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China’s Hostility To Foreign Business Needs To End

Doing business in China is extremely risky. Things can change, literally, on a whim. President Xi Jinping has to navigate multiple crosscurrents when dealing with foreign business, and underlings have their own political concerns. Investors must be wary of over-investing in a country where their investment could degrade overnight. OSI Group is a regrettable example. Trumped-up charges led to workers held without trial and massive economic damage to the company. Ever since Chinese President Xi Jinping took over, foreign businesses have been rightfully complaining at the hostility Xi has shown them. For much of the past two years, Xi has been pushing his agenda for reform, revitalization, and restructuring. In the process, however, foreign businesses have been subjected to harassment, fines, bureaucracy, and in some cases, outright fabrication of criminal activity. Meanwhile, state-owned enterprises receive government favoritism, and things like intellectual property rights are being dismissed, or adhered to on an ad-hoc basis. The American Chamber of Commerce in China reports that 60% of foreign businesses feel unwelcome, up from 40% last year. The result has been ever-declining foreign investment in China. For example, investment fell 17% in July and 14% in August, year-over-year. Here’s a brief list of some incidents, and then we’ll look at reasons and consequences. Earlier this year, GlaxoSmithKline (NYSE: GSK ) was hit with a $489 million fine for alleged bribery, in a trial held behind closed doors. Earlier this year, Qualcomm (NASDAQ: QCOM ) paid a $975 million fine to settle an allegation that the company had charged “unfair” and “excessively high” royalties for the use of its smartphone technology. Part of the settlement included a reduced royalty calculation that, to one analyst, seemed to be totally arbitrary. Microsoft (NASDAQ: MSFT ) had its China offices raided last year as regulators allege breaches of anti-monopoly laws. Then, without warning, the government banned Microsoft’s Windows 8 operating system from government computers because it was allegedly filled with spyware. The company has been in data privacy dust-ups with China for awhile, but the pettiness and hostility of China towards Microsoft, whose revenue from the country is negligible, illustrates how out of control this issue has become. Yet the most egregious story comes from Illinois-based OSI Group, which should make anyone fume. In July 2014, two employees of the Shanghai government-owned Dragon TV applied for jobs at Husi Foods, the Chinese subsidiary of OSI Group. These “investigative reporters” were hired, but clearly under false pretenses . These reporters strapped on hidden cameras, and one filmed another intentionally dropping meat on the floor. This “shocking evidence” was magically leaked back to Dragon TV, which then aired a trumped-up “exposé”. The fiction grabbed attention of the government, which raided the plant on July 20, 2014, and later arrested six employees of Husi Foods. Subsequently, the Shanghai Food and Drug Administration (SFDA) claimed that Husi sold expired and repackaged meat to its customers. That kind of reputation damage led to lost sales, the loss of KFC (NYSE: YUM ) and McDonald’s (NYSE: MCD ) as clients, and have cost OSI Group hundreds of jobs and hundreds of millions of dollars . Emboldening state-owned media to manufacture evidence serves nobody. According to Professor Joshua Eisenman in testimony before the U.S.-China Economic and Security Review Commission, “In some cases, like that of meat distributor OSI International in Shanghai, entrenched domestic interest and local authorities appear to have made it far more difficult for foreigners to do business in China by clamping down on their operations and employing innovative discriminatory tactics to restrict their ability to conduct business.” No kidding. So what’s going on? Why is China engaging in such antagonism with foreign businesses? One of my sources that does business in China boils things down. Xi has to walk several tightropes. On the one hand, China needs Western intellectual, business, and technological assets to support its own developing tech industry. Paired with this is America’s need to access China’s massive population that has access to the internet – as many as 750 million people. Xi may have been maneuvering for negotiating position. By setting fires that he can also put out, he puts himself in the position of extracting concessions from America, both political and economic – such as killing retaliatory sanctions for its cyber attacks on our federal agencies. Xi also needs to be seen as protectionist, both to the Communist Party and to the general population. China comes first, the West comes second. He must create a delicate balance of carrots and sticks, so that the Chinese reap the benefits of outside investment without sacrificing the competitiveness of Chinese companies. Does this sound like China is focused too much on the macro issues? They are…and they aren’t. According to one source of mine who regularly does business in China, the issues are cultural and political. “The Chinese look at the larger picture, whereas Americans are more discrete in their perspective. Whatever incident occurs, there’s always something behind it that it totally opaque. Sometimes you are being sent a signal. Sometimes you’ve unintentionally offended someone. You cannot pinpoint the specifics of what actually happened. You never know when you are being made an example of, or for what reason, or if you just stepped over some invisible line. It may not even be about you at all, because there are multiple layers and crosscurrents constantly at play.” He provides an example. “Suppose you plan to release a movie in China, and it has a scene where dentists are being made fun of. Six months from now, the International Dentist Conference will be held in Beijing. So the person in charge of policing content pulls out the dentist joke because he doesn’t want to get blamed if the dentist joke offends someone.” Unfortunately, this all comes at the expense of basic human rights. It also comes at the expense of China’s own economic health. Meanwhile, monthly outflows from China have grown from $5 billion to $100 billion, according to the International Business Times . The government has tried to keep the money in-country by monkeying with currency exchanges rules and limits. The AP reports that GDP growth is slowing in the second-largest economy, growing by 6.9% in Q3, the slowest since the financial crisis. Growth in factory output fell to 5.7% in September from 6.1% in August. The government has had to cut interest rates five times. The situation is so bad that it isn’t only foreign investment that’s pulling out. Ever wonder why Chinese firm Dalian Wanda Group purchased the AMC Theatre chain? Or why Shuanghui International spent $7 billion to purchase Smithfield foods? Or any of the other massive deals that have occurred ? Or why, talking about real estate with an agent in Montenegro, so many Chinese are buying land there? So Chinese businessmen can get their money the heck out of China. The future is in China’s own hands, but until it reconciles itself with the fact that the West is going to help it grow, and drops politics from its agenda, it’s going to continue to scare business away. As for investors, I would be extremely cautious about investing in companies that derive significant revenue from China. It’s one thing to understand risks that are quantifiable and invest with an eye towards those risks. With China, however, you may as well invest in a war-torn third-world country where the government might nationalize assets at any time. As my source says, “Your contracts with the government are always at the risk of being broken with two simple words: ‘things changed'” China’s behavior has not only made setbacks to any given company a possibility, but a completely random one. As we’ve already seen, if Xi wakes up one morning and decides to hassle a business whose stock you own, that stock could crater. I would avoid all ETFs that invest heavily in China, ETFs that weight China more than 5% of a portfolio, and any company that derives more than 5% of revenue from China. Yes, that eliminates some big names from your portfolio. However, as a risk-averse, long-term diversified portfolio advocate, why expose to risk you don’t need?

We Eat Dollar Weighted Returns – VII

Photo Credit: Fated Snowfox I intended on writing this at some point, but Dr. Wesley Gray (an acquaintance of mine, and whom I respect) beat me to the punch. As he said in his blog post at The Wall Street Journal’s The Experts blog: WESLEY GRAY: Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance. “No problem,” you might think-buy and hold and ignore the short-term noise. Easier said than done. Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009 . The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period. What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.” The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially. In other words, fund managers can deliver a great long-term strategy, but investors can still lose. That’s why I wanted to write this post. Ken Heebner is a really bright guy, and has the strength of his convictions, but his investors don’t in general have similar strength of convictions. As such, his investors buy high and sell low with his funds. The graph at the left is from the CGM Focus Fund, as far back as I could get the data at the SEC’s EDGAR database. The fund goes all the way back to late 1997, and had a tremendous start for which I can’t find the cash flow data. The column marked flows corresponds to a figure called “Change in net assets derived from capital share transactions” from the Statement of Changes in Net Assets in the annual and semi-annual reports. This is all public data, but somewhat difficult to aggregate. I do it by hand. I use annual cash flows for most of the calculation. For the buy and hold return, I got the data from Yahoo Finance, which got it from Morningstar. Note the pattern of cash flows is positive until the financial crisis, and negative thereafter. Also note that more has gone into the fund than has come out, and thus the average investor has lost money. The buy-and-hold investor has made money, what precious few were able to do that, much less rebalance. This would be an ideal fund to rebalance. Talented manager, will do well over time. Add money when he does badly, take money out when he does well. Would make a ton of sense. Why doesn’t it happen? Why doesn’t at least buy-and-hold happen? It doesn’t happen because there is an Asset-Liability mismatch. It doesn’t matter what the retail investors say their time horizon is, the truth is it is very short. If you underperform for less than a few years, they yank funds. The poetic justice is that they yank the funds just as the performance is about to turn. Practically, the time horizon of an average investor in mutual funds is inversely proportional to the volatility of the funds they invest in. It takes a certain amount of outperformance (whether relative or absolute) to get them in, and a certain amount of underperformance to get them out. The more volatile the fund, the more rapidly that happens. And Ken Heebner is so volatile that the only thing faster than his clients coming and going, is how rapidly he turns the portfolio over, which is once every 4-5 months. Pretty astounding I think. This highlights two main facts about retail investing that can’t be denied. Asset prices move a lot more than fundamentals, and Most investors chase performance These two factors lie behind most of the losses that retail investors suffer over the long run, not active management fees. Remember as well that passive investing does not protect retail investors from themselves. I have done the same analyses with passive portfolios – the results are the same, proportionate to volatility. I know buy-and-hold gets a bad rap, and it is not deserved. Take a few of my pieces from the past: If you are a retail investor, the best thing you can do is set an asset allocation between risky and safe assets. If you want a spit-in-the-wind estimate use 120 minus your age for the percentage in risky assets, and the rest in safe assets. Rebalance to those percentages yearly. If you do that, you will not get caught in the cycle of greed and panic, and you will benefit from the madness of strangers who get greedy and panic with abandon. (Why 120? End of the mortality table. Take it from an investment actuary. We’re the best-kept secret in the financial markets.) Okay, gotta close this off. This is not the last of this series. I will do more dollar-weighted returns. As far as retail investing goes, it is the most important issue. Period. Disclosure: None

An Interest Hike Doesn’t Mean That Gold Price Must Crash

Summary The Fed chairwoman Janet Yellen stated that the U.S. economy is strong enough for the Fed to start raising the benchmark interest rate. The pace of the U.S. GDP growth and the inflation rate don’t indicate that there is any need to raise the interest rate. Any interest rate hike will be probably only symbolical and it won’t be followed by another interest rate hike anytime soon. History shows that gold and GLD prices often react on the interest rate changes in contrary to the theory and general expectations. Gold price has been in a strong downtrend for the last couple of weeks. The SPDR Gold Trust ETF (NYSEARCA: GLD ) reached a new multi-year low, just shy of the $100 level. It represents a more than 10% decline since the middle of October. The decline was driven by increased expectations that the Fed will raise the key interest rate as soon as in December. The probability was further supported by a very strong October job report . Although the November data are a little weaker and some of the economists, including Peter Schiff claim that the state of the U.S. economy is worse than the numbers show, statements of the Fed representatives still indicate that the interest rate may be hiked this month. According to Janet Yellen, chairwoman of the Fed, the U.S. economy is strong enough for the Fed to start raising the benchmark interest rate. Is an interest rate hike needed? The probability of a December interest rate hike is high, although I don’t see any good reason why to raise it. Yellen explained why the Fed wants to raise the interest rate when she stated : Were the FOMC to delay the start for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from overshooting. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into a recession. Yes, the reason is good. The above-mentioned statement makes sense. But the officially-presented data don’t indicate any risk of an overshooting anytime soon. The annual pace of the GDP growth rate is only slightly above 2% and the inflation rate is at 0.2%! Actually, the deflation is much more probable than overheating of the economy, according to the official data. There are a lot of discussions about the accuracy of the officially-presented data. For example, according to John Williams and his website Shadowstats.com , the current inflation rate is close to the 4% level using the 1990 methodology, and it is around 7.5% using the 1980 methodology. In this case, we can start to speak about overheating of the economy. It really seems that the Fed publicly presents one set of macroeconomic data and it makes policy decisions based on another one. (click to enlarge) Source: Trading Economics Moreover, raising the interest rate too much may damage the U.S. economy. The strong USD already has a negative impact on the U.S. exporters. It may also damage the foreign economies, as a lot of the companies around the world have big USD-denominated debts, and they are dependent on revenues denominated in other currencies. As the value of these currencies falls, the companies will have more and more problems with the debt service. There are a lot of reasons why to expect that if there is any interest rate hike this December, it will be only symbolical and it will probably take quite a lot of time before another hike will occur. There are various economists who have the same opinion and they don’t see any good reason to increase the interest rate right now. One of them is Peter Schiff who expects that the Fed will leave the interest rate unchanged or it will raise it by 0.25%. He assumes that both of the outcomes will be positive for gold, as the markets have already factored in substantially more than a 0.25% interest rate growth. How did GLD share price react in the past? Although theory says that GLD price should decline after an interest rate hike and it should grow after an interest rate cut, history shows that this anticipation is often wrong. The financial markets always try to predict the future development, and the interest rate change is often reflected by the asset prices before the rate change itself is officially announced. And if there was a strong trend before the rate change, the trend may get disrupted for some time, although it tends to resume after the dust settles down. 22 interest changes occurred since the inception of GLD. In 12 cases, the interest rate was increased and in 10 cases it was decreased. The table below shows the development of GLD share price 20, 10 and 5 trading days before the rate change and 5, 10 and 20 days after the rate change. It is interesting that on average, GLD price grew before the interest rate change and it was in a slight decline 5 and 10 trading days after the rate change. But 20 trading days after the rate change, it was back in green numbers. Only in 4 out of 12 cases (33.33%), the GLD price recorded any losses 20 trading days after the interest rate hike. It declined by 4.73% on average. On the other hand, in 66.66% of cases, the GLD price recorded gains (5.08% on average). In 4 cases (33.33%), the GLD price just kept on growing, without any reaction on the interest rate hike. After the Fed started to cut the interest rates, GLD was down in 50% of the cases after 20 trading days. After the interest rate cuts on March 18, 2008, October 8, 2008 and December 16, 2008, a strong growth trend turned into a steep decline. It shows that GLD often reacts contrary to the theory not only after interest rate hikes but also after interest rate cuts. (click to enlarge) Source: own processing, using data of Yahoo Finance and the Fed Conclusion If the Fed hikes the interest rate during its meeting on December 15/16, it doesn’t mean that gold and GLD prices must crash. The official macroeconomic data don’t indicate that the U.S. economy should start to overheat anytime soon; moreover, a too strong USD may hurt not only the U.S. economy. Any rate hike will be only symbolical and it will probably take a long time before another one will occur. The markets may actually welcome that the more than a year long saga is finally over, and the GLD price may react positively. As the not-so-distant history shows, it wouldn’t be the first time when GLD price grows after an interest rate hike. Adding to it the problems the gold miners have to face at the current gold prices and the high demand for physical gold, GLD presents an interesting contrarian opportunity.