I recently sat down with Wallace Forbes to discuss investing in China and other emerging markets—the interview is now up on Forbes.com. The text of the article follows below:
Using ETFs To Play China
Wallace Forbes 03.01.10, 5:00 PM ET
John Rutledge, founder and chairman of Rutledge Capital, discusses with Wallace Forbes investments in China and other emerging markets.
Rutledge: Needless to say, this is a tricky time for people trying to forecast the economy since there are so many policy changes in the wind. I think what we’ve got to realize is that last year, 2009, was really dominated by an undervalued or broken market that came back to life. In March 2009 we had the opportunity to buy a dollar of equities for 50 cents, and we captured most of that value by the end of the year.
The problem is that now we don’t still have a free lunch. We’re going to have to earn our money by finding things to buy that can actually generate profits and cash flow, and have rising values. To begin with, the global economy this year, like last year will be driven by China, which is responsible for more than half of the growth of the entire world economy.
What’s driving that growth is the reform and opening of China along with technology change that has allowed capital to flow very quickly into high return areas like China. Where the U.S. will grow by, say, 2% this year, China will grow by 10%. And over the next 10, 20, 30, 40, 50 years China will continue to have a dramatic growth advantage over the old economies in Western Europe and the U.S.
The way I like to look at equity investment is to use a metaphor from meteorology, which is really like the evening news covering today’s weather. We all know that when we see a storm on a weather map something’s going to happen. Storms take place when high and low pressure regions come together, and they make rain, snow, thunder, lightening, tornados and hurricanes. In economics the equivalent situation takes place when high and low return capital comes together, and investors take advantage of that gap to redeploy their assets from low to high return situations.
I use that metaphor to invest a pool of capital in Switzerland, and on my weather map we have three storm systems. One is the end of the credit crunch. Very clearly the financial markets now are coming back to life, and the blackout that happened in the credit markets is ending.
That means it’s late to make money by owning banks and financial stocks. The one exception to that I would make is that I’m very interested in the Blackstone Group. That’s because in the private-equality business the general partner, which is Blackstone, makes almost all of its money for the decade in the two years following the end of a credit crunch. When companies’ trailing histories show low profits, their owners are impatient in waiting for a sale.
Their creditors are forcing sales, but the prospects going forward look good and banks are again beginning to make leverage loans available. I think Blackstone at today’s price of about $14 is vastly undervalued compared to where it will be in a year or two year’s time. Plus, it has a dividend yield of 8.7%. So I have a sizeable whack of money today invested in Blackstone and the leveraged buyout or private-equity sector.
A second storm system, to use my initial analogy, is the growth of emerging markets led by China. The trick there is that Chinese property rights, audits, financial statements, courts are all very weak. So if you want to gather in the value created by the growth of China, which is really the only top-line growth happening in the world over the next 10 years, you’re going to have to do it by investing in somebody that makes money from China but whose governance is located in a safer place.
There are several examples of that. The typical one people talk about is FXI, which is the exchange-traded fund for the Shanghai stock market. It is not bad. It’s actually invested in Chinese companies. But when China grows, it buys its technology from North Asia, especially Korea, and Japan, and Taiwan.
China buys its natural resources from South Asia, in particular Australia, New Zealand, Indonesia, Malaysia. And it buys its money by going to the capital markets increasingly from Hong Kong and Singapore. And so this is one way to play these dynamics.
Forbes: Interesting combination.
Rutledge: Absolutely. There is one stock that captures four of those markets. The ticker is EPP. It is the collection of the stock markets of Australia, New Zealand, Hong Kong and Singapore. And within Australia you have coal and natural gas. The same with New Zealand: You have the capital markets in Hong Kong and Singapore, both of which have been rated as more open and free economies with easier business conditions than the United States.
Forbes: Now this is an ETF that trades on the New York Stock Exchange?
Rutledge: It is. The ticker is EPP. There’s a second one that captures the bulk of China’s IT and communications technology needs which is the Korean ETF, EWY. The largest company in that ETF is Samsung. And Samsung is responsible for something like half of all of the mobile phone technology finding its way into China.
For people who don’t like ETFs but like a little more bravado in their portfolios, the most interesting one to me right now is Freeport McMoran. That stock has been weak recently because they’ve had an issue with a government permit in Indonesia. But Freeport McMoran produces gold and is also is a very dominant producer of copper.
When China grows, it does infrastructure spending in real estate. There are 150 million migrant workers in China, all on scaffolds. The government there is very interested in keeping them on the scaffolds and off the streets. And when they build buildings, of course, they use copper.
At the moment, many, many more buildings have been started than have been completed over the last 6 to 12 months. So, there’s going to be a surge in copper demand from China happening in the next six months, which I think will show up in the price of FCX.
That stock is currently trading in the market at about $74. The trailing 12-month price-earnings ratio is 12.9. The dividend yield is just under 1%. But earnings, which were $5.86 last year, this year look like they’re going to approach $8, and next year $9, almost all of which comes from the increase in copper prices that happened over the last year.
Forbes: That’s a fascinating set of items to be suggesting, John, as always. We go from Blackstone to a couple of specialized ETFs in the Far East and then down to Freeport as a single way to play that opportunity, or at least as a driving force in it. John, that’s terrific. I appreciate your taking the time to share your thoughts with us.
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Yesterday, 
OnlineSchools.org posted an article called “100 Best Twitter Feeds for Your Financial Intelligence.” The article highlights the many Twitter feeds out there that discuss finance, economics, business, entrepreneurship and other financial-minded topics, and provides a list of their top 100 picks to get you started. And out of the 100 chosen, John’s feed (@johnrutledge) made the list! Check out the article to find other great financial Twitter Thinkers to follow and to see their description of John’s feed!
You can now listen to one of John’s recent speeches online! Check out the audio of John’s March 11, 2009 speech at UC Berkeley’s Information School by downloading the file or listening to it through your browser.
Titled “Lessons from a Road Warrior,” his speech delves deeper into the science behind his Thermo-Economics framework and talks about how that framework, in conjunction with other fields such as network theory and neuropsychology, relate to today’s economy. The mp3 file contains the full speech and following Q&A period, and runs about 1 hour and 22 minutes long.
For additional media files, you can also visit our Press Materials page in the Resources section. You can also read more about Berkeley’s Information School and the groundbreaking research they’re doing there at their website.
When people asked Leonardo da Vinci the secret of his creative and inventing genius, he replied “Saper Vedere,” to know how to see. Our objective is to help people see the link between government policy, capital formation, and growth, then help them see strategies for growing their businesses, increasing the value of their investments, and improving their economic lives.
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Expand All: How We Think
Thirty years of traveling the world have convinced me that growth is the answer. Economic growth is the only reliable engine for lifting people out of poverty and improving their lives. Access to capital, along with the people’s focused productive energies, are the principal drivers of growth.
Capital comes in many forms; modern equipment, efficient factories, new technologies, high-speed communications networks, and improved education. All represent the stored energy of previous generations of investors, innovators, entrepreneurs, and workers. All make workers more productive, increase output, and provide the resources for people to achieve their economic, personal, and social goals. Incentives for creating capital and for the productive use of energy are the keys to increased growth.
As a young economist I taught graduate and undergraduate students in macroeconomics, monetary theory, international trade and finance, and econometrics. Like other academics, I taught students how to build and manipulate all the textbook models of economic behavior. I did so for three reasons. The models were mathematically elegant, which made them both beautiful and easy to teach. Publishing journal articles about them was the key to advancement in the profession. And, having never set foot in the real world, it was all I knew how to do. Later I ventured into the real world where I learned the models were not always up to the task of helping policy makers, business managers, and investors understand change. While keeping my healthy respect for the limitations of economic models, my colleagues and I developed a framework of our own to guide our thinking. That framework-which is, of course, a permanent work in progress—underlies all of our work.
The first pillar of our thinking is also the simplest: Stuff Matters. No macroeconomic analysis is complete without accounting for people’s multi-trillion dollar holdings of Stuff. Stuff describes the items on our balance sheets, including tangible assets (land, office buildings, collectibles, used cars, and other claims on future services), financial assets (stocks, bonds, bank accounts, and other claims on future cash flow), and all forms of liabilities (credit card debt, mortgages, and the obligation to service and repay the national debt).
Analyzing the income statement alone, i.e., GDP and its components, is just not good enough. That’s because there is so much stuff out there. This year US GDP will be just over $11 trillion, compared with total assets (not including more than 700 million acres of government-owned land) worth more than $120 trillion at market value.
Stuff matters because the values of the individual items on our balance sheets determine our net worth, and our solvency, collateralize our obligations, and influence our behavior. Those values are set in markets based on the relative risks and after-tax returns of different assets and liabilities. Government policies that result in abrupt changes in relative risks and returns induce massive responses from private investors. These responses are the most important channels of economic and financial change.
In the late 1970′s, for example, rising inflation added an artificial capital gains component to the return on tangible assets, while rising income tax rates artificially depressed the after-tax returns on financial assets. The resulting shift of investor demands drove a boom in hard asset prices and destroyed three-quarters of the real value of the stock market.
As a second example, the 1981 Reagan policies of falling inflation and falling tax rates reversed this shift by boosting financial asset returns relative to returns on tangible assets. This led to a decade of restructuring in US industry, and to an eighteen year bull market in bonds and stocks which triggered a huge wave of investing in the 1990′s.
As a third example, the 1996 Telecom Act artificially subsidized the returns of some communications companies–cable operators and CLECs (Competitive Local Exchange Carriers, such as MCI and AT&T)-at the expense of the regional Bell operating companies. The resulting wedge driven between their respective returns on capital led to massive overinvestment in the former, and to a multi- trillion dollar loss of market value for the latter, and contributed to both the stock market bubble of the late 1990′s and the severe recession since then.
Shift happens internationally too. The opening of China to foreign investors has exposed the gap between Chinese returns and ours. The result has been a massive flow of capital out of the US , the EU, and Japan and into China , millions of unemployed manufacturing workers, and growing trade tensions.
Our valuation approach is simple. Investors own securities for one reason-to get paid. Stocks and bonds are simply claims on the future cash flow generated by the underlying assets. The present value of those future free cash flow streams is the Intrinsic Value of the securities.
Intrinsic Value estimates will only be as good as the estimates of the value drivers for the underlying business–sales, price, cost, margins, tax rates, capital requirements, and cost of capital-behind the calculations. These value drivers are strongly influenced by government policies.
From time to time the interactions of buyers and sellers in the asset markets result in market prices which we find to be significantly above or below the Intrinsic Value of the securities. That’s when stocks or bonds are over-valued or under-valued. Investors who consistently buy securities when they are undervalued, and/or sell securities when they are over-valued, will earn a higher-than-market return.
For a more detailed discussion, see Tracking Value.
Intrinsic Risk
Risk does not mean volatility; risk means losing your money. That happens when a business fails to deliver the operating performance embodied in the price an investor paid to acquire it. We call this Intrinsic Risk, and we measure it by explicitly estimating the probability the Value Drivers that underlie a market price fail to deliver the implied free cash flow stream.
