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.
Stand back, we are about to export my thermo-economics investment framework to India. There is a review of my book Lessons from a Road Warrior in the April issue of The Analyst, the finance journal of Icfai University Press in Hyderabad, India in which I have published several articles. The reviewer did a very careful job capturing both the substance and the flavor of the book and was more kind than an author deserves. You can read the review by clicking here.
PS: We are working on a Chinese translation to be released in China later this year.
This morning I woke up in the dark to do a 7AM spot with Alexis on Fox Business Money for Breakfast. Our topic was Geithner’s first trip to Beijing to meet with the Chinese officials on U.S./China economic issues. What issues would be on the table?
That’s easy. They want to know what the U.S. is going to do to protect their $2 trillion in U.S. Treasuries and other dollar-denominated securities from inflation and a falling dollar. Doogie is going to try to convince them that we have it all under control—we will get that deficit down soon as the economy starts to grow again. They won’t buy it.
A few weeks ago I received a request for a private meeting with Vice Premier Zeng Peiyan to discuss economic issues between our countries. He was most eager to understand two things. First, why was the U.S. government spending so much money on the stimulus packages. (China’s stimulus package was not as big as advertized, mainly accelerated infrastructure projects that were already in the budget.) Second, why was the Federal Reserve flooding the market with dollars? Bank reserves in the U.S. have increased from $85 billion one year ago to roughly $1000 billion today.
I explained that the crisis first became visible in June 2007 when banks revealed they were holding some $300 billion of toxic (covenant-light) leveraged loans. From then until August, 2008 the Fed talked stimulus but walked tight money–bank reserves grew only 1% during this period–because the Fed acted to sterilize the impact of their newly-announced liquidity measures (Bear Stearns, AIG,…) by selling Treasury bills from their portfolio (idiots!). But in September, after the near run on money market funds, after depositors began to take money out of their banks in earnest, and after Lehmann died the Fed panicked and started shoveling reserves into the banking system, which is why reserves have increased 10x in 8 months.
Explaining the budget explosion was not so easy. Some economists in Washington actually believe that increasing government spending raises GDP growth like it says in the textbooks. (I am not one of those economists.) But most of the spending increase was the result of Hank Paulson’s ($700 billion) power grab last fall and the change in administrations that allowed the Obama team to come in and take advantage of the crisis by adding every program they have ever dreamed of to the Federal budget. As a consequence, Obama’s first (2010) budget will spend $1.8 trillion more than revenues and the CBO projects deficits of roughly $1 trillion per year, basically forever. (And the budget does not yet include national healthcare!)
To a holder of $2 trillion in U.S. securities all this isn’t the best news. He then asked a third question: what can china do to protect the value of its assets from U.S. inflation and a falling dollar? I told him that if I were in his shoes I would have a quiet conversation with Geithner and arrange a private transaction in which he would swap all his Treasury holdings for inflation-protected Treasuries, or TIPS.
I wonder what they are talking about at the meetings in Beijing today?
The credit crisis is all you hear about from officials in Washington and from talking heads on TV. Indeed, the credit shortage is still alive and well. Employment is still falling and small business owners–the only real source of new jobs–have an even tougher time getting working capital loans from banks than they did 2 months ago before bankers fell in love with the new government bailout plans. But it’s time for investors to move on to the next story.
The credit crisis is ending. The wall of money created by the Federal Reserve to extinguish the credit crunch and deflation that they, themselves, had created has rigged the deck so banks will make money. The banking system today is being run as a de facto monopoly bank by the Fed. The Fed is paying them interest on reserves, which at $990 billion are roughly ten times the level they were just eight months ago. Over the same period, bank depositors withdrew roughly $90 billion from their bank accounts to keep at home just in case their bank failed. As I pointed out in a post yesterday, there are signs people are beginning to exhale–currency holdings are no longer rising. When they once again feel safe they will put that $90 billion bank into their accounts, which will swell bank reserves by the same amount from 10x to 11x times last August levels.
This tsunami of reserves since last September translates into bank profits at no risk. The Fed pays the same 0.25% interest on bank reserves whether the bank lends the money to customers or not. How much? One quarter percent of the $1 trillion reserve increase equals $2.75 billion per year in incremental bank earnings. The spread between deposit rates–effectively zero–and lending rates, including fees is huge. And the FASB accounting rule change at the end of the first quarter that allowed boards of directors the leeway to value assets based upon their expected cash flow rather than firm quotes from dealers was a huge boost to bank balance sheets. That’s why bank stocks have knocked the lights out since then. And those reasons are why bank stocks have been the biggest bet in my portfolio this quarter with returns 17% over the market so far this year.
Now it’s time to change the bet gain. I still have big bets on bank and financial stocks but have been increasing my exposure to two other bets, China and inflation. Both bets have been working nicely.
My visits with Chinese leaders and Asian CEOs at the BOAO Forum in April convinced me that we were going to see a long string of positive growth surprises from China and its main suppliers around the Pacific Rim–Singapore, Hong Kong, Australia and Indonesia.
The inflation bet is still early. But the recent run of commodity prices and weakness of the dollar suggest it is not too early. Once the credit crunch and recession are off the front page people are going to focus more and more on two factors. First, the Fed tsunami of bank reserves will sooner or later translate into rising price levels. If the Fed allowed the reserves it has already created to remain in the market after the crisis is over the U.S. price level would rise to about 9x its current level over a small number of years, i.e., the $3 vanilla latte you bought at Starbucks today is going to cost you $30–you better start saving your money. Of course, the U.S. political system will not allow a nine-fold increase in the price level so sooner or later the Fed is going to have to take steps to reduce bank reserves. Hint: the same guys who brought you the current disaster are going to be the ones who will be in charge of shrinking reserves. This is not going to be elegant.
The other reason, of course, is that government spending is completely out of control. Ever since last fall when Treas. Secretary Paulson convinced Congress to give him $700 billion to spend however the hell he wanted with no controls or oversight the barn door has been open. Obama’s team has pushed trillions of dollars of new spending through that door in the space of a few months. The result is the $3.5 trillion budget Obama proudly presented to Congress. That budget projects budget shortfalls of roughly $1 trillion per year for the next decade. And that does not even include the added cost of his new national healthcare system.
Those huge spending numbers, of course, mean that Congress will soon increase every tax rate in the book including taxes on ordinary income, dividend income and capital gains as well as higher corporate taxes. We can also expect increased excise taxes on tobacco, liquor, and energy of a forms. Last week the White House also floated the idea of adding a national sales tax–they call it a value added tax–that would be a huge increase on working families. The problem is these tax rate increases are not going to generate much revenue–they never do–because people can easily avoid them by either using tax shelters or by simply deferring or avoiding the realization of income. Over the past 6 decades tax rates have varied all over the map but tax revenues, the amount people actually pay, has been 19% of GDP +/= one percent.
If spending is out of control and the government can’t raise more tax revenue we are going to have massive budget , or budget deficits, shortfalls every year. The Treasury is going to have to sell truckloads of new Tbills and bonds into the market every year as well as roll over the ones already out there. That is the scenario that is now beginning to spook the bond and currency markets. Big bank reserve growth, big spending increases and big budget deficits mean the market is being floods with dollar assets, which has to drive down the value of all assets denominated in dollars. That’s why the long Treasury bond yield has increased by more than 100 basis points, or one full percentage point, in recent weeks. And the dollar is posting new lows against both the Euro and the pound. And that’s why the vice Premier of China asked me last month if there was a way China could protect its $2 trillion Tbill portfolio against inflation and a falling dollar.
Faster growth in China and higher inflation point you in the same direction–commodity stocks. I have been increasing my exposure to oil (STO), coal (BHP) and copper and metals (FCX). I expect to add more to these positions next week.
It has been a long time since we needed to worry about the impact of budget deficits on interest rates. But now we do. The best analysis I have done on the topic is Chapter 4 of my book Lessons from a Road Warrior. Over the next few days I will write a series of blogs to help readers think through the issue.
China’s energy supplies are heavily concentrated in coal, which is one reason so much effort is being expended to clean up the air and water and devise cleaner energy sources. The Chart below, taken from a McKinsey report, China’s green opportunity, suggests that China’s policies can do a lot to mitigate the problems in coming years. Very optimistic report.
Which reminds me. On Forbes on Fox tomorrow morning (10:20 EST) we have a spirited debate about the impact of green policies on the economy. I take the position that the proposed cap and trade legislation is a massive tax on working people and would have a very negative impact on growth. At the end of the day our living standard will be exactly as high as the amount of work that is performed int he economy. That includes work done by people, work done by current sunlight (agriculture and solar power), and work done by transforming stored solar energy (oil, gas, coal, uranium) into goods and services.
(May 16, 2009) In spite of what many people think, entrepreneurs don’t only happen in America. They happen everywhere people want to build a better life—in China, in India, in Colombia and in Brazil. And as I keep reporting week after week from our Fox Business Saturday show, there are tons of entrepreneurs in America too. Entrepreneurs are the source of the energy that makes the world grow and keeps living standards rising.
America is the richest, freest country in the world. We need to make sure we nurture and grow entrepreneurs and small businesses in America if we want to stay that way. That’s why I make such loud noises on TV when politicians do thing–taxes, regulations, mandates–to make it harder for people to start and grow businesses.
I Just received an email from my good friend Ed Hotard who is in China this week. Ed divides his time between Beijing and Houston–his travel schedule makes me look like a homebody.
Ed is in Kunming participating in the Annual Entrepreneur Forum to make a speech on how entrepreneurs are dealing with the financial crisis and to discuss policy actions China can take to help people start and grow businesses. Ed wrote to tell me there are 1200 entrepreneurs at the meeting, from CEOs of start-ups to Liu of Lenovo and Zhang Ruimin of Haier. Ed says the energy in the room is extraordinary.