September 28, 2012

By Derek On October 2, 2012 Under September 2012

Praise the Lord and pass the ammunition.” – Naval Chaplain Howell Maurice Forgy

 Observations.

Recent joint central bank action from the big boys that matter have galvanized investors around the globe. Other central banks are likely to follow. According to data from EPFR Global, in the week ending September 19th, weekly inflows into equity funds reached $17 bn – a four year high. The biggest winners were emerging markets, which saw $4.3 bn of fund inflow in that week alone, or 25% of total. This is a very large number when you realize that emerging markets have a tiny 13% weighting in the MSCI All Country World Index (the US alone is 48%). If this asset allocation shift continues, would the “magic” decoupling of emerging markets finally happen? Instead of reluctantly following along with the US, the case for index outperformance would indeed be stronger.

EM: Small Yet Curiously Attractive

Ruminations

Research

I tried so hard
And got so far
But in the end
It doesn’t even matter…” – Linkin Park

GDP Growth vs. Stocks?

As every economist on the street agonizes over cutting their China GDP forecasts, it is useful to take a step back and ask the simple question, does it even matter, or should I just go hit the bars? There is much debate over the correlation between stock market performance and GDP growth. At the most basic hayseed level, equity returns can and do exceed GDP growth because those returns essentially measure profit. GDP growth is a measure of volume, or sales and doesn’t measure the profitability of those sales. You can boost sales by cutting the price of your product or service to below cost but your shareholder returns will tank and so will your stock: just ask Mr. Sockpuppet from Pets.com.

Shareholders pay for the expectation of a return. GDP growth is a lagging indicator while stock markets are leading indicators so really; stock markets tend to predict future GDP growth, not the other way around. And GDP forecasts are often like dry leaves in the wind; they make some rustling noise in the background but are soon blown away. As famed Fidelity PM Peter Lynch once remarked, “If you spend 13 minutes trying to predict the economy, you have wasted 10 minutes.” A well-known study by Dimson, Marsh and Staunton (here) concludes after looking at 110 years of market returns in 83 different countries,  “There is not a positive association between a country’s real growth in per capita GDP and the real returns from its stock market.” They continue; “Past economic growth does not act as a leading indicator of superior stock returns.” Hmmm. Interesting. Then why the hell did I learn Chinese?

Dimson and his pals mention, however, that for individual markets, “…there is a highly significant relationship between GDP growth and the equity return in the previous year.” Stretching this out more than one year at a time, however, the correlation disappears. Aha, market performance is correlated to expected GDP growth of the following year.

Jim “BRIC” O’Neill looked at this study and zeroed in on that last point. His view (here) is that, given the changes in how economies and markets work, it is pointless to compare how things were 100 odd years ago when the Qing Dynasty still ruled (parts of) China and believe you are comparing horse apples to horse apples. Rather, Jim found the following;:
“Almost universally, revisions in the current year (GDP) forecasts have no meaningful effect on equity prices. Revisions in the next year forecasts, however, are very significant.”

A 100 bp revision in GDP growth forecasts would, on average, result in a 14% change in equity prices for the developed world. For developing markets, however, that change was almost twice as much: a 26% change in equity market movement occurred, with India and China being the most sensitive to this and Korea the least.
Relatively confused after looking at all this and with a few minutes on my calloused hands, I decided to compare nominal equity market returns for Shanghai, Hong Kong and the US since 2000 until now. Wow. Here is what I found:

2000 – 2012 YTD Total Market Returns

Shanghai +48%
Hong Kong +22%
S&P 500 O (flat as a freakin’ pancake)

Throw in the currency effect and it is even more startling. The RMB has appreciated 24% over the period against the dollar, while the USD, as measured by the DXY index, has fallen 22%. If you measured the dollar against oil, or gold, or Elvis records, it would probably be even worse. So, if I put $100 into the stock market January 1, 2000 in China, HK and the same amount into the S&P 500, on a currency adjusted/purchasing power basis my returns look like this:

Shanghai $170 (+70%)
Hong Kong $122 (+22%)
S&P 500 $78 (-22%)

The Hang Seng Index was up 22% in nominal terms over this period but after adjusting for currency – thanks to the peg – your returns my friend, are Zero. Despite the quality of growth, China continues to grow at three times the level of the US. Simplistically, and over time periods that rational investors actually care about, GDP growth expectations apparently do matter.

Research.

“Enough of sweetness, women need to get out there and fight again.” – Miuccia Prada Prada came out with stonkingly strong first half results Monday: consolidated net revenues +36%, EBIT +56% and net income soared 60%. Same store sales growth hit an impressive 19%. You can leaf through Prada’s interim results presentation (here). Revenue growth was driven by the continued push into operating their own retail stores; now at 81% of sales vs. 75% a year ago. 74% of capex was spent here and all of that was from cash flow internally generated by these strong results. This is a bull market story within a global recessionary backdrop. During the first half, 28 new stores were opened bringing the total of directly operated stores to 414. New markets that were penetrated included: Morocco, Brazil, Ukraine and Mexico. Prada is an emerging markets story.

Where is Prada?

(What Prada calls “Greater China” – China, HK and Macau – comprises 22% of total net sales).

Of those net sales, 62% are leather goods; that chic black leather stuff the Italians do so well. (I may not be a consumer – black just isn’t my color – but I can appreciate it from afar).

All About China

Europe is in the tank and flirting with disintegration, why are the Europeans hoovering up expensive Prada goods? Well, they’re not. Prada puts it this way, “[We enjoyed] outstanding performance of Europe thanks to travelers.” Right. Who are the travelers? The Chinese of course. In an effort to avoid China’s punitive luxury tax (around 30%) and to buy the real article – not some toxic black piece of junk cranked out of a sweaty factory in Shenzhen, Chinese have been flocking to Europe on shopping sprees. (They aren’t there for the cathedrals). There is also a huge black market smuggling operation involving roping in travelers (almost always other Chinese) to buy Prada bags and then hand them over to the smugglers in order to avoid customer purchase limits the company imposes in its stores.

On the conference call management even commented that the US has weakened in the last two months and they cited the reason as due to less Chinese travelers. Just looking at the math with “Greater China” itself accounting for 22% of net sales and I would guess more than half of Europe’s sales are also China related, plus a chunk of US sales demand is actually coming from China, we may be looking at China demand accounting for well over a third of total sales – easily Prada’s most important market.

The Chinese may be tired of Burberry (who isn’t?) but they are just discovering Prada. However, you would think that when they go to Prada stores in the US or Europe and see that all the other customers are from the next province over, the exclusivity and snob appeal of the brand surely will be tarnished.

With the stock up 70% ytd and the free float just at 20%, will the Prada fashion juggernaut continue, or is it time for a breather? The company doesn’t need the cash as growth is funded internally and they had an IPO a year ago. However, the wife and husband duo that control Prada and own most of it, Miuccia Prada, Chairperson and Patrizio Bertelli, CEO couldn’t be blamed for thinking about another liquidity event, given strong recent returns and that 80% of the float sits in “Prada Holding BV,” the Dutch private partnership entity. When that happens is anyone’s guess.

Lots of Pain in the Sector.

Rather, what is more likely to dent the share price is Prada exposure to a slowdown in demand coming from China. You certainly can’t see that in their competitor-crushing results but these things don’t go up in a straight line forever. Burberry (BRBY LN) shocked the market two weeks ago when they reported sales growth in China was far slower than expected. The stock fell 21% without touching the sides on that announcement and has continued its slide since. With 37% of Burberry sales coming from Asia, this data point is significant. “We know we are not alone in terms of what we’ve seen in the last couple of weeks,” came the chilling warning from Burberry CFO Stacey Cartwright. Tiffany (TIF US) cut its full-year profit forecasts late August. Right after that, Harry Winston (HW CN), the Canadian diamond miner and jewelry retailer also said luxury demand is falling. De Beers has also just said that demand for diamonds in China is slowing, growing now at 10% this year, half of last year’s level. According to China’s National Bureau of Statistics, jewelry sales in China in Q1 grew 20% vs 59% a year earlier. Watch sales are not ticking along either, 15% growth in Q1 vs. 40% Q1 11.

Some of the reason for the cooling of luxury demand in China comes from Beijing, which is imposing a “frugal working style” system on government officials as of October 1. They will no longer be allowed to spend public money (ie, the money they carry around with them) on banquets, foreign cars, etc. Expensive gifts will also be scrutinized. The China Daily had this to say on the matter, “Luxury products are highly expensive and civil servants, whose salaries are about Rmb 5,000 a month, cannot afford them. So officials who possess luxury products should give convincing explanations on how they got them.”

My view: Ahem. That’s going to hurt. Obviously, bribery is entrenched in China, as it is in every ancient culture, and greasing palms as a way of getting things done is not going away. This campaign, like all the ones before it, will at best have only a temporary effect on behavior endemic since chopsticks were invented.

Another headwind is this talked-to-death leadership transition in China. I do want to add though, it is worth noting that the 18th National Congress will see 7 of the 9 most powerful in China retiring from the supremely powerful Politburo Standing Committee. Not only that, but up to 70% of the member ship of the Central Military Commission and the executive committee of the State Council are also going to pasture. This is basically all the people that matter and is a massive shift in personnel and personalities which will have a far reaching impact on the course China takes in the future. As a client pointed out to me, many of those newly promoted won’t officially take their positions until March and from then will start to wield the power they have likely coveted their whole life. This means the underlings, bag carriers and hatchet men are all going to change next year as a result. What does this have to do with luxury demand in China, one might naively ask? Well, we don’t know who to bribe yet is the short answer so hold off on buying those expensive “gifts.”

Now, Who Do I Give These To?

While watches, jewelry and expensive wine are prime gifts for currying favor, does Prada fall into that category as well? Are you going to give the local party boss Prada shoes, or a Prada bag? No, but you might give it to his wife, or one of his dozen mistresses, who knows? My view: Prada will find it increasingly difficult to remain above and immune from this broad based slowdown.

So far, Prada does seem immune. They have much tighter cost control than Burberry with virtually all their products made in house at 10 different manufacturing centers around Italy (and one in the UK that makes bad shoes: Church’s). Prada takes pains to point out, “In many cases, the raw materials are exclusively produced for the PRADA Group, on the basis of rigorous and specific requirements of the style department.”

(Cool. Can you imagine telling people you work in the “Style Department” at Prada?)

When asked about a broad slowdown in luxury market demand in Asia, Prada CEO Bertelli commented, “I think we must stay calm and be less hysterical,” (!!) and reiterated his view that the firm will reach its targets this year.

Valuations Are a Problem

Prada trades at a current consensus PER of 24X, with 12 buy, 6 hold and 2 sell recommendations. This is expensive compared to other luxury brands listed in Hong Kong: Chow Tai Fook (1929 HK) trades at 16 x, Chow Sang Sang (116 HK) trades at 13 x. Internationally, even top shelf jeweler Tiffany trades at only 18 x, and LMVH at 18x.

Consumer analyst, Janey Dillon, created the chart above and despite the wonderful operating metrics, she too is concerned about valuation. She notes Prada is actually trading at 2 std deviations above the 10-year average 12M forward PE for the sector. That’s fine as it probably is the best stock in the sector. However, after the recent re-rating, consensus earnings forecast of 20% growth for 2014 and 2015 after this year’s 40% surge does look challenging. While an excellent company measured on any operating metric, given the stretched valuations and building headwinds some profit taking at this level may be warranted.


Tip: Don’t Buy Prada PA (if you live in Hong Kong or Singapore)

Italy does not recognize Hong Kong as a “regulated stock market” (!) and applies punitive taxation on BOTH dividends AND capital gains to investors based in Hong Kong, or Singapore, who buy and sell Prada. The Italian government has made strenuous efforts to sign double taxation treaties with the US and other important economies, such as (I’m not making this up) Albania, Uzbekistan and Zambia, but NOT Hong Kong. Therefore, if you are an individual shareholder, or a corporate shareholder domiciled in Hong Kong, you will have 20% of your Prada dividends taxed (withheld by the company before payment) and you will suffer another ignoble 20% capital gains tax. Wait, the indignity continues because you will also have to then file an Italian tax return! I have been to Italy, it is a wonderful place, and I can order pizza and wine in the local trattoria but that’s the extent of my bastardized Italian. It would take a lot of chianti for me to attempt an Italian tax form.

You can find the law, amusing at it is, in the Prada Tax Booklet (here).

Oppan Gangnam Style

Prada too expensive? As profiled in last week’s Emerging Markets Illustrated, the Korea department store sector is an attractive way to play the growing demand for luxury goods among Asia’s cash-rich consumers. 80% of luxury goods in Korea are sold through department stores and current valuations are near trough levels, top picks Shinsegae (004170 KS) is trading at a 12-month forward PE of just 6.4x and Hyundai Department Store (069960 KS) at 8x. Analyst Yumi Park in her sector initiation, “Sweet & Sour,” forecasts earnings CAGR of 12% over the next three years. You have growth, low valuations and an unassailable market position without the spooky shadow of political uncertainty.

Sinorama.

According to the media, China and Japan seem to be inching closer toward actual military conflict over questionable ownership of some rocks scattered between Taiwan and Okinawa. (In fact, one of these rocks is located just 100 nautical miles northeast of Keelung, Taiwan). Nobody gave the islands much thought since they were discovered 600 odd years ago until 1968 when it was announced there might be oil in the area. It isn’t know if there is oil yet but the possibility of such a bonanza overnight turned the Senkakus (according to Japan) and the Diaoyu Tai (according to China and Taiwan) into most desired real estate.

To heat things up a bit, Tuesday this week China finally officially launched its first aircraft carrier, Liaoning, named after the province where she has been docked for 10 years undergoing a massive refit. The story of this ship would make a great movie. China doesn’t have any aircraft carriers and lacks the ability to make one. This is their first step in that direction and as with many new adventures it has been a comedy of mini-disasters the entire way.

Future Casino?

Liaoning was originally designed as a Kuznetsov class multi-role aircraft carrier in the former Soviet Union and her keel was laid almost 30 years ago in 1985. Construction stopped in 1992 when the Soviet empire unraveled, and the unfinished ship was handed over to Ukraine – which had even less money than Russia. She was stripped and abandoned and rusted away quietly for six years with no engines and not even a rudder. Enter China, who probably found her on E-Bay, and put in the winning bid of US$20 mn. But China couldn’t buy an aircraft carrier directly without alarming her suspicious neighbors so the funds came from one “Chong Lot Travel Agency,” a small Hong Kong based company whose board members live in Yantai, Shandong Province (just across the water from China’s major naval base in Dalian) and whose chairman was a former PLA officer. Cue the smoke and mirrors at this point.


Keep a Knockin’ But You Can’t Come In

After winning the prize, Chong Lot Travel Agency announces plans to tow the empty and much rusted hulk back to China to turn it in to a casino. That makes sense, what else would they do with it? This is where things start to go wrong for China. Since the “vessel” was located in Ukraine, it had to pass through the Bosphorus Strait to reach the Mediterranean and Turkey said, “We don’t want that thing coming through here.” Istanbul steadfastly refused permission for passage for 16 months during which time the vessel was being towed in circles around the Black Sea. China flew in “high level officials” to negotiate and reportedly offered the Turks promises of shedloads of cash rich Chinese tourists as an inducement for letting the vessel go through her waters. (Now you have to ask, all this for a casino??)

Permission is given and the ship is towed through the tricky Bosphorus into the Mediterranean where they immediately encounter a Force 9 gale. All tow lines are broken in the monstrous and dangerous seas and the rusting hulk begins to drift crazily towards Greece. Yikes. Eventually, they get her under control after the weather subsides and continue the tow all the way to China. Three months and 15,000 miles later the ship arrives in Dalian. (Cost of the tow: $5 mn). She is put in drydock and the rust is sandblasted off her while the Chinese negotiate a multi-billion dollar deal to buy 50 Su-33 fighter aircraft from Russia. Wait, let me check. Yep, Su-33s are designed for carrier work, not casinos. The deal falls through, however, when Russia realizes China is copying the Su-27 fighter and calling it their J-11B with big hopes of exporting it all around the world. I think I have seen that strategy play out in factories across China and it usually doesn’t end well.

Where’s the Karaoke Lounge?

After extensive sea trials, Liaoning is officially commissioned but what do we have here? It is basically an aircraft carrier that has undergone a 10-year refit and now has lots of karaoke rooms and massage parlors on board – but no airplanes. China does not have any aircraft, or pilots, that can land and take off on an aircraft carrier. What good is an aircraft carrier without aircraft? As Mr. You Ji, a senior research fellow at the National University of Singapore put it, “The fact is the aircraft carrier is useless for the Chinese Navy. If it is used against America, it has no survivability. It is used against China’s neighbors; it is a sign of bullying.”

My view: Liaoning is a political sideshow put on for domestic consumption. The ship will have to be used “for training purposes only,” and has very little ability to project military power. Or maybe they will turn it into a casino. China’s neighbors can relax and get back to the water cannon fights they are now enjoying in the Senkaku/Diaoyu islands.

The Last Page.

 

Derek Hillen, CAIA
Mirae Asset Securities

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