Monday, March 22, 2010


Aside from grazing the subject in previous posts, I have refrained from directly addressing China and the inherent economic issues. We are by no means experts on China, and the implication of Chinese economic policy is not usually a factor in building our client portfolios. However, the macroeconomic (big issues) world we live in today, requires more thought on subjects like this than at any other time since we started managing investments. We have also been asked our opinion on China in many conversations with investors and friends. So here is my opinion, and I will try to keep this within the specific context of our investment principles. There are many issues that contribute to a well rounded analysis, but my focus here is on that of price.

The Divinity of Price

Our investment strategy, focused on EVA-producing businesses, favors markets that are generally unencumbered and free to translate value through price. The goods and services of the businesses we invest in should be priced to reflect the inputs of labor, capital investment (that includes the cost of capital), and any value that a business creates in excess of these inputs. That extra value is known to us as economic profit and is what ultimately drives capital allocation in the market. Investors will seek out those businesses that consistently deliver economic profit. Equally important is that investors abandon those that destroy value.

Of course, there are factors that interfere with an efficient pricing mechanism, such as uncertainty over changing tax policy and regulation, among many others. For the most part, however, the capital market allows for value-creators to be rewarded and value-destroyers to be punished. It differentiates the good and bad stuff, allowing for both success and failure. Obviously I could launch into a discussion here of the consequences of the bank and auto bailouts of 2008 and how that doesn’t fit this model at all, but I’m trying to stick to the subject here. We clearly understand and are troubled that free-market principles are quickly abandoned when the going gets tough. Stock market returns over the past 15 years and, in turn, our investment returns have been, at times, driven by the forces of market manipulation and intervention.

So, very simply, anytime a pricing mechanism is controlled or distorted, the ability to correctly translate value breaks down entirely. The history of global trade and economics is full of pricing distortions. The driving force is always political and self-serving. So let’s be clear about our politics. The U.S. is a market-based, democratic country legislated by Democrats, Republicans, and a few Libertarians, while China is a centrally-planned economy with a single party government run by the Communist Party of China (CPC).

I don’t have to go much further for you to understand my point, but it should be abundantly clear that the two ideologies approach economics and markets from very different points of view. However, tinkering with market prices is tempting for both. International trade utilizes a natural pricing mechanism in currency exchange rates. Those rates are meant to translate the value of inputs from one economy to the other. China’s policy of a fixed peg of the Renminbi to the dollar is simply a price control. Price controls obstruct free markets. China creates seemingly endless GDP growth, yet without a real price, they likely destroy value and hide losses.

The Yin Grows

Why do the Chinese engage in such overt market manipulation? Some might argue that the Chinese have gone a long way to accepting market principles. I just want to get right at the core of the issue here, knowing we can rationalize or qualify this endlessly. The Chinese are, by definition, Communists. The CPC explicitly uses Marxism as one of its guiding principles. After all, Marx literally wrote the book on communism. In the Communist Manifesto there are statements that reject free trade and free markets. Marx also recognized that capitalism does not tolerate over-capacity. Persistent over-capacity drives returns below the cost of capital to the point of loss. Capitalism and free markets thrive on allowing failure so capital is redirected away from non-productive uses. China is the poster child of over-capacity in today’s world, building vacant cities in anticipation of future growth (Read this article in FT about Chenggong. See this video about Ordos City).

The wealth of the working class in China is suppressed and controlled by an overwhelmingly dominant single party political system, for the (supposed) eventual benefit of the whole. In the short-term, the benefits are disproportionately endowed on exporting industries and state-owned enterprises. The working class absorbs the short-term economic loss for the benefit of increasing total employment. By pressing continually on with investment in more and more capacity, China slowly transfers the means of production away from other countries. On the global stage, this is a power play, leveraging off an economic model of large trade surpluses to gain economic influence in the world.

The Yang Shrinks

The U.S. fell into the trap, with little pause or consideration of the consequences. Lured by a price too good to pass up, the U.S. has repeatedly justified manufacturing and consumption decisions. We fooled ourselves, living in an economy where price supposedly reflects value and aggregates all inputs, we rationalized that China just has access to more resources, more people, enjoying comparative advantages. With unemployment at low levels in the U.S. for many years, largely because asset prices and lending were supported by loose monetary policy, we hardly noticed the growing consequences. (Thanks to our own price fixers at the Federal Reserve – for a better look at that I recommend reading William Fleckenstein’s book “Greenspan’s Bubbles”).

Here we sit with 17% under/unemployment, structurally impaired from years of misallocated capital. Small businesses have little access to capital and banks are not increasing lending. Consumers have pulled back and everyone is yelling about deficits and healthcare. (By the way, the next great misallocation of capital is well underway in healthcare. It is by far the fastest growing component of consumption expenditures AND employment). I am at least encouraged that the political debate in this country is raging. People are paying attention. The fix may well be in on our side of the equation, with much work left to be done.

Yin Must Equal Yang

Welcome to the consequence phase. Too little too late for debate on the subject of currency manipulation, in my mind. The die is cast and we now find ourselves at the end of the debt rope. In order to run persistent trade deficits while maintaining high levels of employment, we have been borrowing in the pursuit of prosperity. How convenient for the Chinese to have been the natural source for much of that credit. Not convenient at all really. It is by design. They seem to have bought into the story as well. As hedge fund manager Hugh Hendry describes it, it’s as if Bernie Madoff was in charge of U.S. GDP accounting and China was the largest investor. The worst thing then for China is a derailment of the U.S. growth story as promised, especially in the form of a banking crisis. As the U.S. hits the debt ceiling, no longer able to borrow excessively as markets deny a further misallocation of capital, growth is short-circuited. China (and other surplus countries like Germany in Europe) must naturally face the consequences as well.

Bubble Hunting

Is China a bubble? I’ve read many who think so, such as Jim Chanos and Hugh Hendry, and they sound very compelling (read Chanos’ thoughts, read Hendry’s thoughts). But I don’t analyze China for investment purposes, have never been there, and I don’t have good insight on the numbers. What I can say, is that manipulating price prevents the market from purging losses. This type of price fixing is meant to rig a country for GDP growth and employment, not value creation. That is similar to how we ended up with the Dot Com and housing bubbles, as the price of money was set by the Federal Reserve to prevent the loss of jobs and GDP growth. In the end, we destroyed value, eventually reflected in falling asset prices. If China is in a bubble of some kind, without free market mechanisms, they may well blow hot air longer than we expect.

China Is As China Does

Financial headlines are ablaze that China must float the Renminbi now. No one seemed to care much until it all went wrong. It’s gone wrong, but there is no value in blaming China. We have been willing participants believing that prices reflected value. Now we confront the circumstances of having reached our borrowing limits and looking for retribution. Retribution, according to many in Congress, comes in the form of trade barriers. So, in essence, instead of manipulating price, we suspend pricing entirely. Let’s only hope this stays within the bounds of a diplomatic resolution. (Follow this link to find Taiwan on Google Maps).

My belief is that China holds the Renminbi peg (or close to it) beyond any pressure applied from the U.S. That circumstance will only serve to enforce the necessary process of deleveraging and the incipient deflationary forces in the U.S. With or without trade barriers, the U.S. must reign in debt and start saving more. Any radical adjustments in policy at this point would likely spark greater uncertainty and exacerbate that process.

This continues to favor our aversion to general equity market risk and keeps us close to “dollar” assets. Within equities, that requires larger holdings in defensive stocks such as consumer staples and very select utilities that pay above market dividend yields. We have continued to hold the high quality corporate bonds we purchased in late 2008 and early 2009. We also hold a fairly high cash position that protects against adverse market reactions. It also gives us flexibility to exploit investment opportunities that will be present as market volatility is likely to continue.

Fighting Words?

One last, rather well known quote from Communism’s founding father. Whether this is relevant or perhaps even prophetic, we might need to reconcile what it means in today’s world.

Freeman and slave, patrician and plebian, lord and serf, guild-master and journeyman, in a word, oppressor and oppressed, stood in constant opposition to one another, carried on an uninterrupted, now hidden, now open fight, a fight that each time ended, either in a revolutionary reconstitution of society at large, or in the common ruin of the contending classes.”

-Karl Marx, The Communist Manifesto, 1848

Consider this as the China story continues to unfold on the global stage.

Peter J. Falker, CFA

March 22, 2010

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