China's Speculative Real Estate Bubble
We looked at things like Japan in
1989. We looked at Ireland and Spain in 2007, and what stunned us was the size
of the Chinese residential real estate market. To this day it still stuns us in
China. It is the biggest real estate bubble in history.
They're still building a 1.8
billion square meters a year of residential, which is 20 million apartments
because the average Chinese apartment is 90 square meters. We've long gone past
‘We’ll build it and they will come.’ The rural people won’t move into it
because these apartments aren't affordable for people who are moving from rural
to urban. They are only being built at this point for speculation. Depending on
how you want to figure out the ancillary real estate stuff, it's anywhere from
20% to 25% of their GDP.
The problem is that the government policy has been loose in China regardless. The one restriction they have in place is the House Purchase Restrictions (HPRs), which apply for second and third homes. But people who own more than a couple homes are almost always speculators. The bulls are saying the government will loosen the HPRs, but the problem is that the government doesn’t want speculation in real estate. So I think that’s a pretty bad argument. Secondly, the flood of construction has continued apace, and the unsold inventory is piling up. What if the speculators turn into sellers as opposed to buyers when the HPRs are relaxed?
-Shadow Financing Loans
-Similarities with Japan in the 80's and 90's
Anyone who is counting on the government to fix that market is, I think, counting on hope rather than analysis. This is a bubble that has a long way to go on the downside. Residential real estate prices, in aggregate in China, at construction cost, are equal to 350% of GDP. The only two economies that ever saw higher numbers at roughly 375% were Japan in 1989 and Ireland in 2007, and both had epic property collapses. So the data does not look good for China.
I also think the renminbi is overvalued. If there is some depreciation of the currency, that could lead to cheaper products from China, which could actually help the U.S. economy. Places like Australia and Canada and Brazil would be hit pretty hard, however, because they rely on exporting commodities to China.
It was a once in a lifetime build out of infrastructure in the most populous country of the world. After you have your third international airport in Hainan, China, you probably don’t need a fourth one — especially when no one is using the second one. In this case, things are really two or three standard deviations from the norm, and that’s what you need to be looking for. If iron ore prices were $50, I really wouldn’t care, but at $140-$180 with more capacity coming on and lower demand in the future, I think we’re in for a disaster.
It’s all about incentives. In China, everyone's incentive is GDP. They are fixated on growth. In the West, we go about our economic lives, and at the end of the year the statisticians say, this year your growth was 3%. But in China, it’s still centrally planned. All state policy goes through the banking system. They decide what they want growth to be and then they try and figure out how to get there. The easiest way to do that, in an economy where consumption is only 30% of the total economy and net exports are determined by the world markets, is to stick a shovel in the ground and build another bridge, since that contributes to GDP. So a random party chief knows they will never be sacked if they make their GDP targets.
On his first few jobs and Banker's incentive to maximize fees-- not helping clients
There was a defining moment, however, when I realized investment banking wasn’t for me. A year into my stint at Blyth, we were working on a recommendation for McDonald’s to issue a bond. At that point in its history, McDonald’s was generating a lot of cash and reinvesting it back into its restaurants, each of which generated high returns. But the stock market was valuing McDonald’s at only 8 or 9x earnings despite the company growing at 20–25% a year pretty consistently with real cash earnings.
This was at a time when interest rates were at double-digits. I ran some numbers independent of the blue book that the associate, the senior banker and I were compiling, and determined that instead of the debt deal, we should recommend that McDonald’s buy back stock with some of its cash flow and cut back its expansion slightly. This could lead to a larger EPS increase relative to the bond issuance and they wouldn’t have to add leverage to the balance sheet.
Given where rates were, the impact on EPS from buying back stock rather than issuing debt was dramatic. When I made this case to the associate, he turned white and said he wanted no part of presenting this idea to the senior banker. Being pretty naïve and not realizing the political implications of such a recommendation, I handed out a two page memo to the senior banker discussing the impact of buying back stock. The senior banker looked at me with an icy stare and stated that we were not in the business of recommending share buy- backs to our clients; we were in the business of selling debt. This was my first douse of cold water regarding Wall Street and I became pretty disillusioned after that episode. I had learned that Wall Street wasn’t necessarily doing things in their clients’ best interest but was instead focused on maximizing fees.
On finding the right sources and being intellectually curious
The CFO will always have an answer for you as to why a certain number that looks odd really is normal, and why some development that looks negative is actually positive.
A second mistake some people make is not reading all of the documents. I guide people to always start with the SEC documents, and then go to other sources for information. It’s amazing how few analysts actually read SEC filings. It blows me away. We have the greatest disclosure system in the world and people by and large don’t take advantage of it. I am a big believer in looking for changes in language in a company’s filings over time. During the year we were short Enron, each successive filing had incrementally more damning disclosure about the company’s off- balance sheet entities. It was obvious that internal lawyers were pushing management to give investors more detail on these deals that were being done, as they felt uncomfortable about them. Language changes are not accidental. They are argued over internally.
G&D: What are some characteristics of the best analysts that have worked for you?
JC: The thing I look for most is intellectual curiosity. One of the best analysts we ever had was an art history major from Columbia. She had no formal business school training. She was so good because she was very intellectually curious. She was never afraid to ask why and if she didn’t understand something she would go figure out everything she could about it. This is almost something that you can’t train. You either have it or you don’t.
On for-profit education
I think for-profit education business is a flawed business model. The outcomes are very poor, as I feel that these degrees are sold, not earned. Anyone that wants to sign up for these things can get in, but tuition is up there with many private schools. People are coming out of these schools with $20,000-$50,000 in debt and many don’t even graduate but incur the debt nonetheless. Some of the technical schools do good practical training, but most of the business has now shifted to online degree granting because it is more lucrative. I remember a couple of years ago, the head of human resources at Intel was quoted in a front page New York Times article saying that if someone came in from an online college, they won’t even look at them. The types of jobs these graduates get are no better than if they just had a high school degree, and yet they are incurring all of this debt.
Ultimately defaults will go so high in the student loan area that the federal government will see mounting losses and will change the student loan program guarantee to force institutions to take a bigger chunk of the risk. Once this happens, the business model is broken. The only reason these companies exist is because of the federal loan guarantee on student debt.
Baldwin-United
One of the first stocks they had me look at was insurance holding company called Baldwin-United. Baldwin was growing very rapidly by selling annuities that were uneconomic. To plug the hole that was developing within their insurance subsidiaries, the holding company was closing acquisitions. In exchange for the insurance companies’ cash, the holding company was providing the subsidiaries with overvalued securities. However, the regulators of the insurance subsidiaries were becoming wise to the development as Baldwin-United’s stock shot up. We acquired a copy of the insurance department public files and we were able to see from regulators’ letters that they were becoming increasingly concerned about the valuation of those affiliated assets held by the insurance company. They went as far as to imply that if Baldwin-United didn’t downstream additional capital to its insurance subsidiaries, they would have to declare the subsidiaries insolvent. While this was occurring, every brokerage house was recommending the stock. Although the company was rapidly growing earnings, those were all non-cash earnings because Baldwin-United was using gain on sale accounting when it sold annuities. This fictitious “gain” was based on the expected persistence of the policies and the present value of the estimated spread generated by their returns on investment in excess of the annuity pay- outs. The problem was that they were paying 14% on the annuities and were far too optimistic on their investment return estimates. My first research report was published in August of 1982. I recommended a short position in Baldwin-United at $24 based on language in the 10-K and 10-Qs, uneconomic annuities, leverage issues and a host of other concerns. The stock promptly doubled on me.
This was a good introduction to the fact that in in vesting, you can be really right but temporarily quite wrong. I put another report out in early December of 1982 with the stock at $50 and reiterated my thesis while pointing to additional evidence that had come out in the interim. I went home to visit my parents for Christmas and received a phone call from Bob Holmes telling me that I was getting a great Christmas present — the state insurance regulator had seized Baldwin-United’s insurance subsidiaries. Baldwin filed for bankruptcy shortly thereafter.
On Shorting and Valuation
Valuation itself is probably the last thing we factor into our decision. Some of our very best shorts have been cheap or value stocks. We look more at the business to see if there is something structurally wrong or about to go wrong, and enter the valuation last.
On hedge fund structures and hierarchy
From an approach point of view, one of the things that distinguish other hedge funds from us is that a typical hedge fund has the intellectual ownership of an idea separate from the economic ownership of that idea. By that I mean you have the partners and the portfolio managers at the top and you generally have the analysts, who are more junior at the firm, at the bottom. The way the model works at most firms is that the guys at the top command the people at the bottom to come up with good ideas from which the portfolio managers ultimately select the additions to the portfolio. The problem with this model is that the profits go disproportionately to the people at the top of the pyramid but the risk — or the intellectual ownership of the idea as I like to call it — resides at the base of the organization with the most junior, inexperienced people. Consequently, if things go right, everyone makes money, but if things go wrong, the person at the bottom dis-proportionally shares the blame and the risk. This is why turnover is so high in the hedge fund industry. People try to do carve-outs, which I think are very bad policy.
This model puts all of the power of the idea generation, and therefore the alpha generation, with the most junior people in the firm, whereas the senior people are just doing portfolio allocation. We’ve always viewed it the opposite way. We have six partners at Kynikos who have 150 years of experience in the securities business among us and we have been together 100 years in aggregate. For example, my number two has been with me for 20 years. Because of our experience, we generate ideas up at the top. We are looking for the new ideas and we’ll do the first read-through of a company’s 10-K and other research in addition to talking to people in the industry.
The next step is to then send the idea down the chain to our research team to process. I will never blame the analyst for a stock that goes against us. Putting the stock in the portfolio is my responsibility and the other senior partners’ responsibility. I think this leads to a better intellectual environment at the firm. So we get analysts who love working here and will stay for 10 or 15 years. It’s a much more stable model in terms of process than some other models.
On the EU
Clearly the European Union has made an example out of the country. As has been said, the problem with the EU is that it’s a currency union without a fiscal union. The incentives are all skewed. People who say that Germany suffers from having to share the EU with these Southern countries like Greece are missing the point. Germany is very happy to have those Southern countries in the EU, because it keeps the currency lower than otherwise. If Germany had its own currency, it would go through the roof, and harm German exports, which are the big driver of that economy. So in effect what’s happening is that German taxpayers are bailing out European banks, who’ve lent money to the Southern European countries, which are buying German products. The problem is that it’s a political issue and so many people just want to look at it as a financial and economic issue. There’s an interesting alignment of interests where the taxpayers in the donor countries are upset, and rightly so. In other words, the typical German taxpayer is saying, why should I pay for this? The other thing is the recipient countries are upset, too. It’s not as if the typical Greek citizen wants this money. They’re not seeing any positive results from the money — it just goes right to the European banks. It’s not financing any new growth initiatives. I’m not going to apologize for Greeks who didn’t pay their taxes or retired at 42. The stories are out there and they’re all true. But be that as it may, there are an awful lot of law abiding Greeks who are being destroyed by what is going on in Greece now. The new twist in 2011 is that the donor countries installed their technocrats in Greece’s ministries to oversee tax collections and interior policy, and that has really hit a nerve. Now Germany is basically dominating Europe. You ignore that political calculus at your peril. All of this connects to historical issues, such as how the Germans treated the Greeks in World War II. Greece lost one million people in World War II out of a population of eight million. The only country with a comparable (and higher) ratio was the Soviet Union. In the fall of 1941, after the Germans invaded Greece, they left the Greek government intact but they put Reich’s ministers in charge of all the ministries to oversee them.
One of the things they did was to loot the country of its harvest. Eight hundred thousand Greeks died in that famine of 1941. Almost every Greek family has someone who died in that famine. So this twist has opened up a 70 year old wound. Keep an eye on Spain and Portugal because they’re next. The other issue that is coming about is cutting your way to growth. Is austerity key to getting these countries back on track? So far the evidence is pretty poor that it is. We may look back and say, wow, what a policy mistake.
2012 short on natural gas
Currently we are short the natural gas industry in the U.S. for a few reasons. First, there has been a major technological innovation — fracking — that has created displacement. This has driven prices from high single digits per MCF of natural gas down to $2 per MCF. Most of the companies in the natural gas area began an exploration boom that has created this glut. These companies counted on the price to remain above $6–7 per MCF. A number of companies that had structured their balance sheets and paid up for acquisitions with this expectation of higher prices are now struggling. So they’ve got weakened balance sheets in a commodity business that is in oversupply, and on top of that, many of them are engaged in some pretty egregious accounting games, like hiding negative cash flows in various ways. I think this area will be a very fertile area on the short side for a number of years. The good news is that this happens to be an amazingly positive development for the U.S. because energy prices have dropped so much.
As an ancillary development, the other industry that gets killed by this is coal. Natural gas prices are now half the price of coal. Coal used to be one of the cheapest sources of energy, but it was the dirtiest. Now it’s becoming one of the most expensive fuels and is still the dirtiest. Utilities and others are rapidly transforming from burning coal to burning natural gas, which I do not think bodes well for the coal industry.
On Capital Structure
You have to remember that if you are shorting a leveraged company, with 90% of the capitalization in debt and 10% in equity, a 50% decline in the stock price only wipes out 5% of the total capitalization. You have to look at the total capitalization. In some of these cases the total capitalization is only down a little while cash flow has been cut by 75%. This is the reason that some investors get killed in value traps. They look at the stock and they don’t look at the total capitalization. They don’t realize that the debt burden is forever, meaning it’s not shrinking, whereas the equity capitalization may fluctuate in the market. If the cash flows have diminished dramatically the company’s ability to service the debt, then the stock going down by half doesn’t mean anything. You could still be at risk of losing all you capital.
Macro model for analyzing fraud, which is the Kindleberger-Minsky model
We look at the macro environment
and what we found down through the historical narrative is that the fraud cycle
follows the financial cycle with a lag you know like really with a lag and
often is amplified by markets in which disruptive technologies are the main
factors.
So what you'll see is that for example the dot-com we saw interestingly much more idiosyncratic fraud after that bull market then previous or even the immediate the bull market immediately after and so part of it is is that people begin to suspend their sense of disbelief.
And as the bull market goes on and more people are sucked in you begin to believe things that aren't true and companies and or management's begin to proliferate that are happy to sell you stories that aren't true and so it's why most frauds are revealed after a market rolls over.
Think about Madoff or others because at their core a lot of frauds of Ponzi schemes and when people close up their pocketbooks and demand their money back. Most frauds can't deliver.
We've seen this down through the centuries quite literally the wrongdoing doesn't get exposed until after the peak ---same in the dot-com era ---we saw Enron and WorldCom at the tail end be revealed.
So I think that that you'll be interesting to see in this bull market if that plays out similarly but it's been a consistent it's been a consistent macro observation and over the 300.
It makes pro cyclical sense to me because you need a revenue slowdown to reveal you know whether you have revenue fraud expense fraud or balance sheet fraud--
you have to have that rate of change slow down to reveal also easy credit creation
The banks will take their loan last position the provisions after the fact companies will start to go down then you'll see the issues. You'll also tend to be much more suspicious after you've started losing money you pull open the file again.
I've often said that that stock prices are the very best defense councils and prosecutors for fraud because when stock prices are going up companies are bulletproof. It's not till they start going down that people begin looking close or law enforcement government gets involved because there's political pressure for them to get involved yep I've lost a lot of money it's not my fault they defrauded me
So what you'll see is that for example the dot-com we saw interestingly much more idiosyncratic fraud after that bull market then previous or even the immediate the bull market immediately after and so part of it is is that people begin to suspend their sense of disbelief.
And as the bull market goes on and more people are sucked in you begin to believe things that aren't true and companies and or management's begin to proliferate that are happy to sell you stories that aren't true and so it's why most frauds are revealed after a market rolls over.
Think about Madoff or others because at their core a lot of frauds of Ponzi schemes and when people close up their pocketbooks and demand their money back. Most frauds can't deliver.
We've seen this down through the centuries quite literally the wrongdoing doesn't get exposed until after the peak ---same in the dot-com era ---we saw Enron and WorldCom at the tail end be revealed.
So I think that that you'll be interesting to see in this bull market if that plays out similarly but it's been a consistent it's been a consistent macro observation and over the 300.
It makes pro cyclical sense to me because you need a revenue slowdown to reveal you know whether you have revenue fraud expense fraud or balance sheet fraud--
you have to have that rate of change slow down to reveal also easy credit creation
The banks will take their loan last position the provisions after the fact companies will start to go down then you'll see the issues. You'll also tend to be much more suspicious after you've started losing money you pull open the file again.
I've often said that that stock prices are the very best defense councils and prosecutors for fraud because when stock prices are going up companies are bulletproof. It's not till they start going down that people begin looking close or law enforcement government gets involved because there's political pressure for them to get involved yep I've lost a lot of money it's not my fault they defrauded me
On world credit
I call it the ‘pig-in-the-python’, where the python is the world credit situation. If the pig at the end of the snake is the U.S., the pig in the middle is Europe, and the pig being eaten now is China and Asia.
https://medium.com/graham-and-doddsville/jim-chanos-rooting-out-fraud-6eca8e6387adhttp://portal.som.yale.edu/sites/default/files/files/MGT%20848-01%20Financial%20Fraud%20A%20Forensic%20Approach%20-%20Spring-2%202015.pdf
Keith McCullough interview
No comments:
Post a Comment