Thursday, October 17, 2019

Benefitting from the Asian Meat Shortage

Benefitting From the Asian Meat Shortage
By: Michael Molman 

So far 2019 has proven an interesting year in financial markets, as global economic growth begins to pause, geo-political tensions rise, and a trade war between the world’s largest economies riles markets. The increase in volatility has created numerous opportunities for investors and traders who look past the scary headlines. Often these opportunities occur in markets that are wholly under the radar. Recent rallies in boring utilities stocks, volatile and un predictable dry bulk shipping, tanker futures as well as long-dated government bonds show that no matter the overall sentiment there is always a bull market somewhere (I am very sorry to have to quote Jim Cramer on that one). One over-looked corner of the market that provides some of the most interesting trading opportunities, at the moment, is livestock. 
Now its fully understandable why most investors do not think of livestock as an especially attractive industry or commodity to invest in. The market for livestock, including hogs and beef is volatile, complex and difficult to trade. When you add in the effects of the China – U.S trade war, which has mostly shut U.S meat producers out of the world’s largest meat market, the industry becomes even more unattractive. However, a recent, and severe, breakout of African Swine Fever in China has significantly reduced the supply of pork in Asia (the world’s largest market for the meat). Current estimates from the United States Department of Agriculture (USDA) show that nearly 28% of China’s pig herd will have died by the end of 2019. In response the Chinese government has been on a global meat buying spree and encouraging its population to supplement pork for other meats, such as beef and poultry. This sudden and vast decrease in global pork supply and increasing demand for meat imports from Asia, has opened up tremendous opportunities for U.S livestock and meat processors. To understand this opportunity and to understand how to effectively take advantage, investors first need to understand the workings of the global meat market. 

Chart showing global meat production from 1961 to 2014. Meat production soared 4.5x over this period with much of the gain coming from Asia. 
           The first thing one needs to understand about the global meat market (and this statistic might upset the vegans out there) is that both production and consumption have been increasing at a rapid clip over the last 6 decades. Since the 1960’s global consumption of meat (on a per capita basis) has nearly doubled from 23 kilograms in 1961 to over 43 kilograms in 2013. Production has increased at an even quicker rate, tripling over the last 40 years and increasing 20% in just the last 10, to over 320 million tons and this number is expected to double yet again by 2050. This surge in production and consumption is due to rising incomes in developing countries, especially Asia. The amount of meat different countries and regions consume is highly variable but almost always tracks the growth in per capita income. Essentially the wealthier a nation is the more meat its citizens consume. So with this in mind it’s no surprise that developed countries in North America and Europe consume more than twice the average amount of meat than the rest of the world. It’s also not surprising that countries that have experienced rapid positive economic growth over the last several decades have seen the fastest growth in meat consumption. Since 1961 Asian meat production has increased an astounding 15 fold to 135.71 million tons in 2014 and consumption has increased around the same amount. Due to this fact most of the global meat trade revolves around Asian consumers. 
Now not all meats are created equal and different meats (such as pork, beef and chicken/poultry) have their own unique trade patterns and supply and demand fundamentals. Some meats are more popular in certain regions then others, for example in the United States, Australia and Argentina, beef is incredibly prevalent in meat diets, meanwhile in Asia, pork is king. Chinese consumers eat about 122 billion pounds of pork a year and pig-meat accounts for two-thirds of per-capita meat consumption. With so much pork being consumed, China and the greater Asian region has some of the largest pig herds in the world. In 2018 China alone had a pig population of about 440.6 million, in comparison the 2ndand 3rdlargest pig herds belonged to the European Union and the United States who had pig herds of 150.26 million and 73.15 million respectively. In fact in recent years China has been home to over half of the worlds pig population.
Despite being the largest producer of pork in the world China still has trouble satisfying its population, who increasingly want to spend their growing incomes on better food, which includes more meat. As such China has become a major importer of pork and represented 20% of total pork imports (1.561 million tons) in 2018, according to the USDA. Meanwhile the largest exporters continue to be the European Union, United States, Canada and Brazil. With Chinese demand crucial to the global hog and pork industry the status of Chinese pig herds is closely watched. 

Chart showing China's share of world meat imports from 2014 to 2019. China is expected  to represent 25% of total global pork imports in 2019. 

This brings us to the catalyst for the investment opportunity in livestock. In August 2018 a violent and ongoing outbreak of African Swine Fever spread through Asia, devastating pig herds across the continent. African Swine Fever is a highly contagious viral disease, which although harmless to humans, is almost 100% lethal for pigs. With no vaccine currently available an infected hog is expected to die in two to ten days. The disease has spread to over 50 countries including; China, Vietnam, Cambodia, Laos, Myanmar, Philippines and Mongolia. It also is not just contained to Asia with the disease present in European nations such as Russia, Italy, Ukraine and Poland as well as in Africa. According to the World Organization of Animal Health, the disease is present in countries that represent 75% of global pork production. 
The effect of the disease on pig supply has been astounding. Estimates for how much of China’s pig herd has been wiped out vary. Reuters reported that nearly 40% of China’s pigs have died since the disease surfaced, analysts at Rabobank believe China’s herd will fall 50-55% from beginning 2018 numbers. In a report published on October 10th, the USDA forecasts that China’s swine herd at the end of 2019 will be roughly 310 million heads and that the herd will fall to 275 million in 2020, down 28% and 11% respectively. This would mean a decline of nearly 40% from 2018. 
In neighboring Vietnam, the worlds 6thlargest pork producer, where the disease is also prevalent the data is grim. Pork is even more prevalent in the Vietnamese diet than it is in China. Pig-meat accounts for 75% of meat consumption in the country and most of the nation’s 30 million pigs are consumed domestically. Since the government reported the outbreak of the disease an estimated 10-20% of the nation’s pigs have died. In the Philippines pork production is expected to fall by 16% in 2020. 
Overall it is virtually impossible to calculate exactly how many pigs have been lost to the disease worldwide or the current status of the global pig herd. However, current baseline estimates from the USDA  show that total global swine stocks will fall 15% in 2019 with total pork production falling another 10% in 2020.

Map showing countries where African Swine Fever has been reported. The disease is present in countries representing 75% of global pork production. 
Chart showing size and percentage change in China's hog herd from 2010 to 2020. Total pig inventory  is expected to fall 40% over the course of 2019 and 2020. 

The sudden and dramatic decrease in Chinese and Asian pork supplies has had several effects the most obvious of which is the rapid increase of pork and hog prices in China. Wholesale pork prices in the country have soared roughly 64% as the nation expects to see a 10 million ton pork deficit this year. The shortage and subsequent price increase have led to an increase in imports which tend to rise and fall inversely to domestic production. The USDA expects Chinese pork imports to soar over 66% in 2019 to as much as 2.6 million tons and increase another 35% to 3.5 million tons in 2020. The effect of this decrease in supply and increase in export demand is that global pork production will fall 10% in 2020 while exports will increase by 10%. That dynamic offers significant opportunity for pork producers and traders in certain countries. 
            However, the spread of African Swine Fever did not just affect the global market for hogs it also caused an increased demand for other livestock as well. The entire global trade in pork in 2019 is expected to total about 9 million tons, this means the world simply does not have the supplies to fill China’s meat deficit. In response the Chinese government has attempted to ration the supply of pork and encourage consumers to buy other meats, like beef or chicken instead. As such, Chinese buying of all meats around the world is causing meat prices to surge in almost every market. 
            In Brazil poultry shipments to China have jumped 31% from a year ago and as a result of the lower domestic supply of chicken, retail prices of the meat have jumped 16%. In Europe retail pork prices are already up 5% and lamb prices in Australia are up 14%. In Argentina, one of the world’s preeminent beef producers, steak prices have surged 51% as beef exports to China have doubled (although this increase in price is also attributable to Argentina’s growing economic crisis). Global exports of beef are expected to increase 4% in 2019 and the USDA is expecting Chinese beef imports to surge 15%. Meanwhile Chinese imports of chicken are forecasted to increase 20% in 2020. Overall global meat prices as measured by the Food and Agriculture Organization’s (part of the United Nations) meat index has jumped 10% in 2019 to highest level since early 2015. 

Chart showing Chinese pork production alongside imports from 2000 to 2019. This year China is expected to import a record amount of pork. 
           Now the question becomes who actually sets to benefit from these incredibly positive dynamics in the global meat trade. The answer would be the countries with the most plentiful supplies of pork and beef. However, many of those countries have their own unique problems with production, which either limits their production of meat or limits their exports. 
The European Union, home to the world’s second largest pig herd has traditionally been a dominant player in the Chinese pork import market. The European Union has expanded shipments to China by 39 percent and is expected to remain the top supplier with 61 percent market share year-to-date.  High stocks of pork and weak domestic demand have increased supplies available for export. However, with that said, the presence of African Swine Flu in some member countries (in Eastern Europe) and environmental regulations have curtailed growth in production. Both these things pose significant threats to Europe’s pork trade going forward. Meanwhile dry weather conditions over the last year have also reduced the European Union’s cattle herd. All this means that although it is a major power in livestock, Europe may not be the one to benefit the most from this current opportunity. 
Brazil is also a major player in the pork trade, with exports to China up 30% through August. Despite strong demand, exports are constrained by facility approvals that limit eligible product. China needs to approve meat plants in countries hoping to export to the world’s largest meat market. China approved 25 new Brazilian meat plants in September, but just one plant for pork. The approved plant has a slaughter capacity of 5,000 hogs per day, only moderately increasing potential export supplies. Brazil will however, be one of the prime beneficiary of higher Chinese beef imports, and will steadily redirect exports to the Asian market. 
Canada also benefitted from increasing Asian pork imports, with the country having the 2ndhighest share of imports into China, after the European Union, at 15%. However, despite imports of pork from Canada to China soaring 51% in the first half of the year, China placed restrictions on imports of Canadian beef and pork in early June (part of an escalating trade rift between the two countries). This has significantly reduced Canadian meat exports to China and further limits the amount of places China could go to buy pork. 
That leaves the United States. Obviously it’s impossible to mention trade between the United States and China without taking into account the growing trade war between the two countries. As the United States levied tariffs on $360 billion of Chinese imports, China responded by placing tariffs on America’s primary export, agriculture, including livestock. On September 1st, China raised tariffs on U.S pork to 60% in addition to the usual 12.5% tariff placed on pork imports. This brought effective tariffs on U.S pork to 72%, essentially squeezing U.S imports out of the market. This dynamic though is changing. As pork prices around the world surge and large suppliers struggle to supply China the U.S has become one of the only nations China can turn to plug the whole in its meat deficit. U.S pork supply is expected to increase 3% in 2020 after a 4% increase in 2019. As such supplies are growing faster than elsewhere in the world and American production is not threatened by the African Swine Fever, making American pork cheaper than global competitors. 
This could explain why in recent weeks Chinese imports of U.S pork have been increasing. In the week ended October 3rd, the USDA reported China purchased a weekly record of 142,300 tons of U.S pork. In comparison total U.S pork exports to China in September totaled 19,900 tons. With the skyrocketing price of domestic pork, U.S imports are actually somewhat competitive, even with the tariff (although still more expensive than imports from other nations). The U.S meat export federation expects American pork exports to grow 12% in 2019 and 13% in 2020 to 3.1 million tons, with China driving much of the increase. This estimate also assumes the tariffs will still be in place, if they are removed the total amount of exports would soar much higher. 
The chances of that happening have improved recently with President Trump announcing a partial trade deal with China that would see China boost its purchases of U.S agriculture. It is safe to assume that cheap U.S pork would be at the top of the Chinese agricultural shopping list. U.S pork could become even more competitive as prices in China are expected to soar even higher in the next few months as pork stockpiles run dry. U.S pork is also set to benefit from increased sales to Mexico (the largest market for American pork) as retaliatory tariffs are removed as well as steady demand from South Korea and Japan. Essentially, even if tariffs remain in place, as Asia soaks up more of the worlds pork, more opportunities will open up for cheap U.S exports. 
U.S beef is also set to benefit as global beef supplies are bought up by the Chinese as well. U.S beef production is projected to increase by 3% in 2020 and exports are set to increase by 6%. The U.S is set to grow market share in its traditionally strong export markets of Japan and South Korea as well as China, especially as Australian beef production (a major competitor to U.S beef in Asia) continues to fall due to drought conditions. All this being said, increased export opportunities for U.S livestock driven by strong Asian demand as well as lower global supplies, coupled with cheap prices in the U.S, mean that U.S livestock prices are bound to go higher. 

Chart showing U.S weekly pork exports from 2013 to October 2019. Export sales have recently surged as a result of Chinese buying. 
           Now that the investment opportunity in U.S livestock is clear, the question becomes how to take advantage. Most people are uncomfortable buying up live cattle and hogs and selling them to the Chinese. Thankfully there are a number of financial instruments as well as equities that allow investors the ability to gain exposure to livestock. 
            The first of which would be the livestock futures traded on the Chicago Mercantile Exchange. These futures include contracts for; lean hogs, as well as for live and feeder cattle. As the main opportunity exists in increasing pork exports, lean hog futures would be the most precise way to bet on increasing pork prices. Lean hog futures have been volatile the last few weeks as traders weigh the counteracting bearish forces of increasing supply with the bullish forecast of increased Asian purchases. That means hog prices have remained relatively low despite the chorus of bullish data out there and with exports already increasing and global supplies substantially decreased, lean hog futures stand a good chance to rally.
            For those investors who are more conservative and do not want to risk owning a herd of pigs by not selling the lean hog futures before expiration, there are a couple of ETF’s that allow you to invest in livestock. The first of which would be the London traded Wisdom Tree Lean Hogs ETF (HOGS.L). This ETF is traded in U.S dollars and tracks the Bloomberg Lean Hogs Sub index and provides an easily tradeable way to get exposure to the price of hogs. Another possible ETF that also has direct exposure to livestock would be the iPath Bloomberg Livestock Sub index ETN (COW).  This ETF tracks an index composed of lean hog and live cattle futures which allows an investor to play the broader trend in rising livestock prices and not just speculate on the price of hogs. COW is also traded in the U.S which means it is easier for retail investors to buy. 
            Futures and ETF’s offer the most direct exposure to livestock prices, but there are equities that are benefitting from the bullish developments in the global meat market. Those equities belong to companies like Tyson Foods (TSN) which are global meat companies with operations spanning, beef, pork, chicken and prepared foods. As a global meat processor, distributor, and marketer, Tyson Foods stands to benefit from large supplies in the U.S and global shortage worldwide. 
            Whether you choose to invest in livestock through, futures, ETF’s or equities one thing is perfectly clear, when supply falls as much as it has and demand continues to grow there is an opportunity. This opportunity becomes even more appealing when you consider that so far it has been underplayed. With so much attention being paid to trade tensions most investors overlook the opportunity in livestock. As Asian meat supplies continue to shrink and global prices begin to rise it’s only a matter of time before U.S livestock prices follow suit and soar! 

For those interested in learning more about this opportunity I highly recommend reading through some of the articles and reports attached below. They provide a much more detailed description of the global meat trade and the specific supply and demand fundamentals. 


Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor. 

Thursday, January 17, 2019

Opportunities In a Volatile Market: Virtu Financial (VIRT) and High Frequency Trading

Opportunities In a Volatile Market 
Virtu Financial (VIRT) and High Frequency Trading
By: Michael Molman 

It is no secret that 2018 was not the friendliest year for global markets. In fact it was the worst year for the S&P 500 since the financial crisis over a decade ago. The index fell over 6%, as sectors from technology to financials were devasted by consistent bad news, ranging from rising interest rates to a U.S government shutdown. Fund managers, such as BlackRock and Vanguard, who championed passive investment products and who benefitted strongly from the placid market environment of the previous few years, saw themselves crushed by the return of volatility (these types of fund managers saw their stocks fall 29% on average in 2018). Institutional investors also got singed as asset classes like commodities and bonds sold off sharply along with equities, leaving no safe haven to protect portfolios. Even hedge funds, long thought to be the smart money on Wall Street, were unable to navigate the new market conditions. However, while most players in the market desperately tried to fend off the storm of volatility, a certain industry saw it as a breath of fresh air. That industry is composed of the proprietary and high frequency trading firms. 
            Generally when people think of proprietary and high frequency trading the first images that come to mind are of professional day traders and ultrafast computers trading ahead of retail investors in public markets. To some extent that is true, however these types of firms provide a valuable service in that they improve the efficiency and liquidity of those same public markets. They do this through their main business of market making. This business has been in existence almost since the beginning of the stock market and through advances in technology has been rapidly sped up and automated. Increasingly most of market making is being done by controversial high frequency trading firms. The question is why does this matter? The reason is because these firms were some of the only market players who saw the blow up in volatility last year as a good thing and saw a sharp improvement in their earnings. This presents an opportunity. To understand it though, one needs to understand how market makers and high frequency trading firms make money. 
            In order for a financial market to function there needs to be liquidity, buyers must always be able to find seller and sellers buyers. When there are limited counterparties to trade with the market becomes illiquid and therefore difficult to maintain. In order to make sure that does not happen, exchanges often ask different banks and brokerages to continuously provide a bid ask spread to the market. With the “bid” being the price these firms will be willing to buy at and the “ask” price being the price they are willing to sell at. Essentially, these firms “make” a market in a particular security and make sure there is always a willing buyer and seller available in the market. The spread between the “bid” and “ask” price that the market maker offers is called the market maker spread. This represents the profit a market maker makes from every trade in the security. This spread is usually only a few cents but due to the heavy volume of trading this few cents adds up. The less liquid or more volatile a security, the larger the market maker spread, the larger the spread the more money the market maker makes per trade. 
            Over the last 10 years high frequency trading firms have increasingly taken over the business of market making. Their superior technology and speed have made the business much more efficient and have squeezed many other types of proprietary trading firms out of the market. High frequency trading has been under scrutiny, especially after Michael Lewis published a damning review of the industry in his best-selling book “Flash Boys”. Most criticism of high frequency trading revolves around the strategy of “order flow prediction”, where these firms try to predict the market orders of large institutional players and take positions ahead of them. Although that is a controversial trading strategy it is not the main strategy of high frequency firms. Most of these firms have strategies that revolve around market making and increasingly execution strategies, which is where these firms act as brokerages and execute large orders for institutional players. In any case, market making and high frequency trading require high trading volumes and volatility to generate strong profits. The lack of both leading up to 2018, translated into a sharp downturn for this line of business. It now appears as though market conditions are changing, which means the high frequency trading industry could see a strong turnaround. 
Chart showing High Frequency Trading Revenue from 2009-2017. Industry revenues have fallen along with volumes and volatility.
              High frequency trading firms have been some of the biggest losers during the tranquil market period of the last few years. In 2009 industry revenue, according to consultancy Tabb Group, was $7.2 billion, in 2017 total revenue for the industry fell below $1 billion. This corresponded to a steady fall in trading volumes in the U.S. According to the Wall Street Journal Market Data Group, 8.31 billion shares a day were traded in 2010, by 2017 that number had fallen to 6.43 billion. Similarly market volatility as is measured by the CBOE volatility index (VIX) continued to average lower and lower levels. According to Harvest Volatility Management, the VIX had an average level of 16.68 in 2015. It averaged 15.85 and 11.1 in 2016 and 2017 respectively. For reference, the average level of the VIX since 1995 is estimated to be between 18-21. In fact 2017 showed the calmest market conditions in decades. The absolute daily percentage change for the DOW in 2017 was 0.31% while for the S&P 500 it was 0.30%, those were the smallest daily percentage changes since 1964. At the same time monthly market volatility was lower than any point since 1970. This caused a significant head ache for short term traders like high frequency firms, which suffered from fewer opportunities to trade due to falling volumes. As well as shrinking profits per trade due to low volatility. These factors coupled with increasing data costs and competition put the industry under pressure. 
            However, with all that being said, historical trends show that it is very likely that the market environment of the last several years was an anomaly. In 2018 volatility returned with a vengeance. The VIX soared 157% last year, as fears grew about slowing global economic growth, an ongoing trade war, and rising interest rates. Intra-day swings for the S&P 500 averaged 1.2% in 2018 and the higher volatility increased trading volumes by 11% to 7.2 billion shares daily. This change in conditions gave life to the suffering high frequency trading industry and as expectations of an upcoming recession intensify along with political headwinds it appears as though the volatile conditions are here to stay. 
Chart of CBOE VIX index from 1990-2018. Volatility has been steadily falling since the Great Recession but has soared recently. Long term average level for the index is 21.

Most companies in the high frequency trading space are private, making it nearly impossible to get a detailed glimpse into the finances of the industry or benefit from its good fortune. Thankfully, one of the largest players in the space is public and gives investors a good opportunity to benefit from the high frequency trading comeback. That company is Virtu Financial (VIRT). 
Virtu Financial is a high frequency trading firm with a current market cap of $4.9 billion that trades in over 25,000 different securities at over 235 venues in 36 countries. As the only public high frequency trading firm (whose IPO was nearly derailed by the publication of Michael Lewis’s book “Flash Boys”), the company has become a poster child for the industry. Indeed the company offers investors a rare glimpse into the fortunes of this once secretive sect of the financial services sector. Unsurprisingly, those fortunes have not been great in the pre-2018 market environment. From its IPO in July 2015 to the beginning of 2018 Virtu stock fell 21% while the broader market rallied nearly 30%. Over that period of time adjusted EBITDA fell from $352.4 million in 2015 to $251.4 million in 2017. Net income, meanwhile, fell from $272.8 million to $92.1 million. This is against a 25% rise in revenue, about $800 million in 2015 to just over $1 billion in 2017. Even this was not a result of actual business growth but rather an effect of Virtu’s merger with, fellow high frequency trading pioneer, KCG Holdings.
Overall those are hardly impressive statistics, but the turnaround in Virtu’s results as volatility returned to the market, show how the company could provide a hedge against rising volatility. In the first 3 quarters of 2018, Virtu showed $1.44 billion in revenue compared to about $563 million in 2017. Based on Virtu Financials preliminary 4thquarter 2018 results, total adjusted EBITDA for 2018 was just over $600 million, compared to $251.4 million in 2017, an increase of about 130%. Total adjusted net-income in 2017 was $92.1 million while in 2018 it is estimated to end up being $346.6 million. As a result Virtu stock soared 47% in 2018, what a difference a change in volatility makes. 
However, despite this surge in stock price, Virtu financial is still valued at a similar multiple that it has been in previous years. Presently with a market cap of $4.9 billion, the stock is priced at about 8x its trailling twelve month (TTM) adjusted EBITDA  and 14x TTM normalized adjusted net income. In January 2018, Virtu had a market cap of $3.5 billion, meaning the stock was valued at about 14x TTM adjusted EBITDA and 38x TTM adjusted net income. At the same point in 2017, the stock was valued at 8.32x and 16.4x respectively. In 2016 those numbers were at 8.5x and 11x. In other words despite the surge in the stock price, based on earnings and its historical average Virtu stock remains fairly valued.
An added bonus to Virtu Financial is that the company continues to expand into the lucrative brokerage business through its recent purchase of Investment Technology Group (ITG) for $1 billion. Although the deal still needs the approval of the regulators, if it closes, it will diversify Virtu’s business and deepen its move to trade for institutional clients. Virtu also stands to benefit from the wave of consolidation that has hit the high frequency trading industry. The poor trading conditions of the previous years as well as rising costs have forced many mid-sized players to sell out to stronger competitiors. It is now expected that the industry will be dominated by a few large firms, which have the advanatge of trading larger volumes and a multitude of different strategies. Virtu Financial is set to be one of those firms. However, the main opportunity in Virtu is the company’s success in capitalizing on periods of volatiltiy. 
Chart overlay of Virtu Financial stock and VIX from January 2017 to January 11, 2019. Virtu stock tends to be positively correlated to volatility.
         As the chart above shows, Virtu stock seems to be positively correlated to the VIX. This makes sense given the company’s reliance on volatility to generate strong earnings. As such Virtu stock allows investors to bet on increased long-term volatility without being forced to endure the violent daily moves of the actual VIX. Even better, Virtu stock allows investors to do this while receiving a 3.7% dividend. As to where volatility is going, historical data as well as macro economic trends seem to point to continued market choppiness. 
            From a historical basis, the market calm that existed prior to 2018 appears to be a rare occurance. The average long-term daily change in the S&P 500 is estimted to be around 0.66% twice as much as the daily move in 2017. Although that level is lower then the daily swing in 2018, it seems to indicate a return to the extreme calm markets for a sustained period of time is unlikely. Meanwhile, the VIX averaged between 16-17 in 2018, below the estimated average of 18 to 21. That means even though volatility seemed to “blow up” in 2018, on an annual basis it still remains below its average.
            When looking at macro-economic trends, it also seems that heightened volatility is here to stay. A survey of economists, conducted by Bloomberg, showed that fears of a ressession occuring within the next 12 months is at at 6 year high. Nearly 25% of participants see an economic slump occuring within that time period. In December a similar Bloomberg survey put the percentage at 20%, clearly the market slump in December changed some minds. Median projections for 2019 U.S economic growth have edged down to 2.5% from a previous 2.9%. The continued U.S government shut down, which President Trump has threatened to continue for years, also adds to uncertainty. Besides the fact that it is a drag on economic growth, it also delays the release of government data such as retail sales, which investors and analysts use to make decisions. 
            A short term recent rally in stocks aside, the medium and long term pictures for the U.S economy and the market appear to be cloudly. This likely means that volatility will remain heightened. Virtu stock, with a negative beta of -0.75 and a 3.7% dividend yeild gives investors a chance to hedge this risk while being paid to do so, that is an opportunity investors should not ignore. 


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Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor. 

Tuesday, September 25, 2018

Vietnam, an Opportunity Amongst An Emerging Markets Meltdown

Vietnam, an Opportunity Amongst An Emerging Markets Meltdown
By: Michael Molman

            So far 2018 has been shaking up to be a much more interesting year in the financial markets than 2017. Trends that have held for years have suddenly broke amidst a refreshing bout of volatility. This presents investors with an opportunity, if they know where to look. Some of the best opportunities could be found in specific Emerging and Frontier markets. 
Recently Emerging Markets (which were some of the best performers in 2017) have been going through a sharp downturn. The MSCI Emerging Market Equity Index has fallen into a bear market (a drop of over 20%) since hitting a high in January (after being up 32.5% in 2017) while the MSCI EM Currency Index is down 8.5% over the same period. Much of the sell-off is due to a combination of rising U.S interest rates, contagion from economic meltdowns in specific Emerging Markets (namely Venezuela, Argentina and Turkey), and a brewing trade war between the U.S and China. Throw in a rising U.S dollar and a slowing Chinese economy and you get a good old fashioned panic in Emerging Markets. However in the blind dash for the exit, investors are abandoning some markets that are largely healthy. These healthy markets are now trading at much lower valuations then previously, which presents an amazing buying opportunity. Amongst the best looking is Vietnam. 
Chart of iShares MSCI Emerging Markets Equity ETF from 2011 to September 25th 2018. Emerging Market Equities have fallen 20% from their highs.

For many Americans when they think of Vietnam, they picture American helicopters needlessly bombing a jungle or maybe they think of Rambo. In reality though Vietnam is one of the most dynamic developing countries in the world. Over the last 30 years the country has become significantly more attractive to foreign investors eager to take advantage of the country’s young, well-educated population, cheap labor and rapid development. The rapid increase in foreign investment has led to strong economic growth and development. This growth is only expected to continue, PricewaterhouseCoopers (PWC) even estimates that by 2050 Vietnam would be the 20thlargest economy in the world. Not bad for a country that has been a backwater for most of its history. However to fully understand the opportunity the current Emerging Markets panic has created in Vietnam, it is necessary to understand what is driving the country’s economic boom.
Vietnam’s shift from a communist backwater to a Frontier Markets jewel started in the late 1980’s when the country started the transition from a highly centralized planned economy to socialist oriented market based one. The country moved to open up its economy to foreign investors and began to privatize many state owned companies while encouraging small business practices. According to World Bank statistics these reforms (dubbed Doi Moi) helped turn Vietnam from one of the poorest countries in the world to a low middle income nation. To understand just how much Vietnam transformed one must only look at the country’s basic economic numbers. According to the World Bank, in 1985, Vietnam had a GDP of just over $14 billion, the latest data from 2017 shows the country now has a GDP of over $223 billion, that’s an outstanding rate of growth. Meanwhile the country’s population has expanded from 60 million in 1986 to 95 million in 2017 (it is expected to grow to 120 million by 2050), 70% of the population is also younger than 35. Vietnam’s young and growing population is certainly a positive sign for the country’s outlook but it is the nation’s emerging middle class that demonstrates how promising of a market the country can be. Currently 13% of Vietnamese households are considered middle class, but that percentage is expected to increase to 26% by 2026 (some firms including Boston Consultancy estimate that almost 1/3 of the population will be middle class as early as 2020). A large emerging middle class means more disposable income making the Vietnamese market prime for even more growth. Not only is Vietnam’s population is growing in wealth and size it is also relatively better educated then most of it peers. Vietnamese students consistently score high on international tests distributed by the Program for International Student Assessment (PISA). 
Vietnam is also a regional leader in infrastructure investment, with 4.5% of GDP getting invested into roads and other infrastructure, as of now 90% of the country’s population is connected by all-weather roads. Access to household infrastructure has also improved, in 2016 99% of the population had access to lighting, compared to just 14% in 1993. That year, only 36% of the population had access to sanitation facilities and only 17% to clean water, those statistics now stand at 77% and 70% respectively. A large, young, well-educated population and developed infrastructure has made Vietnam a prime destination for new industrial production especially as companies increasingly want to diversify out of China. In 2017 Foreign Direct Investment (FDI) in Vietnam hit a record $17.5 billion. The vast expansion of industrial production and FDI have led to increasing exports, which in turn continues to propel the economy to new heights. 
In 2017 Vietnam’s  GDP increased over 6.8% and growth in 2018 has remained strong, with GDP growing at annualized rate of almost 7% in the 2nd quarter. This represents the strongest 2nd quarter in 11 years and shows the continued resiliency of Vietnam’s manufacturing and exports. The country also continues to attract foreign direct investment, which is 9.2% higher in the first 8 months of the year compared to the same period in 2017. The global ratings agency Moody’s forecasts that Vietnam’s economy will continue to expand at an average annual rate of 6.4% until 2022, and as a result upgraded the country’s external debt on August 10thfrom Ba3 to Ba1 (this link shows Moody’s debt rating scale; Moody's Ratings Scale). Meanwhile the World Bank has upgraded its forecasts for Vietnam’s growth this year to 6.8% from 6.5%, and some analysts, especially from Standard Chartered, are even more bullish believing growth for 2018 could top 7%. The International Monetary Fund (IMF) also decided to chime in on Vietnam’s growth prospects in its first review of the nation’s economy since 2014. In it’s report the IMF proceeded to upgrade its forecasts for GDP growth and praise the government’s  continued efforts to privatize and reduce the size of state owned enterprises. 
Chart showing Vietnam’s GDP from 1985 to 2017. The country’s economy has grown at an annual rate of 5% since 1990.
All the bullish data coming out of Vietnam has not gone unnoticed by investors. The country’s stock market has had 6 straight years of gains, surpassing 6% and surged 48% in 2017 and another 19% in the 1stquarter of 2018. This made Vietnamese stocks some of the hottest in the world as investors bid up prices in the effort to get in on the action. Vietnamese stocks not only benefitted from the strong economic growth but also from reports that Vietnam will be officially classified as an emerging market by MSCI. This would mean inclusion in various broad based Emerging Market ETF’s and increased buying of Vietnamese equities (at the moment Vietnam is classified as a Frontier Market). 
However, market optimism, especially in emerging markets, is often a delicate thing. Developing countries, including Vietnam, have obvious risks that investors are only too eager to highlight when conditions suddenly change. At the moment Emerging Markets are under pressure from a number of different external factors. These factors include the renewed strength in the U.S Dollar, which has rallied over 9% between its low in late February and it most recent high in mid-August. A rising U.S dollar hits countries who have large current account deficits and are reliant on dollar loans for financing. A stronger U.S dollar makes repaying these loans much more expensive and as the dollar rose, countries like Argentina and Turkey, who have large amounts of dollar denominated debt, started to topple. 
At the same time the rising dollar coupled with an economic slowdown in China has depressed the price of commodities. Most commodities are priced in dollars and a more expensive dollar makes commodities more expensive to purchase for none U.S buyers, thereby reducing demand and by extension prices. Meanwhile China is the largest consumer of raw materials in the world so any slowdown in the Chinese economy has outsized effects on the price of raw materials. This is particularly damaging to emerging markets since many developing countries rely on commodities exports to fuel economic growth. 
Another thing hurting sentiment in emerging markets is the tightening of U.S monetary policy. Higher U.S interest rates mean investors no longer have to hunt for high yield in risky developing countries and could instead invest their capital in the relative stability of the U.S. In the decade since the Great Recession Emerging Markets benefitted strongly from the low rate environment. However as interest rates begin to normalize, foreign investors are starting to pull their money from these riskier markets. When you include all these factors and throw in an escalating trade war between the U.S and China, it is easy to see why emerging markets are in the midst of an economic bloodbath.
This recent economic tumult has not spared Vietnam. The country’s stock market plunged over 25% between April and July, while volatility surged to an 8 year high. Declining share values led to margin calls in the heavily leveraged and relatively expensive market, which exasperated the selling. Foreign Investors, who had only months before were consistently buying Vietnamese large caps (foreigners net bought $1.48 billion worth of Vietnamese equities in the first half of the year), started to dump their holdings. This only worsened the sell-off as Vietnam’s top 20 blue chip companies (which were favored by foreign investors) account for 2/3 of the total stock market capitalization, and any large selling in them tends to bring down the rest of the market. For 75% of the days during this period investors pulled money out of the market. Foreigners dumped $70 million worth of Vietnamese stocks in the first half of July alone. 
At first sight dumping Vietnamese assets right now makes sense, especially as the U.S-China trade war intensifies. Vietnam counts both nations as its top trading partners, which means the country may find itself in the middle of a trade war between the 2 largest economies on Earth. As I mentioned earlier, Vietnam has been reliant on exports (as well as FDI) for much of its economic growth. Shipments surged almost 4 fold between 2008 and 2017 and annual exports topped $226 billion in the 12 months ending in March 2018. Trade as a percentage of GDP currently stands at 200% which means any dent in global trade will have negative effects on the country. More concerning is Vietnam’s trade dynamic with China and the United States. 
China is Vietnam’s largest trading partner and the nation relies heavily on its far larger neighbor to the North for raw materials, equipment and capital for its labor intensive manufacturing industry. As such Vietnam runs a huge trade deficit with China, at the same time the United States is Vietnam’s largest export market (you might notice how a lot of your basic goods now say “Made in Vietnam”). As a result Vietnam enjoys a large trade surplus with the United States. This dynamic could mean that the small South East Asian nation may earn itself the ire of U.S President Donald Trump who has vowed to renegotiate trade pacts and reduce America’s trade deficit. Pressuring a small export dependent country like Vietnam with tariffs would not be out of character for the unorthodox President and is a major concern for investors in the small nation. In fact $5 billion worth of Vietnamese exports that are part of Chinese supply chains may already be exposed to U.S tariffs. Vietnam also houses many production hubs for the Chinese manufacturing sector, which only exposes the nation more trade frictions. 
As these risks mount traders are pushing down the value of the Vietnamese currency, the Dong. The currency is loosely pegged to the U.S Dollar and in a bid contain the currency the Vietnamese central bank quietly devalued it by 1.1% this year. If exports start to slip, it is likely the central bank will take more aggressive actions,  which does not bode well for Vietnamese assets. Throw in rising inflation (which in June and July topped the central bank’s target of 4%) and you can understand why investors are fearful of increasing their exposure to Vietnam. However, it is possible that these risks are overstated and that the recent sell off in Vietnamese equities actually presents a long term opportunity. 
Chart showing Vietnam’s dependency on exports. As you can see Vietnam is much more dependent on exports then its other South East Asian peers. This exposes the Country to trade friction.
          To understand this opportunity investors have to look deeper into the factors behind the recent sell-off. Let’s start with the elephant in the room, the main driver behind the recent flight from Vietnam, the rapidly escalating trade war between the U.S and China. Any trade war, inevitably causes collateral damage, not just to the intended target but to the many players involved in the various sprawling supply chains. However, in this case, a trade war between the U.S and China might be accelerating a trend that has been benefitting Vietnam and other South East Asian countries. This trend is the shift of the manufacturing and industrial bases away from China. As wages at Chinese factories continue to rise, multi-national corporations are increasingly moving out in search of cheaper labor. With Chinese made goods now the target of U.S tariffs, companies have all the more incentive to move away from the country. 
Vietnam is a natural place for companies to set up their new Asian production centers. According to VinaCapital (one of Vietnam’s largest asset managers) Vietnamese laborers are 66% cheaper and just as productive as their Chinese counterparts. This coupled with the nation’s relatively well educated, young population and a rapidly developing infrastructure, make Vietnam an attractive destination for new industrial investment. Multiple companies have already moved their production to the country. One of the larger ones has been Samsung, which has invested $17 billion in Vietnam and now uses the country as its main manufacturing hub for its best-selling smart phones. Clothing companies are also shifting their manufacturing, the U.S Fashion Industry Association released a study in July which shows that 2/3 of all textile companies are expecting to lower their production in China. Some of these companies, like Adidas, have already moved to Vietnam (Adidas now manufactures twice as many shoes in Vietnam as it does in China). As the production processes continue to flee China in favor of South East Asia, it makes sense that Vietnamese manufacturers continue to see new growth. In August the Nikkei Vietnam Manufacturing Purchasing Managers Index (which measures manufacturing activity in the country) recorded in 33rdstraight month of increases.
In fact, despite the massive broad based pull back from Emerging Market, cashflow from other Asian countries into Vietnam is still trending up. Properties in the country are priced at a significant discount, compared to those in neighboring Singapore and Thailand, and properties in Ho Chi Minh City are 1/10ththe price of similar properties in Hong Kong. This makes Vietnam one of the best real estate plays in Asia and gives the country a strong advantage over other South East Asian countries viewing to attract industrial investment.  So even as investors fear that a trade war could dent Vietnamese exports and hurt the country’s stellar growth, it is actually attracting greater FDI and is expanding the nation’s industrial and manufacturing base. 
The other risks that have weighed on Vietnamese markets may also be exaggerated. Let’s take the higher dollar and rising interest rates for example. As was mentioned before, these things hurt nations with large amounts of dollar denominated debt and who run current account deficits. Vietnam is not Argentina or Turkey, although the country maintains an uncomfortably high debt to GDP level (which is at 61.5%) the government has taken concrete steps to solidify the nations finances. These steps, which include deficit reduction and divestment of state owned enterprises, are expected to contain public debt. About ½ of Vietnam’s external debt is financed through favorable terms with large multilateral institutions, like the World Bank, IMF and the Japan International Cooperative Agency. This is in stark contrast to other Emerging Market countries who have financed there growth primarily with bank loans.
 The Vietnamese government has also restricted lending to less productive industries and has been forcing banks to reduce their bad debt (the bad debt ratio for the Vietnamese banking industry fell to 2.09% in late June compared to 2.46% in late December of 2016). In addition to these actions the Government has moved to modify the country’s debt structure in order to reduce reliance on foreign denominated loans (something that has sunk the economies of Argentina and Turkey). According to Moody’s this has made the Vietnamese economy less vulnerable to external shocks, which incidentally explains why Vietnam’s credit rating is being upgraded even as fears of default rise in other Emerging Markets. Meanwhile, the country’s strong exports mean the nation runs a steady current account surplus which only reduces the need for foreign debt. Throw in robust growth in personal consumption caused by rising household incomes and expansion of private credit and it is hard to be concerned about Vietnam’s growth and finances.
Concerns over rising inflation and the falling Dong also seem to be overplayed as well. Although fears of inflation increased over the summer (inflation in June and July was 4.67% and 4.46% respectively) as the Dong sold off, there are signs that prices and the currency are stabilizing. The State Bank of Vietnam and a survey of economists conducted by Focus Economics expect annual inflation to run below 4% (which is the Central Bank’s target) in 2018. The country has also been steadily increasing its foreign exchange reserves, which it could use to prop up the Dong if necessary. In March the nation’s FX reserves stood at 25.7% of GDP compared to 21.75% in December of 2017. However as the dollar begins to stabilize, following its recent surge and Vietnam’s strong growth continues, it is unlikely that the Dong will depreciate further. Despite the devaluation of its currency, the Vietnam’s central bank has done a good job keeping the Dong pegged to the dollar. The state bank has ensured that the Dong does not shed more than 3% against the U.S dollar annually. This explains why Vietnam’s currency is only down just over 1% against the greenback while other South East Asian countries like Indonesia have seen their currency plummet as much as 10%. So when you consider the fact that FDI is expected to continue increasing, the decreasing dependency of foreign denominated debt, stabilizing currency and contained inflation, it is easy to see the recent sell-off in Vietnamese assets as an opportunity. 
Chart showing Vietnam’s Current Account from 2013 to 2018. The country has run relatively consistent current account surpluses which makes the country less vulnerable to external shocks.
Chart showing Vietnamese FX reserves from 2008 to 2017. The country has been building up its reserves which allows it to prop up its currency. 
           It has become clear that investors have been trading emerging markets as a block with little regard for the fundamentals of specific markets. This presents an opportunity to dive back into emerging markets that have proven to be more resilient to the turbulence, markets such as Vietnam. Even as Vietnamese shares sold off in the face of foreign liquidations, earnings have continued to grow at a historic rate. This means earnings multiples for Vietnamese stocks are at the lowest level they have been in a very long time, giving investors a perfect entry point into the market. 
            Prior to the Emerging Markets sell-off, some analysts were concerned that Vietnamese large caps had gotten too expensive. This is understandable given that at the top of the market in March, Vietnamese stocks traded at an average P/E of over 20x, a much higher multiple than other emerging markets. However, following the recent market sell-off that multiple has fallen to around 16x, and if you do not include the top 5 listed companies, the average P/E for Vietnam’s main Ho Chi Minh index is about 14.5x. This puts Vietnam’s equity valuations just about in line with other South East Asian countries and 21.32% below their own historical averages. Additionally, but when you compare Vietnam’s equity valuations to GDP growth, it becomes obvious that Vietnamese stocks present much better value than stocks in other comparable nations. For example, Vietnam’s GDP growth in 2018 is expected to be around 6.5%, and as mentioned before, it’s main equity index has a P/E of around 16x. The Philippines has a higher expected GDP growth of 6.8% but on average its equities trade at a high P/E of 19x. Thailand, meanwhile, has equities trading around 15x forward earnings but has a much lower GDP growth of 4.5%. Other South East Asian countries, the Philippines and Indonesia specifically, have also been running consistent current account deficits and have been gorging on dollar loans. This makes them vulnerable to the same external shocks that sent Argentina’s and Turkey’s economies reeling. Throw in the added political instability (yes Philippines I am talking about you) and you can understand why Vietnamese stocks trading at the same valuations as equities in its neighboring countries presents an opportunity. 
            This dynamic could explain why Vietnam fared better in the current situation then its neighbors and why, despite the broad sell-off in emerging markets, foreign investors still net bought Vietnamese equities this year. According to Dragon Capital, foreign investors withdrew $5.6 billion from the Thai market this year through August, $3.7 billion from Indonesia and $1.6 billion from the Philippines. Meanwhile foreign investors net bought $1.8 billion worth of Vietnamese stocks. Vietnam’s general statistics office views these capital flows as a positive sign, despite the increased volatility in the country’s financial markets. Some Vietnamese based funds, including Dragon Capital and VNDirect Securities, have echoed this sentiment. With every industry reporting earnings growth in excess of 20% year over year through the end of the 1stquarter, and with equities trading at these valuations it’s hard not to be excited about Vietnamese stocks. 
Chart showing Vietnam’s main VN stock index from 2016 to September 25th2018. The index soared 48% in 2017 before falling over 25% between April and July. It is currently up 13% from its lows.
           Vietnamese stocks look relatively cheap to their historical averages, earnings and international peers. When you consider the country’s macroeconomic stability and growth it is easy to see why Vietnamese equities have rallied 13% since hitting their lows in July. Unfortunately, it is difficult for retail investors to get in on the action since it is virtually impossible to invest directly in individual Vietnamese stocks. Luckily, there are a number of liquid ETF’s out there that allow small investors to gain exposure to the country. 
            The most popular one is the VanEck Vectors Vietnam ETF (VNM). This U.S traded ETF is probably the most pure way for investors to gain exposure to Vietnam. The ETF has total assets of about $278 million and is composed of companies that are incorporated in Vietnam, generate half their income in Vietnam, or have half their assets in the country. The funds main objective is to track the MVIS Vietnam index and managers invest at least 80% of the fund’s assets in securities of the underlying index. Another option for interested investors is the VinaCapital Vietnam Opportunity Fund (LSE: VOF). This fund trades on the London Stock Exchange and is a closed ended investment company aiming to achieve medium to long term returns in Vietnamese assets. The company mainly invests in Vietnam focused listed and unlisted companies, debt instruments, private equity, real estate and other opportunities. Given that the fund trades at a 18.9% discount to its net asset value, it gives investors a cheap way to gain access to a more actively managed Vietnamese investment portfolio. 
            Of course there are many risks in investing in Vietnam or any developing country for that matter. The country’s financial markets are considerably more volatile, prone to wild swings and asset bubbles. However, for investors willing to take on the additional risk, Vietnam offers an amazing macro based opportunity. The Vietnamese government continues to push for the privatization of state owned companies and is planning on loosening regulations to make it easier to start businesses and invest in the country. According to Deloitte, the government’s continued actions to open up the economy and encourage foreign investment will keep the Vietnamese market attractive for at least the next 5-10 years. With valuations in the country depressed following the sell-off in Emerging Markets, investors have a rare opportunity to gain cheap exposure to one of the most impressive developing countries in the world, just as it begins to realize its potential. 

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Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor.