What's Next For China?

Back in December, I posted a reflection on on the terrible track record of long-term forecasts, and it was mindless euphoria about the Chinese economic miracle that stimulated that post. David Beim of the Columbia University Graduate School of Business has written a paper for the NBER, "The Future of Chinese Growth," that brings a thoughtful eye to the consensus forecasts.

China's economy has had a thirty year run, ended 2010, where real GDP growth averaged 10% per year! This is extraordinary by any measure. Beim points out that this performance was driven by two, high octane sub-periods. The first was the explosion of Chinese entrepreneurship launched by Deng Xiao-Ping in the 1980's in which the central government subsidized and sponsored private enterprises in China's villages. These efforts distributed their benefits widely throughout the country and were domestically focused.

Beim identifies the next phase as being driven by the annexation of Hong Kong and by the political accession of politicians with Shanghai loyalties. These two forces led to the development of large, coastal-oriented enterprise clusters that were export-oriented, with mainland China supplying large, efficient production and distribution facilities and cheap provincial labor, with the Hong Kong Chinese supplying management expertise and finance. Continuing huge capital investments financed by Chinese banks fueled the export boom that has brought us to where we are today. The benefits of this phase have accrued to a new elite, and this drive was one hundred percent export oriented.

Invoking the neo-classical growth model of Solow and Swan, Beim shows that China is already experiencing diminishing returns to capital, and he suggests that Chinese banks may be ignoring balance sheet issues associated with their cowboy underwriting standards during the export-led boom. Everybody, even the popular press, has written about the need for the Chinese economy to shift to domestic consumption growth. Beim's thesis is that this will be easier said than done. If this is the case, it would seem that the bubble inside the Chinese miracle could end badly. It's definitely thinking outside the box.

Framing The Issue of Educational Reform

Mainstream media have framed discussions about educational reform as referenda on the qualifications and salaries of public school teachers. Of course, everyone knows this is misleading and off the mark, but it serves to obfuscate the real issues and to polarize the debate, ensuring that nothing gets done.

As Bill Gates found for himself when he undertook to study the question, it's what Gates Foundation scholar Marguerite Roza calls a "wicked problem." He's speaking about the issue today in a public forum.

It begins with the convoluted way in which public education is financed. School districts are funded locally through the property tax system, which seems eminently reasonable and logical. However, then the states get involved in parcelling money back to localities. For this, the states are entitled to set all manner of regulations touching things like class sizes, teacher compensation, teacher educational requirements and tenure systems. Whatever costs this crazy quilt of regulations imposes on localities, the local taxpayers absorb, without any direct influence or control. The final layer are Federal regulations affecting everything from school lunches to requirements for innumerable special interest programs. For all these additional regulations that impose costs on local taxpayers, the Federal government only contributes about 9% of an overall school district's funding.

By now, the system has drifted far away from the basic service of delivering a quality education to students on a local level, with transparency and accountability to the local taxpayers who still supply the bulk of school district funding.

Another fundamental issue is financial transparency. We argue incessantly about details of US GAAP financial disclosures for corporations, delving into minutiae and trying to standardize internationally. In public sector education, for reporting at the school district level, there is no transparency at all. Gates Notes has some interesting research on this topic.

According to Gates Foundation staffer Marguerite Rozas, it's impossible to determine at any level how much is spent actually educating students in mathematics for example, or how much is spent to achieve outcomes in the subject. At best, Rozas reports, there are categories like "Instruction," which cover more than fifty percent of a school district's budget, but it's not possible to drill down from this mega-category into anything useful. At best, we can come up meaningless national averages, like the United States spends $10,000 per student, which we then compare to equally meaningless numbers from other countries. We then talk about funding gaps.

Rozas points out that districts have no way to compare what is spent for mathematics in different schools in a district, which might give clues as to effective or ineffective resource allocation within a district. In local districts, there is often a disconnect between teachers and administrators, who are rarely former teachers. These administrators come from a variety of backgrounds, and they enter the field by getting a postgraduate degree in educational administration. Administrators should be culled more from the ranks of successful teachers who have been soldiers before they become generals.

Congratulations to the Gates Foundation for taking on these issues. If Bill Gates needs help figuring out how money is raised and spent for public education, then we definitely have reporting and transparency problems.

Kings of the Blues

It seems like everywhere I turn on the radio, someone is recording with B.B. King, and the endless tributes deservedly flow to a blues master. I recently rediscovered a disc from the neglected Albert King, with his Flying V guitar, "Lucy." I guess that I hadn't listened to his discs in a while, and it struck me how raw Albert's sound is compared to that of B.B. King.

The guitar tone is not big and round, like B.B.'s Lucille. Albert's guitar tone is stinging, and his voice and diction are less urban and more back country. I heard a song, "Angel of Mercy" that knocked me back in my seat. It's an unforgiving portrait of credit crisis and unemployment told by a great blues master in his best voice, singing his heart out. Lucy throws in her accents and fills at just the right times. This is a classic that time has forgotten, in my opinion. Albert's use of horns, and an organ to give a nice bottom to the band is also something that distinguishes his style. Give it a listen and tell me what you think.

The King who has really fallen by the wayside is Freddy King, from Gilmer, Texas. He's probably my favorite in the pantheon. His loud, reverb heavy guitar backed by a great piano player and small band is a unique signature. I was blown away when I first heard Eric Clapton's solo on "Hideaway," which is on the first album by John Mayall and the Bluesbreakers. Years later, I found Freddy's original solo, which Eric had ripped off, note for note, even with the heavy reverb! That's how it goes for the innovators. Freddy King is always worth a listen.

Best Buy's Chinese Expansion

The headlines characterized Best Buy's closing of its Chinese stores as a pullback from globalization. But, as much as shareholders pine for their portfolio's big retailers to go global, especially in emerging markets, does it make sense? I would say, "No."

When Best Buy arrives in China or India, what is the comparative advantage that it brings to these kinds of large, fragmented markets? Domestically, it has a strong brand identity (that great yellow sale tag, big stores, low prices, the latest technology), buying power, efficient distribution, and a low margin--high turn business model. In India, for example, the domestic market constraints, such as inefficient customs, transportation and low labor productivity hamstring a retailer like Best Buy and make it as mediocre as any local competitor.

In a country that doesn't have a high regard for "intellectual property," an Indian competitor can open a store called "Best Bye" with the same format, layout and yellow tag, and there goes the brand identity. Price breaks from manufacturers now occur at much smaller break points than in the past, so a local big store probably gets similar pricing, except perhaps on a private label product. Store construction times and construction materiel procurement are nowhere what a Best Buy is accustomed to in the U.S. Labor productivity in markets like India is low, turnover high, and training times are long.

Grey markets are prevalent in emerging markets, which have largely been purged in developed markets. All in all, the guts of the low margin, high turn model are eviscerated in India and China.

Local entrepreneurs find it much easier to deal with the bureaucracy and corruption than do Western, public retailers, with corporate codes of ethics. So, at the end of the day, the lack of the social, political and physical infrastructure--things which U.S. companies take for granted--all conspire to level the playing field for local, well financed entrepreneurs. Although Best Buy might have to look elsewhere for its growth potential, shareholder interests are better served by pulling the plug on China.

Is Shareholder Control Beneficial?

I perused a recent paper about the optimality of shareholder control, and though it didn't generate any interesting conclusions, it raised a good question. The recent issue with St. Joe Company comes to mind. The institutional shareholders are making a move to take control of the board and to steer the company in a completely different direction.


The board and the management of the company have only themselves to blame for being in the cross hairs of savvy institutional investors like Fairholme Fund and Greenlight Capital. They made a huge bet on development in the Florida Panhandle, centered around the binary event of whether or not a new airport would be built. The airport is built, but it turns out to be only a very small piece of the puzzle, and the board and management took an expensive and unhedged way to place this bet. Unfortunately for them, Fairholme drank the Kool Aid when they bragged in one of their annual reports about the unrealized value in all the Florida land their investment owned. Now, we'll see what shareholder control does in this case.


The recent case of Sears comes to mind. Much was made, rightly so, of the fact that the management simply couldn't run or merchandise stores very well. Shareholders voted with their feet and sold the stock. The story then became the value of the underlying prime real estate that Sears owned or controlled. Meanwhile, another terrible cast of executives were busy fiddling while Kmart burned slowly. Enter hedge fund manager Ed Lampert who took control of Sear merged it with Kmart, while confusing both sets of customers, who were distinct segments of consumers. Years later, Sears' repeated experiments with soft goods have failed miserably, but we didn't need to a change of control to know they couldn't execute. The appliance and home and garden segments are still the reason most people enter the store. An iconic brand of American retailing seems on the precipice of going the way of Woolworth, W.T. Grant and Montgomery Ward. Last year ended with Sears comps down 6% for December and 3.8% for the year. The environment in Sears stores is positively funereal. Most of the analysts have downgraded to neutral or under perform, with a few sells. Has shareholder control been beneficial in this case? I don't believe so.

Most institutional shareholders are good at what they do: constructing and managing portfolios, which is a very profitable business where mediocrity is rewarded since most money managers under perform their indices. Running a business, other than money management, is something that seems to be outside of their comparative advantage. St. Joe will be another good data point on the question of benefits of shareholder control.

Fairholme Stops Standing Still on JOE

There is a flurry of news today about St. Joe Company (JOE), a subject of a few posts a while back, first triggered by the informative presentation by Greenlight Capital. Into the argument came Bruce Berkowitz and the Fairholme Fund, owners of almost 30% of JOE, who poo-pooed all the arguments brought forward by Greenlight. Well, it appears today that Fairholme has finally awakened from its romance with the stock and has come out swinging MMA style.


CNBC reported today that Fairholme will seek to nominate Bruce Berkowitz and Charles Fernandez, directors of the company and executives of Fairholme, to the positions of Chairman of the Board and Vice-Chairman, respectively. CNBC reports that Fairholme will seek to dramatically shift the business model, including cutting the expense structure, perhaps stopping some planned asset sales, and looking for partnerships and new acquisitions.

A Morningstar analyst who has been quite bullish on the company, and who carries a $40 fair value on the stock, is fearful that momentum now being built up in the company's value-creating activities will be blunted by the Fairholme moves. It's hard to see what he means by this, as it's clear that some progress has been made--the company is not hip deep in a peat bog any more. However, to characterize anything JOE is doing as "momentum" seems a real stretch. Institutional investors control about 65% of the shares, and so it would seem that the Fairholme play should be a fait accompli barring the ability of the company to divide the shareholders, which would seem unlikely.

It's good to see Fairholme waking up, and its initially glib, dismissive attitude to the Greenlight Capital report has now been replaced by a sense of urgency. It should be good for the shareholders, once their plans are made more specific.

Another Foreign Policy Debacle in Cairo?

Between our global intelligence apparatus and our Foggy Bottom brigade at the State Department, events in Cairo and elsewhere in the Middle East, have taken us by surprise and we are reacting, in our usual manner: ready, fire, aim. Newspaper headlines trumpet, "US Breaks Away From Mubarak." To whom will we go?

President Mubarak made some courageous moves, unfortunately they were almost a generation ago. Making peace with Israel was a historic moment, and his staying free from assassination was a preoccupation for many years. Unfortunately, in the intervening thirty years, he did almost nothing to build up the economic infrastructure in Egypt, and the educated, multicultural elite and middle class have largely emigrated. That's done and dusted. A second wave of emigration would be the angry, disenfranchised and under skilled twenty somethings.

In a parallel to Pakistan, the Egyptian army does hold some cards here. Who will they throw their support to, and what will they ask in return? Just as in Iraq and Afghanistan, exiled Westernized Egyptians are returning and holding press conferences touting themselves as Presidential wannabes. But surely we've learned in both Iraq and Afghanistan, these medicines are often worse than the disease. Let's not overreact and buy into one of these solutions.

We also don't really know who's in the streets and where the money is that's supporting and fomenting the unrest. Some newspapers have suggested that we don't have to worry about fundamentalists in Cairo. No? Tell that to all the dead, wounded and exiled Coptics. Our European allies are absent in the crisis as usual.

President Mubarak must become more visible, clear and strong about his plans--going or not going? Clear transition plans, expressed with visible presence from the military, legislative and cultural leaders. He has to become engaged, and we should work with him, even as an interim solution. Saying that we are cutting him loose in the absence of a well thought out alternative will be a repeat of our other foreign policy failures.