Extreme Financial Games



A hedge fund that I oversee for my family office client had the following energizing comment in the fund's most recent quarterly letter:

There is no secret sauce for successful investing beyond a proven process and humility.

Certainly a number of hedge fund managers have been humbled recently by persistent underperformance against the S&P 500 as this unmanaged index marches ever higher.  For example, the Dow Jones Credit Suisse Long-Short Hedge Fund Index has gained only 4.3% year-to-date through September 30, 2017 compared to a total return of 14.1% for the S&P 500.  Despite the generally exorbitant compensation in the industry, I have some empathy for hedge fund managers that have consistently underperformed the S&P 500 because they've employed a risk mitigation, hedging discipline of shorting richly valued stocks (a bet that a stock price will go down) with flawed or failing business models and/or inferior management.  You lose money shorting a stock if it rises in price for speculative, technical, or other reasons despite its rich valuation and perceived poor fundamentals.  This year a broad swath of hedge fund managers' egos have been left dazed and confused by the irrationality of today's markets.

I believe the hedge fund manager's reference above to a "proven process" is a reference to the proving grounds of a sustainable investment approach of performance measured over a full market cycle - both bull and bear phases.  The rigor and discipline of an investment process is only truly tested in a period of bearish market volatility and declining prices.  Like great women and men, it is in the trial that an investor is made.  Just like precious metals in a furnace it takes intense heat and pressure to reveal the inherent beauty and shine of an investment process.

Since its founding in 2005, Servant Financial's primary investment objective has been to take a risk aware approach to preserve client capital and maintain the real value of portfolios while growing capital over the long-term.  Our investment strategy provides for the essential tenets of a fiduciary driven approach by providing broad diversification, low transaction costs, low portfolio turnover, and tax efficiency.

We achieve these investment objectives through risk-based asset allocation and a core passive index strategy.  We overlay active management elements through a relative value discipline among asset classes and employing select active fund and stock selections.

As we've written about frequently in the past, investors have generally been penalized for taking a global, broadly diversified investment approach.  Simply stated, with the benefit of hindsight investors would have significantly outperformed by being solely long U.S. equities over the last eight years.  This issue was explored in a recent article from PIMCO entitled "Are Diversifying Assets Up Next In The Return-Seeking Cycle?".  The article cites some stark comparisons of performance across asset classes:

Since the lows of the global financial crisis in March 2009, U.S. stocks (proxied by the S&P 500) have returned 270%, or 16.8% annualized, outpacing every other major market over that period.  Contributing to that outperformance were highly differentiated returns among asset classes, particularly in the three calendar years following the “taper tantrum” sparked by comments from then-Fed Chairman Ben Bernanke.  Starting in 2013 and through 2015, the S&P 500 Index gained 52% cumulatively, whereas core bonds returned 4% (proxied by the Bloomberg Barclays U.S. Aggregate Bond Index) and an equally weighted basket of diversifying assets actually lost value, returning −12%.  In other words, diversifiers lagged U.S. stocks by 64% for the 2013–2015 period.

Futurist and inventor Elon Musk's statement that "There's a one in billions chance we're in base reality" immediately came to mind.  In summary, Elon took game theory to the next level when he stated that he believes we are living in some advanced civilization's computer simulation.  Essentially, the world in which we live is the ultimate in fake news and our markets are a form of entertainment called extreme financial games.  When one looks at this issue through the lens of valuation, I think there is something to be said for Musk's argument that U.S. equity markets are some form of computer simulated entertainment.  

Within this realm of extreme financial gaming, Servant's investment process has been dynamic and interactive and has consistently included forward-looking expected return inputs to supplement the longstanding investment advisory practice of using past returns to forecast future returns.  Research Affiliates recently posted an article entitled, "The Most Dangerous (and Ubiquitous) Shortcut in Financial Planning" - using historical returns to forecast the future is the shortcut methodology.  I'm unsure who is the puppet master in this extreme financial game, but I'd like to use the rest of this feature article to update investors on S&P 500 valuations and expected future returns by summarizing the work of three investment research firms that we religiously follow that use forwarding-looking return forecast models.

The first research firm expected return forecasts we'll look at are from GMO.  GMO is a global investment leader with expertise in managing multi-asset class strategies as well as focused strategies in a number of specific asset classes.  GMO's investment approach seeks to identify asset classes and securities where investors are paid to take risk and utilizes a long-term investment horizon, a belief in the power of mean reversion, discipline, conviction, and a commitment to research (emphasis added).  As we've covered in the past, mean reversion is a key assumption in GMO's asset class forecasts. GMO assumes asset class valuations will revert to their historical mean valuation levels over a 7 year forecast period.  For the S&P 500 this approach implies that GMO expects that the current Shiller price to earnings (PE) of ratio 31.3 times at the 100th percentile of its historical valuation range would revert to approximately the 50th percentile over the next 7 years.  In other words, the lower valuation multiple applied to the S&P 500 over time is expected to result in mark to market valuation losses by GMO.

GMO recently published their 7-year asset class real return forecasts as of September 30, 2017.  As you can see from the chart below, GMO expects that investors will lose money over the next 7 years on a real basis (after inflation) for all asset classes except emerging market equities (+2.4%), emerging market debt (+0.4%), and cash (+0.1%).  U.S. large cap (-4.1%) is expected to be the worst performer over this forecast period.


GMO Asset Class 7Yr 9-30-17


The next body of valuation research we will look at is from Research Affiliates.  Research Affiliates is a global leader in smart beta and asset allocation.  Dedicated to creating value for investors, Research Affiliates seeks to significantly impact the global investment community through their insights and product innovations.  The scatter plot below shows Research Affiliates' 10-Year expectations of risk and real return for portfolios and asset classes.  Follow this link above to Research Affiliates' website where you can click each of the individual dots, or make selections from portfolio and asset lists to get more information about each portfolio or asset class.  The portfolios connected by the dashed line below represent efficient, highest return per unit of risk, portfolios.  These efficient portfolios are governed by a set of diversification standards which can be seen by clicking the "Efficient" label in the portfolio list at their website.

These expected returns are based on a set of routines which model both expected cash flows and changes in asset prices (reversion to the mean), and not by extrapolating returns of the past (pervasive short-cut approach used by most financial advisors).  You can learn more about Research Affiliates methodology for valuing assets here.

In general, I would characterize Research Affiliates' methodology as a more robust version of GMO's basic methodology described above.  Note that Research Affiliates projection period is 10 years versus GMO's 7 year forecast period.  There are obviously other significant differences in assumptions and methodology as you'll note for example that Research Affiliates has projected a 10 year real return for emerging market equities of 6.3% with volatility of 22.9% compared to GMO's 7 year expected real return of 2.4%.


\Margin Adj CAPE vs. Act S&P 12yr


The third and final research firm's work we'll look at is Hussman Funds.  Hussman Funds was founded by John Hussman, an economist, stock market analyst, and mutual fund owner.  He publishes a weekly market commentary and is broadly known for his public criticism of the U.S. Treasury and the Federal Reserve policies and for predicting the 2008-2009 U.S. Recession.  He has written extensively about the extreme valuations of the S&P 500 and other asset classes precipitated by Fed monetary policies and, not surprisingly, is predicting another market crash and financial crisis.  

Like GMO and Research Affiliates, Hussman has performed extensive investment research and valuation analysis. In his latest weekly commentary dated October 9, 2017 is entitled "Why Market Valuations are Not Justified by Low Interest Rates."  Hussman describes how his team has back tested some 15 different valuation approaches and determined the methodologies that have the highest correlation and predictive value for future expected returns.  One of his favorite methodologies is Margin-adjusted CAPE (cyclically adjusted price earnings/Shiller PE).  Hussman's introduction to this method is as follows:

The chart below is based on (Hussman's) margin-adjusted variant of Robert Shiller’s cyclically-adjusted PE (CAPE). Specifically, the CAPE (calculated here as the ratio of the S&P 500 to the 10-year smoothing of inflation-adjusted earnings) is multiplied at each point in time by a factor equal to the 10-year smoothing of corporate after-tax profits to GDP, divided by the historical norm of 5.4%. The resulting measure is similar to the S&P 500 price/revenue multiple, the ratio of market capitalization to corporate gross value-added, and other measures that share a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.

As expected, the (log) margin-adjusted CAPE acts as a “sufficient statistic” for actual subsequent S&P 500 total returns, particularly on horizons of 10-12 years (which is the point where deviations from historically normal valuations most reliably damp out). Also as expected, adding additional information about interest rates (green) does virtually nothing to improve the reliability of the resulting projections; a result that can be understood from our earlier valuation examples. If anything, low interest rates actually worsen expected future market returns here. If extreme valuations were not enough, depressed interest rates suggest the likelihood of below-average economic growth as well.

As you can tell by the green and blue lines in the bottom right corner, Hussman expects negative nominal returns for the S&P 500 over his 12 year forecast period.


Margin Adj CAPE vs. Act S&P 12yr


The last and perhaps most telling chart on current extreme valuations below is Hussman's margin-adjusted Shiller PE.  Since the current profit margins of the S&P 500 are well above the historical norm of 5.4%, Hussman estimates the Margin-adjusted Shiller PE is something like 44 times today or significantly in excess of the 40 times for the 1929 market bubble, the dot.com bubble of 2000 at 41 times, and the current Shiller PE of 31.3 (without making an adjustment to normalize margins).

By these metrics, we are clearly in an extreme financial game simulation or some other artificially created financial and market situation.  The question is are these "fake" markets of an alien origin or do they emanate from Fed monetary policies as Hussman and other market historians would vehemently argue?  My intuition is that it is Fed induced rather than E.T., the Extra-Terrestrial, playing an advanced video game.


  Margin Adjusted CAPE

The Charm And The Unknown Of Emerging Markets


Trusted Insight Logo

In last month's blog feature we ventured into new media with the introduction of audible.com to describe some thoughts on summer readings.  This month I'd like to explore the media frontier of Trusted Insight and share a video from their 2017 Alpha Investment Conference with you.

Trusted Insight (TI) is the world’s biggest network of institutional investors.  Think of it as the LinkedIn of institutional investors.  The TI network allows lead investors to syndicate investment opportunities to family offices, qualified institutional buyers, and other institutional investors across asset classes such as Venture Capital, Private Equity/Buy-out, Real Estate, Infrastructure and others.  TI also manages its own platform fund(s) and acts as syndicate lead in seed stage venture capital funds.

With over 140,000 members on the platform controlling over $18 Trillion in assets, TI is one of the fastest growing and most trusted alternative asset syndication platforms.  Each week 30,000 institutional investors engage on the TI platform.  These institutional investors are actively investing in alternative assets, primarily private equity, hedge funds, real estate and private companies.

Founded by Alex Bangash, TI started in 2010 and is venture-funded and revenue producing. Its investors were the first investors or founders of Facebook, LinkedIn, Mint, Match.com, and Blackstone, among others. The company has offices in NYC and San Francisco.

TI hosted its first annual Alpha Investment Conference in San Francisco in June.  I was fortunate enough to participate as a panel member on Reassessing The Golden Age Of Private Equity with Dale Hunt, Managing Director - Private Equity at Ascension Investment Management, Josh Stern, Director - Private Markets at Robert Wood Johnson Foundation, and Tristram Perkins, Managing Director - Neuberger Berman.  Please click on the image below to hyperlink to a 14 minute video from this panel discussion entitled The Charm and Unknown of Emerging Markets by TI.

Although the discussion is primarily targeted to institutional investors, I think it provides helpful perspectives for individual investors as well, particularly in the complex investment landscape that investors find themselves in. TI prefaced the discussion as follows: "Emerging markets take a sizable chunk of institutional capital from developed countries.  But as domestic private equity has been providing steady returns, is the risk of going into emerging markets still worthwhile?  While some warn that investors should be careful betting on emerging markets, others argue investors need a little patience and a “buy-and-build” approach.

In part three of TI’s private equity panel, investors discuss their experience and observations on emerging market investing. The panelists also answered questions from the audience."


Trusted Insights Logo


In the video, I reference a new book from Sam Zell. Please click the image below to a hyperlink to the audible site to listen to the book read by Sam. Enjoy. 


Am I Being Too Subtle?


We've also been busy over the past year or so contemplating the establishment and progression of Servant Financial over the past 12 years and going through a refresh of our branding and marketing materials to ensure proper reflection of our founding mission, values. and raison d'être.  This journey started with a new corporate logo which you see below.  Please note the heraldic shield that forms the V in Servant.  We believe investment and wealth management is a noble profession.  The assets that we manage for clients represent their dreams for the future whether it be a college education for a son or daughter, vacation home, secure retirement, or eldercare for aging parents.  At the center of the shield is a key which represents our vision of providing better client solutions through experience, passion, and integrity represented by the three rings at the bottom of the key.  The mustard plants coming forth from the key symbolize our mission to serve clients and communities with good and faithful financial advice and cultivate the growth and fulfillment of their dreams.


Servant Colored Logo


Summer Reading



The end of summer is upon us as we wind down the season over the long Labor Day weekend.  I thought it appropriate for this August newsletter to cover topics from my summer readings while vacationing in early August.  Consider it sort of like that book report we all had to prepare for the first week of school. We went to Saugatuk, MI for family vacation as we have every summer for more than a decade, but this time we took two consecutive weeks in this Cape Cod-like Midwestern retreat on Lake Michigan.  The extra week changed the pace of everything.  It was a magical trip of communing with nature, family and friends through running, kayaking, beaching, car racing, live music, dining, and, of course, reading, or in my case listening to a books on Audible.  (I found that I retain more information by hearing rather than reading.)  This is the tale of the experience as seen through the lens of my summer readings.

The odyssey began by climbing the 282 steps to the top of Mount Baldhead, or simply Mt. Baldy, above Oval Beach on Lake Michigan.  At the top of the mountain, I spied three tents of knowledge - one for Steve Case, one for Aldous Huxley, and one for Ben Bernanke.  I traveled from tent to tent soaking in each sage's wisdom.

The first tent was called Revolution after Steve Case's venture capital firm.  Steve is an American entrepreneur, investor, and businessman best known as the co-founder and former chief executive officer and chairman of America Online (AOL).  AOL was the leading company at the dawn of the consumer internet.  Steve wanted to talk to me about his new book "The Third Wave: An Entrepreneur's Vision of the Future."

Case predicts the future of the U.S. economy and describes what he calls the "Third Wave of the Internet."  AOL and other companies introduced early consumers to the Internet in the first wave.  Then search giants such as Google and companies such as Apple have led us into the second wave of the internet, the app economy.  The third wave that Steve envisions will be "the Internet of things", in which every experience, product, and service will be transacted online.  He imagines this Third Wave as being much less tech focused and more driven by centers of expertise in sector verticals.  He sees the tech geeks partnering with the industry experts to develop sector tailored tech enabled solutions.  He foresees partnerships developing in healthcare, agribusiness, manufacturing and production and other industries around existing, longstanding centers of excellence across every region of America.  These regions will have network density of expertise within sectors.  For example, in healthcare services we think of Mayo Clinic or in agribusiness with think of the Midwest and America's bread basket.  No longer will all the technological answers flow predominantly from Silicon Valley and the Bay area.  Other regions of the country will also prosper in what Steve refers to as the Rise of the Rest.  He foresees that skills around creativity and collaboration will be of critical importance in the Third Wave.  He punctuated this point with an African proverb that describes the requirements for success in the Third Wave - “If you want to go fast, go alone. If you want to go far, go together.”




I thanked Steve for sharing his wisdom and moved on to the second tent called "The Doors of Perception" hosted by Aldous Huxley.  Aldous was an English writer, novelist, and philosopher.  He is the author of nearly fifty books.  His best known work is his novel "Brave New World", set in a dystopian future while his non-fiction work "The Doors of Perception" recalls his experiences taking mescaline, a psychedelic drug.

Aldous relayed that Jim Morrison named his Los Angeles based band The Doors after Huxley's groundbreaking book.  The book itself was a reference to a quote made by poet William Blake, "If the doors of perception were cleansed, everything would appear to man as it is, infinite."  Huxley relayed that Morrison had developed an alcohol dependency that sadly led to his very early death at 27.



Aldous relayed that young Jimmy was unable to effectively process his feelings of indignation, fear and doubt.  Huxley believed that "when we bury our feelings of indignation, fear and doubt, we bury them alive."  He believes it is physically and psychologically unhealthy to bury disagreeable emotions.  We need to transform these hurts into something beautiful, virtuous, and personally fulfilling.  He says that is the way to open the doors of peace and prosperity.  He suggested that we need to practice mercy by never holding on to the bitterness.  We should be prone to forgiveness, and suppress the desire for revenge.  He recommended reading "The Paradoxical Commandments" by Dr. Kent Keith as a way to open the transformative doors of perception.  Huxley's favorite version of "The Paradoxical Commandments" was written on a wall in Saint Teresa of Calcutta's home for children entitled "Do It Anyway."

People are often unreasonable, illogical and self-centered; Forgive them anyway.

If you are kind, people may accuse you of selfish, ulterior motives; Be kind anyway.

If you are successful, you will win some false friends and some true enemies; Succeed anyway.

If you are honest and frank, people may cheat you; Be honest and frank anyway.

What you spend years building, someone could destroy overnight; Build anyway.

If you find serenity and happiness, they may be jealous; Be happy anyway.

The good you do today, people will often forget tomorrow; Do good anyway.

Give the world the best you have, and it may never be enough; Give the world the best you've got anyway.

You see, in the final analysis, it is between you and Your God. It was never between you and them anyway.

I bid Aldous adieu and headed on to the third and final tent hosted by former Fed Chairman Ben Bernanke.




Now I must tell you a few things before we relay the wisdom imparted by Bearded Ben.  First of all, Ben's tent was not a tent at all, but an orange Volkswagen vanagon.  Secondly, it was the most popular of the three sites, more popular than Case's Revolution tent, and Huxley's Doors of Perception.  There was a large crowd milling about the vanagon and the air was thick with anticipation like just before a Door's concert was about to begin.  I asked Ben what the story was with the massive crowd.  




Ben advised that he believed the people were attracted to the wisdom of his gray beard and proceeded to regale me with the history of the beard.  He advised that the Judeo-Christian tradition teaches us that God created man in His own image and that custom holds that God has a beard.  God’s beard, called Mazal, is seen as the source of all life and sustenance in creation. Mazal literally means “flow” and all fortune and goodness “flows” from God’s beard.  God's beard has thirteen knots and the untangling of these knots allows sustenance or God's mercy to flow, leading to good fortune, wisdom, and personal fulfillment.  

I was amazed at Ben's knowledge of facial hair, but had a Paul Harvey-like intuition that there was more to this story.  I commented to Ben that his gray beard was quite fashionable and perhaps "good fortune" and wisdom may flow from his beard, but surely that cannot be the sole reason for the large crowd around his VW.  I pressed him again and again until he finally confided to me that the VW vanagon came equipped with a printing press.  And, very shortly at a touch of a button "good fortune" would flow from his VW like manna from heaven.



And that is how I spent my summer vacation.

Mexico Private Equity Day

Fotolia MEX


In early June I attended the Mexico Private Equity Day conference in New York hosted by AMEXCAP, the association of Mexican private equity firms. The mission of AMEXCAP is the dissemination of information on industry opportunities, challenges, and trends for private equity investment in the country. Given President Trump's often inflammatory rhetoric during the campaign and since his election about building a wall at the Mexican border and renegotiating the North American Free Trade Agreement (NAFTA), I thought it would be beneficial to provide you with the Mexican perspectives on these and other matters.

From a macro perspective, the Mexican economy is accelerating with first quarter of 2017 GDP at 2.8% compared to 2.1% for the fourth quarter of 2016. Mexican micro-economic reforms to open up the energy and telecom sectors to private investment are beginning to bear fruit, particularly in the energy sector.

Mexican production is not simply low cost manufacturing, but rather highly complex, value-added production. The three countries of NAFTA are highly interdependent and integrated from a production standpoint and each party understands and appreciates its role in the supply chain. Imports and exports within the NAFTA block are expected to increase rather than decrease despite Trump's rhetoric. Many conference speakers held the view that Trump's preferences for U.S. strategic direction had met with institutional constraints by the Federal government which would result in compromise. For example, the U.S. withdrew from the nascent Trans-Pacific Partnership (TPP) but longstanding NAFTA is still on the books and progressive renegotiations are expected. Conference panelists generally expected the news flow on NAFTA would be relatively quiet until the 2018 Mexican presidential election process picks up steam.

In a speech on macroeconomic conditions, Gerardo Rodriquez a BlackRock emerging markets portfolio manager forecasted upside to GDP growth for developed market economies as we enter the final years of this expansionary cycle. This trend in turn is accelerating the emerging market economic expansion led by the manufacturing sector based on improving purchasing manager indicators (PMIs). As the BlackRock chart below depicts, Mexico and its LaTam peer Brazil are two of several emerging economies with PMIs that are in positive territory and improving.


Emerging PMIs


As the chart below depicts, emerging market analysts are beginning to revise GDP growth forecasts for emerging markets upward. After bottoming out in 2015 at about 4.25% annual growth, emerging market economic growth as a whole is expected to accelerate to approximately 5.0% for 2018. Similarly, after several years of downward revisions, GDP growth forecasts for Mexico are likely to be revised upward for this year and next. The consensus GDP growth forecast for Mexico for 2017 is presently at 1.8% and very much in line with U.S. growth forecasts.


EM GDP Growth Forecasts


BlackRock's Rodriquez cited a common issue with growth forecasts in that analysts were consistently revising GDP growth forecasts down over time in years just after the 2008/09 crisis. In hindsight, analysts had anticipated quicker economic recoveries than what actually happened. This issue was universal across developed and emerging markets. He theorized that perhaps analysts are now being too conservative with growth forecasts after this period of being too optimistic on economic growth.




The Mexican private equity business is a growing and vibrant part of Mexico's economic development. In some respects the Mexican private equity market has recently jumped into the fast lane. According to a recent report by Bain Consulting on global private equity, the once nascent industry in Mexico reached a number of milestones in 2016 as the industry invested around government privatizations in the energy and telecom sectors. In terms of number of transactions, firms, and broad ecosystem, private equity in Mexico has a low penetration rate compared to Brazil and other emerging market peers, but the industry is experiencing robust growth in Mexico. For example, there were more private equity deals in Mexico in 2016 than in Brazil.

One significantly positive secular trend that will drive the Mexican private equity industry is legislation in the past decade that opened private equity investments to Mexican pension plans. The age of the average Mexican worker is only 42. This is much lower than the average pensioner in the U.S. and other developed economies. From an investment perspective the longer term nature of these pension liabilities for the average Mexican worker makes private equity an attractive asset allocation alternative for these theoretically more risk tolerant and less liquidity sensitive investors.

Others acknowledged that in this globally competitive world private equity investment is an international play. The broad capital needs for Mexico for private investment are competing for investment dollars with other developing nations like Turkey, India, and Indonesia. Broadly speaking the private equity asset class in Mexico is uniquely positioned to back the best entrepreneurial firms, but this was viewed as both a blessing and a curse as there is a "scarcity of top managers who think like owners." At this stage in the development of Mexico's private equity ecosystem, there is a clear shortage of successful operators that have experience creating successful entrepreneurial enterprises. Mexico's entrepreneurial class is still in its development phase.

We can see the development of an entrepreneurial class manifested in economic statistics. As the chart below depicts, Mexico's productivity growth has been one of the lowest in the world. Mexico's productivity growth from 1980 to 2010 was 0.25%. This compares to the leaders in productivity growth of 1.5% to 2.0% for Ireland, South Korea, and China. Meanwhile, the developed U.S. experienced productivity growth at twice the pace of Mexico at 0.5%.


MX Productivity


There were several speakers who touched on the underlying factors driving Mexico's low productivity growth. The two most often cited factors were rule of law and control of corruption. Enhancement of rule of law will be an important aspect to continued development of the private equity market in Mexico. For example the Mexican government is moving forward with its goal of privatizing the energy sector. The government has been holding auctions on exploration and production opportunities in Mexico that would previously have been solely the domain of the state-owned energy company Pemex.

Here are some noteworthy comments on this topic. One panelist shared a comment by a Houston-based energy CEO who indicated that she likes Mexican reservoirs but said that "it seemed like the Mexican government went around the world looking at energy concession contracts and picked the most complex and onerous provisions as requirements for the Mexican auction contracts." Another large energy investor raised questions about Mexican rule of law and the lack of separation of the judiciary branch of government.

BlackRock's Rodriquez stressed this issue as well. He indicated the rule of law and control of corruption continue to be the most significant challenges for LaTam. The World Bank ranks countries on these development factors as well as several other worldwide governance indicators.

The following table displays Mexico's percentile rank against all other countries on the World Bank's rule of law governance indicator as compared to Latin America & Caribbean region and Brazil for 2005, 2010 and 2015 rankings. Mexico lags Brazil and the region but perhaps even more telling its percentile rank in 2015 is below where it was in 2005.


WB Rule of Law


This next table shows the World Bank's percentile rank of Mexico on its control of corruption governance indicator as compared to Latin America & Caribbean region and Brazil for 2005, 2010, and 2015 rankings. Once again Mexico's rankings lag the region and Brazil. Perhaps more disturbing is the precipitous drop in Mexico's ranking from 2005 to 2015.


WB Control of Corruption


BlackRock's Rodriquez noted that there are limited historical examples of emerging market countries piercing the ratio of 20% of U.S. GDP per capita. South Korea is one longer term example of a country that was able to continue on a steady path of wealth and prosperity for its people. China has just recently moved its GDP per capita to 25% of U.S. GDP per capita. Chile is a LaTam country that stands out as favorable player on this metric. Rodriquez cited that the reasons for the productivity lag in Latin America and the reason emerging market countries generally plateau around the ratio of 20% of U.S. GDP per capita is a) rule of law, b) control of corruption and c) failures in the education system. Research by Rodriquez indicates that GDP per capita is highly correlated to good scores on these three institutional development measures and the 20% ratio of U.S. GDP per capita threshold or ceiling reflects this dynamic.

This final chart below from Rodriquez's presentation depicts this phenomenon. The y-axis ranks countries on these three measures against the median percentile score represented at the zero horizontal line and the x-axis measures GDP per capita in U.S. dollar on a purchase price parity basis (PPP). Note that while Mexican GDP per capita has grown from 1996 (MEX'96) to 2015 (MEX'15), Mexico remains ranked below the median on these governance scores. Meanwhile, Chile (CHL) GDP per capita and governance rankings are both higher than Mexico and on par with South Korea (KOR). So in short, Mexico and other similarly situated developing countries could have higher GDP growth if they can meaningfully address their weak institutional oversight of rule of law and control of corruption.


Country Governance and GDP per Capita


In his recently published book "Am I Being Too Suble?: Straight Talk From A Business Rebel" billionaire and highly successful investor and entrepreneur Sam Zell wrote, "When you invest in emerging markets, you're trading rule of law for growth." Based on BlackRock's analysis by Rodriquez, the important corollary to this frictional cost of emerging market investing is that the leadership of emerging market countries, like Mexico, are sacrificing even higher GDP growth along with greater wealth and prosperity for their people by not addressing the meaningful productivity costs of weak institutional governance of rule of law and corruption.

China's Consumer Class



Over the past few years I've featured several articles on the favorable investment opportunity set in emerging market (EM) equities.  I've written about the attractive relative valuations and longer-term fundamental economic and demographic growth rates, particularly as compared to domestic equity markets that have garnered the lion's share of capital flow and investor attention.  Last December, 2016 just before the holidays I was with a group of investment professionals with an emerging market real estate focused private equity firm.  The group was in general agreement about the prospects for emerging market investments relative to developed market alternatives in the aftermath of corrections in EM public equity markets and currencies.  We debated the best investment opportunities for 2017 across the EM landscape.  We eventually white-boarded each individual's top EM investment idea as an official record and for group accountability.  

My emerging market "pick to click" was the Chinese consumer.  This selection was primarily driven by the favorable underlying trends I was seeing in certain Chinese consumer focused businesses within private equity funds I manage for a family office client.  The consumption data from these funds greatly contradicted the media coverage and conventional wisdom on China.  The contrarian nature of the selection was also evident in its stark contrast to the generally unfavorable consensus economic view of China for 2017 by the "experts."  Many brilliant hedge fund managers had been calling for a economic hard-landing for China and its currency, the renminbi.  This feature article will provide an overview of the Chinese economic performance so far in 2017 and an in-depth discussion on the rapidly expanding Chinese consumer class from a couple of different bodies of research followed by short cameos on two Chinese consumer focused private equity companies.

At a macro level, China’s gross domestic product (GDP) growth in the first quarter of 2017 was 6.9%, compared to 6.7% in the first quarter of 2016.  This growth rate was higher than market expectations and signaled that the Chinese economy was off to a good start in 2017.

Retail sales grew by 10.0% in the first quarter of 2017 while online retail sales grew by 32.1%, accounting for 12.4% of China’s total retail value, indicative of increasingly deeper penetration by online channels.

Real per capita disposable income, a key driver of personal consumption trends, maintained its high growth of 7.0% during 2016, with income of rural residents growing at 7.2% compared to urban resident’s growth rate of 6.3%, narrowing the gap between rural and urban populations.

These data elements suggest that China’s economy is off to strong start to 2017 with most major macro metrics meeting or exceeding expectations.  I view the macro environment in China as very favorable for long-term secular trends in increased consumer discretionary spending (consumerization) and a move towards more expensive premium products (premiumization).  These secular trends in China were expounded upon by reputable researchers at McKinsey and Goldman Sachs.

In a March, 2015 excerpt entitled "Why China’s consumers will continue to surprise the world" from the book One Hour China - Five Stories That Explain The Brutal Fight for One Billion Chinese Consumers authors Jeffrey Towson, a managing partner of the investment firm Towson Capital, and Jonathan Wetzel, a director in McKinsey’s Shanghai office, highlight that the most exciting aspect of Chinese consumption is the trend in rising discretionary spending.  The author's relay that "Chinese citizens are now moving beyond being able to only afford the basics of life, and their discretionary spending is taking off.  Growth in spending on annual discretionary categories in China is forecast to exceed 7 percent between 2010 and 2020, and growth of 6 to 7 percent annually is expected in a second category of “semi-necessities.”  Both of these categories are growing faster than spending on actual necessities, which are expected to grow around 5 percent a year, about the same as expected GDP growth."  Please see the chart below from this article (click on image to a link to the article and a larger image).





So too in Goldman Sachs’ latest macroeconomic insight report titled “The Rise of China’s New Consumer Class” wherein Goldman reports that "Across Asia, rising incomes are creating an enormous new class of consumers.  Much of that growth is coming from China, whose working population is larger than those of the U.S. and Europe combined.  As more Chinese consumers gain purchasing power, their needs and preferences will have a powerful effect on the global economy."  As the chart below depicts, China’s 770.4 million working population is a multiple of total workers of 146 million in the U.S.  Only 11% of China's population is considered middle class.  Rising incomes from the industrialization and urbanization of China are contributing significantly to the expansion of the middle class and the formation of a new hierarchy of consumer classes in China.  




The middle market bulge in China's working population is comprised of the Urban Middle and Urban Mass.  The Urban Middle class, defined by Goldman Sachs as families having an annual income of $11,733 per a capita, is depicted in the chart below.  This growing demographic of 146 million people (equivalent to total U.S. working population) consists of financially comfortable corporate office workers and those with government jobs on the public payroll.  This is the main focus of marketers as the middle class consumer tastes develop and incomes rise.  




The Urban Mass is made up of 236 million blue-collared workers and migrant workers with average annual income per capita of $5,858.   Income for this group has the biggest potential to rise in the next few years enabling them to incorporate discretionary spending into the mix along with basic non-discretionary consumption.  




Goldman concluded that even today nearly half of China’s consumption goes to more discretionary “needs” like clothing (looking more beautiful) and food (eating better).  The chart below shows the clear differences between China’s middle market consumption patterns with those of the US.  The comparison of an emerging working class with that of a developed economy shows that with rising wealth and income spending will shift over time from pure necessities to more discretionary items.




My oversight role of a portfolio of private equity funds includes a few with Chinese consumer focused portfolio companies where I was able to see the rise in China's consumer class beginning to play out in a big way in 2016.  Through attendance at fund advisory board and annual meetings and review of fund quarterly investor reports over the course of the year, my conviction increased that these Chinese consumer businesses were doing quite well and earning the high risk-adjusted returns an emerging market investor should expect to receive.  Many of the general partners involved in these Chinese companies have been consistently advising their investors that Western conventional wisdom on China was mostly wrong.  The Western view throughout 2016 was that all Chinese of means were anxiously seeking to get their money out of renminbi.  Admittedly wealthy Chinese were prudently diversifying their investments, but these funds saw firsthand important bullish indicators of Chinese company operating metrics.  Secondly, they took great comfort that their local Chinese partners were displaying longer term conviction by investing in China's future through increased investment in these businesses.  Let me highlight a couple of private company on a no names basis as examples of the rise of Chinese consumption for you.




The first noteworthy business is the master franchisee in mainland China (PRC) of a western market quick service restaurant (QSR).  The company’s master franchise agreement grants it the exclusive right to develop, operate, and sub-franchise this brand's restaurants in the PRC until June 2032.  At the time of investment, this business had about 60 system-wide restaurants.  Consistent with the research outlined above, the private equity firm's original investment thesis in 2012 was to capitalize on growing middle-class demand for convenience foods with a proximate goal to open 600 restaurants over the next 5 years.  Now five years into it, the QSR business has exceeded their store growth target while the profitability of the business is very strong and improving.  The platform has capitalized on its operating leverage and has had excellent consumer response to its tailored, innovative menu offering.  For 2016 the company exceeded its revenue and EBITDA budgets by wide margins by sustaining high comparable sales growth of over 15% for the past couple of years.  The company has successfully grown system-wide restaurant count to over 650 stores, or more than 10 times the footprint at investment.  Having clearly demonstrated successful execution in operations, the private equity firm has recently been able to secure increased borrowing capacity from local Chinese banks on favorable terms that will enable continued capital-efficient growth.  The PE firm has begun exploring strategic options for the fund's holding.




The other highly successful Chinese consumer business owned by another private equity fund is a low cost producer and distributor of high end wallpaper for homeowners.  The fund's thesis was that China's consumer markets will follow the same general market development pattern that occurred in the U.S. and other developed markets as they industrialized.  The fund partnered with one of its longstanding Chinese partners with which the fund had invested earlier in a consumer paper products business - paper towels and toilet paper.  With only a 3% penetration rate for wallpaper in China at the time of investment, the fund looked forward to successfully growing the business rapidly given its huge total potential addressable market.  The fund's equity capital was primarily used to purchase capital equipment for the production of wallpaper which the PE firm believed established a reasonable downside for the venture at the liquidation value of the production equipment.  The firm's high end wallpaper offering is highly similar to the best European wallpapers in design and quality but can be sold at a much lower price point given local labor rate savings and substantial shipping cost advantages.   In just a couple of years, the wallpaper business has grown into the world's largest wallpaper producer.  The private equity firm currently expects to sell the business to its Chinese partner now that the business is through its business development phase.  Its founder would like to consolidate the profitable and rapidly growing wallpaper business with its other listed consumer paper products businesses.  

Prompted by these insights on fundamental Chinese consumption trends, we endeavored to identify whether or not there was a liquid, publicly traded exchange traded fund (ETF) to ride the wave of rising consumption by China's massive middle and urban mass populations.  We quickly identified the Global X China Consumer ETF (symbol: CHIQ) featured below. CHIQ has a price return through June 20, 2017 of 29.2% compared to 12.4% the broader iShares China Large-Cap ETF (FXI).   Unfortunately, we have not yet added CHIQ to client portfolios because its assets under management (AUM) of $80 million does not yet meet our $100 million minimum threshold.  However, we believe that we are in the early innings of this Chinese consumerization trend and will continue to monitor the performance and growth in AUM of CHIQ and expect to add the position to client portfolios at some point in the future.




The Global X China Consumer ETF (CHIQ) is based on the Solactive China Consumer Index.  This index is designed to reflect the performance of the consumer sector in China.  It is comprised of selected companies which have their main business operations in the consumer sector and are domiciled in China or are domiciled elsewhere but have their main business operations in China.  The fund invests at least 80% of its total assets in the securities of the underlying index and in American Depositary Receipts ("ADRs") and Global Depositary Receipts ("GDRs") based on the securities in the underlying Solactive index.  Sell side analysts' forecasts of the underlying companies roll-up to ETF level revenue and earnings growth projections of 12% and 20%, respectively, in 2017 followed by 16% and 19%, respectively, in 2018. The following table provides summary valuation metrics and historical view on CHIQ's price to earnings (P/E) ratio based on data compiled by the ETF Research Center (subscription required).


CHIQ Valuation


The chart below summarizes the consumer sub-sector exposure of CHIQ (click image to go to Fact Sheet and larger image). You can see that CHIQ is keenly focused on more on areas of consumer discretionary spending.


CHIQ Subsector


Barron's recently summarized a longer China research report by Morgan Stanley strategists Laura Wang, Jonathan Garner and Charles Clavel entitled, "What Morgan Stanley Expects for China Stocks."  These strategist assessment was wholly consistent with the boots on the ground reports from the Chinese private equity firms.  Morgan's principal conclusion reads: “We expect China to avoid a financial shock and achieve high income status by 2027.  Our view is that moving to higher value-added activities will propel the economy forward and drive the continued medium-term outperformance of MSCI China versus MSCI EM, providing significant investment opportunities”.  As relates CHIQ, the Morgan strategist recommended five thematic sectors for investment: a) Healthcare, b) Mass-market consumption; 3) Environmental protection; 4) Technology/High-end manufacturing; and 5) Defense/Aerospace.

 Of note, The Wall Street Journal reported earlier today that MSCI agreed to include China A-Share locally traded shares to its indices.  This decision follows three straight years of rejections and opens up the Chinese market to more foreign investment.

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