March 2012

March 20, 2012

China: even pessimism may be over-optimistic

There are signs that the good times may be coming to an end in China. Exceptional growth has been fuelled by government spending, a heavily under-utilised workforce being put to work and an undervalued currency boosting competitiveness.

All three tailwinds are now turning to headwinds as evidenced by certain anecdotes shared by the panel. Vehicles producers (a good indicator of consumer activity) are only expecting growth in revenue of around 5% in 2012. That contrasts clearly with the expectations of a 17% growth in consumer spending. Some companies are starting to repatriate labour away from China – an anecdote has HSBC starting to employ call centre workers in Glasgow as it is now cheaper to find English speakers there than it is in China. Ditto several small manufacturers in England. Wealthy individuals are also starting to pull money out of China, partly due to the political uncertainty, but partly because of the perceived over-valuation of the currency.

Air freight volumes out of Asia have for a long time been a good indicator of the strength of the economy. That those are now diving is sobering for anyone still expecting a luke-warm 7% Chinese GDP growth. A much lower figure seems more likely, and interesting that sentiment is much more bullish on China outside of Asia than inside it. A case of being too far from the coal face?

Peak margins, peak multiples

At Kennox, we are particularly wary of two things: peak margins and peak valuation multiples. The Panel noted that both are prevalent at the moment, and particularly in the US.

Somewhere around 6% is the long-run average for corporate profit margins in the US. Anything nearing 8% has always been unsustainable (as seen in 1967, 1997 and most recently in 2006). They are now over 10%. It is possible that “this time it’s different”, but the Panel could not think of a single reason to support that belief. Increased competition, labour wage hikes, higher taxes and inflation have always brought profit margins down in the past, and we strongly believe they will do so this time as well.

Due to this tendency for profits to revert to mean, 12-month trailing earnings multiples can be misleading. Whilst the US may not look wildly overvalued on a 14.5x trailing earnings multiple, a cyclically adjusted PE multiple (CAPE) of around 24x is significantly above its long-run average.

Markets may be more expensive than they first appear.

Pockets of value

Given the paragraphs that have gone before, it is clear that the Panel sees significant risks to the markets. Consumer staples is a good example of a sector that has become a consensus trade (which is not our speciality investment style, to say the least). Those that rode the wave have done very well (the sector was up around 10% in 2011), but expectations are high at present, and earnings are at peak levels.

We have looked elsewhere to find pockets of value in generally expensive markets.

Telecoms continue to offer utility-like cashflows, but remain out of favour. There are well-publicised problems facing the sector (rising capex requirements, changes in consumer usage patterns, increased competition), but double-digit yields are an indicator of just how far the prices have fallen.

Despite a small resurgence in 2012, insurance companies are also looking interesting, with a number of them trading at around book value. Operating on their own cycle (with pricing strengthening after a year of terrible claims experience in 2011), this may also be an opportunity.

Peter Hollis, Russell Napier, Angus Tulloch and the Kennox investment team.

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