Charlie Munger, in his usual brilliantly succinct manner, spit out a few terrific zingers at the Berkshire meeting: “If an investment comes with a high commission, don’t even read the prospectus [run away]” and “Prostitution is a step up for compensation consultants” and “If short-term performance is something that turns you on, you should not be in this room.”  Watch this interview with Munger.  He is too old (88) and too rich to try to be politically correct – he is very refreshing.

Seek out people who disagree with you
While answering a question on his political views and their impact on Berkshire (see question 13), Buffett said something that really resonated with me, though for a different reason: “If you are going to choose your friends and your investments if they agree with you, you are going to have a very peculiar life.”

I have a dentist friend. He was born in Russia, moved to Israel when he was 7, spent 20 years in Germany, and then moved to Denver about 10 years ago.  He is extremely smart, very well-read, and a thoughtful person. His multi-continent background gives him a unique perspective on things.   However, I have yet to meet a person with whom I disagree more about US and global politics.  In the past I used to get angry at him.  After one of our regular debates, I’d sometimes go into avoidance mode for a few months.  His disagreements were passionate but also well-thought-out and backed up with facts and his own theories.

Last winter he invited to me to go skiing with him.  Overall he is a pleasant person, but I was a bit hesitant – it is a two-hour drive each direction from Denver to the mountains.  Four hours of disagreements in one day?  But I went along, and instead of disagreeing with him I started to listen.  I tried to identify the specifics of our disagreement, what assumptions both of us were making.  And then tried to focus the discussion on these more precise points of disagreement.  In the end we each learned from the other.  Our views have not changed much (political views are like religion beliefs, nearly impossible to change), but this summer we are going to go off bicycling together, and I am looking forward to it.

This applies to investing as well.  When you are long a stock you are naturally trying to seek out investors who have the same opinion, and naturally stay away from those who have contrary views.  Instead, we should try to do the opposite, seeking out smart people who, after doing their research (a very important point), came to a different conclusion from ours.  This point is a bit more nuanced.  If I talk to a momentum growth investor about Xerox, I know exactly why he’ll be avoiding it; there is no momentum in the stock price.  His view will bring me very little insight.  However, the perspective of a smart fundamental investor who’s done thorough research but arrived at a different conclusion might be very valuable.  When we find someone who disagrees, we need to identify exactly where the differences in opinion lie (assumptions, new/missing important data points, etc.) and then methodically and objectively try to refute those points.  If you cannot, maybe you are not as right as you thought you were.

I’ve seen Jim Chanos do this.  When he presents an idea he’ll say, “Bulls make the following assumptions…” and he’ll impartially spell them out; and then he’ll go, “But here is why we think they’re are wrong” (or the results are not achievable etc.).  Speaking of Jim, he was interviewed in the Graham and Doddsville newsletter.  I really liked this interview, because it went deep into Jim’s unique investment process. He also recently participated on an investment panel on China at the  Milken Institute.  It is worth watching.
The budget deficit is a stimulus
In answer to a question, Buffett said something along the lines of “When government runs a 10% deficit, it is a stimulus, though nobody calls it that.”  But the bond market will not let us run 10% deficits forever.  Unless an unlikely miracle happens and, due to super economic growth, we fill in that hole, taxes will have to go up, government spending will have to be cut, and/or money will have to be printed.  It is hard for me to see how the current (artificially set by the Fed, insanely low) long-term interest rates will stay there.  As Buffett mentioned, elimination of the deficit will be destimulating, so the future may hold a weird combination of low real growth and still-high interest rates.

China = post-bubble Japan?
On a different topic, The (UK) Telegraph has a fairly bleak article on the sorry state of the Chinese economy, which is coming to resemble the Japanese post-bubble economy at an increasing rate.  Here are some scary excerpts, with my comments:

• “China’s electricity output – watched religiously by bears – slumped in April. It is up just 0.7pc over the last year.” – This number is the hardest to cook.  The rate of growth has been declining for a few months.
• “State investment in railways has fallen 44pc, with an accelerating downward lurch over recent months. Highway construction has dropped 2.7pc.”
• “The Yangtze shipyards tell the tale. Caixin magazine said eight of the 10 largest builders in the country have not received a single new order this year.”
• “Housing sales slumped 25pc in the first quarter, testimony to the zeal of regulators. This has since fed into a drastic fall in new building.… floor place under construction fell 28.3pc in April.” – The housing market is extremely important for Chinese federal and local governments – see next data point.
• “Land sales provide 70pc of tax revenue to local authorities and 30pc to the central government.”
• “The People’s Bank said new loans fell from $160bn in March to $108bn in April. Non-conventional lending seized up altogether. Trust lending fell by 96pc, bankers’ acceptance bills by 90pc.”
• “Yes, consumer price inflation is 3.4pc – though falling – but consumption is a third of GDP. Fixed investment is 46pc, and here prices have dropped 3.5pc in six months. Export prices have dropped 6.6pc.”  This is not a dynamic and healthy economy; its growth was completely predicated on large-scale fixed-income investment.  Though it looks like the Chinese government has succeeded at fighting inflation, the system is so addicted to stimulus/construction that if they don’t restart building more empty cities and bridges to nowhere, the economy will stall.  It is a no-win situation.  (Is it already stalling?)

Etc…
I had the pleasure to participate (third year in a row) on the Value Investing Panel at Creighton University.  Bruce Greenwald – charismatic, brilliantly smart Columbia University professor – was on the panel as well.  Bruce and I had a lively debate about the usefulness of discounted cash-flow analysis.  I realize that for civilians (non-finance geeks) this disagreement is like two paleontologists arguing about dinosaurs’ procreation habits. You can watch it in its entirety (scroll to the bottom of the page – the video is horrible but the audio is fine).

While in Omaha I was interviewed by Yahoo! Breakout’s Matt Nesto.  We talked about Facebook, Microsoft, and Electronic Arts.  We were outside of Borsheim’s, a large jewelry store owned by Berkshire Hathaway.  There were probably a few thousand people who could not wait to buy jewelry and get their hands on free booze and food.

A year ago I did a 90-minute lecture at Johns Hopkins University in DC on China and Japan.  It has finally made its way to YouTube.

I was going send out an article in this email, but this is already too long – I’ll save it for next time.

And this is a good time to start a new a new tradition: at the bottom of each email I’ll include a link to my favorite music clip (I’m a classical music fan, so don’t get too excited).

My parents always loved classical music; in fact I don’t remember them listening to any other music.  When Mom put me to sleep she’d employ her favorite record, Rachmaninov’s Piano Concerto Number 2.  I think Rachmaninov is dear to me because it brings out memories of childhood and my mother.

When I came to United States I discovered a young Russian pianist (he is now a few years older), Evgeniy Kissin.  He was a child prodigy.  I’ve heard many pianists play Rachmaninov, but his interpretations touch me the most.  Here is the Rachmaninov Piano Concerto No. 2 with Evgeniy Kissin (part 1-1, part 1-2, part 2-1, part 2-2, part 3-1, part 3-2).

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

P.S. Watercolor “European City. Evening.” is by my father Naum Katsenelson

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

On January 18, 2011 I had a great pleasure to give a lecture on China and its impact on global economy at Johns Hopkings University Applied Physics Lab.  You can watch it now on youtube, click on this link

Deadline to register for VALUEx Vail is May 1^st. 

I am very excited about one of our “dessert speakers,” Jon Markman, who’ll speak about Jessie Livermore, one of the most successful (until he failed) and interesting traders ever, who lived in the first half of the last century.  No one knows more about Jessie Livermore than Jon, as he annotated one of my favorite books, Reminiscences of a Stock Operator.  Here is what I wrote about it a few years ago: “Jon’s skillful annotation takes you behind the scenes of Livermore story and provides important insights into characters and the backdrop of that very interesting time period.  Jon’s annotations are almost like a book within a book.”

Omaha!

It is Omaha time again!  This year Value Investor Congress, which I’ll be attending, has been moved to Omaha.  Congress is Sunday (May 6^th) through Monday.
May 4^th – Friday

May 5^th – Saturday
 

May 6^th – Sunday
 

China bubble today vs. Japan bubble in 80s

I am back from San Francisco, where I had the great pleasure of attending and speaking at FAME Symposium, diligently put together by students at San Francisco University.  One of the other speakers was a famous international investor, Charles De Vaulx.  During a break Charles and I were discussing the Chinese bubble today vs. the Japanese bubble of the  late ’80s.  This conversation got me thinking.  In Japan the bubble was the most prominent in commercial real estate and to a lesser degree in residential real estate.  The house-price-to-income ratio (just take the average house price and divide by average income) in Tokyo at the height of the bubble was 9, while in China in 2010, in the big cities this number was much greater (Beijing 15, Shanghai 13), and in fact the ratio for the whole of China was over 8.  The commercial real estate bubble might have been greater in Japan; it is hard to tell.  I remember reading that at the peak of the Japanese bubble the Imperial Palace was worth more than a state of California.  But from different reports I’ve seen, China has plenty of empty skyscrapers.

But China also has a couple more bubbles, in industrial overcapacity and overinvestment in infrastructure.  Japan did not have an infrastructure bubble, for several reasons: first, it was a more developed country than China.  Second, the government played a much smaller role in the economy – Japan did not have a command-control economy, and it did not try to build for social/political stability reasons.  Japan had your garden variety real estate bubble: easy credit, inadequate banking laws, etc…

Also, and this point is hard to quantify, but the quality of Japanese construction is better than in China.  There are many reasons for that: less corruption, no five-year plans (i.e., output-per-capita targets), and the Japanese put a higher value on human life.  I remember reading an interview, just a few years ago (before the high-speed-train crash in China) with a Japanese high-speed-train executive.  At the time the Chinese were showcasing their high-speed-train system and rubbing in Japanese faces the fact that their trains traveled at higher speeds.  The Japanese executive said something along these lines: “Our systems are very similar, since the Chinese stole our high-speed railroad designs.  We could run our trains at faster speeds, but we just don’t think it’s safe.”  Japan has a population of 130 million people, which is shrinking.  China has over a billion people and its population is growing.

The quality of Chinese construction is horrible; you read stories of glass and masonry falling off of buildings, and the latest story was of a girl swallowed by capsized pavement.   So they’ll have to do a lot more rebuilding in the future, and thus their return on capital, which was already very low, will actually be even lower.

Japanese economy, despite Government debt to GDP doubling, has been stuck in a rut for over two decades.   Just saying…

Dot-Social and dot-cloud bubbles

At the FAME Symposium I was asked if we are in the midst of another bubble – the social and cloud bubble.  I said that if one really wants to make some money quick he should start a company and call it “SocialCloud”.  I read a lot of articles defending Facebook paying one billion dollars for a company with less than a dozen employees, with an app that has terrific photo filters and 30 million users, but with no revenue and no network.  Once you take a picture, Instagram gives you the ability to post it to a half a dozen places, including Facebook and Twitter.  But Facebook will be paying for this acquisition with funny money – it has a $100 billion market cap on three or four billion of revenues.

The Instagram acquisition by Facebook has likely injected a lot of fertilizer into the angel investing bubble. I am sure there are a lot of startups out there that will be raising money from angel investors dreaming of selling themselves to the Facebooks and Googles of the world for billions of dollars.

I looked at recent IPOs, and their valuations appear bubbly.   Yelp – a terrific company (more on it in a bit) – has a market capitalization of $1.3 billion, and analysts expect its revenues in 2012 to hit $180 million.  Angie’s list – a website I recently used, since we were remodeling the house – has a valuation that is as silly as Yelp’s, except that its website is a slight improvement over Craig’s List.

I know the enormous appeal Facebook has to advertisers. Never before could advertisers target their customers with such precision.  Facebook knows your address, your age, where you went to school, the music you like, whether you are married or recently engaged, where you travel, etc… All this information we volunteer when we fill out our user profile. I get it, it is incredible.  I’ve yet to meet a person who doesn’t think Facebook will do well on its IPO.  But what if Facebook struggles to monetize its enormous user base?  There are only so many ads it can put up on a page before they start impacting the user experience.  The counterargument here is that since these ads are so finely targeted, they are more expensive and thus Facebook will not need as many.

What if people will simply get tired of the social thing?  Social networking may turn out to be a fad, or at least the amount of time we spend it on it may decline a lot.  I know large employers are blocking access to Facebook left and right; it is a huge productivity drain.

Zynga is another stock that looks bubbly (though less bubbly then when I looked at it a few weeks ago, the stock is down 40% or so).  Social games could be another passing fad.  At the conference I described a company that we recently purchased that may benefit tremendously from social games, but for them it is an added bonus (an option), while for Zynga social games are everything.  I don’t know if I am right on these stocks or not – maybe their businesses will go at a much faster rate than I expect.  But I can definitely sense that the second we mention the words social or cloud our objectivity in judging businesses dissipates.  This doesn’t just apply to dot-clouds or dot-socials, it applies to boring, real companies feeling the pressure to be in the space, who are paying insane valuations for dot-social and dot-cloud businesses (Centurylink buying Savvis at 10x EBITDA comes to mind).  Since we own plenty of real companies, my concern is that they’ll overpay for their dot-stuff.

Yelp

The last time I was in San Francisco, a portable GPS was a very expensive novelty.  That was early 2006.  My best friend and I were on a road trip, driving from Denver to San Francisco and back.  We had a GPS attachment connected through a USB port to a laptop and used Microsoft mapping software.  All phones were dumb (even Blackberry, the smartest phone at the time, was dumber than a brick compared to today’s iPhone).

This time around armed with iPhone, I was surprised how good the Yelp app was.  Though they are trying to expand beyond it, Yelp is a social app where users review and rate restaurants.  It is crowd sourcing at its best.  All I had to do was type “sushi,” select the distance from my current location that I was willing to travel, and Yelp showed me all sushi restaurants around me and their ratings.  In the absence of any other data points, you start heavily relying on Yelp’s ratings, especially since many restaurants have several hundred reviews.  The feature in the app that I found astonishingly innovative was the “monocle.”  You click on the “monocle” button, point your iPhone in any direction, as if you were taking a picture, and it shows you the restaurants and their ratings in that direction.

Apps like Yelp’s will have a significant impact on restaurants.  They facilitate the word-of-mouth restaurant recommendations between friends and extend them to strangers. They’ll also likely expedite the failure rate of restaurants.  Restaurants with high reviews will get more customers, and the ones with poor reviews will die a quicker death. 

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

]]> http://ContrarianEdge.com/2012/04/25/omaha-bubbles/feed/ 0 http://ContrarianEdge.com/2011/12/27/krugmans-missed-call-europechinajapan-sideways-markets-profit-margins-microsoft/ http://ContrarianEdge.com/2011/12/27/krugmans-missed-call-europechinajapan-sideways-markets-profit-margins-microsoft/#comments Tue, 27 Dec 2011 19:57:19 +0000 Vitaliy Katsenelson http://ContrarianEdge.com/?p=3056  I wanted to share with you my interview with my friend Bob Huebscher who runs a terrific website Adviser Perspectives.  I am very excited about this interview because in a very unconstrained format we had a chance to discuss Paul Krugman’s  latest bearish article on China, the linkage between the European crisis and Chinese and Japanese bubbles.  We revisited sideways markets, profit margins (I picked a bone with Apple’s high margins), and concluded with Microsoft.

Here are some pictures (I took close to 1,300 only a dozen or so are worth sharing) from my November trip to Spain (Barcelona and Madrid/Toledo) and South Africa (requires facebook login).   On our way to Madrid, my brother Alex and I had a (intentionally long) layover in Atlanta.  My friend Aaron Edelheit picked us up from the airport and took us to one of my favorite places in the world – Stone Mountain park (here are some pics, facebook login required).  Imagine an enormous granite boulder 800 feet above ground, surrounded by a picturesque forest and a lake. And of course, the largest relief sculpture in the world, the size of two and a half football fields that pictures three Southern generals (in the South you still often hear the Civil war called the “War of Northern Oppression”).  It took almost 60 years to complete it.

Funny thing happened.  Here I am in the middle of this paradise and my iPhone keeps beeping and vibrating with emails.  Every time it beeps I diligently checked my email, deleted it, and put it back in my pocket.  Aaron, being a good friend, said “Vitaliy I used to do that too.  If you are not careful this little device will turn you into a Pavlov’s dog.  I figured out a trick, turn off the sound and vibrating on your phone.  This way you can check your emails on your time and the impulse to check email will go away.”  I followed Aaron’s advice and killed email notification on both my iPhone and iPad.  I have to tell you it is extremely liberating.  Now I go through the whole dinner at home without checking email once!   I hope you do the same.

Finally I wanted to wish you a very happy, healthy and prosperous 2012. – Vitaliy

Vitaliy Katsenelson on Krugman’s Missed Call

We spoke with Vitaliy on December 20, 2011.

Paul Krugman wrote about China in his New York Times column last Monday.  That’s a topic that you have researched closely.  He said that “China’s story just sounds too much like the crack-ups we’ve already seen elsewhere,” referring to the financial crisis in the US and the Japanese lost decade. Do you agree with his assessment?

Yes.  You can draw a lot of parallels between the Japanese and US real estate bubbles.  But China’s bubble is much larger; it spreads beyond residential real estate to commercial real estate, the industrial sector, and infrastructure.  Also, though there were government fingerprints on the US and Japanese real estate bubbles, the Chinese real estate bubble was directly and entirely caused by the Chinese government.

The Chinese bubble has been inflating for years.  It should have popped during 2008 recession.  But China fire-hosed a stimulus equal to 12% of its GDP into its economy and was able to keep the bubble growing.

When is it going to pop?  It has already begun.  You see sales volumes and prices plummeting at double-digit rates in second-tier cities.

I agree with Krugman’s assessment.  What perplexes me is why the Nobel Prize-winning economist wrote this column now, when the problems he describes are plain for all to see, and not a few years ago.  You’d think he would have been alarmed over the consequences of monstrous government intervention in an economy the size of China’s.  But perhaps Krugman, who describes himself as a liberal economist, secretly hoped that the Chinese government would be able to manage the economy better than the free market.

But even over the last few years China’s growth has remained relatively strong – certainly as compared to the rest of the world – just not as strong as it was in the years prior to that.

It was completely driven by fixed-asset investment and the bad loans that came with that – not a sustainable type of growth.

One of the things Krugman pointed to was the lack of reliable data from the Chinese government. To what extent does that cloud your analysis, and how certain can you be in your forecast and your analysis, given the uncertainty, or unreliability, of Chinese government data?

He is right. When you look at Chinese government data, it has a couple of biases. Number one is in the way they collect data: it comes from municipalities and local governments that are given growth targets. The federal government says, “You need to grow, let’s say 10% of GDP per capita, for your municipality.”  The local bureaucrat has to get that growth.  The easiest way to do it is to build, and that is why they have had a real estate bubble.

But the problem is, if the local bureaucrats fail to deliver the growth they know they’ll lose their jobs. So they start cooking the numbers, and they start sending numbers to the top that are falsified. That is the number one bias.

The second bias is that this is a government that is very concerned about its image. It is very good at propaganda. The government puts people in jail for writing anti-government articles.  The economic statistics are the output of a propaganda machine. You truly can’t trust the data coming from the government.

But that is wh

y you look at anecdotal evidence, and the data points they can’t or just don’t bother to cook. During the 2008-2009 recession, the global economy was contracting and the Chinese government was showing that GDP was growing at a fairly healthy pace.  However, other data points, like the tonnage of goods shipped through railroads, were down by double digits. Electricity consumption declined too.

Eventually, we started seeing empty cities popping up here and there.

What made it easy for me to understand China is that I was raised in Soviet Russia for the first half of my life.  This experience helped me to understand how inefficient, dysfunctional, and corrupt an economy that is run by the government can be.  You start seeing and piecing together the small bits of anecdotal evidence.  You build a framework that helps you to understand their economy.

Are there any policy options that are still available to the Chinese government, for example, stimulus measures that it could take to avert the kind of crisis that Krugman predicts and that you say is already occurring?

I am fairly certain that, once the pain of economic slowdown is felt, the government will do what it did in 2008: It will try to re-inflate the bubble.  But that will add another layer of future problems on top of the existing ones.  For instance, according to Pivot Capital, toxic shadow banking, which was almost nonexistent in 2008, is estimated to be $250 billion in 2011.  The Chinese government may manage to keep the bubble from bursting for a little longer, but at some point the basic laws of economics will assert themselves, and there is absolutely nothing the Chinese will be able to do.

Continue reading at Adviser Perspectives…

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

Segment 2: China

China is slowly starting to face the consequences of its actions — loans grew over 30% a year over the last few years — and inflation is rising fast.  Inflation in developed countries is unpleasant, but it is tolerable.  For a developing country — and China, despite its size, is still a developing country — it can be catastrophic.  In developed countries, we spend two or three times less on food as a percentage of our income as do people in developing countries.  Therefore, though food inflation is unpleasant, we have a much greater tolerance (margin of safety) for it.  While food inflation the US can mean fewer trips to restaurants or no summer vacation, food inflation in China leads to hunger.

The Chinese government is desperately trying to put the brakes on the economy.  It is shutting off lending to land developers and has raised bank reserve requirements five times this year.  However, its success on the inflation front will likely lead to a slowdown of the economy and high unemployment.  Ironically, those were the issues party planners tried to cure when they stimulated the hell out of the economy over the last few years.

China bulls are arguing that the almighty Chinese government will be able to soft-land the economy. Unlikely, I’d say.  Forced lending was at the core of Chinese economic growth. Simply put, there is too much debt to go bad.   According to Ernst and Young, one-third of the $700 billion in loans taken out by local governments may face repayment problems.  The People’s Bank of China estimates that Chinese banks’ exposure to local government loans is 14 trillion yuan ($2.2 trillion), according to the June 17 South China Morning Post.  Once lending is cut off, property prices will stop appreciating (and likely collapse — that is what usually happens in a Ponzi scheme). Also, the overcapacity in the industrial sector and commercial real estate will come to the surface. And suddenly everyone will discover that the venerable emperor has no clothes.

I often hear the argument that China will not have a real estate crisis of US proportions because home and condo owners have to put 30-40% down when they buy.  So where do people get the money to buy a house that costs, on average, 8 times their annual income (a figure several times higher than in the US)?  Some of it comes from savings, and some comes from borrowing from relatives.

Let’s pause for a second.  In the 1990s, the Chinese banking system basically collapsed.  To revive it, the Chinese government took bad loans from banks’ balance sheets and put them into off-balance-sheet vehicles (Enron would be proud of that financial ingenuity).  Banks started to function as though nothing had happened. To finance the off-balance-sheet assets, the government set deposit interest rates at very low levels: 1% or so.  In a country with a very high savings rate and 5% inflation, this resulted in a 4% annual loss of purchasing power.

Chinese consumers were punished severely over the last 10 years for the banking crisis of the late ’90s.  And they’ll be punished even more soon.  Keeping money in the bank didn’t make that much sense, and investment alternatives were limited. However, they could invest in an asset that supposedly never declines in price – a house or condo.  So they did.  As China slams the brakes on the economy and as housing prices fall, the banks will lose plenty of money. But more importantly, it is the people who bought tremendously overpriced houses, and their relatives who lent them money, who will lose.  The wealth and hard work of more than one generation will be lost, and this kind of pain leads to political unrest.  That is the Chinese Black Swan!

• Also see presentation – China The Mother of All Grey Swans

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

Copyright Vitaliy N. Katsenelson 2011.  This article may  be republished only in its entirety and without modifications.

It was a slightly surreal experience, because the presentation was right across the street from the Pentagon.  So the Russian immigrant who until 1987 believed Americans were horrible people (read the story of how my family emigrated from Russia) was lecturing Americans on the virtues of capitalism at the doorstep of the Pentagon!

Here are some random thoughts on subjects unrelated to investing.

DC, Wright Flyer, Blackbird…

I had been in DC a few times before but never really had time to see the city.  I took my almost-ten-year-old son Jonah with me on this trip, and we had an amazing experience.  It was father-and-son, embrace history, see new things, eat donuts every morning for breakfast at Dunkin’ Donuts time (mother was not there to set us straight).  Here are some pictures from this trip.

We spent a lot of time browsing Smithsonian museums – Air and Space, American History, and the Air and Space Udvar-Hazy (giant hanger with over a hundred planes, by Dulles Airport).  The Wright brothers’ first plane (the Wright Flyer) was really a shocking exhibit.  The Wright Flyer looks like an oversized wooden kite, with strings and a few levers.  It barely looks like a plane.  In its first flight it only went 120 feet – that was it!  If  you look at the planes that came out a decade or two later, they were real planes – metal wings, wheels, a pilot’s seat, etc. But the Wright Flyer was the paradigm breaker, it proved that an object heavier than air, powered, and operated by a human, could fly.  It unleashed the imagination of the generations who followed.

Fast forward six decades, and you find us standing in front of the plane that impressed the most: the Blackbird.  The Blackbird is a reconnaissance plane; it has no weapons, just cameras.  It was the first plane to use stealth technology, though it wasn’t until decades later that that technology was perfected. The Blackbird’s engines are each the size of a small plane.  Despite being developed 47 years ago, it is still the fastest plane today, flying at Mach 3, over 2,100 miles an  hour!  It flew from LA to DC in 64 minutes.  It flew so high, at 80,000 feet, and so fast that if it was detected by radar the pilot’s strategy was not to go to evasive maneuvers but to push on the throttle.  Not a single Blackbird was ever shot down. What’s ironic about Blackbird is that it was discontinued not because the US came out with a better or faster plane, no, but because of the development of satellites.  Satellites don’t cause international incidents, don’t put pilots at risk, and don’t cost $85,000 an hour to operate.

Productivity is very difficult to observe in the short run, but in the long run it is really incredible how we manage to do ever more with ever less.  In the American History Museum there was an exhibit on ports and ships, where I found this remarkable statistic:  “1960: 25 million tons handled by 15,000 longshoremen at the West Coast ports.  2000: 250 million tons handled by 10,000 longshoremen at the West Coast ports.”  Two-thirds of the people did 10 times more – that is productivity!

I was really reluctant to go to the Holocaust museum, as I did not want to subject myself to the pain I knew would come with it, but my wife convinced me and Jonah to go.  I am glad we listened to her.  There are two things that stuck with me.

There was a wall of photos, five hundred or so family pictures and portraits from a small Lithuanian town that was home to 4,000 Jews for 900 years.  I was magnetically attracted to the photos, but it took me a few minutes to figure out that these people looked like my relatives.  A young fellow in his thirties looked just like my uncle at that age, a 15-year-old kid looked like Jonah will look five years from now, a Hassidic gentleman looked just like my cousin who is a rabbi in Rego Park, Queens, and so on.  These pictures impacted me a lot more than the pictures of dead bodies, pictures from the concentration camps, that I’ve seen so many times over the years, which my brain has learned how to dehumanize.  I could relate to these photos a lot more.  Nazis killed ALL the Jews in that village, including women and kids, in two days.  900 years of history and tradition were wiped from the face of the Earth in just two days!  I have to admit I could not keep my eyes dry after.

A quotation on the wall at the very end of the exhibit really underlined why this museum is so important.  It was written by a German pastor, Martin Niemoller:

First they came for the Socialists, and I did not speak out —
Because I was not a Socialist.

Then they came for the Trade Unionists, and I did not speak out —
Because I was not a Trade Unionist.

Then they came for the Jews, and I did not speak out —
Because I was not a Jew.

Then they came for me — and there was no one left to speak for me.

As a parent you try to instill values into your kids that you may not always possess; but you want your kids to have them, and your children inspire you to be better people.  Jonah and I had a long discussion about how, when we see injustice that doesn’t really touch us, we should not sit still.

Jonah had a blast in DC, but the culmination for him was our trip to the Pentagon.  I had a meeting at the Pentagon, and to keep Jonah occupied while I was busy, he received a private tour of the place from a lieutenant colonel.  Jonah was absolutely stunned – a few days later his eyes are still glowing when he talks about it.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here. .

Copyright Vitaliy N. Katsenelson 2011.  This article may  be republished only in its entirety and without modifications.

China Japan Presentation – By Vitaliy Katsenelson – ContrarianEdge

I am a very nervous flyer.  Whenever there is a little bit of turbulence, I look out the window, see shaking wings, and start to wonder whether they’ll keep holding the plane up.  Then my rational self kicks in, and I tell myself that statistically it is safer flying than driving, that the pilot’s incentives are aligned with mine (it is not like he has a private parachute). Eventually the turbulence subsides and I go back to whatever I was doing.  That said, I do like flying, as it is probably my most productive time, since there are so few distractions. I put on my headphones and start typing (this is how I think).  I wrote two chapters of the Little Book on the plane to Italy this past summer.  The iPad made my travel experience even more productive – unlike a laptop, an iPad has a 10-hour battery life.  I cannot type on glass, thus I bring an external keyboard.

On Monday, my brother Alex and I are flying to the VALUEx conference in Zurich/Davos, then on February 7th I am giving a half-day seminar at the Value Investing Center in Frankfurt.  I am not going to be writing another book for a long, long time (if ever), and I don’t have any new thoughts for another article, so to keep my brain cells going I came up with this idea: email me your questions, and I’ll try to answer them while I spend 20 hours in the air (I did Q&A with FT readers last year; it was a lot of fun).  I don’t promise to answer all questions, but I’ll give it a try.  I’ll post the answers online and will also send them out in my next email.

One last thought. The Little Book was light on tables and charts, so I have come up with supplemental tables, charts, and even a spreadsheet of how Tevye valued Golde (sorry, you have to read the big or the Little Book to know what I am talking about), and you can find them here.

Set the Bar High

The world today is riddled with unique economic, political, and demographic risks.  Finding attractively priced assets that will perform well in spite of these challenges is excruciatingly difficult.  For investors, though, one segment of the market – the highest-quality stocks – still offers attractive risk-adjusted returns.

First, it’s important to understand the risks that make most other asset classes perilous in the current environment.

Where to begin? China, the world’s second largest economy, is facing an enormous overcapacity bubble in commercial, industrial, and residential real estate.  Japan, the world’s third-largest economy and second-most-indebted nation (Zimbabwe holds that title) is in a debt bubble, addicted to unsustainably low interest rates and able to borrow at rates normally reserved for near-riskless borrowers. However, its significant indebtedness and horrific demographic profile (every fourth Japanese is over 65 years old) should barely qualify it as a subprime borrower.

Although the US economy is steadily recovering (unless you are unemployed), the rate of growth in this recovery is unsustainable, as it is propelled by government intervention (such as QE2) and stimulus – neither of which can be relied upon as a long-term driver.

These are the top three global economies, and all face huge challenges going forward, which is why I’ve been skeptical about the health of the global economy for a while now (and I haven’t even mentioned Europe being rampaged by PIIGS).

It is hard to tell if we’ll have inflation, deflation, or both; but problems in China and Japan will likely lead to higher global interest rates, since they are the largest foreign holders of the US debt, and as their respective bubbles burst they’ll be forced to become net sellers.  Over the next few years, global GDP growth will be lower than in previous decades, as consumer deleveraging will be followed by government deleveraging, which will also force higher taxation.

There is no safe place to hide; every shelter carries a different risk.  Bonds will do great if we have deflation, but they will be decimated in case of inflation.  Gold is not a cash-generating asset, and nobody really knows what it is worth. (“Higher price” is not a valuation metric.)  China is the incremental buyer of industrial commodities (here is a factoid: it is responsible for two-thirds of global demand for iron ore), so even if we have inflation, commodity prices will still decline with plummeting demand when China cuts back.  Exposure through bonds or equities to the countries that have fared the best so far – the likes of Canada, Australia, and Brazil – will not protect you in the future, since those countries have been the primary beneficiaries of the Chinese bubble.

Before I depress you further, don’t despair and reserve a space in a cave, stocked with canned food and ammo.  Instead, this is the time to own high-quality stocks – no, the highest-quality stocks – with strong balance sheets, so higher interest rates will not dent their profitability.  Their businesses need to have a competitive advantage and the power to raise prices for their goods or services in case inflation hits, or maintain their prices in case of deflation.

And they need to be noncyclical businesses. Let’s pause for a moment, because this point is paramount.

For a long, long time, the street yawned at cyclical stocks – they never received high valuations; in fact, the only time they would trade at above-market P/E is when declines in earnings (usually during recession) outpaced declines in price.  The street’s indifference was understandable: if the company in question was a commodity producer its fortunes were at the mercy of a very volatile commodity; if it was a capital equipment maker it went through feast-and-famine cycles of the economy.  However, in the late 2000s the market perception towards cyclical stocks changed – they had grown earnings at double-digit rates for six years, and even in 2008 – the year the US economy entered the Great Recession – their earnings still went higher.  They were not marching to the drum of the US economy, but to the beat of the Chinese drum.  They were no longer priced as cyclical stocks, but as secular “growth” stocks.  They sported high valuations on top of very high earnings, with profit margins at multi-decade highs.  The global financial crisis changed the street’s perception of them briefly; but today, only a few years and a few trillion in stimuli later, these companies are reclaiming their “growth” status, and high valuation that comes with it.

I cannot recall a single instance in history when the same bubble was reinflated twice in a row, but this is exactly what has happened to cyclical stocks: the pre-Great Recession bubble is being reinflated today.  Coordinated global stimuli will do that.

Take Caterpillar, the maker of big tractors and giant earthmovers.  CAT is at a higher price today than in 2008.  It is trading at 16 times its 2011 earnings of $5.80 a share, the highest earnings in its history, and its profit margins are close to an all-time high.  Caterpillar is a great company, but it is not a high-quality stock –   It is highly cyclical, has large amounts of debt ($15 billion of net debt), and, like a home builder, the products it sells today have a very long life and compete with tomorrow’s sales.  In a slower-growth global economy, or a world in which China will no longer be able to afford to build empty cities, the world will need a lot fewer earthmovers. Suddenly investor will discover that CAT’s earnings power is not $5.80 but $2 or $3, and the stock is not worth $90, but $30.  In the past, deeply cyclical stocks like CAT were never considered high-quality stocks, but today they are mistakenly considered as such.

For a company to be truly high-quality, its business has to be insensitive to the health of the global economy.  Interestingly, historically there was usually a premium built into high-quality company valuations, as investors are willing to pay more for their high returns on capital, strong balance sheets, lower risk, and the certainty of their cash flows. Deeply cyclical stocks have traditionally traded at a discount to the market.  Not today – low quality is expensive and high quality is cheap. Dirt cheap!

By way of example, what follows are a few companies that I consider to be highest-quality, and I own these stocks in our accounts. The first two are in healthcare.  Though the uncertainty that Obamacare brought is behind us and its impact on the industry will be relatively small, healthcare stocks did not get the message.  Pfizer (PFE), the largest pharmaceutical company in the world, is trading at less than eight times earnings.  It is generating enormous cash flows, pays a 4.5% dividend (which it just raised), and will be debt-free in the not too distant future.  Yet the market puts zero value on its enormous pipeline of drugs in development and the $10 billion PFE spends annually on R&D.  Medtronic – the maker of pacemakers – is trading at 10 times 2011 earnings.  If you look at its stock chart for the last decade, you’d think MDT’s business had stagnated; it has not.  MDT has grown sales and earnings 14% a year over the last 10 years.  Both PFE and MDT have an enormous tailwind behind them: baby boomers around the world will be consuming more drugs and more medical devices over the next three to five years, no matter what happens in China or Japan.

We recently bought Cisco Systems (CSCO) and Computer Sciences (CSC).  Cisco – the maker of internet plumbing – disappointed Wall Street, gave lower guidance, and its stock suffered huge losses as a result.  Today it is trading at about 11 times next-year’s earnings, or less than nine times if we adjust the price for the $25 billion of net cash it has on its balance sheet.  Though there is some cyclicality to Cisco’s business, as we consume more data and video over the Internet, the demand for Cisco’s products will increase more than enough to overcome the business cycle.

Finally, the most boring of this bunch is Computer Sciences, an outsourcing company for large corporations and the federal government.  It is trading at nine times next year’s earnings, and the company has announced a stock buyback of close to 12% of its shares.  It is a very stable and growing business, as the trend toward outsourcing non-core functions continues.  CSC has about $1 billion of net debt that it can pay off in about a year if it chooses.  CSC is the only public business in its field: due to the attraction of high recurrence of revenues, every public competitor has been bought by someone else – Affiliated Computers by Xerox, Perot by Dell, EDS by Hewlett Packard.  Though our CSC purchase will work out without it, in the world of QE2 and (artificially) very low interest rates, CSC becomes an easy acquisition target.

I am asking you to see things that have not happened yet, because success in investing comes not from drawing straight lines, but from the ability to see around the corner.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here.

Copyright Vitaliy N. Katsenelson 2010.  This article may  be republished only in its entirety and without modifications.

In Russian there is an expression: The wise man learns from someone else’s mistakes, the smart man learns from his own, and the stupid one never learns.  You’d think I’d be putting the Chinese government in the latter category – obviously the Chinese have not learned from Dubai’s mistakes, and they don’t seem to want to learn from their own – empty shopping malls and cities which, based on these Google Earth images, are scattered all over China.

So erecting a $1.3 billion “seven-star hotel,” when Beijing’s office vacancy rate was over 20% just a year ago (I doubt it has changed much, considering how much they’ve built in a year) would appear to be less than smart. Wrong! It is brilliant!  The report also states, “The Saudi side was expected to foot the entire bill.”  The “Saudi side” will bear the eventual losses. The construction of Burj Khalifa 2.0 is brilliant on so many levels: the Chinese government gets the “Saudi side” to finance its objective of growth and full employment at any cost, the Guinness Book of Records gets another entry with a Chinese name, the Chinese communist propaganda machine has another news story for us all to digest, and a few years from now Burj Khalifa 2.0 will be bleeding money and the Chinese government will bail out the “Saudi side” at 20 cents on the dollar.  Brilliant! brilliant! brilliant!

I wrote about a year ago in Dubai’s Shot to The Moon, an article that is as relevant today as it was then.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of  upcoming The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here.

If you’ve read my Little Book and have thoughts to share with future readers, please leave feedback on the book’s Amazon page.

I’ll be attending and briefly speaking at VALUEx Zurich / Klosters Conference on Feb 2-4.   Attendance at this conference is free, and it is a great opportunity to spend time with other value investors, not just in the classroom but on the chairlift and while sharing meals.  You can find more information about the conference here.   Right after that, I’ll be giving a presentation for the Center for Value Investing in Frankfurt Germany, on February 7th.

The Coming Decade of Sideways Markets By Robert Huebscher January 4, 2010

Vitaliy Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates, Inc., a Denver-based money management firm.  He is also the author of the highly acclaimed book, The Little Book of Sideways Markets (Wiley, 2010), which is available via the link above.  His web site is Vitaliy’s Contrarian Edge.

I spoke to Vitaliy on December 29.

Your latest book, The Little Book of Sideways Markets, was just published.  What is a sideways market?

Let’s begin with some definitions so we can speak clearly about this.  When I talk about markets, I’m talking about secular markets that last longer than five years, usually decades or longer.

When we think about secular markets or markets in general, we tend to think of them in binary terms: “bull” markets are going up, “bear” markets are going down.  But over the last 100 years markets spent half the time in bull and half the time in a “sideways” phase.  Secular bear markets happened a lot less often than we think.  The only secular bear market we had was the Great Depression.

Think about sideways markets this way: The economy has a lot of small (cyclical) bull and bear markets, but when we are in a sideways market in the long run it just stagnates. This is similar to what S&P 500 did over the last 10 years – we had two bear and two bull markets, and yet the market is still not far from where it was in 2000.

To understand why this happens, you have to understand the simple arithmetic of why stock prices go up in the long run.  They are really driven by two factors: earnings growth and change in price-to-earnings ratio.  If price-to-earnings ratios had not changed over last 100 years and stayed at 15 (their long-term average), you would have had no market cycles, and markets would have gone up in tandem with earnings growth.  Earnings in the long run would have grown in line with GDP, or about 5 or 6% a year, so stocks would have gone up gradually over time as the economy expanded.

But investors get overexcited about stocks, and they take price-to-earnings ratios from below-average to above-average levels.  That is when you have secular bull markets.  And then investors take price-to-earnings from above-average levels to below-average levels, which is when you have sideways markets.  This happened consistently over the last hundred-plus years.

In sideways markets, earnings growth is offset by price-to-earnings decline, and markets go nowhere.

In bull markets, you have earnings growth and you have price-to-earnings expansion.  That is why the returns are so good.  This is a very important point: Over last hundred years or so, economic growth was not that much different during sideways and bull markets.

What stage is the US market in now?

We are in the middle of a sideways market, and we still have another decade to go.

How do I know this?  The principle is that P/Es go from above average to average to below average, and they stay at the below-average level for some time.  If you look at the last sideways market, which was from 1966-1982, price-to-earnings did not just go from above average and briefly touched below average level before we had a bull market.  No. Price-to-earnings spent half of the time at below-average ratios before the next bull market (1982-2000) started.

Though the stock market briefly visited below-average P/E levels during the Great Recession, that dip was not likely the end of the current sideways market.

With regard to price-earnings ratios, are you using normalized P/E ratios?

Yes.  This is a very important question, because the “E” in one-year P/E ratios is heavily affected by the cyclicality of the economy.  Profit margins play a very significant role in what one year (trailing or forward) earnings are at any given moment of time.

Profit margins today are very high, and they rarely stay above their average for long.  Therefore, if you look at stocks based on forward earnings, they don’t look that expensive, but those earnings anticipate continuation of very high margins that are not sustainable.

P/E computed on ten-year trailing earnings more accurately describes how cheap or expensive the market is, as earnings averaged over ten periods capture the complete economic cycle (high and low margins).  Historically, the average P/E ratio based on 10-year earnings was about 18, slightly higher than the 12-month trailing P/E.  Today the normalized P/E is close to 25 times earnings.

Stocks in general are still not cheap.

Can the difference between 18 and 25 be justified by the fact that interest rates are so low?

I talked about this in my book.  This is a very important point.  It is not just enough to say interest rates are low and therefore P/E ratios should be high.  You must understand where interest rates are – in one of three zones: inflation, normal, and deflation.

Today’s interest rates are very low not because the economy is great, but because it isn’t.  The Federal Reserve is afraid of deflation.  Deflation is not good for stocks, because it would be accompanied by slow economic growth, and you would have higher corporate bankruptcies and defaults.  This means higher risk.  The Federal Reserve is trying to move rates lower, not just on the short-term side of the curve but also on the long-term side, because they are afraid we are going to have another recession.

It is not necessarily good for stocks if interest rates are low because you are afraid of deflation.  You want interest rates to move from the deflation zone to the normal zone.  If long-term rates go up to 5 or 6% and short-term rates go up to 3 or 4%, that would be good for stocks, because it would mean the economy has stabilized.  That is not what is happening today.

Of course, having very high interest rates is not good for stocks either.  But the point is that just because interest rates are low, that does not necessarily mean that you should have high valuations. Today interest rates are low for a very important reason that is not conducive to higher price-to-earnings.

One last point on this: Japan had very low interest rates for 20 years, and their price-earnings ratios did not expand; they contracted.

Are there signals that will indicate that we are moving out of this long-term secular sideways market into a bull market stage, other than interest rates moving up?

A good clue would be the media basically throwing in the towel on equities and saying that nobody wants to own equities ever again.  I’m so glad that Business Week did not go bankrupt, for many reasons. I don’t want those reporters to lose their jobs, but another reason is that I am looking for them to be the contrarian indicator – to write an article on the “death of equities” like they did in the early 1980s.  That would be another sign that we are out of the sideways market.  I don’t see those signs yet.

Right now, sentiment is very, very bullish, and people basically expect the bull market to continue.  So the sideways market is marching on.

We did have a fairly substantial move by individual investors into bond funds for most of this year.

That’s right, and now they are trying to get back into stocks.  Part of the rally we had was because individual investors are afraid to miss the boat.  If you look at the AAII [American Association of Individual Investors] sentiment, it is at a multi-year high.

Within your clients’ accounts now, how much cash are you holding?  As a value-oriented investor, what downtrodden and neglected asset classes do you consider attractively priced?

In the fourth quarter of 2010, our cash balances peaked at 35% as we were selling stocks that became fully valued.  Our cash balances have declined since to 28%, however, because even though the market was going up, some stocks declined and became good bargains.

You find value today in an unexpected place.  When I look at the economy today, I’m not necessarily sure that this recovery is sustainable, or the speed of the recovery is sustainable.  Therefore, we have positioned the portfolio very conservatively for a very slow recovery.  The stocks you want to own in that environment are high-quality stocks.

Ironically, these are the stocks that are cheap today.  Usually you pay premium prices to hold high-quality stocks.  Today, they are priced at a discount.  We see a lot of value in high-quality, stable stocks in the health care area, priced at seven- to eight-times earnings, with strong balance sheets and high dividends. They also have strong pricing power in case we have inflation, and they’ll be able to maintain prices if deflations pays us a visit.

Let’s talk a bit about China, because you have written a lot about that country.  What is your overall outlook for the Chinese economy?  How will it affect the US economy and US investors?

China is extremely important to the global economy.  China to some degree helped to pull the global economy out of recession with its enormous stimulus.  However, I expect China’s economy to get worse at some point in the not too distant future

The Chinese economy grew at a very fast rate for long period of time.  The Chinese government is extremely concerned that if the growth rate of its economy slows down it is going to have high unemployment.  Ironically, though, this country that is supposed to be communist has less socialism than we have in the United States.  The social safety net is absent for the most part in China.  When people lose their jobs, there are no unemployment benefits and no healthcare provided by the government.  The unemployed are not just temporarily inconvenienced while they are looking for a job, they go hungry and they cannot afford to pay for medical bills, so they don’t complain; they riot.  The government is concerned that high unemployment will bring social instability, which is why they want to maintain full employment and thus grow at any cost.  Once you start looking at what is happening in China through this lens, the government’s actions start making more sense.

When the global economy slipped into recession, China resorted to the mother of all stimuli. Its stimulus package accounted for 14% of its GDP and was fire-hosed into economy at a very fast rate.  Lending went vertical; it went up about 30% in 2009 and 2010.  The easiest way to maintain employment is to build, so they built.

China already had a lot of overcapacity going into the recession, but they took that overcapacity even further.  You have a lot of empty cities in China. The most infamous city, Ordos, was built for 1.5 million residents, and it is completely empty. China has second-largest shopping mall – the South China Mall – and it is empty.

And there are a lot more examples like that in China.  Housing prices went up nationwide. In Beijing, housing prices reached 22 times average income. In Japan, in the late 80s, at the peak of the housing bubble, for reference, that ratio peaked at around 9. In the US in 2007 it peaked at 6.4. For China as a whole, that number is now over 8.

When you try to fire-hose a lot of money into the economy, you are going to misallocate capital.  China has been ranked as one of the most corrupt countries in the world, and that guarantees that you are going to have even more misallocated capital.  China has a lot of overcapacity in many different areas.

You cannot have vacant cities, empty shopping malls, and a real estate bubble and not have a lot of bad debt.  But the bad debt is covered up by growth and will surface when growth slows down or stops.  I hear the argument that China only has 30% debt-to-GDP, so it is stronger than many other global economies and has a lot less debt than the United States, for instance.   Well, Ireland had very little debt before the financial crisis.  Now it is one of the “I”s in the PIIGS, because its government had to bail out the banking system.  The difference between Ireland and China is that Ireland had a choice of whether to bail out its banking system, whereas China owns its banking system, so it will have to bail it out.

Why do we care about what happens in China?  Several reasons: It is the second largest economy; it is single-handedly responsible for the rising prices in most industrial commodities; and, according to a paper authored by the Reserve Bank of Australia, China is responsible for two-thirds of the global demand for iron ore, one-third of global demand for aluminum, and more than 45% of global demand for coal.  Any Chinese decline will tank commodity prices globally.  So if your portfolio is heavily exposed to commodities – an asset class that worked well as of late – you are exposed to China.

But China’s influence doesn’t stop there. Chinese growth has benefited a lot from commodity-producing countries like Canada, Russia, Brazil, Australia and many others.  Only a decade ago, for example, exports to China accounted for 5% of Australian exports, now that number is pushing 25%.  Readjustment in the Chinese economy will cause a significant readjustment for those countries as well – so if you have a lot of exposure to these countries, you are exposed to China.  Finally, China has been the largest holder of US Treasury securities; as its economy weakens, its demand for our fine paper will decline, which will lead to higher interest rates in the US.

Could China face a banking crisis if, for example, its central bank has to raise interest rates in order to stem rising inflation?  Do you see that as a potential threat?

It is very difficult to see exactly what is going to do China in.  It’s very difficult to figure out which straw is going to break China’s back.  China’s central bank is raising interest rates because they have significant inflation.  When you inject as much money into the economy as the Chinese government did, you are going to have inflation.  The more leveraged the system, the more sensitive the economy becomes to higher interest rates.

Here is what puzzles me: Everybody looks at the Chinese government and thinks that it manages its economy so well, and therefore it will find the right mix of interest rates and fiscal policy measures. Americans, however, think that our government has done a horrible job of managing our economy.  I doubt if the Chinese government is any better at managing its economy than our government is at managing ours.  High interest rates may be what does China in, but who knows?  I think it is more important to identify the bubble than the prick that will burst it.

I want to wrap up with a fairly specific question: What is your outlook for the US markets for 2011?  What do you think the return will be on the S&P?

To have an outlook about the market you have to get a couple things right.  You have to get the economy right, and you have to get the response of the markets to the economy right.  I have some doubt about the sustainability of today’s recovery, or more accurately about the sustainability of the current growth rate.  That is number one.  Even if you get economy right, predicting what the market will do in response to the economy is a crapshoot at best.

In addition, we can’t find enough good stocks to buy.  That is why we hold a lot of cash. (Our cash is a byproduct of our inability to find stocks that meet our criteria and our unwillingness to compromise on what we own, not our belief that we can time the market.  We cannot.) So I am, naturally, not excited about the market, though I am excited about specific stocks we own.  Despite having written a book that makes an argument that market will be going sideways for another decade or so, I really have no idea where it is going to be next year.  It is random.

Where do you think interest rates are headed?

Interest rates are a very interesting subject.  The Federal Reserve is desperately trying to bring down long-term rates through QE2, and short-term rates are already at zero.  So far, in its latest attempt, the Fed has had little effect on long-term rates, though the Fed will likely keep trying.

I am conflicted on this topic.  On the one hand, higher interest rates are not good for the economy in the short run (especially for the housing market, though they are good for savers). In the longer run, however, interest rates that are set by the free market, not by 12 guys sitting in cushy chairs in the Fed’s boardroom, are a big positive.  For this recovery to be sustainable, we need less government interference and more free market. We don’t need a recovery that is orchestrated by the Federal Reserve, because that won’t work in the long run.

Also, considering that two largest foreign holders of the US debt are China, which we already discussed, and Japan, which is the most leveraged first-world country [see Vitaliy’s presentation on Japan here], I believe we’ll have lower demand for US debt going forward from overseas. We’ll likely have higher interest rates.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of  upcoming The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here.

Poststeroid Economics

By Vitaliy N. Katsenelson

During the ’80s and ’90s, ignorance was bliss. The global economy was growing nicely, and analyzing it (or even paying attention to market cycles) seemed like a waste of time, as the economy came in only three flavors: good, great and awesome. Even if you misread the flavor, the downside was that you’d just make a little less money. Value investors prided themselves on being bottom-up-only analysts, focused on scrutinizing individual stocks, while top-down analysis — making investment decisions by looking only at the macro picture — became unfashionable, viewed as market timing.   (I know the above statement may sound a bit over the top, but over the years I have read and listened to dozens of interviews with famous and successful investors who declared that they do bottom-up-only analysis and don’t pay attention to the economy.)

Prolonged and virtually uninterrupted growth brought complacency, excesses, and debt. Bottom-up-only analysis worked until it stopped working, as investors discovered during the recent crisis that the global economy can come in additional flavors: bad, horrible, and downright nasty. Today the cost of misreading the economy is much higher.

Two years ago the Great Recession waltzed in — to the great surprise of homeowners, the Fed, and the banks — and everyone discovered that house prices don’t always go up. The financial sector, the lifeblood of our economy, started to drown in the sea of bad debt. As the troubles in that sector began to spill into the real economy, the government felt it had no choice but to step in, and the bailouts and stimuli began.

Today it is hard to take a walk through our economy and not meet a friendly Uncle Sam; he is everywhere. He’s buying long-term bonds and thereby keeping long-term interest rates artificially low. Since he took over the defunct (for all practical purposes) Fannie Mae and Freddie Mac, he is the U.S. mortgage market, because those organizations account for the bulk of mortgages originated. Of course, he is also on the hook for their losses.

Our dear Uncle Sam rolls in style; he doesn’t know how to bail out or stimulate on the cheap. U.S. government debt (at least, the debt that is on the balance sheet) leapt from about 60 percent of GDP before the Great Recession to more than 100 percent in 2010. The party of overleveraged consumers has been crashed by an overleveraged government.

To understand the consequences of the Great Recession, consider this analogy: The U.S. economy is like a marathon runner who runs too hard and pulls a hamstring, but finds himself with another race to run. So he’s injected with some industrial-strength steroids, and away he goes. As the steroids kick in, his pace accelerates as if the injury never happened. He’s up and running, so he must be okay — this is the impression we get, judging from his speed and his progress. What we don’t see is what is behind this athlete’s terrific performance: the steroids, or, in the case of our economy, the stimulus.

Obviously, we can keep our fingers crossed and hope the runner has recovered from his injury, but there are problems with this thinking. Let’s address them one by one:

• Serious steroid intake exaggerates true performance. Economic stimulus creates an appearance of stability and growth, but a lot of it is teetering on a very weak foundation of government intervention.

• Steroids are addictive; once we get used to their effects, it is hard to give them up. When the first home-buyer tax credit expired, it was extended for anyone with the patriotic ambition to buy a house. It is hard to give up stimulus, because the immediate consequences are painful, but long-term gain has to be purchased by short-term discomfort.

• The longer we use steroids, the less effective they are. Take Japan, which was on the stimulus bandwagon for more than a decade. With the exception of tripled government debt, Japan has nothing to show for its efforts; the economy is mired in the same rut it was in when the stimulus started.

• Steroids damage the body and come with significant side effects. In the case of the economy, the side effects are higher future taxes and increased government debt, which brings on higher interest rates and thus below-average economic growth. The hopes that we’ll transition from government steroid injections back to an economy running on its own are overly optimistic.

So what does this mean for investors? When we purchase a stock, we are buying a stream of future cash flows. By doing only bottom-up analysis, investors implicitly assume that external factors (the winds and hurricanes of the global economy) have no impact on these cash flows. That is a brave and careless assumption, especially in a poststeroid world. Instead, investors should take a more holistic approach, mixing bottom-up insights with top-down analysis.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing” (Wiley, 2007) and the upcoming The Little Book of Sideways Markets (Wiley, December 2010).  To receive my future articles by email, click here

P.S.  I want to bring to your attention two articles from the NY Times.  The first one takes a deep look at Ordos, the infamous Chinese ghost town built for 1.5 million residents (here is a slideshow from Time magazine).
A few excerpts:

Kangbashi was projected to have 300,000 residents by now. And the government claims that 28,000 people live in the new area. But during a recent visit, a reporter driving around for hours with two real estate brokers saw only a handful of residents in the housing developments.

Analysts estimate there could be as many as a dozen other Chinese cities just like Ordos, with sprawling ghost town annexes. In the southern city of Kunming, for example, a nearly 40-square-mile area called Chenggong has raised alarms because of similarly deserted roads, high-rises and government offices. And in Tianjin, in the northeast, the city spent lavishly on a huge district festooned with golf courses, hot springs and thousands of villas that are still empty five years after completion.

If excesses in the Chinese economy were limited to Ordos, it would just be a little multi-billion-dollar pimple on the pinkie of a $5-trillion economy.  But unfortunately Ordos is symptomatic of much greater excesses all over China.

“I bought two places in Kangbashi, one for my own use and one as an investment,” said Mr. Zhang, who paid about $125,000 for his 2,000-square-foot investment apartment. “I bought it because housing prices will definitely go up in such a new town. There is no reason to doubt it. The government has already moved in.”  Asked whether he worried about the lack of other residents, Mr. Zhang shrugged off the question.  “I know people say it’s an empty city, but I don’t find any inconveniences living by myself,” said Mr. Zhang, who borrowed to finance his purchases. “It’s a new town, let’s give it some time.”

The second article in the Times tells the very depresseing story of what is taking place in Japan. A few excerpts:

In 1991, economists were predicting that Japan would overtake the United States as the world’s largest economy by 2010. In fact, Japan’s economy remains the same size it was then: a gross domestic product of $5.7 trillion at current exchange rates. During the same period, the United States economy doubled in size to $14.7 trillion, and this year China overtook Japan to become the world’s No. 2 economy.

This has a such a familiar ring to it; in fact it sounds exactly like the prediction we often hear that the GDP of the Chinese economy will overtake that of the US by 20xx.  Though it may happen, I would not make this prediction solely on the basis of drawing straight lines to extend the growth of the last two decades into the future.  This type of analysis is too simplistic, and dangerous.  It is important to understand the roots of past success, and often past success is the precursor of a less-than-bright future — Japan is a great example of that!

The decline has been painful for the Japanese, with companies and individuals like Masato having lost the equivalent of trillions of dollars in the stock market, which is now just a quarter of its value in 1989, and in real estate, where the average price of a home is the same as it was in 1983. And the future looks even bleaker, as Japan faces the world’s largest government debt — around 200 percent of gross domestic product — a shrinking population and rising rates of poverty and suicide.

… the small-business owner, who sold his four-bedroom condo to a relative for about $185,000, 15 years after buying it for a bit more than $500,000. He said he was still deliberating about whether to expunge the $110,000 he still owed his bank by declaring personal bankruptcy.

I am a value investor and rarely have a view on currencies; I don’t know how to value them.  But the yen hitting a fifteen-year high against the dollar makes no sense whatsoever.  The US has plenty of problems but it is not Japan, at least not yet.  In fact the strong  yen in itself will likely lead to a substantial decline in the yen, as it is crippling Japan’s export-driven economy.



I had the pleasure of presenting my thesis on China and Japan at the Casey Research Summit in San Diego in early October.  I made a small family vacation out of the trip, taking along my wife and kids. Here is what I learned: You want to go Sea World in early October on a weekday – Sea World was 80% empty (or 20% full, if you like).  There were no lines – in fact we went on a few rides with the kids twice – the weather was kind, and Shamu was happy to see us – it was a great vacation.

I stumbled on this incredible slideshow by Time Magazine that shows Ordos, in Chinese Inner Mongolia.  Ordos is one of the most egregious examples of Chinese Late Stage Growth Obesity.   Built for one million residents, it is completely empty.  Take a few minutes to look at the slideshow, it is well worth it.

Here is a link to my updated presentation on China and Japan (Japan starts on slide 40).

I also did an interview with David Galland of Casey Research, and the transcript is below.  I have to warn you, it is very long.

Shadow over Asia

(From October 2010 Volume III, Issue 10 The Casey Report)

An interview with Vitaliy Katsenelson, Chief Investment Officer, Investment Management Associates, Inc., and author of Active Value Investing. Profiled in Barron’s in September 2009, Vitaliy, who was born in Murmansk, Russia, and moved to the U.S. in 1991, from 2007 to 2007 was an adjunct faculty member at the University of Colorado at Denver’s Graduate School of Business.

TCR: What our readers are looking for is a better sense of China and Japan, both of which are very important in the context of the global economy. As we have to start somewhere, let’s start with China.

Today the conventional wisdom is that somehow the Chinese economy is better managed than its competitors, very similar to how people viewed Japan in the 1970s and 1980s. Back then people were absolutely convinced that Japan was the superior country with superior policies and that its economy was unstoppable. We all know how that ended.

So, let’s start there. Is China’s system better than everyone else’s? Is it really possible the Chinese economy can keep steamrolling along?

VK: A few months ago, I watched a movie about Ayn Rand and it talked about how Americans in the 1930s looked at the Soviet Union’s flavor of managed economy as being superior to the American version of capitalism. At the time America was just coming out of the Great Depression, so that view made a lot of sense. So in the short run, and especially after the ugly side of creative destruction has paid us a visit, the grass of managed economy may look greener.

So when we look at China, the conventional wisdom says that the government is very, very smart, and therefore they can do a very good job in steering the economy in the right way. Chinese government may have the best intentions, its leaders may have IQs of 250 each on a bad day, but it is impossible to centrally manage an economy of China’s size.

I am a big believer that in the boxing match between a visible and an invisible hand, though the invisible hand may lose a few rounds, it will win the match every time. Last century we had the most amazing economic experiment take place when after World War II, Germany was split into two countries with different economic and political systems. But they were the same people, with the same language and culture, separated by a wall. We know how that story ended.

Of course, for a time, having government control over the levers of the economy can have advantages. For example, by taking prompt action, the Chinese government was able to pull the economy out of the recession remarkably fast, basically by fire-housing the stimulus package that was equivalent to 12% GDP. That’s the advantage. The only problem is that these kinds of short-term advantages come with long-term, painful consequences.

For example, when you have a huge government presence in the economy, you also have a huge bureaucracy, and bureaucracy brings corruption. This is one of the reasons why China is rated so poorly on Transparency International’s annual corruption rating. Corruption breeds misallocation of capital, because the capital flows not to the best use, but it basically flows to whatever the political connection or whatever the bribe is directed to.

In addition, when you have a government-managed economy, it creates excesses. China has huge excesses in the industrial sector, as well as in commercial and residential real estate. We see plenty of evidence of these excesses, but they are likely to be much greater than we can measure today as they are covered up by robust economic growth. The true magnitude of these excesses will come to the surface once the economy slows down.

TCR: In essence, you’ve got a relatively small group of individuals who are making big decisions about China’s economy and where production should be, in what sectors, etc. If history is any guide, that really can’t last, yet many people seem to think it can. That said, China’s economy has certainly done remarkably well in the global economic crisis. In fact, according to their government, their GDP is almost back to where it was pre-crash. Why?

VK: Sure, the growth you see today in China is there, but it’s not a sustainable growth. It’s not a growth that you’ll see a few years from now. That is an important point for readers to understand.

TCR: Why is it not sustainable?

VK: Because the growth is being induced by government spending, by a misallocation of capital.

I’ll give you an example. The vacancy rate on commercial real estate in China is fairly high, but they still keep on building new office buildings because they think they will always grow. So therefore as long as they keep building, that activity will be registered as growth, until they stop. And when they do stop, they’ll drown in overcapacity, and they won’t be building new skyscrapers for a very long time.

TCR: We read that note you sent about the South China Mall, which is pretty stunning. It’s the second largest mall in the world but is mostly empty.

VK: That’s right. But as outrageous an example as the South China Mall is, there’s an even more outrageous example – namely that the Chinese built an entire city, Ordos, in Inner Mongolia for 1.5 million residents and it is completely empty. These are classic examples of the sort of excesses going on in China.

TCR: The equivalent of building bridges to nowhere, but on a very large – Chinese – scale.

VK: Exactly. There are no shortcuts to greatness. As long as they keep building new bridges, the economic numbers will register that there is growth, but at some point the piper will have to be paid, and these projects have a negative return on capital.

TCR: It seems the Chinese are following the script Japan used to dig itself out of its postwar doldrums, deliberately keeping their currency low in order to build an economy on the back of low-cost manufacturing. But that game inevitably has to end – already we see more and more things being made in Indonesia, Pakistan, India, and so forth. If China loses the manufacturing core of their economy, won’t they be in big trouble?

VK: Well, once you move manufacturing to other countries, it’s very difficult to get it back. So you could probably argue that China will maintain its manufacturing advantage for a while.

The problem with China is pretty much same as with any bubble. Though it may have had a solid foundation under it, it is simply a good thing taken too far. If you look at the railroad bubble in the United States, the country did need railroads, but we built too many.

The same thing happened with the technology bubble in 1998. The Internet was transformative to our economy, no question about it. But, again, it was taken too far.

There are some other countries that are lower-cost producers than China, but they probably can’t do it on the same scale that China can. But my point is that China is just a good thing taken too far, and if you add government involvement and corruption into the mix, you will get a bubble that is taken a lot further than you would normally expect.

One way of thinking about it is that the actions taken by the Chinese government, especially after the recent global recession, have basically supersized the bubble that was already forming.

TCR: Their government is sort of a holdover from a largely bygone era when many nations were communists, so isn’t it true that they need to maintain some fairly strong forward momentum, otherwise they could run into some political problems? Is that why they were so quick to unleash the massive stimulus or encourage their banks to lend an amazing amount of money? You have a chart showing those loans amounted to 29% of GDP in 2009. What kind of quality of lending can that be?

VK: Let’s try to understand why the Chinese government did the things they did. As everyone knows, the Chinese economy grew at a very high rate for a long period of time. When the global economy slowed down, their economy slowed down as well (though official numbers did not show it). The Chinese government is extremely concerned about the economy slowing down because that is likely to lead to political unrest. A lot of that potential friction comes because a lot of people moved from villages to the cities. China has an almost nonexistent social safety net system. So people who lose jobs don’t complain, they riot.

So, yes, the Chinese government is afraid of political unrest, and therefore they quickly released a tremendous amount of stimulus into the economy, then followed it up with encouraging bank loans equal to 29% of GDP in 2009, a huge increase. When you infuse this much debt into an economy, it’s impossible to have good capital allocation decisions. While the economy is growing, the bad debt won’t be so apparent, but it certainly will be when the economic growth slows.

A good analogy might be that when you analyze a credit card company that is growing very, very fast, and that has opened new accounts, you don’t see the bad debt because that debt is covered up by new loans. The true nature of the past lending decisions only becomes obvious when the company’s growth falls off.

One way to think about the Chinese economy is by comparing it to the bus in the movie Speed with Keanu Reeves and Dennis Hopper. In the movie, a bus was wired with explosives that would blow up if the bus’s speed dropped below 50 miles an hour.

Since China is manufacturer to the world, that manufacturing business comes with a lot of fixed costs. Factories, equipment need financing, and they are mainly financed by debt – another fixed cost. The high level of fixed costs doesn’t afford China an economic slowdown, but when it happens, the consequences will be dire. High fixed costs are great when revenues are rising as income grows at a faster rate than sales. But they are devastating to profitability when sales decline: costs decline at a slower rate than sales and you start losing money, fast.

TCR: Interestingly, there’s clearly a slowdown in the U.S. and Europe, China’s two biggest markets, so you would assume that China’s export industries would have suffered a fairly sharp decline since the go-go days before the crash. That has to be putting pressure on their growth. How important to the Chinese is it that the U.S. and the European economies recover and Western consumers get back into the game?

VK: I think a return of U.S. and European consumers is extremely important to the health of the Chinese economy. Some analysts think China’s internal demands can overcome the demand decline from U.S. and European consumers, and I think it is possible in the long run. But in the short run, I don’t think that’s possible. Let me explain the reasons for that.

Chinese consumers represent one-third of a 5-trillion-dollar economy. If you look at the size of the U.S. and European Union together, they are equal to a 30-trillion-dollar economy, and the consumers there constitute about two-thirds of those economies.

So on the one hand, you have U.S. and European consumers representing 20 trillion dollars in purchases, versus Chinese consumers at about 2 trillion dollars. In other words, U.S. and European consumers are 10 times the size of the Chinese consumers. As a result, a very small change in consumption in the U.S. and Europe has to be overcompensated by a huge increase in consumption in China, and that is going to be very difficult to do, especially considering that the Chinese currency is kept at artificially low levels. That, of course, diminishes the purchasing power of the Chinese consumer. Over time the Chinese consumer will play a larger role in the economy, but it’s going to take a decade, not months – not even a few years.

TCR: You’re pretty bearish on the outlook for China; do you have a theory about what might trip them up? What’s the thing that readers should be watching for that would suggest things are starting to unravel?

VK: It’s very difficult to know exactly what’s going to be the straw that breaks the camel’s back. It could be a slowdown in the Japanese economy, or a double-dip in the U.S., or some other factors that are not apparent to us today. It could be just the simple fact that the Chinese government is trying to put the brakes on the economy and mistakenly does too much.

I don’t trust government-reported statistics, thus I’d watch numbers that the Chinese government is less likely to fudge: electricity consumption, which was down during the global recession, same-store sales of American fast food restaurants in China, tonnage of goods shipped through railroads, and, though they may lag, sales by American and European companies in China.

TCR: If you look at inputs like copper imports and even copper stocks in Shanghai, by all appearances China is at least pretending that it’s business as usual. In fact, I think in August they imported 22% more refined copper than they did the year before. But if this is just to build bridges to nowhere, then it supports the idea that this is not going to be sustainable.

VK: That’s right. That is the problem with looking at this kind of data, because a lot of it is going to building things that have a negative return on capital. Therefore, you look at the data and the data does not really tell you that much – until it does. Because, basically, it’s the government’s involvement that is driving a lot of the demand.

You can make the same argument that the U.S. economy was doing great in 2004, 2005, 2006, despite the obvious problems in real estate and its financial system. Likewise, a lot of people said great things about what was going on in Japan in the late ‘80s. Of course, the U.S., and Japan before it, were experiencing huge real estate bubbles that few saw as being a problem, until they were.

There was an article in the Wall Street Journal a couple of weeks ago talking about a Chinese state-owned enterprise that operated salt mines, but now it’s building office parks. Those are kind of the signs you start seeing in an economy in the late stages of a bubble, where a state-owned enterprise starts building real estate projects because it’s almost like you can’t lose money doing this. But one thing that makes predicting the end of this bubble very difficult is the amount of firepower the Chinese government has. The government can drive this bubble further than a rational observer would expect.

TCR: Because they’ve got so much in the way of reserves?

VK: Because they have a significant influence over the economy. Chinese government can force banks to lend and can force companies to borrow and spend (or build).

TCR: On the topic of real estate, I was speaking to a very well-off Chinese friend recently who had bought a very expensive apartment in Beijing. When I asked him about buying at bubble prices, he commented that it really didn’t matter. The money was almost irrelevant, given the status that came from having an apartment in that particular part of town. He said it was very good for his business and that he didn’t really plan on using it very much. It was an interesting perspective, how he saw real estate.

VK: In the same way that everyone in the United States decided they “must” own a house, this belief was reinforced by continuously rising house prices. You can see how big a problem this became in big cities such as Beijing and Shanghai where the affordability ratio is horrible, so the property-value-to-income ratio in Beijing is pushing 15. In Shanghai it is over 12. If you look at the national average, it is over eight times.

TCR: Can you explain that ratio to our readers?

VK: You get the ratio by taking the property value and dividing it by annual disposable income.

Basically, if you spent all your money, after you paid your taxes, just to pay off the mortgage, it would take you 14 years – which means you didn’t pay for food, electricity, etc.

This ratio is important because it helps put the scale of the Chinese real estate bubble in its proper context. In Tokyo, at the peak of the massive Japanese bubble, the ratio stood at nine times. In Beijing it’s already 14 times. In Shanghai it’s over 12 times. The national average for China is pushing 8.2 times right now. So housing affordability is very, very low, and the housing prices are extremely high.

Here is another interesting piece of data: property investment in China in 2009 was 10% of GDP, up from 8% in 2007. In Japan, at the peak of its bubble, it did not exceed 9%; in the U.S. it never exceeded 6%.

A recent study found that 64.5 million apartments basically don’t use electricity because they are empty. Chinese people buy those condos, and they don’t rent them. Similar to new cars in the U.S. when taken off the lot, in China an apartment is worth less once rented out. So they just keep them unoccupied with the hope to flip them, and you know how that story ends.

TCR: Yes, after Japan’s real estate bubble collapsed, prices in the major cities fell by about two-thirds and have rebounded only very little from the post-crash lows.

If a lot of Chinese lost a lot of money in real estate, one has to assume they’re going to be very unhappy. I recall a conversation with another Chinese man who lives in the States half a year and in Beijing half the year. When I asked him about the real estate bubble in China, his comment was, “Well, the government would never let it fall,” and he said the same thing was true of their stock market. To put it mildly, he had an inordinate amount of faith in the Chinese government’s ability to prop up bubbles.

VK: As you can tell from my accent, I was born in Russia and spent half of my life in Soviet Russia. From my direct experience, the Russian propaganda machine was very, very powerful, and so many people believed how smart the leaders were and that they could do nothing wrong.

China is not that much different from Russia in that respect. Due to the government’s control of the media, the average citizen has been brainwashed into thinking of the government with respect. They has led to an unconditional belief that the Chinese government walks on water, that the laws of economics are somehow suspended when they touch things (except they also did a fine job convincing not just their own citizens but the West as well). Sure, they have a greater control of the economy, but at the long-term cost we talked about earlier. That’s point number one.

Point number two can be understood by asking why people are buying those apartments, why are they buying this real estate? In part it is because if they put money in the bank – where the government basically sets the rates on savings accounts and the checking deposits – they are getting very little interest on their savings. Therefore they look at real estate as basically a form of savings.

Some analysts will argue that it can’t be a bubble because of the lack of leverage, given that in China you have to put 30%-40% down when you buy an apartment. It is a large down payment. But think about how much wealth will be destroyed when real estate prices decline – and that in itself could trigger a serious crisis in China because it would destroy a lot of wealth, and that could lead to political unrest. So that would be very important psychologically and for the political stability of the Chinese economy.

TCR: What would typically trigger the end of this real estate bubble?

VK: To some degree, a real estate bubble is like a Ponzi scheme. As long as there is an incremental buyer, prices keep going up, but at some point everybody who wants to buy a house has bought a house, so when an incremental buyer is not there, the prices start declining and then it becomes self-feeding. It’s very difficult to time the end, but there is always an end.

TCR: What about commercial real estate?

VK: If you look at commercial real estate, it’s often one subsidiary that is borrowing money from another subsidiary to put a down payment to build or buy a building. And a lot of times land is used as collateral. As land prices decline, so the loan-to-value ratio can jump through the roof very quickly when real estate prices collapse.

TCR: Talk a little about the renminbi. The Chinese government has been making noises about possibly allowing it to rise against the dollar, but from a practical standpoint, can they actually afford to let that happen?

VK: They could let it rise on a very gradual basis, but they absolutely cannot allow it to rise very rapidly because that would quickly diminish the value of the foreign reserves. But there is a conundrum. When the Chinese economy bursts, there is a very good chance the renminbi will actually depreciate, because you are going to have a flight of capital leaving China. So right now you may argue that China’s currency is too cheap, but during the crisis it’s probably going to get cheaper.

TCR: What’s your general sense about how much longer they can keep the game going before they collapse? And is collapse the right word?

VK: I really don’t know. In the case of Japan, their government basically ran out of chips. I think the Chinese government still has enough chips to keep the bubble going awhile longer. These bubbles usually last longer than the reputation of the person who predicts their demise.

TCR: Do you think it will occur within a decade?

VK: I think so, yes. GMO became famous for predicting the Japanese bubble collapse, but they started predicting it in 1986, so they were “wrong” for a while because it actually burst in 1989-1990. The point being, these bubbles typically last longer than you would expect, but it’s going to burst.

TCR: Let’s talk for a minute about some of the potential implications of a bursting Chinese bubble. There are some fairly obvious ones, like Chinese real estate, but there are a lot of somewhat less obvious consequences, for example the hit this would cause to the Australian economy because its export sector depends heavily on China.

VK: China has been responsible for a very large portion, if not all, of incremental demand for commodities in recent years. If you’re talking about copper, about oil, or  pretty much all the industrial commodities, China was responsible for a very large portion of the demand. When the economy slows down and the bubble bursts, then the demand for those commodities will decline dramatically.

It’s going to impact economies that benefitted tremendously from China’s ascent, so Australia will be impacted, Russia will be impacted because oil prices will decline and Russia is basically a commodity-driven nation. Brazil will be impacted. Any economy you can think of that benefitted from China’s ascent will get hurt from its descent as well.

Let me clarify this. I’m not saying that China will cease to exist or that it’s going back to the stone-age – I’m saying there is a bubble and it’s going to burst. It’s going to go through readjustments.

TCR: But it will be a serious crisis.

VK: The bubble burst will have significant consequences.

TCR: So you’d be cautious on sort of base commodities.

VK: Yes. But also think about industrial goods. Getting commodities out of the ground, building empty shopping malls, ghost towns, and bridges to nowhere requires a lot of equipment. Industrial goods companies benefitted tremendously from Chinese demand. In the past, those were very cyclical companies, and it seems like this time they almost didn’t have a normal cycle. They declined but then came back very fast because the demand came back very fast, and a lot of that demand came from China.

TCR: And what would you invest in, are there any opportunities you see?

VK: Unless you short stocks, it’s very difficult to see an opportunity in a Chinese downturn. As a portfolio manager, I look at it as a risk, and I say, all right, what can I do to immunize my portfolio from that risk. I have very little exposure to commodities and industrial stocks, and very little exposure to countries that will get hurt from China’s bursting bubble – the countries we mentioned, like Australia, Brazil, Russia, etc.

TCR: Canada would have to be on that list.

VK: Yes, very true.

TCR: Let’s talk briefly about Japan. Bud Conrad, our chief economist, has done a lot of looking at Japan and concludes that it’s basically past the point of no return. What are your general thoughts on the implications of that country tipping back into a serious crisis? After all, it’s a very big economy, and so that would have to have a big impact on the world.

VK: Japan’s story is very simple. The economy slowed down in the 1990s. To keep the economy growing, the government lowered taxes and increased government spending, sending budget deficits up. In order to finance those deficits, the amount of government debt has tripled.

The only reason they were able to finance that debt was because over 90% of the government debt was purchased internally; therefore, thanks to Japanese interest rates declining from 7.5% to 1.4%, the government was able to dramatically increase the amount of debt without the total borrowing costs going up.

Today, Japan is one of the most indebted nations in the developed world, and its population demographics are horrible because every fourth Japanese is over 65 years old. There’s no immigration into Japan, and the population is aging rapidly, and the savings rate went from the middle teens to quickly approaching zero.

TCR: So there is less demand for Japanese government bonds.

VK: Yes, exactly. With the demand for Japanese bonds declining, they are going to have to start shopping their debt outside of Japan, and the second they do, they’ll realize that no rational buyer would buy Japanese debt yielding 1.4% when they can buy U.S. debt or German debt with yields double that.

So the Japanese are going to have to start paying high interest rates, and they can’t afford that, because one-quarter of the tax revenues already goes to servicing their debt. If their interest rates were to double to just 2.8%, it basically wipes out the funding for the country’s Departments of Defense and Education. So this is a situation where they go from deflation to hyperinflation, because they’re going to have to start printing money to be able to keep paying off their debt, so this is the case where they are going just from one extreme to another.

TCR: Their economy has been hugely helped by their trade surplus, but their trade surplus has been going down steadily, in no small part because China has been stealing market share.

VK: Exactly. A lot of manufacturing went to China from Japan, so that hurt the economy too.

So when you ask me about what could trigger Chinese problems, well, you know, Japan is still a big trading partner for China, so Japan’s decline would impact China as well, and vice versa.

TCR: We have heard a lot about Japanese demographics. That seems to be an intractable problem.

VK: Recently I heard that the Japanese were considering trying to solve their demographic problems by allowing immigration from China to Japan. I almost fell off my chair when I heard that, because there is a lot of animosity between the two countries. They love each other as much as Armenians love Turks, so it’s very difficult for me to see that happening just because of the cultural issues going on.

TCR: And it seems that the tensions are actually getting much worse.

VK: Too true. But the key point is that Japan is past the point of no return. It’s like the Titanic has already hit the iceberg and you know it’s going to sink, you just don’t know just how long it will take to go down. That’s basically what is taking place in Japan.

TCR: Sticking with that metaphor, it seems like people need to begin donning life jackets and edging toward the nearest lifeboat.

So we’ve got some serious issues with Asia, which obviously will have some global implications. How does this tie back to the U.S.? Our take has been that – at least on a short-term basis – when things start to come unglued, it will benefit the U.S. as a purported “safe harbor,” but then people will begin to realize that if two out of three of the world’s biggest economies can fall, so can the U.S.

VK: In the short run, it may benefit the U.S. dollar because the value of currencies is relative, right? As my friend Barry Pasikov says – the U.S. dollar is valedictorian in summer school. So if people are afraid of Japan, afraid of China, they would be running towards the U.S. currency. By the way, the Japanese currency made a 15-year high recently suggesting what could be the trade of the decade.

I’m a value investor, so I generally don’t spend much time on currencies, but I think this is a case where shorting Japanese yen makes a lot of sense.

It may work against you for a while, but in the long run, I think it could turn out to be the trade of the decade.

Again, I think the U.S. dollar might benefit in the short run, but don’t overlook that China and Japan are the largest foreign holders of U.S. debt. If Japan becomes a net seller of U.S. debt and their debt starts competing with U.S. debt, then that’s going to be negative for our economy because we are going to have high interest rates. If China also becomes a net seller of U.S. debt, again, it’s negative for our economy.

The big question, once they start selling, is how fast will they sell their U.S. debt. If they sell it very fast, maybe because they have to, it’s going to drive our interest rates higher. If it’s something that develops over a long period of time, it may not drive our interest rates as much as you would think.

TCR: But ultimately, if they hit a real bump in the road, they’re going to have to start selling.

VK: Exactly. Plus, the Japanese government bonds will start competing with our bonds. In the past the Japanese people were able to consume the government debt internally, down the road the government is going to have to start selling its bonds to the same people who are buying our bonds, and instead of paying 1-2%, they’ll have to start paying 5, 6, 7%.

TCR: Which would be devastating for the Japanese economy, given the scale of their debt.

VK: Absolutely, At that point, they are going to have a very high inflation because they’ll be forced to print a lot of money.

TCR: Not a very positive outlook but I think very useful. You’ve written a book about managing a portfolio in sideways markets. What’s your advice to investors at this point?

VK: I just finished a book titled The Little Book of Sideways Markets. It is a follow-up to Active Value Investing I wrote in 2007. My research leads me to believe that the U.S. markets will continue their sideways journey over the next decade, much as they did in the previous decade.

In such markets, the traditional buy-and-hold approach doesn’t really work, so you need to modify your approach, starting with the idea that you want to become a buy-and-sell investor. You want to buy stocks when they’re undervalued, but when they become fairly valued, you want to sell them.

Secondly, in the absence of good stocks to buy, you should be willing to hold more cash. I’m not an advocate of trying to time the market but rather saying that if you look at the market and you don’t see stocks that meet your criteria, just hold more cash. The opportunity cost of holding cash is a lot lower in this environment than it would be in a cyclic bull market.

Third, you want to favor stocks with a high dividend yield. You don’t want to buy stocks just because of the dividends, but if, everything else being equal, you can find stocks that have an above-average yield, that’s going to become very important in this environment because in the past dividends accounted for 90% of the return during the sideways markets.

Fourth, you basically want to increase your margin of safety. If a value investor typically looks to buy a dollar for, let’s say, 70 cents, I would recommend start looking for dollars selling for 50 or even 40 cents. That’s point number four, and it’s extremely important.

The book walks readers through the fundamentals of investing in sideways markets, and I think it will help most investors do well in what will be an otherwise challenging environment.

TCR: When is the book out?

VK: In mid-November.

TCR: We look forward to reading it – and maybe having a separate conversation on those concepts in a future edition of The Casey Report.

VK: That would be great.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles by email, click here.

My nine-year-old son Jonah and I have been playing chess a few hours a day.  I never thought I’d enjoy playing chess as much, but I do.  In fact, over the past year I’ve probably played more chess than in my whole life.  I win every game!  When I win, I win.  When I lose I win – seeing your son (your student) beat you gives you an enormous satisfaction as a teacher.  In fact, I never thought I’d enjoy losing so much.   Jonah has this quality that I need to nurture in him – he never gives up.  Even a game that is a clear loser for him, he plays till the end.  What a great quality to have in life!

I am also enjoying seeing my four-year-old daughter Hannah grow up.  We have yet to find an activity we both enjoy doing together (other than hugging to death), but we’ll get there.  She has almost learned how to ride a bike without training wheels; maybe we’ll do cycling together.  They’ve been going to a summer camp that is half a mile from my work and six miles from our house.  A few times a week, while I tug Hannah in a bike-stroller, Jonah and I ride our bikes 30 minutes to the summer camp, through the park.

I envy my kids; they have the pleasure of spending time with their grandparents.  My grandparents lived thousands of miles away from me – I saw them once a year for a few weeks and that was it.  My wife’s and my own parents live just a few miles from us.  My father’s house is a block away from my office; I stop by a few times a week for breakfast before I go to work.

My father gave Jonah a 50-state quarter collection for his birthday.  Now, every day before Jonah goes to sleep, he and his grandfather spend half an hour on Skype learning about each state; and once they are done with a state, Jonah puts the coin at the proper place in the board. They also play a game of chess on Skype chat.

I gave a presentation last week at the Value Investment Seminar in Trani, Italy (here is a link to the PDF). I strongly suggest you visit their website in a few weeks, as it will have presentations and videos.  It was a terrific event; I learned a lot.

I spoke about China, Japan, and our favorite stock idea: eBay.  I changed the title of the China presentation to “China, the Mother of all Grey Swans” (instead of “Black Swans”).  A while back, when I shared this presentation with my readers, I was corrected: China is not a black swan, because a black swan is a rare, significant, and unpredictable event.  However, the consequences of what is transpiring in China and Japan are for the most part predictable (especially if I am writing about it).  We don’t know when they will play out, but they are predictable.

Nassim Taleb, one of my favorite thinkers, who brought the black Swan to life in his books Fooled by Randomness and The Black Swan (I like both books, but Fooled by Randomness is my favorite, plus, it is by far an easier read than Black Swan), solved my dilemma with China by creating a new swan: “grey”– a rare, significant, but predictable event (though the timing is still unknown, or perfectly known only with the benefit of hindsight.)

I spent a few days at the seminar discussing and debating China with some very smart folks, who stirred up some random thoughts.

What really amazes me is how people who would not trust the US or European governments to do their laundry, have unconditional faith in Chinese government involvement in its very complex economy.

The Chinese government brainwashes its people the same way the Russians and Soviets brainwashed theirs: by controlling and censuring media.  So I understand when Chinese people who live in China speak highly of their leaders – they are brainwashed (I have experienced this first-hand).  However, I am amazed that the Chinese government has been able to brainwash people who reside outside of China.

No, an economy in large part controlled by the state is not superior to ours.  Greater control over their economy allows the Chinese government to pull the economy out of recession a lot faster than in the democratic countries, but there is no free lunch.  Their actions will just lead to greater excesses and imbalances down the road.

It seems that as Westerners we have an inferiority complex when it comes to Asian cultures.  Chinese uniqueness is praised today the same way Japanese superiority was in the 1980s.  I even remember reading Russian newspapers in Russia, in 1989, praising the Japanese work ethic and their unique culture and spouting predictions of the continuance of Japanese dominance.  I can only imagine how the mainstream press in the US was caressing Japanese uniqueness in the late ’80s, especially as the Japanese were invading (buying) Times Square and the State of California.

What is very interesting about it is that today all those Japanese cultural advantages are looked upon as disadvantages.  For instance, “saving face” did not allow Japan to deal sufficiently with failed companies; their economy was full of semi-dead, zombie companies, which did not allow the healthy ones to prosper.  Their employment-for-life system that was praised to the heavens during the Japanese golden age is now killing productivity of the economy.  I recently read that 12-17 million people in Japan are employed who should not be employed (for an economy of 120 million people, these are huge numbers).  In other words 12-17 million Japanese show up for work every day and receive a paycheck, but add little or no value to their employers.

Back to China.  Even if the Chinese are harder-working and more entrepreneurial than Americans and Europeans, that doesn’t mean the laws of economics are somehow suspended in China – they are not.  The Chinese economy was geared for high global growth, while now much lower growth is in the cards. The excesses created by 14% of GDP being “stimulated” into the economy through a fire hose have led to significant overcapacity.  It will take time for these excesses to be dealt with, even in a country full of super-hard-working people.

A friend asked, “But what about Singapore; its government plays a significant role in the economy, and Singapore is thriving.”  The clear answer: government can only succeed in running very small and relatively simple economies.  Let me give you this example.  I have a game on my iPad called Flight Controller – my kids love it.  The point of the game is simple: you are an air-traffic controller and your job is to land planes.  Planes come in three colors, red, yellow, and blue, and each plane has to be landed on the runway matching its color.  The objective is not to have mid-air collisions.  I can land ten planes no problem, twenty gets more difficult, and forty I cannot handle (Okay, I played the game a few times).  The same is true for economies: the more complex the economy the more difficult it is to be centrally planned.

Government is not and never will be an efficient allocator of capital.  It empowers bureaucrats, which in turn leads to corruption, which further misallocates capital.  The size of the bribe or strength of the personal relationship decides the flows of capital instead of the invisible hand that funnels capital from low to high uses.  (A side point: Singapore is one of the most uncorrupt countries in the world; this may explain in part the government’s success.  China is not Singapore; it is infested with corruption).

I often hear that you have to go to China to understand it.  But tourists who go to China don’t see the real China, the same way that tourists who go to Moscow don’t see the real Moscow.  I was in Moscow a few years ago, and I was impressed by how clean and beautiful it looked; in fact it didn’t look much different from the center of Brussels.  Of course, I was only in the center of the city, where you see fancy restaurants, gift shops, museums, theaters, etc.

I went to see my college friend who lives in the real Moscow – I saw a very different picture.  The second you veer off the main road, it turns into pothole hell, and the streets are anything but clean.  My friend lives in a nine-story apartment building that has not been painted in decades; paint is peeling both inside and outside.  Interestingly, most of the sides of the buildings that face large streets in Moscow and in Murmansk (the city where I spent all my Russian life) are usually painted, but the sides that face small streets have not been painted in generations.

My friend – a lawyer – and his wife and kid have to live with his mother, as they cannot afford to live on their own.  But you won’t see this Russia if you are a tourist visiting Moscow.  People who visit China even multiple times harbor an illusion that they understand it – they don’t.  In fact they so overwhelmed by its grandness that they stop being rational in their analysis.

I keep thinking about the possible consequences of the Chinese overcapacity bubble pop.  It is relatively easy to understand what will happen in Japan: deflation will quickly turn into hyperinflation as government is forced to print money to service its debt and social obligations.  They’ll announce and may even execute austerity measures, but those will be a decade or two too late.  The Japanese yen will likely decline, though maybe not right away, as Japan owns a lot of US dollars and may be forced to sell them.

The Chinese situation is far more complex.  China has tremendous overcapacity, but overcapacity is deflationary.  It will drive prices for commodities down, and prices of Chinese-made goods will likely decline as well.  Demand for industrial goods will collapse, pushing their prices down.  But China will also have to deal with a lot of bad debt and will likely have to print money to do so – which is inflationary.

The popping of both the Chinese and Japanese bubble economies will lead to higher US, and likely global, interest rates.

Japan, as the title of my presentation suggests, is past the point of no return.  Internal consumption of its debt will likely turn negative very soon.  Its post office, which includes a postal savings system that was historically one of the largest buyers of government debt) announced recently that it will be a net seller this year.  The situation is out of the Japanese government’s hands.  It will probably not be able to intervene in the economy for much longer, so rates will rise and there will be little they will be able to do about it.

China is different from Japan.  Its government is trying to slow down lending, but at the same time we have started seeing news of possibly another multi-hundred-billion-dollar stimulus over the next few months.  The Chinese government’s actions are the wild card that will determine the duration and the magnitude of the bubble pop – the longer they intervene, the more dire the consequences will be.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles by email, click here.

 China: the coming costs of a superbubble

China may seem to have defied the recession and the laws of economics. It hasn’t. When China’s bubble bursts, the global impact will be severe, spiking US interest rates.

By Vitaliy N. Katsenelson

The world looks at China with envy. China’s economy grew 8.7 percent last year, while the world economy contracted by 2.2 percent. It seems that Chinese “Confucian capitalism” – a market economy powered by 1.3 billion people and guided by an authoritarian regime that can pull levers at will – is superior to our touchy-feely democracy and capitalism. But the grass on China’s side of the fence is not as green as it appears.

In fact, China’s defiance of the global recession is not a miracle – it’s a superbubble. When it deflates, it will spell big trouble for all of us. 

To understand the Chinese economy, consider three distinct periods: “Late-stage growth obesity” (the decade prior to 2008); “You lie!” (the time of the financial crisis); and finally,  “Steroids ’R’ Us” (from the end of the financial crisis to today).

Continue reading it …

Then I shared my concerns about the Chinese economy – it has tremendous overcapacity in the commercial and residential real estate and industrial sectors (see this presentation: “China – The Mother of All Black Swans”).  As the Chinese economy painfully readjusts and chews through the excesses, Chinese demand for industrial, energy, and commodity goods will be significantly lower.  Thus in our portfolios we have reduced our exposure to these sectors.  

And finally, I explained our views on Japan.  As you’ll see from charts in the attached presentation (“Japan – Past the Point of No Return”), Japan has an enormous amount of debt (second only to Zimbabwe), a stagnating economy, and the oldest population in the world (this explains why the savings rate has declined from the teens towards zero).  These factors will lead to significantly higher interest rates.  

As an unbiased analyst it is hard to come to any other conclusion about Japan, and I am going to put it lightly: Japan is screwed!  As a consequence, we believe higher interest rates globally are unavoidable, as Japan, now the largest foreign holder of the US Treasuries (together with  China, the second largest holder), turns from buyer of Treasuries to net seller.  So in our portfolio we are making sure that our companies have strong balance sheets and/or significant free cash flows to pay off debt, if (more likely when) interest rates rise.   

With every country mentioned the potential investor got paler and paler; and before I got to the EU, a union that was created, as my friend John Mauldin put it, for prosperity not adversity, he exclaimed, “You are Dr. Doom!” 

I don’t have a PhD, thus I can only be called Mr. Doom – but I am not that either.  A joke told by Warren Buffett comes to mind: a patient, after hearing from a doctor that he has cancer, tells the doctor, “Doc, I don’t have enough money for the surgery, but maybe could I pay you to touch up the x-ray?”  Hope and self-deception are not a strategy.  I analyze and accept the conclusions of my analysis, no matter how painful they may be, and adjust my actions according to my findings.   I am neither a pessimist nor an optimist, I am a realist. So at my firm we look at risks and constantly ask ourselves: What can we do to avoid them (or benefit from them) in our clients’ portfolios?  So don’t call me Mr. Doom, call me Mr. Realist. 

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

China – The Mother of All Black Swans – By Vitaliy Katsenelson
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But the comment that really drew my attention was not about the collusion, but what the best banker in the country – Jamie Dimon, the head of JPMorgan – thinks about the Chinese banking system.  In this excerpt, an employee who was present at the meeting sums up Jamie’s thoughts on China:  

Considering to buy a stake in a bank in China and asked if it makes sense to do so at current prices. Jamie replied that the concept is ok, but not now, too expensive, adding that so far “in China it is a one way street” with them wanting to get all and letting you get nothing, and that there will be more and better opportunities when China has a downturn. 

Also, too difficult to know what you are buying: many of them do not yet have integrated systems, possibly a meaningful amount of political loans, etc. [emphasis added] 

Jamie is not your typical banker; he doesn’t dance (like Chuck Prince) just because the music is playing.  His caution, long-term thinking, and contrarianism (he cut off risky lending before everyone else) made JPMorgan a  victor in the recent financial meltdown, at least in relative terms.  The stock price is still down from the pre-crisis level, but it is not in single digits or the teens, like Citigroup (C ) or Bank of America (BAC).  I’d be listening carefully to what he is saying about the soundness of the Chinese banking system. 

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive my future articles by email, click here.

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To understand what’s taking place in China today, we need to rewind the clock about a decade. At that time the Chinese government chose a policy of growth at any cost. To achieve that, it kept its currency (the renminbi) at artificially low levels against the dollar — this helped already cheap Chinese-made goods become even cheaper than its competitors’. The US and global consumers were eager to buy them. China turned into a significant exporter to the US. Normally, if free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, if China let its currency appreciate, its exports would have become more expensive and the demand for Chinese products would have declined, and its economy wouldn’t have grown at 10% a year.

But China isn’t your local democracy, and it needed to grow at any cost. So instead, through the government-controlled banking system, China accumulated a couple trillion dollars of foreign reserves in US dollars and euros.  This had an unintended consequence: It helped keep US interest rates at very low levels, and lent a friendly hand in the financing of a huge consumption binge by the US consumer (i.e., China’s largest customer).

The more China sold to the US, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. The US consumer was in turn happy to leverage its future (through the “always” appreciating asset, its house) and delighted to consume cheap Chinese-made goods. (I’m not dismissing the role in what took place of many other factors, like lack of financial regulation; missteps by rating agencies, the Fed, and politicians; securitization; etc., but I don’t want to steal the spotlight from China).

This symbiotic match made in heaven between China and the US consumer worked great as long as housing prices kept rising and the financial machine kept multiplying dollars. But all good things come to an end, and great things come to an end with a bang. The financial meltdown erupted upon us, the US and global banks started dropping like flies … well, you know how that story played out.

So now let’s fast forward a year. Today the global economy is stabilizing, thanks to Uncle Sam and various other “uncles” around the world. But the consumers of Chinese-made goods are overleveraged and now deleveraging, unemployment is high, the banks have got religion and aren’t lending, and there’s not much demand for loans anyway (except from the US government).

Despite this, the Chinese export-based economy, a manufacturer to the world, has clocked growth of 8.7% in 2009. The rest of the world looks at the Chinese growth miracle with envy; it seems that China has got economics figured out. But don’t hurry to trade your democracy for an authoritarian system. The Chinese grass is not as green as it appears. First, China lies. One shouldn’t believe all the economic numbers that are put out by the Chinese government. This is the government that magically managed to report 6% to 8% GDP growth in the midst of the financial crisis, when its exports were down more than 25%, tonnage of goods shipped through its railroads was down by double digits, and its electricity consumption was falling like a rock. It’s hard to manufacture 8% more widgets with a lot less electricity, and no, China didn’t suddenly become energy-efficient during the financial crisis: Electricity consumption rebounded in a few months once the stimulus kicked in.

Despite reported rosy GDP growth, the Chinese economy was contracting during the economic crisis. But don’t be surprised, this is a government that will go to great lengths to maintain appearances to keep its ideology going.

Second, China will do anything to grow its economy, as the alternatives will lead to political unrest. A lot of peasants moved to the cities in search of higher-paying jobs during the go-go times. Because China lacks the social safety net of the developed world, unemployed people aren’t just inconvenienced by the loss of their jobs, they starve (this explains the high savings rate in China) and hungry people don’t complain, they riot. Once you look at what’s taking place in the Chinese economy through that lens, the decisions of its leaders start making sense, or at least become understandable.

Unlike Western democracies, where central banks can pump a lot of money into the financial system but can’t force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The Chinese government controls the banks, thus it can make them lend, and it can force state-owned enterprises (one-third of the economy) to borrow and to spend. Also, because the rule of law and human and property rights are nascent in its economic and political system, China can spend infrastructure project money very fast — if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good.

China has spent a tremendous amount of money on infrastructure over last decade and there are definitely long-term benefits to having better highways, fast railroads, more hospitals, etc. But government is horrible at allocating large amounts of capital, especially at the speed it was done in China. Political decisions (driven by the goal of full employment) are often uneconomical, and corruption and cronyism result in projects that destroy value.

Infrastructure and real estate projects are where you get your biggest bang for the buck if your goal is to maintain employment, because they require a lot of unskilled labor; and this is where in the past a lot of Chinese money was spent. This also explains why, in 2009, new floor space constructed was up 100% and residential real estate prices surged 25%. And this explains why they keep building skyscrapers even though the adjacent ones are still vacant. To make things worse, before the financial crisis and enormous stimulus, China was already suffering from what I call late-stage-growth obesity, inefficiencies that are a byproduct of high growth rates sustained for a long period of time. Though Chinese growth in the past was high, in its late stages the quality of growth has been low.

For example, in an echo of past Chinese government asset-allocation decisions, China built the largest shopping mall in the world, the South China Mall, which is 99% vacant years after construction. China also built a whole city, Ordos, in Inner Mongolia, on spec for one million residents who never appeared.

The inefficiencies are also evident in industrial overcapacity. According to Pivot Capital, Chinese excess capacity in cement is greater than the combined consumption by the US, Japan, and India combined. Also, Chinese idle production of steel is greater than the production capacity of Japan and South Korea combined. Similarly disturbing statistics are true for many other industrial commodities. The enormous stimulus amplified problems that already existed to financial-crisis levels. China is a less shiny but more drastic version of Dubai.

There is speculation that the Chinese consumer will pick up the demand slack for the US and European consumers who are deleveraging and buying fewer Chinese-made goods. This may happen, but it will take decades. The US and European consumers are two-thirds of much larger economies. The Chinese consumer is only one-third of the Chinese economy, and its purchasing power is significantly undermined by the undervalued renminbi.

We look at China and are mesmerized by its 1.3 billion people, its achievements of the last decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. This was the case with railroads in the US in the late 19th century: The railroads were supposed to change the landscape of the US, and they did, but that didn’t prevent a lot of them from going out of business first and investors losing money. The Internet was supposed to change how we communicate, and it did, but in the process it generated a tremendous bubble, followed by the loss of wealth for many. The Chinese economy is no exception. Its long-term future may be bright, but in the short run we’ve got a bubble on our hands.

Everyone wants a shortcut to greatness, but there isn’t one. It would be great if the word (economic) cycle only existed in a singular form, and the only cycle we had in the economy was happy expansion. If there were no cycles, there would be no painful recessions. But as heaven couldn’t exist without hell, or capitalism without failure, economic expansion can’t exist without recession. China has been trying to bend the laws of economics for awhile, and with the control it exerts over its economy it may seem, at least for a short while, that the laws of economics work differently in China. But this is only a temporary mirage, which must be followed by huge pain and drastic consequences. No, there’s no shortcut to greatness, in anything, not in politics, not in personal life, not in economics.

P.S. The last paragraph on “shortcuts to greatness” doesn’t just apply to China (though China, through much greater control of its economy, took it to a new level); it applies to the US, Europe, and Japan as well.  Over the last several decades our respective governments intervened in free markets and actively tried to manage the business cycle – only expansions, or just mild recessions – and for this we are paying today.

More articles on China can be found here. 

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Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.

Trading on a lowly 0.5x book value, Lloyds (LYG 5.1 ↓2.49%) is clearly unloved, presumably because prospective investors aren’t sure how safe its loan book is and are understandably concerned that an increasingly unpredictable UK government owns a 43% stake. Who, after all, wants to own an asset which the government reserves the right to commandeer for its own ends and which has an opaque loan book?

Well, quite a few people it seems, judging by the situation on the other side of the Eurasian plate. Industrial and Commercial Bank of China, for example, is sitting pretty on around 3.5x book value and a forward PE of 14.7x. Yet as far as I can see, it’s 74% owned by the Chinese government and, so far at least, has been subject to far more political interference than anything seen at the semi-nationalised UK banks.

Investors have a healthy distrust, and rightly so, of governments running banks in the US and UK, but for a very strange reason are comfortable with the Chinese government wheeling and dealing with Chinese banks.  Governments, and thus their bureaucrats and politicians, are not fit to make business decisions, not because they lack a certain level of intelligence (though some will argue that is the case), but because they have the wrong incentives.  In democratic countries, politicians’ and bureaucrats’ incentives are to be reelected and thus keep their jobs, and so their time horizon doesn’t exceed their time in office  a few years, or sometimes only months.  Capital-allocation decisions (i.e., making loans) have a much longer time horizon, often decades.  Also, the government is in the business of making populist (popular) decisions that may or may not be the right economic decisions. 

Of course, China is not a democracy and the Chinese government is not really worried about reelections, though it is gravely concerned with maintaining its power.  Hence you get a policy of growth at any cost.  (Read article in the Economist on how Chinese car sales and gasoline sales don’t reconcile.)

If investors don’t feel comfortable owning banks in developed, democratic nations such as the US and UK, where government is a minority holder, their degree of comfort with Chinese banks that are controlled by the Chinese government and have an agenda to grow their economy at any cost should be exponentially lower!  (I know I just opened a big stinking box and I’ll receive emails telling me that privately held, non-government-owned banks got themselves in huge trouble without government help.  I agree, but that is a subject for a different time.)

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles by email, click here.

P.S.  

December 4th marked my 18th year in America.  I have officially spent half of my life in the US.  I pinch myself every day to remind me how lucky I am.  (If you didn’t see it before, here is the storyof how my family emigrated from Russia.)  Though part of me wishes I had been born in the US and enjoyed an easier first 18 years of my life, the other part is appreciative of spending the first half of my life in Russia, because it provided a proper frame of reference, and I tend to take fewer things for granted. 

On a different topic, my website/blog http://contrarianedge.com has been completely redesigned.  I welcome any feedback you may have (no matter how critical).  The idea behind the redesign was to make the blog timeless ( J ): now articles are organized not just by the order in which they were written but by their subjects, e.g., stock analysis, the investment process, macroeconomics, in defense of capitalism, etc.  Hopefully this will be more useful for my readers. Despite being called a “blog,”it is not your traditional blog, since I don’t write specifically for the blog, and write sporadically.  I consider it more a repository of my articles (every article I have ever written is there!).

I am off to Mexico this Sunday for 8 days, with my wife, kids, father, and stepmother. Looking forward to doing absolutely no work, just spending time with the family, reading, and enjoying the Mexican sun. (I am even tempted to leave my laptop at home, though I’m not sure I’m ready for the separation yet.)

Happy Holidays and Happy New Year!

Guangshen Railway announced its results a few days ago for the first six months of 2009: “tonnage of freight transported by the Company amounted to 26.5406 million tonnes (2008 interim: 34.5508 million tonnes).” – a decline of 23%.

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Let me demonstrate it by this analogy:  Let’s rewind 20 years.  It is 1989 and I am writing that the Japanese economy is on the verge of severe decline.  I’m facing a lot of skepticism.  Most people are calling me crazy and throwing heavy objects at me.  After all, the Japanese are on top of the world.  Their economy has been a consistent grower for decades, with a rate of growth that trumps that of the US and Europe.  Japan has the manufacturing thing nailed – they are simply better and more efficient at it than us.  Magazines and newspapers swarm with stories about Japan, how hard working they are, how unique their culture is (we of course, feel inferior, as lazy Americans).  Japanese exports significantly exceed their imports, generating huge capital-account surpluses – they are swimming in dollars and buying up America. Every other restaurant in Hawaii serves sushi and menus are in English and Japanese (not Spanish).  I may be exaggerating with the last part, a little, but not much. 

So, in 1989, who am I to poke holes in Japanese grandness and predict their malaise.  Japan could do no wrong.  Of course, we know how that story played out: a bust of a major banking/real estate bubble, a contracting economy for almost two decades, accompanied by deflation, ballooning debt, etc. 

 Fast-forward, and China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot). 

 Since China can do nothing wrong, everything I write about it is met with skepticism.  Today China projects to the world a similar image as Japan did in the 1980s.  My personal favorite is the incredible spectacle of the Chinese Summer Olympics opening ceremony: the elegant, wonderfully choreographed performance by fifteen thousand people, the marvels of modern technology (the 500-foot LCD screen comes to mind here), the virtually unlimited budget of the Chinese government, and seven years of preparation created a spectacular event that will be hard for any nation to follow.  (I feel bad for Russia and England, who will be putting on their Olympic spectacles next). 

Lately, the Chinese economy has been impressing us with its growth: it was growing when the rest of the world was contracting, fast.  But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending. 

However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is.  I’ve written a lot about this (here and here).  Instead I’ll quote James Grant, the publisher of Grant’s Interest Rate Observer.  Jim is providing the latest issue of his newsletter free, and I encourage you to download it and read his article on China – it is excellent! (Full disclosure: I’ve never met James and have not been recruited to plug his newsletter). 

Here are a few quotes from his article – many things you’ve heard from me before, but he finds a way to say them better:

“In the 1930s, Western intellectuals persuaded themselves that the Soviet economic model was depression-proof.  Today, not a few investors marvel at the vigor of the modified communist economic model of the People’s Republic. 

“A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”

 I think this chart, also excerpted from Grant’s Interest Rate Observer, tells the full story of the quality of China’s latest growth and its lending habits (lending has doubled over a span of a few quarters!):

 “The Shanghai A-share market jumped by 65% in the first half, to a level that fixes its value at 31 times trailing net income, up from 12.8 times at the October lows. Chinese M-2 was 25.7% larger in May than it was a year before.

 “Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember …  Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’  Drexel failed when the junk market did.

 “It’s no small thing that China is especially enamored of the shot-and-a-beer-for-breakfast approach. Nothing about China is small or insignificant nowadays, since the Chinese economy is actually growing. It might, indeed, account for 74% of worldwide GDP growth in the three years to 2010,  the International Monetary Fund estimates.” 

 Finally, the most important part:

 “Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.” [emphasis are mine]

 Need I say more?

Beating a Dead Horse (to Death) Part 2

My “Beating the Dead Horse” article ended with a very insightful conclusion “Need I say more?”.  I received a dozen emails that said – you DO need to say more.  So here I am saying more:

What do we take out of this?  The Chinese ascent over last decade has lowered the degree of separation between China and the global economy.  What happens in China doesn’t stay in China (not anymore); it spills over to the rest of the world. 

Today, Chinese economic growth is the force pushing the global economy. The quality of this growth, however, is low as it is predicated on massive (forced) lending and thus unsustainable.  As Chinese growth slows, China will turn from a wind into sails of global economy to its anchor.  The impact will be felt in many, often unsuspected places. 

It will tank the commodity markets, commodity producers and commodity exporting nations.  Let’s take oil, for instance.  As incremental demand from China collapses, oil prices will follow, taking the Russian economy with it, as Russia is for the most part a one-trick-petrochemical-pony.  According to GavKal Research China accounts for 15% of Brazil’s exports (up from 1.5% a decade ago), significantly impacting the economy of that South American nation..

Demand for industrial goods will fall off the cliff.  China consumed a lot of those goods – $550 billion worth annually (also according to GaveKal Research).  So if Caterpillar expects to sell more of its yellow earthmovers to China, it will have put that thought on hold for awhile.  (Side note: CAT’s CEO expects CAT’s earnings “$8 to $10 per share within five years if the world economy recovers”.  Let me put it into a proper context: in 2007-2008 circa when its margins and sales were at all time high, double their historical average, CAT earned about $5.50 a share.  Good luck!)

Finally, Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boosting our interest rates higher. No more 5% mortgages and 6% car loans.

Identifying bubbles is a lot easier than timing them.  An astute observer could have seen the Japanese bubble developing in 1986, 1987 and 1988, but he would have been “wrong” until 1989.  Now sprinkle on top of this the Chinese government’s willingness to do anything in its power to postpone the bursting of the bubble and the complexity of timing increases exponentially. 

Those of you who are familiar with my writing on this subject may rightfully accuse me of beating a dead horse – or in this case a dead dragon.  But I firmly believe that those who invest in China or ignore the consequence of very likely Chinese economic malaise do so at great peril.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here .

After I wrote the last note about China’s creative calculation of its GDP, a friend wrote: “So what?  Who cares what is going on in China?”  If the Chinese economy was the size of the Vietnamese economy, and it was not responsible for more than 2/3 of our trade deficit and didn’t hold $2.2 trillion in foreign reserves (about half of which is in US dollars), I’d be spending a lot less time thinking and writing about it.  However, what happens in China in the near future will have a significant impact on the world, and more importantly our own economy: it will impact interest rates, the dollar, commodities, and demand for industrial goods; and there will be geopolitical consequences.  China matters a lot!  

Another friend said: “You pick on the wrong governments.  First Russia, now China.  They’ll have you killed.”  Though it makes a cute joke, there is some sense of truth in her comment.  Anyway, call it bravery, call it stupidity, here is my [fixed link] latest article in Sunday’s New York Post (also included below), explaining why the Chinese economy should not make us feel inadequate and explaining the consequences of what is taking place in China on the US stocks.  Here is my interview with BNN TV (the Canadian version of CNBC) on the same topic (my wife thinks my hands need to be tied to a chair when I talk on TV, and though she has a valid point, I cannot talk without my hands).   

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China’s growth an accounting miracle

Now we are learning how China has achieved its “miracle growth.” The country showed positive GDP growth while its electricity consumption declined in the beginning of 2009 – creative accounting that makes Enron’s accountants appear as dilettantes. A paper published by John Makin at American Enterprise Institute explains it well:

“Once China had announced its 8 percent growth target, it began to disburse funds directed at a sharp increase in public works spending. It is important to understand that the disbursal of funds is recorded as GDP growth. So the government can easily control the pace of growth by the pace at which it releases funds that have already been allocated in the stimulus package to the creation of higher production or growth numbers. Funds disbursed for fixed-asset investment by state-owned enterprises or provincial governments are counted as having been spent when they are disbursed. In fact, the funds go out to the state-owned enterprises and provincial governments and may be held until actual projects are identified and undertaken.” (Emphasis is mine.)

But wait, it gets worse:

“…Ambitious planners count shipments [consumer products] as retail sales while end-use demand may be absent. In such cases, the “sales” are made to happen by virtually giving away the products that have already been produced and counted as GDP growth.”

I am not convinced if China will have inflation in the long-run. It appears that deflation is a more likely scenario as China is ridden with overcapacity – the country was geared for much higher global growth. I can, however, see inflation erupting in a very short timeframe as money has been thrown at the consumer/companies, and we are seeing this in the stock market and real estate. But in the long run, inflation appears an unlikely outcome: overcapacity and slower demand from the US and Europe will force Chinese producers to cut prices to increase utilization and stimulate demand.

Lately, we’ve started hearing whispers of the Chinese renminbi contending for the status of the world’s reserve currency. On the surface it more or less makes sense. The US is struggling and Europe has structural problems. John Mauldin correctly put it, “EU was designed for prosperity not for adversity.” It will be hard for the EU experiment to survive in the long run. But that’s a topic for a different discussion.

China on the other hand is chugging along. I heard (though not confirmed) the Chinese stock market now has a greater market capitalization than Japan’s. Though the Chinese economy has the size of a global currency contender, it lacks one not-so-little element that the global economy will require for renminbi to become the world’s currency – political stability. We forget that China is still not a democracy. I am not sure what to call the political system of the People’s Republic of China but I don’t think it’s the “people’s” nor is it a “republic.” The rule of law is a nascent concept in China. Something is only legal if the government thinks it is legal.

And finally, I’m sure China doesn’t want the renminbi to be the world’s currency as it would drive up the value – a suicide for an export-based economy.

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and the author of Active Value Investing: Making Money in Range-Bound Markets.

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P.S. I highly recommend you read Peter Drucker’s paper called Managing Oneself – it is terrific. I’ve read it the first time about six years ago, had a huge impact on my life.  Also, a friend forwarded a very interesting article by Anatole Kaletske (I’ve never heard of him until today), he makes a very interesting case that European Central Bank has outdone even our mighty Fed in quantitative easing.