Three investment strategies
To see why, it is probably useful to understand how investors make trading decisions. This blog entry is going to be a pretty abstract piece on how I think about the underlying dynamics of a well-functioning capital market, and how these apply to China. I have spent the past three days in Spain to celebrate my mother´s 80th birthday, and while here I have been reading Steve Fraser´s excellent cultural history of Wall Street. Re-reading stories about some of the craziness on Wall Street during the 19th Century brings to mind some of the equal craziness in the Shanghai stock markets, and made me think about how markets perform as allocators of capital.
Arbitrage or relative value traders exploit pricing inefficiencies to make low-risk profits. They ensure that markets provide clear pricing signals and, perhaps less acknowledged but more important, they link up assets into a single market by spreading buying or selling in one asset across the asset class. In other words if one asset is heavily purchased, its price will not rise relative to other assets in the same class because as it does, relative value traders will sell that asset and buy the others in its asset class. This forces the market to function as a unified market, rather than as a series of unlinked markets for each individual asset.
Finally fundamental or value investment strategies involve buying assets in order to earn the economic value generated over the life of the investment. The role of this strategy is to channel capital to its most productive use, and it is the decision to confiscate capital from less profitable companies and channel it to more profitable ones that creates the mechanism which allow markets to predict the economic future.
It is the latter strategy – perhaps most famously characterized by the likes of Warren Buffet – that gives the market its predictive ability. By constantly switching out of assets with diminished cash-flow expectations and into assets with rising cash-flow expectations, fundamental and value investors turn the market into a machine that discounts long-term cash-flow expectations, and in so doing, makes predictions about the future. The level of market prices is the sum of these predictions.
Adding and subtracting volatility
Most investment consists of one or more of these strategies combined (although I did once meet someone who traded on the basis of the Zodiac, which I don’t think fits into my model), and they have different impacts on market volatility. Speculators, for example, are often “trend” traders, looking for many opportunities to make small profits, or they try to take advantage of information – such as government signaling, regulatory changes, or changes in liquidity or technical factors – that will move markets in the short term, even if only temporarily. Since they often use leverage, they automatically see their buying power increase as asset prices rise, and are forced to sell when prices drop. All of this means that speculators tend to buy in rising markets and sell in falling ones and this behavior, by reinforcing price movements, can increase market volatility.
Value investors typically do the opposite. They tend to have fairly stable target price ranges, and when an asset trades below or above the target price range, they buy or sell, thereby countering market volatility. For them information consists of anything that might affect the long-term cash generating ability of an asset, or anything that affects the appropriate rate at which to discount the cash flow. They need good macroeconomic data, good financial statements, and a strong corporate governance framework.
Relative value traders look for assets that are mis-priced relative to equivalent assets, and they buy and sell simultaneously to lock in small, low-risk profits. Like fundamental investors, they need good data with which to make relative value comparisons. They also need relatively low frictional trading costs and the ability to short.
A well functioning market requires all three types of investors. Without all three, markets lose their social value of ensuring that economically beneficial projects have access to cheap capital. A market dominated by speculators, for example, tends to be volatile and inefficient at allocating capital.
This is because speculators focus largely on variables that may affect short-term demand or supply for the asset, such as changes in interest rates, margin levels, political and regulatory announcements, or insider behavior. They downplay the importance of long-term economic information, except to the extent that it might affect other investors (a form of the Keynesian beauty contest). Moreover since their investment horizons are short, they can ignore the impact of high discount rates. In a market dominated by speculators, prices can rise very high or drop very low on information that may have little to do with economic value and a lot to do with short-term non-economic behavior.
Value investors, however, keep markets stable and focused on growth. For value investors, short-term non-economic variables are not an important or useful type of information. They are more confident of their ability to discount economic variables that affect cashflows over the long-term. Furthermore, because the present value of future cashflows is highly sensitive to the discount rate used, these investors spend a lot of effort on developing appropriate discount rates.
Who can play?
China does not have a well-balanced investor base. There are almost no arbitrage or relative value traders because they require low transaction costs and the legal ability to short securities, which has only been permitted on the mainland recently and is severely restricted. There are also very few value investors. The vast majority of investors in China tend to be speculators. This makes the Chinese capital markets fairly volatile and very poor at rewarding companies for decisions that add economic value over the medium or long term.
Why are there so few value investors in China and so many speculators? The answer lies in the kind of information that can be gathered in the Chinese markets and how the discount rates investors use to value this information are determined. If we broadly divide information into fundamental information, used for making economic decisions about long-term cashflows, and technical information, which covers short-term supply and demand factors, it is obvious that the Chinese markets provide a lot of the latter and almost none of the former. The ability to make value decisions requires a great deal of confidence in fundamental information, like the quality of economic data and the predictability of corporate behavior, but in China today there is little such confidence.
Poor macro data, inaccurate financial statements, a weak corporate governance framework, and many of the very factors that make speculation such an exciting game in China, make it difficult for relative value investors, and nearly impossible for fundamental and value investors, to ply their trades. With interest rates heavily controlled by the People’s Bank of China, and subject to policy shifts, investors are not even sure what an appropriate long-term discount rate might be.
When it comes to technical information useful to speculators, however, China is very well endowed. Insider trading is common in China. Opaque corporate governance and ownership structures can cause sharp fluctuations in corporate behavior. Illiquid and fragmented markets allow determined traders to cause large price movements. In addition, the single most important player in the market, the government, often behaves in ways that are not subject to economic analysis.
This has a very important effect on undermining value investment and strengthening speculation. In the first place, unpredictable government intervention causes discount rates to rise, since these must incorporate additional uncertainty. Secondly, it puts a high value on research directed at predicting and exploiting short-term government behavior, and so increases the profitability of speculators at the expense of other types of investors. Even credit decisions must become speculative since, when bankruptcy is a political decision and not an economic outcome, lending decisions are driven not by considerations of economic value but rather by political calculations.
A dramatic example of the impact of government behavior on value investing was China Telecom’s initial public stock offering in November, 2002. The offering was scheduled to come out at a time of weak international demand, and there was some concern that it might not be as successful as hoped. Because the meeting of the 16th Party Congress was taking place in Beijing during that time, a successful transaction would have helped validate government policies and a failure would have been seen as a loss of face. In an attempt to bolster demand the Chinese government pushed through a large and unexpected increase in international interconnection fees, which would result in higher profits for the company.
Instead of boosting demand for the stock, however, this actually had the effect of reducing demand. The deal, originally expected to raise over $3 billion, ended up raising only $1.4 billion, even after being priced at the bottom of the expected price range.
Why was the deal a failure? Much of it had to do, of course, with weak global markets, but the final sudden drop in demand came about largely because by its actions the government made it clear that they would allow non-economic factors to affect the company’s profitability. Value investors, who dominate the large international markets and who would have been the main buyers of China Telecom, felt that their ability to judge the company’s future cashflows had suddenly been damaged. They saw that the company’s profitability depended not just on economic factors, which they are able to judge, but also importantly on political factors, which they cannot. As a consequence they raised their discount rate – that is, they lowered the price at which they were willing to buy shares.
This illustrates one of the main problems facing the development of local capital markets on the mainland. China is attempting to improve the quality of macroeconomic and financial information and is trying to make markets less fragmented and more liquid, but although these are important steps, they are not enough. Value investors need not just good economic and financial information, but also a predictable framework in which to derive reasonable discount rates.
Here China has a problem. It is difficult enough to estimate discount rates in an environment of regulated interest rates and pricing inefficiencies in the market, but in addition, Chinese discount rates must account for excessively high levels of uncertainty. Some of this uncertainty represents normal business uncertainty. This is a necessary component of an economically efficient discount rate, since all projects have to be judged not just on their expected return but also on the riskiness of the outcome.
But Chinese investors must incorporate two other – economically inefficient – sources of uncertainty. The first is the uncertainty surrounding the quality of economic information. The second is the large variety of non-economic factors – market manipulation, insider behavior, opaque ownership and control structures, the lack of a clear regulatory framework that limits the government’s ability to affect economic decisions – that can influence prices. These factors force investors to incorporate too much additional uncertainty into their discount rates.
This is the important point. It is not just that it is hard to get good economic and financial information in China. Even when good information is available, because of the variety of non-economic factors that affect value the appropriate discount rate is so high that it rarely will lead to a buying decision from a value investor except at a very low price. In China, value investors are essentially priced out of the market.
Speculators however can be much more confident about the information they use and so it is their behavior that drives the market. The consequences are not surprising. Markets in China respond to a very large variety of non-economic information and rarely respond to estimates of economic value.
Under these conditions it is not surprising that the Shanghai market is extremely speculative and that most investors, whether they admit it publicly or not, are largely engaged in speculative behavior. Take most fund managers out for late-night drinks and they will readily admit that the two most useful pieces of information that they crave is information about changes in underlying liquidity conditions and information about which way the government would like to see markets go.
A market driven almost exclusively by speculators, and with little to no participation by fundamental or value investors, is not a market that pays much attention to long-term growth prospects. It is driven largely by fads, technical factors, liquidity shifts, and government signaling.
So what does this year’s crash in the Shanghai stock market tell us? It might be saying something about the impact of the European crisis on export earnings. It might suggest that liquidity in the system is being driven into real estate rather than into stocks. It may reflect contagion and nervousness about the fall of stock markets abroad.
But we should be cautious about reading too much into it. In fact attempts by Beijing to hammer down real estate bubbles in the primary cities without addressing underlying liquidity expansion may simply push asset price bubbles elsewhere, and this could easily cause a surge in the Shanghai stock markets. But this should not then be interpreted as signaling a surge in the economy.
Shanghai’s markets will go up and down, but they are not driven by investor evaluation of long-term growth prospects. China does not yet posses the tools to make such evaluation useful, so be careful about reading too much into the stock market numbers.