November 22, 2012

By Derek On November 22, 2012 Under November 2012

“Thanksgiving, when the Indians said, “Well, this has been fun, but we know you have long voyage back to England.” –
Jay Leno


This abbreviated issue of EMI is early due to the short workweek in the US.

US markets fell almost 5% after Obama’s “surprise” re-election. Wall Street got it wrong betting on Romney. Since we have already sifted through the intellectual detritus on that issue there is no need to “Re-fry cold rice,” as the Chinese say. Yet, it is interesting to note that the American Association of Individual Investors, publishers of the Bull/Bear Ratio, report that retail investor pessimism is the highest since August, 2011 when the US rating cut occurred. The gauge measures investor expectations of stock prices over the next six months. Much like certain analyst recommendations (no names!), the B/B Ratio is often an effective contra-indicator. Back in August last year at the last B/B Ratio peak, the S&P was at 1200 and then rose 22% to its recent peak of 1460. Other technical indicators, such as RSI (Radio Slovakia International) also show the market is oversold.

Q3 earnings season is over and 62% of companies beat the street, the worst quarter in three years. The game, as many know, is for corporates to lowball expectations and then easily “beat” them. Consensus estimates for 2013 earnings is for around a 12% increase over 2012 and many feel Q3 was the trough. However, year to date earnings in the US have grown a weak 3.9% and if Q4 is just OK, maybe we see 5% corporate earnings growth this year. What were analysts forecasting 11 months ago at the start of the year? 11.5% growth….

China Profit Margin De-Rating

Profits in China are even harder to predict for various reasons, including the Great Firewall, the Great Chinese Wall and the Great Stonewall but one thing is certain: they have been trending down for a while. Despite the economy showing signs of recovery this year, corporate profits remain flat. According to China information vendor Capital Vue, net profit for the 2,500 mainland listed companies rose a tiny 0.4% in Q3 vs. Q3 last year. Profits may not be growing but costs are and the squeeze is hurting. We talked about corporate China not paying its bills in an earlier issue of EMI with 2/3 of listed companies reporting account receivables rising across the board.

The heavier wage bill has been another drag as worker salaries are up an impressive 73% in the manufacturing sector over the last five years. The redback has appreciated 20% against the greenback over the same time period, adding further woes to exporters. Average net profit margins for listed companies in China have dropped from 12% in 2007 (those halcyon, carefree days of yesteryear. Oh, where did they go?) to 8% now. Malinvestment in excess capacity is to blame for much of the pain being felt. Every player is determined to keep producing, no matter if there is any profit in it, just to drive the other guy out of business. A cursory glance at the steel sector is a nice example.

With profits ever harder to come by in China, it seems more and more entrepreneurs and others with wealth are interested in getting what they have out of the country. Last week we reported on the amazing statistic that came out of a recent Hurun survey which indicated of those in eastern and southern China with assets 10 mn Rmb and above, 70% want to emigrate. I mentioned this 70% number to a Mainland Chinese acquaintance of mine at a social function last night here in Seattle. His stunning comment was, “It should be higher, I think.” Leaping lizards, Batman.

China’s interest in pursuing higher education in the US continues to grow in both undergraduate and post-graduate degrees. First time enrollments by Chinese students have jumped 22% this year. The latest data from the Institute of International Education show that as recently as six years ago, China and India each sent about 100,000 students to the US annually. And today? Today, China is sending nearly twice that number annually and India is flat. (At least India is holding steady. Looking at Japan, the number of Japanese students here has plummeted 41% in the last five years as that country turns inward and accelerates its road-to-nowhere destiny).

Many of these Chinese students will stay in the US, start businesses and contribute to the economy. The Chinese Academy of Sciences reports that since 1978, of all the students who left China to study in the US only 27% returned to China. This number rose to above 30% during the last two years as a combination of gov’t incentives in Beijing and high unemployment in the US lured more back home to work. However, if normal trends hold, over 70% of the new 200,000 Chinese students arriving this year in the US will stay. This is a serious brain drain of China’s best and brightest.

It isn’t a two-way street: the number of Americans studying abroad remains flat. We import just about everything so I guess it is easier to import the “international experience” to college campuses as well. Fordham University in New York reports that 40% of their international freshmen this year come from China. The top three US universities for international students, (around 9,000 in each) are: USC, University of Illinois and NYU. Given Chinese attitudes toward their own country, those numbers look likely to grow.


“J’adore Vivienne, habillez-moi
Gucci, Fendi, et Prada.
Valentino, Armani too
Merde, I love them Jimmy Choo” – Lady Gaga

Prada: Hell Bent for Leather

Mirae’s head of consumer research, Janey Dillon, has initiated on the China consumer discretionary sector with a focus on Hong Kong listed retailers (here), which despite attractive fundamentals and broker hot air, has underperformed the market for the last two years. Janey is still not impressed with most of them and with inventory days rising to all-time highs and costs outpacing SSSG, the most enthusiasm she can muster for the sector is a “Neutral” rating. She does really like Prada (1913 HK), however.

Prada’s share price relative to HSI

I highlighted Prada’s outstanding operating metrics post results in an earlier issue of Emerging Markets Illustrated but voiced concerns about valuations. Despite weakening demand for luxury goods in China, Prada’s most important demographic, Janey believes the best opportunities for Prada still lie ahead. The market obviously agrees and the stock has moved higher since my lukewarm review end of September.

Prada’s share price relative to MSCI Luxury Goods

Despite a sector-wide slowdown, Janey believes Prada is relatively immune due to its store roll out and desirable product positioning. The company has a much smaller store network than Gucci or Ferragamo, while LV and Burberry, closer in size, have retail networks 86% and 57% larger. China is absolutely key to Prada’s growth strategy and Janey estimates that the company has the second largest luxury business in China in the fashion and leather category and has achieved this with a store network less than half the size of its peers.

Importantly, demand for the product Prada persistently pushes is growing along with greater sophistication of Chinese luxury consumers. Apparently, larger numbers of them no longer want to wander around with bad haircuts and plastered in large, loud logos. They are gravitating toward a more “subtle look.” Will social graces enjoy a similar improvement?

Clothes do make the man….
Janey just visited Prada in Milan on Monday and had this update:

  • Prada read her report and were very interested in her analysis of store networks and price points
  • Asia and the Gulf continue to be strong while Japan and the US are slowing
  • Europe is possibly the strongest region right now (Xie xie, Chinese tourists)
  • Demand for classic luxury is strong and the Prada brand continues to outperform Miu Miu
  • Minimizing working capital is an obsession
  • In Korea Prada is paying little or no rent in the department stores thanks to strong product demand
  • Prada will increase the dividend payout ratio from 30% to 50% over 2-3 years

With new store rollout and strong sales growth providing operating leverage, Janey forecasts EBIT margins at Prada will increase by 4.3% over the next three years to 29% and EPS CAGR over that time period will be 27%. While this will provide room for consensus EPS upgrades, it also means Prada should trade at least at the sector PE of 23 times. Prada currently trades on a 12-month forward PE of 21X, in-line with Ferragamo but below the 30X multiple Hermes commands. Given the sustainable growth outlook for the stock and extremely positive operating metrics, Janey believes Prada should command a PE of 23X. I’m convinced. More stylish upside ahead.

Investing legend Jeremy Grantham (the “G” in GMO) released his 3Q letter yesterday. Jeremy Grantham was born in Doncaster, UK, also the birthplace of abrasive television presenter Jeremy Clarkson and Royal toilet installer Thomas Crapper. Not surprisingly, Grantham has spent most of his life in the US. I always find his thoughts, while sometimes turgidly expressed, to be an educational read.
In “On the Road to Zero Growth” Grantham takes a very pessimistic view of the future. He is math and data driven and according to his numerical analysis, here is what we have to look forward to:

  • The old US GDP growth rate of 3% a year is gone forever
  • Resource costs have been rising at 7% a year since 2000 and will continue to do so
  • The climate is going to hell and we along with it. Learn to swim. Well.
  • Other developed economies will experience zero growth by 2050
  • Failed and failing states will multiply in number

Overall his Malthusian prognosticating makes for grim reading. To his credit, Grantham does give a nod to the new energy revolution occurring in the US with a note on fracking, which he calls, “a rare positive.” However, the gains are already in the system and there is nothing to look forward to… I guess you can take the boy out of Doncaster but you can’t take Doncaster out of the boy. As the song says, “It’s grim up north.”


Thanksgiving in the US as a holiday is similar, in some ways, to that of Chinese New Year: it is a time of family reunion, no matter how difficult. This is why the holiday is often the peak travel time of the year – don’t make a trip here then if you don’t have to. (To better understand the phenomenon, check out “Planes, Trains and Automobiles,” a great John Hughes cult classic 1987 film starring John Candy and Steve Martin about two very different guys trying to cross the country by any means possible to get home in time for Thanksgiving dinner. Highly recommended).

Bizarrely, Americans only cook and eat whole turkeys twice a year: Thanksgiving and Christmas. The birds, like many of those eating them, are huge and Thanksgiving leftovers last a week or more rendering everyone sick of the experience by then. But wait, in a few short weeks it’s time to do it again.

As children in school, we were taught the first Thanksgiving happened in Plymouth, Massachusetts shortly after the Pilgrims first arrived. In order to give thanks for their first successful harvest the Pilgrims held an outdoor dinner and invited those nice Indians next door who showed up washed in freshly pressed buckskins, smiling and carrying pumpkin pies. This ridiculous narrative is actually maintained throughout your whole school career and becomes virtually unchallenged doctrine. (All depictions of the event in schoolbooks show happy, smiling faces – beaming so much their cheeks must hurt. I remember, in my tender youth, being disturbed by this and I used to draw frowns, scars and pirate eye patches on all the players. Maybe, I was just disturbed, but I grew into a normal adult; each morning I plug in some Metallica and drive my daughter to nursery school).

Not unique to the US, Thanksgiving is celebrated in Canada and even Australia. According to the website, the holiday Down Under is all about “Thanking God…thanking each other.” Religious overtones are heavy and curiously, there doesn’t seem to by any turkey consumption. The one place in Oz the holiday is really celebrated is on lonely Norfolk Island, 900 miles offshore of the mainland. Thanksgiving was introduced there by American whaling ships (along with rats and syphilis). Probably with all the great weather and outdoor activities, Aussies have better things to do.

It is traditional at an American Thanksgiving to say what you are thankful for.

I am thankful you have read this far.

The Last Page

Resolving to surprise her husband, an investment banker’s wife pops by his office. She finds him in an unorthodox position, with his secretary sitting in his lap.

Without hesitation, he starts dictating, “….and in conclusion, gentlemen, credit crunch or no credit crunch, I cannot continue to operate this office with just one chair!”

Derek Hillen, CAIA
Mirae Asset Securities


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