Going Global

Morningstar in China -- An Individual Investor's View

China is such a hot market that any business thinking about going global is considering whether there is a China strategy that makes sense for their business.  And for individuals who don't have a business to take to China, there seems to be an insatiable interest in finding Chinese stocks to ignite their portfolio.  With that in mind, I thought I would share some of the insights contained in the current issue of Morningstar's StockInvestor newsletter.

Paul Larsen, the newsletter's equities strategist and editor, just returned from a month in China, training stock analysts for the company's new office in Shenzhen as well as getting his own arms around what's happening in the mainland's market.  He devotes much of the April issue to his observations.

He sees a number of competitive advantages enjoyed by Chinese companies, including:

• lax environmental restrictions ("[y]ou can forget the stories about an emerging environmental disaster happening here.  It has already happened". For more on pollution in China, see one of the many detailed posts relating to this subject on the China Law Blog)
• lax safety standards (the subject of a recent post on this blog as it relates to the lower cost of Chinese exports)
• a political structure which allows macro economic decisions to be made quickly without debate (depending on how those decisions turn out, this of course could be a disadvantage as well -- so far so good for the most part).

He also cites a number of competitive disadvantages:

• imperfect capital allocation (the invisible hand "is only operating with three fingers in China").
• corruption, nepotism and other systemic inefficiencies.

The principle issues that he sees facing investors in China are:

• the government's role as both major shareholder and regulator creates conflicts of interest which pose an uneven playing field for the individual investor;
• the markets do not have a mechanism such as short selling to allow market efficiencies to operate in both up and down market cycles;
• because Chinese investors are not permitted to invest outside of China and the only competing publicly available investment vehicles are low yielding bank deposit accounts, the country is flooded with capital, causing Chinese stock prices to be inflated in excess of their intrinsic value.

As a result of these issues, Larsen is left exactly where it seems so many stock advisory services come out when looking at China -- noting that it is an undeniably hot economy as a whole but facing great difficulty in specifying individual companies that trade at an attractive current price relative to their valuation adjusted by a reasonable margin of safety.  While he does delve deeper into a few specific companies that he thinks have potential, his bottom line conclusion is "unfortunately everything I found was either too scary (far outside my circle of competence or risk tolerance zone), too expensive (I'm here late in the boom), or cannot easily be purchased by foreigners". 

My own experience is that Morningstar is among the most rational (straight-talk, not hype) analytical services for individual investors, so I put some stock in what Larsen has to say about the Chinese market.  All things considered, building a business in China may well be the most sensible way to profit from its booming economy.  At least you have some control over the value that is created.

Unintended Global Consequences of Domestic Policy

With the political tensions in many of the key petroleum producing nations of the world, it would be hard to argue against any policy designed to lessen dependence on foreign oil supplies.  It is in this vein that the U.S. has enacted initiatives to increase the use of ethanol and other plant based fuels.  The Energy Act of 2005 mandates a three fold increase in the amount of ethanol based fuel produced over the next 5 years.  The policy is also supported by a sizable government subsidy paid to ethanol producers in an effort to make ethanol and other bio-fuels competitive at the gas pump since its production costs exceed gasoline even at the current high prices for a barrel of oil.

Between mandates and subsidies, the level of crop production going into ethanol as opposed to the food supply and feedstock is rising quickly.   According to an article in last Monday's Wall Street Journal entitled "Crop Prices Soar Pushing Up Cost of Food Globally", the volume of grain dedicated to ethanol production is expected to double from 2006 to 2008.   Of course this new source of significant demand, as implied in the title of the WSJ article, is causing prices to rise -- and not just for the crops themselves, but also for beef, eggs and poultry, all of which use corn feed as an input, as well as the myriad of processed foods that contain corn syrup as an additive.

Food prices in the United States are expected to rise faster than the general rate of inflation as a result of this policy, but the percent of income spent on food in a wealthy country is such that it can certainly be absorbed by the majority of consumers.  Higher food prices are simply the tax that must be paid in order to support the policy mandating the development of alternative fuels (although it is a regressive tax given that it is largely a tax imposed on necessities).

This may not be the case, however, in developing countries where a much greater percentage of the population lives on subsistence wages with a high percentage of income devoted to basic necessities such as food.  The inflation rate for food supplies in India, for example, is currently running at an annual rate in excess of 10% -- and that's at current levels of supply and demand.   As more and more of the world's grain supply is diverted to the production of alternative fuels, it is reasonable to expect food prices to soar even faster.  As food prices escalate ever faster than average wage rates, the result is likely to be an even greater hunger problem among the poorer populations in China, India and sub-Saharan Africa.

In addition to stemming dependence on foreign oil, a second driver of ethanol based fuels is environmental, although the validity of this impetus is less clear given the amount of energy currently required to convert grain into usable fuel, as well as the fact that these fuel products are more corrosive than petroleum based fuels, making it necessary to transport the fuel by truck rather than through pipelines.  For purposes of the interest here in international commerce, however, what is important is that pollution is also a global commodity.   As developing countries are required to devote more of their government budgets to offsetting rapidly rising food prices, you can bet that they will be forced to devote even less to environmental protection and pollution abatement.  While I am not aware of any study on this point, I can certainly imagine any gain in environmental quality produced in the U.S. and Europe being more than offset by increased pollution elsewhere on the globe.  And while plenty of people would like to pretend that problems such as poverty and hunger in foreign countries are not our problem, it is more difficult yet to make the case that their pollution is not going to be our problem as well.

One of the realities of globally integrated economies is that a policy in one country that affects the supply or demand of a critical commodity will have consequences elsewhere in the world.  In this case, those consequences could range from increased environmental degradation to higher rates of starvation.  Accelerating the development of ethanol and bio-fuels may in fact be the right thing to do, but I am concerned that I don't hear the people pushing this agenda thinking through or talking about the negative global consequences of this policy and whether or not we have any responsibility to ameliorate that impact.

Unique Financial and Business Challenges in the Islamic World

One of the things I enjoy about the challenges of international business is that there are always new ideas and perspectives to learn and understand.  It constantly challenges your world view and keeps your edge sharp.  I must say today I really had my eyes opened to an issue of which I was embarrassingly unaware until reading about it in a place no less accessible than the front page of the Wall Street Journal in an article entitled "Malaysia Transforms Rules for Finance under Islam".

I confess at the outset that my experience in business in the Muslim world is relatively limited.  While I have opened up distribution, put together manufacturing and sales JV's and been responsible for foreign based operations in Asia, Europe and Latin America, my business in the Middle East has been limited to a few LOC / cash-in-advance spot export sales.  The few times I had occasion to discuss broader distribution arrangements with potential Middle Eastern partners, when it got down to discussing credit terms, it seemed as if they wanted us to carry the financing for inventory but refused to pay anything for extending that credit.  I assumed that they were being needlessly difficult negotiators on a straight forward point of business and didn't expend the time to sort through the road block given the existence of easier and more lucrative business elsewhere in the world.

While I might have had some vague cognizance of the Islamic view of credit in reading at some point about the origins of the old saw "neither a borrower nor a lender be", it was not until I read the WSJ article that I understood that charging or receiving interest payments apparently violates a Quranic prohibition.  Perhaps my would-be Middle East partners were not intentionally being difficult business people as much as they were trying in earnest to abide by their Islamic faith.   At a minimum the true motive got lost in translation and the potential deals were killed even before they got off the ground.

The focus of the WSJ article is how Malaysia, being more distant from the more traditional Muslim faith centers in the Middle East has come to dominate Islamic international banking through the development of innovative financial products which mirror in many ways the workings of an interest paying bond, but which do not, strictly speaking, pay interest.  Instead, they are structured as profit sharing or real property rental pools based on business assets which secure what otherwise looks very much like a western debt instrument.    Not surprisingly, as with any issue tied up with a tenet of religious faith and the interpretation and application of religious doctrine, not everyone in the Islamic world concedes that these innovative financial instruments in fact comply with the requirements of the faith.

The result of all this is an entire shadow world of Islamic banking that parallels western banking, but which cannot easily or fluidly mesh with predominant international financial structures.   It seems the impact is enormous and far reaching.   At a first level, it has to make it considerably more difficult for businesses owned or controlled by Muslims to obtain the capital necessary to expand and compete easily in global market places unless they have direct access to the oil revenues largely controlled by the ruling sheikdoms.  Access to broader markets is limited and the opportunities for entrepreneurial start-ups of small businesses is hamstrung.  Indeed, when it comes to ordering any business idea around a rational assessment of risk and reward, it is going  to be more difficult in the absence of embedded interest rates, which at some level are the market's price indicators of normal risk return requirements.

It is often pointed out in financial guidebooks that one of the characteristics that separates the rich from the poor is that the poor have to work for their money while the rich have their money work for them. In an economy that prohibits the payment or collection of interest, it is virtually impossible for a person without the substantial wealth necessary to invest in sophisticated financial instruments to earn any return on whatever money they do have.  The WSJ article indicates that customers of the largest Islamic financial institution in Saudi Arabia have $18 billion in no-return checking accounts and that "because of concerns about illicit interest , savings accounts do not exist there."   Nor, I would assume, do CD's, money market accounts, bond mutual funds, or other simple savings tools which constitute the average person's entree onto the road of financial investing and intelligent money management.

On a more subtle level, the need to develop and maintain a parallel financial structure with complicated financial instruments secured by income producing assets has to increase the transactional costs to businesses throughout the Islamic economy.  I don't envy Muslim business people trying to succeed in a fast paced financially driven global marketplace given these limitations that inherently segregate them from many avenues of international commercial opportunity and necessarily disadvantage them relative to business people of other faiths who can operate without such fundamental financial restrictions. 

Having just begun to ponder all this, I don't have any brilliant insights, and it is a subject about which I will certainly seek to learn more.  It is certainly a dimension that anyone seeking to do business in the Islamic world needs to understand if they hope to structure deals that work for everyone involved.

Wheat Gluten and the International Sourcing of Raw Materials -- Is There a Cost / Risk Trade Off that We Need to Better Evaluate?

Every business is looking for a cost advantage, and many think they have found the answer in international sourcing of raw materials.  This is particularly attractive when it comes to a true commodity.   After all, if "parts is parts", then why not go with the lowest cost supplier.  Of course these days, that supplier is more likely than not going to be in a developing market such as China.

In all honesty, I'm not entirely sure what wheat gluten is, but I am certain that it has commodity written all over it.  Bought in bulk containers, it ships well.  It's no surprise that China would offer a potentially attractive alternative source of supply to U.S. manufacturers of pet food (and human food) looking to cut costs and improve margins.

A part of the cost advantage that developing markets such as China have in the manufacture and sale of many products is the low cost of labor, but how much labor is involved in producing an agricultural based bulk commodity like wheat gluten?   That thought leads me to ponder a second element of the cost advantage often found in developing markets -- i.e. they have a much lower regulatory cost burden in ensuring compliance with health and safety standards and in the quality control and  testing necessary to ensure consistent compliance with rigorous product quality specifications.

In doing business with suppliers from the U.S. or the E.U., many companies shift the burden of incoming product quality to the supplier, relying on the supplier's certification to reduce their own costs of quality control and monitoring.  As demonstrated by the contaminated Chinese wheat gluten that recently led to the recall of millions of tons of pet food and the illness and death of many beloved pets, there is much greater risk involved in shifting that burden to less well known suppliers operating in markets with less rigorous regulatory environments.  The lawsuits will come, and in all likelihood, the liability will rest primarily with the servable domestic sellers of the products, not the more judgment proof Chinese raw material suppliers.  But even before the lawyers get a hold of this, I am sure that the U.S. pet food brands are already feeling the pain of the damage to their brand reputation from having sold food that is unfit to eat -- I think there are fewer fears in the marketplace more visceral than the fear that what you are about to feed your loved ones could kill them.

So one question is, did the pet food manufacturers save enough in lower costs on the wheat gluten to offset the liability created by the contaminated wheat gluten?  I doubt it.  Of course hind sight is 20/20, so a further question is whether any of the manufacturers considered the risks of new suppliers in more loosely regulated environments as a possible offset to the cost savings?   Again, I doubt it, but there is a good lesson here for the rest of us going forward on risk/benefit analysis in international sourcing and purchasing decisions.