How Growth Destroys Value

–It turns out that November 3rd—the day the Bernank abandoned the defence of a strong U.S. dollar—was a much more consequential day for investors than the U.S. election on November 2nd. Since that announcement of at least US$600 billion in Quantitative Easing (inflationism), there has been a chain reaction of mostly negative events for investors.

–Today’s Markets and Money won’t chronicle all of them. And the main focus—via Greg Canavan’s essay  on how consistently high returns on equity lead to large increases in market value—is on Australian assets and how they might benefit from shifting global capital flows. It’s an important topic, especially given the takeover of Mt. Gibson’s board by Chinese interests at yesterday’s annual general meeting in Perth. More on that shortly.

–But we’d be remiss if we didn’t bring you up to speed on Ireland and China. Confidence in Ireland’s banking sector is waning. Bond vigilantes and depositors alike realise that the banks are stuffed and the government will stuff itself by agreeing to help the banks, which stuffs everyone else in Europe. There’s a whole lot of stuffing going on—and it’s not even Thanksgiving yet.

–The Financial Times reports that customers of Irish Life and Permanent bank withdrew nearly €600 million in August and September—11% of deposits. There’s a crisis of confidence in the banks because there’s no confidence that the banks have adequate capital to withstand losses on the many bad loans they are carrying.

–Yesterday’s action on the Ireland story was mostly political. Teams of lawyers and bankers from the IMF and ECB converged on Dublin to try and force a deal on the Irish government before a failing bank in Ireland puts pressure on struggling banks elsewhere in Europe. And the Europeans are keen to prevent Ireland’s problems from undermining confidence in the Sovereign Debt of countries like Spain and Portugal and Italy and Greece.

–Jeez. And we thought the U.S. dollar had it bad. The Euro’s woes have stabilised the dollar’s plunge into currency ignominy. But more importantly, the weakness of the world’s two large reserve currencies (and the underlying debt woes, sovereign and household, that plague both) is causing investors to take their money and run to places where it’s treated better.

–One place investors think money might be treated better is China. But there is no easy way for capital to find its way into China at the moment (arguing for a speculative punt on countries at the periphery of China’s growth). And China, meanwhile, is suddenly facing its own inflationary crisis, having imported the Bernank’s policy of inflation.

–Today’s Asian Wall Street Journal reports that, “A statement from the State Council on Wednesday pledging to use administrative measures to tame rising prices of food and energy, and to cushion the poor with higher welfare payouts, appeared mainly to reflect government concerns that inflation could trigger social unrest.”

–Just to be clear, these are old-fashioned command economy style price controls. Just last week the Chinese were laughing at U.S. Treasury Secretary Timothy Geithner for recommending to G-20 finance ministers a command economy style cap on national trade surpluses of 4% of GDP (bad for Brazil and China, good, maybe, for America). Chinese Vice Foreign Minister Cui Tiankai said, “The artificial setting of a numerical target cannot but remind us of the days of planned economies.”

–He probably said that without any sense of irony, since China sets a GDP target roughly commensurate with the need to keep employment growing in China and avoid social unrest. But meanwhile, the numerical target whereby China fixes its currency to the value of the U.S. dollar has unleashed a rash of undesirable consequences in China’s economy which we like to call “higher prices.”

–The Journal says that, “Accelerating food prices—the biggest single component of China’s inflation, now running well above the government’s target of 3% for the year—are hurting China’s neediest households, and their plight could get worse as the country heads into what is forecast to be an unusually cold winter that threatens to disrupt transport and bring new fuel shortages.”

–At last week’s Gold Symposium in Sydney we suggested that higher food and fuel prices—the things that hit ordinary people every day—would force the world to decouple from the dollar standard more quickly than it had planned to do. This dislocation in markets would produce volatility, bigger capital flows, are larger asset price swings as investors try to buy assets which aren’t losing value in one currency or another.

–Which brings us to yesterday’s action in Mt. Gibson. The Western Australian Business News is reporting that, “Chinese corporate shareholders in Mt Gibson Iron have seized board control of the local iron ore producer at a sensational annual meeting in Perth today.” The article continues:

Steel group Shougang and Hong Kong-listed APAC Resources, which indirectly speak for around 40 per cent of the company’s shares and are its biggest iron ore customers, today seized a majority of positions on the seven member board.

The two Chinese groups, which were declared associated parties by the Takeovers Panel in relation to another matter involving Mt Gibson in 2008, today used their combined votes, and those of Shougang-associate Fushan Energy, to prevent the re-election of independent director Peter Knowles.

–And now it gets interesting. There are $2.6 trillion reasons why China Inc. would seek hard assets instead of owning U.S. Treasury bonds. But the key issue here is whether the customers of a company—Shougang and APAC Resources—are the best people to maximise profitability of that company on behalf of Australian shareholders. Customers typically seek the lowest prices possible—which is exactly what you’d expect customers do.

–Herein lies the dilemma of having open and free capital markets where your assets are for sale to anyone with cash. Will those assets be run to maximise shareholder value? Or will they be run, in this case, to guarantee price certainty and iron ore supply to Chinese customers? If the answer to the second question is no, will Australia get the most benefit from its mineral reserves?

–Our thoughtless answer is that the projects which the Chinese are allowed to invest in or takeover might not find capital from Aussie investors anyway, so there is a net benefit in jobs to Australia (if not profits to Mt. Gibson’s Aussie shareholders). The government is going to block the takeover of all the mining sectors crown jewels (Oxiana’s assets in SA, Chinalco’s bid for Rio). The lower quality iron ore deposits (lower quality ore and smaller deposits) are perfect for the Chinese and otherwise might not get developed at all. Capital should be welcomed.

–However, for Aussie investors there is a more “evergreen” issue here: are the managers of the stocks you own pursuing growth strategies that add or destroy value to your holdings? In the essay below, our friend Greg Canavan shows how consistently high returns on equity generate greater market value and bigger shareholder returns. Given BHP’s recent plans to produce growth through acquisition, Greg’s analysis on how growth can sometimes destroy value is pretty useful.

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "How Growth Destroys Value"

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You can raise the value of ‘E’ in ROE by paying excessive dividends out of capital using extend and pretend balance sheets like the Australian banks. Using the ROE measure in a ponzi banking enterprise justifies the normalising of extortion and rent gouging committed upon the wider economy and masks deteriorating productivity in that key sector. Ayn Rand followers don’t understand much about anti trust though and couldn;t muster an argument along those lines. In fact they’re just plain dopey about it.

One here for Watcher7. Being logistically minded more than sentiment minded is probably the cause of my negativity at the mid point of this year. I see building inventories as a negative whereas markets go with sentiment and a view of the activity in building that inventory. Unless building inventories has a positive feedback it just builds more depth into the next dip. Of coarse watcher has his dip built in for next year on his wave and could be proved correct. I’m getting whooped on my market course but my basic premise on deflation first in the US… Read more »
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