November 16, 2012

By Derek On November 16, 2012 Under November 2012

“If God didn’t want them sheared, he would not have made them sheep.” - Calvera (Eli Wallach)


The Magnificent Seven

The winners of the top level of China’s leadership transition have finally been announced. We still have four more months of horse-trading and backroom deal making to decide on the faces and places of lower ranking officials across the country and before the new, now seven member, Politburo Standing Committee formally takes over in March. This implies uncertainty will continue but it will be less threatening than before. Xi Jinping, as expected, has gathered the reins of power with Li Keqiang, the first PhD in the Politburo, saddling up in the number two slot.

Another notable member includes number three-ranked Zhang Dejiang, a North Korea-trained economist. This struck me. Who would go to N. Korea to study economics? That must be like joining the Swiss Navy. But don’t worry; he will only be in charge of all state owned enterprises. A hint of what that may mean for the economy comes from an earlier speech by Mr. Zhang, unearthed by Bloomberg, exhorting SOEs to become, “stronger, more excellent and bigger.” The SCMP labels Mr. Zhang, “the iron-fisted enforcer,” while the English language People’s Daily just describes him in simple anthropological terms as, “a male ethnic Han.”

Did Their Time, Toed the Line

All the official profiles of the new leadership read like that: just a list of the facts of where they were and their official titles at certain times. None of them ever stood for any specific policy or principle but all did their time and conformed to prevailing party politics.

Those hoping for political reform will be disappointed that Wang Yang and Li Yuanchao didn’t make the short list. Time will tell how ably they navigate the treacherous waters they see themselves in but, overall, the new line up predictably seems rather old, staid and conservative. The Communist Party’s biggest fear is that any lifting of the boot off the throat of society will result in China becoming the next Soviet Union. The leadership also views the recent Arab Spring as further evidence of what can go wrong with any relaxation. Indeed, political scientist at HKUST, David Zweig, described the new members as reminiscent of the old politburo in Russia under Brezhnev. Words like, “hope,” or “colorful,” certainly seem out of place here.

Are You Naked?

The Shanghai stock market reaction to the “news” was a thumbs-down, falling 1.2% that day. The continued funk prevalent throughout the country is evident in recent news reports that claim, “nearly two-thirds of the country’s wealthy elite want to emigrate.” This has resulted in popular terms like “naked official,” or “naked businessman.” The newly unclothed are those who have moved their family and wealth overseas (always to developed Western countries) yet remain in China to work. According to a Banking White Paper written by the Hurun Research Institute and the Bank of China, 70% of respondents in eastern and southern China with a net worth in excess of 10 mn Rmb want to leave the country. I just find that to be an amazing statistic.

The new Politburo made no policy announcements and there is no ideology left that people can believe in. The Chinese Communist Party really only stands for the Chinese Communist Party and it can be said, like all institutions its purpose is to perpetuate itself. In other words, survival.

My view: Any political reform will be at the margin. Economic reform is also unlikely. We should expect more of the same: FAI will continue to drive the economy and the state sector will continue to grow at the expense of the more efficient and job-creating private sector. Consumers will get wealthier and they will spend more but as a percentage of GDP their contribution is likely to keep falling, as it has over the last dozen years.

But hey, steel stocks in China are moving up. The China Iron and Steel Association says that its members may have lost money in the first nine months of the year but they expect them to “turnround” and be profitable by year end. Benchmark iron ore prices are up 40% since September. New railway, urban subway and highway projects and steady to rising FAI mean despite sector-wide overcapacity, steel demand seems to be stabilizing. Same as it ever was.


Chow Tai Fook (1929 HK) issued a profit warning late last week, less than 12 months after its IPO. The stock is off a third since listing. The company said they were facing slowing demand and that a technical issue with hedging a rapidly rising gold price will cut gross margins by 3%. Mirae’s Head of Consumer Research, Janey Dillon, initiates on the company now with a Reduce recommendation. Janey comes to us after 10 years on the buy-side, including five years spent covering European consumer companies at Fidelity. Read the full report here.

All in the Family

88-year old Dr. Cheng Yu-Tung, Hong Kong’s 4th richest tycoon and his family own 89% of the float via a BVI holding company. Dr. Cheng is Honorary Chairman, his eldest son; Dr. Henry Cheng is Chairman and sits on the Remuneration Committee. His son and Cheng Yu-Tung’s grandson, 32-year old Adrian Cheng is an executive director, responsible for marketing and is heir apparent. Chow Tai Fook is very much a family business with the family in the driver’s seat and you, the minority shareholder, stuffed somewhere in the back between the flatulent grandmother and an amorous Great Dane on your long road trip to hopeful prosperity.

Perhaps following Prada, Chow Tai Fook also chose the year of founding, 1929, as their stock ticker. The rough meaning of the odd-sounding name in English is, “All around lucky.” Active in Macau and Hong Kong since the late 1930s, the company opened its first branded CTF store in China (Beijing) in 1998 and opened their 1,000th point of sale in China two years ago.
Janey likes the company but believes ongoing pricing and inventory issues mean that consensus numbers for year end March 2013 are just way too high.

What’s Good

CTF runs an integrated business model from factory floor to retail storefront, which allows them to control customer experience. They control sourcing and buy gems directly from DeBeers, Rio Tinto and have just signed an agreement with Alrosa in Russia. CTF has three gem cutting and polishing centers to supply its higher margin gem-setting business. For comparison, peer companies, such as Chow Sang Sang (116 HK) and Luk Fook (590 HK) source their diamonds through middlemen. CTF “self-operates” 70% of their store network vs. less than 10% for Luk Fook, for example. Given “uneven” management practices and curious attitudes towards service in China, this counts.

Chow Tai Fook also has a strong brand, which is important in what is basically a commodity business where customers can buy similar goods at competitor stores across the street. The company operates in a very consolidated sector and is the clear leader with a 20% market share in Hong Kong. The China market is more fragmented, however, and Chow Tai Fook reportedly has a 12.6% market share, which while less dominant is impressive – until you realize the surveyed numbers do not include retailers with revenues less than Rmb 500 mn and so are probably vastly overstated.

What’s Not Good

The whole sector has seen growth grind to a halt. As we discussed in earlier issues of EMI, luxury demand in China is waning, not only due to an economic slowdown but also due to anxiety surrounding the opaque and mysterious leadership transition ongoing in Beijing which will result in government officials around the country changing chairs, hats and even mistresses. In Hong Kong, average growth rates for jewelry demand were 42% in both 2010 and 2011. So far this year they are just 8%. China has seen growth rates plummet as well from 45% to 15% over the same period.

Another headwind is the slowdown in the appreciation of gold prices. Interestingly, there is an 80% correlation between gold prices and volumes in Hong Kong. Ever practical, Chinese don’t buy jewelry just to get laid, there has to be a monetary angle to it as well. If gold is no longer a hot investment then that shiny brocade or gaudy ring just isn’t shiny or gaudy enough. Tiffany (TIF US) has recently made comments supporting this view and says the Asian consumer views jewelry not just as a neat gift but as an “investment” and store of value.

Lower margin gold products account for 53% of sales compared to less than 25% of sales at Tiffany. This helps explain why Chow Tai Fook’s gross margins at 27% are less than half that of Tiffany. While 90% hedged to gold price movement, the company suffered a mismatch between mark to market prices and derivative contract expiry leading to management’s profit warning last week. However, the company is also exposed to a ballooning inventory problem with inventory days up 50% year on year to March this year, the latest data available. In response, management has rationally been slashing prices. Importantly, this is a sector-wide phenomenon, not unique to Chow Tai Fook.

Shopping Last Week

Janey visited a few CTF stores in Hong Kong last week to check on these price reductions and was told by staff the massive sales and low prices being offered had never been seen before. Price cuts of 30% on higher margin gem-set jewelry and 10% on karat gold and platinum products are now to be had. As Janey says,

“If we learnt (she’s British) one thing from our time covering European retailers it is this: do NOT own an inventory correction.”

Janey believes the sector has more price-cutting and inventory liquidation to look forward to, which will drag on margins. At the same time, costs are going straight up, particularly in Hong Kong. Rent renewals are typically seeing increases of 40-50% (still!) and staff wages are up 10-20%. Janey forecasts Hong Kong costs will soar 21% this year while sales growth will only be a tepid 8%. The result: EBIT margins fall another 2% to 13.6% for 2013.

The chart above is where Janey can prove that pricing has hit margins. Janey has done this by cleverly calculating the contribution/loss the hedging activity has had on margins and compared it to reported gross margin. In the second half of this fiscal year and last, hedging resulted in a slight boost to margins which helped hide the REAL problem: that of discounting a bloated inventory, (1.3%). The company late last week announced that hedging will likely whack margins by “up to 3%” for this next period. But that does NOT include the discounting of prices, the impact of which will become very apparent when CTF reports at the end of this month. We think the market will be surprised and therefore, consensus estimates will be revised downward then.

Once CTF clears inventory, Janey believes that gross and EBIT margins should remain stable and the company will generate EPS growth of around 15-25%. However, trading at a 12-month consensus forward PE of 14X and given the weak near term outlook, Chow Tai Fook is too expensive. While the most attractive amongst its listed peers, Janey uses a 13X multiple and on her 12-month EPS estimate, she sees another 15% downside to the stock from here. Reduce.

Although CTF benefits indirectly from a rising gold price via rising sales, due to their hedging policy the company is not a true “gold play.” That distinction falls to competitor Luk Fook which does not hedge its gold exposure. This leaves an investor in a win-lose binary situation, admirably reflected in the name of the counter; “Luk” if gold goes up and you own the stock, “Fook” if it doesn’t.


The Shanghai Composite Index (A-shares to its friends) is just 2% away from testing the 2,000 level again. The divergence in share price performance between Shanghai-listed Chinese companies and those same companies listed in Hong Kong is notable. Historically, A-shares have traded at a premium to H-shares due to capital restrictions on domestic investors placing funds overseas resulting in a lack of investment choice. Like a long crowded flight with Burt Reynold’s movies and American beer on offer, China is the total captive market. Foreign investors however, are turning more positive on the market. In the run up to the leadership change in Beijing, EPFR Global reports $2.8 bn was poured into Chinese shares last month, the largest amount since January. Furthermore, according to a survey of fund managers by BAML released yesterday, 37% of asset managers surveyed are overweight global emerging market equities, up from 32% last month.

Recent economic data from the Middle Kingdom also support a more bullish view on the market. Exports rose the fastest in five months for October and are up about 10% in both September and October from last year vs. just 3% gains in the two months before. Earlier this week, according to China’s customs administration, overseas shipments are up 11.6% compared to this time last year. The closely watched PMI is also rising. Mirae economist Joy Yang is of the view that, “China has definitely bottomed out.”
Citigroup’s “Surprise Index” for China, which measures how much new economic data exceeds or disappoints forecasts, is soaring. The index has jumped from -40 (boy, these numbers suck) to 27 (boy, these numbers rock):

Yet, domestic punters remain unimpressed and unconvinced. The Shanghai stock market is off 2/3 from its 2007 high and, in my view: we are trundling along the bottom right now. The difference in outlook between foreign investors who can move money freely into HK and domestic investors in China is amply demonstrated by this chart of the performance of Hong Kong listed H-shares vs. Shanghai-listed A-shares:

Another way to look at the divergence is the old A/H share premium chart. Where do we stand now?

As always when locals desert the market, authorities have “suddenly” discovered the attractions of foreign capital and have been busy loosening restrictions and raising investment quotas. State pension funds are also being encouraged to invest in equities. All these things mark a bottom being reached.


I Legalize Pot

In last week’s US presidential election each state had various initiatives and propositions on the ballot vying for voter approval as well. In my new home state of Washington, I legalized pot and approved gay marriage. Or, I should say, those two measures which I voted for passed. Marijuana use is still prohibited by federal law (“the feds”) but state police in Washington and Colorado, which also approved legalization, will now not enforce those laws. Currently, medical marijuana is legal with strict supervision in 18 states. Canada, Spain, Austria and the Netherlands also allow some medical marijuana use. What Washington and Colorado have done with the “Vote to Toke” campaign is make pot legal for recreational use.

This, however, does not mean you can start growing weed and dealing it out of the back of a van. “The feds” are watching and they will swoop in and bust your suburban ass right into jail for trying. It is an interesting legal conundrum and nobody really knows what to do next. My view: full legalization in the US is only a matter of time. “Grass”-root support is, ahem, strong and in the opinion of many the position of the feds is really quite antiquated and reactionary.

According to the UN, cannabis is the most used illegal drug in the world with over 162 million regular smokers. While illegal almost everywhere, according to respected British medical journal, The Lancet, cannabis use is less harmful than that of alcohol or even tobacco.

Man has known about cannabis for at least 10,000 years and according to some archeological sources, its earliest known use may have been in Taiwan. The Chinese character for hemp, or pot, is “ma,” and shows two plants growing under a shelter. Always a more laid-back place, could early Taiwanese have been the original potheads growing weed in the house?

More recent history from the US that I found interesting details cannabis use as a truth serum in World War Two by the OSS, the forerunner of the CIA. It was effective and caused one suspect being interrogated reportedly, “to be loquacious and free in his impartation of information.” That is certainly more preferable than other interrogation methods such as electric shocks to the privates or being forced to listen to Kenny G records over and over.

This being America, entrepreneurs have jumped into the breach to take advantage of a new market. There are even some listed companies that one can invest in to play the “greening of America.” The sector is smoking.

Medbox (MDBX US) has caught my eye because that stock is up 367% today – after jumping 306% yesterday. Talk about getting high. The company has a market cap, as of today, of $4.2 bn but it was just $45 mn a few days ago. They are involved in selling patented medical-marijuana dispensary machines, which they envision will be the new way to buy pot at the pharmacy.

Cannabis Science (CBIS US) has a market cap of $60 mn and the stock has doubled in a month. They are a research lab experimenting with using marijuana in medicine to treat HIV and cancer patients.

Terra Tech (TRTC US) is a microcap with a market capitalization of $35 mn. The stock has also almost doubled in the last week or so. The company sells hydroponic equipment online – useful for growers turning Mom and Dad’s basement into a cannabis forest.

I don’t smoke anything (well, just cigars at stag parties) but I have been busying sampling wines from California, Oregon and Washington state since we left Hong Kong six months ago. Not only am I keen to support local businesses but it is also an educational experience to taste and experience the difference between the varietals of various regions – or at least this is how I explain it to my teetotalling, frowning wife. However, despite my good efforts I have yet to find an affordable bottle of wine ($20 is my price point) that tastes any better than Listerine.

Francis Coppola, the director of “Apocalypse Now,” has been in the wine business for a while. I thought I could trust him. The other night I splurged and spent $30 on a bottle of Francis’ plonk. As I coughed up the necessary funds at the checkout I envisioned the man himself telling his loyal and sweaty grape picking crew,

“Well, my name is going on the label boys, so it’s gotta be good.”

But it was so bad it makes you ask why he put his name on it at all. This wine should have been called, “Francis Coppola’s Arsehole Neighbor,” or “Francis Coppola’s Napalm in the Morning.”

I’m not yet desperate enough to start rolling my own and lighting up a joint over the barbeque but sour experiences such as this do make me wonder.

On the Bookshelf:

The Last Page

A Financial Education

A young boy goes off to college, but about a third of the way through the semester, he has foolishly squandered what money his parents gave him.

“Hmmmm,” he wonders, “How am I gonna get more money?” Then he gets an idea and calls his father.

“Dad,” he says, “you won’t believe the wonders that modern education are coming up with! Why, they actually have a program here that will teach Fido how to talk!”

“That’s absolutely amazing!” his father says. “How do I get him in that program?”

“Just send him down here with $1000,” the boy says, “I’ll get him into the course.”

So, his father sends the dog and the $1000. About two thirds through the semester, the money runs out. The boy calls his father again.

“So how’s Fido doing, son?” his father asks.

“Awesome, dad, he’s talking up a storm,” he says, “but you just won’t believe this – they’ve had such good results with this program, that they’ve implemented a new one to teach the animals how to READ!”

“READ?” says his father, “No kidding! What do I have to do to get him in that program?”

“Just send $2,500, I’ll get him in the class.”

His father sends the money.

At the end of the semester, the boy has a problem. When he gets home, his father will find out that the dog can neither talk nor read. So he shoots the dog. When he gets home, his father is all excited.

“Where’s Fido? I just can’t wait to hear him talk and listen to him read something!”

“Dad,” the boy says, “I have some grim news. This morning, when I got out of the shower, Fido was in the living room kicking back in the recliner, reading the morning paper, like he usually does. Then he turned to me and asked, ‘So, is your daddy still messin’ around with that little redhead who lives on Oak Street?’ ”

The father says, “I hope you SHOT that lyin’ dog!”

“I sure did, Dad!”

“That’s my boy!”

Derek Hillen, CAIA
Mirae Asset Securities

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