February 29, 2012
by Edward Lam and Dominic Johnson
"The absurd is the essential concept and the first truth."
- A. Camus
Last month I offered the judgement in passing that there were some Taiwanese memory chip manufacturers that ought to be bankrupt. I have actually held this view (though perhaps it has hardened over time), since I first started covering Taiwan in 2006. I spent nights sharpening my modelling skills and days talking to tech analysts from investment banks that had been in finance since before I left primary school (or so I was told). The reason these analysts at the top investment banks refuse to be anything other than positive on weak issues is of course, as it helpfully states on their reports that they want investment banking fees – and fee flows from companies desperate for capital are surprisingly or unsurprisingly large. It turns out anyway that I am still wrong. It was Elpida the Japanese memory chip manufacturer that filed for bankruptcy on the 27th February. Ironically the financial position of Elpida is probably not substantially worse than some of its Taiwanese rivals; in a sense its management is just acting more rationally by not asking for one more roll of the die; perhaps they have a sense of honour; “hara-kiri”. In keeping with what I said last month about the fact that conditions can suit a stock even when the valuations are deadly wrong, the Taiwanese memory chip manufacturers were limit up on the day Elpida originally made clear its financial difficulties. The optimism has moderated a little since but the example is illustrative of the great dissonance or creative tension in markets at large. Indeed the strong performance of some of the more precariously positioned stocks and markets (DRAM, Chinese property, Turkish Lira) makes it possible that the credit cycle has in fact turned positive again though somewhat against the run of fundamental data. Employment numbers coming from the U.S. have looked a little better but the real components of aggregate demand (c.f. the conference board of coincident indicators) as yet looks extremely weak, if not recessionary. Rather, in keeping with the way distended markets appear to be working, what actually makes me apprehensive of a continued rally in markets is the latest German Ifo Institute survey. Despite the collapse in the Euro wide supply of credit, companies in Germany that are reporting restricted access to credit have fallen to a level not seen since 2003. This artificial oversupply of credit to an area that does not need it carries with it the possibility a bubble as pressure can build to make superfluous use of this capital. From the charts below one can see that 2003 stakes a claim to be the beginning of the first credit cycle of the 21st century and also coincides with the start of a long bull market in the DAX (amongst others) which rose 200% by 2007. The ECB main rate is also interesting because it suggests that between 2009-2011 we may have already completed another mini-cycle. That this should be apparent from the ECB rate rather than the Fed Target rate is largely because the ECB remains an ‘honest’ money balance targeting central bank whilst the Fed is really or has become a credit targeting central bank. The charts below and other fundamental data hint at something else though as a caveat, which is that though a new cycle may have started, (and this is yet an ‘if’), we should also be wary that it may well be a very short one: the last cycle was short; the U.S. economy remains in the balance; oil prices have already shot to strained levels; and I think that the Chinese credit cycle has yet to come to a conclusion, which would upend the fruit cake once again.
In terms of portfolio position, over the last two months there has been some reorganisation. Aside from the timely decision to enter the Indian market we also took a decision to buy the fund’s first mining stock. Likewise, this decision was not taken lightly as I have repeatedly pointed out that resource sector returns on capital are not necessarily as high as they appear on paper. In this case we have bought Tambang Batubara, an Indonesian coal mining stock. The ROE here (on paper) is close to 40% but is fundamentally supported by a resource base that is a) easy to mine, being of shallow, open pit extraction b) long life, perhaps of 100 years. The return profile of the resource base reminds me a little of Kumba Iron Ore in South Africa which we might have owned at the inception of the fund but for our already high weighting in South Africa and some of the regulatory issues in that country. The dividend yield on this stock is just under 3% but has the potential to grow substantially. Just as importantly the asset is state controlled so though there are issues raised because of this, at least we are not getting involved with the kind of family problem that Nathaniel Rothschild is encountering in his Indonesian coal mining investment. To make room for some of these new investments we have cleared out some positions that we have had reservations about for some time: Mediatek and two telecoms stocks, Mobile Telesystems (Russia) and MTN (Southern Africa). Though we have ejected two telecoms stocks overall there is not a substantial change in portfolio characteristics, given that Mobile Telesystems was not defensive as it should have been in 2011 (falling around 30%) and Mediatek was one of the more volatile stocks. Indeed a key reason in selling MTN is its large exposure to Nigeria, a problematic market given global macro conditions. Overall turnover remains low. There may be further changes to be made though not least because we may have the opportunity (again) to tender our shares in Mobinil, the Egyptian telecoms company (news of this potential tender offer from Orange accounts for perhaps 0.9% of this month’s absolute performance).
I have no sympathy for Albert Camus’ philosophy or his violent politics but the observation and phraseology in his prose is often to the point. Whether we like it or not the Eurozone’s absurd monetary labyrinth is somewhere near the heart of financial markets at the moment, and the results are not something to be fought against. Whether central bank action can force us into some kind of queasy bull market at this stage remains to be seen. But it also reminds me of one pseudo-Heraclitian financial joke: what is the difference between a bull market and an irrational one? The bull market knows when to stop.
