Do an intellectually lazy post on a short- to medium-term outlook of Chinese economy.
Hmmmm, so we are taking more debt while selling less and earning less. Not a good sign, is it?
There is a news piece about the Chinese SOEs (state-owned enterprises). If you are not familiar with how the Chinese system operates, it would be quite inspiring.
MoF as an Activist Investor: What A News Piece Reviews
The news is about the negotiation between the SOEs and SASAC (State-owned Assets Supervision and Administration Commission of the State Council, a long name that you should remember). SASAC is a government agency that manages the SOEs worth $1 trillion -$4 trillion, including major resource-based, government-monopolized Fortune 500 companies.
The story goes that because of diminishing profit in ‘08 ($100 billion or 30% below ‘07 level, after 30% increase in ‘07), SOEs are pleading for a deduction in budgeted profit turn-in, but SASAC is not relenting, stating that the money is of crucial use, for things like capital investment in strategically important SOEs and capital replenish for the weakened state-owned utilities and airlines. MoF weighed in to support SASAC’s view.
I have thought that Chinese companies hold too much cash, and paying out extra cash to relocate the capital may be a good idea, despite of the less efficient capital market. (As a reference point, share buyback have been a popular move for S&P 500 corporations in recent years.) Since the CEOs are increasingly richer and more powerful, most individual investors could only act as dividend takers.
It is a completely different case when the government steps in. It must be a tough act for the SOEs.
The Long Value Chain
What’s more interesting is the nexus of money of the colossal Chinese SOE system. I’ve raised the issue when looking at China Shenhua, a partially-listed, state-owned coal and utility company.
Let me belabor the point with yet another example – PetroChina.
How the government runs the SOEs such as PetroChina? You may ask. The answer is quite complicated, but here’s a quite telling executive order. The order mandates that SOEs shall do a separate book-keeping with the government, with items including budgeted profit turn-in, capital gains from selling state-owned shares (which is another complicated matter that drives the vicissitude of the Chinese stock market), etc.
In return, I assume that the government would (have to) ensure the overall profitability, in one way or another. What’s socialism is about otherwise?
Should you Invest with China, Inc.? Individual Investors’ Perspective
If you are an individual investor asking for stock advices on PetroChina and its ilk, I don’t know what to tell you – I am not prepared for this. The success very much depends on how well you read the multi-trillion China, Inc. and how it works. In other words, besides reading the 10Ks of the listed companies that is only a tip of the iceberg, you should read the much bigger (somewhat opaque) book behind.
The good news is that instead of an invisible hand, the hand is visible. The bad news is that it is quite unpredictable: imagine to tell the fortune of a child with powerful parents, who would presumably take care of his interest. But it is a big family and parents are busy with a range of considerations. That child - though spoiled a bit - may not be the preferred from time to time.
Warning: This post could be a bit technical. It may well end up with I-don’t-know-what-I’m-talking-about. Apologies.
I’ve been thinking about PPIP recently, in order to safeguard the tax payers. My previous posts can be found here and here.
The Deal
Let me restate the deal here: private investors will bid for a pool of loans or securities as equity investors, say the settling price is $100; private investors will put down $100/14=$7.1 in equity; the Treasury will match the amount in equity, in this case another $7.1; FDIC would leverage the $14.2 up to $100, by guaranteeing $85.8 debt, or 6X equity (or less on a case-by-case basis).
The Option
The FDIC guarantee could be seen as writing a European put option with the following parameters: S0=100, St=85.8, (assuming that) dividend=3%, I=3%, annual Std=10%~20%, t=8 years.
The put option is worth $3.8~11.2 (a note for those technical readers: Delta=-0.1935, Gamma=0.0088, Theta=-0.0009).
In other words, if the bidding price is a fair price (without overpaying), FDIC is giving a 1.9~5.6% subsidy to selling banks. If the total pool is $1 trillion, it is $19~56 bn.
On the other hand, FDIC is also receiving fees on this one. Suppose that the premium is 1%, cumulative default is 30%, they may have a break-even.
Gains and Losses
So weird, isn’t it? I thought it is a deal to subsidize the banks with tax payer money, now it turns out that the tax payers have more on the up side. Thoughts could be volatile sometimes.
But the gains must come from some guys. The possible candidates are: the banks (because of depressed market price) and the debtors-to-be (because of low interest rate), and the possibility skews towards the banks. If so, why are they selling?
I may well be wrong. Something is missing here..
Economies grow – they generally do, albeit recessions.
Today’s recession is by all accounts a severe one. Talking heads like to compare it first to the Great Depression, then to Japan’s Lost Decade. This time I shall tell you about the latter one.
Introduction
The Japanese economy had a tremendous growth after WWII, a period referred to as the Miracle of Japan. During the 80s the Japanese seems to be winning in all economic fronts – the Japanese auto companies are beating up the Detroit Three (and unfortunately they still do) – so that there are predictions that Japan would soon surpass the United States to become the #1 economic power.
Then suddenly it crashed. The crash led into a prolonged stagnation, now called the Lost Decade.
What Happened
I will give you some facts and figures of the Japanese economy from 1980 to 2004. What I found is reminiscent of what we are experiencing today and quite scary. I hope you can tell me why.
From 1980-90, real GDP expanded 3.9% CAGR; from 1991-2004, it was 1.4%.
If I tell you that the U.S. growth rate was 3.1% from 1991-2004, it may not seem a huge difference, right? But the mere 2% resulted in a 25% lead over years.
The Japanese economy added literally no jobs during that period.
What triggered the downturn was a spectacular double bubble burst of the stock market and the real estate market.
Bank of Japan, the central bank, has cut discount rate towards zero, so that everybody would use it as an example for the Liquidity Trap.
Business borrowing cost dropped along the way and corporate borrowing was almost free (it may be a bit more complicated).
The government spent quite a bit on deficit as well. Today its Debt/GDP ratio is among the highest.
A mild deflation (decrease of price level) was allowed to happen – a bad thing according to most people.
There was a severe credit contraction: the government was borrowing big on top of the net debt outflow from the private sector.
Businesses profitability hurt a bit.
They stopped investing in production capacity (?).
Financial institutions plunged into and stayed in trouble.
Lessons Learned
I am ok with recessions - who doesn’t catch a cold from time to time? You can usually walk it off. But a recession of a decade? No way.
The scary part of this episode is that it reminds us of today: double asset bubble burst, credit contraction and deleveraging, troubled financial institutions, dampened corporate profit, zero interest rate and whatnot – and it’s global. Who knows whether we would end up into a Lost Decade of the World?
Heck, let’s have an hyper-inflation.
If you have a long investment horizon (i.e., many years before being eligible to receive social security checks), get your money out of money market and load up on General Electric.
“But GE has just been downgraded!” Stop! Listen to me and I will tell you why.
Share Performance
Its share price dropped 70% in last year, a clear winner vs. S&P 500 in the race to the bottom. The market value is $114 bn, or 6X earnings.
The Business
Here’ a summary of last five years’ income statement by segments.
A caveat emptor first: I don’t know anything about the business of General Electric, except than I was using a GE microwave oven and that it owns GE Capital, which is a bank.
The Valuation
Anyway, tell you how I put up with a price.
The company has five segments – energy infrastructure, technology infrastructure, NBC universal, capital finance and consumer & industrial. The capital finance part is the bank.
Banking business is quite fishy these days, so I will give the capital finance segment ($8.6 bn profit ‘08, 10X leverage) out for free; The consumer & industrial part ($365 mn profit ‘08) is small compared to the other segments, I will also give it out for free.
The rest three segments (again, I don’t know what they are doing) had a combined profit of $17 bn ‘08. By the current market value, it gives a P/E of 6.7.
Now suppose that the economy is really bad in the next two years (C’mon, even Google is laying off people), and those three segment makes zero profit in ‘09 and ‘10, then return to the ‘08 profit level in ‘11 and grow in line afterwards with the U.S. GDP at 3.5% (2.5% real growth plus 1% inflation).
If you discount the earning stream at 10%, the P/E would be 1/(10%-3.5%)/(1+10%)^2 = 13X, or a market value of $221 bn, about 200% of the current.
You may say that “hey wait a minute, that’s not cash.” Let me tell you this: GE had a historical dividend payout ratio of 80%, or so I heard. Take a 80% discount if you wish to.
Besides, I seriously think the growth rate is underestimated. Here’s a part 10-year summary: The CAGR of earning growth was a solid 6%.
Besides, don’t forget that I gave you GE Capital and Commercial & Industrial for free. Besides, I wiped the rest’s earnings out for two years.
A Comparison
Admittedly, there are many earning-depressed quick picker-uppers out there these days, but GE is obviously one of the worst (see above).
