Armageddon Off The Table?

Armageddon Off the Table?

It was reported recently that 2 new luxury flats in Hong Kong had been put on the market for a record per square foot price of HK$75,000 (US$9,640) as the buoyant economy and stock markets on the Chinese mainland had lifted demand for exclusive properties even beyond pre-crisis levels. Sun Hung Kai Properties, the world’s biggest developer by market value, now aims to sell the three-storey apartments – on the 91st to 93rd floors of twin 270m towers – for HK$300m each, HK$50m more than previously priced.

Singapore Property Price Index had risen so much so fast that in fact the government had to recently take steps to cool down the housing market.

The Standard & Poor’s 500 Index has had the biggest rally since the 1930s as it has climbed over 50 percent in six months; the Shanghai Stock Exchange Composite Index nearly doubled from November to July before pulling back last month and the Indian stock exchange has almost doubled from its lowest point this year.



On the other hand, Nuriel Roubini, the NY University professor also known as “Dr Doom” who in 2006 foretold the worst financial unraveling since the Great Depression wrote in the FT that, “There is a big risk of a double-dip recession,” He had earlier written in March that the advance was a “dead-cat bounce,”.

Interviewed recently by CNBC Roubini said "It's going to be death by a thousand cuts. The financial system is severely damaged, and it's not just the banks. The gap between supply and demand is so huge we could stop producing new homes for a year to get rid of all the inventory," he said.

So are we there yet or not – remember that during the decade-long Great Depression there were many stock rallies, including a 67% gain in the Dow in 1933. So is this what it is – a dead cat bounce, as Professor Roubini calls it?

Don’t know, but please see below the movement in BSE Sensex since Jan 2007 and its PE multiple:



What seems clear is that the Indian market is now back to where it was in August/ September of 2007. And just like those times, it is very difficult to find value in the prices – at 20+ x on PE, I am not sure if things are cheap anymore. There are other factors such as dividend yield and Price to Book which are giving the same message.

Fact is that we have heard a lot about the “green shoots”, but the way the markets have moved up, it seems everyone is already discounting that the green shoots will soon become large forests. To me, it seems that though some of the imbalances underlying the credit crisis are ebbing, others are persisting and new ones are being created by policymakers’ attempts to stimulate economies and markets. Everything is not yet hunky dory and to my mind atleast 2 issues remain:

1. US fiscal issues and related issues
2. Bubbles in emerging markets

On the US fiscal issues, I came across a nice statistic recently – one year after the collapse of Lehman Brothers set off a series of federal interventions, the government is the nation’s biggest lender, insurer, automaker and guarantor against risk for investors large and small.

Hence, the US government is financing 9 out of 10 new mortgages; if you buy a car from General Motors, you are buying from a company that is 60 percent owned by the government; if you take out a car loan or run up your credit card, the chances are good that the government is financing both your debt and that of your bank. And if you buy life insurance from the American International Group, you will be buying from a company that is almost 80 percent federally owned.

For much of the period since the Second World War, the dominant force in global demand has been consumption in the developed nations, with US consumers being the largest single block. The mirror of this was in Asian countries, which had low consumption but managed to expand their exports and built large FX reserves in the process.

However, the recent crisis had a dramatic effect in reducing these imbalances rapidly. The US trade deficit shrank from around –5% percent of GDP in early 2008, to –2.4% in early 2009. The household savings ratio fell close to zero during the boom as a result of easy credit, but rose steeply as the crisis intensified, reaching almost 4.5% in the early months of 2009, taking it halfway back to the level of around 9% that prevailed for three decades before Mr. Greenspan’s expansionary Fed policies. Will this remain at the same levels or will the consumption go back to earlier levels soon?

Can the Asian countries, faced with export declines of between a quarter to 50%, regain growth without relying on the (earlier) booming consumer markets like the US and boost domestic demand on their own? Can the developed economies of today manage to keep their banking systems stable and can its consumers reduce debt relative to income gradually rather than suddenly?

In 2007, the US accounted for about 30% of world con¬sumption while China accounted for 5.3%. It is being projected in some quarters that China will overtake the USA as the largest consumer market by 2020. By then, China is expected to account for 21% of global consumption, and the USA for 20%. The assumption is that this will result from a combination of China’s income growth, currency appreciation, demographics, in addition to the deleveraging effect among US consumers.

This view is widespread. Recently, Sir John Major, former Prime Minister of UK was asked as to which countries he thought will likely lead us out of this recession. His answer: China. Perhaps followed by other parts of South East Asia as well.

Are we relying too much on China – whose transparency in facts and figures are much in suspect? Are we at the cusp of a historic shift in consumption pattern from the developed to the developing nations? Is the market recovery too soon too fast? Are there bubbles forming – property/ stock prices etc, fueled by easy money availability?

I don’t know the answers to this and the many questions that are being asked. What I do know is that with price and value in reasonable balance, the future course of the markets will largely be determined by future economic developments that defy prediction. There are very few names that are compelling buys at this point in time.

On balance, I do think that while Armageddon may be off the table, better buying opportunities may lie ahead. Unfortunately I am sure there are many others like me (not to mention institutional funds) waiting to invest their monies at the hint of a fall. So either the fall has to be huge and dramatic, or else we just need to go back to being tactical in investments again and not look for the easy kills anymore. Time will provide the answer to that one. Meanwhile, my money is lying safe in my bank account. I hope.

Active or Passive Voice?

Active or Passive Voice?



We had once recommended a stock called Merck Limited on our blog. It seemed to be a value investor stock by all counts.

The cash flow of the company is reproduced below:



Looking at the last 5 year results, the company has made a good (and stable) profit and the average cash flow from operations works out to around Rs 93cr. – the last years cash flow fell because of higher inventories and receivables – a sign that the company probably tried to push its products at the end of the year. Nevertheless, a company with high cashflows.

Its dividend has been rising over the years – from Rs 2 per share in 1988 to Rs 20 per share in the 2007. However, in 2008 they did drop the dividend to Rs 17.5 per share to conserve cash, keeping the tough economic conditions in mind. Even at this reduced dividend, the dividend yield works out to around 4.5% on the CMP of Rs 398. Certainly, a situation where we are being paid to wait for the stock price to appreciate.

The company’s current market cap is around Rs 670cr, of which are Rs 330cr (as at the Dec’08 closing) was held as cash/ bank/ investments (not adding another 36-40cr in cash that they made till June’09). Hence, the market is valuing the company with an average cash flow of say 80-90cr a year at Rs 340cr (market cap of Rs 670cr less cash held of Rs 330cr). Say around 4-5 X of cash. That should be considered cheap.

Surely in the near term the prospects look tough given that around 50% or more of the company’s products are covered under the Drugs Price Control Order (DPCO), which means that to that extent they do not have the freedom to price their products (mostly vitamins). With input costs having gone up, this has meant reduced margins – which is showing in their recent performances. But thinking the contrarian way, Merck, being an MNC would like to introduce more products to get out of the DPCO’s grasp. And the company has been on the ‘prowl’ (as reported in a newspaper article in 2003) for an acquisition in the Indian market and has been conserving cash (almost 50% of their market cap) for that purpose.

But 2 years into my personal investment, lets relook at these assumptions: Merck (the parent company) has a 100% subsidiary through which it is reportedly introducing new products (this way they don’t have to share their profits with the minority shareholders). And why has the company not been able to find any acquisition target in India despite being on the ‘prowl’ for the last 6 years?

The market usually tires of waiting for a catalyst and that is true for Merck as well. But despite this, the price chart below shows that even during the period 2008- early 2009 when the markets went for a long holiday, the stock has actually done well to hold its own and didn’t fall by much. It has therefore served its purpose as a defensive stock when it was recommended in June 2008 (its market price then was around Rs 330 and hence has provided a 20%+ return).



But whereto from here?

Either we give up – admitting that it is unlikely to reach its expected value – which to me is atleast around double of its current market cap. Or else we wait.

But besides this, is there another choice? Should we just act as a Buy and Hold investor or try to be THE catalyst? That is the subject matter of this article.

Ronald D. Orol has covered this in a book called Extreme Value Hedging, wherein he has written on value investing v/s shareholders activism to catalyse value and about the pros and cons of the 2 styles.

He writes that Mohnish Pabrai, managing partner at Pabrai Investment Funds of Irvine, California, is a true value investor. Unlike activist investors, at no point will Pabrai engage or even seek to talk to the executives at the companies he allocates funds.

Executives at one company called him one day to see if he had any advice or ideas. Pabrai, an 18 percent investor in the corporation, says the call was a big mistake. "I have never made a phone call to any management of any of the companies I am an investor in," Pabrai says. "The way I see it, if they need my help, there is a problem."

In fact Pabrai questions whether activists, in their drive to raise the value of corporate shares, are actually improving the long-term businesses interests of their target companies.

Opportunity Partners' Phillip Goldstein (now runs a hedge fund called Bulldog Investors) takes issue with the idea that activists aren't contributing to the long-term viability of corporations. On the other hand, sometimes value investors infuriate activists with their passive approach. Goldstein says he once approached a value investor who held a substantial position in a company to see if that manager would support a possible proxy fight he was considering. Goldstein was contemplating a proxy contest to oust directors and pressure executives there to sell the business. The support of this particular value investor would go a long way toward putting sufficient pressure on the company's management. But without them, Goldstein says, he didn't believe he had enough leverage to sway the executives.

"I said to them that I believed the company was on a course for declining value and that it needed something to change its direction," Goldstein says. The value investment fund managers responded in a way Goldstein didn't expect. No decision would be made one way or another on a proxy contest until it happened. The manager was unable to tell Goldstein whether he would support his possible endeavor. "Do they even know why they own the stock?" Goldstein asked. "They want to stay aloof, but what they are doing is harming their investors."

Which approach is better? Goldstein says it's unfair to compare the profitability of the two approaches. It depends on a case-by-case, fund-by-fund analysis. Either can be successful or a failure in different instances, and when one strategy is successful, it often may be because it took advantage of the other strategy.

There are some definitive differences and similarities. While value investors, for the most part, quietly sit and wait for their investment to appreciate, activists must be successful at wooing other investors to support their efforts.

But unlike traditional value investors, activists will use their knowledge of the company's legal structure, their ability to file lawsuits, engage and negotiate with management, and launch proxy fights to provoke change and improve value. Insurgents argue that value investors must be careful not to fall in the value trap, that is, invest in a company they expect to appreciate in value within five years and find out five years later that because of management or external factors that company still remains intractably undervalued. (I am close to 2 years in my investment in Merck India.)

Zeke Ashton, founder of $50 million Dallas-based value fund Centaur Capital Partners, says a key difference between activists and value investors is temperament. "To be a successful activist investor, in many cases, takes a confrontational personality;' Ashton says. "It requires someone that will fight with management to accomplish certain goals."

Goldstein agrees that temperament is important to the approach. A successful activist can't get aggravated or lose sleep when faced with lawsuits or screaming CEOs. He adds that an activist must enjoy being the catalyst. "How much abuse can you take before you say this is not right?" Goldstein asks. "You can't be a shrinking violet and run for cover anytime somebody sues you; otherwise, you're going to get bullied."

Many traditional value managers will become reluctant activists if they become sufficiently aggravated about a particular situation. Even value investor extraordinaire Warren Buffett, arguably the most successful stock picker, has on occasion taken an activist tack. In a 2001 confer¬ence call, Buffett expressed his displeasure with real estate company Aegis Realty Inc.'s decision to buy P.O'B. Montgomery & Company, a Dallas-based shopping center developer, for $203 million. He also was involved in several quarrels with management of Berkshire Hathaway before he bought enough shares to take over the company in 1962.

Value investor Christopher H. Browne, managing director of Tweedy, Browne Company LLC, another firm that we think are amongst the true value investors, also grudgingly engages in reluctant activist efforts in some situations, when provoked.

On the other hand, Walter Schloss, (called a ‘superinvestor' by Warren Buffett) and a value investor about whom we had written in May’08, is truly of the old order. He likes to buy and wait, his usual holding period being 4 years. “Something will happen”, he likes to say.

In comparing value investors to activists, it is unclear whether the approach favored by Schloss, Pabrai, or Goldstein makes the most sense.

To me, the best investors are those that can adeptly engage in both value and activist strategies based on changing circumstances. Goldstein was once asked whether as a hedge fund manager he was more interested in the activism or in making money. His response: “I am out there to make money. The activism is the means to the end. “

I have to agree with that.

At my own end, I am clear that companies like Merck do not deserve to be listed on the stock market unless they can efficiently allocate capital. They need to either acquire a company at the right price (which I am sure would have been available a few months back when EVERYTHING was cheap) or distribute the cash as dividend. Or acquire the public shareholding by doing a buy-back. But surely something needs to be done.

While it can’t be me (I have a day job), I am hoping that just as in the cartoon someone will come out of the woods and insist (with a growl, I might add) that the management stops thinking that the company is their own backyard. The investors need their living room space too.

Till that happens, I am willing to wait – its not as if there are a lot of other investing opportunities right now in the Indian market and hence the opportunity cost is not high. All said and done, Merck continues to be a defensive bet even in the present market. And being a rationalizing person, I would think that I am still only at half of Schloss’s normal holding period. Maybe something WILL happen.