As far as I know, Indonesian business magnate Aburizal Bakrie and Italian prime minister Silvio Berlusconi have never met. But the former could be forgiven for blaming the Italian prime minister for his big problems.
Indeed, Europe’s debt difficulties are the only game in town at the moment. They’re shaking world markets like nothing else. And implausible though it may sound, Italy’s inability to get a grip on its finances has put an Indonesian conglomerate on the edge.
That’s why it’s more important than ever for investors to pay attention to the quality of what they’re buying.
The Bakries get into trouble – again
In case the Bakrie name doesn’t immediately mean anything to you, Bakrie & Brothers is one of Indonesia’s largest conglomerates. It’s politically powerful: brother number one, Aburizal Bakrie, is chairman of the Golkar party and formerly the country’s welfare minister. There is a significant chance that Bakrie, or a placeman, could be in the running for president in 2014.
Bakrie businesses include property, telecoms, palm oil and many other commodities. But the prize assets among these are the coal miners Bumi Resources and Berau Coal Energy. Both are Indonesian firms, but after a rather complicated bit of financial engineering last year they have also been London-listed through Bumi Plc, which owns 85% of Berau and 29% of Bumi Resources.
During the 2008 crisis, Bakrie & Brothers teetered on the brink of collapse. The family had taken out loans against their listed shares and as the value of these shares collapsed during the market panic, creditors began to get antsy and demanded more collateral.
Ultimately, the Jakarta Stock Exchange was closed for three days at the peak of the panic while the Bakries tried to untangle the mess. Much to the surprise of many, they managed it and kept all the businesses intact.
But it seems they didn’t learn that much from the crisis. Because after the recent upheaval, Bakrie & Brothers is once again in trouble – and almost exactly the same trouble as last time. Once again they took out loans secured against their shares, except this time the collateral was London-listed Bumi Plc rather than their Jakarta companies.
Perhaps they figured we wouldn’t see another panic like 2008. Perhaps they believed a London-listed company would hold up better. Regardless, they miscalculated: Bumi Plc is off almost 50% from its peak (see chart below), lenders are again demanding more collateral and the Bakries are scrabbling to plug the gap.
The loan is reportedly now subject to margin calls and there are various rumours circulating about what happens next. The most likely one seems to be that the Bakries may have to sell a stake in Bumi or other parts of the group to commodity traders Glencore or Vitol.
They’d resent doing it, but it would allow them to escape again. And ultimately, I’d think some sort of deal is likely and Bakrie & Brothers will survive. But in the meantime, it’s not doing Bumi Plc any good.
The firm has had to put off complicated plans that would have put more of the Indonesian assets directly under Bumi Plc’s ownership. And plenty of shareholders who bought into this exciting resources story when it first appeared in London last year must now be realising the kind of baggage that goes with those cheap-looking coal assets.
Europe will keep rattling markets
The link between the Bakries’ troubles and Berlusconi’s woes that I suggested above is very indirect – but very real. If markets weren’t so terrified about the prospect of eurozone defaults, Bakrie and Brothers wouldn’t be in trouble.
Bumi shares wouldn’t have collapsed in the first place – there’s nothing going on at the company itself. And if they needed to roll over some debt, there’d be no shortage of lenders. But at a time like this, things are different. Even if you’re not overleveraged like the Bakries, liquidity is definitely tighter.
For example, Export-Import Bank of Korea raised US$1bn in new debt at the end of September. Despite being a state-backed borrower, lenders demanded interest rates at least a percentage point higher than they would have a few months ago. Barely anyone who doesn’t have to is issuing new debt in Asia.
And unfortunately, this is likely to set the tone for the next few years. While some of Europe’s politicians may believe they’ve solved the eurozone debt crisis, they haven’t. Greece’s writedown isn’t big enough, while none of the other countries are yet facing up to reality. The entire process is being dragged out, which will mean frequent panics as the next stage of the crisis becomes obvious.
That means that intermittently, stocks are going to plunge, debt markets will freeze and companies such as Bumi will get shaken around. These companies did fine in the care-free 2003-2007 boom. But they’re not well suited to this new era, where markets are more volatile and credit is tighter.
Today, investors need to be concentrating on good quality companies. Those that are well run, don’t have excessive debt, don’t have the kind of connections that could drag them into trouble and so on.
Stick to quality stocks
Indeed, to my mind there’s little reason to buy a stock like Bumi in the first place (except when it’s distressed and you can hope to make a quick trading profit). Quality is almost always a better bet.
The perception a lot of investors have is that you need to be buying riskier stocks to get better returns. But the evidence doesn’t bear that out.
Buying riskier assets definitely seems to give you a chance of better returns: small cap stocks have clearly outperformed US government bonds over the long run, for example. However, once you’ve selected a riskier asset class you want to buy the better quality instruments within it.
The chart below comes from a recent note by Dylan Grice of Société Générale. It shows the average return of stocks ranked by their Piotroski F-scores. This is an attempt to create a quantitative measure of quality based on measures such as leverage, margins and cashflow. A higher F-score is better.
As you can see from this chart, higher quality stocks have delivered higher returns on average. What’s especially interesting about this is that there’s no measure of value involved: the chart is simply ranked by quality.
Indeed, if you sort by valuation and Piotroski F-score, you find that good quality companies have actually been more expensive on average (see chart below). Yet they’ve delivered better returns.
The message is clear. Quality companies are worth a premium twice over: once for their greater safety and once for their high returns.
Unfortunately, the vast majority of companies in emerging markets and elsewhere aren’t high quality. And the vast majority of fund managers don’t have a quality focus, however much they claim they do. Investors need to focus on finding one that does.
For example, I generally think the Aberdeen Asset Management team does a good job on this score. So for an Asian regional fund, I like the Aberdeen New Dawn Investment Trust (LN:ABD), which mostly holds solid companies such as Singapore’s Overseas Chinese Banking Corporation (SP:OCBC), Taiwan Semiconductor Manufacturing Company (TT:2330, US:TSM) and Australia’s QBE Insurance (AU:QBE).
The portfolio may look staid compared with some peers. But it’s up 20 percentage points more than the MSCI Asia ex Japan benchmark over the last five years. Yes, past performance is no sure guide to the future – but as long as the managers continue to focus on quality, I’d expect that to continue.
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