Vertical Pulse

The Link Between Chinese Demand and Urbanization

Anyone who follows the news can tell you that commodity prices have surged because of demand in China, India, and other emerging markets. Other factors figure into why commodities have boomed the last couple of years, but let us focus on the fundamentals for today. Let's look at demand in China.

In "China Shakes the World," by James Kynge, he states in the beginning of his 240-page book about the economic giant that demand will grow as long as the Chinese landscape continues to urbanize. He uses statistics that find 400 million Chinese currently live in towns and cities, but is expected to rise between 600 and 700 million to a total of 1 billion or 1.1 billion people. "Even at that level, China may be only slightly more than 70 percent urbanized, compared with prevailing rates of around 90 percent for the United Kingdom and the United States, just over 80 percent for France and Germany, and 77 percent for Japan."

"The investment required to settle so many people in an urban environment is impossible to calculate with any accuracy, but it is clear that worldwide demand for steel, aluminum, copper nickel, iron ore, oil, gas, coal, and many other basic metals and resources may remain strong for as long as cities in China expand at a rapid clip."

The Business Development Academy, an affiliate of IncreMental Advantage, organizes seminars around the U.S. and will be hosting its "Managing Transactions in China" on Jan. 29 in Boston, March 18 in New York City, and March 31 in Washington D.C. For more information please click on previous link.

Mergers & Acquisitions of Chinese Companies

According to a survey by Duke University and CFO Magazine, 37% of Chinese companies surveyed plan to acquire other companies or buy assets over the next year. That compares with 40% of U.S. companies. Nineteen percent of the Chinese companies surveyed said they plan to sell all or part of their own firms.

These are some of the issues that will be discussed at The Business Development Academy's course on Chinese transactions. More information is available at www.bdacademy.com.

Chinese Real Estate

Emerging markets have been playing a bigger role in investors' portfolios for several years now. Not only are the stocks and bonds of most companies domiciled in emerging markets highly sought after, but real estate is a hot commodity in Asia and East Europe. Let's focus on China, since the media and investors give it the most attention out of the emerging market scene.

In March, the National People's Congress approved a major piece of legislation that enforces private property rights. Though the law has many shortcomings, it will definitely mean land value will rise in the coming years. Good news for investors who act timely. Also, the Chinese government is tightening its industrial land policy in order to pursue a more "sustainable" path of economic growth. China's state-controlled press reported that some of the reform measures' goals is to restrict the appropriation of farmland for development purposes, prevent economic overheating, and establish a system of minimum prices for industrial land use rights.

Writing for Real Estate Forum in September, Andrew Ness reported that these policies are "serving to establish a more transparent framework for industrial land sales, which allows international investors to compete on more equal terms with local players. This, in turn, is giving developers, large-scale manufacturers and third-party logistics companies more confidence in acquiring land." Land values have increased also. In Beijing industrial land has increased by 22%, while rates in Shanghai grew by 24%, between the first quarters of 2006 and 2007, he added. Second- and third-tier cities will feel the impact of this land reform law as industrial bases look to relocate to the cheaper fringes of urban areas.

"Over the longer term, the adoption of the new measures will act to significantly increase the total costs of industrial real estate in China," wrote Mr. Ness, who is the Hong Kong-based executive director of CB Richard Ellis Research Asia.

As far as March's private property rights enforcement law is concerned, The Economist pointed out there is plenty of shortcomings in the law: It does not give peasants marketable ownership rights to the land they farm; it does not let peasants use their land as security on which they could borrow and invest to boost productivity; and it does not clear up who owns what. However, The Economist notes, "a revolution (is) waiting to happen (in China)—or perhaps two. One is the bourgeois revolution led by the emerging property-owning middle class that the new law will help. The other is the potential for the simmering resentment in the countryside to boil over, perhaps in frustration at the law's shortcomings. Property rights are at the root of both—which is why the dozing NPC delegates may have started a process this month (March) that will one day change their country completely."

These are some of the issues that are discussed at IncreMental Advantage's real estate conferences. For more information, please visit www.incrementaladvantage.com.

Decouple From The U.S.

Any literate American knows that the best investment opportunities lie in the developing markets where annual GDP growth rates vary anywhere from 6% to even 20%. Much better than North America, Japan, or Western Europe. The buzz word for today is "decoupling." That is, foreign markets are no longer catching colds when the U.S. sneezes. "It's increasingly clear that the U.S. isn't any longer the sole engine of global growth -- that other economies have, in effect, decoupled from it," a Wall Street Journal story reports today. The story went on to report that Europe, China, South Korea, and other foreign economies are doing well and growing their middle classes. "For U.S. investors looking to cut exposure to a weaker U.S. economy, the key is to find companies that benefit from global growth and avoid those that are domestically focused or have big exposures to the housing market," the WSJ story continues.

"Despite my current views on the death of New York, I just cannot believe this will ever be the case. It has infrastructure, distribution and lots and lots of customers. Where it suffers is brain drain. All its best bankers are in London," opines Fintag.com, a blogger who also manages a hedge fund.

Along with supposed brain drain, the U.S. dollar continues to plummet. This bodes well for some, but overall its not good news for U.S. consumers who will have to pay more for imports, commodities, and oil. As a result, expect a slowdown in consumer spending, which accounts for 70% of U.S. GDP. As the dollar falls some Middle Eastern nations may look to "unpeg" their currencies to the dollar while also diversifying their exchange reserves into other foreign currencies and assets. Perhaps, oil being priced in Euros is not too far behind. "Qatar's $50bn sovereign wealth fund has trimmed its exposure to the dollar to around 40% of its portfolio, down from 99% two years ago, reported Reuters. About 40% of the Qatar Investment Authority's portfolio was invested in euros and another 20% in currencies including sterling," reports ameinfo.com.

The U.S. looks to be less appealing long term as well. Consider the political atmosphere. A lash back against free trade, impending higher taxes, increase in regulation codes, and out-of-control government spending will probably curtail a lot of the growth the U.S. might experience once the housing crisis is over. The constant propaganda (oops, I mean advertising) that moveon.org, environmental organizations, politicians (i.e. Vermont Senator Bernie Sanders), and other interest groups have poured on the American people have taken its toll. Most voters are convinced that open market policies, which are responsible for 200 years of growth, are now bad ideas.

Time to start thinking about a residence in the Caribbean.

Observations From Abroad

Regular readers have noticed my nearly three-week hiatus from posting entries on Vertical Pulse, which, to some, came at a bad time while me and my colleagues were closely following the news surrounding the "Sub-prime Summer." For the past couple of weeks the sub-prime fiasco has crept into the broader economy and now this nasty little credit crunch has crimped business around the globe.

Much to my delight, while all of this was going on I was exploring the cities and country-sides of Italy and France. I will not bore you (or make you jealous) with the details of all the sites, sounds, foods, and $5 cappuccinos I indulged myself with for 16 days. Instead, I will write about my observations of the dire economic conditions both Western European countries find themselves in.

My first five minutes in Rome I could already see the lack of investment in the once great city's buildings, infrastructure, environment, and most of all, its citizens. Aside from tourism and the businesses that feed off of it (restaurants, clothing, etc.) there is no commercial activity to speak of. I had the chance to talk to a handful of Italian college students in the Abruzzo Region, where all of them complained there are too few job prospects in Rome or Southern Italy. The youngsters ranged in majors from linguistics to mechanical engineering to marketing, but yet all of them had difficulty finding work. They said in order to find work one would have to head north, far from home, to Germany, France, or somewhere else like that to find a job.

Later, I was able to meet and talk to a well-to-do older gentlemen (through a translator) who is employed in management for a consortium of companies. He complained to me about how the Italian economy has suffered and that taxes are crushingly oppressive. Some of his relatives had to have their stock option investments managed in Poland, where the tax impact is much less than Italy's 40% tax on long-term capital gains. When I mentioned to him that in the U.S. there is only a 15% tax on such investments, his eyes lit up in disbelief. He remarked that he wished the government would either lower the tax or simplify the tax code.

One family I met with in Central Italy said it was extremely expensive to travel abroad. Their children, now in their college years, never have had the chance to visit Paris, which is similar to driving from New York City to Charleston, S.C. This is a middle class family in Italy, a supposed wealthy developed western nation. They found other goods and services too expensive that middle class families in America take for granted.

When I drove through the country-side I saw many, many dilapidated neighborhoods. While this is not true throughout the entire country (and I saw some beautiful neighborhoods and also met wealthy individuals) the proportion of rich to poor is lopsided in Italy in favor of the latter. Despite this, Italy is a gem to visit and the people are extremely friendly.

Regulation has also taken its toll on the business environment in Italy. When traveling on the Eurostar, operated by RailEurope, my reservations got mixed up. Navigating the Roman Terminal to correct the error was a nightmare. Lines were long, people agitated, and the service did not cater to the customer like here in the States. "Welcome to Italy," commented one Canadian man who stood in front of me in line after he overheard me complain. The airport was no better.

Returning home my luggage was delayed in Paris (connecting flight) and I did not receive it until three days after being in the U.S. When I was talking with one of Delta's baggage customer service representatives at JFK Airport he said Rome and Paris were some of the worst airports in the world with regards to baggage handling. "Everyone is a government worker over there," he said of the baggage crews. The representative had informed me that a week earlier before I left for my trip the baggage crews at the Roman airport had went on strike and allowed 50,000 pieces of luggage to pile up at the airport. That must have come with heavy price for the airlines, business, and tourists.

According to the Index of Economic Freedom 2007, Italy ranked 60th among 157 nation-states polled. There are a number of despotic regimes in the Middle East and underdeveloped nations in Africa and Caribbean that scored higher. The lesson here is that big government, especially Italian style, only impoverishes its citizenry and cripples entrepreneurship and business, choking off much needed investment in its people and resources.

New Iraqi Hedge Fund Open For Business

Amazingly, amid the daily carnage, machine-gun fire, bomb blasts, and other horrors that have come to symbolize Iraq, yesterday the Iraq Fund Management LLC was able to launch its first hedge fund, which will buy and sell the securities of Iraqi banks and state-owned enterprises. According to the Hedge Fund Lounge, Dave Packard, the fund manager, said, “The primary investment objective of the Partnership is growth of capital. The business of the Partnership is buying and selling securities of small to large capitalized companies, including stocks, warrants, rights and options of U.S. and non-U.S. entities. The Partnership seeks to engage initially and primarily in proprietary trading on the Iraqi Stock Exchange, focusing on the banking sector and State Owned Enterprises (SOE’s) of Iraq."

The story also noted that yesterday was the first day of trading on the Iraqi Stock Exchange. The hedge fund will be domiciled in Delaware. One hedge fund strategy that has seen a lot of growth in recent years is in emerging markets. Consider just yesterday that Threadneedle Investment Services Ltd. announced it has acquired emerging market hedge fund Convivo Capital Management Ltd. for an undisclosed price. According to Hedgeworld.com, Threadneedle launched its hedge fund business in 2000 and will now manage roughly $3 billion across nine strategies, of which three will be in emerging markets.

IncreMental Advantage is in the midst of planning a hedge fund strategies conference for sometime in January. The aim of the conference is to have top hedge fund industry sources talk about what they believe will be the best performing strategies in 2008. In the meantime, I am interested in hearing from you of what you think will be the most profitable hedge fund strategies in 2008. Click here to cast your vote.

In Hopes Of A Goldstein Victory

Hedgeworld.com reported today that Philip Goldstein, co-founder and principal of hedge fund firm Bulldog Investors LLC, was found in violation of Massachusetts securities laws that prevent hedge funds from soliciting non-accredited investors. Allegedly, Mr. Goldstein's firm had provided a non-accredited investor details about the hedge fund's performance, staff, and other information through an e-mail. Mr. Goldstein has appealed the decision to a higher state court and will use the First Amendment's free speech clause to argue his case.

The U.S. SEC has imposed a similar ban on hedge funds and other sophisticated investment vehicles from advertising their products to ordinary people (non-accredited investors).

Regarding actual individuals, the SEC defines accredited investors as a person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million and with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. This definition fits 8.4% of U.S. households. The SEC is currently toying with the notion of modifying the criteria used to identify an accredited investor, which would further reduce those able to invest in hedge funds to about 1% of U.S. households.

Since 1933 politicians have justified this law as "protecting" Joe Sixpack, who is not "sophisticated" enough to invest and possibly lose all of his or her money in risky assets. Let's interpret: if you don't have a million bucks your too much of a lame brain to contemplate such an investment. Rubbish, I say. Such legislative arrogance undermines man's and woman's faculty of reasoning and ability to engage in complex pursuits no matter their economic disposition, which philosophers during the Age of Enlightenment expounded on better than I am able to.

Why do Australian regulators give ordinary people the benefit of the doubt, where any citizen can invest in a hedge fund, unlike in North America or Europe. According to July's edition of Accredited Investor, a publication put out by Lipper Hedgeworld, two-thirds of Australian hedge fund assets come from retail investors. Many workers in that country have placed some of their retirement money into hedge funds, as well.

"Occasional fund blowups notwithstanding, that doesn't seem to worry Australians, in sharp contrast to complaints in the United States about the dangers of retail spread," the article states. "Wider choice for the masses has not led to any worse investment decisions than in other countries." It should be noted that Australian hedge funds are licensed and regulated under the country's securities laws. According to the Index of Economic Freedom 2007, Australia ranked third, right above the United States and below Singapore. I believe this is an embarrassment that hangs over the head of American government regulators, and which by the way, contributes to the growing gap between rich and poor.

Going back to Mr. Goldstein's case, he feels his chances are good at claiming a victory in Massachusetts Superior Court. "I really want to win on [the First Amendment] because I think it's going to have the greatest impact on the whole regulatory regime of securities law," Mr. Goldstein told Hedgeworld.com. "I think that the regulators have had a free ride, thinking that somehow … regulators and securities laws are exempt from the First Amendment."

Let us be thankful for the wisdom of our founding fathers.

The Sarkozy Victory

Investors all around the world no doubt cheered over Sunday’s news that conservative Nikolas Sarkozy defeated Socialist Segolene Royal for the French presidency. A country wracked by burdensome regulation, heavy taxation, and an interventionist government has produced meager economic growth and high unemployment around 9%. President-elect Sarkozy will have his work cut out for him to revive the French economy that will require tough battles with the powerful labor unions and far-left youth movements.

Decades of statism have taken its toll on French society. According to the Index of Economic Freedom 2007 France ranks 45, between Hungary and Jamaica. A number of African, South American, Caribbean, and Middle Eastern nations have better rankings in terms of economic freedom than France – a Western European nation that has been free from worries of military aggression and political instability from its neighbors in over 60 years unlike some of the other countries that ranked higher in economic freedom. The only other major Western European nation that scored lower in the study is Italy, which ranks 60.

Sarkozy, standing at 5’5" which has earned him comparisons to Napoleon from the media and his detractors, will draw a lot of criticism from labor unions and socialists (as we saw violent crowds protesting his victory Sunday night on TV). Several major Sarkozy policy initiatives will likely enrage the far left of France:

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Aligning French interests with the U.S.

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Cutting taxes

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Reducing the renown French bureaucracy

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Loosening rigid labor laws

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Curbing immigration

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Cracking down on crime

In order to secure France’s future as a leader in Western Europe Sarkozy should start with the education system. Judging from socialists’ strong support among the high school and college population very few youngsters understand the obvious merit and benefit of a free market system. Last summer Newsweek reported that high school text books in France, Germany and elsewhere in Europe blamed entrepreneurs for unemployment, alcoholism, Internet fraud, and cell-phone "addiction." Globalization is called an unmitigated catastrophe and the texts encourage students to consult the radical anti-globalization protest group Attac for further information.

This blatant disinformation reveals why capitalism is viewed in such a negative light in some European countries. It is the result of gross political incompetence as well. Such anti-business attitudes have caused the EU to fall 22 years behind the U.S. on economic growth, BusinessWeek reported in March. The U.S. reached the current EU rate of GDP per capita in 1985 and its levels in employment and research investment almost 30 years ago. In 2004 French citizens enjoyed a per capita GDP of $27,500 while across the pond Americans enjoyed a per capita GDP of $37,800.

"These are all aspects of the broader truth: European governments tend to be more invasive than their American counterparts. Brussels bureaucrats with taxpayer-funded sinecures undoubtedly benefit. But this approach doesn’t foster the high-tech industry vital to a modern economy," wrote CNet correspondent Declan McCullagh.

Investors should take note however, that Sarkozy is no Ronald Reagan or Margaret Thatcher. Some of his campaign rhetoric took aim at hedge funds, along with Turkey and immigrants. The president-elect has also said he supports state intervention in order to promote France’s "industrial champions." All politics aside, with the rise of Sarkozy, Germany’s Angela Merkel, and Eastern Europe’s free marketeers, the battle between Adam Smith and Karl Marx just shifted again in favor of the former. One can conclude from the fire and smoke filling the air of the French ghettoes that it shifted just in a nick of time.

Rwanda, a Stable Country Once War-torn, Is Open to Investment

The Republic of Rwanda’s economy grew 5.8% in 2006 keeping pace with the rest of the African continent, which grew about 6%. To some people this might be shocking growth number in a region that has been wracked by civil wars, disease, hunger, and poverty – with some notable exceptions such as South Africa.

In a recent interview with Rob Fogler, founder and managing director of Thousand Hills Venture Fund (THVF), he expressed much optimism for Rwanda. Mr. Fogler’s venture fund operates exclusively within Rwanda where it aims to close the financing gap with seed capital, ranging from $50,000 to $500,000, for promising Rwandan startups. “No one is serving that gap,” he said, adding that such venture capital funding is crucial for Rwandan entrepreneurial activity. “Everyone understands that the small to medium enterprises will be the engine for economic growth in these countries,” Mr. Fogler said.

The Thousand Hills Venture Fund has about 25 investors on board, all U.S. based, with the exception of one Canadian and one Rwandan. The only for-profit venture capital fund investing in small and medium-sized enterprises in Rwanda has been operating there for about three years and closed two investments thus far totaling $500,000. Mr. Fogler said some of the biggest opportunities in Rwanda laid with companies that can take advantage of the “exploding” growth and/or companies that can sell products to the growing economic base within the region. Some sectors he identified were tech, retail, and agricultural processing factories.

THVF’s success relies on its principals’ ability to cultivate relationships with local entrepreneurs, business people, and human resource professionals. “We spend a lot of time with them in the communities,” Mr. Fogler said. “We are constantly meeting with business people and entrepreneurs. We have been fortunate to meet a lot of great people over there and establish a strong reputation that gives us access to deal flow.” Mr. Fogler travels to Rwanda every two months and his partner spends a greater amount of time there deepening and broadening their relationship with the business community. The country has made large strides since its well known civil war in the 1990s.

Rwanda plunged into chaos in April 1994 when the Hutu – the ethnic majority – killed about 800,000 Tutsi – the ruling group of Rwanda for generations – sparking a civil war. After Tutsi rebels emerged victorious the genocide decimated Rwanda's fragile economic base, severely impoverished the population and eroded the country's ability to attract private and external investment. Since then the country has held successful elections and recently achieved stability.

In Mr. Fogler’s view conflict is no longer a risk to THVF investments. “Things are going very well there – it’s a very stable country,” he remarked. He credited the political leadership of President Paul Kagame, who took office in April 2000, as part of the reason why stability has come to Rwanda. Corruption, which runs rampant in Africa, has been minimized in Rwanda. From a business perspective, exit opportunities are not a problem for private equity in Rwanda. The single biggest risk, Mr. Fogler said, is similar to any startup operation – finding the right management team, piecing together a good board of directors, and plan execution. Another is the lack of access to financing that entrepreneurs need in the beginning stages of their business plan. “The [Rwandan] financial markets are not well developed at all,” he said.

Rwanda has also been successful at curbing excessive bureaucracy. Most entrepreneurial activity throughout Africa has been crushed by the weight of ridiculous regulation, taxes, and other barriers to entry. Reason why, aside from corruption, is that colonialism’s lasting legacy to the continent of Africa has been civil law, which begets excessive government bureaucracy, Mr. Fogler said.

Mr. Fogler is also a partner with Kamlet Shepherd & Reichert, LLP and is chair of the firm’s Private Equity & Venture Capital practice area. He has assisted private equity investors in evaluating, structuring, negotiating and completing a variety of transactions. He has counseled numerous investors, including angels, venture capital and other private equity funds and investment banks. “So being a private equity lawyer it was easy for me to form the fund,” he said. “I became interested in Rwanda three years ago because I see great opportunity for investment for investors in countries like Rwanda.”

For more information about THVF visit www.thvf.com

These are some of the issues that are discussed at IncreMental Advantage's conferences. For more information, please visit www.incrementaladvantage.com.

Australia: Kangaroos and Crocodiles

A few years ago I read Australia: A Biography of a Nation by Phillip Knightley. Australia is a very well-written and informative book about Australia's history, culture and political system. Not to trivialize Australia but below is some interesting information about kangaroos and crocodiles, both of which are prevalent in Australia.

Kangaroos

Australia slaughters five million kangaroos per year for their skins and meat but this barely keeps the kangaroo population under control. In 1999 it numbered between 20 and 25 million, beating the human population by between 2 and 7 million. Kangaroos simply have acclimated to Australia's conditions better than the Australians. Kangaroos need little water. In temperatures where humans need ten liters a day, the kangaroo can get by on two liters a week. They can even survive on saltwater.

Kangaroos have an amazing breeding pattern. The female begins her reproductive cycle at 15 months of age which, since she has a life expectancy of 20 years, is as if the human female began having babies at the age of five. Her gestation period is only 15 days, after which the newly-born kangaroo climbs from the uterus into the mother's pouch and attaches itself to a teat. The mother then mates again but keeps the new embryo in suspension in her uterus until the first 'joey' starts leaving the pouch for brief excursions. When it leaves the pouch permanently after 235 days, or dies for any reason, the mother then activates the dormant embryo and it is born about 24 hours later. So a female kangaroo has three offspring on the go at any one time - one in the uterus, one in the pouch and one at her side.

Crocodiles

Crocodiles has been around for 200 million years, can grow to seven meters long, weigh more than a ton and have no natural predator except man. Crocodiles can live in salt, brackish and fresh water and drink all three. They can see equally well by day or night and have a transparent membrane, like a pair of swimming goggles, to protect their eyes underwater. It needs to eat only once a week and can go for several months without eating at all. It has a continuous supply of teeth - if one breaks there is another underneath. If it needs to sink quickly in an emergency, it can move its large organs backwards in its body cavity, like a submarine shifting its balast. Once on the bottom it can reduce its heart rate to two or three beats a minutes and remain submerged for up to an hour without breathing.

Crocodiles are smart and patient. They try to identify habits in their prey, like returning to the same spot each day to drink or swim or fish. Then they lie in ambush and wait for the right moment to strike. The crocodile has only a couple of muscles to open his mouth but 40 to close it, so once he has his jaws around his prey, the chances of escape are thin.