Download October 25, 2013 - Emerging Markets Illustrated

EMI 102513
“Everyone likes a clown but nobody will lend him any money.” - Anonymous
The US, to the embarrassment of us who live here and to the concern of everyone else, narrowly
avoided a voluntary sovereign default last week. The impact on markets of this clown show was very
short term and as I expected, no default occurred. However, it is worth looking at the issues behind this
extraordinary and to some, bewildering turn of events as it has had and may continue to have an
insidious influence on world growth and confidence.
Angry white men
The root cause of the incredible divisions apparent in today’s United States, as always, are economic at
source. A growing chunk of the population, mainly rural white men over the age of 45, are seeing a
formerly high standard of living falling and armed only with deer rifles and outdated skill sets, that is not
going to change. Up to one fifth of Americans “identify” with the Tea Party Movement. This is a
grassroots, decentralized crusade which votes Republican and which frames the US Constitution and the
concept of “The Founding Fathers” in almost religious overtones, fervently worshipping both in stolid
ignorance. Sarah Palin is quite rightly the proper face of the Tea Party, amply demonstrating her grasp
of the facts in a now infamous television interview. While spouting off about “The Founding Fathers”
Ms. Palin was asked to name her favorite “Founding Father.” She hemmed and hawed but finally could
not think of a single one. George Washington? Thomas Jefferson? Ben Franklin? Never heard of them.
The goal of the Tea Party Republicans in this fiasco was to halt an increase to the debt ceiling until
funding was removed for the new national health plan, the Affordable Care Act (ACA), or “Obamacare.”
One should not forget the ACA is the biggest change to US healthcare in almost 50 years and was voted
on and approved by both houses of Congress, the President and even the Supreme Court. It is the law.
Get over it.
How can a crazed minority like this hold the entire country hostage? Much of it has to do with legislative
corruption otherwise known as “Gerrymandering.” The redistricting of population areas into groups
that favor narrow political interests helps ensure re-election for the incumbent party – the party that
was responsible for the redistricting. (“Redistricting” is the polite word for “gerrymandering,” much like
saying “borrow” instead of “steal”).
“Gerrymandering” is a portmanteau of the last name “Gerry,” from Massachusetts Governor Elbridge
Gerry and “salamander,” as the shape of one district redrawn by the good politician resembled the
shape of such an animal. And this occurred in 1812. The US has been guilty of allowing this practice
unabated pretty much since then; over 200 years! It did not even work out that well for Governor Gerry
who lost his re-election bid. (Afterward, he did however become the fifth vice president of the United
States serving under James Madison. That did not work out so well either: he died just over a year into
his term). The largest scale example of gerrymandering was probably the admission to the union of
South Dakota and North Dakota. Not that even a slightly busy person would ever give this any thought
by why did we need two Dakotas? It was because two separate states would boost the fortunes of the
Republican Party at that time.
Unlike the US, Australia, Canada and the UK avoid flagrant gerrymandering by appointing non-partisan
organizations to decide geographical voting constituencies. It may come as a shock but when politicians
themselves are given this job coincidentally it tends to be done with their re-election foremost in mind.
Driven by the Census
What drives the process in the US is the once a decade census, mandated by federal law, after which
congressional districts for the House of Representatives need to be redrawn. The US Senate does not
suffer from this blight as Article One of the US Constitution stipulates each state is guaranteed two
senators regardless of population.
We have met the enemy and the enemy is the Tea Party
Given the above, does this mean the divided US political landscape will cause the country to
permanently lurch from crisis to crisis? I do not believe so. I think it is safe to say the Tea Party has
fruitlessly shot their wad and the backlash is coming. While many US voters sympathized with the ideals
of the Tea Party movement; smaller government, lower taxes, etc., they do not feel the same way about
their methods: extortion and willingness to destroy the US economy on ideological grounds. In the
minds of many this has put the Tea Party into the category of the greatest threat to national security
since Al-Qaeda.
No more shutdowns
Already Republicans are distancing themselves from the Tea Party. Senate minority leader Mitch
McConnell (the head Republican in the Senate) said this week, “…there will not be another government
shutdown. You can count on that.” Business leaders are also stepping up to ensure the idiocy does not
continue. Midterm elections are next year and primaries start in a few months. The US Chamber of
Commerce has already said it intends to be more active in the primaries. The chief lobbyist for the
National Retail Federation has been quoted as saying, “Business has woken up to the reality that it can’t
allow the Republicans…. to be dominated by a few activist types…”
Conclusion is Bullish
The conclusion for markets is bullish. There will not be another US government shutdown in January.
There will be no US default in the near future. With tapering expectations regarding Fed action, markets
continue to move languidly upward.
The future’s uncertain and the end is always near….
While that is all well and good, Jim Morrison was right however, and the US will default, again. As we
are all born naked and die the same way, the US was born in debt and will die that way as well. The
United States began existence after the Revolutionary War deeply in debt. Two decades later in 1812
the country was broke again and couldn’t pay the military. Then the US defaulted in 1814. Admittedly,
having the newly built White House and Capitol building razed to the ground by invading British troops
did not help matters. Roosevelt’s 1933 Executive Order 6102 confiscating all privately held gold and
immediate 40% depreciation of the dollar in the United States arguably is another default. Finally, there
was even a “technical default” in 1979 blamed on a back-office bottleneck when legislators again waited
until the very last minute to raise the debt ceiling causing a week-long delay in payment by Treasury of
$122 mn in maturing T-bills, supposedly the world’s “safest” investment.
But like mathematics has to have a zero from which all things are measured, so too finance needs a
“riskless asset” from which to price everything. Does zero really “exist” and is there really a “risk-less
asset?” Answers to existential questions like that may perhaps be best left unanswered.
The Kospi has been on a tear; up 12% in the last two months and the index just reached a two-year high
driven by improvement in liquidity and fundamentals. According to data provider Yonhap Infomax,
international portfolio flows into Korea have totaled just over $13 bn since July 1st, more than reversing
the $9.4 bn in outflows H1. Interestingly, about 60% of foreign investor net buying has occurred since
the Kospi hit 2,000.
Korea ships a quarter of its exports to China and 10% to the US where economic recovery, while weak,
still seems to be in play. On the trade front Korea has ratcheted up surpluses for 19 months in a row and
Mirae strategist, Seungsun Ryu expects monthly exports will hit a new record in October or November.
One completely unloved stock that is recovering here is S-Oil (010950 KS), the top Mirae pick in the
Korean refining sector. Economic recovery, such that it is, in China and the US and now even Europe
should lead to a rise in refining margins which after falling to break-even levels, look as if they have
bottomed out:
S-Oil reported last night and results smelled about as good as standing downwind of a refinery going at
full capacity. This means they were bad. This was because they were not going at full capacity. While
sales jumped 16.5% q-q, OP fell 75% due to facility repair issues which led to a lower utilization rate.
That issue in their RFCC plant seems to be behind them and I note last night the stock only closed down
50 bps. Either the bad news is in the price or the momentum behind the story is overwhelming the weak
quarter.
Worries of overcapacity in the sector coming on stream will be tempered due to sizeable regional
scheduled maintenance shutdowns. China will close 100,000 bbl/day facilities in 4Q13 and Japan will
take offline another 380,000 bbl/day in 1Q14. Also, local resistance to refinery construction for some
projects in China and India may mean delays or outright cancellation of scheduled capacity increases.
Trading at 13.5X forward PE and just at .6X book, S-Oil is an US$8.5 bn market cap company in the early
stages of an earnings recovery. The street is so far unconvinced with Buys and Holds almost evenly split.
While not a bulletproof story, given last night’s bad results, the recovery of S-Oil’s fortunes and share
price might be worth investigating further.
Smog and EBITDA
Recent pictures of Harbin have to be seen to be believed. Pollution levels there are so high and air
quality so low it looks like the aftermath of a volcanic explosion. With rising levels of education, no
longer can locals believe this to be just “fog,” rather they are beginning to see know it is something
much more dangerous. Hospital admissions in the city have surged 30% - this ain’t fog, folks. Roads and
schools are shut, flights cancelled and that means aside from the always ignored health aspects,
productivity takes a hit. Doctors are telling people to wear masks and….eat pears. Yes, pears. Chinese
believe pears help heal lungs. Yeah, that’ll solve it.
Quoting chest thumping GDP numbers without taking into account the real economic cost of destroying
the environment and health of the workforce is farcical. I see it as similar to looking at EBITDA as a true
measure of profitability. Depreciation has a real cost and ignoring it paints an overly rosy picture of what
is going on inside a company. Some rational discount needs to be applied to Chinese growth numbers
and I am sure locals are doing just that and starting to question the whole model itself. Harbin residents
yesterday were commenting on Sina Weibo, “You can hear the person you are talking to, but not see
him.” Another wrote he couldn’t see the person he was holding hands with, always a dicey proposition.
I suppose this means a surge in tourism OUT of Harbin for those who can afford to go. In all surveys I
have seen Chinese rank tourism as the one area they are least willing to cut back on. Having been only
recently freed to travel, and only to certain approved countries, the window has been opened for the
first time ever and many birds are flying out to look around. According to the China Tourism Academy,
“China has officially become the world’s largest outbound tourism market with an estimated 83 million
overseas trips made by Chinese citizens.” The UN World Tourism Organization reports that Chinese
travelers in 2012 spent $102 bn on international tourism, an incredible jump of 40% from the year
before.
“I never stay in that hotel. The towels are so thick I could hardly close my suitcase.” - Yogi Berra
This is great news for the travel industry, unless you are a hotel it seems. According to a recent global
survey by hotel booking site, hotels.com. the majority of guests tend to pilfer hotel rooms in some
manner. Grouped by nationality the survey focused on what, if anything, guests take from hotel rooms
when they leave. The results show former Viking marauders, the Danes, to be the most “honest” with
88% claiming to never have even swiped a comb with the Dutch a close second at 85%. Items most often
taken from hotel rooms are always either “linen/towels” or “magazines/books.” However, a full 34% of
mainland Chinese polled admitted to taking not linen or magazines but full-on furniture with them when
they depart. Stripping rooms and stuffing their bags with clocks, lamps, paintings and everything that
could fit in a suitcase makes for an interesting story but what about the hotel business in Asia right now?
Shangri-la Asia (69 HK) is a good one to look at; the stock has been pummeled this year but is just now
recovering:
The company has suffered weakness in its Mainland China hotels this year due to the clampdown on
luxury spending (a temporary problem). According to interim results released in August, after tax profit
from China fell from US$15.1 mn for the same period last year to just $2.5 mn.
The profit driver for Shangri-la is the hotel operation with steady income coming from its property
rentals. Last year, after tax property rentals accounted for just over a third of total after tax profit and
hotels were more than half. This year both divisions are now almost equal in contribution due to the fall
in profits at the hotel division.
Weak results were reflected in weighted average room yields (RevPAR) in China which saw a 9% y-y
decline. This lead to an overall decline in RevPAR of 1% y-y.
Trading below book at a P/B of .91 the stock is not expensive. However, on an earnings basis, consensus
forward PE is almost 15X, given the recent bounce. Why get into it now? I think the stock has been
oversold and the outlook is less grim than many analysts believe (90% have a Hold recommendation).
With high fixed costs it is hard to avoid a slowdown but any pick up in consumption in China for Shangrila goes straight to the bottom line and they are leveraged into that recovery. Perhaps the share price is
beginning to discount that upturn right now.
The company is net cash, having borrowed a bit of coin with just over a billion USD sitting in the bank
and a net debt to equity ratio of 54.4%. Shangri-la Asia is still in a high growth phase and has opened
hotels this year in West Shanghai (508-room Jing An Shang), Qufu (birthplace of Confucius, 482 rooms),
Shenyang (424-rooms) and Istanbul (186 room Shang Bosphorus). Nine more hotel developments in
China are scheduled to open next year, including Lhasa (instead of a porn channel they will sell oxygen,
or maybe both at the same time) and Ulaanbaatar, Mongolia, while the Hung Hom hotel project in
Hong Kong is due to begin construction shortly.
The company’s hotels in China next year will grow by almost a third to 41. China will account for more
than half of Shangri-la Asia’s hotels by then. China will be the metric to watch for the company from
next year onward. Any relaxation in the atmosphere of fear surrounding conspicuous consumption will
help boost the bottom line. Of course, recent interim results showed Cost of Revenue has increased 3%
while revenue was pretty much flat. They will have to nail down that furniture.
Time for a classic: this was published in the Far East Economic Review at least 20 years ago and is a
recording of a telephone conversation between an English guest and Room Service in a certain SE Asian
hotel.
Room Service: "Morny, Ruin sorbees"
Guest: "Sorry, I thought I dialed room-service."
RS: "Rye...Ruin sorbees..morny!
Djewish to odor sunteen??"
G: "Uh..yes..I'd like some bacon and eggs."
RS: "Ow July den?"
G: "What??"
RS: "Ow July den?...pry, boy, pooch?"
G: "Oh, the eggs! How do I like them? Sorry, scrambled,
please."
RS: "Ow July dee baychem...crease?"
G: "Crisp will be fine."
RS: "Hokay. An Santos?"
G: "What??"
RS: "Santos, July Santos?"
G: "I don't think so."
RS: "No? Judo one toes??"
G: "I feel really bad about this, but I don't know
what 'Judo one toes’ means."
RS: "Toes! Toes!...why djew Don Juan toes?
Ow bow singlish mopping we bother?"
G: "English muffin!! I've got it! You were saying
'Toast' fine. Yes, an English muffin will be fine."
RS: "We bother?"
G: "No..just put the bother on the side."
RS: "Wad??"
G: "I mean butter...just put it on the side."
RS: "Copy?"
G: "Sorry?"
RS: "Copy...tea...mill?"
G: "Yes. Coffee please, and that's all."
RS: "One minnie. Ass ruin torino fee, strangle ache, crease
baychem, tossy singlish mopping we bother honey sigh,
and copy....rye??"
G: "Whatever you say."
RS: "Tendjewberrymud."
G: "You're welcome."
Cheers.
Derek Hillen, CAIA
Mirae Asset Securities
www.emergingmarketsillustrated.com