CKUA

[KastelCo]

http://siliconinvestor.advfn.com/readmsg.aspx?msgid=24497216

US vs. China:

“Peking Inflation”

As you read this month’s report, don’t forget the context; our systematic approach to
investing in businesses. We must find businesses trading at a discount to intrinsic value.
To obtain a conservative estimate of that value, we need to have confidence that the
return on equity we adopt as the future businesses performance can be sustained. To
determine if it can be sustained, one of the things we need to know is whether the
business faces headwinds or is enjoying tailwinds. Forming a view on which companies
have bright prospects is dependent on forming a view on whether their customers will
prosper. And prosperity to some degree is dependent on your geographic location.

As you will find out if you are selling your products to a US retailer, you may find it
tougher than if you are selling cotton, wheat, coal or uranium to China. That latter
business won’t even know there is a recession in the United States.

In December I travelled to New York and Miami – the former to attend John Schwartz’s
Value Investors’ Conference and the latter, ground zero for the sub-prime crisis,
mortgage stress and house price declines.

In Florida, we talked to locals, retirees literally sunning themselves on South Miami
Beach, a couple of billionaires and every business owner who wanted to have a chat to an
Aussie with a desire to find out what is really going on.

It was from that visit that we could see the US was already in a recession. Housing, auto
manufacturing and financial institutions were reporting numbers quite different to the US
government’s aggregate statistics. We also formed the view that the depth of the credit
crisis was being underestimated. The visit confirmed our view that the problems facing
the United States cannot be reversed in a couple of months.

When Americans travel, they often comment about being harangued by beggars. I felt
exactly the same way at Miami Airport, only the beggars had uniforms, worked a full day
ferrying your luggage and hoped for tips. The appearance of full employment had been
created but we saw literally hundreds of ‘working’ unemployed. These individuals had
low purchasing power already and any increase in prices of food, petrol or services would
serve to only reduce their purchasing power further.

We marveled however at the low prices for virtually every consumer item and were
stunned by the ubiquity of the ‘Made in China’ label. When you are being paid 6 pesos
an hour (sorry, I meant to say US dollars) you absolutely must have low prices. Even
Australian wine was significantly cheaper than the same product here. Think about that;
Australian dirt, Australian water, Australian grapes, Australian packaging, shipping half
way around the world and yet cheaper than the same product locally.

To ensure low prices, the US has been trading off the goodwill it has built over the last 50
years. But I couldn’t help feeling the accountants should think about an impairment
charge against that goodwill. For as long as I can remember, winning a customer in the
US was branded ‘lucrative’ and your business was described as having hit the ‘big time’.
Succeeding in New York, Manhattan and Los Angeles still brings with it a certain cache
but I wonder how long before it is replaced with Shangai, Beijing and Guangzhou.

Last week I returned from a self-funded trip - this time to China. The contrast to the US
trip could not have been starker.

What first impressed me were the modernity and scale. Train stations that made Sydney
International Airport look like a rural hub and a transport system that rendered the
architects of Sydney’s system seem woefully under-qualified. Bullet trains travelled at
400km/hr, the ports - filled with containers arriving and leaving - looked like cities from
the air and spread out from the water’s edge like the tentacles of urban sprawl.

I travelled an hour along an eight lane freeway (eight lanes in each direction!) and saw
nothing but high rise apartments and office towers.

I realised I was witnessing the industrialisation of a country and the planning of cities all
at the same time. John’s Batman’s journal entry on 8 June, 1835; “this will be the place
for a village” was followed in 1841 by a formal incorporation of the town of Melbourne,
the reservation of land for public parks and Robert Hoddle laid out the grid upon which
Melbourne was built. What is going on today in China is no different. It’s just the scale
and the pace that varies from what people must have witnessed in Melbourne in the mid
1800’s.

China’s economic growth is the fastest in recorded world history and at street level it is
palpable. Building construction continued to the horizon (on the days I could see the
horizon) and while my first thought was ‘speculative bubble’ I remain cognisant of the
fact that 500 million rural Chinese are expected to move into the cities over the next 20
years. These people will need cars, appliances, heating, electricity and food and lots of it.

Indeed all these buildings – offices, apartments, factories, wholesale markets, exhibition
centres, ports, tunnels and roads and far too many casinos – to service a population of
1,500 million people will need power just to keep the lights on.

I marveled at the demand for energy that will be required even after all the nation-
building is done – and that alone is going to take decades. Uranium, oil, thermal coal and
when that all runs out, wind and solar will all enjoy their very long day in the sun. While
I was there, two European car manufacturers announced they had increased production
by 15% in a month to meet rising demand from ‘emerging’ markets. Once these cars are
sold, they will need fuel to power them on top of the fuel required to manufacture them.

While I was there the government was also musing publicly about mandating more
holidays, which you could take only if you travelled domestically.

China’s wealth has been built on being the western world’s contract manufacturer but I
noticed a growing number of brands in which the owners, store staff and customers took
great pride in the ‘Made in China’ label. Brands like Shanghai Tang and 361 could cut it
against Abercrombie & Fitch, Adidas and Puma on the global stage and reflect the
development of intellectual property upon which higher returns on equity can be
sustained.

People were driven, eager to help and nothing was too hard. Mao’s ‘serve the people’
mandate remains entrenched despite the enthusiastic adoption of the more selfish
capitalist model. Everyone displayed entrepreneurial spirit. Even the two homeless men
who were pointed out to me by my interpreter were each reading the business pages of
the local newspaper.

For the Chinese, the US isn’t in recession. For many Chinese, the US doesn’t even exist.
You could see it in shopping malls. The European stores were bigger drawcards than US
brands although KFC and McDonalds were ubiquitous. When the Chinese middle class
can afford to purchase their own value-added output, the currency can rise significantly
without a detrimental impact on aggregate manufactured output from the likely decline in
exports.

While the western world has feasted in China’s exported deflation, unfortunately we will
soon see the reverse. As any stationary importer can tell you, China has already begun to
export inflation (internal inflation at over 8% is at a 12-year high) and the impact on
Australian businesses will be magnified as their currency appreciates.

On top of this is a snowballing financial crisis as well as a global food crisis. Add an oil
crisis in the next decade and you have a challenging environment in which to invest.

I will make one final observation. I spent a day in the Special Economic Zone of Macao
and while I enjoyed the Portuguese-inspired food, it was the scale once again – this time
in the casinos – that bowled me over. I visited the Venetian Casino which opened in
August last year as part of the Macao “mega-tourism” development. Its website
understates the grandeur: “The Venetian Macao boasts the world’s biggest casino (some
600,000 square feet of gambling space, about five times the size of your state-of-the-art
Vegas gaming floor), 3,000 hotel suites and acres of swimming pools, 850,000 square
feet of shopping, a 15,000-seat showroom, and a 1.2-million-square-foot convention
center.”

I should remind you that all of this was inside a building, with ceilings, carpets,
powerpoints and halogen lights. I should also add an international soccer field is about
77,000 square feet.

In 2004 China’s power consumption was 2050 billion kWh more than 10 times
Australia’s total consumption. Per capita statistics however reveal that each person in
China consumed just 1590 kwh. Australians, in the same year individually consumed
11,200 kWh, (Amercians 13,500 kWh each and India 457 kWh each).

At Clime we are continuing to invest in those businesses that offer bright prospects and a
substantial discount to intrinsic value. Our 51% cash weighting and the discussion above
should tell you something of what we think about the present market’s ability to offer
both.

Roger Montgomery
Clime Capital Limited
14 April 2008