Scoops Lane
Tuesday, 29 April 2014

By Kris Sayce, Melbourne Australia

  • Don’t be in a rush to bet on infrastructure
  • The world’s most intriguing economy
  • You’ve heard of the ‘American dream’, what about the ‘China dream’?

It happens nearly a quarter-billion times a day in the USA: A car, truck or other vehicle is driven across one of the nation’s 63,000 structurally compromised bridges…

Nearly one-tenth of the 607,380 bridges in the National Bridge Inventory, a database of information on bridges and tunnels, are rated as structurally deficient by the Federal Highway Administration; the average age of those bridges is 42 years. FHWA has estimated that the nation would need to spend about $20.5 billion a year to eliminate the backlog by 2028; the USA spends about $12.8 billion annually.

USA Today, 24 April 2014

I’ve just got back from a three-week trip to Southern California — four days in San Diego, and 18 days in Los Angeles.

It’s a great place to visit. It’s good weather at this time of year, and if you hire a car California is a pretty easy place to get around.

You barely have to drive five miles on a freeway before you reach an interchange for another freeway. If you get lost, just drive north, east, south or west and before long you’ll reach a freeway and you’ll find your way home.

Of course, the huge freeway network isn’t by chance. California led the way when it came to building freeways in the 1950s. It’s the US’ most populous state, with the most cars on the road.

With so many cars, it requires a lot of road infrastructure. The same goes for the rest of the country. But when you have that much infrastructure it creates an obvious consequence — someone has to pay to maintain it.

In this case, according to USA Today, the US needs to spend a total of US$307.5 billion over the next 15 years to clear the backlog of maintenance works.

That’s a lot of money.

The world’s most intriguing economy

But that’s something mainstream economists and commentators don’t think about when you hear them talk about the need for infrastructure spending.

I’ll have more on that in a moment. But first a note about today’s second article. It comes from our new emerging markets analyst Ken Wangdong. You’ll hear more from Ken over the coming weeks and months as he introduces himself to you.

Ken has a unique view of emerging markets, China in particular, due to the fact that he grew up there and spent the past few years working in China and Hong Kong.

Now that he has relocated to Sydney, he joins my team to offer his views and analysis on emerging markets, including the world’s most intriguing economy — China.

You’ll read more from Ken below.

Until then, back to infrastructure (of course, China has its own infrastructure programs, which have been a boon to Aussie resource stocks, in particular iron ore). The mainstream economists and commentators always claim that infrastructure spending is an asset. They’ll say that investing in infrastructure is a great way to stimulate the economy.

What’s more, they’ll say that Aussie retirement funds and the government should ‘invest’ directly in infrastructure projects in order to build an asset for the future.

But as extensive as the California freeway network is, there’s no getting away from another key feature of the network: it’s in a terrible condition.

Almost every stretch of road along key freeways such as the I-5, I-405 and the I-605 is cracked and potholed.

The poor road condition no doubt has a detrimental impact on the road worthiness of the cars and trucks that use it every day. If the cost to repair all the ‘structurally compromised’ bridges in the US is over US$305 billion, then the cost to bring the road surfaces up to standard must be many times that amount.

You have to wonder. If the government plans on ‘investing’ in new roads or encouraging retirement funds to invest in new roads, just how do they plan on making a return when after 10 years the maintenance costs start to compound?

After all, it’s unlikely that these new roads will be toll roads. When it comes to state-funded toll road schemes the track record is woeful. In order to avoid the embarrassment of motorists not using the toll roads, politicians would rather make the roads free to everyone — then there’s a guarantee motorists will use it.

But how will that generate a return for investors? And who will pay the maintenance costs?

The high cost of maintenance

This is a problem that will eventually have to be faced by the likes of ASX-listed Transurban [ASX:TCL]. There’s no getting away from the fact that Transurban investors have had a good run. The stock was below $4 in 2009. Today it’s trading at $7.30.

It has shown good revenue growth over the past 10 years, and the company has recorded profits for the past four years. It’s also paying a tidy 4.4% dividend yield.

That’s by no means the best on the market, but it’s not bad either.

However, Transurban is a toll road operator. That means it has to operate and maintain a bunch of its toll road assets.

That’s not cheap, as today’s announcement from the company reveals:

The additional lane capacity proposed will improve travel time reliability for the currently 150,000 vehicles, including 14,000 freight vehicles, that use Western Link every day. The approximately $850 million project will deliver significant improvements to the movement of goods and services on Melbourne’s orbital network. It will also provide an economic boost to Victoria, supporting jobs in construction and related industries.

Ah, the stimulus effect.

But whatever stimulus there may be from a new road, $850 million is a big cost.

And remember, it only helps the economy if it means firms can produce, sell, and transport a greater number of goods than they otherwise would before the road improvements. In other words, the economy needs to grow. If the economy doesn’t grow then it’s an expense without the corresponding increase in revenue.

How will Transurban pay for this project?

In the short term it will most likely come from a share issue and debt facilities. Longer term it means higher toll fees. Considering most people who use the tollway likely don’t derive a direct economic benefit from the toll road (ie. they use it to get to and from work) then the higher tolls are nothing more than an extra cost.

The reward doesn’t match the risk

Compared to California’s extensive but ‘rotting’ freeway system, the network in Melbourne is pristine. But it’s also a much less mature network. In the coming years infrastructure firms like Transurban will start to see the costs mount — assuming they retain control of the tollway ‘assets’.

According to the last financial report Transurban already has $5 billion of debt. And it appears to need a combination of cash, borrowings and share issues in order to maintain its dividend level.
That may be sustainable…or it may not.

As I’ve mentioned above, shareholders in Transurban have had a good run as the stock has doubled since 2009. But how long can the good news last?

If California’s decaying freeway system is anything to go by then the good times could last for a few years yet. But with $5 billion of debt, a market cap of $10.8 billion, and volatile earnings, it’s not the kind of stock that gets me excited about the long term, especially as costs increase and opportunities for revenue growth diminish.


You’ve Heard of the ‘American Dream’, What About the ‘Chinese Dream’?

Ken Wangdong, Emerging Markets Analyst

There is no shortage of gloom and doom when analysts talk about China.

‘Structural overcapacity’, ‘credit bubble’ and ‘social instability’ are just a few of the buzzwords in the airwaves.

However, something has changed.

China has seen a new government under Xi Jingpin, spearheading towards greater reform, market liberalisation, environmental sustainability, and anti-corruption.

There is also a central bank with a steady finger on the monetary policy trigger. It’s determined to calm an unsustainable property bubble in China, and to facilitate a historical transformation in the nation’s economic and social structure — whether it will be successful or not is another point.

Not to mention China’s growing dominance in regional politics, particularly over territorial conflicts with a handful of neighboring countries.

So, should you trust Xi Jinpin and his government? Should you bet on China? And what version of China should you bet on? The answers to these questions have profound implications for our investment strategy.

China dream

Perhaps this is a good place to start deconstructing China’s situation. Yes, you guessed it, the term originated from the term ‘American Dream’. The American Dream arguably was a desire of the American people to break free from the limitation of resources in Europe at the time. Another too-often cited interpretation is that anyone can achieve success through hard work in the land of opportunities. Xi Jinping coined the term ‘China Dream’ with no official explanation for the term. Xi meant to encourage the average guy in the street to decide what this dream may be.

There is no doubt that this is gesture of democracy, in that Xi is implying the future of the country is made up of the dreams of each individual Chinese. The time has come for each person to decide what sort of future they want for themselves and for the country. This is all well and good. But what do ordinary folks think?

In 2013, the local media ran a small program to capture the live responses to this question. One man’s answer summed up pretty much the average view in China. When the man was interviewed on TV, he was eating a bowl of noodles, which is somewhere around 4–8RMB, which is between 66 Aussie cents and AU$1.32.

Needless to say, this man was not a rich person. That made him the perfect target for the question. Responding to the interviewer, the man simply shouted ‘Go Away!’, while he continued to eat his noodles (he actually used the ‘F’ word, making it even more hilarious).

This video quickly went viral on Weibo (China’s Twitter equivalent, an early dominator in the Chinese internet space; now facing increasing competition from companies such as Tencent) and Wechat (China’s Facebook equivalent, under Tencent, a tech company with phenomenal social media presence). The man’s response wasn’t surprising. How can anyone believe in a dream that is inherently and practically empty?

To describe just how bad things actually are, look at three indicators:

  • Income to apartment price ratio (questionable upside for property related investments in the short term, although there may be some sentiment lifts from relaxed restrictions in some cities)
  • Income disparity ratio (luxury goods are still a good investment area, currently hit by anti-corruption probes and broad economic weakness) and
  • Pollution this will become more serious in five years, with lung cancer rates to shoot through the roof, so good investment opportunities here).

In addition, there seems to be a severe trust crisis in China as well, which is likely worse than it was during the Cultural Revolution.

A different China

So there has to be a different China than there is now, because the current system simply won’t work anymore, and the government realises this.

Why is there a property bubble? It’s partly because of demand, but mostly due to speculative investments backed by credit from banks and shadow banks; subsequently, the market rewarded anyone with an appetite for risk.

And yes, those people who got in early got rich. Becoming a millionaire is (or was) easy in China. Take a local taxi in Beijing or Shanghai. You’ll be surprised by how many taxi drivers are richer than you.

Taxi drivers in big cities tend to be locals of that region; this means they got into the market early, usually under government or state enterprise assistance schemes. They usually control two if not three properties. A two bedroom apartment in a convenient location in Beijing is north of 3 million RMB, which is AU$550,000. Having 2–3 properties can easily push your net worth into the millions in dollar terms.

So if so many people became ‘rich’, why is there income disparity?

It’s because there has been growth, facilitated by an easy credit system; a financial system that transferred wealth from consumers to investors; a tax system with lots of loopholes and countless corrupted government officials.

The easy credit had a knock-on effect. It is a big reason behind the high pollution levels.

Because China built so many factories, it has been responsible for China’s urbanisation, productivity growth and employment growth. Essentially, pollution was the discharge from growth. The higher the growth rate, more severe is the pollution.

Blindfold off

The government realises these issues and has committed to solving the problem. Whether they can solve it or not is another issue. What you should expect to see is a China in transition. With all the promises of market reform, China will see pain down the road, but a prudent stance from the central bank and the government.

The latest fiscal move into railways is good, because China needs more railways. However, don’t be surprised if there is waste and inappropriate investments, as always happens with stimulus spending. You can expect to see ‘railways to nowhere’ or a railway from a major city to the hometown of an important Communist Party figure.

Financing through bond funds is a good step forward, because it relieves pressure on the local government financing system. However, do expect this sector to be backed and bailed out by the central bank if things head south.

Upgrading housing for low income households is a program with good political payoffs, showing the government cares a lot about its image. No surprise there; China is indeed at a critical juncture in its transition.

Lowering taxes for small companies is almost always good. Small to medium sized companies are the primary employer of labour in the world, and this is also true in China.

Believe it or not, lowering tax for small enterprises goes hand in hand with the government’s slogans to encourage graduates to pursue entrepreneurship. But behind this is an uglier truth; labor supply far exceeds labor demand for graduates in China.  This is reminiscent of the good old days, when students who had been highly involved in the Cultural Revolution in each city were becoming a surplus population, unable to be absorbed by industrial machine inside cities. On direct order from Mao, these were sent to the countryside for ‘re-education’ during the Cultural Revolution.

It was because nobody knew where to put them, and now it’s graduate entrepreneurship. (However, more entrepreneurship is being backed by more government grant programs, R&D patent encouragement programs. Even more incubators, accelerators and venture capital money.)

The government seems to be wiser than before. It’s avoiding ‘massive’ stimulus. Instead it’s keeping a tight rein on shadow banking, which is depressing the property market.

Any banker in China would tell you that policies have indeed become more stringent, credit is flowing towards small and medium enterprises, away from property. A real estate agent would tell you that he or she is changing career because sales have stagnated, while prices stay stubbornly high.

The heavy and light industries — metals, energy, paper & pulp, cement — they’re seeing restocking in their inventories, a significant proportion of the entire secondary industry is operating below cash cost (still extremely depressed, meaning there is value in many out-of-favour sectors). Producer prices and commodity prices are evident of the deflationary phase China is going through.

Pain is good, especially when it’s spent on change. For China, the question is not whether the government is committed to change; it’s rather what the transition period will look like and what kind of China will emerge on the other side of the tunnel.

Ken Wangdong
Emerging Markets Analyst