Monthly Investment Letter – August 2010

Russia witnessed a hot summer of burning skies over Moscow and other parts of the country, while extreme gyrations in global markets saw the MSCI Emerging Markets Europe fall a punishing 24% between 15 April and 5 July.

Many, if not most investors, were assailed by renewed concerns that US unemployment and stalled GDP leading to a double-dip recession would derail the global recovery.

We assign scant credibility to that view, although our portfolio construction geared to broad-based cyclical expansion themes was adversely affected.

So, the unending macro debate continues and “Doubting Thomas” has now staged a four-month filibuster on the floor of global exchanges.

It all started in this part of the world, when the Russian investment community first came to the view that the Greek contagion and the Euro crisis were about to usher in a second credit crisis.

Then followed a widely-held belief that the certain end to Chinese commodity demand would devastate CIS-related commodity exports, and thus the Russian investment case.

And most recently, in August, came the unrealised fear that persistently high unemployment in America would send economies into contraction, which once again pushed risk-assets into retreat.

But to be absolutely clear – we firmly maintain that baring an appearance by the now infamous “Black Swan”, the likelihood of a global double-dip recession is zero.

Moreover there can be no serious question as to whether or not a global V-shaped recovery will happen, since it has already happened, starting in March 2009.

The only sensible discussion should now centre on the relative sustainability, trajectory and duration of the rebound. Certainly nothing lasts forever, and the V-shape has already flattened in some economies, and perhaps even reversed in others.

Our internal discussions have centred on whether the slowing US economy is heavy enough to drag down the economic rebuilding going on elsewhere, or whether it simply smoothes a further upward advance by a measure of degrees?

We voted with our wallet on the latter. So much so in fact that our current asset allocation has 142.2% net equity exposure, leverage of 76.9% and gross short positions of just 27.1%.

This is not 2008 all over again. This is 1932, 1942, 1974, and 2002 all over again.

Here is why

  • Global GDP and associated commodity demand are increasing
  • Leading global economy Korea just recorded a 7.2% Q2 GDP number back-to-back with an 8.1% Q1 GDP
  • Indian GDP grew at 8.8% in Q2
  • Chinese GDP will not be less than 9.5% for the whole of 2010
  • Australia, Canada, Brazil, Norway and other resource-based economies are booming
  • Germany, the world’s manufacturing and export juggernaut is dragging the entire Eurozone back to the black
  • Japanese style deflation risk on a world-wide scale is fantasy
  • many leading economies have already turned the corner on inflation watch and have raised rates in 2010; some have two rate hikes
  • emerging markets’ share of global equity capitalisation climbed to a record 25 percent in August, up from 22 percent a year ago
  • but emerging markets GDP in PPP is >50%, and growing at 3x the rate and thus the share of global equity capitalisation will continue to rise
  • Global auto sales are booming, driven by emerging markets as hundreds of millions of people join the new global middle class.
  • The global luxury goods market is now larger than pre-crisis highs and being driven by Asian demand. Millions of people in the new global middle class have become very wealthy
  • Urbanisation and industrialisation are accelerating at a fearsome clip… one million people per week move from rural areas to cities in emerging markets. This means huge and growing demand for coal, electricity, oil, gas, copper, industrial glass and infrastructure, and still greater, unending demand for materials and basic resources. August 2010 y-o-y electricity demand in China grew at 18%! Not nuclear, not solar, not wind; this is all about coal.
  • Even euro zone consumer confidence has surprisingly reversed with powerful jump in August report – and the EU was pronounced dead just three months ago

But what about American unemployment?
Yes, the American Century is over, but a slowing 2% USA (or even a 1% USA) is not going to untrack the rest of the world (“R.O.W.”).

The US consumer is no longer the driving force of global economic activity and will be eclipsed by her counterpart in China in just five years.

China’s retail sales, estimated to grow at 14.5% per annum, will be greater than U.S. retail sales, reaching 34 trillion yuan ($5 trillion) by 2016.

We still hold to the politically incorrect position that the longest, most protracted, anaemic rate of job recovery (provisionally growing) would be optimal for current portfolio construction.

With apologies to the unemployed, in the context of global GDP expansion with associated demand for commodities, a multi-year period of muted (although fractionally positive) job creation in the US, is good for hard assets.

This is because from the perspective of the “risk-trade,” more imporant than any near-term (modest) improvement in the US employment numbers in driving asset appreciation are:

  • near zero real rates for an extended period
  • the possibility of additional Fed stimulus
  • most importantly, the declining USD

This is the very fuel to fire the risk-trade, emerging markets, raw materials, “Russia” and Russia-related assets.”

While the following may inspire chuckles and hoots, it is our s perception that even many developed markets, including the US, look very attractive right now.

While as imperfect as all other gauges, perhaps the best predictor of future US economic activity is the Leading Economic Indicator total composite, which includes average workweek, jobless claims, consumer goods orders, pace of deliveries, orders of non-defence capital goods, building permits, stock prices, M2 money supply, the interest rate spread and consumer expectations. It looks very attractive right now.

Stocks are the cheapest asset class with yields higher than bonds. The SPX trades at a 30-year low of 11.7x 2011 earnings with 34% EPS y-o-y growth in 2010 and 18% in 2011. Of the major investable markets, Russia has the lowest valuations and highest growth profile.

Russia Investment

In 2008, after leading all the major markets for a decade, Russian stocks crashed. The RTS fell 80% from 2,500 to 500. So even after the powerful market retracement of 2009, stocks are still a bargain in 2010, trading at 6x estimated earnings and a 50% discount to the BRIC composite SHCOMP (China) / IBOV (Brazil) / SENSEX (India).

But even including the 2008 crisis, Russia was still top performing global market for a decade and the fundamentals remain intact. Russia remains both the cheapest major market and the highest growth major market in the investible universe.

Where are we now?

Our investment thesis remains predicated on global GDP growing at 4.0%, driven by >7% expansion in emerging markets.

Global industrial production is +10% y-o-y, urbanisation will accelerate and corresponding commodity consumption will only intensify.

But at any time when financial markets give credence to recessionary scenarios, aggressive positioning in cyclicals, industrials, metals, financials, shipping, construction and specifically Russia, will underperform.

The risk trade remains unfashionable as bond yields drop to record levels, gold rallies and cash is king. Credit markets get richer and stocks remain the least expensive asset class with equity risk premiums at historic highs. The Fund has not hedged away its Alpha, and thus has significant directional exposure – by design.

While bearish sentiment is at the highest levels since the trough of the 2008 crisis, we maintain the unpopular view that the March 2009 bull market remains solidly on track and that the next unanticipated market move is higher.

Performance Attribution
Over the reporting period, we increased leverage by 5% to 80.7%, trimmed financials from 17.3% to 14.9% and mining from 14.2% to 12.3% gross exposure.


Having correctly positioned Chinese exposure in the spring when we reduced country weight from 10% long to 7% net short in March 2010, we largely missed the 25.36% selloff in Chinese markets through July.

Based on the perception that the Bank of China has successfully engineered a near perfect deceleration and will be supportive of capital markets in the medium term, we began buying China again in August 2010 and anticipate a full 10% of country weight in the next 60 days.

Our investors were rewarded with a +13.79% month from Xinyi Glass (868 HK) 1.17% AUM, but this is not just a China story.

The single top performing portfolio line item +371%, in the trailing 12 months (TTM) is Charoen Pokphand (CPF TB) Thailand, +45.71% 3M and +9.43% August with 8.75% AUM. Charoen Pokphand has been a core holding since 2006 and recently our single largest line item before we sold 1/3 position in August with a nearly 50% annual return.

Along with Petroneft (PTN LN) Ireland, Hyundai Mipo Dockyard (“101620 KS”) South Korea is the top performer over 3M + 26.30% with 5.54% AUM.

Our long-standing global investment theme is that as discretionary incomes rise in emerging markets, people trade up the food chain and consume a larger co-efficient of caloric intake from proteins.

Between 1980 and 2000, China’s per capita consumption of beef tripled. That times 1 billion people = powerful dynamic.

A similar paradigm taking place in former Soviet Union countries with higher consumption of ocean fish, beef, and poultry.

CPF is the leading global supplier of milled animal feeds, a building block in the protein creation chain. Pig food, chicken food, shrimp food and fish food, as well as fresh/frozen shrimp, fresh/frozen meats, poultry and processed quick meals.

Positive news flow coming from aquaculture business: Gulf of Mexico shrimp are doomed from BP’s ecological blight, and the Infectious Myonecrosis Virus is infecting shrimp in the other two primary fisheries in and Brazil.

Some expect a 40-50% hike in shrimp prices world-wide in 2011. Shrimp and shrimp feed = 21% of CPF = margin expansion. Being a fully-integrated shrimp producer, CPF benefits from rising value-added shrimp exports and shrimp feed sales.

The company’s overseas business (13 countries including Russia) is booming – India +54% y-o-y, Turkish and Malaysian units are fast. Russia operations ahead of schedule and expected to break even YE 2010, food exports to USA are growing +50% y-o-y. Their recent earnings report was excellent: EPS +25% y-o-y, global expansion accelerates. Domestic (Thai) poultry prices rising. Low-priced forward contracts for raw material (used in animal feeds), specifically course grain and corn, are locked in to year end 2011 – smart (lucky). Retail plans – company expects to open 700-800 CP Fresh Mart brand stores by mid-2011. Our Fund remains constructive despite selling 1/3 position in August.

In building out this EM protein consumption investment theme, we maintain large meaningful positions in MHP Group (MHPC LI), the largest poultry producer in Ukraine, which just obtained export rights to the largest market in the CIS – Russia, and in Marfrig (MRFG3 BZ) Brazil, the lowest-cost slaughter house and beef producer in the world and a key supplier to the former Soviet republics

Largest declines for the month centred on financials and mining including Sberbank Pref (SBERp03) in Russia -3.33% and in Eurasia Natural Resources (ENRC LN) -8.53% and in Kazakhmyc (KAZ LN), both in Kazakhstan -7.06%.

In terms of the fund’s geographic dispersion, both Russian and Kazakh weights declined slightly, with China, Australia and Canada advancing.

Our asset allocation remains short gold, short bonds (AUS, CAD) and short safe haven FX (55% gross AUM) and long commodity FX (Rouble, CAD, AUD), materials, metals (copper, platinum), tanker futures and crude oil.

Our largest equity sectors remain miners, shipping, financials, real-estate, construction and E&P. The Fund has zero exposure to defensive sectors of healthcare, consumer staples, telecommunications, food retail and electrical utilities.

Slava Rabinovich is CEO and CIO of Diamond Age Capital Advisors Ltd. and the Diamond Age Russia Fund, a hedge fund run from Moscow.

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