A Year of Consolidation

FALLS CHURCH, Va.–The news on the US economy and the global credit crisis is still gloomy, and it will remain so for some time. But as long as the global financial system doesn’t collapse, and my working assumption is that it won’t, the current market volatility provides excellent opportunity to buy Asian stocks.

As I noted here a month ago, “Asia looks ready for a rally, bear market or otherwise. Pessimism reigns supreme, and analysis of how the region’s being distracted is in full swing.” (See Silk, 23 January 2008, The Fed is Your Friend.)

I maintain that view. Global markets are trying to rally, and they may succeed. But few investors I’ve spoken with expect the rally to be strong enough. Usually, when the majority doesn’t expect something to happen, it will take place. Only time will tell, and a few momentum indicators aren’t confirming yet, but market action has been more positive than negative in the past month.

This is the year that Asia will consolidate and get ready for the next leg up in this a long-term bull market that commenced at the bottom of the Asian crisis in 1998.

And what a difference the past 10 years have made. Before the Asian Crisis, the continent was in a tailspin: Everyone from this side of the globe was giving advice on how Asian countries should deal with their liquidity/credit problems. The path Asia was forced to follow was one of tighter credit and prudent economics.

Although this advice almost destroyed the region, it also helped the economies sober up and get their finances and businesses back in order. This is why the Asian Crisis is so important to the fundamental case for investing in the region.

The western financial system is going through a similar problem right now: Debt levels are high and no one really knows who owns what, particularly in terms of collateralized debt obligations (CDO) and the like. The difference now is that few advocate the hard medication that was prescribed for Asia back then.

It’s true that Asia can’t go it alone yet because it’s not big enough. China and India consume around 10 million barrels of oil per day, while the US alone consumes 27 million. This is why the longer the developed economies stay above water, the best it will be for everybody. Asia and other developing economies such as Russia and the Gulf states will continue to contribute to saving the banking system (i.e., cash infusions to big banks) and hope for the best.

My strategy for this year remains quite simple: Buy quality companies that offer long-term growth potential, and also keep some hedges on for good measure. I’m still more bullish than bearish, without ignoring the problems that the global economy and its financial system are currently facing.

At the end of the day, I want to be invested where the growth is and the economic fundamentals are in good shape. And that place is Asia.

More Infrastructure

As I wrote last week, I expect Chinese investment in transportation infrastructure to continue with railways in the driver’s seat.

To recap, according to the government’s plans, the national railway network’s total length should reach 90,000 kilometers (km) in 2010 and 100,000 km in 2020 from 75,000 km in 2005. Fifty percent of the total is expected to be double-line rails (one of which can be electrified) and outright electric. The plan calls for the construction of eight passenger transport lines and three intercity high-speed railway transportation systems, and enlargement of as well as improvement to the existing network.

Given that Chinese passenger and freight transportation has been increasing at an average of 18 percent a year, the government’s urge to upgrade and expand transportation is logical. China is planning to spend more than USD170 billion updating its railways, and construction machinery companies should benefit because around 46 percent of the rail investment goes to construction.


Source: Ministry of Railways

China Infrastructure Machinery (Hong Kong: 3339, OTC: CIMHF, CIM) is the only Chinese heavy machinery company that individual investors can easily access because it’s listed in Hong Kong. It’s the second-largest loader producer in China under the brand name Longgong. It’s also diversified into producing forklifts and excavators recently, which should help future earnings growth.


Source: China Infrastructure Machinery

The company’s success is founded on its excellent marketing techniques (sales are up 36 percent per year in the past three years) and low pricing.

CIM is expected to surpass competitors and become the largest loader producer in China by sales volume. Because of its success, the company is planning to allocate more money in its research and development (R&D) program in order to improve quality. Currently, its loaders have a lower service life by a couple years in comparison to some of the more established domestic competitors.

Because of high demand, this year CIM is planning to double its production to 40,000 units because it’s added a new plant in Shanghai, and profits from loaders are expected to continue to grow by 25 percent per year. And as the chart below indicates, 43 percent of CIM’s sales come from road, railways, and bridges, so the company will be a big beneficiary of the boom.

China’s construction machinery industry has become the third-largest producer in the world behind the US and Japan; 2006 marks the year that China became a net exporter.

As quality improves and pricing remains competitive (10 to 60 percent lower than the more established competitors), Chinese companies have been gaining market share around the world. Developing regions like India, Africa and the Middle East are rapidly becoming big marketplaces for Chinese companies.

Although CIM isn’t one of the biggest construction machinery companies in China, it is one of the most profitable, and it’s coming strong from a low base. For instance, the new product lines introduced in the last couple years–forklifts and small excavators–have been growing strongly. The company is expected to sell just more than 700 excavators this year, up from 44 in 2007. And the same kind of growth is expected in the forklift division. CIM is also one of the cheapest stocks in the sector and boasts one of the higher returns on equity (ROE) at 40 percent.

China Infrastructure Machinery is a new addition to the Silk Long-Term Holdings Portfolio.


Source: Company data

As always, I prefer the local shares to the over-the-counter (OTC) listing. And because Hong Kong is easily tradable through serious brokers in the US as well, I strongly recommend you buy the stock locally.

Not every brokerage is coming along. Some simply don’t want to expend the effort needed to open their business beyond run-of-the-mill New York Stock Exchange or Nasdaq common stocks. If you find your broker isn’t being cooperative, one option is to open an account with Interactive Brokers.

Interactive Brokers’ trading platform offers easy access to US-, Canadian-, European-, Japanese- and Hong Kong-listed stocks alike, among others. The company boasts cheap commissions and also has a great system for handling currencies. You can choose to convert all or part of your account into British pounds sterling or euros to handle buys in Europe at favorable rates. The minimum amount to open an account is USD10,000.

A more mainstream broker that can now handle some international trading online is E*Trade. Commissions are slightly higher, and the Web site is particularly easy to use with solid news and quote feeds for most foreign markets. Note that the brokerage operations are entirely segregated from the firm’s troubled mortgage operations and are federally insured as well.

This is by no means an exhaustive list. If you’ve had positive experiences buying foreign stocks with other brokers, please drop us an e-mail, and we’ll include them in an upcoming issue. And if you plan on getting into some of our non-US-traded stocks, be sure to check out your current broker’s capabilities.

Reiterating Japan

Five months ago, I recommended adding more money in Japanese banks as a value play (see Silk, 26 September 2007, Contrarian Buys). Since then, the stocks have been basically flat, but they still represent strong long-term value at these levels.

In the Long-Term Holdings Portfolio, I recommend bank Mitsubishi UFJ Financial Group (Japan: 8306, NYSE: MTU).

The company has been making the right stockholder moves during these volatile times. It has announced a dividend increase (always a pleasant surprise in Japan), and has been buying back shares for the first time, up to USD1.4 billion last December. Furthermore, the bank is also evaluating acquisition targets given the low sector valuations due to the global credit woes. And more buybacks are expected.

I’ve made the case for Japan’s long-term potential on numerous occasions. The main idea is that the current economic cycle in Japan will be stronger and more enduring than most market observers anticipate. This view is based on the structural changes taking place in the Japanese economy (including changes in government financial institutions) and the eventual end of deflation.

Also, as many years of depression come to an end, the Japanese domestic demand will increase substantially, allowing consumers to eventually use some of the money that’s been sitting in bank accounts for investment and consumption.

The political situation in Japan remains murky, and former Prime Minister Junichiro Koizumi is greatly missed. The unwillingness of the current government to be more proactive with economic change will hurt Japan short term, but the hope is that the complacency won’t be able to derail Japan’s long-term potential. On the other hand, if everything was politically harmonious in Japan, there would be no value opportunities. Buy Mitsubishi UFJ Financial Group.

Cleaning House

I’m selling some stocks from the Alternative Holdings Portfolio this issue, and I’ll be adding new ones in coming weeks. Note that although this portfolio includes companies I’ve recommended for longer-term or more fundamental reasons, and they represent additional exposure to favored investment themes, it also has more volatility because many of the picks are riskier.

I do clarify in which category each stock belongs, and I’m working on a visual system that can be inserted into the portfolio to indicate volatility. For more on the basics of this publication, see How Silk Works at the end of this issue.

As a reminder, Silk’s reported performance is based on the Long-Term Holdings Portfolio.

Sumitomo Mitsui Financial (Japan: 8316, OTC: SMFJY) is the first on the list of sells. Long-term Holdings Mitsubishi UFJ is a better bet right now and will benefit equally once the Japanese economy does turn. Sumitomo is down around 30 percent since my initial recommendation. Sell Sumitomo Mitsui Financial.

Korea Electric Power (NYSE: KEP) has also been a disappointment (down 15 percent), and it seems uncertain now that utilities will be a top priority for the newly elected government in South Korea. Sell Korea Electric Power.

Bio-Treat Technologies (OTC: BOTRF) has had some ups and downs but has lost 21 percent since my initial recommendation. Sell Bio-Treat Technologies.

Finally, sell iShares Malaysia (NYSE: EWM). It’s time to book our 45 percent gain because Malaysia has become an expensive market.

Portfolio Moves

The removal of Malaysia opens up the way for Taiwan to rise in the Fresh Money Buys. Taiwan has been a favorite here for sometime, initially because of its low valuations and the respectable dividend yield that market offers: 4.3 percent.

Chunghwa Telecom (NYSE: CHT) has been my preferred Taiwanese play, and I continue to favor the company because it offers a sustainable yield of 4.3 percent and decent growth opportunities, especially through the potential monetization of its real estate holding. Buy Chunghwa Telecom.

Alternative Holdings Portfolio recommendation iShares MSCI Taiwan (NYSE: EWT) offers broader exposure but remains my second choice because of its high exposure to technology stocks.

The important catalyst short-term will be the outcome of the presidential elections scheduled for March 22 and a potential victory of the pro-China Kuomintang (KMT) party. It seems that the Taiwanese electorate is ready for a change that will allow closer economic ties with the mainland because the Taiwanese economy will remain an underperformer without it. Buy iShares MSCI Taiwan.

The Short Trade

During the November market turmoil, I recommended shorting the Chinese insurers for extra protection. (See Silk, 13 November 2007, Flash Alert: Hedging the Portfolios.)

My US trading recommendation was to short China Life Insurance Co (NYSE: LFC). The profit was around 30 percent as of Feb. 26, 2008. If you’ve shorted China Life Insurance Co, stay with the position, and set your stop-loss at USD66. This is a hedging trade for a long-only portfolio, which is why the stop-loss is fairly loose.

Fresh Money Buys

The investment process is constant. So if you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the portfolios on the left-hand side of your screen for details.

  • Russia (energy, telecommunications)
  • Hong Kong (banking, real estate, infrastructure)
  • South Korea (banking)
  • Philippines (telecommunications, real estate)
  • India (pharmaceuticals)
  • China (consumer, telecommunications, machinery, coal, e-commerce, oil)
  • Singapore (banking, telecommunications, industrial)
  • Taiwan (telecommunications, ETF)
  • Japan (banking, industrials)
  • Europe (communications equipment)

How Silk Works

The Silk Portfolio has been constructed around the view that domestic economic demand and investment are driving Asia’s economic ascent.

The Portfolio should be viewed as a whole rather than an assortment of stocks. It’s my hard-earned assumption that investors seldom follow such advice, so I also offer some direction in an effort to assist with the decision-making process in the Fresh Money Buys.

In this section, I rank countries and sectors so readers will have a guide at all times. The ranking changes often, so pay attention.

The ranking starts with the countries I prefer and then lists specific sectors you should look into. When I mention a sector, it’s assumed that the first pick will be from the Long-Term Holdings. Then, if more exposure is warranted, additional picks will be from the Alternative Holdings.

Of course, if a country isn’t represented in the Long-Term Holdings, refer to the Alternative Holdings for a selection (which is the case for Macau).

Portfolio recommendations should be taken at face value. For instance, if a stock is recommended as a buy and trades below the price indicated in the portfolios, the recommendation stands for newcomers as well as longer-term readers.

Occasionally, I recommend that long-term readers take profits off the table by booking any gains while letting the initial capital invested. The same is implied when a country or a sector is moved down in the Fresh Money Buys.

In other words, I expect investors to look at their profits (i.e., how much money they’ve made above the initial investment) and then calculate how many shares they needed to sell in order to take those profits off the table.

If you’re not a long-term reader, chances are you probably don’t have profits to take from the specific stock; you’re unaffected by the recommendation. The fact that I haven’t advised selling the stock outright indicates that it remains a good, long-term holding.

Silk has one main portfolio, the Long-Term Holdings, and an alternative, the Alternative Holdings-Permanent Hedges. Look first to the Long-Term Holdings for asset allocation in the markets covered here.

In the Alternative Holdings-Permanent Hedges Portfolio, readers can track permanent hedges and shorter-term recommendations. It also includes companies I’ve recommended for longer-term or more fundamental reasons, and they represent additional exposure to favored investment themes. For example, Lukoil (Russia: LKOH, OTC: LUKOY) provides extra exposure to a favored theme: Russia and energy.

On the left-hand side of the Web site’s main page, under Portfolio Performance, you can get a snapshot of the Portfolio’s return compared to other major indexes.

On the Portfolio page, you can click on the asterisk next to each holding to review the original commentary and recommendation. I plan to enhance the portfolios with extra features and welcome comments and suggestions.

Many new readers have also asked, “What do we do when the market drops substantially?”

Since Silk’s inception, I’ve been skillful and lucky enough to have booked profits before precipitous falls, in which case I recommended sitting still through the turmoil. I’ll also get word to you via Flash Alert if events turn too quickly.

Silk is built around a set of core themes. I often revisit those themes or certain analyses through a link to a previous article or by reproducing relevant paragraphs. You can also read previous issues in the Archives to gain an understanding of the investment philosophy of the publication.

Or you can ignore my advice and try to find the next big hitter the Portfolio will produce. You may succeed, but be aware that I don’t play that game; “fast guns” are wasting their time with this publication, as well as Asia and the rest of the international markets as an asset class.