What if China's Real Estate Market Does Pop: U.S. Outlook

On the heels of Alex's post on his on-the-street view of the Chinese real estate market, I wanted to provide a good sense of what the actual risks are. As you may have seen earlier, I don't buy into the double-dip recession hypothesis except if there is a large unforeseen shock. Now, as soon as I wrote that, a reader might have gone "AHHHHH!!!! They've said this all before!" Indeed it does sound awfully familiar. Indeed, some friends of mine may know that I thought the 2008 recession, which I admittedly called in 2007, would be shallow and long in the absence of a total freeze in credit markets. In truth, even short of Lehman, it appears that it would have been deep in any case. So, I guess to try to be better prepared it might help to examine what are the potential channels of a relapse.

The first one we might want to examine, because its effects set in the quickest, is on the banking side. I drew up this little table that showed bank risks by country as of Q1 2010. I am quite sure these haven't changed much since then.

In relation to the risks that our banks took in the real estate sector, the risk to China is small potatoes. Even in the event of a total calamity, maybe 30% of that would be written off. Spread among the various banks that lend to China, it's not a particularly big deal. Now, I put in Japan and Korea because it's possible that some of the large financial institutions there have also been providing credit to China. I can't find data on that because: 1. The relevant websites are in their native languages most often and 2. Disclosure in most other countries isn't as good as it is here. It's actually one of the reasons the U.S. has commanded lower risk premiums over the years, recent experiences notwithstanding.

A second channel some might point to is the U.S. Treasury market where China might sell off assets and repatriate money in the event of a major financial crisis. There is actually historical precedence for that where in World War I France and the UK repatriated assets from the U.S. and helped contribute to a rather nasty decline in equity markets here. The fear is that China would cause interest rates to spike prematurely, raising borrowing costs for corporations and governments alike and that the interest rate shock could completely unsettle financial markets. However, this is only really a problem on a short term rather than a long term basis as what can happen is that the Federal Reserve could step in and soak up the sales and slowly work that off over several months in order to keep markets orderly. There is no guarantee that the Fed would do this, but they could do this.

The third major channel is of course through exports. Now, U.S. exports to China are running at about an $80 billion annual rate or so. This is about .7% of GDP. Even a huge hit to these exports of, say, 40%, would not be enough to drive the U.S. into recession, even in our presently weakened state. I have said as much before. However, I did some more thinking on this and of course there are other spill overs. Other trading partners including Brazil and Australia buy decently large amounts of capital equipment including mining machines from the U.S. in order to extract raw materials to sell to China. Add up the $36 billion at an annual rate we sell to Brazil and the $14 billion at an annual rate we sell to Australia along with maybe another $30 billion to other large natural resource extractors and you get, well, around another China's worth of secondary effects. I haven't looked closely enough at the trade data with each of those countries to know how much of what we export is actually economically cyclical, but the odds are that it is quite a bit.

Even with all of this, it would not be a calamity, but it could be enough to grind growth to a complete halt for a time given how modest growth is right now at maybe 2% annualized in the third quarter. Luckily, China seems to be dragging this real estate cycle out long enough that a crisis might not occur until our growth is a little more self-sustaining. As for some other economies, anything Australian-related worries me. They have this potential pitfall as well as their own housing bubble. Brazil would suffer badly if China suddenly stopped importing so much iron ore among other things. The same holds for Peru and Chile and whatever commodity-export countries you might think of.

Now, the Chinese real estate market should give plenty of warning signs before a collapse in both residential and non-residential investment might occur. The first would be stagnation in prices followed by a pullback of some sort. As prices drop, expectations about future returns drop leading to cancellations of building projects and a slow down in new projects. This in turn leads to a drop in the imports of raw materials and machinery. All of that actually takes some time to manifest and you can spot it in advance if you are looking for it.

What's Next for Millicom (MICC)?

Several of my friends know that I am very excited about the prospects for Millicom (MICC). For the uninitiated, MICC is a Luxembourgian (though Swedish in origin) provider of cellular phone service in developing countries ranging from Costa Rica to the DRC in Africa. Africa, incidentally, is far and away the largest driver of sales growth in recent quarters. It also has a cable business in some central American countries, but that is not its predominant product line.

Most of what MICC provides is pay as you go cellular service, which fits developing markets well. Rather than having smartphones that even a middle class American might go broke on, they distribute cheap, damn near disposable phones in these markets and allow their customers to purchase however many minutes they want. In countries where landlines are almost non-existent and they went straight to cell phones this makes a lot of sense. Phones are used on a limited basis in most of these countries, often only for essential purposes. With low incomes, paying a recurring monthly charge for service you are not using makes little sense.

In any case, after a brush with bankruptcy in the early 2000s, MICC revamped and has been growing at a good solid clip ever since. Revenues have more than doubled in the last four years and will likely nearly double again in the next five. For all of the growth they have seen, the company still only had just over $3.4 billion in revenue in 2009. This isn't a great comparison, but just for the sake of something to compare to, Verizon (VZ) had revenues of $107 billion. Operating margins have also improved from 75% in 2006 to 82% in 2009. Net profits have been a little hard to interpret due to many acquisitions, divestitures, and their associated write-downs and one time profit gains. Based on operating profits though, there has been steady improvement.

The balance sheet is not overly leveraged with its cash position growing in line with its long term debt. This is important from the standpoint that if there is, God forbid, another financial shock like 2008, MICC is not vulnerable to a financing crunch. I've become more cognizant of that as an issue with companies since the crisis.

The recent earnings report, released just this last Tuesday was a thing of beauty even though on the surface it looked like a bad miss. The market realized this too, and the stock was notably higher by the end of the day after selling off in the morning. Revenue growth of 14% (11% after currency adjustments) and earnings growth of 17%. Customer base growth was near 20%, which is a promising sign for future revenue and earnings growth. All of this leads to a stock that trades at a modest 13.4x forward earnings. That's hardly steep and in normal times with their growth rates would be a steal.

As mentioned briefly earlier, the growth rates in Africa are astounding. Fully 3/4s of the subscriber growth came from Africa in the last quarter, partly driven by depressed numbers elsewhere from divestitures, but still this is an amazing thing. Africa has averaged just shy of a million new customers a quarter in the last three quarters.

Now, they do have competition for these rapidly growing markets, but market share has been steadily ticking up. It's always a good thing to have a growing portion of a rapidly expanding pie. The African numbers looked like a disappointment, but actually the market share number took a hit from entry into Rwanda since they had no presence there before. Adjusting for that, market share is growing in Africa.

All that said, the outlook for MICC looks promising and I think this is reflected by the fact that the stock has held up quite well during the recent sell off in the broad market the past few months and its gains when the market rises tend to be greater than the overall market. That said, it is a lightly traded stock at less than a million shares a day and often less than 500,000. It can be easily moved in a bad day and drop $4-6 a share. If you cannot stomach that, it might not be right for you. Still, opportunities to play growth in Africa directly are rare, even when they are a little volatile.

Are Indian Bank Stocks Good Buys Now?

For years, the Indian bank stock, principally HDFC Bank (HDB) and ICICI Bank (IBN) have traded at earnings multiples that would make even an aggressive growth investor flinch. Back in the heady days of 2006 (at least they were heady days for emerging markets), these banks often traded at 30-40x forward earnings. That compares to the general practice of only paying 15x forward earnings or less for most bank stocks. Part of this discount, regardless of growth rate, comes from the fact that banks can in fact be prone to massive calamities. Of course, we wouldn't know anything about that. Speaking of which, I haven't seen my shares of Wachovia recently. Do you know where they might be? (Disclaimer: I never owned Wachovia)

That being said, after a few years of continued earnings growth and stagnant stock prices, it might pay to see where we are here. IBN, on its surface, seems to be the better buy, trading at around 14x next year's earnings and growing earnings at a torrid pace. HDB trades at over 21x next year's earnings with a very similar growth clip, though the market may be indicating that analyst estimates might be in error. Frustratingly, I must confess I know little of the Indian banking system, being much more familiar with Brazil's among the BRIC countries. What I do know is that the central bank is currently tightening which will probably keep these stocks under pressure for some time to come as their net interest margins come under pressure. I would say then that there is little reason to nibble here for now, but in about six months time it may be fruitful to buy one or both of these banks as long term holdings. The lofty estimates for earnings growth should be obtainable so India is a country with relatively low credit utilization.

Of course, there are those that are skeptical of India's long term prospects. I am not among them and I actually favor the long term prospects of India over those of China for the reason that I believe India to have a more fundamentally sound political system. I am sure there is going to be a great difference of opinion on that point.

A Brief Note on Financial Crises and Safe Harbors

One of the great new contrarian pieces of "knowledge" has been that you can hide from a developed market financial crisis in emerging markets. This was said in 2007 and 2008 when we went into the soup and it was said again this time during the ongoing European financial crisis. Just to show how silly that idea is, here is a chart from June 1, 2008 through March 1, 2009:

The green candlestick line is the S&P 500, the olive line is the FXI from yesterday, the purple line is the iShares MSCI Emerging Markets Index Fund (EEM) and the light blue line is the iShares Brazilian Index Fund (EWZ). As you can see, over this period, the U.S. outperformed all of those markets for the duration of the worst of the crisis.

Similarly, in the current crisis the pattern has been continued:

The pattern is repeated, to varying degrees. So, what is the safe harbor? U.S. Treasuries have been, are, and will likely continue to be the last best hope for investors in the midst of a crisis. I could show the chart from 2008, but that's just beating a dead horse. Here's the most recent performance with the iShares Barclay's 20+ Year Treasury Bond Fund (TLT) represented by the.... I guess that's salmon colored line:

As you can see, long-duration U.S. Treasuries are a good safe harbor for assets in short term financial crises, regardless of whether they are here in the U.S. or if they are in Greece, China, Japan, or wherever else there might be a crisis. That being said, as a long term prospect, I am not thrilled with the outlook for Treasuries at the moment as I have indicated previously. As interest rates rise in the future, you will get slaughtered for a large position in them. In the short run they might be appealing, though even here I'm not sure how much more upside they have. I think we are probably within a couple weeks of the worst of the European crisis being behind us, though it will get ugly before it is over.

Someone may ask "What about gold?". In response I say, "Treasuries > gold" in a crisis. It was true in 2008. It is true now. Gold is only superior in a time of hyperinflation.

Anyway, those are my thoughts.

Investing in China: Now, Later, or Never?

I will preface this entire discussion by saying I am not an expert on China. I do not know a word of Mandarin (or Cantonese for that matter), I do not know the names of more than 25 Chinese companies, and I have never been there. I do, however, know a fair amount about Chinese history and Chinese economic development. As there are a few of you that know more about certain aspects of China, I welcome your input.


Of course, when any economy is growing 11% a year, there is a great temptation to want to invest in that country's markets. With China, where the economic prospects seem so favorable, this is particularly true. However, historically the Chinese stock market has proved a treacherous mistress. For most of the ten years leading up to 2006, Chinese stocks, measured by the CSI 300, did not do particularly much of anything even while the economy boomed. Then, between 2006 and early-2008, Chinese stocks increased nearly six fold, one of the most powerful rallies by a major economy's markets in history. Then, over the next ten months, stocks fell 73%, wiping out most of the gains of the past three years. Over the ten months from October 2008 to August 2009, stocks rallied by better than 100%, out-pacing most other markets. 


Since then, however, China has been an unusually poorly performing market, even rivaling some of the troubled European markets. The CSI 300 has fallen from 3,750 in August to 2,762 now, making it one of the few bear markets anywhere in the world. Its best proxy listed here, the iShares FTSE/Xinhua China 25 Fund (FXI), has badly trailed the S&P 500 over 
the past year. Despite all of the talk about China being a better place to invest, the
markets have said otherwise:

Stock Picking: Consumer Staples

Yes, probably the most boring sector, but one that is useful for analyzing when constructing the core positions of your portfolio.

As nearly anyone who knows me is familiar with, I have a large position in Procter and Gamble(PG). While this has performed well for me over the past nine and a half years, it is increasingly apparent to me that it may no longer be the best choice in the sector. In fact, it may not have been the best choice in the sector for the past few years.

Colgate(CL) and Church & Dwight(CHD)have been posting far better growth numbers as well as better stock performances in the last few years. P&G's earnings report this last week was fairly disappointing as well. It had appeared to be positioned nicely to move into the high 60s if only the earnings report and the subsequent forecast had been solid. Alas, they were not, and the stock has languished in the low to mid-60s for the past several months.

P&G is making significant efforts to increase its emerging markets exposure where there is plenty of growth potential, particularly in Latin America and India. The problem has been that Unilever, CHD, and CL are already a few steps ahead of them and have posted much better unit volume growth. That being said, P&G is fairly attractive if they can restore any form of growth at all. With $4.12 a share expected for next year's earnings, they trade at barely over 15x earnings, fairly cheap by their standards. That plus a 3.10% dividend make the stock palatable.

However, CL and CHD both trade at much the same forward PE and have a clearer forecast for earnings growth. CL has a decent 2.5% dividend as well, but CHD has a puny 0.81% dividend. Those differentials are important in determining which of these stocks to buy.

If I had to deploy new money right now to one of the three, CL seems to have the best story to tell on the three counts: growth, valuation, and dividends. Colgate's dividend may be lower than P&G's, but on the other two counts, it is vastly superior.