Why Institutional Money Is Often Dumb Money

Submitted by Asia Confidential on 10/12/2013 12:30

I must admit to having a serious neck strain from the continuous shaking of my head since the proposed appointment of Janet Yellen as Federal Reserve chief mid-week. It wasn't the appointment itself, which came as no surprise. Instead, it was the investor reaction to it. Investors overwhelmingly endorsed the announcement, suggesting it would represent a continuation of the Ben Bernanke policies which had steered the U.S. toward recovery. The problem with this is in the definition of "recovery" for this is the slowest upturn from any economic slowdown in the U.S. since World War Two. If it's a sub-par recovery then surely, as a matter of simple logic, Bernanke's policies haven't been so successful. But try telling that to the investors who prefer to believe in mythology rather than facts. I suspect it's because Bernanke has been good for stocks and good for them, more so than the economy.

Anyhow, it got me thinking about how institutional money, and the groupthink accompanying it, often represents dumb money. And by institutions, I not only refer to institutional investors but publicly-listed companies which aren't run by owner-operators (those with a significant amount of their wealth invested in the company). These institutions are often rewarded by short-term performance (less than three months for many investors and less than one year for listed companies). Inevitably, this leads to a herd-like mentality and silly decision-making: chasing the latest "hot" trend, acquiring companies at exorbitant prices in the name of a short-term earnings boost, buying back shares to lift near-term earnings per share and manager pay packets and so on. Unsurprisingly, under-performance is a regular result.

Which leads me to several large merger and acquisition (M&A) deals happening in Hong Kong. Previously I've talked of how a number of Hong Kong billionaires were IPO'ing property assets and that was a clear warning signal for investors in this sector. Now, Asia's richest man Li Ka-Shing is offloading many Hong Kong assets in order to raise cash to buy beaten-down European companies. And two of Hong Kong's four family-owned banks are selling their businesses.

It's clear that large Hong Kong insiders are madly bailing out as they see elevated valuations combined with dimming prospects for growth in the territory. And guess who the likely buyers are? Institutions/institutional investors, of course. These guys obviously know something about Hong Kong and the assets up for sale which Li Ka-Shing and his ilk don't!

Today, Asia Confidential is going to look at the M&A deals in more detail, why institutions feel compelled to participate and the key takeaways for individual investors.

Hong Kong insiders madly selling

Li Ka-Shing isn't dubbed "superman" for nothing. He's not only proved a canny businessman but is still going strong at the ripe old age of 85.

Born in China, Li's reputed to have gone to Hong Kong as a refugee. Because of his father's death, Li left school at the age of 15 to work at a plastics trading company. And he saved up enough money to start his own plastics manufacturing firm. He diversified into real estate development and eventually listed a company, Cheung Kong Holdings, in Hong Kong in 1972.

The deal which put him on the map though was the takeover of Hutchison Whampoa in 1979 from HSBC. The purchase created a mammoth conglomerate with interests across Hong Kong and the world, including ports, electricity, retail and property development.

Today, Li is Asia's richest man and the world's 8th wealthiest, worth close to US$31 billion. He's the world's largest operator of container terminals, among other things.

The picture below is a famous wax statue of Li in Hong Kong.

The big news of late is that Li is looking to sell a slew of prized Hong Kong and Chinese assets, including:

• Spinning off and listing pharmacy chain A.S. Watson for around US$10 billion, assuming a 25% free float and total value of US$40 billion. Watson's shares a duopoly with Mannings in the pharmacy market in Hong Kong.
• Selling Hong Kong supermarket operator ParknShop for around US$3.9 billion. ParknShop has a duopoly with Wellcome in the territory's supermarkets.
• Spinning off Hong Kong electricity operator Hongkong Electric to raise US$4.9 billion. Hongkong Electric is one of the territory's two main electricity generators.
• Office buildings in China - Guangzhou, Shanghai and Shenzhen - are also up for sale.

These asset sales are aimed at raising cash in order to buy beaten-down telecommunications businesses in Europe. Since 2011, Li has taken advantage of the European crisis to buy four telecommunications companies there for US$4 billion in total. And he's looking to do more.

He isn't the only one offloading Hong Kong assets though. Two family-owned Hong Kong banks Wing Hang Bank and Chong Hing Bank have put themselves up for sale. The former has a market value of close to US$4.5 billion while the latter's at US$1.85 billion.

Also, several large Hong Kong property companies are selling down assets, including:

• New World Development is looking at a US$1 billion IPO of some of its hotels.
• Great Eagle Holdings listed its hotel arm, Langham Hotel Trust, in a US$549 million IPO in Hong Kong in late May.
• Hopewell Holdings pulled a US$780 million IPO of its Hong Kong property arm in June due to market volatility at that time. It's likely to pull the trigger on this soon.

Reasons behind it

The obvious question is: why are a who's who of Hong Kong's wealthiest selling out now? Well, Li Ka-Shing has alluded to some of the likely reasons behind the sales. This year, he's warned residential property investors in Hong Kong not to expect too much of future returns given the government's determination to stabilise prices. This followed a half a dozen measures from the Hong Kong government to slow the pace of property price growth.

Li's also been remarkably candid about the potential threat from the Shanghai free trade zone to Hong Kong. The zone may allow freer yuan convertibility, liberalisation of interest rates and relaxation of restrictions on foreign investment.

Li says the development will "impact Hong Kong heavily" and the territory needs to raise its competitiveness to ensure that it doesn't lose out.

You can probably add a few other reasons for Hong Kong insiders selling out. The potential for U.S. tapering of stimulus is an obvious threat to Hong Kong. Hong Kong has been the one of the biggest beneficiaries from U.S. quantitative easing and low interest rates. Yield hungry investors in the West have flooded into growth markets such as Hong Kong, and catapulted property and other asset markets. For instance, residential property in Hong Kong is now the world's most expensive per square foot and yields barely above 3%. All of this could sharply reverse if tapering occurs.

Also, there's the threat from a further slowdown in China and the impact that it would have on Hong Kong. Hong Kong has not only been the beneficiary of U.S. stimulus but Chinese stimulus too. As the credit bubble in China unwinds, the resultant impact on the territory may be serious. And not to mention that the Chinese have been key buyers of Hong Kong property, retail, tourism-related ventures, healthcare and so on.

Finally, rising asset valuations are likely playing a part in the decisions to sell. For instance, the sale of Wing Hang Bank may fetch up to 3x book value (net asset value). That's despite the bank only achieving a 2012 return of equity (ROE) of 9.9%. In simple terms, that gives a prospective buyer a theoretical potential return of about 3.3% p.a. (9.9% ROE divided by 3x book). Given this, I'd be a seller too...

Why institutions are buying

The question then becomes: which institutions may be buying these assets and why would they be purchasing them? Three companies are reportedly in contention to buy ParknShop: China Resources Enterprise, Japan's Aeon and Australia's Woolworths. For Wing Hang Bank, Australia's ANZ is thought to be a frontrunner. And for Chong Hing Bank, Chinese conglomerate Yue Xiu Group is in line to buy it.

The potential buyers have several things in common:

1. All of them are not run by owner-operators. That is, they're not run by people with substantial proportions of their own wealth invested in the companies. This means the CEOs are likely to take risks that owner-operators wouldn't because they have less to lose.
2. Almost all of them are publicly-listed. Yue Xiu isn't listed but subsidiaries are. It means most of these companies are under shareholder pressure to perform in the short-term. M&A is often perceived as an easy way to boost earnings (not returns) and improve share prices.
3. A number of the companies are growth-starved and are desperately looking for a growth angle to excite investors. And let's face it, Hong Kong and China are still some of the sexiest growth stories going around, at least in the eyes of many institutions.

As for the spin-offs of A.S. Watson and Hongkong Electric, institutional investors will be the backbone of coming IPOs. Many of these investors are also not run by owner-operators. They're also subject to the same short-term performance pressures as listed companies, if not more so. The vast majority of institutional investors are judged on performance month to month and they know they're jobs are on the line if they underperform.

As you can imagine, that doesn't make for sensible, long-term decision-making. But it goes a long way to explaining why institutional investors are likely participants in the Hong Kong IPOs. They'll be looking for a short-term spike in share prices post-IPO before they cut their holdings or exit altogether. Anything to boost near-term performance...

Key takeaways for individual investors

From the above, here are some of the key lessons for individual investors:

1. Institutions move in herds and often represent dumb money. Avoid blindly following them. In fact, moving in the opposite direction can pay dividends.
2. Don't get sucked into hot investment trends like many institutions do. Institutions have to chase short-term performance and are prone to jumping on the next sexy theme, to their detriment. As an individual investor, you don't have the same short-term performance pressures and that gives you an enormous advantage over institutions. Use it.
3. In the end, price is what matters. Institutions often ignore this; you shouldn't.
4. Be a minority or majority shareholder in owner-operated companies or assets which may be sold to the schmucks known as institutions. This is how you can make serious money. Just ask the shareholders of the family-owned banks which are being sold in Hong Kong.