Friday, June 6, 2014

China and the value trap

The above chart shows how value added (or alternatively excess returns) is distributed across the Global electronics industries. Although, it reinforces what we already know about it for long, the chart allows for more deeper analysis. After looking at the below chart, it strikes to me that most of the world's most successful businesses have followed this operating model for atleast past two decades and some for even longer, examples include Coca Cola; VISA, Qualcomm, Apple, Cisco, Nike, even Colgate and P&G, 

Strikingly, firms in the hi-tech business that were active across the value chain (including manufacturing) are experiencing or have experienced problems in the past, examples: Hp, IBM, Intel, almost all Japanese electronic firms. One reason being, their investors primarily value them as hi tech companies rather than low tech manufacturing hubs which is sometimes untrue when low value add is more of the revenue mix than high value add. 

A modern company contradicting this trend and still steeply overvalued is Amazon which is diversifying from high value added activities (its potent online platform) into lower value added and more capital intensive ones (company owned warehousing and now logistics). It will be interesting to see whether Amazon proves to be an exception to the rule or will its market price react to this trend over time (now that is a short idea!). 

(Aside: This also reminds me of our original investment thesis in Aramex (high on brand, low on capital intensity), and why Aramex is truly under-appreciated.)

Infact, in Emerging countries there are many instances of listed entities moving from high to low value added. Usually, the devil lies with the initial success, as cash builds up, management in companies with poor corporate governance and shareholder monitoring, are motivated to reinvest the surplus and grow the size of the firm than to distribute the same to shareholders. Expanding downhill is more easier and certain than uphill which makes the decision look prudent for time being and safer for incumbent management. 

It also tells me something interesting about China and how probable it is for that country to make into the upper echelons of the income pyramid. China over the past three and half decades has grown mainly by becoming the workshop of the world -the activity which has least value addition across the chain. That success was made possible with fortuitous combination of 1) large initial supply of cheap factors of production Land, Labour and Capital. Being a authoritarian state, the government owned the land, made capital cheap by repressing market clearing interest rate (which also explains the real estate bubble in China). In an urgency to get unemployment and poverty down for hundreds of million of unskilled people after "The Party" came to power, what better than create low skill, low pay jobs by creating subsidies manufacturing base. Externally, this process coincided with the trend of rising Globalization and economic integration in 80s. 90s and 2000s. 

However, China has not been able to move upscale to more value added activities and it is likely that when the wind is out of the sails on the initial trigger factors (labour, land and capital), China will increasingly face the same risk that other middle income countries face -of stagnant incomes. Infact China's case it will be even difficult because liberty and freedom are prerequisites for providing the environment to innovate. Now, that tell us that whether "The Party" will have to go or Chinese aspirations will have to settle for less. 

The GCC economic growth in many ways is similar to that of China, given almost all GCC countries are authoritarian states of varying degrees. A large percentage of non-oil, non-consumer services GDP comes from low value add manufacturing in industries such as petrochemicals, aluminium, fertilizers, steel, etc. These sectors are globally competitive as long as they have access to cheap feedstock. Though the GCC is lauded for its economic stability and growth rates in excess of 5% and the bureaucracy extolling the growing role non-oil sector. The concerning point is that the non-oil sector is viable to a large extent only due to the indirect subsidies and surplus from the oil sector. That dependence on oil and how fast non-oil GDP can crumble when oil is removed from the equation, justify why long dated GCC assets (high duration bonds, equities and real estate) should correctly trade at a discount to other countries with similar growth but without the oil induced distortion. 

This line of thought also explains why Mr. Alabaar's (Chariman of Emaar) proclamation of Dubai real estate trading at a discount to London or Singapore should be taken only with a grain of salt. A large grain indeed!