January 11, 2013

By Derek On January 11, 2013 Under 2013

The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation.Vladimir Lenin

So dawns the New Year, 2013 for most of us, or the year 6763 if you are Assyrian. Hominids emerging from their holiday cave peering squinty-eyed over the plains below and out to the future beyond may be wondering what this year will bring. More food? More women? Or just more cave bear attacks? There are plenty of other hominids out there trying to tell them. I prefer to look backward and to perhaps gain some perspective examine what happened one hundred years ago before we begin to look ahead.

I just changed the lithium crystals on the time machine so let’s step inside and set the dial to 1913. What was important then?

Markets were hovering before the crash that came with the beginning of WWI the following year. However, before that happened we will look at five major events about to unfold in the magic year of 1913.

1)      16th Amendment to the US Constitution = Income Taxes!

The US population had never suffered the indignity of annual income taxes “until death do us part” but passage of the 16th Amendment made it clear on how income was to be defined (basically anything in your pockets) and how it was to be taxed (forever). The tax started at 2% for the top rate which is now, surprise! 40% – and rising.

2)      Federal Reserve Act

The Act, signed by President Woodrow Wilson, established the central banking system of the United States that we know – and love today. Previously, the US had had two 20-year chartered banks both named, “Bank of the United States” but several financial panics at the end of the 1800s and the beginning of the 1900s led to demands for banking and currency reform. Thus, from 1913 onward, the Fed, just like income taxes, was now to be with us forever.

3)      Ford Motor Company perfects the moving assembly line

Ford was the first company to take the assembly line idea that originated in Chicago slaughterhouses (where they “disassembled” beef) and apply it to manufacturing using a moving conveyor belt. This simple innovation increased production eight-fold and allowed Ford cars to roll off the production line in three-minute intervals. Production costs fell so much Ford slashed the price of the Model T by 30%, pretty much driving everyone else out of business.

4)      Stainless steel is invented

A research boffin by the name of Brearley in Sheffield (of course) discovered and industrialized the process. Hey, it’s useful stuff.


1)      “Raja Harishchandra” is released and Bollywood is born

“RH” was the first feature film made in India. It was silent, 40 minutes long and about the mythological story of King Harishchandra. Within 20 years of its release, India was producing 200 films a year. Most recent data shows India is the largest film producer in the world and produced an amazing 1,288 full feature films in 2009 alone. The photo above is taken from one of my favorites, “Dil Se” which has an amazing dance scene on the top of a train wending its way through the southern Indian landscape, check it out here.

Now that 2012 is dead and gone many are glad of it. It was a year some very high profile forecasts went, shall we say, “The other way.” Globally, the hedge fund universe did not cover itself in glory with average gains, according to the HFRXGL index, of just 3.9%. Take your “2 and 20” out of that and the investor is left with goat droppings. While the top decile of hedge funds last year returned over 30%, The Economist reports for the last ten years, hedgies as a group have consistently underperformed the S&P 500. The magazine concludes: “The average hedge fund is a lousy bet.” My view: They must be referring to investors not principals.

Europe is still huddling together in the cold rain of despair, battered but not broken, much to the chagrin of John Paulson who bet against euro debt heavily and lost heavily. In the US, the SPX climbed 16% last year. The average forecast of 12 strategists one year ago called for only a 7% rise in the S&P, they got it wrong by the most since 2003, according to BBG data.

Vix Kix

Those watching market volatility last year will have noticed the VIX recently plummeted 23%, its biggest annual drop since 2009. Not only that but right at the turn of the year the Vix saw its largest weekly percentage downward drop since the index was launched in 1990: a sudden 39% collapse occurred while no one was watching and on huge volume. Not that my PA would move the market but I wasn’t trading December 31st and January 2nd when the move occurred. Who was? It might be hard to read much into this. Probably time to blame the HFT guys again.

Last year, China was probably the biggest disappointment, the (second) hardest market to get right. GS loudly called for a 36% rally in the CSI 300 12 months ago, which as it turned out, only just squeaked out a rise of 7.6%; the entire gain in the last two weeks of the year. According to BBG data, of 3,000 recommendations for Chinese A-shares listed in Shanghai and Shenzhen analysts forecasts were 33% “too enthusiastic,” the second-most among 45 global markets (Churchill’s “riddle, wrapped in a mystery, inside an enigma,” Russia, was first with analyst optimism diverging from reality by 45%!).

Cheap Taxes, Cheap Market

Swinging our periscope to the east, Russia’s Micex index ended 2012 almost flat despite the strenuous efforts of her breathless, wild-eyed analyst community. All snickering aside, it is worth noting that market is valued at just 5.9X PER – the cheapest among the 45 global markets measured by BBG. The CSI 300, as a comparison, trades at almost 13X earnings. Given the fact earnings estimates in Russia are way over the top it is possible the REAL PER for the market is higher than stated but still attractive with a dividend yield of almost 4%. Can France’s most famous screen stars, all of whom seem to be defecting to Russia, add the glamour and sheen that place so desperately needs?

Value is to be had this year for the BRIC markets overall. While the MSCI BRIC index gained 10% in 2012, it still trades at 10X earnings, a 13% discount to its three-year average and almost a third less than the multiple of the MSCI All-Country index, according to BBG.



The Four Noble Central Banks

In Buddhism there are the Four Noble Truths: The Noble Truth of Suffering, The Noble Truth of the Cause of Suffering, The Noble Truth of the Cessation of Suffering and the Noble Truth of the Path leading to the Cessation of Suffering. Note: it is all about suffering.

Now we have Four Noble Central Banks printing and spraying money around like crazed F1 drivers clutching enormous champagne bottles on the podium. As can be seen from the nifty chart below, the economies they reign over account for over half of global GDP; 54.7% in 2011 dollars to be precise. If China joins the bandwagon – and my view is they will – that moves up to 64.4% of world GDP will have its foot on the monetary accelerator. Once China eases, all the emerging markets will follow, especially those in Asia that are loosely called “the Rmb Block.” As with the Four Noble Truths, the actions of the Four Noble Central Banks too, will lead us down the path of suffering.

Starting with the Fed, then the BOE, and finally the ECB under Draghi, all the major central banks are pursuing very aggressive monetary policy. Japan, always fashionably late to every party, has joined the reflation bandwagon (and while Japan is the latest she will not be the last). The immediate result is an 11% swan-dive of the Japanese yen in three months. Japan, suffering from deflation and a deteriorating current account, now has a new gov’t.  Prime Minister Abe wants to prime the pump aggressively – giving new meaning to his title as “Prime” Minister. His party, the LDP, has a 2/3 majority in parliament so he will get what he wants despite any superficial resistance from the Bank of Japan. Abe has set a 2% inflation target and the printing presses will be rolling. The likelihood of further yen weakening is great and this is very bullish for Japanese stocks in the short to medium term.

Emerging markets, many of whom in Asia are export-dependent, will be forced to join the global central banking party. This is bullish for equities and commodity prices, especially for oil and copper in the short to medium term and my favorite, gold, in the longer term. But it may be a false prosperity and the checks being written will at one point need to be paid for.

A Great Decoupling

Meanwhile, back at the ranch….even with abysmal economic growth and high unemployment, last year we saw double digit gains in the asset classes of equities, credit and real estate. This is likely as not mostly attributable to persistent central bank action “underwriting” the recovery. According to JP Morgan, in the economies of the Four Noble Central Banks, governments account for 75% of ALL borrowing that is taking place and central banks account for 60% of all the lending – historically high numbers. 2013 will be no different. In fact, in my view: we could see even further asset class price appreciation as more central banks follow the Fed and markets decouple from economic performance.

These are broad brush strokes to be sure, but they provide some framework from which to look ahead, I find. Banks, near and dear to policymakers everywhere, will continue to benefit from policy largesse (as long as they can withstand the now almost constant bloodletting in the form of billion dollar fines for past egregious behavior). However, while global banks have recently enjoyed a nice bounce, inside the house and down the stairs, way down, in the dark dank basement that nobody ever goes lurks big trouble.

This leads me to a question worth asking over and over again and one I frequently get wrong which is this: When does a stock move from the realm of investment to that of just pure speculation?

Over the holidays, The Atlantic magazine published a great in-depth article by Frank Partnoy, “What’s Inside America’s Banks?(here).  Partnoy, a well-known financial author and current Professor of Law and Finance at San Diego School of Law, walks us through the recent annual report of America’s most respected and with a market cap of $183 bn, now largest bank: Wells Fargo (WFC US), an exercise he colorfully describes as, “The financial equivalent of Dante’s descent into hell.”

What’s inside? In short, we don’t know and we can’t know what risks the banks are exposed to. All we are told is the real risk is massive. Partnoy interviews several influential figures involved in bank regulation, all of whom express the gravest misgivings concerning the swirling cauldrons of dog parts and unquantifiable risk large money-center banks have been swilling.

Here are some interesting quotes from the article by regulators close to the situation:


Don Young, a former board member of the FASB:

After serving on the board, I no longer trust bank accounting.

Ed Trott, another former FASB board member when asked if he trusts bank accounting:

Absolutely not.

Kevin Warsh, former Federal Reserve Board member on current bank disclosure:

The disclosure obfuscates more than it informs, and the gov’t is not just permitting it but seems to be encouraging it.”

Andrew Haldane, BOE’s Executive Director for Financial Stability:

For investors today, banks are the blackest of boxes.”

As Enron did with SPEs (Special Purpose Entities) a dozen years ago, banks have moved a lot of their visible risks to off-balance sheet structures now called VIEs (the same type of scheme used by many US-listed China stocks: Variable Interest Entities). Banks lend and borrow money from VIEs – Wells Fargo’s total exposure is $1.46 trillion. No more detail is provided than that…. Just trust us. Given the bank’s capital reserves are only 10% of that amount it would be nice to see exactly what risks are involved here. The other big banks are no different.

Citibank: Uninvestable?

As with the China stocks listed in the US that are now under threat of being financially defenestrated and sent packing to China due to the accounting issues we wrote about at length earlier: owning these stocks has moved from investment to speculation once the risks of ownership cannot be quantified. Still, there is definitely a view out there among many clients that Baidu, C-Trip and the others will not suffer a delisting. Reasons given to me have ranged from, “It’s just too big,” to “Unthinkable.”

However, the law is clear and China and HK-based accounting firms auditing US-listed China stocks are in breach of it. Punishment is also clear: suspension of accounting registration which leads to delisting of those firms in the US. What isn’t clear is this: will China bend enough so the SEC can accept some compromise that follows the letter of the law? Here is the great unknown. I see it as a coin flip and coin flips are notoriously speculative.

I met a guy working at Taco Bell the other day stuffing burritos. He used to have all his money in Bear Stearns. His luckless brother works at MacDonald’s making Happy Meals. He had his retirement in Lehman stock. In financial markets, as in life itself, BIG bad sh*t happens all the time.

As Paul Singer of hedge fund Elliott Associates says, “There is no major financial institution today whose financial statements provide a meaningful clue” about its risks.

Those enjoying the recent bank rally in the US would be wise to read this article and contemplate the wolf at the bottom of the stairs that sits quietly, hidden in their portfolio.



Fire, Earth, Wood, Water and Samsung Electronics

Probably one of the most exciting stock stories of 2013 will be Samsung Electronics (005930 KS). Yes, I know that of the 52 brokerages that cover the stock 51 have “Buy” ratings. (The one “Sell” rating is from a very lonely analyst in Tokyo at Ji Whiz Securities, in a report 7 months old that the market has since proven very wrong). Our analyst, Hyunwoo Doh adds his chops to the barbeque and sees 25% upside from current levels to his target price of Won 1.9 mn (here).

Samsung has reinvented itself, moving away from boring cyclical memory into making much desired fashion items: its smartphone line up. OP contribution from the memory business is likely to decline to 28% by 2015 vs. 72% in 2005. Due to decades of heavy capex, the company now pretty much owns the vertically integrated supply chain to make the hottest consumer electronic items and has become the world’s largest TV and smartphone maker. Demand for its Galaxy Note II is strong with Q4 operating profit beating results and further momentum is likely to come from their new tablet as well.

SEC is currently trading at a FY13E P/E of 7.5X and P/B of 1.7X. Despite the record high ROE of 22.9%, the stock is at a discount to its 2009-2011 average P/B of 1.9X. Compare this to Apple’s 3.3X P/B and 32.7% ROE. Analyst Doh forecasts higher ROE is here to stay and should rise to an average level of 20.4% over the next two years compared to the previous 6-year average ROE of 15%.

Samsung: The Fifth Element?

In techland many pundits in the US refer to, “The Four Horsemen of Tech” - Apple, Google, Facebook and Amazon. Some are now pointing out there should be a fifth one: Samsung Electronics. With only four horses to go around I prefer to think in Asian terms of the five elements; fire, earth, wood, water and metal. Either way, Samsung has joined the global major leagues and may even become a real innovator this year.

While Samsung is currently dependent on others for its software, notably Android where it has almost a 50% global market share, the company has just announced it will begin producing Tizen-based smartphones. Tizen is a Linux-based open source OS that may allow the company to break free from Android and “own the ecosystem.” One of the main things that makes Apple so profitable is it owns the whole show and knows who its customers are. Samsung doesn’t. While a long way off, Samsung’s potential move away from Android could herald the beginning of the company getting control of its customer base and becoming even more profitable as a result.

Regarding Korea’s ever present Japan threat, the recent surge in the yen is less of a worry to our story as Samsung competes against the likes of Apple, not Panasonic or Sony both of whom have major troubles of their own. The current main headwind for the company will be the strengthening won, also known as the ever debased dollar. Rough estimates indicate a 3% hit to EPS for every 5% of won appreciation.


With new product launches ahead, a move away from Android and possibly improving profitability, at the end of the year you don’t want to call up the analyst Hyunwoo Doh, look at Samsung’s outperformance, slap your forehead and say, “Doh! Why didn’t I buy it?”


The Last Page:

A man and his wife are awakened at 3 o’clock in the morning by a loud pounding on the door. The man gets up and goes to the door where a drunken stranger, standing in the pouring rain, is asking for a push.

“Not a chance,” says the husband, “it is 3 o’clock in the morning!”

He slams the door and returns to bed.

“Who was that?” asked his wife.

“Just some drunk guy asking for a push,” he answers.

“Did you help him?” she asks.

“No, I did not. It is 3 o’clock in the morning, and it is pouring rain out there!”

“Well, you have a short memory,” says his wife. “Don’t you remember, about three months ago when we broke down, and those two guys helped us? I think you should help him, and you should be ashamed of yourself!”

The man does as he is told, gets dressed, and goes out into the pounding rain.

He calls out into the dark, “Hello, are you still there?”

“Yes,” comes back the answer.

“Do you still need a push?” calls out the husband.

Yes, please!” comes the reply from the dark.

“Where are you?” asks the husband.

The drunk replies, “Over here — on the swing!”


You can find all previous issues of “Emerging Markets Illustrated” at our new website:www.emergingmarketsillustrated.com

Derek Hillen, CAIA

Mirae Asset Securities

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