Research Watch

Will investors lose the taste for equities? Shorting China. The strategy for 2012. There’s money in garbage trucks. Watching China’s exits. On video: Buffett the Younger.

PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.

Despite so few IPOs – and so many wild market swings – selling equity is still said to be one of the safest ways for a major company fund itself. So when McKinsey forecasts a massive shortfall in demand for equities in the future – with the additional risks to the global economy that poses – investors should take note. In the short term, Research Watch presents investment ideas from Credit Suisse, which has uncovered a curious emerging markets indicator; and Dave Rosenberg, for whom caution is key. Find out why the latest bout of good news for China bears is bad news for gold bulls. Investors bet that oil prices will collapse – or skyrocket – depending on who you talk to. Learn how to predict China’s financial collapse. Finally, take a tractor ride with Warren Buffett's unlikely successor, as this week's video takes a peek at the life of the future boss of Berkshire Hathaway.

Mind the equity gap '¦ “In less than a decade, the world economy could face too many companies wanting to issue equity and too few stock buyers. The equity gap will change how companies fund themselves in ways that will introduce more risks into the global economy. Analysts at the McKinsey Global Institute '¦ looked at future demographics, investment trends and equity needs among 18 nations. They calculated that by 2020, companies in these nations will need to raise $US37.4 trillion of new capital, with equity being the preferred source of funds. But investor demand for equities will only amount to $US25.1 trillion, leaving a gap of $US12.3 trillion '¦ In developed nations '¦ the ageing population, growth of alternative investments and regulatory changes will shift investor preference away from equities. Emerging-market investors, although big savers, have a bias against stock investing, preferring bank deposits instead. At the same time, emerging-market companies will need greater amounts of capital to fund growth. Since fewer investors will want to buy stock, more companies will have to depend further on debt '¦ In times of stress, 'equity is a highly effective shock absorber’, the paper says. That is not true of leverage. 'Companies with more debt will face a possible liquidity crunch in recessions, leading to bankruptcy,' says Susan Lund, director of research and a co-author of the report. 'We will be adding more volatility to growth rather than smoothing it out’.”

(McKinsey via the Wall Street Journal, December 9)

Food for thought '¦ “Emerging markets remain our key strategic overweight. Valuation metrics in emerging markets are undemanding relative to their developed world counterparts, particularly in light of structurally stronger economic and earnings growth potential. In addition, with inflation pressures easing thanks in large part to declining food prices, cyclical dynamics are solid. On this front, the graph shows that a decline in food prices [like we have experienced] tends to lead to strong emerging market relative performance.”

(Credit Suisse via Pragmatic Capitalism, December 12)

Good news for China bears '¦ “Shorting the credit of companies positioned to do badly from a Chinese slowdown has proved to be one of the hedge fund industry’s most successful trades of 2011. Hugh Hendry, the outspoken UK hedge fund manager known for his bearish, often contrarian views on the global economy, has seen his 'China short’ fund rack up gains of more than 52% so far this year, investors have told the Financial Times '¦ Hendry’s credit fund is constructed from a portfolio of short positions against highly cyclical Japanese corporate credits that have high exposure to Chinese demand. His larger flagship Eclectica Fund, which also has a portion of its portfolio in credit default swaps contracts against Japanese credits, has performed well, too. Investors report it has made gains of 12.2% so far this year.” (Financial Times, December 12)

Bad news for gold bulls '¦ “Should Asian economies begin to struggle, it is possible that gold will follow. Certainly in the short term the Asia risk impact on gold price is clearly visible. The chart below shows how gold futures have been moving in tandem with China’s stockmarket.”

(Sober Look, December 14)

Oil to $US150! Oil to $US50! “Investors and traders are buying large numbers of oil contracts that would profit from a price super-spike – and a collapse '¦ The number of financial market bets on oil prices hitting $US130–155 a barrel by the end of next year has risen more than 25% over the past six months to 93,500 contracts, a sign of growing concern about upside price risks '¦ But at the same time, investors have been loading up the opposite financial bet: put options, or contracts that give holders the right to sell. According to Nymex data, the open interest for put options at the $US45–60 a barrel price level for next December has increased more than 33% over the past six months to just above 60,000 contracts.” (Financial Times, December 12)

The markets most at risk from a low-carbon economy '¦ (click for full image)


  • Click on image for a larger version.

From CarbonTracker.org comes this very useful accounting of global fossil fuel reserves, by market listing on stock exchanges. The risk identified in their report, Unburnable Carbon – Are the World’s Financial Markets Carrying a Carbon Bubble?, is that markets have accorded value to energy resources that may never be extracted. The reason? A rather hopeful one. According to the group, “the threat of fossil fuel assets becoming stranded as the shift to a low-carbon economy accelerates”. (Carbon Tracker via Gregor.us, December 11)

Dave Rosenberg's 2012 investment strategy '¦ “Many investors increasingly want preservation of cash flow as well as preservation of capital. We concur and have consistently recommended a focus on SIRP '” safety and income at a reasonable price, with a primary focus on stability and prudent risk-taking.

  • Focus on safe yield: High-quality corporates (non-cyclical, high cash reserves, minimal refinancing needs). Corporate balance sheets are in very good shape.
  • Equities: Focus on reliable dividend growth/yield; preferred shares ('income’ orientation).
  • Whether it be credit or equities, focus on companies with low debt/equity ratios and high liquid asset ratios; balance sheet quality is even more important than usual. Avoid highly leveraged companies.
  • Even hard assets that provide an income stream work well in a deflationary environment (ie, oil and gas royalties, REITs, etc).
  • Focus on sectors or companies with these micro characteristics: Low fixed costs, high variable cost, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity (utilities, staples, healthcare – these sectors are also unloved and under-owned by institutional portfolio managers).
  • Alternative assets: Allocate significant portion of asset mix to strategies that are not reliant on rising equity markets and where volatility can be used to advantage.
  • Precious metals: A hedge against the reflationary policies aimed at defusing deflationary risks – money printing, rolling currency depreciations, heightened trade frictions, and government procurement policies.” (Dave Rosenberg of Gluskin Sheff, December 9)

Robust rubbish investments '¦ “Real assets such as public infrastructure, farmland or timber have become a relatively common part of the allocation of many pensions and endowments in recent years. The cutting edge for real asset investment managers, however, is tangible assets that are mobile and require specialised and ongoing management. Garbage trucks, intermodal shipping containers, flight simulators, medical equipment and even portable toilets have the potential to generate consistent lease income '¦ and the leverage associated with assembling a fleet of shipping containers or dumpsters can be more manageable than the leverage typically deployed in commercial real estate and will have more limited geographically specific risk '¦ Wood Creek Capital Management is one of the firms at the forefront of this market. With more than $US650 million in committed capital, the firm has a team that includes 13 sector-focused analysts covering real asset opportunities spanning both tangible and intangible properties. For managers like Wood Creek, the perception of illiquidity in the tangible asset segment is an advantage. 'Today, a lot of the hard asset space is quite well populated,’ says Brett Hellerman, Wood Creek’s CEO and chief investment officer. 'There are lots of investment managers focused on the energy infrastructure space, for instance, or on public infrastructure. As a result, these markets are increasingly efficient and, therefore, they are not cheap’.” (Alchemy, November 26)

How to predict China’s demise '¦ “Based on my own anecdotal experience in Iran, one cannot predict the timing of a collapse with certainty, but a good leading indicator is when rats start leaving the sinking ship in droves '¦ Since 1990 around 18,000 officials have fled, taking an average of around $US7 million per flight. Special purpose credit derivatives (perhaps you prefer the term 'discredited' derivatives) are a leading indicator for China’s hard landing. I call these 'China chaos' derivatives, or 'Chanos' derivatives. If the rate of change of public officials fleeing the country, df/dt > x, where x is yet to be defined, or the acceleration in fleers, d^2f/dt^2 > y, where y has yet to be defined, or the rate of change of the average amount of loot dl/dt > z, where z is yet to be defined, then conditions of the Chanos Equilibrium have been violated and destabilisation will occur. Stated differently, when you see the absolute amount of embezzled wealth fleeing the country suddenly increase, or when you see a sudden increase in the absolute number of Chinese officials leaving the country on 'holiday,' or when you see an acceleration in the number of officials leaving the country in a stealthier way, you’ll know China is sinking.” (Janet Tavakoli of Tavakoli Structured Finance, December 8)

Video of the week: Meet Warren Buffett's successor '¦ Howard Buffett, 56, is a farmer with no college degree, who also travels the world helping the poor farm their crops more efficiently.

(60 Minutes, December 11)