Tiburon Partners LLP

Remember 1993? That’s how far back you have to go to have made any money (ignoring dividends, admittedly) in Hong Kong’s retail landlords. Retail capital values have risen over 3X in the intervening period. The sector is unaffected by government regulatory action (unlike the residential segment), and availability of space for high-end retailers in Central and Causeway Bay is essentially zero. Discounts to NAV have virtually never been bigger, and on the few occasions over the last 30 years when they have been comparable, Hong Kong has been in a state of acute depression. The Thatcher negotiations, 1987, Tiananmen, SARS, Asian Crisis, 2008…we were there on all of these occasions, and it doesn’t feel remotely like any of them. Chinese visitor arrivals are rising 20% plus YoY, and they are spending like LVMH might run out of handbags (watch and jewellery sales are up 40% plus). Wharf, the pre-eminent retail landlord, has underperformed even the UK retail property plays over the last couple of years, where we can see no good news at all. This is surely one of the best value plays in the region.

‘Asian markets down on concern over Europe’ is now a Bloomberg headline in danger of burning itself into one’s computer screen. In a year when the US markets are almost flat, Asia and Europe (the latter index crammed full of bankrupt banks) are level pegging, down circa 20%. It seems that Asian investors are interpreting all news as bad, as exemplified by the uniformly negative reaction to the (not that surprising) demise of the Dear Leader of North Korea. No one knows or can even usefully guess at what will happen, but the immediate reaction was to panic over a war breaking out. An equally or more likely outcome is some form of rapprochement and some degree of integration back into the world at large. Our base case is the status quo. Yet the default at the moment is to assume the worst, and with Asian markets suffering a double whammy of fund flows from both international capital and panic-struck retail investors (who are being influenced primarily by doom and gloom over Europe) and who still matter much more in markets such as Korea, Taiwan and China than in the institutionally intermediated Western markets, and who by their nature are high beta investors – all in or all out. Low market volumes exacerbate this effect. The good news is that it also works in reverse when sentiment stabilises. We do not need a ‘solution’ to European woes for this to happen. Indeed, anything other than a disorderly break-up of the Euro is probably enough to prevent disappointment from current expectations – and in that case Asian equity performance might be the least of ones worries. » Read more: Mark Fleming – December 2011

Following a traumatic year in Japan, ranging from the tragic earthquake to persistent yen appreciation, we enter 2012 convinced that the early part of the year will face similar problems. An unresolved Eurozone outlook accompanied by a severe European recession will continue to outweigh the positive signs of recent economic improvement in the US and a likely moderation in the Chinese slowdown and will translate into a limited risk appetite on behalf of investors. Global bonds appear expensive but still exhibit safe haven characteristics. The potential for a significant rethink for markets lies principally in the unlikely scenario whereby governments are able to finance growth as opposed to the current focus on austerity in order to trim budget deficits. Perhaps the ECB unleashes the dramatic QE but we sense this only occurs at a moment of maximum alarm and despair, which probably suggests that equity markets will be at much lower levels. Where does this leave the Japanese equity market?

Fortunately Japan has a few positive factors. The economy will respond to the significant post earthquake reconstruction spending that will offset the more sluggish manufacturing export conditions. Corporate balance sheets are awash with net cash and consequently remain well placed, especially given the yen levels, to accelerate their overseas acquisitions, a more noticeable trend from Q4 2011. Industry consolidation will accelerate as will the more aggressive restructuring at individual companies. Shareholder awareness will continue to maintain a level of pressure on corporate managements and hence share buybacks at many companies will occur for the first time although it would be premature to expect the Olympus debacle to change overall corporate thinking in the near term.
» Read more: Rupert Kimber – December 2011

Markets continue to demonstrate extreme volatility based on constantly changing expectations for the financial health and future of the Eurozone. In this environment those investors in Japan who see only cyclical attractions continue to trade accordingly and hence the market remains heavily correlated to external events. However the reasons for maintaining an exposure to the market remain quite different in our view. We are very heartened by the decision that Japan will enter talks to join the TPP as this represents an opportunity for the government to embark on longer term structural reform, especially in certain domestic sectors that are currently closed to foreign involvement. This should compliment the already aggressive restructuring in the corporate sector. Furthermore it can potentially provide foreign investors, the only marginal buyers, with a reason to expand their portfolios to include a wider non global cyclical component. Valuations in Japan are starting to look cheap with dividend yields in certain sectors not dissimilar to global competitors but the PB discounts require significant ROA improvements, a trend that we believe is well underway. A difficult 2012 global economic environment and a persistently strong yen will again provide further reasons for corporate management to implement further restructuring. It is also interesting to hear managements starting to effect share buybacks using the rationale that the discrepancy between bank funding costs and the cost of equity is now too great and that a slightly higher degree of balance sheet leverage is not such a bad idea. Given investor scepticism over these trends, encouraged by the lack of research on many of the companies and a continuing over emphasis on short term earnings trends, certain share prices may take longer to reflect these changes but ultimately these types of companies should generate the most significant longer term returns. We are shortly to visit Japan again and will report our findings in the next report in more detail.

November has been in many ways a re-run of September, with problems in the Eurozone dominating sentiment and news. It seems that market consensus is rapidly swinging to contemplating life after the Euro, and while it seems desirable for the periphery to devalue to improve competitiveness, and possibly now to also lower debt service costs (as their inability to print currency is now more of a hindrance than the umbilical cord to Germany’s interest rate structure has been a positive), the political will is not yet there. As and when it gets there, the mechanism for fragmentation of the Euro is, to say the least, unclear. The universe of politically feasible solutions does not intersect with those that are economically rational – in particular, avoiding the complete implosion of the banking system as currency blocs realign. That said, a lot of negativity over Europe is now priced, and elsewhere there has been slightly better news. Data out of the US has had a more positive tone to it (spending and employment) and more importantly we are seeing the Asian policy responses that we have been awaiting. Regional interest rate cuts and a move to ease SME funding in China have been followed by the first move to lower reserve requirements in China. This is an important change in policy direction and we hope this portends a rather more rational market over the next few months.

Return on equity is one of the market’s favourite parameters for measuring corporate profitability and management competence. Frequently and erroneously mentioned in the same context as price/earnings rather than price/book, its overuse in analytical terms relies on capital being reinvested in the business at the same rate as that currently extant (often wrong for cyclicals, businesses in niche markets or with franchises or intellectual property that do not lend themselves to expansion via financial capital alone and where the ‘book value’ does not include these intangibles), and like any ratio is prone to manipulation – in this case both numerator and denominator are vulnerable. A low ROE can be a function of low stated profits or a ‘lazy’ balance sheet. Call us old fashioned, but in the current climate we view strong balance sheets as good things. For the banking sector we would say they are essential. We would also be wary of high stated banking profitability – dodgy borrowers paying munificent up-front fees, clever derivative strategies that could unwind or result in law suits….the list goes on. So we like Singapore Banks. ‘Boring’ and ‘overcapitalised’ are positive attributes, not insults. The banking regulator retains credibility for ensuring financial statements are not filed alongside their European brethren in the fiction department, and the market awards them a very low valuation – 10x per, 1.2x book – because the perception is that they have little scope for growth. Yet the likely wholesale departure of European bank capital – from good credits – back to a domestic ‘haven’ leaves a potential hole in Asian credit markets that the Singaporeans could fill, and at higher than current margins as credit availability shrinks. These are virtually the only banks worldwide that we are enthusiastic about. » Read more: Mark Fleming – November 2011

In a volatile month for global equities Japan proved no exception although ongoing concerns on Yen appreciation muted the bounce in the index from the lows. The cyclical sectors recovered some of their steep losses on evidence of stronger US economic growth, better than expected US earnings, albeit against sharply lower expectations, and easier Chinese monetary policy comments. Near term euphoria over an avoidance of a financial crisis in the Eurozone proved significant, although that situation is far from resolved. The issue that continues to trouble us is the global growth outlook especially in Europe which will continue to have an impact not only on Japan but also China. Optimists point to secular growth stories in China for industrial automation but against the backdrop of sharply weaker operating environments, it seems highly plausible that companies will be more cautious on capex in the near term.

For Japan Inc. 2011 is shaping up as one of the most difficult on record. Having just recovered from the earthquake, the manufacturing sector has now had to contend with floods in Thailand and, despite forex intervention, a persistently strong Yen which is starting to act as a major drag on profits. We continue to attribute the latter partly to the recent withdrawal of the Swiss franc as a safe haven currency. The recent share price trend of Samsung Electronics provides a telling indicator of how competitive advantages within Asia appear to be changing. Whilst it is therefore easy to be gloomy, given the previous comments, let us now consider the other side of the coin.
» Read more: Rupert Kimber – October 2011

There has been plenty of hysterical cock and bull recently about a (so far largely hypothetical) deterioration in Chinese growth and its potential effects on the commodity markets. The iron ore price has become the touchstone for market sentiment, with copper taking an unusual back seat as the talking heads on CNBC, few of whom could tell the difference between haematite and kryptonite, opine over the likely demise of the steel industry’s main input. It is certainly true that fixed asset investment in China cannot continue its current heady pace of growth (in part due to the law of large numbers) and that local Government finances are in poor shape – though they are probably rather better than those of Harrisburg or the State of Illinois. Social housing, however, is booming and this will probably at least compensate for any hiatus in private sector housing or railway infrastructure demand, with the latter unlikely to be constrained for long anyway. As far as local government debt goes, read Federal, at least in a functional sense. They will not be allowed to default and recent moves to allow bond issues for the provinces is a step in the right direction. It is also clear that the leadership in Beijing is on the case and is actively targeting an easing in liquidity conditions for private enterprise – including some of the steel mills.

On the supply side of the equation, there are quite a few major projects under way in the Pilbara, Brazil and (eventually) in Africa. Yet at current prices (circa $130/tonne, 62% Fe), approximately 200m tonnes per annum of domestic Chinese production is marginal (compared to cash costs for the Wallabies and the Brazilians of around $50). Prices may dip below this Chinese cash negative cut off for a while, especially as one can now speculate in the futures, but won’t stay there for long. Yet the stock market is valuing many of the mining stocks on the basis of prices being around 35% below current spot into perpetuity. Too harsh, we feel.

While new sources of iron ore have been identified, there are several minerals that do not enjoy this prospect. Rare earths are once again interesting to us as we mentioned in last month’s missive, but we would add zircon and the titanium rich mineral sands into the mix as well. For the mining cognoscenti the supply demand imbalance of zircon and high quality rutile (a mineral composed primarily of titanium dioxide) is well known, but the recent fall in markets (as the risk off/China is finished trade took hold) provided an opportunity to get set. Zircon is a required material for ceramic tiles and refractory materials while titanium dioxide is the essential ingredient for white pigment. The paint industry has had a free ride on cheap rutile for years. This is now changing as legacy contracts at artificially low prices run off and are replaced by market based ones. Supply is constrained primarily by geology and a new pricing paradigm seems set for the foreseeable future. Listed producers of these materials should do very well over the next few years.
» Read more: Mark Fleming – October 2011

We were recently asked in a presentation what the risk of ‘policy error’ was in the global economy. After some reflection it seems reasonable to reply that markets will continue to price the same depressing conveyor belt of bad, spur-of-the-moment, treat the symptoms not the cause type of panic-stricken decision making that we have come to expect over the last ten years until we have evidence to the contrary. We were particularly struck by the fusillade of stones from the US Treasury glasshouse as Tim Geithner complained loudly over the failure of the Europeans to grasp the Greek nettle. At least the solvent European nations haven’t put themselves within hours of avoidable default due to political bickering. On the other hand, the Europeans don’t appear to have grasped the necessity to cauterise the Greek wound to prevent unnecessary contagion – or if they have, they can’t say so publicly as it would upset too many fiscal and monetary hawks in the North. Bad policy is not, however, exclusive to the developed/Western economies. The RBI in India is over-tightening, Brazil is moving to overt protectionism to insulate domestic manufacturers (see recent moves on the requirement for local content for autos) and Australian policy is being driven by 3 or 4 individuals who can play the hapless Labour administration off against the Liberals to generate some very electoral-unfriendly results.
All in all, a depressing laundry list of failure. The good news is that markets have given up on an economic rabbit being produced from the policy makers’ top hat. Providing we expect nothing more than a broken egg, at least we won’t be disappointed. » Read more: Mark Fleming – September 2011

Perhaps common sense within Euroland is finally starting to appear and whilst the path to a long term solution will be very volatile there is little doubt that global stock markets will initially react favourably to any such outcome. That said we remain concerned over the mid-term outlook for economic growth especially in western developed economies without a significant change in fiscal policy and a looser monetary policy in China, neither of which seem likely in the coming few months.

Against this backdrop, Japan has many appealing attributes, not least of which are the strong cash positions in the corporate sector and a banking system awash with excess liquidity. Whilst weak economic growth overseas will inevitably slow domestic economic growth and corporate profits, we still expect corporate earnings in 2012 to prove the most resilient within developed markets whilst allowing certain companies the opportunity to improve their global positioning through overseas M&A whilst domestically the focus remains on industry consolidation and restructuring. » Read more: Rupert Kimber – September 2011

The U.S. economy is about to double dip. The Eurozone may break up. Policy makers are powerless to help. Broadly speaking, this has been our base case for some considerable period of time. That this is now consensus surprises us not at all. What has come as a shock has been the speed of the shift in sentiment, which as usual has resulted in the knee-jerk ‘risk-off’ trade, with Asia’s perceived beta contributing to a bigger fall than in most of the Western markets despite the overwhelmingly superior fundamentals. Even more bizarrely, the Euro worries have continued despite Italian bond yields falling sharply, courtesy of the ECB, while the European Index is within 10% of its 2009 low. We would still avoid the Western Banks, but the broader market is now offering great value, and Asia in particular is littered with mis-priced stocks. There are even some tentative signs that the transmission mechanism for low interest rates to stimulate the economy may be coming back in a modest way as refinancing activity in the U.S. mortgage market picks up.

Many commentators are keen to compare current market action with that of 2008, and this has clearly rattled a lot of investors who (us included) would rather not relive that period. We would agree that we are in a different phase of the same crisis, with the excessive debts having migrated primarily to sovereign borrowers. We would also agree with the consensus that policy options are few and likely to be ineffective. However, there are some major differences. Companies are cashed up and not beholden to their creditors. This is a crucial difference as we invest in the private sector, not in politicians. The second significant difference is that we know that whatever liquidity is required will be provided to keep the banking sector functional, which is why the cost of interbank funding has moved only moderately. This was the key unknown in September 2008. » Read more: Mark Fleming – August 2011

Our recent extensive visit to Japan has reconfirmed the positive investment case notwithstanding the near term hiatus in global markets.

Corporate Japan is looking very solid, with the abundant net cash positions likely to lead to a more concerted overseas M&A boom as managements continue to look overseas to generate new growth especially in emerging markets. Critics will point to recent examples of high prices paid, as in the case of Kirin in Brazil, but they fail to understand that the purchase price represents only two years of cash-flow; hardly a major gamble. We expect financial companies to follow suit given that in some cases considerable cash reserves have been amassed for this purpose.

The recent yen appreciation is not especially material for the competitiveness of Japanese manufacturers as many have already moved costs very aggressively overseas and hence can compete in foreign currency contract bidding with overseas competitors. The impact is more relevant to the translation of overseas earnings. The domestic sectors currently hold most attraction for us given further signs of imminent industry consolidation and specific company restructuring. Our recent meetings with senior managements of several companies confirmed that this process still has a long way to go from here. There was confirmation too that the bureaucracy, METI, are actively encouraging this trend, an interesting new policy objective given their historic concern about the impact on employment that has for so long extended the obvious over capacity issues in many industries. Whilst unlikely to proceed, the very thought that Hitachi and MHI might engage in a partial merger offers concrete evidence of this new management strategy. » Read more: Rupert Kimber – August 2011