Jim Chanos, China, and Canada’s Big Problem

Jim Chanos, China, and Canada’s Big Problem
Jim Chanos photo via Insider Monkey (CC BY-ND 2.0)

entering a nuclear winter (my words, not his). Mining capex in 2013 was twice the 2007 level. Think about it for a second. We had an overcapacity bubble in real estate in 2007 that was truly global, taking in the U.S., Europe and China. You would have thought that when the bubble burst in the U.S. and Europe, capital spending on mining equipment would decline, but China single handedly doubled global mining capex.

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Jim’s idea for stocks: short Caterpillar. I had always thought of Caterpillar as the poster boy of the Chinese commodities bubble, so I was interested in Jim’s take. He thinks that although Caterpillar at $80 doesn’t look expensive — management projects earnings should hit $10 in a few years, compared with a consensus estimate of $6.84 in 2013 — it is a value trap because its earnings power after the commodities cycle bursts will be a fraction of today’s. Its margins are too high, and its accounting is aggressive. Also, in the near term, competition from Chinese heavy equipment makers will increase because they’ll forgo margin to steal market share. If Cat’s operating margins fall from the current 11 to 13 percent range to 6 percent, earnings will be $3 a share. If you put a price-earnings ratio of 10 on those, you’ve got a much cheaper stock.

During the question-and-answer session, Jim was asked about Japan. He said it has not been his focus, but he pointed out that the weaker yen may not universally help export-oriented Japanese companies’ earnings because a lot of them have been offshoring production for years. So don’t blindly assume that a weaker yen will benefit Japanese exporters. And the weaker yen is certain to annoy Japan’s neighbors, such as South Korea and China, which are competing for the slow-growing global GDP pie.

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Canada’s China Problem Is Greater than Its Housing Problem

Brian Bosse was the token Canadian this year at my annual Valuex Vail conference for value investors, his third time at the conference. Brian is vice president at Goodman & Co., Investment Counsel, where he works for one of the smartest, richest and nicest men in Canada: Ned Goodman.

When Brian and I discussed his presentation, I asked him to give us something on Canadian banks. I keep hearing that Canada is in the midst of its own real estate bubble, and I wonder if our northern neighbor will have its own banking crisis soon. Brian loved the idea of exploring this idea, but he did not really know what he would discover. (Also, when he gave his talk he felt the need to enlighten Americans by showing them pictures of Canada’s largest export, movie stars, and every few slides he inserted pictures of Canadian actors we think are American — take a look at his presentation for examples.)

Brian made a very compelling case that even though housing prices look somewhat high in Canada, the bulk of appreciation is limited to Vancouver and Toronto. Moreover, Toronto is growing at a faster rate than the rest of the country — it has 154 construction cranes — and it is adding jobs faster than the rest of Canada. Thus real estate prices in Vancouver and Toronto should not be compared with those of most U.S. cities but instead with those of other destination towns, such as New York City.

There are also some major differences between Canadian and U.S. banks. In the U.S. mortgages are basically nonrecourse: You walk away from your house, the bank takes it, and that is as far as your liability goes. In Canada, if you walk away from your house, the bank will go after your other assets. In theory, this should lead to more-responsible behavior by homeowners, and there is more collateral in case of default. Because there are only five major banks in Canada, competition is less cutthroat than in the U.S., where we have hundreds of banks. So Canadian banks have been more responsible than their U.S. brethren (though my Irish editor can attest that having fewer banks does not necessarily cultivate more-responsible behavior). And troublesome condo loans are a tiny portion of total real estate loans in Canada, while underwriting standards are more stringent, with no teaser rates or so-called ninja loans (“no income, no jobs, no assets”).

Canadian interest rates usually follow the interest rates of the U.S. (according to Brian, the correlation between U.S. and Canadian rates is 85 percent). So if U.S. interest rates continue to rise, it is very likely that Canadian housing prices will drop and defaults will go up. But two thirds of Canadian mortgages are insured by the Canadian Mortgage and Housing Corp. (CMHC), the Canadian version of Fannie Mae. CMHC is owned and guaranteed by the government. Thus the government will be on the hook, not Canadian banks. Canadians have therefore skipped a step: If (or, should we say, when) their housing crisis happens, there won’t be any argument in the media about “too big to fail”; the government will take care of it.

Jim Chanos of Kynikos Associates (who is not short Canadian banks), made an interesting point after Brian’s talk. He is more worried about problems in Canada from incomes declining once the China-induced commodities supercycle ends — after all, Canada has benefited tremendously from it. To Jim’s point, Canada reminds me of Australia, another beneficiary of the Chinese commodities party: Low-skilled people who used to work at McDonald’s restaurants in Sydney or Canberra began moving to the west coast and getting jobs driving trucks at iron ore mines, instantly making more than $100,000 a year.

So the good news for McDonald’s Corporation (NYSE:MCD) restaurants across Australia and Canada is that their hiring difficulties are unlikely to persist for much longer.

You can view slides from VALUEx Vail 2013 presentations here.

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I was born and raised in Murmansk, Russia (the home for Russia’s northern navy fleet, think Tom Clancy’s Red October). I immigrated to the US from Russia in 1991 with all my family – my three brothers, my father, and my stepmother. (Here is a link to a more detailed story of how my family emigrated from Russia.) My professional career is easily described in one sentence: I invest, I educate, I write, and I could not dream of doing anything else. Here is a slightly more detailed curriculum vitae: I am Chief Investment Officer at Investment Management Associates, Inc (IMA), a value investment firm based in Denver, Colorado. After I received my graduate and undergraduate degrees in finance (cum laude, but who cares) from the University of Colorado at Denver, and finished my CFA designation (three years of my life that are a vague recollection at this point), I wanted to keep learning. I figured the best way to learn is to teach. At first I taught an undergraduate class at the University of Colorado at Denver and later a graduate investment class at the same university that I designed based on my day job. Currently I am on sabbatical from teaching for a while. I found that the university classroom was not big enough for me, so I started writing and, let’s be honest, I needed to let my genetically embedded Russian sarcasm out. I’ve written articles for the Financial Times, Barron’s, BusinessWeek, Christian Science Monitor, New York Post, Institutional Investor … and the list goes on. I was profiled in Barron’s, and have been interviewed by Value Investor Insight, Welling@Weeden, BusinessWeek, BNN, CNBC, and countless radio shows. Finally, my biggest achievement – well actually second biggest; I count quitting smoking in 1992 as the biggest – I’ve authored the Little Book of Sideways Markets (Wiley, 2010) and Active Value Investing (Wiley, 2007).
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