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Another Look at Emerging Markets

Fitzroy McLean — Thu, 19 Feb 2009 19:41:54 +0000

After passing much of 2008 standing thankfully on the sidelines, we believe that with current valuations, opportunities have returned for putting capital back into long-term positions in emerging markets.

In fact, we believe that emerging markets will recover faster and outperform developed markets over the long term.

In our December 2007 edition of Without Borders we wrote:

“So much money has been sloshing around the globe in search of an “above average” return that even risky assets have been bid up tremendously. At this stage, however, with new holes in the financial dike showing themselves almost weekly – more holes, we suspect, than officialdom has fingers – the money flows are building toward a reversal. This will hammer the emerging markets the hardest because, historically, in times of crisis, capital packs up its bags and goes home. When that happens, shares of good companies get sold at the falling bid simply because the seller must get liquid, whether to calm his fears or to cover his losses elsewhere. Asset prices become screaming passengers strapped into a luge ride.

“This creates opportunity, of course. Even though the economies of all the most prospective emerging-market countries are strong enough to weather any likely storm, their financial systems aren’t. This is emphatically true in India, China, Brazil, and other fast-track economies. Even so, when foreign financial capital has fled, the physical and human capital will remain, it will still be valuable, and good investments will be cheap in the extreme. But the opportunity won’t be available for everyone – just the investors who’ve been patient.”

Then in April 2008, we gave our presentation on “Bottom Fishing for Stocks in Emerging Markets,” during which we highlighted that the single most important factor in emerging-market stock markets is capital flows. In the emerging markets, the time to invest is when capital has fled the country.

We know we disappointed the crowd when we said that there was not one emerging market we found attractively priced and that shorting in emerging markets is almost impossible, so our strongest recommendation was to do nothing.

It’s quite a skill to do nothing and do nothing well. We sidelined ourselves and watched, staying away from emerging markets for most of 2008.

But now… finally, the catastrophic sell-off in global financial markets had the effect that we expected: there was a huge sucking sound coming from public equity and currency markets in Russia, Brazil, China, Taiwan, Malaysia, India, South Korea, Colombia, Chile, etc. Foreign institutional investors came face-to-face with the reality of lower risk tolerance and deleveraging and were forced to sell. Everything.

The ensuing flight to quality left emerging markets and their currencies decimated… but herein lies the opportunity. We just hope the IMF and World Bank will run out of money or leave them alone, thereby preventing the return to the boom/bust cycle of the 1990s.

Bullish long-term outlook

Remember, the sell-off in emerging-market equities, bonds, and currencies reflects a rush for the exit sparked by global deleveraging and a need to raise cash, rather than any change in the fundamentals. When the current turmoil subsides, we believe that emerging markets will fare better than developed markets and will outperform the latter over the long term. As such, we find that current valuations are solid entry points for putting our hard-earned capital into long-term positions. Consider:

* Emerging-market economies will prove resilient during this economic slowdown and may account for all of world economic growth in 2009 as developed markets slow to zero.

* Emerging economies are not nearly as dependent on consumer spending and almost not at all exposed to consumer credit.

* Emerging markets by and large suffer neither the demographic imbalance nor the entitlement imbalance that plague the developed nations.

* Corporate and personal balance sheets in emerging markets are stronger than those in the developed markets.

* In many emerging markets (Brazil, most of South East Asia, India) as well as several African nations, domestic or regional demand is now more important than exports for GDP growth.

* Among stronger economies, high foreign-exchange reserves and lower foreign debt levels act as insurance against the global slowdown; reserves have grown six-fold to over $4 trillion over the last ten years.

* Over the past ten years, emerging-market companies have produced higher profits with lower (but not necessarily low) leverage, while profits expanded annually by double digits during the past ten years.

Cash Rich, Resource Rich

Compared to the late 1990s Asia crisis, the present situation is much more stable for emerging markets. While we expect current account surpluses to deteriorate given the global slowdown and recessionary pressures, emerging markets will face this challenging period with cash in their bank accounts.

The importance of this change cannot be overstated.

Much like individual households that stash away something for a rainy day, many emerging-market countries now have a greater reserve of wealth with which to buffer financial market headwinds. This gives them the option of taking fiscal stimulus measures to offset the effects of a developed-markets slowdown without having to go into debt. While we decry these neo-Keynesian actions as throwing water on an electrical fire, historically they have boosted share prices.

As part of their fiscal stimulus, we also expect to see higher infrastructure spending by countries with the financial muscle to do so. China, for example, which is projected to have more than 200 cities with populations exceeding one million people by 2025, up from just 23 in 2005, announced in early November 2008 a two-year infrastructure investment and stimulus package of up to 4 trillion yuan ($586 billion). While much of this stimulus will come in the form of strong-arming banks, there will be substantial cash injections in the Chinese economy, and they have the cash to do it: highways, railroads, and airports. The government hopes that this stimulus package will also encourage increased consumer consumption. All this is good news for raw-materials companies, one of which is an undervalued Chinese cement company that is a cornerstone of our portfolio. (Learn more about this company here.)

The turning point

Emerging markets will be the catalyst for global economic recovery, not the West. Like China, many emerging markets that have been saving for a rainy day have the cash and political will to spend on development projects that require raw materials. Others, like Chile and Angola, have the raw materials to sell. Even more so, a few countries like Brazil and Saudi Arabia have both. The economy will get jumpstarted with these countries initiating their own trade without the leadership or consumptive traditions of the Western world.

Perhaps even more pointedly, we foresee a highly inflationary environment over the next several years… all of the dollars with which President Obama will be flooding the world will have to find a home somewhere. This will more than likely spark another commodities boom, which is supported by the world’s ever-growing demographics, resource scarcity, and climate-change legislation.

As such, resource-rich emerging markets are going to find themselves being the future home to foreign investment capital again. Institutional capital will trickle, then gush into these markets as the world wakes up one day and finds oil and copper trading at twice their present levels.

Consequently, today’s emerging markets will be the net recipients of the future inflation that is being created by the West.

Capital Flow Conclusions

We have long said that capital flows are the most important indicator for emerging equity markets. Investor outflows in the second half of 2008 already equal one-third of the total inflows into emerging-market equity funds over the prior five years. This is a positive sign for contrarians looking for a bargain. There has been a bloodbath, and this is a buying signal.

We recognize that the ride will likely be bumpy. Fiscal stimulus, trillion-dollar deficits, and politicoramus bickering may cause a roller-coaster ride to the top… but the evidence strongly suggests that, once institutional funds finally realize that U.S. Treasuries are a fool’s bet, remaining capital will be on the hunt and flowing back into emerging markets. The window is open, and we are dedicating our efforts to finding the most undervalued companies with rock-solid management and balance sheets.

Source: Another Look at Emerging Markets

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The Smoldering Iron Ore War

Dan Denning — Sat, 05 Apr 2008 23:08:23 +0000

The global wise men of asset prices and capital flows have weighed in on Aussie house prices. They have been found overvalued. Crikey. Hey, you can’t say we’re being knee-jerk bears on this one. “Australian property is among the most overvalued in the developed world and the risk of a correction in house prices is high by international standards,” reports Adrian Rollins in today’s Financial Review.

–Where did the gains come from, the IMF wants to know? Was it a boom? Was it a bubble? Did they come in through the bathroom window?

–”The IMF warns that about 25 per cent of the increase in house prices between 1997 and 2007 cannot be explained by fundamental economic factors such as income and population growth,” Rollins reports. Like in America, housing affects the equity market because of the central role rising house prices play in consumer finances. It’s the wealth effect from property.

–”The IMF says households are relying more on rising house prices to get access to credit and fund spending, making them much more sensitive to changes in property values-a shift with significant implications for monetary policy.”

–In other words, if the RBA raises the cash rate on May 6th (in response to persistent inflation), and the banks anticipate that rise by raising THEIR rates first, then consumers are going to be in for a very bad winter in Australia.

–If consumers can’t tap their homes (or incomes) to finance consumption, they either turn to credit (as they have in the UK in record numbers in the first quarter) or they do something even more drastic: they slow down consumption. You reckon that would be bad news for Harvey Norman and David Jones?

–About the only good news from the IMF study on Aussie house prices is that it is not as bad here as it is in other places. Ireland, the Netherlands, and Britain all rank ahead of Australia in terms of the their vulnerability to a drop in home values. So we’ve got that going for us.

–From one pillar of the Australian dream (housing) to the other pillar of this historically good economic run: iron ore. Gold and coal are the other big export earners for Australian resource firms. But iron ore is, in many ways, at the rusty red heart of the boom, not least because it’s so key to the earnings growth of Australia’s two big miners, BHP Billiton and Rio Tinto.

–Yet here we are, three full days after the new annual contract price is normally settled between Aussie miners and Chinese steel markers… and still no contract price for 2008. It isn’t a stalemate. But in chess, surely this would be the end game, where hostilities have to be initiated, strategies executed, and glorious victory secured. Let’s review what’s happened so far this year.

–On February 1st 2008, the Aluminum Corporation of China (Chinalco) joined forces with Alcoa in an overnight raid on the London exchange. The companies paid $14 billion to buy 14% of Rio’s London-listed shares, giving them a 9% stake in Rio’s Australia listing. That stake has been called a “blocking stake” here in Australia because it’s believed China is trying to block the merger of Rio Tinto with BHP Billiton-a merger that turns Australia into the Saudi Arabia of iron ore, with huge pricing power of Chinese steel producers (you can see why China wants to block the deal).

–On March 13th, 2008, Chinese metals behemoth Sinosteel made the first ever hostile bid for an Australian company. The target? Midwest, an iron ore junior south of the Pilbara region in Western Australia. Sinosteel offered $897 million. It is the first-but surely not the last-Chinese bid for a publicly listed Australian company with the valuable mineral and metal assets China seeks to secure for its long-rate strategic economic plan.

–On April 2nd, Australia’s Takeovers Panel, citing “unacceptable circumstances” blocked an attempted takeover of Mt. Gibson Iron ore by Chinese-backed steel maker Shougang. The panel said Shougang already owned a sizable position in Mount Gibson due to its stake in Hong Kong-based APAC Resources Ltd. which owns 20.2% of Mount Gibson’s shares. Under Australian law, a shareholder must make a formal takeover bid once it acquires more than 19.9% of a target’s shares.

– The Australian miners want the same price hike Brazilian giant Vale extracted from Nippon Steel in Japan and Posco in Korea (a increase between 65% and 71% over last year’s contract price. The Chinese are-represented by Baosteel-are unwilling to budge. Vale got a big increase because the cost of shipping the ore to China from Brazil is about $67 a ton. Because it’s a lot closer, it only costs the Chinese about $23 a ton to ship ore back to the mills in China.

–Australian producers want what they’re calling for a “freight premium.” And they seem more than willing to wait for it. In the meantime, Rio Tinto has exercised an obscure provision in its contract with Chinese steel mills to sell ore into the spot market, where the price is getting on US$200. If no agreement is reached between Chinese mills and Aussie miners by June 30th, the Aussie miners are free to sell ore into the spot market.

–Australia’s miners seem to be taking it for granted that the Chinese mills will buy from them even at higher prices, because, well, that’s what they’ve always done.

–But it’s worth considering the possibility, however remote, that China is truly offended at the negotiating strategy of BHP and Rio and is serious about getting its ore elsewhere. “If Australia succeeds in getting a freight premium and the price of Australian ore increase a lot,” says Chen Xianwen, the deputy director of the China Iron and Steel Association, “this would mean that Australian ore is not as competitive as Brazilian iron ore.”

–Chen also told the Financial Review that, “Australia accounts for 40% of China’s iron-ore imports. But if Australian ore is not as competitive, steel mills won’t buy from Australia. This will be a heavy loss for Australia. The world economy will slow down this year and China steel production will slow down. If Australia cannot sell their iron ore into China, where will their iron ore go?”

–The Chinese steel makers claim they can’t sustain another big increase in ore prices and still remain profitable. The Aussie miners obviously reckon the Chinese can pay much higher prices and still absorb them comfortably. Besides, it is not good business policy to extort profits from your clients merely because you have a strong position.

–All in all, the strategic game for Australia’s mineral assets is unfolding right before our eyes. We reckon there are two possibilities. Australia could stuff it all up by ruining the relationship that is at the heart of the boom. That would be consistent with Bill’s ironic philosophy that people and institutions have to find a way to destroy themselves and squander their good fortune.

–However, it’s a lot more likely that the Chinese mills and the Aussie miners will come to some sort of agreement before June 30th and that iron ore prices will go up. This makes all of Australia’s economically demonstrated reserves of iron ore much more likely to be developed… and opens the door for the junior producers in the Pilbara and Midwest to cash in on the boom.

–Does Australia have an energy security policy? If it didn’t, it would be alone. America doesn’t seem to have one either. Caltex director Des King told investors yesterday that Australia would import 50% to 70% of its refined fuels by 2030. “This is a huge energy security risk,” he added.

–The trouble is that the Australian refinery industry is not competitive with refineries being built in Asia, King said in today’s Australian. For example, Reliance Industries in India is currently building a single refinery with a capacity of 600,000 barrels per day-greater than the combined capacity of Australia’s seven operating refineries (590,000 bpd).

–Refined fuels, mind you are different than crude oil. An industrial economy needs all manner of specialty petroleum products to keep the wheels of commerce from squeaking. It’s not just petrol for transportation fuel and kerosene for jet fuel.

–But demand in Australia for refined fuel products is growing faster than the current refineries can keep up with, forcing Australia to import more from refineries in Asia (especially Singapore). Australia’s seven operating refineries are listed below in a chart from a 2004 report prepared by the Howard Government called “Securing Australia’s Energy Future.”