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The Flip Side of Risk
11/29/2012 10:45 am EST
The flip side of risk is opportunity, and for deep value investors in a world wrapped up in global entropy, there are some interesting places of opportunity, notes Soo Chuen Tan of Discerene Value Advisors.
Gregg Early: I am here with Soo Chuen Tan, managing member of Discerene Value Advisors. Soo Chuen, I wanted to ask you since you have a broad global outlook and we've just come through some major elections, not only in the United States but also in Asia, with major economic powers like China and Japan, where you see the opportunity and where you see the risk at this point.
Soo Chuen Tan: It is an interesting question and it's also not an easy question to answer right now, because frankly I don't see a lot of truly compelling opportunities.
Starting with the US, I think that's a well-trodden path. We all know the structural issues that the country faces that are quite intractable and, it doesn't seem like there are readily apparent solutions to them. Whether it is the persistent budget deficits, the trade deficits, the high-debt-to-GDP ratios that keep climbing and then the fiscal cliff being a near-term issue, the issue is a little bit longer term, and a little bit more structural than that. You also have an aging population. You also have ever larger entitlement programs that will start kicking in as the population ages.
You have pretty serious issues here in the US and people tend to focus on near-term policy decisions. But the underlying issues are more problematic and more long-term than that.
Then if you move across the Atlantic and look at Europe, it's not too surprising that people are worried about what's happening there. Basically, Europe has very similar issues to the US The difference is institutionally Europe makes decisions at a different pace than the US primarily because of the way Europe is set up. So, the issues are the same, it's just the mechanisms for addressing those issues are a little bit more unwieldy and therefore, responses are a little bit less coordinated and that's a problem.
Now, the flip side of risk is always opportunity. For us, given we're deep value investors, we are quite contrarian in the way we invest. It's usually when things are perceived to be the darkest and the most pessimistic that we become most interested.
So in Europe ironically to most investors, we are most interested in the most dislocated parts of Europe. The perfect example being Greece.
There, the crisis, including quite dramatic scenarios of Greece leaving the euro, going to the drachma, etc., that's already built into the prices, so one can buy what we think are pretty decent assets often unleveraged, with very cash rich and asset rich balance sheets at truly shooting-fish-in-the-barrel valuations.
And again, this does not mean buying the entire Greek market, because if you try to buy the entire market in Greece, you end up buying a lot of banks that are radically under-capitalized. But if you are careful and go down the market cap you can find some quite interesting smaller companies in Greece that we think are good investments.
Gregg Early: I see this trend towards value as almost encouraging in and of itself because you have to have earnings that go along with prices and for a long time earnings have been the biggest issue for a lot of stocks and corporations, so, I guess as deep value investors there is something encouraging in the fact that there are actually stocks out there, especially in these economies that have been decimated, that actually have any value at all.
Soo Chuen Tan: As deep value investors we often look at earnings, what we call sustainable through-cycle earnings power of a company and that's not necessarily the earnings the company is making this specific year.
All companies go through cycles with times when they make more money, then times when they make less. Depending on the particular industries they are more or less cyclical, so not all of our Greek companies are profitable at this point of the cycle.
The common theme across these companies is that first, there is a reason for them to exist. They provide a service or product that through-cycle creates value for customers. Some companies are more resilient where the earnings are affected less, but valuation multiples compress dramatically because of fear and panic and so you get to buy these businesses at very low multiples of what you would call trough earnings.
On the other extreme, you have more deeply cyclical businesses that becomes unprofitable or starts losing money at the bottom of the cycle-and there are some industrial companies we own that fall into that category.
Here, the question becomes what's the through-cycle earnings power of this business? Does this business actually have a reason to exist?
Are you buying the assets of a particular industrial company at large discounts to replacement cost of those assets and are you sure those businesses won't go under because they are not leveraged or they have a lot of cash on the balance sheet that allows them to manage through a difficult time? Do they have good management teams that can manage the cash burden even in the worst economic recession in Greece perhaps that they have ever had?
In both cases, where a company's profitable and a company is not, the litmus test is that a company can survive and we get to buy them at large discounts to their intrinsic value.
Gregg Early: It's a fascinating concept.
Soo Chuen Tan: If we look to Asia, again we're covering another pretty well-trodden path, which is Asia increasingly dependent on China and has been increasing its trade dependence on China for the last decade.|pagebreak|
I grew up in Malaysia. If you go across the region, so much of the economies of these smaller Asian economies actually depend on China and that's an issue because as we all know, China is always a little bit of a black box.
It is still very much a command economy despite its liberalization over the last 20 years and so much of the economy still depends on government spending especially on construction and CAPEX items as opposed to consumer spending. That is really difficult to predict and really difficult to take to the bank, because who knows what the government will decide on spending, how much they want to invest in infrastructure, how much they want to invest in developing the Chinese hinterlands, and then how will they pay for it.
So it is really difficult to underwrite and very difficult to predict. It is difficult for an investor to really figure out what intrinsic value various businesses have if so much of the earnings power of those businesses depend on what a small group of people in Beijing may decide to do or not do.
As a result of that, Asia is a region that one needs to tread particularly carefully when trying to decide what to invest in.
A second area of concern that has become more discussed lately but has always been true is corporate governance and minority protection rights. These are the Chinese frauds that have been in the news lately, Indian frauds as well but if you go down the list across various Asian countries-whether it is Thailand, Malaysia, Philippines, Indonesia, Korea or any of these countries-you will find that minority protection rights as written into law aren't as well-defined as we have come to expect in the West. On top of that you have not just the law but the enforcement of the law, the legal system, the enforcement system is simply just not as developed.
If you layer on top of that the fact that so many of the companies that are publicly traded are run by first and second generation entrepreneurs that may or may not be used to western style shareholder capitalism, you run into all kinds of issues of trying to figure out whether in fact, as a minority shareholder, these public companies are run by guys looking out for your interest or not. And if they're not, what rights do you have, what basket of legal and political rights do you have to actually protect your rights. In practice, the answer to those questions are, not a lot.
That's kind of generally speaking of course. And investing, in the end, is in the particular not the general, and then Asia is quite heterogeneous. It is just not one region, but it is many different types of economies.
If you go through economy by economy, industry by industry and then company by company there are interesting investments, but there simply aren't that many.
Where I am most interested in today are some of the smaller domestic companies in Korea. Korea is an interesting little case study in what we have been talking about in Asia. In some ways the rights for the minority shareholders are still quite poor.
Financial protections are quite significantly under-developed. But in other ways, what is interesting about Korea is, it is probably among the economies in Asia where American style capitalism or shareholder capitalism has taken root.
What that means is you have a deeper bench of publicly traded companies that in fact are investable. If you go down this bench of companies, you do find once in a blue moon, management teams that run businesses the way that we think they ought to be run, that are conservative and careful and sober in the way they manage the business and they manage their capital and then we can invest with them at reasonable valuations at different points of the cycle; at points in the cycle where everyone is chasing growth in Indonesia, we look in Korea. When everyone wants to look in Korea, we look elsewhere.
Japan is the market that has always attracted value investors because of the balance sheets of companies there, but it is a difficult one for well-covered reasons. What's more, it's a business culture that is particularly difficult to penetrate as an outsider. Even though I am Asian, I am not Japanese, and therefore, it's quite difficult to really get to a point where we are comfortable enough to invest large chunks of money and to become long-term shareholders in some of these companies.
Of course from a macro perspective the issues that Japan faces are not that different from the US, just larger and longer. Japan went through its own bubble economy and in the aftermath of that, experiences an even more rapidly aging population, and a more intractable debt issue.
Much of Japanese sovereign debt is owned by their own population, but even so, there is a very large amount of debt outstanding and they have no particularly good solutions for addressing those issues in the long-term, so from a macro perspective Japan is a difficult place to invest as well.
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