Evergrande is seeking to perpetuate a number of myths. The first is that both its profits and business are growing rapidly. The company’s narrative—that it is investing for growth—is used to justify its high debt levels. In reality, while gross profits have increased in line with sales in recent years, the additional profits have gone to other providers of capital, specifically minority investors and holders of its perpetuals, while underlying profits attributable to shareholders have actually fallen. The large cash outflow during this period was needed to correct the previous failed strategy focusing on peripheral locations; future growth will require additional investment.
There have been a number of examples recently of Chinese companies whose valuations seem to have lost touch with reality. One of these is Mascotte Holdings (ticker: 136.HK); its share price had already nearly tripled between the start of April this year and early June when trading in its shares was halted. Mascotte subsequently announced that Evergrande and Tencent would acquire a 75% shareholding in the company through a subscription of new shares. When trading resumed on 3 August, the share price immediately jumped by as much as 150%. It has since fallen back somewhat, closing at HK$0.48 on 5 August. Though this is still nearly 70% higher than the pre-announcement price and gives Mascotte a pro forma valuation of HK$78bn.
There has been some strange behaviour recently from Evergrande, even by the company’s standards. Just a month after raising HK$4.6bn through a share placing, the company started buying back shares. It has since repurchased more than the number of shares placed, pushing the share price up by more than 40%. Furthermore, it has bought shares at prices above the placing price taking into account the recent dividend.
Tesco’s share price has increased by around 40% from its low point in December last year. The renewed optimism reflects investors’ favourable response to the new chief executive, Dave Lewis and a growing belief that the UK business has reached a turning point. The current share price is discounting a rapid return to “normal”, as the company reasserts its still dominant market position. The implicit assumption is that a resumption of growth in the UK business will automatically lead to a strong recovery in profits, even if margins do not return to prior levels.
However, this ignores the underlying structural issues facing the UK business. Sales productivity, measured in sales per square foot, has consistently fallen since 2007. At the same time, Tesco is saddled with high legacy costs that will be difficult to reduce: rental payments have ballooned following a decade of sale and leasebacks. It risks losing out to more nimble competitors. The level of future profitability is unclear, but will inevitably be much lower than it has been historically. Given the deep-rooted problems and considerable uncertainties, the shares are expensive. I am short Tesco.
Sometimes foresight may not help. If someone had said on 28 August last year (just before Tesco announced its second profit warning of 2014 and a 75% cut in its interim dividend) that over the next few months the company would issue three profit warnings (halving expected profits for the year), stop paying its dividend and admit to a major accounting misstatement, which company would you have expected to perform better: Tesco or Sainsbury? If you’d guessed Sainsbury, you would have been wrong. The chart below shows the performance of both since then: Tesco has fallen by “only” 15%, while Sainsbury has declined 17%. The market may, of course, be supremely efficient, having already discounted Tesco’s problems (Tesco has fallen more over the last 12 months), just as it is now starting to anticipate a recovery. Perhaps.
The arguments for and against active and passive fund management continue unabated. Even Warren Buffett has come out in support of index funds in Berkshire Hathaway’s latest letter to shareholders. A recent article in the Financial Times, Active management industry in bafflingly good health, by newspaper’s Senior Investment Columnist, John Authers, discusses the potential impact of the growth in passive investing. The article makes some interesting points, but also illustrates a number of common misconceptions.
I have just published an article on Seeking Alpha, Asian Luxury Hotels: Valuation and Benchmarking, that summarises some of the research I have recently done on Asian hotel companies, including Mandarin Oriental, Shangri-La Asia and Hongkong & Shanghai Hotels, which operates the Peninsula chain. It has provided no new investment ideas, but provides a useful read-across for Great Eagle Holdings, which is one of my largest positions.
In my first post asking whether Hong Kong property is a bubble (see Part 1 here), I focused on historical price trends and ratios. I concluded that residential property prices are currently around 50-60% above historic trend levels; and suggested that, for this not to be a bubble, there had to be something different this time. The aim of this post is to look in detail at some of the possible reasons for the recent run-up in prices to try to determine what if anything is different this time.
One of the key lessons with investment trusts is not to buy them when they are trading at a premium to net asset value. Why pay more than the actual underlying value of the assets? Anecdotal support for this comes from recent volatility in Baillie Gifford Shin Nippon (ticker: BGS), the Japanese smaller companies investment trust, which clearly illustrates the dangers of investing at a premium.
As early as 2009, commentators have been asking whether Hong Kong property is a bubble. Since then, the debate has continued as, apart from a brief pause in the second half of 2011, prices have continued to climb inexorably upwards; despite efforts by the Hong Kong government to cool the market. Prices have more than doubled from their recent low point at the end of 2008. In fact, for most people, whether or not the property market is a bubble is not in doubt. The question now being asked is when the bubble will burst.