Sunday, December 07, 2008

Under the Mattress or A New Mat?

What a year it has been! 2008 will go down into financial history as the worst collapse after the 1929-1932 crash.

About a year to six months coming into this, we at MOS have been forewarning of what is to come, with posts last May like Canaries in the Chinese Coal Mine, etc and This Time It is Different. In the latter, I almost shudder at how prescient we were in calling then that "every conceivable asset class that we know of, from real estate to infrastructure to commodities to junk bonds, are trading at steep valuations." This time is, indeed, very different; in that, there is no hiding place!

As this is no self praise exercise, we must confess that the extent of the deleveraging that followed had totally escaped us. Perhaps many investors would have wanted to take heed at our advice in February 2007 to pack up for a getaway to Phuket to enjoy the Andaman Sea breeze and sun instead. Whilst you would have missed the market roller coaster, your pocket will probably be lined with more cash these days.

And so the demi-god Warren Buffet was spot on again. The carnage left by what he famously labels as the "weapons of mass destruction", which took down one of the oldest bank on the Street, Lehman and left several other reeling for the count out, showed that many market participants were actually swimming naked as the tide washed out.

Daddy once warned us that it is liquor and leverage that destroys grown men. The banks have pulled the lines on businesses and individuals when credit was needed the most. No particular reference is intended but it is almost like the banker removing the umbrella when it starts to rain, isn't it? As a result, asset prices have tumbled. The CMBS and private real estate markets have frozen. The volatility index, VIX, is making new recent highs. Prices of several commodities like oil and copper have been trashed. Corporate bond yields have spiked out. US investment grade corporate debt have widened to record levels of more than 6% - spreads last seen during the Great Depression! (if the editor allows me to slip this in - these are levels which we find increasingly attractive).

In Singapore, you can find stocks trading at 2x historical earnings, while some trade way under book. A simple screen would indicate that the market is pricing them as being worth more dead than alive. By that I mean the shares are available for less than the net cash (net of total liabilities sometimes) on their balance sheet. So, such companies are better off being taken private and liquidated. Many of these are the much maligned S-Chips such as China Taisun who have fallen out of favour as liquidity was totally retrenched from the system. It is ironic that a lack of scrutiny of corporate balance sheets brought us to where we are. Investors had blindly piled into growth stocks. Debt was cheap then so we hailed firms with business models which promised growth and more. Alas, it turned out to be blind and misplaced faith. Yet today, this same investor is ignoring how cheap things have become - relative to what is available on the balance sheet.

REITs are yet another asset class which are offering some of the widest spreads I have witnessed in my investing career. Sure, some of them are trading on a cum rights basis and are factoring a downturn which necessitates the loss of tenants and rising vacancies, but a judicious investor can surely sieve out those unduly battered from the deserving.

Our regular readers, if there are any, know we spilled a fair amount of ink on these pages poking fun at those who bought into CapitaRetail China Trust in Jan 2007 when it traded at S$2.10. Today, the same REIT is available for about S$0.46. It is pretty much the same business except maybe without the visionary Pua who have gone on to bigger things. Granted that the land title system in China is not the most developed in the world (but it is inconceivable to me that things will not improve over time) and cap rates will increase, but the current price offers one nearly 50% to last appraised value. If you can get comfortable with its debt expiry profile, one is essentially enjoying a healthy yield with an option on rising Chinese middle class consumerism which these malls are aiming to tap. To us, that's almost like "Heads I win, tails I win too" - akin to holding a distorted call option with premium paid to us! This is certainly a proposition we much prefer over the put options which investment banks have insidiously made retail investors sell through structured notes so that Grandma can earn a paltry 1% spread in return for taking on the credit risk of hedge funds disguised as banks.

If we were to put all this witch hunting and crucifying aside and peer into our crystal ball, what do we see in the months ahead? In a market this volatile where writers can be made to look foolish almost within a day or two after publication, we can only venture our best guess.

Whilst we do not think the US will slip into the 1930s style depression, our base case still assumes that they pull out of their rut only gradually over the next few years. We have completely ruled out a V shaped global recovery. In fact, we think that there will be another few shoes to drop, particularly in Middle East. With oil prices back at around US$50 (which we think is undervalued!), the rapid rise of the Gulf States will surely be under tremendous pressure.

What worries us most is that the American policymakers are cornered. Rates cannot be lowered further without raising concerns of trapping the American economy in the Japanese style liquidity trap. But the swift and decisive steps to pump prime through fiscal policies - ie, printing greenbacks will surely help and sooth the frayed nerves. The fact that inflation will rear its ugly head when the dust settles appears to be besides the point now. Fortunately for the Americans, the world still lack options and the Chinese remain happy holding onto US IOUs even though a critical analysis of America's balance sheet leaves a lot to be desired. Perhaps the Chinese are trapped in a "chicken and egg" loop and they cannot afford for the American music to stop.

We are definitely sanguine about the long term prospects of China but unfortunately, the Middle Kingdom is but a nascent piece in the global economic jigsaw today. In a world where the American consumers are swiftly deleveraging - after spending a dollar fifty when they have only a buck in their pockets, there remains a fair bit of slack for the thrifty Chinese to pick up. After all, the Chinese like the Japanese have, in general, a habit of keeping money under the mattress rather than splurging on a fancy new mat. So, we see that the net effect on the global economy would be one of a gradual recovery.

We will write again when we have more to get off our chest or if we find some time to leave the candy store of value this market has presented to us. Until then, stay liquid but don't ignore the apparent values.




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9:19 PM  

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