Tuesday, April 21, 2015

Week Ending 4/25/2015: The PLA is Coming

When discussing the H-shares market, "the PLA is coming (解放军来了)"  is a fun phrase being tossed around. One gets the image that Chinese money is amassing at the HK border, ready to "liberate" Hong Kong stocks. In reality, this pool of money will likely not only come from mainland China, but from the global investment community as well. In that case it might be more fitting to say  "the Eight Nation Alliance Army (八国联军) is coming". But of course, that ended up in a humiliating defeat for China, so "the PLA is coming" is a better phrase.

In my previous post, I mentioned that momentum and sentiment is in favor of the HK stock market, but did not elaborate much beyond the valuation discrepancies between A vs H shares. Here are some points to add on the liquidity/technical side (and signs that "PLA" is indeed amassing at the border)

  • People are literally smuggling money into HK
  • Talks of lowering the minimum account size for retail investor to participate in SH-HK Connect (current minimum is about ~80k USD)
  • New rules to contain A shares, such as making shares easier to short, signals the government's plan to further reduce limits of arbitrage.
  • Fund managers are forming Shanghai-HK connect funds to "go south" and take advantage of the A-H arbitrage
  • A separate Shenzhen to HK connect will start later this year.
We now have a great backdrop for HK stocks to appreciate. You already have cheap absolute valuation on various single names, and cheap relative valuation versus their A-share counterparts. But now a wave of liquidity is coming. Macroeconomics could surprise to the upside as well. Right now the China macro picture is rather conservative, dominated by talks of slower/quality growth, temporarily lower consumption due to corruption crackdowns..etc. But macro could surprise to the upside if policies start to work (loosening monetary policies, One Belt-One Road initiatives...etc) late this year.

That's much better than the U.S. picture, where you have a fully valued stock market pumped up by all time high margin debt and high 2016E expectations, all while corporate earnings are slowing.

There is another sign that capital is be amassing at HK. The USD:HKD exchange rate is at it's limits (see below). It's not impossible that one morning we wake up and found that HK decided to break its USD peg.


Recent Moves: Piling in. Let Liquidity Be a Catalyst.

I have piled into HK stocks. When the market spiked in early April, I promptly doubled down on my winners in HK, added a few more names and even bought 2 ETFs. Within the past 2 months, HK stocks went from 0% to 20%+ of my portfolio equity. That is a huge move by my standards, and I'm sitting a bit uneasy. It does not help that despite the big market run up, my profit is small due to subsequent adds at higher prices.

The work now shifts back to the fundamental side. At the end of the day, you still have to buy good companies at good prices. What this all means though, is that if I see a solid company at a reasonable prices, I'm willing to buy without any fundamental "catalyst" to unlock value. Liquidity could be its own catalyst.

ETFs:  2833.HK and CHXF 

I bought two ETFs to position for 1) A vs H share price discrepancy narrowing, 2) increased liquidity.

2833.HK is the Hang Seng Index ETF. It is way too heavy on financials and property for my taste.

To balance that out, I also hold CHXF (WisdomTree China Dividend ex-Financials Fund). This is a U.S. listed ETF that invests in H-shares but excludes the financials and properties sectors. Roughly 45% of holdings are dual listed stocks trading at steep discount to their A-share equivalents. More than 95% of holdings are eligible stocks under the SH-HK program. Average LTM P/E is in the low teens. This seem to me a less risky vehicle for the A-H valuation arbitrage.

Over the coming months my plan is to gradually replace these with single names as price discrepancies narrow.

Wednesday, April 8, 2015

Catching a Bull Market - And Chinese Toll Roads

"When I see a bubble forming I rush in to buy, adding fuel to the fire. That is not irrational." – George Soros

Soros didn’t say “when I see a bubble reaching its peak”. He says “when a bubble is forming” – basically this is just spotting a bull market. For that, learning to think like part of the crowd is a good skill to have. It could be as obvious as reading a front page article on The first paragraph basically points out that mainland bulls are heading south to Hong Kong. For those who don’t read Chinese here’s the Google translate: “Policy blowing warm air frequency , funds have to move south, the Hong Kong stock market ushered hot . Hong Kong stocks opened 1.72 percent higher this morning , nearly seven years since the financial crisis hit a new high , up nearly 3 percent midday break through 26,000 points…” English media echoes the sentiment

To confirm that Chinese mainland investors are looking south, I checked the Hang Seng China AH Premium Index. It is indeed retracing from an all-time high, with plenty of room to go!

To be more concrete, here’s a list of dual listed shares. The H-shares basically went through massive re-rating the past couple days, with some going up 20% or even 40%. Is this a real bull market forming? I don’t know, because yesterday’s price action are surely exaggerated by 1) limited supply, 2) H-shares coming off a long weekend while A-shares have ran up. But overall it seems that:

  • Even retail investors in the mainland are worried that A shares are overheated.
  • But the bull is still alive. Government appears to be easing policies (for example tweaking housing rules, lowering power tariffs…etc).
  • Hong Kong shares look cheap on relative basis (and often on absolute basis too).
  • Difficulty of shorting A shares, so Chinese investors more likely to buy H Shares as a relative value play instead.

In any case I still have to do the fundamental work, but knowing that momentum and sentiment tilts the odds in my favor does allow me to be a little more aggressive.

When looking for H-shares, it’s also useful to put them into 3 broad categories/levels with varying support from market technical:
  1. Dual listed shares under the Shanghai-HK Stock Connect scheme. 
    1. These are the most direct beneficiaries. The A share having a strong bid does indicate some level of pent-up demand for the H-shares. 
    2. Toll Roads look interesting: Shenzhen Expressway (548.HK), Sichuan Expressway (107.HK), Anhui Expressway (995.HK). I will discuss in the next section.
  2. H Share stocks with Shanghai-Hong Kong Stock Connect, but not dual listed.
    1. Should still benefit as well but not as much. 
    2. Beijing Enterprises Holdings is an example.
  3. H shares without Shanghai-HK connect. 
    1. These are indirect beneficiaries. But in the future there’s no reason why China wouldn’t open up the capital market further and expand the SH-HK connect to these stocks. 
    2. Investors will have to assume no lift from market technical and focus on the fundamentals. 
    3. Welling Holdings is one such stock I own. 

Exploring the Chinese Toll Roads

For the first category (dual listed shares which have maximum benefit from the bull market), the toll-roads look interesting. These are Shenzhen Expressway (548.HK), Sichuan Expressway (107.HK), Anhui Expressway (995.HK).

The A vs H-share premiums are anywhere from 54% to 106%, providing some basis for H-shares prices to increase. They all pay good dividends. Valuation is cosmetically cheap on (9-12x area on P/E basis). I’m not sure traditional valuation metrics are valid here because toll road concessions are not perpetual – they have finite end dates. But in a bull market, my guess is people will just look at low P/E, high dividend yield, big discount to A-share and bid up the stocks.

Some qualitative considerations:

  • Low oil prices will encourage driving.
  • China’s auto sales have been on a tear the past few years and that should increase traffic on the roads.
  • Toll roads are relatively be defensive –stable cash flows and all.
  • Great visibility – traffic data are available month on the internet
  • There’s a theory out there that toll roads could become local government platforms for financing & investments. Some reports invoke vague notions of SOE reform & asset injections. I’m not sure these are necessarily good things, but if the market is finding reasons to get bulled up about the sector, I’m not going to argue.
  • The worst policy issues could be over, as some of the tariff cuts already happened. (see the risk section)
  • We now have discussion on increasing tariffs. 1) There’s a government draft out there that could lead to extension of toll periods. 2) Guandong is exploring new pricing policies that will likely increase tolls. This could serve as a model for other provinces.

Risks & Why are they cheap
  • Again, traditional valuation metrics may not be reflective of value because of limited concession periods. If you were to value these using a DCF, there would be no “terminal values”.
  • Share prices would collapse if talks of tariff increases turn to tariff cuts.
  • Government has a history of arbitrarily one-off tariff cuts in response to populist demand. These have plagued the industry the past few years.
    • Examples include toll-free policies during national holidays, waviing toll fees of fresh farm products (“绿色通道政策”)…etc.
  • Periodic public backlash against high tolls.
    • Could even lead to charges of “corruption”, which seems to be a very loosely defined term in China. Whatever the definition, to me the risk is high level management gets detained in some secret dungeon, get interrogated by the police, while the company collapses. 
    • Op-eds like this make that sentiment clear.
  • Development of alternative infrastructure (railroads, competing roads…etc) would siphon away traffic. 
  • “Diworsification” (for example Anhui Expressway owns a pawn business that charges 4% per month for car loans. You would think if a toll road company wants to go into the lending business they’d buy a bank. I guess not.)

I still think the upside is more than the downside because some of these issues sounds worse than they actually are. For example if tariff cuts happen, revenue would decline but probably not that much, as the traffic volumes are for the most part fairly stable. Then dividends would help recover some of your potential losses (although I’m more likely to cut my losses fast instead of waiting for dividends).

These are probably not the best investments in the world. As far as spotting a bubble and rushing into it though, they could have a lot of upside. I will allocate a small amount, and be quick to cut losses if things don’t work out.

*** the market is popping as I write this!!   BUY BUY BUY BUY BUY!

Monday, April 6, 2015

Using Leverage to Reduce Currency Risk?

Sounds weird that leverage could reduce any sort of risk. But in the context of currency risk when investing internationally, I believe you can.

At least that's my understanding. If I'm wrong, some one please correct me before I lose money.

First, an example of how currency risk hurts returns, then an example of how leverage mitigates that.

Hypothetical Assumptions:
Home currency is USD
begin EUR:USD:  1.10
end    EUR:USD:  0.88 (down 20%)
interest rate on local currency debt: 4%
simplistically, no taxes - should not matter in the example

Example 1 (Unhedged). How FX hurts returns. Say I invest in some European stock. I first convert USD to EUR, then I use the EUR to buy some stocks. Now say that stock then goes up 20% in local currency. Great, but EUR depreciated 20% against USD during that time. After converting back to USD, I end up with (1.2)*(0.8)= 0.96 of my original investment. I just lost 4% despite solid stock picking.

Example 2 (Hedged). But how if I borrow in local currency first? Say I want to buy 100 of this European stock. I'd borrow 100 first then use that to buy the stock. Again, stock goes up 20% in local currency, and EUR depreciates 20% against the USD.

My 100 of stock became 120. I use that to pay down 100 of local debt, along with 4 of interest on local currency debt for a net return of 16. Translate that back to USD, I'm net gain about ~$14 USD despite the 20% currency depreciation.  Net return is (20% - 4%) * 0.8 = 13%.

This makes sense because by borrowing in EUR first, I effectively hedged FX by shorting the euro against the dollar. Only the gain of 20 was unhedged. The interest expense here is my hedging cost.


Interactive Brokers let you do this and that's how I'm currently buying foreign stocks. I'm not sure how others are doing it. Is the hedging cost / interest expense worth it? I think so. After all when I buy stocks I'm looking for a lot more than 4%. On the other hand if local interest rate is 15% then this is probably not a good idea. The other consideration is my allocation for foreign stocks is limited by my own fear of leverage.

In my pre-crisis life of structuring asset backed securities, we had all sorts of ways to shift risk around. The total, absolute amount of risk does not change, but the idea is that each slice of risk went to their most appropriate owners - "better buyers", so that the collective utility for risk owners were increased. Here too, arguably I'm just shifting one form of risk into another (from FX to leverage risk). But some risk are more preferable than others depends on who you are and the situation. Here I prefer taking on leverage vs FX translation risk.

In hindsight - that whole MBS/ABS episode did not end up too well, and it's possible that this post is just one big brain fart. So again, if someone sees some false logic here please let me know.

*** updated 4/11/2015

Just got off the phone with a friend and I realized I have not made myself very clear. First, here's what we agree on. In example 2 in my original post, (for an USD based investor), the act of borrowing in EUR is equivalent to entering into an FX swap shorting EUR against the dollar. Like an FX swap, the idea is you locked into a particular exchange rate. But instead of paying whatever whatever hedging cost associated with an FX swap (bid/ask, transaction fees...etc), you pay an interest expense (conceptually equivalent to your hedge cost).

What this is NOT is hedging with an option, where you pay a cost and have asymmetric upside/downside. So in example 2 below, if EUR goes up the hedged positions will clearly underperform the unhedged approach. That would be true whether you use a currency swap or borrowing in a foreign currency.

The other thing is you have to be extra sure of your stock picks. The worst case is if stock pick AND currency both move against you. So if stock was down 20% and Euro was up 20%, then your net return would be (-20% return on stock - 4% interest expense) * 1.2 =  29%!.  The losses on your stock pick are magnified. That is because the principal amount of your loan (or think of FX swap notional) is hedged, but the subsequent gain/losses are not.

When attempted "hedges" are not hedges at all

That's why my friend argues this is not a hedge. I said even if you use a currency swap, you would have the same results. Then my friend says yes, but using a currency swap is not necessarily a hedge either because correlation complicates the matter.

So if you're investing in the stock of an European exporter, and euro was up 20% the stock would probably get killed. Then like the above paragraph, your losses would be magnified by a rising euro. In that scenario your "fundamental stock call" is really a macro bet shorting the euro, and by trying to "hedge the currency" (again via an FX swap or local currency loan), you're actually doing the opposite - you're shorting the euro more and doubling down on that directional FX bet.

In that situation he's definitely right. So always know what you're betting on exactly. If your single name stock idea has a macro component (and most companies have that to some extent), then be really careful about layering on "hedges".

Sunday, April 5, 2015

Beijing Enterprises Holdings (北京控股) - Growth at A Reasonable Price


· Natural gas will grab an increasing share of China’s growing energy mix. Favorable government policy as well as coming supply glut will speed adoption. Chinese gas distributors will benefit and Beijing Enterprises Holdings Limited (BEHL) is well positioned to capture that trend.

· I expect 35-45% upside in 2 year time frame, likely more due to multiples expansion. Ultimately I hope to hold this over the next decade.


Beijing Enterprises Holding Limited ("BEHL", 0392.HK) is a conglomerate with ~80% of its net profit coming from natural gas distribution and transmission. The other 20% of profit comes from a mix of water treatment, waste treatment, and beer businesses. The company has many opportunities to deploy cash into various projects and grow. 

Other than the beer business, the rest of BEHL fits neatly into an environmental theme. The integrated theme gives them synergy in acquiring new customers outside of Beijing, since decisions regarding natural gas, water, and waste treatments are often made through the same political relationships.

The Industry Opportunity

The growth runway for natural gas in China is long and strong. Natural gas contributed only 5% of China’s total energy use in 2012, but the government targets that number to be 10% by 2020 due to environmental reasons. In 2013 natural gas demand was 168 billion cubic meters (bcm), by 2020 the target is estimated to be 360 bcm. Even by CNPC’s lower estimate of 310 bcm, that is a strong 9% CAGR from 2013 levels.

A wave of gas supplies coming to China over the next decade will help demand growth by holding prices down. Over the next decade, China is expected to grow its unconventional production (shale, coal bed methane…etc). Meanwhile, global LNG supply (including American LNG) is set to increase, and China has pipeline deals with Central Asia suppliers as well as Russia. Taking these sources together, one broker project that total supply will reach 334 bcm by 2020, outpacing demand growth. This would in turn contain prices and speed up the adoption of natural gas.

Chinese gas distributors will be beneficiaries, as they benefit from higher volume while still taking a steady spread between city gate prices and end user prices.

In the intermediate term however, gas is facing some headwinds from the recent drop in oil prices. First, low oil prices have made natural gas less competitive versus alternatives such as LPG. Second is property exposure. For many Chinese distributors, “connection fees” contribute half of overall gross margins. These are one-off fees charged set up new customers. With China's slowing property market this revenue source will face some headwinds.


BEHL has the least exposure to these near term headwinds, yet will still benefit from long term industry upside. In terms of price competition with other substitutes, BEHL’s customer base is mostly power generation and heating, with very little industrial exposure which is arguably the most price sensitive. Demand is mostly mandated by the government as the city of Beijing actively shifts away from coal and toward natural gas. BEHL also has low exposure to property slow down. Natural gas use in Beijing is already highly penetrated, and it does not make money from connection revenues.

Management guidance is for gas volumes to increase by a cumulative 40-60% by 2016E (from 2014). This is mostly due to gas fired power plants coming online in 2015 and 2016. However, one reason BEHL is cheaper than its peers is the perception that it has limited growth prospects beyond 2016E, as natural gas is already > 70% penetrated in Beijing.

I would argue otherwise. BEHL has a long growth runway with a plethora of growth opportunities. Just to list a few:
  • As the gas supplier of the country’s capital, BEHL is in a prime position to grow as China executes its strategic integration of Beijing, Tianjin, and Hebei (京津冀一體).
  • Expansion into suburban areas around Beijing.
  • BEHL owns over 20% of China Gas, which has gas operations all over China. This relationship provides BEHL further investment opportunities across the country. 
  • Shaanxi-Beijing Pipeline 4 to come online over the next 2 years. Future gas imports from Russia could provide more growth opportunities in the midstream sector.
  • LNG/CNG could take off in the longer term, especially a few years down the line when gas supplies flood the market.
  • Water treatment and solid waste management are fast growing areas. For example, revenue at subsidiary BE Water grew 39% in 2014. 

Now, growth opportunities are good only if new investments can earn a return that exceeds cost of capital or some minimum hurdle. As a rough proxy, I looked at historical return on new invested capital (RONIC). I estimated historical RONIC to be about 7-8.5%. But much of capex and acquisitions were funded with cheap debt, so return on incremental equity is more like 9-11%. Given the stability and growth runway of this business, I consider that adequate.

Implied Valuation for the Core Gas Business

Typical of Asian companies, BEHL has a messy corporate structure with ownership of multiple listed subsidiaries. What I like to do is use market prices for the main publicly listed subsidiaries, and then back out the implied valuations for the rest of the business. 

Corporate structure and segment profit breakouts are shown below. 

Beijing Enterprises Holdings corporate structure

Beijing Enterprises Holdings - business mix

There are two publicly traded subsidiaries that directly correspond to BEHL’s segment reporting. Beijing Enterprise Water Group Limited (371.HK), and Yanjing Brewery (000729.CH) maps to the water treatment segment and brewery segment, respectively. Using the public market value for those segments, we can back into the implied valuation for the gas and corporate segments (conservatively allocate all debt and corporate expenses to the remaining operations, which includes Beijing Gas, shares of PetroChina Beijing Pipelines, China Gas, and other listed but immaterial subs). 

As seen below, BEHL’s publicly traded water and brewery businesses alone worth $27 HKD per share. That implies ~34 HKD / share, or ~44bn market value for the core natural gas business and corporate. With ~3.7bn HKD of net income in 2014, the market is valuing the core natural gas business at 12x 2014 earnings.

Implied valuations for main segments (excluding water and beer segments)

SOTP implied valuation

Even If I were to be super conservatively and 1) subtract any suspected non-recurring items out of those earnings, 2) attribute all of them to gas & corporate, the implied valuation for the gas business would be ~15.5x 2014 earnings. 

Peers such as China Gas (which BEHL has a stake in), China Resources Gas, and TownGas trade at 15-20x consensus 2015E earnings and 13-16.5x 2016 earnings. Thus BEHL’s gas operation appears outright cheap.

Peer comparison of price/earning ratios 
BEHL - valuation comp

Expected Returns and Holding Period

For me this one is more about controlling the downside and let the upside take care of itself. Aside from short term market technicals, the biggest risk is potential tariff cuts, particularly around pipelines. But overall downside is limited given high visibilities around volumes and gas distribution gross margins, as well as the low valuation multiple. 

Although the upside is not my focus, it’s worthwhile to do a quick back-of-the-envelope calculation using management guidance. Volume is expected to grow 26% and 16% in 2015E & 2016E, if it grows even 5% in 2017 then that’s 53% more volume from 2014 levels. Gross Margins will lower by RMB 0.02/cubic meter, an -8% drop. Take the higher volume with lower margin, 2017E net income would easily be 35%-45% higher from 2014 levels, even assuming no further margin gains from SG&A leverage (for reference, current street consensus expects 2017 EPS to be 50% higher from 2014 levels). This 35-45% is my expected return. Multiple expansion can provide further upside, given BEHL trades at 2016 forward P/E of ~11.5x, a big discount to peer average of 15x.

More importantly though, I’m trying to buy a company that, 10 years down the line, will most likely have higher per share earnings and cash flows. I believe BEHL’s stock offers that at a good price