Show me the Money!

For a great many investors, perhaps “You had me at Emerging Markets!” would have been more appropriate, but the truth for so many is that profits and market performance have too often lagged economic growth.

As I have commented in previous posts, Governments have interfered with markets to create national champions that are spectacularly inefficient, at the same time they have often turned a blind eye to corruption that has drained profits into offshore banks, or the property markets of London, Dubai, and Miami.

I was reminded of this conundrum this week whilst talking to a potential client, who asked me about China, and the somewhat bearish views of Michael Pettis. The point he was taking from Mr. Pettis’s work was that mathematically Chinese growth has to slow down more than currently expected as the economy rebalances from an investment led model to a consumption led model. I think where I disagree with Mr. Pettis is probably only a matter of timing; I think it will take a few years longer to slow growth in investment, and that raises the spectre of more malinvestment accumulating that ultimately has to be written off.

I did, however, start to think a little harder about being wrong. What would it mean if investment did slow faster or consumption grew faster than expected? I kept coming back to the 3^rd Plenum last year.

Ironically, Mr. Pettis’s argument could imply a stronger case for investing in China, as it would mean that the reformers were gaining the upper hand and actually cutting the damage being done in and by the State Owned Enterprises. IF the big Chinese SOEs are forced to ration capital and raise the rates of return on investment that would have the perverse effect of raising profits as growth fell. Valuations could actually rise, given the increased transparency.  You might almost get a second wave in investment as FDI came in to take advantage of the new opportunities being opened up.

Sadly, as things stand today, this is just a pipe-dream.

China’s shadow banking system needs to be cleaned up properly first, and the authorities are still trying to hide the problems rather than deal with them.

Recently, a product sold through China’s biggest bank, ICBC, was restructured before it could go “bankrupt”.  The restructuring only involved taking a minimal haircut on interest, but left the principle intact. Given that the underlying company was entirely bankrupt, this is being interpreted as a Government bailout of some sort, even if one is not entirely sure which level of Government was involved. Needless to say, such a move is entirely at odds with the proposed reforms of the 3^rd Plenum, and raised the moral hazard within the Chinese banks significantly. Plus ça Change!

Elsewhere, I am hopeful about Mexico and their attempts to pass reforms. I got some great feed back from the presentation made by Pemex at a recent conference, and the very grounded nature of Senior Management. Everyone was contrasting them to Petrobras and how much more realistic Pemex seemed.

Mexico Sovereign Debt was recently upgraded to an A- rating by Moody’s because of the reforms passed last year that should “strengthen the country’s growth prospects and fiscal fundamentals”. The country was also a winner at the recent WEF meeting in Davos, getting material commitments for new investment.

One area where reforms are taking place, and where we are seeing earnings growth commensurate with economic growth is sub-Saharan Africa. It is an area that interests me greatly and I am looking to get more involved even though I have to eat platefuls of humble pie to say that.

I don’t wish to underplay the problems with these markets; they don’t even qualify as Emerging but are firmly in the pre-Emerging/ Frontier camp. They are often so inefficient that even a slight reform can have a huge difference.

My Nigerian friends swear about the poor service of MTN and the other cellphone providers, but they will follow that up by telling you how much better even that poor service is compared to what they had before, and how it has improved their lives. At the same time MTN has been able to realize, in hard currency, substantial profits, all because the Authorities let a South African company challenge a national monopoly.

It is not just in Nigeria that change is happening. Zambia has been creating a more business friendly environment since Kenneth Kaunda was replaced in 1991. The attached article from the Economist highlights one of the better-know success stories, Zambeef.

Renaissance Capital has just started its 5^th sub-Saharan investment conference in Lagos, and it looks to be a blowout. Merrill will shortly be holding their Sun City conference, which looks to be as popular as ever (it’s a great conference) but the side trips to Nigeria, Kenya etc. look like the real draw this year whereas they were not even available a few years ago.

When I was at business school, too many of my friends from these countries were desperate to get their money out. Now they are all talking about starting businesses and trying to get money in.

I would NOT recommend your average investor go out and fill their portfolio with Nigerian or Kenyan stocks, even if they were actually able to get access to them. I would, however, recommend following them in the newspapers rather than just skipping over them. If you look at say a Guinness or a Nestlé, don’t skip over any discussions of these Frontier markets, but read them carefully, because if you want to see the money, that’s where it is going to be.

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 A couple of interesting videos - I'll leave it to you to decide their relative merits