Reaching Out to China

China market

If you’re looking for new markets or investment frontiers, you should not ignore China.  It is already the second largest economy in the world, and likely to maintain its fast-pace growth for some time to come.  China receives a lot of bad press focused on perceived obstacles to further growth, in many cases the reasons for its inevitable demise.  Instead, we believe it is worth pondering the possibilities of a further rise yet that will naturally bring new investment opportunities to consider.  Let’s get you started with some basic ideas that we will pursue further through upcoming articles on how to enter and focus on promising market or industry segments.

Entering the Reform Era in the late 1970s, China was dirt poor, at the time with GDP per capita less than 10% of the global average.  In the 30 years following, GDP growth averaged 10% per annum and its economy expanded 15-fold.   Despite a slowdown in growth rates in recent years (down to 6-8%) China is now the second largest economy in the world in nominal terms and its per capita income reached two-thirds the world average in PPP adjusted terms.  In the coming years China will outperform the global economy and become the largest in nominal terms, which it already is in PPP terms.

This is probably the consensus view among forecasters, but optimism is often overshadowed, if not called into question entirely, by “doomsday” scenarios that get more attention in media than do statistical realities.  At the “absurd” end of the spectrum are radical sceptics who question China’s growth record based on claims that the country’s economic statistics are “bogus”.  A shade less absurd are “ideological” critics – neo-conservatives or market-fundamentalists predicting the collapse of China since they can’t fathom the success of an economic model under government guidance.  There are sceptics in the mainstream as well.  Not a day goes by that we do not hear a new prediction that China is about crash, collapse or burst, but history shows us that despite all of these claims of imminent collapse, China continues to prosper.

Let’s look at the last 20 years to set the historical record of these doomsday predictions.   Before the Asian Crisis, China was believed to be very vulnerable due to its closed capital markets and fixed exchange rates; when the crisis hit, China was expected to suffer the most and take much longer to recover compared to other Asian economies.  In reality, for these very reasons, China was largely shielded from the crisis and was able to quickly move on to reach greater heights.  Less than a decade later China faced claims of an overheated economy, again sceptics called for bursting of bubbles and the collapse of the Chinese economy, but the government stepped in with the necessary restraint measures, and China continued to grow at a health rate.

The biggest test came with the 2008 crisis, one that left the global economy in ruin.  China was claimed to have even more inflated asset bubbles that were sure to burst, and when global demand tumbled, China was supposed to suffer even more due to its dependence on exports.  China responded with an aggressive stimulus package to maintain 9% growth in 2008, and, despite the collapse of its supposed growth engine, exports, the following year it pushed growth to 10% and in 2010 even above that.  Now China is claimed to have lost its growth momentum, based on a slowdown from 6.7% growth in the 2nd quarter to 6.5% in the 3rd of 2018, and considered to be headed for an even deep recession than the rest of the world, predicted for 2019 or 2020.

If you’re still sceptical of China after it has consistently out-performed expectations, then by all means, stay away, or even bet on its demise.  But if you care to understand the trends of the last 40 years and believe that the system is equipped to guide China into the ranks of the developed world at much higher income levels, then look into ways of investing in China, or at least finding instruments that give you an upside with China’s continuing rise.  Unfortunately, finding those opportunities or instruments will take some effort.

Shanghai Stock Exchange is 6th largest in the world, behind New York, Nasdaq, Tokyo, London, and Euronext – followed by Hong Kong, Toronto, Bombay and BM&F (Brazil) in the top-10.  Earlier in the year Shanghai ranked 4th behind NYSE, Nasdaq and Tokyo, thus has not had a particularly good year – SSE Composite has lost more than 25% from its year-high in January.  China’s second largest exchange, Shenzhen, has not faired very well either, down 30% this year.  Thus, this is not a bad time to get into Chinese stock markets; the general consensus is that both have bottomed out and are ready for a bounce.

However, this is more easily said than done; as a foreigner how do you buy China stocks or trade them? Chinese exchanges have not been fully open to foreigners, but entry is starting to ease up.   Since 2002 Qualified Foreign Institutional Investors (QFIIs) have been allowed to trade on Shanghai and Shenzhen stock exchanges.  Qualification rules are onerous (5-30 years in operation, $50 to $100 billion in funds, depending on type of investor) and repatriation is still difficult, but it is possible.  They also face quotas, limited to only a small share of their equity base.  Nevertheless, many institutional funds developed products, like baskets of Chinese stocks that clients could choose from, and this opened up windows for those looking for exposure to China.

The real opening up came with China-Hong Kong Stock Connect launched in 2014, allowing mainlanders to invest in Hong Kong (mostly China stocks anyway) and Hong Kong investors (together with foreigners due to the openness of that territory) to invest in Shanghai and Shenzhen stock exchanges.  Restrictions still apply with minimum funds that investors must hold in trading accounts, as well as with daily overall limits on flows.  Initially northbound flows were more significant, but soon the balance reversed; now this has become quite a significant conduit for foreign investment in Chinese stocks.  Chinese appear to have lost their appetite for Hong Kong stocks while foreigners are attracted to low stock prices in China with this year’s slump.

This summer, Chinese authorities announced their intention to allow foreigners (from 62 countries) to open accounts with domestic brokerage houses to trade RMB denominated A-shares in both Shanghai and Shenzhen.  The proposal is still subject to debate but looks like this move will open up a new era for foreign investment in China, but no doubt with limits and restrictions to prevent both sudden rushes of capital as well as speculative excesses.  Part of the motivation behind this move is to cut out Hong Kong from the inbound flows; clearly there is too much red-tape and unnecessary fees going into Hong Kong pockets along the Stock Connect route.  However, there is also genuine interest in opening Chinese companies to foreign investment, pleasing domestic interests and foreign critics alike.

Both the Stock Connect and the newly proposed window by the Chinese authorities are significant developments, but bear in mind that even the channels that developed behind QIIFs provide plenty of investment options to consider.  There are Mutual Funds with Chinese companies in them, American Depository Receipts on US exchanges holding Chinese stocks (or rights to them) as well as options on Exchange Traded Products and indexes.

In many respects Chinese stocks have opened up to foreign ownership, albeit with constraints and difficulties, but beware of the risks that come with being exposed to individual company stocks when they become more accessible.  You have to do considerable research into listed companies because reporting requirements are not yet what you might be used to, and perhaps even more important than company fundamentals are the markets and industry segments in which they function.  This is a much more dynamic economy than you’d imagine, rapidly growing, restructuring, changing – be prepared to become a China-specialist.  Also, bear in mind that 75-80% of trading on Chinese exchanges is retail-focused – you have to be able to relate to the sentiments and quirks of an unfamiliar crowd.  However, as China continues to grow and open, there will be significant opportunities for those able to find their way into the market.

Currencies in Peril

We discussed the future of Turkish Lira in a previous article, but this is far from an isolated case of a currency in crisis –  Argentina peso, Indonesian rupiah, South African rand, Chilean peso, Iranian rial, Russian ruble, and even Chinese yuan have all been falling, albeit some more dramatically than others.

Here, we analyze how reserve-ratios and debt levels in relation to GDP can provide some insight into the risks associated with a particular currency.

A fundamental threat running through global financial markets is the ballooning of US dollar denominated debt worldwide – increasing from $600 billion to over $2 trillion in 2000, and reaching $12 trillion in 2018.  Generally this trend is seen as the fundamental problem at the root of all pending crises: bubbles are bursting all around the world due to countries’ inability to meet debt obligations, and more importantly the inability to defend currencies when they come under pressure.

Bank of International Settlements (BIS) has 11 countries on a watch-list – five high-risk, Turkey, Chile, Argentina, Mexico, and Indonesia, and six moderate-risk, South Africa, Brazil, Russia, Malaysia, South Korea, and India.  China and Saudi Arabia are listed as examples of no-risk countries.  These high and moderate-risk countries have to be taken seriously as together they account for more than 60% of the total USD denominated debt worldwide.

There are two key factors to consider when analyzing a country’s currency: firstly, the USD debt level and the size of reserves that could cover that debt in the long run (as well as the liquidity of those reserves to fend off any runs on a currency in the short term); and secondly, the debt-to-GDP ratios of a country as a whole.

In the case of the Turkish lira, foreign reserves can cover little more than half of Turkey’s USD-denominated debt (according to the Bank of International Settlements 54%); Chile and Argentina are even more exposed, with reserves at 37% and 48% of USD debt respectively; Mexico and Indonesia are only slightly better-off at 66% and 72% respectively.  Needless to say, the ability of these 5 countries to cover their total external debt is even more limited (15-25%).

The moderate-risk countries have enough reserves to cover their USD debt – South Africa 133%, Brazil 202%, Russia 242%, Malaysia 255%, South Korea 336%, and India 390% – but fall short of covering their total external debt.

Compare these figures with those from China, a country identified as no-risk and one that holds reserves that are six-times its USD debt and double its total external debt, or with the oil-rich Saudi Arabia, with reserve ratios standing at 4.5 times its USD debt and 2.7 times its total external debt.

Debt-to-GDP ratios (both USD and total external), is also a critical measure of a country’s indebtedness.  Among the 5 highest-risk countries, Mexico can cover two-thirds its USD debt from reserves – seemingly better-off than Chile, Argentina and Turkey – however, Mexico is even more exposed than what this may suggest.  Its external debt (39% of GDP) is not as high as Chile at 66%, Turkey at 55% or Argentina at 40%, but at 60% of its total external debt, its USD denominated debt is 25% of GDP, behind Chili at 36% but higher than Turkey at 24%, Argentina at 20%, and Indonesia at 15%.  Moreover, the size of its USD debt is second highest behind China’s, bearing in mind that China’s USD debt is a mere 4% of GDP.

This is the type of analysis required when trying to identify high-risk situations (opportunities depending on your perspective) but often, further consideration is required: Indonesia, for example, has an external debt-load in relation to GDP of only 35%, lowest among the 5 high-risk countries, and less than half of that is USD denominated (16% of GDP), and its reserves are large enough to cover 72% of its USD debt (highest ratio among the 5); however, since its reserves are still rather limited, Indonesia is still highly exposed, and its currency decline (more than 10% this year) is an indication of this vulnerability.

Compared to the high-risk countries, the six considered moderate-risk all have relatively low levels of USD denominated debt (South Africa, Russia and Malaysia at 11-13% of GDP, South Korea and Brazil at 8-9%, and India as low as 4%) and they have enough reserves to cover their USD denominated debt (India with a margin of 4:1, South Korea 3.4:1, Russia and Malaysia around 2.5:1, Brazil 2:1, and South Africa at 1.3:1).

Their total external debt exposure, however, is much higher in relation to GDP; in fact, Malaysia’s at 68% of GDP is higher than any of the high-risk countries, while South Africa at 52% is only below Chili and Turkey.  The remaining 4, Russia at 33% of GDP, Brazil at 32% and South Korea at 28% are only slightly below Mexico and Indonesia, while India at 20% is lower.  South Korea and Russia have enough reserves to cover most of their external debts, and India is not much farther behind them.  Brazil and Malaysia can cover about half their total external debt, while South Africa is below 30%, closer to the high-risk group.

Reserve-ratios provide some guidance in assessing overall risk levels but do not provide enough information to gauge the state of a particular currency to buy or sell at any particular moment, at least not in any informed way.  As we examined in more detail in the case of Turkey, the currency crisis the country faces is the outcome of deeper financial and economic forces at work; moreover, its socio-political instability is playing a huge role in driving the value of its currency through capital flows (limiting inbound investment while boosting outbound flight).

Currency-crises are typically expressions of wider financial or economic difficulties facing the countries involved.  Their ability to pull out of crises depends on their capacity to stabilize their economies and restore healthy growth, and in this regard socio-political conditions play as much role as the economic fundamentals.  To pass judgment on the future of any currency, be it in high or moderate risk countries, we must understand the broader context through further analysis on a country by country basis.

Cannabis Stocks: A boom or bust?

Call it the green-rush or an unsustainable-bubble, the cannabis investment scene in Canada is an intriguing market for active investors and passive observers alike.  Are we witnessing a “boom” in a newly legalizing industry, or is it a “bubble” that is bound to burst like the .com bubble of the 1990s?

If you’re a follower of the Canaccord Genuity Cannabis Index (CGCI) you might have been euphoric to observe the recent one year increase of 400-450% to September, 2018.  As the Canadian legalization date approached, CGCI’s performance climbed even higher – up 90% in the first half of September (50% above August levels).  However, in the week following Canadian legalization (October 17th, 2018) the market began to fall – 30% decline in the North American Marijuana Index (NAMI).  Many casual investors saw a significant losses, and it has caused many to look upon the cannabis industry with less enthusiasm.

Before passing judgment let’s put the stock price trends in perspective.  NAMI had indeed plunged in the latter part of October, 2018 but it was still double the value it carried through most of 2017, and it has since started to recover, not to the interim October peak but still to the highest levels since February, 2018.  CGCI also experienced a correction but still managed to maintain a valuation roughly double the previous year (not including the huge gains beginning in late summer.  The cannabis industry is now considered ready for a near-term bounce.  Thus, what was experienced in October was a correction, not a bubble bursting.

There were elements of irrational exuberance through 2018, with investors jumping into an intuitively appealing market that they did not quite understand.  The cannabis industry holds a lot of growth potential and will continue to attract new investment, but don’t count on an across the board boom.  One must invest wisely, as there will be plenty of unworthy prospects and considerable volatility ahead.  To realize significant gains in the years to come, one must understand where the industry is headed and how it is going to get there, formulate a strategy, and invest accordingly.  We will get to the industry landscape and how it is expected to evolve in the coming years in another article, but here let’s focus on the stock scene.

An investment firm, Canaccord, with a keen interest in the market and the emerging industry around it, estimates the financial transactions in the last 4 quarters to be close to $5 billion.  There were large items in this basket, $600 million for Canopy and $200 million+ investments for Aphria, Tilray and Aurora – also many smaller ones, especially in the $10-15 million range.  However, this total does not include yet to be realized commitments like the $5 billion Canopy got from Constellation Brands.  Thus, by any standard, transaction volumes are significant.

Among the 350-400 securities in the marijuana stock universe, only a few are on NYSE or Nasdaq; many more are listed on Canadian exchanges (TSX, CSE and TSXV), while plenty more trade on over-the-counter boards.  There are heaps of private placements in the pipeline – mostly start-ups, but also ones with track-records that are preparing for a public listing on senior exchanges rather than enduring OTC-trading for months or years to come.

NAMI, referred to above, has a base of 34 companies – 18 in its Canadian Index and 16 more in the US one.  The Canadian group has a combined market cap of roughly $35 billion, while the American one is about $10 billion.  CGCI is based on 10 companies that are in NAMI as well – 5 of these (3 on NYSE or Nasdaq, 2 on TSX) have market caps of more than a billion (currently Canopy is at $13.2 billion, Tilray $11 billion and Aurora at $8.4 billion, others are in the $1-1.5 billion range).  Of these firms, largest 3 constitute close to 80% of the CGCI-base and are all Canadian.  In contrast the largest US-based marijuana company, GW Pharma, has a market cap of about $4 billion.  Among the other 15 in the US Index only one is just shy of a billion, all the others below $500 million.

The 36 firms that are indexed (CGCI or NAMI) are now valued at more than $45 billion; at their peak in October or January they were close to $60 billion.  What is driving these valuations to these levels?  Simply put, it has nothing to do with earnings; rather it is based almost entirely on growth potential as the legal market opens.

Some do have positive earnings, like Aphria and CannTrust, with market caps at $2.9 billion and $700 million respectively.  Their price-earnings (PE) ratios are 86 and 44, high but not unheard of in the tech-world.  A few others are also revenue-positive but trading at astronomical valuations with meager earnings – Aurora, 2nd largest in market cap, has a PE ratio of 769, Cronos with $1.5 billion market cap at 869, OrganiGram with $740 million market cap at 1900.

Some analysts are optimistic that this situation will change within a year or two.  Canaccord-Genuity, for example, projects an average PE ratio of 30 for the top-9 cannabis companies into 2019, declining further to 16 in 2020.  This is probably wishful thinking; a dramatic turnaround will occur in the future, but it will not be that soon.  Most investors are aware of this reality, and are not expecting huge earnings in the short term.  At this stage, cannabis companies are investing and spending free cash-flow on corporate infrastructures: they are ramping for growth and will normalize their earnings once they mature.

A more realistic valuation measure for this industry, at least at these early stages, is revenue-multiples.  Canaccord does project expected valuations to revenue ratios – for the top-nine 9-times revenue in 2019 and 6-times in 2020.  These targets may not be achieved in the next couple of years, but ratios will improve and eventually get there.  This is a more suitable measure for this industry (at least at this stage) as large cannabis companies follow more or less the same model; scaling up growth capacity at similar unit-costs.  Most of their revenues are derived from growing-and-selling cannabis into a fairly competitive market, where most buyers have access to multiple suppliers.

This is the industry’s core business model, but companies will follow different diversification and vertical integration strategies thereby diverging from the norm.  By then the industry would have matured to place more emphasis on conventional ratios like PE.  Along the way some producers will do better than others but the results can be tracked against standard norms. These issues will make more sense against the background we are going to provide in a subsequent article – where the industry is, at these early stages, and where it’s headed.

To sum up the cannabis-stock discussion, there has been an investment flood into the industry, by both institutional and retail investors.  This is an emerging industry at fairly early stages of development with very strong growth potential, a natural magnet for new investment.  The valuations may seem hyped up but the recent plunge in stock prices should be seen as a market correction with a likely bounce to follow, rather than bursting bubble.

In time existing players will strengthen and grow while many others emerge.  There will be plenty of stocks in the offering but investors and traders must understand the companies they are betting on – market positioning, growth strategies, strengths and weaknesses.  There will also be plenty of IPO and private-placement opportunities in which to participate, but investing in them will require more knowledge – there may be more winners than losers but avoiding the latter will require careful analysis.  This is not a space we would recommend for novice speculators allocating their funds blindly, but there is money to be made for informed investors.

Cannabis Industry Growth

Cannabis Industry Growth

In order to understand investment trends and cannabis stock prices we need to understand the industry’s make up and its growth potential.  There is a tendency to take the market for granted and assume that the companies are claiming a stake as legalization unfolds, but the story is much more complicated and, every decision requires careful study before buying or selling existing stocks, investing in IPOs, or participating in private placements.  We can’t provide you with a comprehensive study in a couple of pages, but at least offer a few reference points.

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Analysis of the Turkish Lira Crisis

The history of currency markets tells us that where there is turmoil, there is opportunity for wise investors to make money; whether by speculating on short-term corrections, or by playing the long-game by analyzing macro trends in the economic and geopolitical movements of a country, currency crises create investment opportunities.  The Turkish Lira crisis of 2018 serves as an excellent case study to analyze the opportunities presented when the value of a country’s currency is in turmoil.

In the first 8 months of 2018, the Turkish Lira plunged 40-50% in value, falling to roughly 7 Turkish Lira to a US Dollar in August – just one of many currency crashes around the world.  This dramatic plunge in a currency’s value presents traders with unique opportunities to earn a profit, and by analyzing relevant indicators, we aim to shed some light on how to evaluate the trading opportunities presented when this type of crash occurs.

There are two key things to consider when looking at a particular crash: the long-term trends of a market, whether a crash is expected to continue, or whether it has reached its trough and is expected to rebound; and the short-term fluctuations resulting from policy measures, institutional framework, political climate, and even aspects of culture that can act to reinforce the downward pressure, or cushion a fall and help stimulate recovery.  Markets are unique, and the better people understand the economic, social, and political intricacies of a country, the better equipped they will be to speculate.

Is the Turkish Lira going to continue to fall, or is now a safe time to buy?  There is a broad consensus that the currency plunge is part of a much larger banking-and-debt crisis, even a sign of much deeper economic instability, and looking at the country’s banking system, its public finances, trade-deficit, the general flight of private capital, and rampant institutional corruption, it is not hard to be pessimistic about the state of the Turkish economy; there are no signs of a recovery any time soon, and this means that any long-term plays hoping for a rebound in value are unlikely to pay off within a realistic time frame.

Turkey’s banking system is highly fragmented, a hodge-podge of quasi-privatized state-banks and extensions of conglomerates that branch into finance – most are undercapitalized and poorly managed, generally serving related or vested interests.  Enticed by low interest rates, banks had been borrowing from abroad and lending, rather carelessly, to domestic clients; consequently, they were highly exposed and unprepared for a plunge in the Lira, and lacking any access to capital, they are likely to struggle immensely in the coming years.

At the same time, the country’s public finances were out of control at the time of the crash.  Massive infrastructure projects over the past few decades were aimed at sustaining population growth and urbanization, and money was thrown at social programs in order to retain popularity, but this frivolous spending left both public and private coffers dry – many projects were mostly debt financed through bank-lending or more creative instruments (BOTs or JVs), but this only served to further expose the country to a crash by coupling private and public finances.

The plunge in the lira also served to exacerbate the country’s trade deficit, a pre-existing condition.  Turkey had previously worked to embrace open trade, deluding itself that it had the export capacity to liberalize imports.  With a relatively overvalued currency, the economy quickly grew dependent on these imports, even on essential items like grains and other foods – products that are now made unaffordable by the currency plunge.  The export capacity was an expression of domestic pride; however, even at now devalued prices, it is hard to see how the country could increase its exports to ease this pressure.

Furthermore, Turkish citizens had acquired the right to transfer their money abroad, a practice that was common before the crash, but would become a major problem when currency began to flood out of the country in response to the crash.  As the Turkish Lira started to plunge, in anticipation of yet worse to come, the more astute among the wealthy were quick to stuff their foreign currency accounts, preferably off-shore.  Calls for “patriotism” fell on deaf ears, failing to persuade the citizenry to keep their money in Lira, and this is likely to continue unabated as the secular elite are worried about increasing market uncertainty.

Conventional wisdom calls for austerity measures and higher interest rates; however, the cost of tightening the public purse strings is losing popularity among voters, and the country refuses to go to the IMF for monetary aid, fearing this would be an inescapable remedy.  Turkey has instead vowed to pursue a home-grown solution, and this is likely to stall out the crises for years to come.

In view of all this, can the Lira avoid a further free-fall?  A long term decline is inevitable but not without upticks along the way; and while there is not much hope for long-term investors to begin earning a profit as Turkey’s economy recovers, there is still ample opportunity to earn money by playing off short-term fluctuations, like the one from 7.2TL to the dollar in August to the subsequent recovery to 5.5TL.

While it is impossible to identify a precise algorithm to profit off of these swings, there are some things to keep an eye on in order to better inform your decision: firstly, understand the political dynamics of Turkish governance, and see that they will pull every trick in the book to disguise the depth of the crisis and display illusions of recovery; and second, be on the lookout for short-term relief efforts, like the gesture by Qatar, that are offered in exchange for political favor in the region.

The Turkish government is adept in playing nationalist and Islamist sentiments in their favour, and will even go so far as to call all patriots to purchase domestic products and to buy Turkish Lira.  These short-term tricks often work to create minor upticks in their currency, and can be used to earn speculative profits: follow the president’s speeches as closely as possible, and expect his charisma to affect the market in a very real way.

Qatar’s loan was made primarily for geopolitical reasons to gain Turkey’s favor; regardless, it served to provide a relatively modest lending facility that helped the Lira recover 10-15% within a matter of days.  In the crazy political power games of the Middle East, we are bound to see more such deeds, lending a false sense of confidence to the Turkish economy.  Do not expect any of these patchwork fixes to actually correct the faltering economy, but do not be surprised if they stimulate short windows of recovery that provide speculative opportunities.

These kinds of efforts will trigger periods of short-term relief, thus present opportunities to dump the Lira for those who had caught the low points to buy.  However, the underlying fundamentals will continue to exert downward pressure on the Lira for the foreseeable future.  Wait for signs of healthy economic growth before expecting an actual turn in the currency crisis, but be on the look-out for the short-term opportunities presented as the market fluctuates toward its trough.