Monday, April 29, 2013

CIA Delivers Bags of Cash to Karzai

In a 2011 post we wrote,
"In President Karzai, the West is funding a presidency which is thought by the population and by international observers to not be legitimate.  It is also deeply corrupt."
A year ago, we wrote,
 Here is an excerpt from a current story from Radio Free Europe/Radio Liberty:
"The Taliban and criminal gangs, old and new warlords, and tribal leaders rule vast parts of the country. The authority of the government, many of whose ministers are considered corrupt, barely extends beyond its offices in Kabul. In order to survive, the Karzai government has to ignore or accommodate all those forces working to undermine it, from the Taliban to the warlords. "
Now, suddenly, our lapdog press reports that the CIA has been delivering bags or backpacks of cash monthly to President Karzai,
 "The C.I.A. payments open a window to an element of the war that has often gone unnoticed: the agency’s use of cash to clandestinely buy the loyalty of Afghans. The agency paid powerful warlords to fight against the Taliban during the 2001 invasion. /...
But the cash deliveries to Mr. Karzai’s office are of a different magnitude with a far wider impact, helping the palace finance the vast patronage networks that Mr. Karzai has used to build his power base. The payments appear to run directly counter to American efforts to clean up endemic corruption and encourage the Afghan government to be more responsive to the needs of its constituents." 
We stand by what we wrote in March,
"The only currency that will work with Mr. Karzai is money, not more of our money, but less of his accessible from his numbered bank accounts or other hidden assets.  Relationships are fine, but this one is dysfunctional and manipulative; we are on the wrong end of the manipulation.  The sooner this gets put on the right footing, the safer our troops, personnel and allies will be as we withdraw."

Friday, April 26, 2013

Chinese Air Pollution and Public Health

                      Since January, the world press has been forced to acknowledge that urban air quality in China is no longer a red herring issue of economic growth, but a national and international public health menace.  Japanese researchers are looking into potential effects of pollution from China on old arboreal forests in Japan. The long-term costs won't be known for decades, when it may be possible to publish results long term studies of effects on coronary and pulmonary health and mortality.  Children, like the little girl in the photo, who are growing up exposed to the toxic soup would be ideal study candidates.
"Let’s start with the gloom. China’s air quality is already dismal, thanks to an ever-growing number of coal-fired power plants, factories and automobiles. The annual average levels of small particulate pollution, PM2.5, in cities is at 75 micrograms per cubic meter, three times as high as what the World Health Organization considers safe. (And that’s an average — in January, Beijing’s pollution levels soared past 900 µg/m3.)"  Source: Washington Post
It's macabre to think that the U.S. Embassy sensors in Beijing only go up to a maximum of  500 µg/m3, a level that would have been viewed as unthinkable.  Middle class Chinese executives and professionals are already sending their children out of the country to private schools abroad to spare them from the air pollution scourge. The parents are soon following when they can work out visa arrangements for the U.S. and Europe. Expatriates are turning down Chinese assignments because of the public health concerns for their families.  

Organizations like Greenpeace, which get exercised about minutiae and non-problems in the U.S., are totally neutered pussy cats in China, where they should be shouting from the roof tops.  India's legendary air quality in Calcutta and Delhi puts it in China's club. It's only a matter of relative sizes of the economies as to how bad both economies are in terms of contributing to global pollution and public health problems.  

What's being done?  Nothing of any import or substance.  Believe it or not, there is a Chinese "cash for clunkers" program.  Public health issues are simply not in the economic calculus of China's national leaders and the system of inefficient public companies and favored enterprises which together have generated the enviable GDP growth and burgeoning reserve balances.  Greenpeace and others await the publication of Chinese CAFE standards for automobiles.  

It's a shame because the Chinese citizenry both in cities and in the countryside deserve so much better from their leaders.  

Thursday, April 25, 2013

Supervalu's Fourth Quarter: Management Gets Down to Basics

Nothing in the most recent fourth quarter results for Supervalu changes the assessment in my January post. The new CEO and senior management team are getting down to the basics of running a pretty simple business model.

CEO Sam Duncan reported on holding a town hall meeting with 200 Save-A-Lot licensees in St. Louis, the city where Bill Moran founded the chain.  The licensee group collectively own 400 stores,  or about 43% of the total licensed stores.  Licensed Save-A-Lots account for about 70% of the chain's 1,331 stores.

What's extraordinary about this meeting is what CEO Duncan was told by the licensee group: "..we (Supervalu) had largely lost our way and were no longer true to what the hard discount format should be." The Star Tribune reports that management was told the chain's costs had gotten out of line.

The entire business model for this format is based on an obsessive focus on costs from real estate to assortment to payments.  What were the previous managements doing all these years to have this message delivered now?  How could Save-A-Lot have been endlessly touted as the future of Supervalu retail growth when either the licensee group or the corporate group, or both, were failing to run the stores properly?

CEO Duncan also announced the formation of a national retail advisory council of independent customers to give ideas and feedback.  This is cited as an "exciting first for Supervalu."  What were the previous management teams and board doing?

Imagine McDonald's having no contact with its franchisees?  Most of their menu innovations came from their franchisees.  Surely, the folks on the ground know their businesses better than the folks at corporate. Things surely have to get better with better connections to the customers.

Decentralization of advertising and assortments is going to be challenging for a company that has been run in a completely different way.  The IT bugaboo will also be interesting.  All told, it was an encouraging quarter, with a turnaround built on basics, much as Best Buy's "Renew Blue."

Tuesday, April 23, 2013

Unwinding Fed Balance Sheet: Another Leap into the Unknown

Today, Goldman Sachs economists projected a lengthy time period for unwinding the Fed's balance sheet.  Here's what they had to say,

"It may take the Federal Reserve nearly a decade to bring its massive balance sheet back toward a more historically normal size, Goldman Sachs economists argue in new research.Forecasters at the firm say that if the Fed presses forward with its expected path of stimulus and continues to buy Treasury and mortgage bonds through the third quarter of 2014, it is unlikely that its balance sheet will get back toward a historical norm of around 6% of GDP until 2022.The Goldman note argues the most likely path for the Fed is that what is now a balance sheet of just over $3 trillion will top out at around $4 trillion when the Fed feels confident enough about the outlook to end its ongoing and currently opened ended campaign of bond buying. The bank expects the Fed to contract its balance sheet by allow its holdings to mature instead of actively shrinking its holding via sales."

We've talked about this being a Great Unknown for a couple of years.  Ironically, Minneapolis Fed President Kocherlakota, who has undergone several chameleon-like changes in his evaluation of QEs, wrote back in 2011,
"In the Stern book, the authors quote Minneapolis Fed President Narayana Kocherlakota as saying that the Federal Reserve's balance sheet in twenty years will likely still have $250 billion of mortgage backed securities on the books.  Unwinding the Fed's $2 trillion balance sheet will not be easy, as we've written about before."
Note that Kocherlakota was talking about unwinding a balance sheet half the size of the peak balance sheet postulated by Goldman Sachs. The GS comments about the Fed letting MBS and CMBS securities mature versus selling deserves some explanation.  Clearly, all the experts in this field are peering into the unknown, as the markets move blithely forward.  Does this remind you of another period running up to 2006?

Wednesday, April 17, 2013

Dreams of European Recovery Fade

As recently as a few months ago, Mario Draghi was hailed as the economic savior of Europe.  It had something to do with "bold action" and instilling "confidence."  It had more to do with printing presses and "lender of last resort."

Now, as reality sets in, forecasts of European growth are being cut as the forecasting wizards of the IMF met at their latest confab.  Today, the Wall Street Journal quotes Germany's top central banker, Jens Weidmann,
"Germany's top central banker warned that Europe's debt crisis will take as much as a decade to overcome, dismissing the view expressed by some political leaders that the worst of the crisis is over."
Later in a question and answer period, Weidmann says,
" In that sense the calm that we are currently seeing might be treacherous and my concerns relate to reforms both at the national and at the European level. I’ve gone out of my way to say that in my view—and in contrast to many declarations we’ve heard in the recent past—the crisis is not over. It is erroneous and dangerous to believe that the crisis can be solved in a year’s time. Overcoming the crisis and the crisis effects will remain a challenge over the next decade."
Without addressing labor market reforms, restoring European competitiveness particularly of France and Italy will be a fruitless pursuit.  I would disagree with Herr Weidmann when he opines the strength of the euro is an endorsement of economic fundamentals.

I would use Bill Gross' metaphor as being apt.  The U.S. economy, and the dollar, in time of risk and uncertainty is the "cleanest dirty shirt."  With the recent moves of Bank of Japan and concerns about spillovers from the Korean peninsula, investors who can't go "all in" on the dollar find the euro appealing, particularly with the ECB backstopping.  So, the euro is the "least dirty, dirty shirt" among non-dollar currencies.

Monday, April 15, 2013

Lessons To Learn From J.C. Penney

I will wager if the question were asked of Wall Street brokers, bankers and analysts "When was the last time you or your family shopped at J.C. Penney?" the honest answers would be "Never," or "I don't remember."  Penney lost its way over decades, and suffered from the total neglect of its board and management.

There was a long-running experiment to become a poor shopper's Kohl's, but this experiment was an utter failure.  National branded apparel also gradually disappeared from the store, replaced by awful private label lines, including the once passable "Stafford" line.  Margin rate became the call word.  The worst private label apparel quality in the middle market segment belonged to Penney.

The stores themselves were dimly lit, understaffed, and were filled with what looked like dump tables rather than merchandise displays.  Customers armed with coupons from newspaper inserts probably felt they were getting a bit better quality and a wider assortment than at Odd Lots.  This, in my opinion, is the background against which to measure ex-CEO Ron Johnson's attempted transformation of Penney. Here are some lessons to be learned.

1. Bill Ackman was right about there being a significant opportunity to create shareholder value at Penney.  Sometimes, hedge fund managers, or other activist shareholders, are required to wake up sleepy managements who are letting their companies wither on the vine.

2. Ron Johnson's experience with Apple's retailing wasn't directly relevant to Penney, as Apple is a cult stock, a niche PC provider, and a company extracting huge economic rents from music and mobile computing.  His experience at Target should have been an asset, in terms of operational experience and relationships with suppliers, but any benefit was overwhelmed by mistakes.

3. "Every day low pricing" doesn't work in soft goods. Breaking the pricing into three tiers was a compromise and confusing for sales people to explain and for customers to understand. However, it was necessary to move customers away from the addiction of double couponing.  This transition should have taken a back seat to the remerchandising and repositioning of the stores.

4. The culture at Penney had to have been broken.  This transition takes time.  Commuting in from California and allowing senior executives to do the same was arrogant and should not have been permitted when Johnson was recruited.  The board, led by Bill Ackman, was foolish to allow this arrangement.

5. Academic studies have shown that the real advantage private equity owners provide over public ownership is not in making better decisions, but in taking them faster.  In this case, a public entity, driven by a private hedge fund owner, was driven to take decisions at "light speed," and a number of these decisions were deeply flawed.

6. Penney's operational structure was less like Target and more like a department store.  This means layers of unaccountable decision making and a bureaucratic mentality.  Communicating messages through this kind of network and weeding out the weak players takes time, and again speed probably killed here too.

7. Bill Ackman was wrong.  Hedge fund managers are really smart people: they are masters of chess, poker, and bridge.  They don't run companies very well at all.  The models for their enterprises, where they take the lion's share of their investors' cash no matter what their own performance, doesn't prepare them well for understanding who or what it takes to turn around moribund public companies.

From here, bringing back the previously ousted CEO, the company needs to clearly communicate to its investors how Penney can get back on its feet by taking the best of what's been done and rejiggering the model to adjust its profitability.  Starting a new experiment or returning to the past would be disastrous.

Friday, April 12, 2013

The Big Hype Begins for Big Data

Back in May 2012, we started looking into "big data," as it was starting to make the rounds of university alumni magazines, technomags, and the occasional CEO speech, as with HP. In this construction, big data was a step-child of "cloud computing," the other big marketing concept.

You can be sure that big data has arrived as a big time concept when academics jump in, and as the New York Times reports, they have done in a big way.

If you want to see how foggy the concept is, check out this video from the Institute for Data Sciences and Engineering, Fu Foundation School of Engineering at Columbia University.  Between one the heads of the IDSE, Professor McKeowen and Dean Goldfarb, they stumble around the edges without being able to cogently describe what exactly the Institute will be teaching and training practitioners to do.

The Times reports today that data scientists will be among the most highly recruited graduates in the coming years.  Among the leading commercial companies employing "big data" concepts are Google and Amazon.  Most of what these future graduates will be working on will be fairly boring and routine. They will become like the "Microserfs" who worked on the early code for Microsoft Office: important work, but mind numbing. Of course, many of these engineers got wealthy through stock options in the then smaller company.

On the other hand, using the statistical, computer science, and decision science concepts for bioinformatics and personalized medicine will be interesting, but the data scientists will probably function like grunts,on an multidisciplinary team headed up by physicians or biological researchers.

Mike Loukides on the O'Reilly Radar has a good introduction to the broad contours of data sciences.

Coincidentally, about two weeks ago, I finished an interesting book by Samuel Arbesman, "The Half-Life of Facts."  Dr. Arbesman's Ph.D. is in computational biology, but his book is about a collection of inter-related issues and makes good reading.

Arbesman warns against the "big data" hype by saying the utility of oceans of data to determine the optimal pattern of traffic light timing is Rio ("Smart Cities") is rather limited.  The thorniest problems will require "long data," i.e. time series and a different set of analytics.

If you're buying HP, Cisco, IBM, VMware or other stocks for the big data play: relax, you're WAY early.

Wednesday, April 10, 2013

HPQ: Up 55% in Six Months. Why Be Afraid?

We were concerned after the annual meeting that the company's directors had emerged unscathed, but we've finally had a small degree of accountability as former board Chair Ray Lane stepped down from his role, and two other board members resigned.  Ray Lane, if he did even a cursory examination of conscience, should have resigned.

Since he became board Chair in 2010, the stock plunged 42% before its rebound.  As Bill George mentioned on Bloomberg, destruction of value was widespread during Lane's disastrous tenure: $1.5 billion paid for ArcSight, $11 billion in cash paid for Autonomy, and plans made to spin out the PC business, which were later rescinded.  Bill George also points out that four rounds of board shakeup occurred under his chairmanship, including former Medtronic CFO Robert Ryan becoming so frustrated that he resigned.  His financial acumen and diligence were then missing during the Autonomy fiasco.

So, over the past six months Hewlett Packard's share price is up 55%, compared to about 15% for Cisco, and about 10% for the SP500.  So, what's not to like?  Goldman Sachs rates the stock a "Sell," which is unusual for a large cap tech friendly investment bank.  The stock price is clearly ahead of its fundamentals and reflects some turn in sentiment and a search for total return in equities with a decent dividend yield.

Financial market commentators talk about bringing  technology gurus and venture capitalists on to the board.  Nothing could be more tone deaf and ignorant of recent institutional memory.  Both ex-Chair Lane and current board member Marc Andreesen are venture capital fund managing partners.  CEO Whitman came in trumpeting that she was from "the Valley."  HP is not a recent exit from a venture capital fund.

It is a company with $120 billion in revenue, and an icon of global technology which is in danger of becoming  marginalized or irrelevant.  It certainly doesn't need to make any more foolish acquisitions.  The board needs some directors who understand how a balance sheet works, and who can empower an embattled CFO with few board allies, to do her job in building  the B/S back up to being bullet-proof and capable of returning excess capital to shareholders. As Bill George suggests on Bloomberg, former Medtronic CFO Robert Ryan was one of these directors, but he felt the need to resign from Ray Lane's board circus several years ago.

Giving the Board Chair to CEO Whitman is unwarranted and bad governance.  Fundamentally, she has said that the HP turnaround plan is an enterprise that will take "years."  If that's true, there is no greater way to add value than to let her and her executive team work the plan every day for years and let the plan work for the shareholders through the stock price.

The quality of the last quarter's outperformance was dubious, and as Goldman Sachs says in their commentary, any "cost savings" relative to some bloated baseline will be offset by continuing deterioration in the PC and Printer businesses, along with the commoditization of high volume server lines.  The turnaround has begun, but it can't reflect the 55% increase in value over six months in any rational calculus.

Finally, the Jekkyl and Hyde stance on Autonomy needs to stop.  "It's the greatest company on the planet, and we didn't overpay."  "We vastly overpaid, and we were lied to by fraudsters."  "It's in the hands of the SFO and the SEC."  "Autonomy remains a crucial part of our plans." Never mind that this most recent statement is completely out of sync with some of the executive statements made during Analysts Day, when it was suggested that their product development and sales processes weren't capable of being repeated in volume. Pick one story and stick to it: give numbers where possible.

Finally, Bill George laments the wimpy shareholder activism of HP shareholders.  The Bloomberg correspondent comes back at him by bringing up Ralph Whitworth's name as a counter-example.  What about Dodge and Cox?  They are, I believe, the largest, fundamental, long-term shareholder.  They have been passive to the extreme.  Like an electorate, shareholders get the company they deserve.

HP employees continue to be positive about some of the cultural changes at HP during CEO Whitman's reign.  Of course, her comparisons are easy against Mark Hurd and Leo Apotheker, but who cares?  Let the turnaround continue!

Saturday, April 6, 2013

Subsea Mining: Solwara Update

The first adjudication date for the dispute between Nautilus Minerals and the Government of Papua New Guinea has been set for June 20, and the company issued an optimistic update on April 4th in which they announced going ahead with a rights offering, positive early discussions with the PNG government, and interest in joint ventures and SSMS projects outside of Solwara.

It remains to be seen if unproductive economic nationalism on the part of PNG scuttles a potentially groundbreaking project for which the environmental safeguards had already been mutually agreed.  The bigger question, as always, is the future market prices for the constituent minerals, as some observers are now forecasting a broad decline in global mineral prices due to slowing Chinese growth, substitution, and a dampening of financial speculation.

Split the Chairman and CEO Roles at JP Morgan Chase: No Excuses

The discussion about splitting the Board Chair and CEO positions has become a referendum on the popularity of Jamie Dimon, or a stroking of his ego by another less-than-stellar board.  More and more companies are splitting the roles: it is clearly not a one-off measure aimed at Dimon.

Our post after reading the London Whale report shows the reasons, based on the board's own discussions,
"The J.P. Morgan Chase board of directors rightly concluded that the CEO should be able to rely on the competence and ethics of his direct reports.  However, it also said that "...he (Dimon) could have better tested his reliance on what he was told."  The board had no choice but to take the approach of "the buck stops here" with CEO compensation, and it did." 
The CEO would be in a much better position to test the veracity of what he is being told by self-interested lieutenants, and to enlist the help of internal audit or whomever he wants if he were not required to be busy planning and running board meetings.

After re-reading the Whale report, it is even more laughable than the first read.  Really, a systemically important institution that can't even measure its own risk profile, turns to some unknown British "mathematician" called "the modeler?"  Getting a handle on these issues requires the CEO's attention to focus his own management team, and this is not the work of the board, except insofar as it forms its own independent view through the audit committee.

Separate the roles and don't make a big deal out of it.  The SEC and the New York Fed should also weigh in through their back channels and insist on the change.

Friday, April 5, 2013

HP Directors Take Their Cues and Exit

Readers of this blog know that we've been on the issue of HP's directors for a long time.  A lot of it has to with the past, including the recent past with the CEO hire of Leo Apotheker and the imbecilic acquisition of Autonomy.  Equally importantly, I think about the future and about the CEO's need to be surrounded by a board that can support her, challenge her and provide assets and insights different from her own.

We'd again like to suggest Marissa Mayer as someone who might provide different assets, insights and perspectives to a reconstituted board.  I'm sure that there are quite a few good candidates out there, and here's hoping that there is a good process for finding and vetting them.

HP's turnaround has begun: just as the stock price was battered too low at $12, it's gotten a bit ahead of the story here. This is typical for market adjustments.  The "roll up your sleeves" phase is just beginning.  With a better board, the odds of success increase.

Best Buy's Smart Move With Samsung

Today's financial press rightly makes a big deal out of Best Buy's move to open up 1,400 of its stores to Samsung's "Experience Stores."  The Korean giant will staff the stores with its own, dedicated cadre of product knowledge experts.  

Back when Best Buy was being left for dead within the analyst community, we made the following observation,
"Some analysts suggest vendors might not have an interest in Best Buy surviving.  Just like 1994, I can't understand what these folks are thinking.  Vendors need Best Buy.  Best Buy hasn't treated the vendors like partners and it hasn't demanded, or merited, the best from them.  This can be fixed."
So, again, I'd disagree with the Wall Street Journal's characterization today that "Samsung's move today throws a lifeline to Best Buy."  Unlike HTC and other companies, Samsung has emerged from Apple's powerful mobile wake as perhaps its only serious competitor.  However, making a retail presence for itself in the U.S., apart from the carriers and Amazon online, would be prohibitively expensive and likely to fail.

Samsung has always made nice, underrated mobile phones.  They work like Swiss watches, have user friendly design features especially in the user menus, and they utilize their batteries well.  Their designs haven't traditionally been candidates for MOMA design awards, but they were fine. I'm on my  second non-smartphone now, only because I lost the first one.  Now, they've sent Apple a wake up call, and they need to make a serious push.

Best Buy's move treats them like a partner, rather than a source of product, and it should expect the best of them in these stores, because it is Samsung's game to win or lose.

Check this out from Samsung's recent Annual Meeting of Shareholders:
"Firstly, Samsung Electronics will work to advance into a company that leads the global electronics industry. To this end, the company has drawn up plans to maintain its lead over competitors in key business areas, including the mobile phone, TV, and memory businesses, while strengthening basic competencies in promoted business areas, including the home appliance, printer, camera, and system LSI businesses. .../

Thirdly, Samsung Electronics will continue to make efforts to solidify its reputation among consumers and gain wider acceptance in society as a trusted and admired company. 

Moreover, Samsung Electronics will continue to advance the culture of mutually beneficial growth with its partner companies, in which knowledge and expertise is shared to enhance the global competitiveness of its partners. 
Don't think for a minute that the presence of  Hubert Joly as Best Buy CEO, an experienced global executive, didn't have a positive impact on this deal.  It should also help its success downstream and open up other opportunities for Best Buy to "Renew Blue."

Thursday, April 4, 2013

China's Breakout: McKinsey's Thoughts

McKinsey partner Gordon Orr has written a piece for the McKinsey Quarterly on issues for the Chinese economy in 2013. We recently posted on Ruchir Sharma's "Breakout Nations," which has a longer-run perspective about emerging markets, but Orr's article tangentially touches some issues of longer-run concern.

In the short run, McKinsey expects Chinese banks to underperform. As a result of the post-2009 economic stimulus and programs in prior years, the Chinese banking system has a a large volume of underperforming loans which need resolution.  As the banks looked for new income streams, they sold wealth management products to well-heeled customers and small savers.  These products, McKinsey says, have to right-sized on bank balance sheets.  The net effect, McKinsey says, is that the system will need 1.3 trillion renminbi ($208 billion) in new capital within the next five years.

Even if this problem comes to light in 2013, its resolution will take years, and the initial extent of the banking system's problems should prove, as in the case of every other other national banking crisis, to be understated.

China consumes 50% of all pork produced globally, and its internal food production, storage and distribution system is already pushed beyond its limits. Pork and chicken prices have risen 100%.  In July 2011, prices rose by 57% year-over-year driven by herd thinning due to high grain prices and by disease.  Foreign imports can't fill the gap, especially because of an "extremely rudimentary cold supply chain."  If the Chinese government wants to see a shift towards consumption, shortages of consumer electronics will not be the issue, but shortages of food and packaged food products may very well be the Achilles heel.

Local protests are said to be rising in frequency and intensity, McKinsey says.  The government is reluctant to begin visible clampdowns in a Twitter and SnapChat-filled communications world.  There is, the author says, a growing resistance to building more pollution-generating projects like mining and chemical ventures in the countryside.

As the push for infrastructure spending increases, the issue of capital efficiency will come to the fore.  Efficient use of capital, some research has shown, is a key for countries to breakout from emerging market status to that of a developed economy.  Chinese capital utilization has been splashy and visible, but not necessarily efficient.

Online retailing may turn traditional Chinese store retailing on its ear.  A particular model being used by Chinese-American entrepreneurs in the U.S. may work very well in China.  The model produces frequently changing designs of consumer textile products on small runs, which encourages new orders and established customers to frequently check the offerings.  If this model were exported to China where labor rates are lower, it might work.  The point is that traditional big box retailing might not have a future in China apart from the super-cities.

Middle class parents are said to be hedging their bets by enrolling their young students in foreign boarding schools, as their parents also acquire property in these countries, from Switzerland to the United States.

Foreign investors, McKinsey says, are increasing their investment in the Chinese Super League, as football club prices in England's Premier League are at relatively stratospheric levels for the top clubs.  This would be a good sign and a potentially good way for foreign investors to indirectly play the rise in consumer income and wealth.  It remains to be seen how, and if, foreign investors can make money and achieve liquidity.

China is increasingly looking to take stakes in foreign agriculture, as it is already the second largest importer of rice and barley, and among the top ten importers of corn.  The country already leases hundreds of thousands of hectares of crop land from Australia to Kazakhstan for growing soybeans. Moving large volumes of grains, seeds and oils is probably one factor in the interesting venture recently announced among Cargill, private equity and Chinese shipbuilders.

Smart, agile traders will have some money making opportunities in the next few years as the Chinese economy adjusts to longstanding imbalances and begins a different stage in its economic development.

Tuesday, April 2, 2013

CalPERS, the Environment, Clean Technology and Municipal Creditors

Ann Simpson is a senior portfolio manager at CalPERS and heads up their global governance efforts.  The Wall Street Journal's recent report on the Environment has contrasting quotes from two portfolio managers.

Ms. Simpson says,
"The financial crisis we've just crawled out of cost CalPERS something in the order of $70 billion. That's the cost of getting it (?) wrong. So companies, whether it's a high-quality audit or it's environmental reporting or good internal controls, we'd prefer that you think about this (?) as an investment.  ...we really want companies to invest the time and the effort in getting these material environmental issues identified, properly reported and then managed." 
So the $70 billion in losses could have been reduced by spending more money on reporting environmental issues?  I thought that the financial cascade failure in the global financial system was triggered by issues at the Reserve Primary Fund; these reflected massive failures among corporate management, their auditors and financial regulators.  Who knew that there were environmental causes?

Turn the page to the inside of the report, and there's a series of quotes from Joseph Dear, the Chief Investment Officer of CalPERS.  According to Mr. Dear, a CalPERS fund devoted to clean energy which began with assets of $460 million in 2007 has generated an average annualized return of (-9.7%) to date.  So, actually investing in sustainability as CalPERS as an objective has been an awful investment for pensioners. Mr. Dear says,
"We have almost $900 million in investment expressly aimed at clean tech.  Well, for CalPERS, clean-tech investing has got an "L-curve" for "lose."  Our experience in this has been a noble way to lose money.  And we're not here to lose money."  
If these funds had been mutual funds sold to the public, they would be seeing an exodus of shareholders, but  CalPERS is privileged as a public system because of its size and political activism.  As a high profile public scold for corporate n'er-do-wells, it is particularly ironic that in 2013 the former CalPERS CEO was indicted for fraud in a pay-to-play scheme to defraud a private equity firm. I guess that their own internal governance checks and balances were not properly managed.

In the Stockton and San Bernardino, California Chapter 9 municipal bankruptcies, CalPERS is resisting any efforts by creditors and bond insurers to treat them alongside the other creditors.  The bankruptcy judge seems to leaning to the preferential treatment avenue for CalPERS while bond holders will be asked to take a substantial haircut to principal.  Nothing like being able to take advantage of an implicit subsidy, which is what the entire shadow banking system did during the financial crisis.  Mr. Dear said that he was not here to lose money, and if preferential treatment is what it takes, then so be it.

At the end of the day, these municipal creditors have only themselves to blame.  If they were too lazy or too stupid to understand their real downside risk, then that's the way it goes: they deserve the pain.  Chapter 9 is good for city managers and  for CalPERS.  Everybody else is left holding the bag.

Monday, April 1, 2013

Breakout Nations: Investors Have to Pick Winners

Ruchir Sharma, who heads up Morgan Stanley Asset Management's Emerging Markets efforts, has written a thought-provoking book for investors and economic analysts called, "Breakout Nations." I'm basing this post on reading the book and on an interview Sharma gave with Professor Robert Wade of the London School of Economics.

2007 was the best year for investment returns from emerging markets, capping off their best decade as an asset class.  Sharma says that the macroeconomic foundations of this outperformance were provided by the easy money policy of the Greenspan Fed, a global commodities boom, and the "financialization" of commodity markets.  Of course, these three  turbochargers can't sustain superior returns against the prior periods.

The overarching premise of the book is that during the decade ending 2007, an investor could have bought almost any emerging stock market or an emerging market index fund and achieved market-leading returns.  Going forward, country allocation, in addition to company selection, will be critical for investors looking for superior returns.  The potential winners in the coming decade may not include the choices trumpeted in the financial press.

In the book, Sharma describes his personal research process when he visits a country.  He meets with a wide variety of non-financial and non-corporate, and non-governmental people, including movie stars, sporting celebrities, and the luxe consumer classes about which so much is written.  He takes auto journeys away from the corporate islands and metropolitan centers.  As he paints his mosaic, he then uses this to challenge the quantitative, financial analyses of Morgan Stanley's analysts and portfolio managers,  He uses these economic travelogues to frame a 3-5 year economic cycle for each emerging market, incorporating the data produced by his analytical organization.

In 2010, money flows into emerging markets were massive, and countries like India recorded record investment inflows.  Of course, the macro drivers included the Bernanke Fed's policies that drove investors to take more risks in order to generate their required rates of return from financial assets. Around this time period, the Economist magazine featured several cover stories about the Valhalla of emerging markets for investors in developed countries.

Of the approximately 180 countries, excluding failed states, 35 are developed market economies, and the rest are either emerging markets or frontier markets, according to Sharma.  Looking at cycles of economic growth, he says that economic growth and stock market performance is never an unending, upward trend line; it is more like a game of Snakes and Ladders.

He cites the probability of a country experiencing GDP growth of 5% per annum or better for a decade as being one in three.  The odds of a fast growing decade being followed by a similar growth decade, he says, is one in four.  The probability of a third consecutive growth decade drops to one in ten.

The literature is filled with linear extrapolations of growth that appear naive and foolish, ex post. Sharma cites the IMF's forecast that the world's developed economies would now have welcomed Brazil, the Phillipines and Sri Lanka.  Going a bit farther back, Sharma cites a projection by Nobel Laureate economist Paul Samuelson that Russia would overtake the U.S. in terms of the size of its economy.  Those are some really lousy forecasts!  Warning: treat all long-term economic forecasts with a great deal of skepticism, as they will be hazardous to your wealth.

So, looking back, what were the real breakout nations?  South Korea and Taiwan.  Both countries have grown their GDP at an average annual rate of 5% for five decades.  For other emerging market stars, the 1980s and 1990s provided global market headwinds, like the '94 Mexican crisis, the '97 Asian crisis, and the '98 Russian crisis.  During these periods, Sharma says, emerging markets as a group average slightly above 3% GDP growth.

Russia, which has experienced GDP growth rates of 7% is seeing forecasts ratchet down to the 3% level.  In terms of the Billionaires Index, something cited by Sharma, Russia is number two behind the United States, despite the fact that its economy is relatively small by global standards.   There has been relatively little churn in the composition of the Top Ten, something which Sharma sees as a negative indicator for the future.

A static composition of the top tier suggests a lack of innovation, a concentration of power, and the suggestion that wealth is created and maintained by preferential connections to the government.  In the case of Russian oligarchs, this is a truism.  Aside from the Russian natural gas  hammer being applied to Western Europe, there appears little to underpin a strategy of strong economic growth in the coming decade.

India has had no churn among its top billionaires.  Sharma sees a widely held perception during his visits to India that the populace sees the blessing of the Central government as being the key to economic success.  He goes as far as saying that this feeling about big business being in bed with a corrupt government is what fuels sometimes violent popular movements like the Naxalites.  China and Korea, by contrast have high degress of churn in their top ten billionaires and millionaires.

China has experiences average annual growth rates of GDP of around 10% for three decades.  It is on its way to becoming a middle income country, and he says that the narrative of the "disappearing Chinese consumer" is a myth.  He also says, however, that the IMF forecast of future GDP growth of 8% is probably unlikely.  China's chances of moving into to the top tier of developed economies is around 50/50 due to the often discussed economic, political, and financial imbalances within the economy.

Brazil has used its riding of the commodity booms of past decades to create a welfare state, and a corrollary has been the almost total neglect of internal infrastructure, which we have alluded to in a previous post about global food production.  Sharma's outlook for commodities in general is bearish going forward.

The overriding influence is China's growth rate, which is slowing, as has its demand for raw materials, including for strategic stockpiling, as for rare earths.  In addition, markets have developed substitutes for certain key materials and reduced the resource content for key manufactured goods.  China's demand accounted for 30-60% of global raw material demand for certain commodities when its economy was growing at 10% per annum during its construction boom decades.  All of these trends, Sharma suggests, are reversing.

The availability of capital from global banks, he says, is drying up compared to prior decades. Fiscal issues will be difficult for some economies, e.g. India were growth is slowing, rural wage inflation is rising, food prices are increasingly volatile, and the current account deficit is large and growing.

Sometimes Sharma's interviews lapse into a journalist's superficiality, but there's no doubt that he's put together a very readable book, identifying food for investor thought.