TAA Vol. 1 Iss. 4 - 64 Million and Counting

The Aspiring Analyst Vol. 1 Iss. 4

64 Million And Counting... [email protected]

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Another month, another ‘Black Swan’. If the matter was not as serious as the Fukushima earthquake

(the 9.0 M earthquake is one of the strongest and deadliest earthquakes in history), we would joke that

this must be an advertisement for Natalie Portman’s movie. Nonetheless, investors seem to have looked

past the earthquake and the continued unrest in the Middle East, as the TSX and S&P indices continue to

power ahead, gaining 5% YTD.

This month’s newsletter will be relatively brief, as we do not have much to talk about. Inflation

continues to be a major concern. When the MENA crisis began in February, analysts claimed that the

global outlook continues to be sanguine as long as oil prices do not breach $120 a barrel. Well, Brent

Crude breached $120 last week and WTI is not far behind. Should we be worried yet?

Furthermore, we see signs of discord at the US Federal Reserve, as several governors have come

forward to warn about inflation and potentially stopping QE2 before its term while Ben Bernanke

continues to hold firm. Will the hawks prevail or will Helicopter Ben continue to print money?

In this issue, we will discuss a topic near and dear to our hearts – Chinese real estate. As you know, I am

of Chinese descent, so I follow news and stories about China closely. Over the past few years, one thing

that struck me as particularly odd was the disconnect between the rich and the poor in China. Who was

actually buying all the million dollar apartments in Beijing and Shanghai when the average factory

worker made less than 2,000 RMB a month? Expats? Tycoons? Corrupt government officials? Or is it just

speculators buying because ‘real estate can only go up’?

We will also provide an update of our portfolio relative to the indices. It was not a pretty quarter for us.

But that is the fun of investing – constantly trying to beat the indices. We may lose here and there, but

we will not go down without a fight.

Jason Chen

The Aspiring Analyst



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64 Million And Counting

We wrote about the Chinese real estate bubble in our January outlook, and it appears the story has

caught on in the land down-under as Australia’s SBS Dateline (a current affairs show similar to America’s

60 Minutes) did an interesting in-depth piece on the 64 million empty apartments in China:

http://www.sbs.com.au/dateline/story/watch/id/601007/n/China-s-Ghost-Cities

While 64 MM empty apartments may not sound that large for a country with over 1.3 Billion citizens,

here are a few more statistics to offer some perspective:

• The US housing stock has approximately 130 MM units1, so this empty supply is equivalent to

half of the US housing stock

• There are approximately 350 MM households in China2, so crudely speaking, this ‘excess’ supply

can house 18% of China’s population

• Or put another way, it will take China more than 33 years to organically gain an extra 64 MM

households, based on current a population growth rate of 0.5%3

Clearly, something is not right. There cannot be a clearer sign of a real estate bubble than 64 MM empty

apartments. We recently had dinner with a finance-savvy couple from mainland China, and asked them

their thoughts on the subject. Their answer was certainly enlightening, if not troubling.

This couple, on the advice of their parents and friends (who still had strong ties to mainland China),

bought two unfurnished investment properties in a secondary city (i.e. not on the list of cities which

have recently introduced price controls like Beijing and Shanghai) in Western China and boasted to us of

making over 100% returns in a few short years. Unfurnished, here, is used in the most literal sense as

these are little more than concrete blocks. Imagine an apartment building finished only on the outside.

The couple decided to leave their apartments unfurnished because 1) they did not want to deal with

tenants and 2) they did not want to incur capital expenditures. In fact, they say, most apartment

buildings in China are typically seven stories or shorter, as developers/investors avoid the legal

requirement of installing expensive elevator systems in buildings 7 stories or taller.

When asked about the 64 MM flats that sit empty, like theirs, they claim they understand the situation

but are not worried because there are lots of rich people in China to whom they can sell to and that

the Chinese government would not dare let real estate crash in China. They predict a moderate pace of

growth in the coming years.

While anecdotally, we agree with the first point (as evidenced by China being the largest market for

Louis Vuitton4), we would like to caution our friends that they are essentially betting on a there being a

1 US Census, retrieved Monday April 4, 2011 http://www.census.gov/prod/2008pubs/h150-07.pdf

2 Wikipedia (cites CIA World Factbook, but unable to find source), retrieved Monday April 4, 2011,

http://en.wikipedia.org/wiki/Demographics_of_the_People%27s_Republic_of_China 3 CIA World Factbook, retrieved Monday April 4, 2011, https://www.cia.gov/library/publications/the-world-

factbook/geos/ch.html 4 The Economist, retrieved Monday, April 4, 2011,

http://www.economist.com/node/18184466?story_id=18184466



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greater fool to buy their properties at some point in the future. Not unlike the “Tulip Mania” in the

1600s and the “Dot-Com” boom in the late 90s. Some more food for thought:

• The average residential price in China is now more than $1,300 per sq. m. (10.76 sq. ft.)5

• According to the World Bank, the Gross National Income per capital was about $2,400 in 20076;

assuming GNI increased at 10% a year, this equates to approximately $3,200 in 2010

• To afford an average 100 sq. m. flat (approximately 1,100 sq. ft.), an average worker will have to

save every dollar of income for over 40 years

Perhaps the rich people they are referring to are really just speculators like themselves who are trading

these houses in-between themselves for paper gains.

Of Fukushima And Silver Linings

Much has been written about the tragic Fukushima earthquake of March 11, 2011, so we will not repeat

the details here except comment on the naivety of analysts’ predictions that the tragedy will be a simple

$250 BB economic setback for the Japanese economy and that there may even be a silver lining, as

Japan’s GDP growth rate is likely to accelerate as a result of the reconstruction efforts. To those

analysts, we would like to point out that:

• The impact to global supply chains will be far greater than currently anticipated. For example,

car manufacturers such as Ford and Chrysler have suspended orders for black or red cars as the

metallic paint pigment Xirallic is only produced at a plant in Japan that was damaged by the

earthquake

• GDP growth does not equal wealth; while GDP may indeed be higher than they otherwise would

be in the aftermath of the earthquake, we have to remember that $250 BB in productive capital

stock was destroyed

• There will be an ongoing social and economic toll from the earthquake as Japan faces decades of

nuclear cleanup and earthquake fears. Ask yourself this, will you have second thoughts about

visiting Japan? Will you still eat sushi if the fish was caught in the waters of Western Japan,

knowing that radioactive wastewater was dumped into the sea7? Will people avoid doing

business in Tokyo due to its proximity to Fukushima?

Beware Peddlers Of Black Swan Insurance

Given the events of 2008, the recent MENA (Middle East and North Africa) social unrest and the

Japanese earthquake, there has been a plethora of investment banks and hedge funds offering investors

hedges for ‘tail-risk’ events8. These were the same investment banks offering investors ‘AAA’

5 Bloomberg, retrieved Monday April 4, 2011, http://www.bloomberg.com/news/2011-04-01/china-s-smaller-

cities-lead-home-prices-higher-defying-curbs.html 6 World Bank, retrieved Monday, April 4, 2011,

http://siteresources.worldbank.org/DATASTATISTICS/Resources/eap_wdi.pdf 7 Japan Times, retrieved Tuesday, April 5, 2011, http://search.japantimes.co.jp/cgi-bin/nn20110406a1.html

8 The Economist, retrieved Monday, April 4, 2011,

http://www.economist.com/node/18443412?story_id=18443412



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investments in Collateralized Debt Obligations that turned out to be worth 10 cents on the dollar; the

same banks that sold interest rate swaps to municipalities and governments resulting in millions in

losses9. Simply put, we think investors should perform their due diligence before buying these so-called

‘Black Swan Insurance’ products. They should make sure they understand the risks they are taking and

the cost of the insurance. There is no free lunch; if it sounds too good to be true, it probably is.

Our preferred insurance against ‘tail-risk’ is margin-of-safety and not some exotic option or derivatives

that may or may not pay off in the event of a ‘Black Swan’ sighting. For example, a common strategy to

hedge tail risk is to buy out of the money options that normally expire worthless but in the event of a

‘Black Swan’, will pay off several times over. But what underlying security should be used? If your

answer is an equity index, it would not have protected you from the historic move of the Japanese Yen

on March 17.

Figure 1: On March 17, the Yen whip-sawed up 4 percent and closed down 2 percent versus the USD.

Source: Financial Times, http://av.r.ftdata.co.uk/files/2011/04/JPY.png

Being Paid To Wait

We wrote about Becker Milk Company (BEK.B-TSX; we own the Class B non-voting shares) in our blog on

March 8, but we believe it is worthwhile to re-post what we wrote given it is a neat little investment

idea for small investors who have patience and do not mind illiquidity.

9 Wall Street Journal, retrieved Tuesday, April 5, 2011,

http://online.wsj.com/article/SB10001424052748704355304576214900864332050.html



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On the surface, BEK does not seem like a very interesting company. The company recently announced 9

month revenues of $3.0 MM and earnings of $0.58 per share. This financial result annualizes to $4.0

MM in revenues and $0.77 in earnings. At a bit less than $11.00, the shares are trading at approximately

14x annualized earnings. So where is the value?

To figure out the value of Becker Milk Co., we need to take a trip down memory lane. The Becker Milk

Co. was founded in 1957 by Dr. Geoffrey Pottow (President & CEO) and operated a chain of convenience

stores with its own dairy production facilities until 1996, when the operating business was sold to

Silcorp. Silcorp itself was acquired by Alimentation Couche-Tard (ATD.B-TSX) in 1999. Since 1996, the

Company has downsized most of its operating staff (BEK only has 5 full and part-time employees in

2010) and the Company effectively operates as a real estate investment company with a portfolio of 69

retail commercial properties. One property is in Toronto while the rest are dispersed in Southern

Ontario. Mac's (a subsidiary of Alimentation Couche-Tard) is BEK's largest lessee, with approximately

80% of BEK's rental income coming from Mac's. The company also has 4 parcels of undeveloped land

and 2 unoccupied buildings.

What attracted us to BEK was this legacy real estate. For a portfolio of retail commercial real estate that

generates $4 MM in annual rental income, the book value of the portfolio is carried at just $12.7 MM.

The reason this real estate has such a low book value (and the reason BEK has become an orphaned

company with little investor following, in our opinion), is because this portfolio of real estate was

acquired over the decades at significantly lower valuations than current market value. To put the value

of this real estate in perspective, applying a market cap rate (used to value commercial real estate) of 8 -

10% on this portfolio implies that the real estate is worth between $40 - $50 MM or $22 - $28 per share!

Moreover, the Company itself is debt-free and has $2 MM in cash. Altogether, we estimate the

Company has an intrinsic value of $24 to $30 per share.

The analysis above sounds great, but what's the catch? The catch is that insiders (Dr. Pottow and his

associates) hold 540 thousand of the 640 thousand outstanding voting shares. An investor in the Class B

non-voting shares participates in earnings and dividend but has no say on the future of the business.

However, we believe one upcoming catalyst is the age of Dr. Pottow and his associates. Although Dr.

Pottow's age is not disclosed in the Company's filings, we deduce he is well above 75 (Company was

started 54 years ago after he received a PhD) and may be contemplating selling the business. In fact, the

Company did put itself up for sale in 2008 by hiring TD Securities, but no deal was consummated due to

the credit crisis. With an economy on firmer footing, we believe it will not be long until BEK once again

explore opportunities to sell its real estate portfolio and realizes the hidden value of its assets.

In the meantime, investors get a 5.5% dividend yield (semi-annual dividend of $0.30 that has been paid

since 1999) and the possibility of sizeable special dividends every few years ($1.75 in 2004 and $2.30 in

2009). If we assume that a special dividend of $2.00 will be paid every 5 years, or an average of $0.40

per year, then the dividend yield on BEK is closer to 9%. Essentially, investors are paid to wait for the

eventual realization of full value of BEK's real estate portfolio (unless Dr. Pottow pulls a Frank Stronach

and demands a significant premium for his voting shares - a real possibility!). We therefore believe

BEK.B should definitely be on the radar screen of any value investor.



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Portfolio update

Figure 2: Portfolio weighting at the end of Q1.

Q1 was not a good quarter for your analyst. While the TSX and S&P500 both gained over 5% in local

currency terms, our portfolio was flat with only a 0.2% gain. We can point to several reasons for our

underperformance:

• First, the biggest contributor to our underperformance in Q1 was our unwise investment in Ram

Power (RPG-TSX, please see our prior month’s letter for the rationale behind our investment).

Recently, the Company released its fiscal 2010 results and forward guidance on capital

expenditures and project developments. Needless to say, it was a disappointing update, with

further delays and extra costs at San Jacinto. It is now impossible to rule out a further equity

raise in the near future. We are in the process of re-evaluating our estimate of the Company’s

NAV, but we suspect there would not be enough margin-of-safety for us to hold this investment.

To date, RPG was a 1% negative hit to our portfolio.

• Another factor was the continued depreciation of USD relative to CAD. Approximately 20% of

our portfolio is held in USD and with 3% depreciation in the quarter, our portfolio lost

approximately 60 bps.

• We also underperformed with our Financials over Industrials pick, Natural Gas over Oil pick and

Staples over Cyclicals pick. We continue to believe our picks will work out in the long-term.

Cash

30.2%

Cons. Staple

14.1%

Energy

9.9%

Financial

13.4%

Industrial

7.5%

Materials

0.0%

Media &

Telecom

3.3% Mining

11.7%

Technology

0.0%

Utilities

0.0%

Cons. Disc.

8.9%

Materials &

Agriculture

1.0%



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Disclaimer: Our goal through this blog is to provide analysis and ideas that you, the reader, might find useful in forming your

own investment decisions and hopefully improve our analytical skills in the process. We are not soliciting for the management

of your investments nor seeking to provide financial advice. The Aspiring Analyst blog and letters will not take responsibility for

any investment losses incurred by readers through the trading of securities and strategies mentioned in this blog or its

accompanying letters. The views expressed in this blog and its accompanying letters reflect the author(s) personal views about

the subject company(ies) and its (their) securities. The author(s) certify that they have not been, and will not be receiving direct

or indirect compensation in exchange for expressing the specific recommendation(s). Readers are cautioned to seek financial

advice from qualified persons such as a Certified Financial Planner prior to taking any action in regards to the securities and

strategies mentioned in this blog or its accompanying letters.

Documents

TAA Vol. 1 Iss. 4 - 64 Million and Counting