Month: May 2015

China’s Stock market boom

This is maybe the best explanation for the rising Chinese stock market,

(…)Even the stock market bubble is only a temporary device to alleviate financial pressure. It has been suggested that elevated stock prices allow SOEs to do a debt for equity swap at sky-high valuations, which would alleviate some of the debt pressures facing those companies(…)

As crazy as this sounds, I consider this perfectly possible.

If you own any Chinese bank stocks, be worried, very worried…



A fresh look at China’s liquidity problem

Very interesting Table produced by Gavekal (h/t youngmoney) showing that receivables (AR) and inventories have increased significantly over the years in China,


This is means that Chinese corporate balance sheets have become less liquid although leverage has never been higher – a fragile situation. The picture is representative of an unsustainable credit expansion where money has been invested in ever more roundabout projects whose payback period lies in the distant future (and which might not materialize for most of them). Once credit stops growing exponentially, the problems surface and borrowers start defaulting.

A worsening sales/receivables relationship  usually is indicative of problems ahead. After all, sales are real only to the extent they translate into cash someday, a process that leaves something to be desired in China. Since sales are an important input in national accounting, an overstatement leads to higher GDP estimate – keep that in mind the next time someone shows you China’s debt/gdp ratio.

Lessons from History

As is well-known, the inflation with which WWI was financed did not lead to an immediate economic contraction, as had been anticipated, but instead to a “war boom” that helped make the war popular in the belligerent countries. The boom was an illusion, of course, and merely represented capital consumption – a phenomenon first described by Mises in this context.

But how did that capital consumption show on corporate balance sheets?

Well, as the governments were printing money to finance WWI, businessmen got paid in government receivables which started accumulating on balance sheets. Initially they were not worried, as decades of convertibility into gold had assured them that government promises (that had been very limited until then) were sound and could eventually be converted into money, i.e. gold. Thus, (false) profits were booked and dividends paid out. Eventually the huge supply of unbacked IOUs resulted in market FX rates deviating from their gold pegs and ultimately all were devalued against gold. Those that anticipated this made fortunes, most were wiped out in Germany and Austria. This did not happen overnight, however, but took many years.

220px-Genoa_conference_1922Participants at the Genoa conference where the gold exchange standard was officially established (source: Wikipedia)

The USD was awarded reserve currency status at the 1922 Genoa conference and devalued only in early 1933 – almost twenty years after the beginning of WW1 and after a constant increases in uncovered deposits during the roaring twenties had exhausted the liquidity of the US banking commercial banking system.

Why it will not take that long in China

I do not think (or is it hope?) that we will have to wait that long for China to give up on its peg. To be sure, since it is paramount for China’s leaders to “save face” they will hold steady as long as possible, just as central bankers bound by a code of honour established during the gold standard years did back then, but ultimately market forces will prevail. Indeed, as I have written in my last post (here), there is evidence that China’s ruling elite doesn’t think the CNY is as good as the USD anymore and has started shifting money out of China. In other words: they know those receivables are largely not going to be collected.

If my analysis is correct, this is just the beginning…

Disclosure: short CNY, short AUD

Update on Calvalley Petroleum

I had invested a small portion in Calvalley Petroleum a few months back and wrote about it here.

The stock has a tiny market capitalisation of USD 120 million and looks cheap with a trailing PE of 5 and PB of 0.6. Calvalley is not only debt free but has USD 84 million of cash and cash equivalents parked in a Canadian Bank, i.e. almost 2/3 of the market value are supported by net cash not subject to country risk! Although not a classic Ben-Graham-type of net-net play I still consider it to have some margin of safety since a typical net-net usually doesn’t have highly profitable operating assets: in 2013 the company had a Free Cash Flow to equity of USD 20 million (operating income – less capex). I would say the potential loss is limited by the Cash at the Canadian bank. It is also good to see management owning 25 percent of the company, with the bulk owned by the CEO and his family trust.

As you are aware, security risks in Yemen have materialized and management has decided to pay out that cash to shareholders, if they so chose (which I have done, since I am not permitted to own unlisted stakes in my fund anyway).


My margin of safety calculation has turned out pretty accurate and management has made the best decision for shareholders. I was aware of the security risks in Yemen, but hoped on a positive development which has not materialized and I am taking the loss. It was confirmed that the youth bulge theory is pretty powerful (and widely ignored in the mainstream media).

Are social networks a threat to Wall Street’s M&A business?

At a time when the markets are approaching lofty valuations, it is no surprise to see increased M&A activity, that good, old contra indicator. What is surprising, however, that a small shop I had never heard of before has advised on USD 152bn in Deals in the past two years alone. From the FT,

Michael and Yoel Zaoui, collectively Zaoui & Co, are sitting in their swanky Mayfair office discussing 12th-century philosophy. The deal-doing brothers may have advised on takeovers worth more than $152bn in the two years they’ve worked together (…)

Although I have always found classic merchant boutiques charming, it still surprised me to see them take that much business  from the big and well-connected Wall Street banks. Not bad.

The article also hinted at a possible explanation for the return of boutique M&A,

(..)”It’s the return of the consiglieri in high-stakes M&A,” says Yoel. Old-fashioned merchant bankers, superseded in the 1990s by rivals at big Wall Street investment banks, are back in fashion. Their tight-lipped services are in demand at a time when proliferating gossip networks, such as Twitter, increase the chances of deal news leaking (…)

Makes sense.

How many people think social networks could disrupt the universal banking model in favour of traditional alternatives…

News from China: Capital Flight is increasing

According to the latest figures by BNP Paribas (via Ft-Alphaville), capital flight from China has gathered pace during the first quarter 2015, coming in at an estimated USD 320bn annualized (vs USD 244bn in 2014). Here is the chart,


(Note: In my last post (see here) on this topic I apparently underestimated the total for 2014 (USD 100bn vs 244bn). It seems I made a mistake adding up the yellow bars in the chart in my post.)

As a consequence of the outflow, Chinese reserve assets are decreasing which is shrinking the money supply in China (and is deflationary on the margin). This explains the seemingly paradoxical attempt by the Chinese authorities to ease credit conditions, while trying to cool the housing market at the same time. From the article,

They are estimates obviously, but still, those are big numbers. And, while it’s probably true the PBoC is reasonably chilled so far, this is another clear and ongoing reason for its defensive easing policies.

As an Austrian I agree with this statement, however I am skeptical as to the ability of the Chinese authorities to control this process (and would not be chilled about that at all). The reason is simple: The Chinese authorities technically can only reflate in CNY, whereas the outflows are occurring in USD – a big difference. Just have a look at the following chart,


As can be expected: foreign (read USD) assets (blue line) have been shrinking for the past twelve months, whereas domestic assets (black) are increasing thereby dampening the shrinkage in the local monetary base. And true, as long as the effect is contained and the majority of market players believe the peg to hold, an increase in CNY money can offset a decrease in USD money supply. However, there is a limit to that as much depends on the perception of CNY stability. And with Chinese foreign debt likely exceeding USD 1 trillion, a reduction of USD availability in China might well lead to a scramble for USD liquidity (see also my post here) among Chinese debtors.

Of course, the Chinese may well decide to default on their foreign obligations and a lot of them certainly will not hesitate to screw foreigners, but this merely means the deflationary effect is exported.

Another interesting aspect of Chinese capital flight is to think about the recipient countries.

Apart from the obvious candidates Singapore and Hong Kong, I believe Chinese capital inflows have affected Canadian and Australian real estate markets disproportionately. For instance, I would be surprised if the exponential increase in housing “investment” in New South Wales (NSW i.e. Sidney, see right chart below) were not due to Chinese “investors”, i.e. flight capital.


More importantly, it is not only real estate that is affected, but the inflow no doubt also pushes up the value of the CAD and the AUD on the margin. Demand for them paradoxically increases, although the fundamentals causing the capital inflow mean the prospects for the economies of these commodity currencies are weakening.


Persistent capital flight means USD monetary conditions are tightening in China and the possibilities of the authorities to counter this effect are more limited than commonly understood. These flows also hint at fundamental changes in China, which weaken the fundamental value of currencies whose economies depend on Chinese demand. Paradoxically, for currencies of countries such as Australia that are major recipients of Chinese flight capital, the worsening economic picture in China has not yet been fully priced in, allowing me average into my short position.

(Disclosure: short CNY and short AUD)

On Position Sizing: The Australian Dollar

Fellow AUD-short traveller, Crispin Odey, has been hit hard by the rebound in the AUD which appreciated sharply in April driven by a recovery in iron ore and on the backdrop of a much better than expected Jobs report. From the FT,

Odey Asset Management founder Crispin Odey’s flagship hedge fund slumped 19.3 per cent last month, after it was caught out when the Australian dollar strengthened against the US dollar.

A drop of 19 percent in one month in this market is remarkable. Given that the AUD appreciated a “mere” 5-6 percent, it follows that Odey must be hugely short the AUD – something like twice his AUM.

Since I have been short the AUD for more than two years, I have read the article with interest. Whereas I do believe Odey’s position is way too large, it has made me think on whether my own position is too small and if I should take the rebound as an opportunity to increase my short.

Meanwhile Down Under

To be honest: I have no clue why the job data for February came in much better than expected. Macro data are backward looking anyway and do not help much in assessing future outcomes. Interestingly, the RBA also doesn’t believe that this is sustainable, since they did cut the benchmark rate further.

Via FT-Alphaville I get this interesting piece which refers to an analysis by the RBA about the housing market. For starters, as is true for most countries in the Anglosphere, Australia’s housing market looks frothy and private debt levels are mind-boggling, leading many to speculate there is a veritable bubble going on down under.

Now the RBA has come out with a study of the Aussie housing market where it contrasts the economics homeownership with those of renting. In their own words,

(…)if real house prices were to continue to grow at the average rate of the past six decades [around 2.4 per cent, after inflation], then buying a house now would be about as costly as renting.” On the other hand, if future house price growth is closer to the average of the past ten years, then Australian homes are about 20 per cent overvalued(…) (I think there is a typo in the last paragraph: it should read undervalued, given that appreciation over the past ten years was even higher)

Of course, the 2.4 percent annual REAL increase in house prices over the past decades has NOTHING to do with the secular drop in interest rates and thus can be reasonably extrapolated into the future!

I had to rub my eyes several times: are these guys serious?

How else can you get a real increase in average house prices, but for a significant fall in funding costs? It is not even clear that economic growth could achieve that, since there is an argument that the richer you are the more affordable housing should be – not that 2.4 percent growth are in the cards anyway


Since the RBA finds that 2.4 expected (real) house price appreciation is needed to justify current price levels, and since I am very confident that this is not going to be achieved for any medium term horizon, I conclude that the housing market is indeed in a bubble. Coupled with a deteriorating export market (China) this further increases the vulnerability of the economy and the banking system. And to round it up, my favorite chart,


Maybe it is time to increase my short position…

More about Rocket Internet

I have written about RI here when I was wondering about their high cash burn rate; basically they used all of the IPO proceeds to buy other internet companies, mostly recently founded start-ups such as Delivery Hero.

RI’s results are out and, unsurprisingly, it shows a loss of EUR 20mln for 2014. This doesn’t sound to bad, but I have zero confidence in this numbers, since many participations are not fully consolidated and Rocket Internet’s holding structure looks like those of a Russian Oligarch tying to hide his traces (here, also read the interesting comment section). Meaningless, basically.

And then…they did it again!

By they I am referring to Delivery Hero, the company founded in 2011 that RI was happy to pay a hefty price for, from the article,

(…)Delivery Hero, a company in which Rocket holds a minority stake, announced the acquisition of the Turkish food delivery brand Yemeksepeti today, in a transaction valued at $589m (…)

Yep, Delivery Hero which RI was happy to value @ EUR 1.5bn way, way back in autumn, just bought a Turkish Internet company at a hefty price. I am absolutely sure that these guys have no clue about the currency risk they are taking.

While it might be true that RI at the beginning was quite successful copying successful US concepts, that is not what they do anymore. Now they buy companies that buy other companies…

Does anyone seriously believe this can work?


Read this excellent post (ht creditbubblestocks) for more color on the VC madness in tech.

Corporates are the marginal buyer – Does it matter?

Interesting Table by Goldman (via ZH) which breaks up US equity flows
We also know that a lot of that buying is funded via debt issuance, or in the words of Stan Druckenmiller,

(…)But then they increase their debt 600 billion. How did that happen if they didn’t have negative cash flow? Because they went out and bought $567 billion worth of stock back with debt, by issuing debt. So, what’s happening is their book value is staying virtually the same, but their debt is going like this. From 1987 when Greenspan took over for Volcker, our economy went from 150 percent debt to GDP to 390 percent as we had these easy money policies moving people more and more out the risk curve. Interestingly, in the financial crisis that went down from about 390 to 365. But now because of corporate behavior, government behavior, and everything else, those ratios are starting to go back up again (…)

Goldman’s figures show that for the past years corporations have been the marginal buyer of US equities. This, I believe, is a very helpful technical input to my fundamental market view.

Contrary to what mainstream capital pricing theories imply, the observed price of an asset is not some objective value where every agent agrees on expected cash flows and risk premium and valuation becomes a discounting exercise in equilibrium (the real world is never in equilibrium). Instead it is the result of the last transaction involving a specific seller/buyer. And knowing that marginal seller gives us valuable information on their expectations. To me it makes a difference whether the last quoted price is the result of, say, Warren Buffet buying from a distressed Goldman, or whether Mrs. Watanabe is the buyer.

So, corporations are borrowing debt at record low rates to buy back debt, is this good or bad? Surely, corporate CEOs are not Mrs. Watanabe (but they are probably no Warren Buffet either).

In order to answer this question I think it is necessary to look at three things:

  • Track record
  • Motivation
  • Implied expectation

Track record

This is an easy one. I am sure you are all familiar with this chart which I have already referred to in the past.


The timing of CEOs over the past cycle was not terribly good, sort of “sell low”, “buy high”. This, of course, is not a statistically significant result, but there is robust academic evidence that acquisitions, which require similar valuation skills, are value destructive. In my experience most CEOs have no clue how to value companies or how to allocate capital and have become who they are either because they are good operators, or skillful in company politics, not because of supreme capital allocation skills. In short: the overall track record of management valuing whole companies doesn’t inspire confidence.


The main reason that’s often quoted as a positive by analysts is that buybacks deliver EPS growth in a low (revenue) growth world.

The problem with this argument is that EPS growth might a good proxy for a positive NPV investment, or it might not be. Technically, as long as the earnings yield of your shares is above the yield you pay on the debt an equity buyback is EPS enhancing. If you believe this to be a reasonable proxy, you also have to be willing to stay in or out of the market based on a simple trailing PE ratio (and nothing else). By the way, that’s probably how Mrs. Watanabe buys stocks 🙂

A second reason has certainly to do with the fact that management compensation is either directly tied to EPS growth, or indirectly, as is the case with stock option compensation where the strike price of the option doesn’t adjust with the changes in shares outstanding. It is easy to see how management will go to great lengths justifying buybacks when given such incentives.

This apparent conflict of interest and the naïve argument given on why buybacks are good do not inspire confidence in me. No doubt, management has an incentive to overpay. Think about who the likely patsy is in this game…

Implied expectation

Now let’s play a little armchair economist.

Stocks are very long-term financial assets. It follows that at a PE ratio over 20 (and assuming that earnings are sustainable and a good proxy for cash flow) payback of the average stock buyback is more than 20 years. Since these are typically funded with debt that matures in 5-7 years, it means that this investment will likely have to be refinanced. Although there is lots of talk about “locking in” record-low interest rates, this nonsense: bond-financed buybacks create large (implicit) maturity mismatches.

I know what you think: debt is paid back out of operating CF (EBITDA or EBIT) and these multiples are way lower than PE ratios hinting at a much quicker payback and no need for refinancing. The problem with this view is that in order to reduce the refinancing risk, management has to divert cash flow from growth or maintenance capex to debt repayment – hardly a bullish argument. To be sure, there certainly are companies out there that need to be liquidated, and funding this via low-interest debt certainly makes sense (for shareholders). But it is the one argument I have never heard as a reason for buybacks.

It boils down to this: by making this bet management assumes that it will be able to refinance at record low-interest rates AND credit spreads over the next 20 years. I know, investors are not overly worried about raising government bond rates, but are they equally confident that that credit spreads will stay at current levels for the next two decades? I think if you frame the question in this way more people would come to the same conclusions as me…


For the reasons listed above high buyback activity is a negative technical indicator which adds to my fundamental worries about the market. My strategy regarding equity stays the same: keep exposure constant until your price target is hit and then load up on puts.