Journal, Zero Hedge.
A few salient reasons why Insurance Australia Group (ASX: IAG and PINK: IAUGF) is an eminently short-able stock:
The stock trades at 42 times P-E — which is 2 to 3 times as much as its peer group anywhere in the advanced economies; the stock is just plain expensive — both by global and Australian insurance sector standards.
To put things in perspective, on one end of the spectrum, there’s the American Insurance giant AIG (NYSE: AIG) that trades at 3.0 times P-E. On the other end of the insurance sector spectrum for a $1+ billion market cap insurer, there is Insurance Australia.
Even comparing insurers of similar market cap, the Dutch insurance provider Aegon (NYSE: AEG) trades at 12.0 P-E and generates revenues far higher than Insurance Australia (5 times as much in revenues to be precise). Intact Financial (TSE: IFC) — a Canadian insurer of similar market cap — trades at 15.5 P-E.
Whether it is Price-to-Sales or Price-to-Book or any other valuation metric, IAG is dearer than virtually any of its global or regional peers by a distance.
IAG’s Price-to-Sales Ratio is 0.98 vis-a-vis the global insurance industry average of 0.54. The company’s principal Australian peers trade at Price-to-Sales ratios of 0.79 for QBE (ASX: QBE) and 0.73 for Suncorp (ASX: SUN).
IAG’s Price-to-Book Ratio is 2.03 vis-a-vis the global insurance industry average of 1.19. For QBE, this ratio is 1.35 and for Suncorp: 0.83.
So, the company’s global and Australian peers command much lower valuations on both these metrics.
Infact, IAG’s Price-to-Tangible Book Value is a staggering: 3.5 vis-a-vis the Insurance industry’s Price-to-Tangible Book Value of: 1.0.
Net margins are very ordinary: 2.9% — which is discernibly lower than even its immediate Aussie insurance sector peer group: QBE Insurance (3.8%) and Suncorp (4.5%).
In essence, on a relative value basis, IAG offers no major industry-leading data point to justify its premium pricing.
As per data compiled by Reuters, IAG has a long-term debt-to-equity ratio that is nearly twice (38.2) the industry average (22.1).
Compared with a year ago, the insurer’s revenues have grown by 14.7% for the most recent quarter (MRQ). On the other hand, the company’s earnings have shrunk by 29.2% MRQ. Even on a trailing twelve month (TTM) basis, the company’s revenues have risen by 12.8% but its earnings have fallen 17.2% from A$250 million in FY 2011 to A$207 million for FY 2012.
Clearly, the markets are rewarding unprofitable growth. The company’s management would potentially defend unprofitable growth by stating that they have entered fast-growing emerging markets like Indonesia and Vietnam. But as one does more research, one learns that there is brutal price competition and a crowded marketplace for any new entrant to contend with in these Southeast Asian markets.
The stock has also made a dramatic run year-to-date for no apparent positive reason, up 41.2% where S&P/ASX 200 has risen only 6.7%. Meanwhile, IAG’s immediate Australian competitors have been trailing far behind with QBE Insurance (QBE) going sideways down -0.3% YTD and Suncorp (SUN) up 8.5% YTD.
Trading at A$ 4.25, the stock’s been breaching 52-week highs on a regular basis. It hasn’t seen such peaks since May, 2008. We all know what happened next to the global economy and world markets. There is little evidence to support its ascent except the company’s growth rates which have been driven by unprofitable expansion into a significantly more competitive insurance market such as the UK — where by the way, the company has stumbled. Due its poor performance, the company’s UK unit is under review for a possible fire-sale.
Australia’s fortunes are largely tied to those of the world — and particularly to those of emerging Asia. As growth rates stall or even decline in various parts of the world as well as in Asia, Australia’s steady, multi-year run of GDP expansion is poised for a reversal. As goes Australia (and to a lesser extent New Zealand), so goes Insurance Australia Group. As it is, the company’s ‘promising’ Asian operations only account for roughly 5% of the group’s revenues. The UK unit is unprofitable. So, for all intents and purposes, there is enormous ‘concentration risk’ in Insurance Australia’s business.
Of course, there are several other strong reasons to support the ‘Short’ thesis on IAG common stock but we can limit our initial assessment to the above.
The catalyst for the decline in Insurance Australia’s stock price will be the slowdown in the Australian economy that is already underway — which would have a chain reaction on the value and volume of policies issued by Insurance Australia — this would then, in turn, affect margins — and thus impact dividend payouts — until the institutions holding on to IAG’s stock begin to desert their positions seeking a steady yield elsewhere. That’s when the stock will begin to unravel.
How, then, can the high valuation and rising stock price of Insurance Australia be explained?
With a view to informing the readers of this blog of value (and sometimes, ‘deep value’) investment opportunities on a regular basis, I am launching this blog-stream that will offer up a few specific investment ideas.
Before I get into specific names, let me define ‘value’ as I see it. There are certain metrics which — either in combination or on their own – will qualify specific investments as deep value in my view:
1. P-E Ratio: Any equity trading less than P-E ratio of 10 or less.
2. 52-Week Trading Range: Any equity that trades within 25% of its 52-week low (in combination with the other metrics).
3. Dividend Yield: Any company that offers a Dividend Yield of more than 3% (in combination with the other metrics).
4. Positive Cashflow Entity’s Negative Event-driven Moves: Any cashflow positive company with net margins of 10% or more whose equity has seen more than a 20% price reversal within a week (in combination with the other metrics). Such equities are particularly well-suited for tactical, opportunistic, event-driven ’snap-back’ trades.
Now that we’ve defined ‘value,’ let us move on to the first edition of ‘value’ recommendations. In this edition, I would like to cover a few mining stories:
1. Vale (NYSE: VALE):
- The world’s largest iron ore producer trades at a modest P-E multiple of less than 6.0
- This Brazilian miner offers a generous dividend yield of 5.1%
- The stock is currently trading roughly 15% above its 52-week lows
2. Anglo American (PINK: AAUKY)
- This large, diversified global miner trades at a P-E multiple of a little over 7.5
- It trades within roughly 20% of its 52-week lows
3. Cliffs Natural Resources (NYSE: CLF)
- This American-headquartered miner trades on a multiple that is a little over 6.0
- It offers a healthy dividend yield of 3.5%
4. Barrick Gold (NYSE: ABX)
- The world’s largest gold producer trades on P-E of just over 9.0
- The stock is trading within 5% of its 52-week lows
5. BHP Billiton – ADR (NYSE: BHP / NYSE: BBL)
- The world’s largest miner trades both its ADR’s on NYSE below P-E multiples of 8.5
- Both of the company’s ADR’s provide a dividend yield higher 3%
In the coming weeks and months, more such ‘deep value’ investing ideas are to follow.
Barrick Gold: World’s Largest Gold Miner and Producer
With 140 million ounces of proven and probable gold reserves and 7.8 million ounces of gold production, Barrick Gold (NYSE: ABX) (TSE: ABX) is simply the world’s largest gold exploration and production company.
Much has been said about gold as a prime “haven” asset to protect against the global macro-economic and geo-political vicissitudes of our times. With its size, experience, expertise and resources, Barrick Gold is positioned extraordinarily well to capitalize on this theme of gold reigning supreme on world markets on a secular basis.
As of December 31, 2010, the company also held 6.5 billion pounds of copper reserves and 1.07 billion ounces of silver contained within gold reserves. In July, 2011, “Barrick acquired Equinox Minerals which adds a further 4.5 billion pounds of copper reserves from the Lumwana mine and 1.2 billion pounds of copper reserves from the Jabal Sayid project.”
To cite a few highlights from Barrick’s 2010 annual report:
- Record adjusted net income from $1.81 billion in 2009 to $3.28 billion in 2010
- Record adjusted operating cashflow from $2.90 billion in 2009 to $4.78 billion in 2010
- Increased dividend by 20% from $0.4/share in 2009 to $0.44/share in 2010
- Record realized price of gold from $985 per ounce in 2009 to $1,228 per ounce in 2010
- Industry’s only ‘A’ credit rating.
When it comes to profitability, using 2010 figures, Barrick generated operating margins of 42.1% and net margins of 29.4% — numbers that would be the envy of companies in any industry – including the basic materials sector. In 2011, the company’s performance has further improved. Its gold margins on a net cash cost basis have improved by an impressive 32% from a Q1, 2010 figure of $821/oz. to Q1, 2011 figure of $1081/oz. The company’s realized gold price has improved year-over-year by 25% from $1,114/oz in Q1, 2010 to 1,389/oz in Q1, 2011.
Infact, as we speak, Barrick’s Q2 results have shown a further improvement in net margins of another 500 basis points over last year’s results in a markedly slowing global economy.
While, at approximately $1800 an ounce, a section of the investment community may argue that gold is a “crowded trade.” On an inflation-adjusted basis, however, the precious metal needs to climb up to US$ 2300 to 2500 per troy ounce before it even reaches its all-time highs. So, at circa $1800/oz., we are nowhere near gold’s all-time peak yet.
Barrick Gold, at 13 times last year’s earnings per share, is still reasonably priced for being the world’s largest miner and producer of – arguably – the world’s most sought after commodity at the present time. So much so that, despite having better fundamentals than its competitors across a variety of metrics, the stock trades at a healthy discount vis-à-vis its peer group (except Newmont Mining which trades modestly lower than Barrick at 12.9 times trailing earnings; please read my previous post on Newmont Mining: here).
Here are a few valuation data for Barrick vis-à-vis its peer group:
Looking at the above P-E multiples, Barrick is trading at roughly half to one-quarter less than its smaller rivals such as Goldcorp, AngloGold Ashanti and Kinross Gold. On Price-to-Book and Price-to-Sales metrics, Barrick places well in the middle of the rankings versus its peers.
According to Ford Investment Research: “…Barrick Gold Corp.’s earnings have increased from $2.90 to an estimated $4.32 over the past 5 quarters, they have shown strong acceleration in quarterly growth rates when adjusted for the volatility of earnings. This indicates an improvement in future earnings growth may occur.”
What this also means is a positive momentum in the stock price of the company.
Crucially, from a shareholder’s perspective, the company improved its Return-on-Equity from 12% in 2009 to 19% in 2010.
Switching gears to industry challenges: One of the biggest issues facing the precious metals industry is the ability to replenish its reserves. Barrick Gold has done an admirable job in this department. In the company’s President & CEO – Aaron Regent’s words: “The Company has consistently replaced its reserves in each of the last five years, and we did so again in 2010. Gold reserves now stand at about 140 million ounces, the largest in the industry. In addition, measured and indicated gold resources grew 24% to 76 million ounces and inferred gold resources increased by 18% to 37 million ounces. Complementing our gold reserves and resources are 6.5 billion pounds of copper reserves, 13.0 billion pounds of measured and indicated copper resources and 9.1 billion pounds of inferred copper resources, plus 1.1 billion ounces of silver contained within gold reserves.”
So, one can safely assert that Barrick is doing a competent (if not a stellar) job in replenishing its reserves in a fiercely competitive, capital-intensive environment where transformational discoveries of new mines is more an exception than a norm.
What also, often goes, unnoticed is Barrick’s significant presence in the global copper market. While 4/5th of Barrick’s revenue contribution comes from gold, roughly 20% of its top-line comes emanates from copper sales. In a rapidly urbanizing world – particularly among the growth economies of Asia, Middle East and Latin America – copper will continue to enjoy robust demand across myriad industries from infrastructure to construction to electrical equipment, among others. Game-changing copper reserves, on the other hand, have not come online for a significant period of time. Hence, outlook for copper is bullish beyond the short-to-medium term window while the Eurozone sorts out its sovereign debt issues and the emerging economies take a breather from a decade long spate of high single-digit GDP growth.
In a period fraught with geo-political unrest in many parts of the world, Barrick enjoys a distinct advantage over other miners by having majority of its reserves and production capabilities located in politically stable parts of North America, Latin America and Australia/Pacific. Furthermore, its geographic presence is well-diversified to hedge against concentration risk as well as from a potential fall-out from “nationalization” of mining assets in any one part of the world.
Looking out into the future, the company is aiming for a gold production target of 9 million troy ounces by 2015. Assuming such production growth occurs on a linear basis, this target represents a modest increase of 300,000 ounces a year from its current level of 7.8 million ounces. The company is not resting on its laurels either; in order to continually strengthen its pipeline of reserves, Barrick’s 2011 exploration budget has increased to $320-$340 million.
Ultimately, Barrick trades in commodities that provide tangible sources of stability and security on the one hand (gold) and growth and development on the other (copper). So, whether one is bullish or bearish on the outlook for the global economy, at less than $50 a share, the stock is a “Buy” over the next 6 to 12 months.
Sources: Barrick Gold, Ford Investment Research, Google Finance.
Images Courtesy: Barrick Gold.
Brokerage: TD Ameritrade & Interactive Brokers.
Disclosure: The author plans to initiate a long position in the company’s stock within the next month. All data has been sourced from publicly-available sources.
What gold producer sells at 2 times book value?
Which global miner has the lowest beta among its peer group?
Which resources company trades lower than 12 times its earnings?
Newmont Mining — a Gold and Copper exploration and production company with mining operations spanning five continents around the world with “proven and probable gold reserves of 93.5 million attributable ounces, copper reserves of 9.4 billion attributable pounds” and an aggregate land position of approximately 27,458 square miles (71,118 square kilometers).
In 2010, the company had attributable gold sales of 5.4 million ounces and equity copper sales of 327 million pounds. Its recent acquisition of the Conga Project in Peru and Tanami Shaft Project in Australia will be adding “400,000 attributable ounces of gold and up to 100 million pounds of copper production per year” by 2015.
According to Newmont’s website, these were but a few highlights from the company’s performance in 2010:
- Record revenues of $9.5 billion, up 24% from 2009;
- Record net cash from continuing operations of $3.2 billion, up 109% from 2009;
- Gold operating margin increased 30% from 2009 on an average realized gold price increase of 25%.
Pick any one of those highlights and one can assume that the company being discussed is a growth company (with a momentum stock).
The stock, however, has been trading in a fairly narrow 52-week range of $50.05 and $65.50 with a P-E multiple that is more reflective of a value stock.
Is there a reason why it should not break out above its upper limit of the trading range?
According to Vickers Stock Research: “NEM pays an annual dividend of $1.20 which, at its current stock price, produces a yield of 2.16%. This is the largest of any company in the Gold & Silver industry, where the average yield is 1.56%…”
According to a company press release: “The third quarter 2011 dividend of $.30 per share (a 50% increase over $.20 per share for Q2, 2011) was declared in consideration of Newmont’s second quarter 2011 average realized gold sales price of $1,501 an ounce .”
In contrast, the company’s 2010 Gold Operating Margin is $737/oz.
At the time of writing this piece in late July, 2011, Gold has crossed the $1600 per ounce mark and is trading comfortably above that level. In a “risk-off” environment, when Gold keeps breaching its all-time highs on a regular basis, Newmont Mining (one of the largest Gold producers) deserves to enjoy a little more buoyancy in its stock than what it has experienced in the recent past. On the one hand, given its exposure to gold production, Newmont is poised to gain in a continued period of “risk-off,” de-leveraging global economy where fiat currencies are being debased across several major jurisdictions. On the other hand, even in a “risk-on” environment when Copper demand begins to soar again thanks to expansionary tailwinds in a rapidly urbanizing global economy, Newmont — being one of the largest copper producers in the world — is positioned to perform exceedingly well as a “long Copper” play.
At an operating margin of over 42% and a net profit margin of approximately 32%, Newmont is one of the most profitable minerals and metals producers — large or small — in the world. The miner enjoys gross margins that are more than 10% higher than its peer group. Furthermore, Newmont is sitting on cash and cash equivalents of more than $4 billion within an asset base of $25.7 billion.
Over the last 5 years, the company’s Earnings per Share (EPS) has grown a staggering 49.41%.
At a P-E ratio that is higher only to Freeport-McMoRan (FCX) within its peer group, Newmont is a “value” stock in a growth sector.
Kinross Gold (KGC), for example, trades at a healthy 16.37 its earnings and Goldcorp (GG) trades at almost twice as much as Newmont at a P-E multiple of 22.13. By the time one gets to AngloGold Ashanti (AU), one is looking at an unbelievable P-E multiple of 105.85.
Whether you look at Return-on-equity or Return-on-assets, Newmont ranks among the top 3 of its peer group.
Here’s a tale of relative value analysis that is as stark as it gets for companies that are delivering virtually identical numbers: The company that Newmont resembles most in terms of gross revenues, net profits, net profit margins, and a whole host of other metrics is Barrick Gold (ABX).
Exhibit 1: Profitability
Net profit margin
Here’s a rhetorical question: Which company is more profitable?
Exhibit 2: Debt
Long-term debt to assets
Total debt to assets
Long-term debt to equity
Total debt to equity
Which of these two companies is less indebted?
Exhibit 3: Returns
Return on avg assets
Return on avg equity
Return on investment
Again, which company provides a higher return?
Exhibit 4: Pricing
Finally, let us look at the all important metric of reserves:
As of December 31, 2010, Newmont had “proven and probable gold reserves of 93.5 million attributable ounces, copper reserves of 9.4 billion attributable pounds.” Barrick, on the other hand, had “140 million ounces of proven and probable gold reserves. In addition, Barrick has 6.5 billion pounds of copper reserves and 1.07 billion ounces of silver contained within gold reserves.”
Barrick has roughly 50% more gold reserves — which admittedly would allow it to command a premium over Newmont based purely on the metric of gold reserves. Gold, however, is not the complete story. When it comes to copper reserves, Newmont Mining has roughly 1/3rd more than Barrick Gold.
In a certain snapshot in time, if we consider valuations based purely on gold reserves (and silver within it), Barrick should be roughly 50% more valuable as a company. That said, given that Newmont has a third more copper than Barrick, it would recoup approximately 7.5% of the value back (adjusting for the price of copper vis-a-vis gold).
Here’s the clincher: With all these metrics where Newmont beats Barrick Gold consistently (except in the key metric of gold reserves), guess which company is more valuable (as of late July 2011)?
It is Barrick Gold at $47.54 billion.
And, what’s Newmont Mining’s market cap?
So, the market is placing 75% more value on Barrick Gold than it does on Newmont Mining. It is established, however, that even when considering mining reserves as a sole determinant of value, Barrick is a little over 40% more valuable than Newmont.
So, which company would you pick based on the above valuations? What company’s stock would have greater upside potential?
In conclusion, one can’t help but wonder: Is Newmont undervalued…by as much as 35% or more?
Seth Klarman: How’s that for margin of safety?
Michael Burry: Is this enough of a value stock for you?
Need one say (or question) more.
Sources: Reuters, Google Finance, Vickers Stock Research, Cooper Financial Research, Barrick Gold, Newmont Mining.
Disclosure: The author owns a long position in the company. All data has been sourced from publicly-available sources.
According to the company itself: “Vale is the world leader in iron ore and pellet production and the second biggest nickel producer.”
Coming out of The Great Recession, Vale (NYSE: VALE) is poised to gain from expansion of the manufacturing base — particularly in markets like China, India, Asia-Pacific, Middle East, and Latin America. The second-biggest miner in the world already, Vale has a growing global footprint of 38 countries with an exposure to most of the world’s high growth markets — not in the least its home country of Brazil.
Furthermore, there are very real geological and geo-political constraints on the supply of minerals Vale (or any of its competitors) can extract, process and sell on the world markets. This demand-supply dynamic has both secular as well as a cyclical themes interwoven. Hence, the global demand-supply dynamic for Vale’s products bodes well for the company’s growth prospects and profit margins for a long-time to come.
Vale is also showing an enormous appetite for bottom-line results with Net Profit Margin almost doubling from a 2009 margin of 21.6% to the Q3, 2010 figure of 40.9% . Even as of 2009, the company was only 310 basis points (in net profit margins) behind the industry’s most profitable of the large mining and metals companies: BHP Billiton.
Vale’s Net Profits are just as noteworthy because the Brazilian company generates revenues that are approximately half compared with another industry leader Rio Tinto — whose top-line figure for 2009 was US$ 41.8 billion compared to Vale’s US$ 23.3 billion. Yet, Vale’s 2009 Net Profits were US$ 5 billion compared with Rio Tinto’s US$ 5.8 billion — which makes Vale’s profits merely 15% less that that of Rio Tinto’s.
In light of the positive fundamentals, the company is on massive expansion drive with a planned capital outlay of US$ 24 in 2011 alone. To contextualize Vale’s ambitious growth plans, Xtrata — the Anglo-Swiss rival has planned capital outlays of US$ 23 billion over 6 years from 2011 through 2016.
There are — however — large, concentrated, inter-connected and material risks to Vale’s growth story. Two that are particularly noteworthy:
1. China, and
According to Vale’s 2009 annual report:
“In 2009, Chinese demand represented 68% of global demand for seaborne iron ore, 44% of global demand for nickel, 39% of global demand for aluminum and 40% of global demand for copper. The percentage of our operating revenues attributable to sales to consumers in China was 38% in 2009.”
If China slows down, Vale’s (and most metals and mining companies’) revenues and profits decline. Furthermore, the company’s heavy exposure to the global steel market makes it vulnerable to fluctuations in the fortunes of this industry — particularly from a downstream steel consumption perspective in industries like infrastructure, transportation, construction and real estate.
The annual report goes on to say:
“Iron ore and iron ore pellets, which together accounted for 59% of our 2009 operating revenues, are used to produce carbon steel. Nickel, which accounted for 14% of our 2009 operating revenues, is used mainly to produce stainless and alloy steels…The prices of different steels and the performance of the global steel industry are highly cyclical and volatile, and these business cycles in the steel industry affect demand and prices for our products.”
There are other lesser risks such as:
- Price volatility of nickel, copper and aluminum that are actively traded on global commodity markets;
- Capacity expansion gestation periods and consequent constraints to meet demand in the short-to-medium term;
- Geo-political considerations given that many of the mineral-rich countries have unstable political and regulatory regimes.
All that said, the company has a growing and diversified geographic market with 50% of its sales coming from the growing continent of Asia. Vale also has a swath of valuable mines being developed in resource-rich Latin America, Africa and Central Asia, among other mineral-rich locations around the world. Over several decades, the company has developed an extensive, defensible, and hard-to-replicate production and distribution capability — again with a global span. With the insatiable demand for basic materials in developing and frontier markets, Vale is a growth story based on strong fundamentals.
Not to mention, given the company’s healthy cash flow generation capability, Vale can be expected to pay out steady dividends in the forthcoming years.
As of December 3, 2010, Vale’s ADR (NYSE: VALE) traded at approximately 14.2 times earnings compared with its other global metals and mining peers’ ADRs:
- Rio Tinto (NYSE:RIO): 14.9
- BHP Billiton plc (NYSE:BBL): 16.8
- BHP Billiton Ltd (NYSE:BHP): 19.5
- Xstrata (LON:XTA): 29.1
- Anglo American plc (PINK:AAUKY): 40.2
Since I added Vale’s ADR to my simulation portfolio on Sept 17, 2010, the position has gone up by 23% in merely two and half months (as of Dec 3, 2010).
Moreover, it is a highly liquid ADR — consistently ranking as one of the highest traded ADR’s on NYSE.
The target P/E one could set for the ADR is a value of 20 times its earnings per share compared with its current P/E of 14.2. Even at a P/E of 20, it is worth “taking stock” (no pun intended) rather than sell-off the entire position.
Given Vale’s exposure to the twin forces of Brazil’s breathtaking economic expansion coupled with the insatiable global demand for minerals and metals that Vale produces, the company’s stock and ADR are poised for a significant upside.
In essence, Vale is really a “buy and hold” play over the medium-to-long run.
Disclosure: The author owns no stock of Vale and has written this research note purely based on publicly available information.
Volkwagen Group (ADR:VLKAY) or (ETR:VOW) is the most dramatic growth story of the automobile industry in the last half a decade.
With growing brands across a range of incomes brackets and geographic markets: Bugatti, Bentley, Lamborghini, Audi, Volkswagen, Seat, Skoda and Scania — the Volkswagen Group has a largely complementary portfolio of brands. These brands account for 198 models — something to please and satisfy most every customer on every continent in the world.
Of course, Volkswagen AG also is part-owned by the quintessential German sports car brand: Porsche. This relationship allows for a significant number of R&D, Product Development and Procurement synergies between the two companies.
The company has delivered a 12.4 percent rise in vehicle deliveries in first ten months to 5.98 million vehicles. The group delivered record number of vehicles in October, 2010 (growth of over 9.8% compared with the market’s 4.5%). That is twice as much as its industry peer group.
Audi: Vorsprung Durch Technik
The group’s premium brand, Audi, has demonstrated a growth rate of 16.4 percent year-over-year by delivering around 916,900 cars around the world between January, 2010 and October, 2010. It is well on its way to crossing the much vaunted ‘million vehicle’ mark by the end of this year. In high-growth markets like China and Asia-Pacific, the brand has seen blistering growth rates of 55.7% and 49.3% respectively (please see chart below courtesy: VW Group).
The group has announced a massive €51.6 billion investment drive for its automotive division over the next 5 years — investing a large portion of that sum in environmentally-friendly technologies. Four-fifths of it will be invested in property, plant and equipment helping it modernize its production capability and expand its turnover capacity. The company’s Chinese joint ventures will invest an additional €10.6 billion between now and 2015.
Infact, with their new planned investments, the group has a stated goal to surpass Toyota as the world’s largest manufacturer of auto-mobiles.
As of end of November, 2010, the group’s stock is trading at a multiple of P/E multiple of 12 compared with its peer group that is trading at least a third of the way higher:
- Daimler (ETR:DAI) is trading P/E of 17.5;
- BMW is at P/E of 17.7;
- Toyota (TYO:7203) is at P/E of 18.6.
When I first allocated the VW ADR to my simulation portfolio on Sept 10, 2010 it traded at US$ 19.71. As of close of trading on Nov 26, 2010, the stock is trading at $28.39.
That is a 44% return over two and half months.
Thanks to its rising brand strength and market penetration in the world’s fastest growing automotive markets, I believe there is plenty of growth in both the fundamentals of the company and its stock.
Disclaimer: The author owns no stock in the Volkwagen Group. He does, however, drive a Volkwagen Touareg and previously has owned a couple of Audis and stands by their build quality and performance.
This MINUTE could last you a lifetime: An investment thesis for a period of secular economic instability
We are living in times where a confluence of several secular and cyclical factors are resulting in a profitable rise of capital requirements for, and allocation in, the Materials, Industrials, Non-cyclicals, Utilities, Technology, and Energy (MINUTE) sectors.
“Well we know where we’re goin’ but we don’t know where we’ve been.
And we know what we’re knowing’ but we can’t say what we’ve seen.
And we’re not little children and we know what we want.
And the future is certain give us time to work it out.
We’re on a road to nowhere come on inside.
Takin’ that ride to nowhere we’ll take that ride…”
- Road to Nowhere by Talking Heads
The inexorable quest for “more”…of everything:
It is safe to assume, everyday, almost all of approximately 6.9 billion people wake up wanting more than they already have. Some aspire for more luxuries; others seek more necessities; a vast under-class, just struggles for more dignities.
Global commerce is an agile, pragmatic force transforming more and more lives than ever before. Thanks to the forces of globalization, we are witnessing a free-er flow of goods, services, capital, and people around the world. Also, largely thanks to globalization, every year tens of millions of people from a wide variety of emerging and frontier markets are joining the growing global mainstream of what broadly constitutes as “middle-class consumers.” This somewhat loose grouping of “middle income” consumers already constitutes roughly half of the world’s population.
More food is needed, produced and eaten. More clothes are bought, sold and worn. More property is being built and inhabited. More cars and trucks are being manufactured and driven. More oil, gas, coal and other conventional energy sources are being harnessed, distributed and consumed. More alternative energy sources are being discovered, produced and commercialized. Trillions of dollars of roads, railways, power plants, transmission networks, dams and bridges are being built and utilized. More paper is being used…and forests felled. More minerals are being mined, processed and used in a wider variety of industrial and consumer applications. More manufacturing is being done and absorbed – on a net global production basis.
It is an insatiable, inexorable quest for more…and more…and more from a planet that has its very real physical limits.
Resources are limited.
Demand is rising. Supply is not. In fact, supply is diminishing for a wide variety of natural resources.
It is that simple.
The real, the tangible, the substantial: The World is Pyramidal
Imagine Maslow’s hierarchy of needs represented in a world that isn’t round, ovular, or even flat.
The world is a four-dimensional pyramid of time, population, demand, and supply.
Due to the enormous pressure on resources owing to a rising global population and various other sub-plots, our times are characterized by exceptional change or instability underpinned by the triumvirate of: uncertainty, ambiguity, and complexity.
What is also undeniable is: because of – or in spite of – globalization, the individual or family is much more disconnected from a social support structure. During earlier times in more settled communities, this support structure was taken for granted. With professional certitude and financial stability petering out, the individual or family is much more vulnerable to the financial consequences of the high-velocity change we experience today and can anticipate to experience for the foreseeable future.
By mixing in the notion of rising demand and declining supply of natural resources, the concoction we have is a period that harkens back to our pre-historic ancestors’ times of operating in a hostile, uncertain, ambiguous, high-risk, constantly-evolving environment.
It is only natural that a Darwinian “survivalist” instinct kicks in among us to seek safe havens.
Investors are us: You and I.
Quite obviously, our investment decisions are not disconnected from the complex interaction of our personal, social, economic, and financial imperatives and choices.
Therefore, what we find is a seamless connective tissue between our psychological makeup which may be in “survivalist” mode and our investment bias to seek a real, tangible protection from the real, intangible economic storm. It is this quest for the real, the substantial that has Gold breaching record highs on a regular basis. Silver is at a 30-year high precisely for the same reason. In a period of secular uncertainty and instability, Gold can be expected to continue to hold its status as the ultimate haven of safety and trust. A haven that has stood the test of time for its ability to act as a reliable medium of exchange and as a store of value (or wealth). Gold has also, unsurprisingly, held its purchasing power over several thousand years of human commercial history. It has, and continues to be: rare, valuable, and tangible.
Due to demand-supply constraints, prices for most commodities are on a secular upwards trajectory anyway. What, however, we are witnessing is something much deeper and more primordial. We have begun to witness a global, long-term, broad, social, “survivalist” quest (beyond just the investment world) for the physical security of the real, the tangible and the substantial.
This survivalist quest is a pragmatic quest.
Manifestation of individual and societal “tail” risks; particularly of the “fat” variety:
The quest for financial security and a steady income at the expense of higher-risk, dividend income (or capital appreciation) is the underlying driver for fixed income security markets booming in most parts of the world.
Baby-boomers in many ageing, developed economies of the West have had multiple setbacks in regards to their retirement savings and entitlements over the last decade. At the start of the millennium came the dot-com bust, shortly followed by the 9/11 attacks and the collapse of financial markets with a deep, ensuing recession. Barely recovering from that shock, the Credit Crisis came bringing along with it the worst recession since the Great Depression.
As a result, a significant number of boomers have seen their nest eggs shrink just at the time when they have been made redundant or have had to accept lower paying positions with fewer benefits.
Hence, the need of (and pursuit for) income security, reliability, and predictability is only going to strengthen in the coming years.
Leading up to the Global Financial Crisis, trillions of dollars worth of “intangible” securities had disastrously evaporated into thin air. During the ensuing global “Credit Crunch,” we were all rudely awakened to the notion of “tail risks,” i.e. Risks that lie outside the confidence interval of the expected range of outcomes on a normal distribution curve. Nicholas Taleb’s “black swans” do exist. In its aftermath, The Great Recession has also illustrated how our inappropriate or inadequate intervention (e.g. not intervening to save Lehman) of regular tail risks can allow them to morph into “fat tail” risks – unleashing a set of devastating, systemic, and inter-connected outcomes in what has come to be called The Great Recession.
Even if “fat tail” risks do not actualize (or not as severely or frequently as in the recent past), our time is still to be characterized by an acute awareness of the possibility of tail risks in general, and “fat tail” risks in particular. Whether at the micro-economic (individual and family) level or at the macro-economic level, the notion of tail risks can be expected to play a significant role in the economic lives of nations, going forward.
A future flush with capital: Sovereign Indebtedness & Fiat Currency Debasement
Post-Global Financial Crisis, whether due to genuine commitment towards the welfare of their constituents or due to political expediency or some combination thereof, governments (particularly developed economies) have demonstrated a renewed sense of purpose to generate employment by investing in “energy security” and “infrastructure upgrade” projects for their respective economies. These investments are expected to be made through various fiscal measures such as:
a) shifting budgetary priorities away from defense, space and entitlements to sectors like energy and infrastructure projects,
b) launching deficit spending measures to invest in new infrastructure projects, and
c) raising taxes as well as growing the tax base, among other measures.
The ironic upshot of the Global Financial Crisis is to add more fuel to the fire that created all the havoc and instability in the first place. Further loosening of monetary policy and expansion of sovereign credit have been used as levers to stimulate economies out of the “credit crunch” that resulted from a crisis of confidence in the financial markets — which to begin with — was induced due to lax and expansionary monetary conditions sustained over an extended period of time. Since the Great Recession began, central banks across most of the developed, and several of the consequential emerging markets, have progressively eased interest rates to near zero. In fact, the prospect (and reality) of additional rounds of quantitative easing by central banks has been another favored recipe to further increase money supply in the global financial system.
Quantitative easing (or sovereign debt and other fixed income asset purchases by central banks through new fiat currency issuance) can continue for some time before inflationary pressures start to seep in to the real economy. As these sovereign credit purchases by central banks expands their balance sheets, ever larger proportions of their respective treasuries’ revenues have to go towards servicing this debt. As the costs of servicing this debt grows, the central bank has to print more money. It becomes a vicious circle.
In essence, all that such quantitative easing measures are doing is to leave sovereign treasuries more indebted, fiat currencies more debased, and asset prices inflated (primarily in nominal terms).
Asset price inflation is, however, very real for the ordinary citizen on Main Street. The component of asset price inflation that is over and above nominal levels owes its increases to rising demand for these assets by a growing number of consumers around the world. Further, one can argue that the “real rate” of inflation, based on fundamental demand-supply dynamics, is also magnified by market speculators betting on directional moves on asset prices thanks to the cheap money available within the financial system. As cheap money floods in from the financial economy to the real economy, the increasingly “financialized” world has begun to show ominous signs of expansive, unintended consequences being unleashed upon the broader society. The Global Financial Crisis, that began to show its first material consequences on the world economy in 2007 (and most will argue is still underway), can be expected to be only the first of many global “events” that will send shock-waves across the global economy for years to come before some sort of global “reset” will have to occur when the collective pain of the debtor nations and corporations gets too unbearable to prolong any further.
Private sector credit creation: A growth imperative for banks in a de-leveraging environment
Meanwhile, proprietary trading is on the way out for the money center banks and investment banks. Therefore, fee-based investment and corporate banking will become ever more consequential for generating profits for these institutions. This reduction and eventual evaporation of trading revenues will entail an aggressive pursuit for increasing lending and underwriting activities among the banks. We are entering a period where, on the one hand, there is a concentration of capital in the financial economy among the hands of relatively few banks. On the other hand, there is diffusion in the real economy where innovation happens and jobs are created. Hence, despite the enormous monetary stimulus programs rolled out by governments, bank lending has tended to remain tight and expensive to a majority of businesses. At some point in the imminent future, however, all the build-up of excess liquidity on bank balance sheets will have to be put to work in the real economy. At that point, despite Basel III compliance obligations, there is a likelihood of banks and other lending institutions expanding their loan books and loosening their lending requirements to win business.
In addition, non-bank, private sector players such as private equity firms, asset management firms and hedge funds are also expected to pursue their profit motive in this new phase of monetary expansion.
Inorganically created trillions of dollars of capital (fiat currency) is about to chase limited real resources and organically growing investment opportunities. The result: value of “hard stuff,” i.e. real, tangible assets (metals, commodities, natural resources, plants and machinery, infrastructure and real estate) is to grow over a secular trend line for the foreseeable future – albeit with a higher degree of volatility. The “hard stuff” also can be expected to out-perform the “soft stuff” (Software & Technology, Media, Entertainment, many parts of Financial Services, Hospitality, and other Services sectors, among others).
Hence, most of the world’s reserve currencies (US Dollar, Euro, UK Pound Sterling) are to come under pressure in this monetary expansionary environment.
Most currencies, in this period, can be expected to face a downward pressure but a few are also likely to stay resilient or appreciate due to the “flight to safety” phenomenon or because they belong to countries that are net exporters of raw or finished goods and services. Currencies that can be expected to strengthen are:
- currencies that have sound macro-economic fundamentals and fewer, more insulated fiscal and monetary variables to contend with (Swiss Franc, Swedish Krona); or
- currencies that are issued by large net exporters of natural resources or finished goods (Canadian Dollar, Australian Dollar, Brazil Real, Russian Ruble, Norwegian Krone, Chinese Renmimbi, Korean Won).
Pursuit of yield and the resulting fixed income bubble:
It may not seem like there is a profusion of liquidity in the general economy, yet the waves of capital are building up around the world and liquidity has already begun to creep into certain parts of the global economy such as a wide array of fixed income securities and emerging markets equities.
There are already signs of a bond bubble building up on the horizon.
Furthermore, central banks around the world are likely to continue to sustain a posture of extremely low interest rates to promote an increase in money supply thereby making a tight lending environment an unattractive proposition for banks and non-banking financial institutions. Government and corporate borrowings, on the other hand, will become ever more attractive to lending institutions’, corporations’ as well as institutional investors’, burgeoning balance sheets. The “promise” of a long-term steady yield would aggressively chase down returns in an otherwise uncertain environment. Therefore, fixed income instruments – whether sovereign debt, municipal bonds, or investment-grade (even high-yield) corporate debt – will increasingly become popular in this environment. Popularity, however, is not going to ensure high returns. Risk of a strengthening investor bias towards bonds is very real. Spreads – between high-grade and the enlarging pool of high-yield (aka junk) bonds – is expected to grow. Spreads – between fiscally austere and responsible governments vis-a-vis spendthrift economies, states and municipalities – is also expected to widen.
In pursuit of yields, investor appetite for high-yield fixed income securities has reached enormous proportions. This ravenous demand for high-risk fixed income securities, so recently after the Great Credit Squeeze, does not seem to abate even when it comes to high-risk sovereign debt such that of countries like Greece, Spain, Ireland or Portugal.
It is for the same reason why even the convertible bonds asset class can be expected to perform better than pure equities across many industries – particularly, the services-oriented industries. It follows that various forms of capital structure arbitrage opportunities are expected to present themselves in abundance during this period of dislocation and change.
It is in this setting that large, old-world behemoth corporations with steady cash flows and dividend payouts are expected to gain investor favor in the equity markets.
It is also noteworthy that, in early autumn of 2010, various Central Banks are still trying to fend off deflationary pressures both in word and in action – across many parts of the developed world.
The Fed, for example, is indeed in a fix. On the one hand, the US economy remains sluggish despite interest rates near record lows inching closer to zero. On the other hand, unemployment rates continue to trend upwards over – what can now be considered – a secular trajectory rather than a cyclical one.
Safety is the theme du jour: Defensible (not necessarily just defensive) industries that get “hands dirty”
So, how can we confidently utilize the above analysis to:
a) preserve capital;
b) grow capital.
It is quite straight-forward, really.
One way is to listen to what legendary investor Jim Rogers professes in terms of the merits of investing in “hot commodities.”
What companies would benefit from the “hot commodities” theme?
Metals & Basic Materials Producers: BHP Biliton (NYSE: BHP), Rio Tinto (NYSE: RIO), Vale (NYSE: VALE), Newmont Mining (NYSE: NEM), Barrick Gold (NYSE: ABX), Freeport-McMoRan (NYSE: FCX), Vedanta (LON: VED), Xstrata (LON: XTA), and so forth.
Energy Producers: Chevron (NYSE: CVX), ConocoPhilips (NYSE: COP), Exxon Mobil (NYSE: XOM), LUKOIL (PINK: LUKOY), Petroleo Brasileiro (NYSE: PBR), Royal Dutch Shell (NYSE: RDS.A), ENI (NYSE: E), among others.
What is noticeable is that a commodities boom will entail alternating cyclical demand for “risk on” assets such as oil, coal, gas, copper, etc. on the one hand and for “risk off” assets such as gold on the other. From a secular growth perspective, however, we are already in the midst of a bull run for both “risk on” and “risk off” commodities.
Capital flows, and consequent capital appreciation, can be expected to occur in miners, producers, harvesters, distributors and traders of commodities. We can fully expect for producers and manufacturers of consumer staples (particularly those with a global reach), basic and intermediate materials, and various energy sources — to see a significant increase in capital allocation as well.
In a multi-year period of de-leveraging across some of the highest consumption-driven (developed) markets, consumer staples can be expected to remain one of the few relatively stable sectors of the economy. Within the food and consumer staples space, companies like Kraft (NYSE: KFT), Nestle (VTX: NESN), General Mills (NYSE: GIS), ConAgra (NYSE: CAG), H.J. Heinz (NYSE: HNZ), Syngenta (NYSE: SYT), Monsanto (NYSE: MON), Bunge (NYSE: BG), and Archer Daniels Midland (NYSE: ADM) are likely to do well during this period. If agricultural commodities traders such as: Glencore, Cargill, and Louis Dreyfuss go public, they would be an attractive companies in which to buy equity as well. Their debt would also be an attractive way to gain exposure to the “food security” theme. Companies like Proctor & Gamble (NYSE: PG), Unilever (NYSE: UL), Johnson & Johnson (NYSE: JNJ), among others are expected to show resilience in the consumer non-durables space.
Our times, however, are not just characterized by rising values of “hard assets” such as: physical commodities, basic materials, and energy sources. Our times are not just about molecules found in nature. Our times will also re-discover the value of hard-to-replicate, “get your hands dirty,” industries like: infrastructure, industrials, utilities, telecoms, distribution and transportation.
The Industrials (Building Materials Suppliers, Construction and Heavy Equipment Manufacturers, etc.) would be attractive investment destinations. Leaders in this space will continue to demonstrate their dominance: Alcoa (AA), Lafarge (LFRGY), ArcelorMittal (MT), POSCO (PKX) are all positioned well to benefit from global growth in infrastructure and real estate development — particularly within emerging and frontier markets for years to come.
Utilities and Distribution industries would benefit from a “flight-to-safety” phenomenon. They would also be viewed as defensible businesses that are hard-to-replicate overnight. Utilities like Pacific Gas & Electric (PCG), E.ON (EONGY), RWE (ETR: RWE), GDF SUEZ (GDFZY), Gas Authority of India (532155) are bound to perform well in an environment of rising energy consumption and high barriers-to-entry for a new energy producer/distributor to replicate the extensive production, distribution and transmission network that these enormous utility companies have laid out over decades.
The Tech (and Telecoms) sector can be expected to retain resilient levels of demand and investment.
In a world of rising telecommunications usage coupled with dramatic adoption rates of first-time users in vast expanses of the developing world, those companies which have a head-start in their respective telecoms (particularly mobile telephony) markets are poised for significant upside. Examples that come to mind: Bharti Airtel (532454), Reliance Communications (532712), Brasil Telecoms Participacoes (BRP), VimpelCom (VIP), Turkcell (TKC), Vodafone (VOD), among others.
In each of the above mentioned sectors, the companies (and their securities) of the following types are expected to do well:
- clear and diversified market leaders, or
- the ones which have significant exposure to emerging or frontier markets, or
- the ones with dominant or monopolistic rights over raw materials, or
- those which are well-managed, low-debt, low-cost structures.
Fundamentals of companies in the ‘MINUTE’ space will point toward the best-performing equities and corporate debt — as long as — their securities are not over-priced vis-a-vis classic valuation metrics.
Fundamentals, at the end of the day, will differentiate the winners from losers even in the highest-performing sectors.
It is against this backdrop, that investors can generate superior risk-adjusted returns by investing in industries encapsulated within the ‘MINUTE’ theme.
“Welcome to your life
There’s no turning back
Even while we sleep
We will find you
Acting on your best behavior
Turn your back on Mother Nature
Everybody wants to rule the world
It’s my own design
It’s my own remorse
Help me to decide
Help me make the
Most of freedom and of pleasure
Nothing ever lasts forever
Everybody wants to rule the world…”
- Everybody Wants to Rule the World by Tears for Fears
Power Shift from West to East: Potential for Trade Disputes, Currency Wars and Protectionism
These are times characterized by structural changes in the global economy as the clichéd economic weight of the world shifts back from the West to the East (for fifteen of the past eighteen centuries, such has been the status quo).
These structural changes have only accelerated since the Global Financial Crisis.
Since the ensuing Great Recession, United States – the wealthiest country in the world – has now approximately one in five of its citizens living in poverty. Unofficially, 16% of the workforce is unemployed or under-employed. United States continues to run enormous trade deficits vis-a-vis China. China is buying American treasuries and United States is buying Chinese consumer products. As of now, it is in both countries’ interests to continue this policy of “mutual engagement.” The situation, however, is untenable.
Hence, the question is: Who will blink first?
Meanwhile, the UK is squeezed from many sides: rising unemployment, surging entitlement requirements, declining tax revenues, increasing need for economic stimulus, falling industrial competitiveness, and a general economic malaise. The country has elected its first right-of-center government (with a leftist coalition partner) in over a decade that is pushing through sweeping austerity measures to curb its out-of-control budget deficit.
Portugal, Ireland, Italy, Greece, and Spain are all dealing with enormous fiscal problems threatening the very existence of the European Monetary Union. There is a good possibility that we have not heard the last or the worst of the Greek fiscal woes or the Irish banking crisis. Default from either one of them cannot be ruled out.
Even hitherto fiscally robust economies like Austria and Belgium, are showing signs of economic strain.
The historically liberal, left-leaning post-World War II Western Europe seems to be building up a rising appetite for anti-immigration, right-leaning, populist tendencies. Nationalistic, anti-immigrant sentiments are beginning to manifest in electoral politics as well as in government policy across liberal and/or socialist heartlands such as France, Germany, Sweden, Denmark, and The Netherlands.
All of these are developed economies. All of these are some of the wealthiest societies in the world.
In this environment, overt or covert forms of protectionism are only a matter of time. Such protectionism, however, tends to help those industries more which are resource and labor-intensive — where jobs cannot be exported over a broadband connection. On this go around, however, there are fewer manufacturing jobs to protect in the West. As it is, the global manufacturing supply chain is extraordinarily intertwined where the component suppliers may be head-quartered in China, Taiwan, Malaysia, Indonesia or India. The final, branded consumer product, however, is – more often than not – designed in the US or Western Europe. Import tariffs, therefore, are not likely to trigger significant changes in global trade flows until and unless, the West brings about structural changes in its economies to support indigenous manufacturing to compete with cheap imports from Asia and elsewhere — particularly, those imports that are more competitive due to lower cost structures as well due to artificial currency depreciation. Any such structural change itself would take at least a generation to show marked effects in global trade flows.
The Eastern governments, for their part, would have to stop (or at least reduce) meddling with their currencies in order keep their exports artificially attractive in global markets.
Meanwhile, the currency row between the US and China is not just indicative of a growing tension between the Western (consumer) economy of the US and the Eastern (producer) economy of China. This currency row is a thinly veiled manifestation of the power struggle and transition we are witnessing from the West to East.
Ultimately, societies that “create” stuff (largely the West) should have more leverage than the societies that “make” stuff (largely the East). Intellectual property rights, however, cannot be as directly and completely measured, enforced and monetized as manufactured value addition. Hence, the West is being viewed as more profligate and less productive than the East and vice versa.
In fact, in very real terms, global trade and savings imbalances are partly due to this very phenomenon where the West is not being compensated in full — for its innovations in hi-technology, bio-therapeutics and conventional medicine, automotive, aviation, distribution and logistics, financial services, media, telecommunications, among other industries. The West is doing the innovation “heavy-lifting” only to see the East create a cheaper, faster, more mass-market version of the product or service that is sold across the globe without much (if any) financial compensation or intellectual acknowledgement offered to the original Western innovators of that product or service.
Meanwhile, the East is now beginning to move up the innovation value chain where it may, increasingly not only produce the products and services of the future, but may also originate the innovations of tomorrow.
As this shift occurs, power will be transitioned — from the West to the East – much like before in the history of civilizations in spasmodic, discontinuous bursts of instability and discord (if not all out combative military interventions or wars).
Global scarcity of resources, birth of new nations and a period of secular economic instability:
Historically, the world has dealt with scarcity for most of its existence. Make no mistake, despite armed conflicts in the past several decades not being as devastating or multi-lateral as World War II, the quest for resources continues to intensify among nations. In fact, one can argue that beneath all the cultural, religious, and linguistic differences that are offered up as the key bases for the independence struggles of various minorities, the central (although not always overtly stated) raison d’etre for new countries being carved out of existing ones is the notion of safeguarding ancestral, “sovereign” economic interests of a minority residing in a resource-rich territory within an existing nation.
Right from the mid-twentieth century – when former South Asian British colonies became independent as India, Pakistan, East Pakistan (later Bangladesh) – the pursuit of economic self-determination has been as much a factor as the desire for political autonomy or social equity and liberty in all independence struggles. Obviously, such a dynamic is not uniquely pertinent to the British empire either, the French relinquished their control over Indochina to give birth to three new nations for a similar set of reasons – Vietnam, Laos, and Cambodia.
Self-determination of political, social – and crucially – economic interests was the common thread across the founding fathers and the indigenous populations that catalyzed the break-down of the Soviet Union. Since the Communist union’s dissolution, a slew of new nations (many of which resource-rich) have come into being: Russia, Ukraine, Moldova, Armenia, Azerbaijan, Belarus, Estonia, Latvia, Lithuania, Georgia, Kazakhstan, Kyrgyzstan, Tajikistan, Turkmenistan, and Uzbekistan.
East Timor became independent a few years ago fuelled by its quest for religious, cultural and economic freedom.
As a matter of fact, there have been rumblings for independence in resource-rich Kurdish Autonomous Region of Northern Iraq (popularly known as Kurdistan) for quite some time. Yet another example of economic drivers playing a significant part in seeking autonomy and independence, many in the Flemish region of Belgium want to separate from Wallonia – in large part, due to the economic disparity and dispensation structure of state-provided welfare benefits.
North and South Sudan may go their separate ways as early as January 2011. In addition to all the ethnic violence that has culminated in the proposed referendum for independence, South Sudan sits on over five billion barrels of proven oil reserves. Economics, again, becomes a critical consideration.
If we peel all the layers of the onion, as it were: Through the centuries and across geographies, the ongoing march of societies staking claim to resources they consider are rightfully theirs, has led (and continues to lead) to conflicts.
We are entering an era where, again, the quest for basic resources is expected to form the basis for many a major and minor future conflict — not just among nations but even within them.
As the sense of scarcity rises and the gap between ‘haves’ and ‘have-nots’ widens: anger, resentment and strife can be expected to follow. Recent strikes by workers in Greece and France over raising the retirement age and reducing entitlements, collective unrest in Pakistan and Haiti over the slow and inadequate response by their governments in the wake of natural disasters, as well as food riots in Mozambique are but a few manifestations of public anger boiling over. Despite those episodes not yielding the desired results for the ‘masses,’ we haven’t seen the last of them. Au contraire, if anything, we can expect to see more such collective manifestations of economic tensions brewing at the international, domestic, community, family unit and individual levels.
The writing is on the wall is: We are entering an era of secular economic and geo-political instability.
Hence, these times are about valuing the basics that sit at the bottom of Maslow’s hierarchy of needs: Food, clothing, and shelter.
“I close both locks below the window
I close both blinds and turn away
Sometimes solutions aren’t so simple
Sometimes goodbye’s the only way
And the sun will set for you
The sun will set for you
And the shadow of the day
Will embrace the world in grey
And the sun will set for you…”
- Shadow of the Day by Linkin Park
“Look thoroughly into matters, and do not let the peculiar quality or intrinsic value of anything escape you.” – Marcus Aurelius
What is Equilibrium?
According to the definition: Equilibrium is the condition of a system in which competing influences are balanced.
In Physical Sciences, the hypothetical interactions of constants and variables can be studied, proved or refuted in a controlled and/or closed system with a high degree of certainty that the expected outcome is uncontaminated by exogenous factors.
In Economics, however, one can argue that any theoretical proof and subsequent practical application of that economic theory should be able to withstand the rigors of operating in a system that is open, porous and influenced by both endogenous and exogenous factors. In essence, therefore, discussing the concept of equilibrium within the confines of a closed system derives limited value for economists, financiers, traders and other market participants as a closed system does not exist in the real, messy, dynamic world of trading.
In this context, may I propose the following hypothesis provisionally entitled: Perpetual Market Disequilibrium Hypothesis.
An open system such as a market — that is continuously and continually dynamic due to the individual influence and collective interaction of an inexhaustible array of endogenous and exogenous factors — cannot attain a state of “balance” of “competing influences” even for the most fleeting moment in time.
Due to the perpetual motion generated by information asymmetries, human emotions, investor sentiments, social perceptions, cognitive limitations, data inaccuracies, economic cycles, demographic transformations, systemic inefficiencies, structural problems, competing interests, global capital flows, global trade, policy shifts, regulatory loopholes, political expediencies, central bank interventions, etc. among market participants in an open system, the market is influenced by an inexhaustible number of variables the interactive impact of which is constantly changing and morphing the state of the markets in profound, imperfect, (and only partly fathomable) ways.
Hence, markets are in a perpetual state of disequilibrium and inefficiency.
Capital allocation, therefore, is also in a perpetual state of disequilibrium and inefficiency.
In philosophical terms, equilibrium or market efficiency is like perfection. It can be aspired for, but never attained. It is imaginary, not real.
In Classical Economic Theory, a “Dynamic Equilibrium” or market efficiency is a state when demand and supply intersect (and are in balance) with a resultant “equilibrium” asset price for that point in time.
The definition of “Static Equilibrium” in Physics is: A system of particles is in static equilibrium when all the particles of the system are at rest and the total force on each particle is permanently zero.
The definition of “Dynamic Equilibrium” in Physics is: The state of a body or physical system at rest or in un-accelerated motion in which the resultant of all forces acting on it is zero and the sum of all torques about any axis is zero.
In the study of markets, however, neither of the following conditions is true:
1. bodies or particles (market participants) are at rest,
2. total force (capital) on each body particle (market participant) is zero.
Furthermore, if we apply Burton Malkiel’s “Random Walk Theory” to the above definitions of “Equilibrium,” then particles (market participants) are not at rest but in a random “Brownian Motion.”
Equilibrium v/s Mean Reversion:
As discussed above, there is no universal, constant and determinate equilibrium price point from which the value of an asset can start, and to which it can revert, without consideration given to the length of time involved in the analysis. What is popularly referred to as Market Value (price) or the market equilibrium point, within a certain snapshot in time, is merely where demand and supply met for that particular instance in the price journey of an asset. Obviously, Time is the independent variable in the concept of equilibrium. Furthermore, as can be intuitively understood, an accurate identification of a so-called “equilibrium point” over a significant period of time would also require adjusting for inflation.
This, however, is where economists and other market participants begin to inaccurately mingle the notion of equilibrium or market efficiency with the concept of “mean reversion.” Conventionally, in Economics, the concept of equilibrium has been used mistakenly and interchangeably with “mean reversion.” The two concepts, however, are distinct.
Most asset prices (Market Values) can and do depict normal or “bell curve” distributions. Over a sufficiently long period of time with a sufficiently large number of inflation-adjusted price points, one would find that asset values do fall within a certain normal distribution, say, a 95% confidence interval. One can, in fact, isolate a “mean reversion” data point across a statistically significant number of data points over a pre-determined length of time for virtually all asset classes. This data point is, in certain circles, misunderstood as the “equilibrium price point” for a particular instance in time but it is not. By its very definition, such a data point is a “mean” or “average” of a collection of data points rather than being a solitary data point representing a moment when demand and supply intersected but were not necessarily in balance, i.e. so-called “equilibrium” or “market efficiency.”
The theoretical construct of an “equilibrium point” is that it is a singular and absolute data point where, in context of Economics for example, supply meets demand at a given instance in time. The theoretical construct of a “mean reversion point” is that it is an average of a collection of data points.
The “mean reversion” data point is misunderstood as an “equilibrium” price point within the relative confines of the data set identified just for a specified period of time. As the length of time under consideration changes, so does the data set and consequently, the “mean reversion” point. Therefore, even in the evolution of the price of a commodity or security, the “mean reversion” point is never a constant as it changes with the change in the time-frame under consideration.
Given the resolutely ephemeral and perpetually evolving nature of markets, equilibrium does not exist in absolute terms and it is misunderstood sometimes as “Mean Reversion” even in time-constrained, relative terms.
Intrinsic Value v/s Market Value (Price):
The other view one can take is that every price point at which a transaction is consummated is an equilibrium point for that fleeting moment till the next transaction ushers in the next equilibrium point supplanting the previous one, and so goes the story ad infinitum.
What we have is an all or nothing proposition. Either one can assert that there are as many equilibrium points as there are instantaneous transactions passing through a market (an open system). Alternatively, one can state there aren’t any equilibrium points because the market is constantly in a state of flux – either moving upwards or downwards due to the innumerable factors impacting it within infinitesimal segments of time.
The challenge with embracing the idea that there are as many equilibrium points as there are transactions, is that markets are inefficient at any given point in time. The price at which a transaction takes place is more a commercial compromise and less a true representation of the Intrinsic Value of an asset. In fact, the demand-supply dynamic is not necessarily an accurate or even fair determinant of an asset’s value. Demand-supply intersection is merely the most widely acceptable yardstick to ascertain the Market Value (price) (rather than Intrinsic Value) of an asset.
One may wonder: if not the demand-supply dynamic, then what is a better and more appropriate determinant of Intrinsic Values of assets?
As Marcus Aurelius says:“…do not let the peculiar quality or intrinsic value of anything escape you.”
The challenge of calculating Intrinsic Value is daunting because the notion of “mark-to-market” or reference points or relative prices is discarded in favor of ascertaining the Intrinsic Value of a particular asset to a specific buyer at a given point in time – notwithstanding how much Market Value (price) the seller or the other potential buyers are placing on that particular asset at that point in time. The ability to value (and price) assets based on the Intrinsic Value of the asset to the buyer is inherently a subjective process. Each valuer would arrive at different valuation figures despite using similar valuation techniques. Not to mention, each buyer has a different motivation and varying degrees of intensity for wanting to purchase the same asset at any given point in time.
For example, at a certain price point and time, a long-only value investor may not be as motivated to purchase the rising stock of Company A as the short-seller intent on covering her/his short bets on the same equity versus a momentum trader looking to ride the rising wave of the same company’s stock.
The proposition of purchasing an asset unhinged from its Market Value, i.e. price (which is largely predicated on the underlying demand-supply dynamic which in turn is based on a wide variety of data) can be a high-risk, high-reward proposition. Investment decisions made by “contrarian” (particularly, value investors or short-sellers) are often driven significantly by this “Intrinsic Value” ethos of investing where they have to trust their independent judgment about the “Intrinsic” or “Fundamental” value of an asset in the face of “Market Value” data that may vehemently negate their investment thesis. A contrarian investor has to take a bold, “against-the-grain” decision on determining the Intrinsic Value of an asset that may be mis-priced by a majority of the market participants either over or under the price band that represents the asset’s true “Intrinsic Value.”
The key distinction to be mindful of is the difference between Intrinsic Value versus Market Value (price) of an asset.
Market Value (Price) of an asset is determined at any given instance by market participants based on popular, realistic (not completely real) or distorted manifestations of the demand-supply dynamic. Intrinsic Value — within the context of Economics — can be defined by the utility that an asset provides to the user, owner, buyer or seller of that asset. The utility that is derived from a certain asset by a user, owner, buyer or seller varies from one to the next in a specific moment in time. The utility derived from a certain asset by the same user, owner, buyer or seller also varies in different moments in time. Hence, Intrinsic Value is a relative concept. Intrinsic Value is relative in terms of who is valuing an asset and it is relative in terms of when the asset is being valued. Each user, owner, buyer or seller is willing to forgo or sacrifice different units of work, i.e. money to procure the same asset under consideration at different times.
Market Value, on the other hand, is essentially the value (price) placed by the highest bidder for a certain asset under consideration based on all the available information available to him/her at that point in time. Hence, Market Value (Price) at any given moment in time is absolute and concrete. Intrinsic value — contrary to popular dogma — at any given moment in time is relative and conceptual (even elusive).
The difference between the Market Value (Price) and the Intrinsic Value of a particular asset is where the “Value Gap” lies. It is this value gap that can be exploited by the savvy investor to fulfill the profit motive. The skill, experience and intelligence of the investor comes into play in ascertaining an appropriate Intrinsic Value and placing an advantageous Market Value to procure the asset such that it beats other market participants before the Value Gap between Intrinsic Value and Market Value gets filled up by other investors who later grasp the extent of the market disequilibrium or Value Gap and act on it.
Sidenote: On a philosophical level, due to its relative and variable nature, Intrinsic Value is really not all that intrinsic afterall. In fact, it is extrinsic — as the value placed on an asset is dependent on the valuer of the asset and not dependent on the asset itself. Of course, this assertion opens up a whole new debate of whether Intrinsic Value truly exists and what is the distinction between Intrinsic Value and Extrinsic Value? Perhaps, such a discussion overturns over two thousand years of philosophical speculation from the days of ancient Greek philosophers such as Socrates, Plato, Aristotle, and Epicurus to more recent thinkers such as John Stuart Mill, Henry Sidgwick and William Frankena. It is a discussion suitable for another more philosophically-oriented piece of work.
Even within the confines of the above definition, Intrinsic Value can be relative as different valuers would value the same company’s plants, machinery, real estate, intellectual property at different price “marks” and hence again, Intrinsic Value is really more extrinsic, i.e. dependent on the subject (valuer) and not on the object (asset).
The Perpetual “Tom and Jerry” Game – In Markets, present (Market Value) is the past; future (Intrinsic Value) is the present:
Now, let us also look at another critical idea presented in the Efficient Markets Hypothesis: The price of an asset (security) at any given point in time has all of the information about that asset priced into it already.
Au contraire, if anything, the Market Value (price) of an asset – which is based on an aggregate mix of data, perceptions, opinions, judgments, rumors (Market Information) of the investment community follows Intrinsic Value of that asset. In other words, the ability of certain investors to profit from market disequilibria or inefficiencies clearly indicates a perpetual “cat and mouse” or “Tom and Jerry” game. Intrinsic Value is the Mouse (Jerry) after whom Market Value (Price) – the cat (Tom) is perpetually after. To extend the analogy – the distance between Jerry’s tail and Tom’s whiskers is the difference between “Intrinsic Values” and “Market Values.” This distance is the profit reaped by the agile and perceptive investors in this most complex, fascinating and perpetual cat and mouse game.
Hence, Market Values lag Intrinsic Values. The corollary of this assertion is: At any given point in time, markets do not have all of the information to arrive at the Intrinsic Value of an asset and hence at that point in time, markets are in a state of disequilibria. They always are. In a time series, at t-0, market perception determines the Market Value-0 ($100) of an asset but the Intrinsic Value of that asset is already at Intrinsic Value-1 ($120). Then at time t-1, market perception catches up and ascribes Market Value-1 ($120) to that asset. Meanwhile, here at that same instance t-1, Intrinsic Value of that asset has already bounced higher to $150. By the time the broad market catches up, perhaps, based on certain adverse fundamentals, the Intrinsic Value of the asset has now halved to $75. Meanwhile, Mr. Market is still celebrating the past at the $150 mark as if it were the present. Of course, Mr. Market does not know any better.
As the legendary ice hockey player Wayne Gretzky famously quoted: “I skate to where the puck is going to be, not where it has been.”
Intrinsic Values of assets do the same.
And so goes the story of “Market Value” chasing “Intrinsic Value” in perpetuity.
Whether it is through fundamental analysis or technical analysis or quantitative analysis or macro-analysis or some combination thereof, the few savvy investors who profit from assessing the Intrinsic Value of an asset – before the rest of the market participants catch up on the same or similar assessment – are the ones who are celebrated amongst the investment community as the ones possessing that “Alpha” factor.
What else would explain the profits reaped by legions of investors trading various assets on a daily, weekly, monthly, year-in-year out basis?
How is it that world-renowned investors such as Warren Buffett (Berkshire Hathaway), George Soros (Soros Fund Management), Jim Simons (Renaissance Technologies), Peter Lynch (Fidelity Investments), Bill Gross (PIMCO), Jack Bogle (Vanguard), Thomas Rowe Price, Jr. (T. Rowe Price) John Templeton (Templeton) among countless other “average Joe’s” have consistently not only generated profits in various capital markets – but have out-performed the markets by a wide margin – often uncorrelated with the larger economic cycles?
It is quite simply because they, undoubtedly, possess “Alpha.” They possess the much vaunted skill and ability to evaluate and perceive the “Value Gap” between the “Market Value” and the “Intrinsic Value” of an asset before the larger investing community — and these celebrated students of the market have the ability and gumption to act on it in a timely, calculated and effective manner.
The famed Soros trade against the Pound Sterling in 1992, or John Paulson’s massive short bet on the US housing market (and more particularly) the credit-linked derivative instruments in 2007, or Prince Alwaleed’s investment in the struggling Citigroup in 1991, or Jim Chanos’ short bet against Enron in 2001 – are all examples of high-profile investments where a savvy and decisive investor perceived a significant Value Gap prior to the majority of the market participants and made bets on the Intrinsic Value of those investments – only to see their bets paid off handsomely when the rest of the market finally closed the Value Gap between yesterday’s Intrinsic Value of the asset and today’s Market Value. In an instant of course, by the time the markets caught on to today’s Market Value “marks,” the Intrinsic Values of those assets had already moved on allowing a new set of contrarian investors to assess the new Intrinsic Values of those very assets and create new “marks” for what would be the Market Values of those assets at a later date.
This ability to successfully chase down Intrinsic Values of assets can be defined as the much sought after “Alpha” – the factor that distinguishes and explains the ability of certain investment managers to outperform the markets for most of the time.
Quantitative strategies pursued by Hedge Funds and proprietary trading desks of Investment Banks and other types of institutional investors have only been able to provide “Alpha” for a certain periods of time and to varying degrees of success due to a few reasons (elaborate later):
- Organic v/s Inorganic Investment Management: The structural rigidities and limitations of inorganic, logical, rules-based, linear, pattern-driven, algorithmic systems trying to model and out-smart the organic, often illogical, wild, non-linear, disobedient markets creates an environment of great disequilibrium in markets – especially as certain markets have come to be dominated by system-generated institutional capital flows setting the Market Value “marks” of certain assets;
- “Value Gap” Crowding Out: The computer-driven, quantitative strategies in pursuit of bringing the markets back from Disequilibria and close the Value Gap actually end up widening the Value Gap by crowding out the market by their large positions – especially when “Stop Loss” and other risk management triggers go off in their highly leveraged positions. In effect, similar quantitative, system-generated hedging “Alpha” strategies and risk management strategies at different institutional investors ends up crowding out the market for a given asset – thereby amplifying and magnifying the very Value Gaps or market inefficiencies or disequilibria they aimed to erase in the first place.
Therefore, human “Alpha” factor or human judgment will always remain the most precious resource in markets laden with, what Prof. Robert Shiller calls, “animal spirits.”
Effectively, both the Intrinsic Value and the Market Value of an asset are moving targets. Both, at the end of the day, are subjective. Both require a subject (valuer) to assess and ascribe an inherently subjective value to the asset (object) under consideration. Both, the Intrinsic and Market Values of an asset, do not have all of the information priced into the asset’s spot of futures price at any given point in time. It is just that Intrinsic Value P-1 is “closer” to the Fair Value of the asset at time t-0 but majority of the market perceives it to be Market Value P-0.
Ultimately, equilibrium or market efficiency is constrained to describing a momentary, ephemeral state (static or dynamic) for a market or an individual asset whose value (as stated above) is inherently, continuously and continually changing. Even in those conditions, however, equilibrium or market efficiency remains an imaginary state; a chimera.
It follows therefore, Equilibrium or Market Efficiency — in the context of Economics — does not even exist.
Application of “Perpetual Market Disequilibrium Theory” and “Value Gap Analysis”:
The concept of “equilibrium” is a cornerstone of Eugene Fama’s Efficient Market Hypothesis. As we have established above, neither is the market capable of being efficient, nor does that ephemeral moment called equilibrium ever arise. If Fama meant to use the “mean reversal point” in his famed capital markets hypothesis, he should have stated it as such — as we have also established that an “equilibrium point” is different from a “mean reversal point.”
The practical application arising from the realization that “Market Equilibrium Does Not Exist and Markets are constantly in a state of disequilibria” is:
As discussed above, the individual impact and collective interaction of numerous endogenous and exogenous factors (both facts and opinions) will ensure that, at any given point in time, markets remain in a state of imperfect information as they relate to the price of any given asset. The price of a given asset has built-in to it a variety of accurate and inaccurate perceptions of its value or worth. Mis-allocation of capital and asset bubbles, therefore, are bound to continue forming due to this perpetual state of imperfections or disequilibria in markets. Momentum investing is a phenomenon that speaks exactly to this kind of disequilibria where routinely markets over-shoot on the upside or downside from a range of price that can be deemed to represent a fair and reasonable estimation of the underlying value of an asset based on fundamentals.
With the advantage of ever greater levels of sophistication in data gathering and analysis, markets can aspire and work towards reducing the extent of market disequilibria (volatility) or the “Value Gap” between Intrinsic Value and Market Value at any given point in time. On the other hand, the very ability to share data instantaneously and ubiquitously also creates an enabling environment where both — fact and fiction (rumors, opinions, speculations, tactical misinformation, etc.) can spread equally effectively thereby magnifying and amplifying the interpolated impact of fact and fiction on the price of an asset.
Indeed, it is also this very perpetual disequilibria that contributes to the opportunities for market participants to wrench out inefficiencies and profit from them on an ongoing basis.
A practical application of the Perpetual Market Disequilibrium Hypothesis is that, for a savvy investor, there are always opportunities to exploit the Disequilibrium or Value Gap for an asset at any given point in time. It doesn’t matter whether the market values (prices) or volumes are on their way up or down. In fact, from a value investing perspective, there is potentially a greater number of opportunities during a “down” market for an investor to enter the market and exploit the “Value Gap.”
For example, as illustrated in the chart below showing Goldman Sachs’ two-year stock performance, just as investors started to move to the sidelines in April, 2009, i.e. trading volumes began to get lower, Goldman’s stock began to climb to reach its two-year highs in September, 2009 when trading volumes were at one of their lowest levels for that two-year period.
The strong negative correlation between prices and volumes depicts the “Value Gap” phenomenon in all the more pronounced and compelling manner because Goldman’s stock performance in the chart below is coming off the lowest point of the biggest financial crisis since The Great Depression. For nimble, contrarian investors with an eye for identifying the Value Gap between the Intrinsic Value and Market Value of an asset or a security, Goldman presented an extraordinarily profitable and uncommon buying opportunity during this period of great uncertainty and disequilibria. Given the trading volumes during those four quarters (April, 2009 to March, 2010), there was less competition to purchase the stock as it began its long climb, and there was greater upside potential for those investors who recognized and seized the Value Gap as the stock went up. The key was to remain patient and confident about one’s judgment on the Value Gap. Ultimately, the application of the Value Gap concept is not ideally suited for rapid, short-term or intra-day trades. It is better suited for medium-to-long term trades where market perception or “technicals” catch up with the “fundamentals” of the asset under consideration.
Conclusion: Due to the complex dynamic of a constantly, endogenously, and exogenously changing demand-supply system, markets are never in a state of equilibrium. To state that the concept of equilibrium exists, therefore, can be arbitrary, subjective, and plain inaccurate.
“Gateway” or “Spiky” markets are likely to lead the way out for the Real Estate asset class
Investment Context & Opportunity: Tier-1 “Gateway” Cities
Savvy, intrepid, independent-minded — particularly, contrarian — investors ought to pay close attention to real estate in global “Gateway” cities.
Gateway cities, or “Spiky” markets, can be defined as a set of global Tier-1 cities to which Prof. Richard Florida’s “Creative Class,” or even roughly, Prof. Anna Lee Saxenian’s “New Argonauts” flock.
The following metropolitan areas would constitute Tier-1 Gateway markets: New York, London, Tokyo, Bay Area (San Francisco and Palo Alto in particular), L.A./Orange County, Sydney, Miami, Toronto, Vancouver, Bombay, Rome, Munich, Paris, Moscow, Dubai, Istanbul, Sao Paulo, Shanghai, Singapore, Hong Kong.
Many of these Gateway metropolitan areas’ high-end real estate is presently under-valued by anywhere from 30 to 60 per cent vis-a-vis their historic inflation-adjusted peaks. With values of high-end real estate inventory at such dramatically low prices across many of these Gateway markets, now is the time to take some bold investment decisions.
Due to continued urbanization, these cities are on their way to transforming themselves into megapolises over the next half a decade or so. Many of these Gateway markets already enjoy megapolis status. Due to the natural limits to their expansion and the constant real estate supply-demand “cat and mouse” game, real estate prices in these markets can be expected to climb along a secular trajectory over the long-term — particularly for high-end real estate. Even in the short-to-medium term, however, these markets are likely to rebound and outperform real estate markets in smaller Tier-2 cities.
Furthermore, “network effects” or “multiplier effects” will continue to lead to a disproportionate increase in productivity in these cities compared with their Tier-2 Gateway peers (identified below). As the world comes out of the “Great Recession,” the productivity enhancements in these Tier-1 Gateway cities will get priced into the real estate asset values before (and higher than) they would in other smaller metropolitan markets. Like people, capital will be more fluid through these highly “porous” global cities. Hence, real estate assets in these Tier-1 cities will be more liquid than assets in other Tier-2 cities.
Starting now, Hedge Funds and long-only PE firms can take advantage of these opportunities by investing in landmark Grade A office space, 5-star hotels, upscale retail destinations and even marquee residential property.
Obviously, Gateway cities in certain emerging markets like Shanghai and Bombay are an exception as the real estate asset values in those markets have reached, and even exceeded, their 2008 peaks in certain instances. Infact, a credible argument can be made that high-end real estate prices are inflated in some of those emerging markets — particularly in Shanghai and other major Chinese metropolitan markets like Beijing, Guangzhou, Shenzhen, Tianjin, Hong Kong, etc.
Arguably, even “over-priced” real estate assets in emerging markets are likely to prove to be sound investments over the next half a decade and beyond. No rocket science. It is simply the crushing force of demographics that will raise price levels for virtually all forms of real estate in these centers of economic and cultural activity.
Furthermore, a small portion of this strategy could be devoted to specialized REIT’s with significant exposure to the above mentioned geographies.
A smaller amount of capital can also be devoted to higher beta, Tier-2 pool of global “Gateway” cities as well.
These would include: Chicago, Boston, Atlanta, Montreal, Rio De Janeiro, Buenos Aires, Cape Town, Melbourne, Bangalore, New Delhi, Milan, Madrid, Frankfurt, Amsterdam, Copenhagen, Stockholm, Brussels, Dublin, Vienna, Prague, Seoul, Beijing, Kuala Lumpur, Abu Dhabi, Cairo, among others.
Investment Entry Horizon:
Next 6 to 18 months would be the “sweet spot” for picking up the choicest assets without contending with bruising competition.
Investment Exit Horizon:
Next 36 to 60 months — depending on the Gateway city in question — would allow for an optimal period for healthy returns on exits.
10% to 20% annualized IRR (depending on which particular market is considered).
Roughly 5% of a diversified Hedge Fund’s total assets under management (AUM) could be a good place to start. Given the scale and scope of this investment strategy, it can absorb as much as 10% to 15% of a fund’s portfolio as the geographic diversity (North & South America, Western Europe, Russia, South Asia, Middle East, and East Asia) asset variety (Hotels, Offices, Malls, and Residential real estate) provides a natural hedge to a portfolio designed with such an exposure.
Fresh capital infusions from a fund’s limited partners would allow a fully or mostly-invested fund to expand its asset base without compromising on its investment philosophy, expected returns, risk management controls, or capital allocation/portfolio diversification principles.