Portfolio manager’s Letter September 2001
The mating dance blossoms, Hewlett Packard beckons. Compaq wiggles her whatever. No one knows now whether this will be a marriage made in heaven, or end up in that much larger category that Buffett says are done mainly for ego gratification. Is this just another case of corporate lust and cute assets or are their solid business reasons for this kind of combination? You will forgive me, if I choose to remain a skeptical.
Deswell Industries
Last week I was reading the 20 F (Annual Report for Foreign issuer) of Deswell Industries. Deswell is a small company incorporated in the British Virgin Islands with operating subsidiaries headquartered in Hong Kong, and all of its production facilities in located Mainland China. The Company is an independent manufacturer of injection – molded plastic parts for OEM’s, and a contract manufacturer of electronic products and subassemblies.
The Annual report contained what, perhaps, was a nice little insight into the future. A future that for me contains many huge questions for large American producers of goods, and particularly tech goods.
Tidbits:
- In 2001 Deswell paid $315,000 income tax on taxable income of $13,431,000, and effect tax rate of 2.3%. (The company is exempted from income tax on profits if the money is reinvested in China.)
- The Companies payroll tax rate is 1.3% of total payroll in China, Versus 13.6%of payroll in the United States.
- All Plant machinery, furniture, fixtures; and equipment can be depreciated in 4 or 5 years. (Fast depreciation lowers taxable income but does not effect cash flow.)
- Hong Kong does not Tax dividends paid by corporations.
- The British Virgin Islands exempts foreign nationals from income tax and capital gains tax. (U. S. Citizens are still required to pay IRS for a income from foreign investment income.)
- The Company leases manufacturing space from local governments in China for about $2.50 per square foot per year. An Example is a building the company leases in Shenzhen China, lease cost = $759,600 per year. Approximate cost for same area of manufacturing space in United States 3,000, 000 – $4,000,000.
These factors have helped Deswell to a 24% return on equity, even though 50% of that equity is currently being held in cash. The company has no debt, and sales increased 33% in the year ended March 31, and 14% the year before. It is selling at 7 times last year’s earnings. Here is an example of what American Tech stocks are going to have to deal with as they struggle to recover from their current recession.
Sequoia’s View
The following is a quote from The Sequoia Fund’s semi annual report. Included in that report was the following quote.
“We are always on the lookout for factors in the economic landscape which may be changing in ways that will impact corporate prospects and profitability, and, therefore, stock values. One issue with immediate consequences for American business and our social fabric is the rising cost trend in health care. Medical costs, as reported by large managed health care and indemnity insurers, are increasing at very high single digit or low double digit rates …
The Wall Street Journal notes that “employee benefit managers across the country report that they have been getting higher-than-expected premium rate increases for next year from various health plans. Some HMOs are asking for increases in excess of 20%.”
A number of companies have recently cited rising health care costs as a source of earnings pressure. With almost all of American industry having zero pricing power in the current environment, if this trend does not abate materially, it will exert noticeable downward pressure on corporate profit margins …
Another issue, the consequences of which may take more time to become apparent, is the threat to American manufacturing posed by the increase in low cost, high quality Chinese manufacturing. One of our companies, Ethan Allen, recently announced a joint venture with a Chinese manufacturer, Markor, under which Markor will manufacture furniture for Ethan …
A second Sequoia-owned company has told us that the very high quality American-sourced product it has been buying from another of our portfolio companies is now very close to being matched in quality at a much lower price by a Chinese company.
China possesses a potent combination of highly educated and skilled engineers; an endless supply of very low paid workers, a huge domestic market for some goods and services and a large potential market for others, an entrepreneurial culture and a strong work ethic. In addition, its legal system offers little protection for patents and copyrights.
The cumulative effect of the cost structure that is driving Deswell and other similar companies is a huge moat. Cheap labor, low taxes, low medical costs create a sustainable competitive advantage. This is a moat with lots of crocodile’s poisonous snakes and a few man-eating sharks. The tech bubble created a temporary draw bridge presently populated by American and European dinosaurs, but someone has pushed the button that will collapse the bridge and the creatures below are now waited for lunch.
Obviously, the impact on American companies will vary greatly from company to company, depending how management deals with the above issues, Some business will be able to out-source production quickly to low cost regions of he world. On the other hand Gateway’s reaction to competition in Asia was to leave. Their answer to the above problem is the “Ostrich Solution” (If you do not like what you see, stick your head in the sand.)
The Companies with the most difficulty are likely to be the largest. The more Capital you have invested in plant and equipment in high cost regions the harder it will be to shift production to low cost areas. Write-offs of capacity that is not cost effective will penalize current earnings and make management reluctant to deal with competitive reality. The recent Tech Bubble is likely to make matters a good deal worse. The bubble provided a lot of cheap money for the expansion of productive capacity in an environment were cost structure did not seem particularly important.
A typical response to this environment will likely see small producers out-source rapidly to steal market share from the dinosaurs. Large Producers profits will suffer a double whammy from this loss of market share and the write-offs as they are forced to abandon the stuff they built during the bubble.
Berkshire Hathaway
In further support of my argument, Ladies and gentlemen of the jury, I offer the example of Berkshire Hathaway. Berkshire Hathaway caught the trend of the nineties before it was obvious to anyone. In the late Eighties Warren was busy buying into the great international brands. What is he buying now? Businesses that are largely exempt from the dinosaur problems:
- How many bricks, or how much wallboard or carpet can you get on a 747?
- How many people are going to travel to Peking to buy furniture for their new home in Peoria, or an engagement ring?
- We will probably not buy a lot of our electricity in China.
Actually, it is not just China, there are other areas in Asia with many of the same advantages that china now offers. Because of its geographic proximity Japan is the first High tax economy that has had to deal with these problems and you can see how much fun it has been for them. Having spent time in Moscow I would say that Russia is not as far behind as most people think.
While statutory tax rates there where high, compliance was close to zero, so the effective rate has always been quite low. Now Putin has lowered the statutory rates to a level much closer to the effective rate. The Russian population is probably better educated than China and equally motivated.
Market Comment
As I was preparing to mail this letter the World Trade Center was destroyed. At this point it is impossible to predict the impact when the market finally does reopen, but here are a few random thoughts.
September 13, 2001 From The Orlando Sentinel
“Economists were preparing to lower growth forecasts of the end of the year and early next year with the expectation that consumers would hesitate to spend money following the shock of the attacks in New York and Washington.”
For the last two days I have listened to a steady harangue of economic gibberish spun out of the television by a stream market commentators, college professors and financial “experts”. These commentators seem to think that our Economy’s reaction to Tuesday’s horror will be to descend like the trade-center buildings into a pile of rubble. This is a nice metaphor, but I doubt it.
Before this weeks nightmare our economy was on the verge of what might have become a minor recession. To project that this attack will intensify this trend, (while it may perhaps reflect the hopes of our enemies) is a conclusion based on a misunderstanding of the character of the American People and disregard of economic history.
My guess that six months from now recession will be a word that has disappeared from our vocabulary. The economy will not be based on what was going on last week or what is to happen next week. It will be a product of this Nation’s response to the threat that confronts us.
Make no mistake we are at war. My guess is that the scale of our Country’s response to this attack will be a great surprise to our enemies, and appears now to our own economists. Spending on the gulf war had a minimal impact on the economy for two reasons: 1. It was very short and the US was able to get large cash contributions from our allies.
It is my belief that things could be a lot different this time around. The Gulf enjoyed only limited public support. I do not think that will be the case now. In the gulf we fought about oil. This war is about our way of life and in that way is more like World War II. In addition because of the nature of the Enemy it seems likely to a much longer conflict.
In no way do I mean to ignore the human cost of this struggle, but that is a subject for a different letter. Addressing only the economic cost of the approaching conflict, it could be enormous. While it is much to early for even a serious guess. Our Experience in the gulf War would suggest that within a month or two the Government will be spending enough money on the war effort that a drop in consumer spending would not be a problem. If the conflict becomes prolonged the like World War II and Vietnam the biggest economic problem will become inflation, and the government will start ask the consumer to please stop spending so much.
As far as the stock market is concerned I see a market that is heavily oversold, I would guess that there are many hedge funds with large short positions. The figures show that for the last 12 – 15 months the public has been pouring money into money market funds and CDs. In to this mix for the last two days the Fed and the European central bank have pouring cash.
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