This week, I’ve been looking at yet another chart. This one comes from Jonathan Allum at Mizuho Securities and shows the prices of two Asian shares, both of which have fallen by 80% so far this year.
Of the two collapses, the first, Tepco, is pretty easily explained. This is the Japanese company that supplies electricity to the Tokyo area from various thermal and nuclear power stations – including the Fukushima plant hit by an earthquake in March. The reason for its plummeting share price is therefore, as Allum puts it “deeply regrettable, but clear.”
But what has hit the second share, Sino Forest, isn’t so clear. Sino Forest is a Chinese company listed in Canada. It calls itself a “commercial forest plantation operator” and has long seemed like an excellent way to get exposure to both the timber sector (something you want in times of inflation) and to Chinese growth.
However, according to various sources – mainly shortseller Carson Block – it does not do what it says on the tin. Instead, it has been alleged that the company doesn’t have legal title to much of the land it purports to own, that its tax affairs aren’t entirely in order, and that there is reason to suspect “stratospheric” fraud.
Sino Forest vigorously denies all of this and has begun to publish documents to try to refute the allegations. But that hasn’t stopped its shares falling by more than 80% since the end of May. A few weeks ago, Sino Forest was a large and reasonably respectable company, with a market capitalisation of C$6.2bn. This week, it is a small company in crisis valued at C$825m.
Now, the point here is simple. Imagine, says Allum, that “a shadowy research outfit” were, out of the blue, to allege that a huge Japanese company, say Mitsubishi Estate, did not really own the vast central Tokyo sites that are the basis of its business. It is unlikely that anyone would pay any attention at all. If anyone did, any accusers would be “buried almost instantaneously” by statements solicited from the land registry and the Tokyo Metropolitan Government, proving Mitsubishi’s position. And that would be that. But confidence in legal and corporate governance has an effect on prices.
Until 2007 or so, emerging market stocks always traded at a discount to developed market stocks. Since then, they have shifted to trading at a premium, thanks to the fact that most investors expect emerging market profits to grow faster than those in our debt-ridden developed markets.
There was a good reason for the discount that used to apply, though. It was based on the idea that not all legal systems and not all concepts of corporate governance are as developed as others. Perhaps it should still apply.
After all, while the markets we refer to as “emerging” have in many ways emerged, if you can’t trust the stated asset values of a listed company, you aren’t going to want to pay a premium for it – regardless of how fast it might or might not grow its earnings.
Sino Forest says it will prove that its business is as it says it is and that it will restore its reputation. But it also says that this proof will take up to three months to deliver. Given that confidence is hard won and easily lost, that is too long. Note that Sino Forest shares continued to fall, even after what was supposed to be a reassuring conference call this week.
One way of checking the confidence levels of investors, at least in the UK, might be to look at the share price of the Fidelity China Special Situations Fund.
I wasn’t particularly complimentary about this at its launch. But most other people loved it and the shares immediately moved to trade at a large premium to the fund’s net asset value. No more. This week they have been trading at a slight discount.
Perhaps the shift away from the idea that emerging markets are worth a premium is beginning to get going – something that might be yet another reason, if you must be in equities, to stick to developed markets for now. Currently, the price-to-book ratio for the MSCI Asia excluding Japan index is around 1.83 times. For the developed world MSCI World index it is slightly less at 1.74 times.
Finally, it might be worth noting something else about the performance of the Fidelity China Special Situations fund. If you had bought into it back in April 2010 at 100p a share, you’d be down more than 5% on the deal today. If, instead, you had bought the Baillie Gifford Japan Trust at the same time, you’d be up around 2%. And, right now, the price to book ratio of the Japanese market is 0.97 times. I know which I’d rather hold.