September 2015
The Monthly
With this commentary, we plan to communicate with you every month about our thoughts on the markets, some snap-shots of metrics, a section on behavioural investing and finally an update on some of the people at MacNicol & Associates Asset Management (MAAM). I hope you enjoy this information, and it allows you to better understand what we see going on in the market place.
“Patience is power, patience is not an absence of action; rather, it is timing; it waits on the right time to act, for the right principles and in the right way.”
– Fulton J. Sheen
The Numbers:
Market Commentary: Bull in a China Shop
As you are likely aware, the Chinese stock market volatility has been at the forefront of all media outlets for the past month or so. After doubling between June 2014 and June 2015, sentiment turned on the over-valued market, which proceeded to lose over 40% of its value over the short period of a week. We addressed this topic in our interim commentary, stating that the notional market drop was not an issue, the real issue and concern stems from the government’s reaction to the drop in the market. For this portion of the commentary, we would like to explain what we meant by that.
Once the market began to turn, the government intervened in a big way; interest rates were cut, short selling was banned, IPOs were halted, state-backed funds and large Banks were ordered to buy stocks in droves, and regulations were even eased in order to ‘allow’ insurance companies and state pension funds to invest in the market. Although wide-ranging and various, all of these initiatives had the same goal: to keep money in the market and stop people from selling. Through its unimpeded rally, the stock market in China has been a major source of consumer confidence, and a legitimate tool which has been utilized by the government to keep the population happy. As such, it is clear that the Government is willing to do whatever it takes in order to keep this tool at their disposal. In addition to the aforementioned measures, stock brokerages are also being investigated and having their transaction records downloaded, with prosecution following for those who are found guilty of ‘market manipulation’ or essentially selling large amounts of shares and damaging the market’s value. Eight executives of state-owned Citic Securities were arrested for just such actions, and a journalist was detained and forced to issue a public apology due to an article they wrote which seemed to evoke negative sentiment towards the stock market. Combined, these government actions have much more important implications than the market decline itself.
Economically speaking, investors are afraid that the government’s actions indicate their lack of faith in the country’s real economic growth. It is feared that this attempt by the government to prop up the market is an attempt to keep investors from peaking behind the curtain and see what’s really going on. If this theory is true, it would legitimize the belief that many hold that the Chinese economy is growing much more slowly than it seems, which would have potentially devastating effects on many ‘China sensitive’ companies, sectors and countries. China is the largest importer in the world, and any economic slowdown would noticeably damage commodity and energy companies as well as China’s largest trading partners such as Brazil, Australia and Germany.
In addition to economic concern, there is also ethical and moral concern as a result of these actions. China has been slowly ‘Westernizing’ their financial market over the recent years, and this is seen as a major step backwards. All of these actions which outlaw free market activity and terrify investors is a major blow to investor confidence, and will likely result in increased hesitance to invest in China. Access to foreign capital is a major boon to economic and corporate advancement, and the Chinese government have hurt themselves in this regard. Although foreign capital is a relative blip on the radar in respect to the entire market at the moment, these actions will also likely cause that figure to diminish in the near term.
The final concern in regard to these actions is the lack of longevity inherent in the positive effects of such actions. This was a quick fix which may very well cause more damage than it saved further down the road. The lack of confidence is one major point in that regard, but the new regulations allowing insurance companies and pension funds to invest in the market is another. The government is now gambling the citizens’ future. If the market crashes again, this will now have a larger direct effect on individual citizens. We have always been wary of investing in China, but for us, this was the nail in the coffin.
Behavioural Investing: Why Markets are Irrational
For the Behavioural section of the monthly, we borrow lessons from Chris Mayer, who is the Investment Director and editor of several columns for Agora Financial. Chris is a brilliant author and will be speaking in person to clients at our Rosedale presentation on September 15th.
In his article, Chris Mayer references a book by Richard Thaler called “Misbehaving: The Making of Behavioural Economics”. The book explains the irrationality of the market as being rooted in the irrationality of human beings, which, he suggests, is the primary proponent of mispricing and volatility. Hypothetically, in a rational market, there should be very little trading, but as we know, the amount of trading volume is increasing by the day. Three behavioural reasons that Thaler believes contribute to this phenomenon are: Loss aversion, or the idea that investors fear losses more than they appreciate gains; overconfidence, which causes investors to become traders and shift their assets around far too often; and overreaction to mundane or inconsequential information, which rallies investors into stocks for little reason or shakes them out of positions without proper cause. This idea was illustrated in a ground breaking paper by Robert Shiller, who set out to discover whether stock prices moved too often in relation to intrinsic value, as measured by the dividend discount model. The chart below shows the results of his findings.
The blue line on the chart represents the present value of corporate dividends, which many believed (and many still do) represent intrinsic value, while the green line represents stock prices. As can be easily seen, prices are much too volatile in the context of how often and quickly intrinsic value actually changes. This chart and study is both fascinating and incredibly important, because, as Chris Mayer notes in his piece, as investors we seek to identify mispriced assets. If markets were completely rational and stocks rarely traded, this would be much more difficult to do. The market is irrational because we as human beings are emotional and irrational, but, much like in life, mistakes create opportunities.
Personal:
It has been a busy start to the “new year”. Labour Day always marks the end of Summer and the beginning of the new investing year.
I recently attended a conference in New York City on Global Online Gaming. We learned plenty about this growing sector. Land-based casinos are something like 10 times larger than their Internet peers. But online gaming is growing nearly three times as fast. And online gaming is a better business.
A number of casinos have gone bankrupt recently. Why? The simplest answer is people took their betting elsewhere.
That’s the problem with a land-based casino. You can’t move. You have huge fixed costs. But an online gaming site has no such problems. At the conference, the roll call of gaming companies was long: Amaya, Intertain, Playtech, theScore, 32Red, Gaming Nation and many more. Many of these are excellent businesses. They generate lots of cash. They’re growing at double-digit rates. They have millions of users all over the world. And the stock market correction has put these stocks on sale.
The industry reminds me a bit of the early days of e-commerce. Online sales, even in the early 2000’s, were still less than 2% of total retail sales. Today, it’s closer to 10%. Someday it could be 30% or 50%. Might online gaming eventually take a bigger share of the gaming pie from its land-based cousin? We think so. Internet businesses in every industry will continue to pressure and slay their weaker land-based peers.
After NYC, I travelled to Dallas, TX to visit a couple of our real estate holdings. My Father joined me on this trip to visit a lifelong friend of his who moved to Dallas with his family back when he was 13 years old. It is really nice to see an 80 year relationship continue to flourish with many old stories and laughs. Tonight, I’m off to see the Dallas Cowboys play the New York Giants in the home opener. This will be my second time in this billion dollar stadium seeing “America’s Team” and I am really looking forward to it!
All of the best.
Sincerely,
David A. MacNicol,
President
Portfolio Manager
MacNicol & Associates Asset Management Inc.
August 2015
