Keeping up with the Index, and other Quixotic pursuits

By Edward Lam, Lead Fund Manager

There is a beautiful passage in a translation of J. Borges’ Pierre Menard, Author of the Quixote, which comes after a succession of other beautiful passages:

There is no exercise of the intellect which is not, in the final analysis, useless. A philosophical doctrine begins as a plausible description of the universe; with the passage of the years it becomes a mere chapter – if not a paragraph or name – in the history of philosophy. In literature, this eventual caducity is even more notorious.

The problem eventually with Borges is that his sensibility is tuned to aesthetics, not use (which is to his advantage as an artist). So, what he mistakes for the unique value of Pierre Menard’s re-writing of the Quixote is really just a peculiar instance of the commodification of value through the evolutionary process of repetition.

There is a similar problem for those ‘trying to keep up with an index’. The attempt to follow in the footsteps and to reimagine the very same constituent parts, but from a different beginning might be an honourable endeavour on behalf of clients, but notoriously ends up as a quixotic pursuit.

As I mentioned back in April, there is a place in this market for an emerging market equivalent of “FANG” (“STTIRUP”, “HTTPS”). I reiterate that it is not our place to do this, though we can learn from the attempt. I continue to emphasize to clients the importance of considering their weighting to emerging markets, in this bull market, over and above what particular vehicle or funds they have allocated to. And what we need to do is to stick to our original ideas and research, whilst paying attention to where these most stick out or most conform.

An important disappointment in this month’s performance was SK Hynix, which fell 2.5% even whilst other technology stocks notably Tencent rose 18% (in USD terms). This has been a key component of our alternative source of value this year; a key reason why we have managed to keep pace with an index driven higher by the flight of Chinese internet stocks. Whilst it is impossible to know how the story will end, we have seen episodes like this before, and I remain convinced of the relative risk-adjusted value of a unique asset like Hynix, trading on 5x P/E versus the valuation of Tencent on around 50x P/E.

It is worth recapping some points on the Variable Interest Entities (VIE) by which most foreign investors lay claim to Chinese Internet holdings (which we last wrote about extensively in May 2011):

  • Strictly speaking they ought not to be valued as equities, as in many cases I have identified that they are a derivative of options structures. For those concerned about Korea corporate governance, Chinese VIE structures are probably worse.
  • One needs to assess them case by case, as each contract I have looked at is different.
  • My own stance has softened slightly since 2011, as there is now one ruling (so far unique) that has upheld a VIE structure to confer foreign ‘ownership’ of domestic Chinese assets.
  • There are in cases outstanding problems over the potential under-reporting of taxes for the earnings of U.S. VIEs.
  • There is an irony to the fact that a regulation post-Sarbanes Oxley designed to make de-consolidation but control a beneficial status of an entity largely impossible, has been inverted to allow reported ownership of a technically un-owned, uncontrolled asset.

Finally, it is also worth consolidating the three reasons why I think we are in a bull market for emerging markets:

  • The global capital cycle has turned decisively in favour of emerging markets (see chart below) as global austerity has waned and global trade has begun to grow much closer to pre-crisis levels. The impact of this is likely to be felt for the next three or more years
  • Emerging market stock pricing reflects the lag of the last 10 years and fails to reflect 10 years of reform and growth, being still 20% below the 2007 high watermark and relatively good value versus developed markets.
  • Returns on capital in a number of industries and countries are at inflection points, or at least declining at much slower rates. For those that worry about how much emerging markets have climbed, I would caution the opposite: there is room to run, and move on.

 

Source: SCM, Bloomberg.

 

 

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