Kostolany on What Makes Stocks Go Up; Capital Flows and Technicals

Andre Kostolany on What Makes Stocks Go Up

I was doing some reading on Andre Kostolany and found something interesting. According to him, what makes stocks go up can be summarized in one simple formula: Cash availability + Sentiments = Market Trend. Basically for a market to go up, people need to have cash to buy stocks, and they have to want to buy stocks. Of the two, cash is the more important one, since high liquidity creates a rising market which would then drives sentiments.

Kostolany gave convincing examples where markets go the opposite way of underlying economic conditions. In a weak economy, people scale back consumption which increases savings rate. Since confidence about the real economy is weak, those savings get channeled to the securities market. Likewise, when central banks loosen monetary policy to support a weak economy, much of that extra cash goes to prop up the markets.

In this framework, what makes stock market go up is about monetary policy, available cash on the side lines, international capital flow and FX. Fundamentals are part of the equation, but mostly serve to influence public sentiments and expectations, as well as rationalize prevailing biases. In fact, an improving economy might lead to negative sentiments regarding corporate earnings, if higher labor and input cost lower profit margins.

This all makes a lot of sense to me. As a result I spend some time on macro the past few weeks, particularly on the topics of international capital flow, balance of payments…etc. 

International Capital Flow and Implications

My rudimentary credit analysis on the USA follows. The U.S. has current account deficit running $400-500bn the past few years, it finances that with capital inflows, which represent foreign claims on U.S. assets and effectively depletes national wealth over time. But that national wealth is incredibly high. The household sector alone has ~$83 trillion of net worth, so technically that current account deficit can persist for 150+years before U.S. networth gets depleted.

So solvency is not an issue, but how about liquidity? For now, foreigners are choosing to finance U.S consumption, presumably because 1) political stability, 2) economically U.S. being one of the “cleaner shirts” among nations, and 3) to a lesser extent strong USD appreciation the past year. Political stability will likely stay around in the coming decades, but relative economic position could change. At some point the U.S. may have so much debt that growth is weighed down by interest payments, while recovery in China and Europe can both draw capital away from the United States.

China is not helping either. In the past decade China piled up U.S. treasury bonds in its FX reserves. That helped to keep the RMB down and sustain its trade surplus. But now it seems to prefer exporting capital to other emerging markets, which not only helps the trade surplus but also enhances its influence and prestige abroad.

If capital reverses direction, that out flow could start a vicious cycle. Capital outflows would weaken the dollar, accelerating withdrawals of hot money. The Fed can raise rates in an attempt to attract capital, but that would tighten money and credit and kill the markets. The economy would have to adjust by consuming less - leading to deflation. At that point decades of accumulated foreign capital at the U.S. could rush out the door and a deflationary cycle sets in.

Value investors like to say “no one gets the macro right”. That’s probably true. I do believe though, that you have to be planned for all scenarios instead of just assume things will be fine in the long run. In terms of money management, it’s not so much trying to guess what the economy will do, but planning out how I will react to different scenarios.

A Technical Experiment - Game Planning

“Stock market goes up in the long run” is a mantra that take hold at top of markets, conveniently serve to justify ever higher valuation - “this stock trades at 25x P/E? Doesn’t matter, buy it anyways because over the long run I’ll be fine.” This mentality has two implications, 1) at some point the public become fully invested – there’s no buying power left, and stocks have nowhere to go but down on the next sign of economic weakness and 2) the market increasingly trade on technicals.

I’m convinced that the broader market is trading on macro/technical with “fundamentals” being merely an excuse to buy stocks. According to this report from Factset, market prices have grown at a faster pace than earnings expectations the past few years. Earning expectations have steadily declined since beginning of the year yet the market trickled upward. The same report also pointed out that market is reacting less to earnings beats and misses than the past – an indication that fundamentals have taken a backseat to technicals.

What to do? A sensible thing to do is target stocks that are less correlated to the broader market: small/microcap/illiquid stocks, special situations, turnarounds..etc. A major portion of my portfolio is mid/large cap value stocks though, and there I sense the fundamentals valuations are becoming less relevant – (and will be even less relevant if the market keep marching upward).

I’m in the middle of an experiment in timing the market with technical analysis. I use SPDR S&P 500 ETF (“SPY”) as a proxy for the market. Here’s the plan.

Current Trading range & initial set up

• Current trading range is 205-212 and we’re currently at $212 per share. We are very close to a strong resistance around 212-213, a line that have held up since February. SPY tested that resistance 3 times the past month with no success. If it fails to break through again, my suspicion is that we’re due for a 5-10% correction. 
• I shorted some SPY with 213 as a stop, so that if it breaks upward past 213 my loss would be limited. This short is ~18% of portfolio equity, with w.a. cost basis of 208.3. So I stand to lose 40bps if I get stopped out at 213.

• I left my single names untouched. Some of them have their own stop losses anyways. These single name exposures are about 90% of equity.
• Note that I’m actually violating proper technical trading principals here in the sense I’m jumping the gun even before a clear breakout or trend emergence. As discussed later, I risk being whipsawed)

If SPY breaks to the upside

• My shorts get stopped out so I take 40bps of loss. But my single name exposures would still be there to take advantage of any potential uptrend.
• Should I reverse course and get longer (would put me on leverage)? Only if a breakout proves that it established a new pricing range. That to me requires the emergence of a new support level (say 213-214 area) – mostly in the form of a retracement and subsequent bounce.

If SPY moves down

• My short position would be showing a profit, but probably not enough to offset losses on my single names. I would think about adding to the short. But only if SPY breaks below support levels such as 205 or 200. 

If SPY moves up past 213, but that turns out to be a false move and SPY reverse downward back to say 208. Instead of establishing a new pricing range, that move would have merely expanded the range.

• This would be tough to swallow. I would have incurred 40bps of hedging cost with no gains to show for it. That’s what you get for jumping the gun before a clear trend emerges. Should I risk another 40bps and risk getting whipsawed yet again? Only if there are proof that a downward trend is emerging. That to me requires 1) Negative fundamental news dominating the headlines (perhaps worries about Europe & China), 2) technical indicators that confirms the trend in the form of ADX/DMI, a lower low…etc. 

The way market is going, I could be stopped out of this trade as early as tomorrow. In that case we might be in for a summer “melt up” as in 2014. I will not fight it.

Week Ending 5/2/2015: Random Notes and Portfolio Review

I missed a home run last month and it hurt. Impac Mortgage (IMH) was the one. I’ve been following that stock on and off for 3 years. A week before earning came out, I had a hunch 1Q15 was going to be a good quarter, so I sat down, went through a rather detailed model and looked over my projected 1Q15 earnings. I passed, thinking the was not worth the risk and reward. When the actual earning came out it was a multiple of my forecast!! I was stunned  (I got the volume pretty much right on but was way off on the margin!). The stock ran up 100%+ in past month alone. Never have I put in that much work in a stock and turned out that wrong before. I mean if I was a portfolio manager at some fund and had a hunch about this stock, and I got my sector analyst to take a deep dive. He comes back saying it's a no go, then the stock goes up 100%...this is the sort of stuff that could get you fired.

So that hurt my confidence. That and the fact that I’ve been very uneasy with the market made me go through my portfolio again.


Healthcare portfolio.  This is a multi-leg investment to capture the long term trend in America’s aging population. I have a mix of managed care, hospitals, pharmaceuticals, and supply chain players that balance out each other.

Managed care ran up a lot in 1Q15 and was a major contributor to my out performance year to date. I decided to cut this down a little bit due to full valuation. I also see near term risk in the next year as we get closer to election year and Republicans will undoubtedly make some noise about Obamacare. But overall this healthcare portfolio is a very long term play and there’s nothing here that I would think of selling if the overall market drops 50% tomorrow.

That said, after a very successful run the past year, my expected return in the next few years is not great – maybe mid/high single digit annualized return. So if something with better risk and reward comes alone I could pare this down further.


Housing portfolio.  This is really more like housing finance and is a mix of title insurance, originator/servicers, mortgage REITS and mortgage heavy banks. The big picture idea is to go long household formation and existing home sales in the next 5-10 years. Unlike the healthcare portfolio, there are some pretty speculative names in here like Nationstar, PennyMac Financial, AGNC…etc. But I’ve cut them down to a point where I’m pretty comfortable for all remaining positions, and certainly on a portfolio basis. 

The core group here is title insurance, which I went through recently thinking about adding. Unfortunately the group look fairly valued. In terms of technicals, Fidelity National Financial (FNF) is a name showing some weaknesses. It is hovering around its resistance level and could see a big break on the downside if next Monday’s earning turn out to be a bust. If that happens I will simply take it on the chin. 

Tankers. I cut down some TNK and bought some more DHT. In the past few weeks TNK stock price has moved up to a point it became too large of a position. I'm also worried that Aframax sector (which TNK is heavy in) will not benefit as much as say VLCC or Suezmax sector. Hence the rotation into DHT, which owns mostly VLCC and Suezmax ships. Luckily, I did this adjustment right before TNK stock took a beating the past few days. The tanker trade is ~6% of my total portfolio and I have 4 stocks sharing the risk. What's preventing me from getting bigger here? 1) This is obviously a very speculative trade and cannot be long term. 2) Global crude oil demand is highly dependent on China, so the tanker trade is to some degree a long China trade -- and I'm already very long China in the portfolio.


Beijing Enterprises Holdings (392.HK). This ran up some 20% and I kept adding to my position on the way up. Although the gain is mostly due to extremely lucky timing, this is a very long term investment for me. I would consider adding more Chinese gas distributors, but only at the right price.


One big China/HK trade basket. Welling (382.HK) has ran up dramatically and I also added on the way up. But I see less upside here and will likely take my profit if the HK market takes a turn for the worse. In recent weeks I piled in and added a mix of indices and (mostly infrastructure) stocks to capture an expected spike in liquidity as well as A-H share premium.

But now that H-shares momentum has flattened out, I’m very worried about the A-share bubble popping and how that might spill over to H-shares. I'm actually investigating ways to short China as a whole while staying long in my current H-share positions, which are all reasonably valued if not outright cheap. I have tight stop losses on every one of these trades and will let the market decide for me.

Updating my views on Apple and Google:

Apple. I’m kind of surprised that the stock did not move that much given the very strong quarter. Demand for the stock could be exhausted. Part of my thesis is a "short squeeze" for those who still don't own AAPL and lags the index as a result. I now see that even a $200bn capital return plan cannot scare the implicit shorts. My original thesis could be flawed and I may cut down or exit instead.

Google. I’m holding on despite the temptation to exit given the persistently negative market sentiments here. I did some rough numbers again. My timeframe is 5 years for this. What’s the worst case? Conservatively, I think EPS can grow 8% a year. It is unlikely to be less given the solid top line growth runway and how much room they have to cut cost, and everything I know of Google.

• 5 years from now EPS would be up 47%. But let’s say 1yr forward multiple (ex-cash) goes down to 17, that would be roughly an -18% hit. Combine EPS gain and multiple loss yields ~29% total return in 5yr, which would be about 5-5.5% CAGR. That is my worst case. 
• On the other hand I think the upside is double in 5yr or about 15% IRR. 
• Given the strong expected EPS growth, forward PE would have to drop to 12x at 2020 for me to lose money. 
• So I’m holding on to this. But maybe get smaller if price moves against me.

The exposures I listed above add up to almost 70% of my portfolio. I’m in the process of revisiting my entire investment approach and don’t expect to add new names. If the market crashes 30% tomorrow, the exposures I'm less sure about (roughly half of what I listed above) would be stopped out, leaving the real long term positions intact. 

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.

USD: HKD 

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.

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 finance.qq.com. 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!

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".

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

Summary

· 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.

Introduction

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.

Why BEHL?

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. 

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)

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 

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

Keep It Simple, Buy Apple and Google

I tend to write about smallish and mediocre companies on this blog, but those are just a portion of my portfolio. In fact, about half of my portfolio are highly liquid large caps that I consider high quality and intend to hold over the long run.

The problem with this mixed approach of "cigar butt" versus quality at fair price is I end up spending most of my time on the former. Built to last companies just don't require as much attention as risky ones. When I buy a "quality" company my intention is to let it cruise along, check in once in a while to see if the thesis still holds, and perhaps add on the dips. This has all worked out very well so far. The problem is there's a strong temptation to equate "large" with "safe", and perhaps run the risk of complacency. I hope writing this blog will help prevent that.

I'm under no illusions that I have any unique advantage when investing in these names. The thing is you don't always need an edge. Investing is not a zero sum game. Nor do you get points for creativity. I think some people read Joel Greenblatt and obsessively ask themselves "whats my edge? is this obscure enough?" But sometimes the crowd is right, and the best opportunities are the obvious ones. (more that here.)

With the market being volatile the past few months, I took the chance to get into Google and Apple at the lows. At today's prices (GOOGL at $565 and AAPL at $126), I would still buy them if not for the fact that they're already full sized positions.

Google

There's a decent chance this can double in 5 years. The way this works out, I think, is earnings double in 5 years (implying a a highly achievable 14% earnings CAGR). If earnings are still growing > 10% at the end of that period, then the market will put on a high P/E which doubles the share price.

For a company that grew its net revenue at 20% in 2014, Google is priced very reasonably, (I look at this in terms of GAAP earnings, and back out the value of net cash, which gets me to <20x 2016E earnings). This deal is available due to worries about what mobile means for Google. Google still makes most of its money from text searches, the fear is that with the world shifting toward mobile and "apps", Google's earnings growth will slow or even decline.

That seems exaggerated to me. Google owns Android and YouTube, so they do have a strong presence in mobile. Ok, they have not really monetize those two yet, but is it that hard to imagine they eventually will? Also, there are 2 trends that converges "mobile" together with traditional internet, where Google clearly dominates. One is that websites increasingly serve up the "mobile" versions, which are getting so sophisticated that there's no difference between normal internet site and an "app". Second, as phones get bigger and tablets more functional, there's less of a difference between the "mobile" world and the "desktop" world. In that sense cell phone, tablet, laptop...etc are all just screens where people interact with the internet.

In 2014, gross profit grew 20%+ while adjusted pretax profit was up only 11%. This is due to Google's high R&D and other investments. These are discretionary investments though. If they just keep expenses under control, they can easily "show" a much higher earning growth.

I'm no expert in tech, but Fred Wilson is. In this recent interview (around 37th minute), he was asked "Can YouTube be bigger than Google search?" to which he exclaimed "Yes! Easily!". Wilson also pointed out that Google's strength in data and the fact that it's still run by its founders.

Apple

For years I had a hard time getting comfortable with Apple. With technology changing so fast, I have no idea what products they will be selling in 10 years, so how can I put anything more than a 10x multiple on this? My thinking has changed into this: it doe not matter. Sure, eventually there is going to be tougher competition from Asia, but I just need to make sure 1) in the interim they will rake it in the next 2 years so that cash is worth something, 2) there are no close competitor in the upscale product /ecosystem / "fashion tech" segment.

Apple made an absurd $18bn in the quarter ending December 2014. In one quarter alone, they made more than the entire market value of some large cap companies! Surely this is peak earning, no? I think there could be more. Growth opportunity could come from 1) higher iPhone penetration in emerging market. Apple's market share in China was only 16% at Oct 2014. Could have doubled at this point, but certainly there's some room to run. Similar idea with France, Germany, Italy..etc. 2) the bigger iPhone 6+ has higher price points. 3) Apple Watch opens another revenue stream that could offset iPad weaknesses. 4) Upside options such as Apple Pay, partnership with IBM, healthcare initiatives could all work out. 5) Apple solidifies itself as a "fashion tech" brand and sells eye glasses, hats, or whatever to fanboys for $400 a pop.

What's the upside? Say earnings grow another 30% in a few years, put on a higher multiple and we could see 40-50% gain from the current price. There's a technical aspect that could accelerate the gains. With Apple being some 3.5% of the SP500, fund managers who are underweight Apple (and implicitly shorting it) could face a short squeeze, especially if iPhone 6 continues its spectacular run and Apple start doing some buybacks.

The downside is Apple Watch turns out to be a flop, which not only fails to replace iPad sales, but also disproves the "Apple as fashion/luxury tech" theory and demoralize Apple boosters. Also, if iPhone 6 sales stalls later this year, the market would reasserts that this is a cyclical business unworthy of a high multiple. This is not a stable buy and hold. The downside is real and I would have to risk manage this if prices fall below my cost basis.



Of the two, I like Google better and will allow it more time to play out.