Long term returns are as much dependent on what one doesn’t own as they are on what one does own. This means we need to continually identify and avoid mistakes in the making.
An avoidable error today seems to be inadvertent exposure to a financial crisis in China — of the kind that would cause a permanent loss of capital to a foreign (dollar based) investor.
This quarter we sold our three Hong Kong based real estate based businesses.
This follows our facing up to the idea that risks to a foreign (dollar based) investor are too great — given the high levels of debt in the Chinese financial system, and likelihood this will result in a severe banking crisis and possibly a significant currency devaluation.
As analysts of businesses our role is to understand business fundamentals such as financial condition, operating performance, competitive dynamics etc. We have found it is usually best to pay less attention to macroeconomic factors, as these are of far lesser consequence for long-term value creation, particularly in good businesses.
Our investment in certain Hong Kong listed real estate operating companies stemmed from several years of following these businesses. Even now, nothing has changed in terms of our fundamental assessments...
Each company has:
It was our firm intention to be long term shareholders in each company, a necessary precondition given that the cycle was likely to deteriorate, and the possibility that discounts to NAV would persist for a long time. However, we cannot deny certain hard truths and we have taken necessarily prompt action.
The basis for our decisiveness stems from a highly regarded book on the history of sovereign defaults, banking crises, inflation and currency crashes1. Its authors conclude that these have occurred with surprising inevitability and that in all cases the common precursor is a build-up of unsustainable levels of debt, whether it be government, corporate or household.
Furthermore, they maintain that in most cases the inevitable crisis seemed an unlikely scenario as during the preceding boom people vigorously maintained that “this time is different”.
We have been watching with growing alarm the massive increase in credit in China. A credible source2 suggests the true amount of bank loans is much greater than what is reported, and furthermore, that there is significant external (dollar based) lending into China. While anecdotally it is clear that much of state directed lending has gone into unproductive fixed asset investment, apparently much of the increase in credit since 2008 has gone toward servicing existing debt, i.e. borrowing simply to pay interest.
It stands to reason that if credit growth stops contributing to GDP growth, but nonetheless continues unabated, then debt/GDP will rapidly rise to unsustainable (i.e. unserviceable) levels. The true level of non-performing loans in China may be many multiples of the reported percentage, leaving the banking system in need of a huge government led recapitalisation.
Despite the facts being in plain sight, we have been just as susceptible as those who, in the past, found comfort in the idea that this time, somehow, is different — that China will not experience a severe negative consequence to its excessive debt accumulation.
A handful of our own arguments appear convincing:
Despite their appeal, we should resist believing that China will prove the exception to history. Perhaps the most strikingly simple revelation will occur when it becomes apparent that not only is debt (the numerator) understated, but that GDP (the denominator) is overstated. This is because Chinese GDP is not sustainable, as it includes such a persistently large fixed investment component.
A simplified3 analogy may be useful: China might build 50 coal fired power stations this year. The (massive) cost of this investment is included in GDP. If a power station has a useful life of 50 years, the contribution to GDP in future years that is truly sustainable should be the replacement rate, or 1 power station per year. Instead, in order to generate GDP growth at a centrally mandated 10%, China will build 55 power stations next year.
We can’t say when or how events will unfold. But if something cannot continue forever, it is certain that it won’t.
Perhaps ordinary Chinese will suddenly figure out, en masse, that many of the loans backing their bank deposits are bad, that the banks are themselves insolvent, and this will trigger a classic run on the banks. This will force the government to bail out the banks, possibly leading to inflation and currency devaluation.
This says nothing of what effect the aftermath of such a crisis (a steep decline in output, rising inflation) may have on such sectors as consumer discretionary expenditure, commercial property leasing and residential property development.
We had believed until recently that our Hong Kong positions’ steep discounts to NAV provided adequate protection. While the renminbi has recently been allowed to depreciate in a gentle fashion, the long-lived HKD peg has been (too) much comfort, and this too may fail in the event of financial turmoil on the mainland.
In maintaining his optimism despite the uncertainty prevailing over the Chinese economy, Ronnie Chan writes:”…we have to live with the country in which we invest.4” As a Chinese citizen with considerable permanently invested wealth (in the form of Hang Lung shares), he cannot (and arguably should not) reduce his investment in China.
We, on the other hand, can. (And should.)
One valuable illustration from Reinhart and Rogoff’s “This Time is Different” shows the proportion of the world’s countries in external default at any one time over the past 200 years. In Chart 1 the normal state of affairs is for a significant level of overall sovereign stress. The recent past has been highly unusual in its low level of external default.
It is not hard to see how this eerie calm could suddenly end and the measure revert higher. Should China see a crisis induced fall in output, those countries which have hitherto benefited from the China lead commodities boom may well come unstuck. In the boom years, complacency and overconfidence led to higher government spending, higher levels of debt, and in particular higher levels of external debt — easily serviced by high dollar based export receipts.
Emerging markets are particularly exposed. But even in an advanced country such as Australia where banks have a significant amount of short term external borrowing, where residential property prices are extremely high relative to incomes, rising bank funding costs and mortgage rates could lead to a real estate crash and banking crisis.
We opened this memo talking about avoidable errors. Far larger than anything China related, that which looms over investors today is the supreme avoidable risk — that of highly priced equities in a world of artificially low interest rates.
Many investors today are driven to hold highly priced equities simply for their dividend yields, and for the perceived earnings growth that is an unsustainable function of share buybacks. We think returns to these investors will be mediocre at best, and quite possibly very disappointing.
The portfolio’s positioning today is a result of our looking in out-of-favour areas, and being very selective with our cash. Doing so has led us into certain areas like seaborne containerized trade and mining, where current valuations are sufficiently depressed to more than pay us for any China related fallout.
Our investments in crop nutrition giants Mosaic and Yara International are grounded in our understanding that underlying demand growth is far more stable and independent of China than other commodities, while supply growth expectations are unrealistic. Aflac’s business is distinctly domestic, and Western Union’s sufficiently global, so that negative effects from China will be minimal. Aggreko, while exposed to mining, serves a diverse array of industries, and furthermore derives a significant portion of profits from its counter-cyclical utility-like business. Together these five positions accounted for nearly 70% of our invested position at the end of May.
We will continue with this approach, and have no doubt we will continue to find attractive opportunities as they become available. We remain comfortable that returns will, in due course, be very satisfactory.
We look forward to writing to you again.
1 Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton: Princeton University Press, 2009
2 Charlene Chu
3 This illustration is certainly flawed, as power stations take several years to construct, and their cost will not be concentrated in one year’s GDP figure. But the principle holds, and applies equally to highways, bridges, oil refineries, airports and high speed train lines.
4 Chairman’s Letter, Hang Lung Group 2015 Annual Report