China Inflation Thoughts

Interesting article in the WSJ today about growing inflationary pressures in China. Inflation has been accelerating in the country, rising above 5% despite the government's efforts to slow price increases. The one-year lending rate now stands around 5.8% and the government has repeatedly increased the reserve requirements for banks in an effort to slow growth. Stoking inflation is rising commodity prices, which the country imports in large quantities, and an effort to raise wages to spur domestic consumption. The minimum wage in Beijing increased 21% last month after a 20% increase in June.  The government is also resorting to price controls in order to offset rising prices however, this action hurts producers exposed to rising costs.

My takeaway is that pressure continues to build to allow the yuan to increase relative to the dollar, which will eventually be loosened. The government worries about "hot money" rushing into the country in anticipation of a rising yuan, but the longer they delay the more pressure is likely to build. The question becomes whether this ends happily with Chinese inflation abating while the economy continues to grow, or badly with hot money over-heating the economy before a spectacular crash that likely takes down the world economy. In my opinion, they would be smarter to start chipping away at the obvious imbalance now before it overwhelms their ability to cope with it.

Under my sagflation theme, I argue that price bubbles are likely to occur due to the U.S. government's aggressive monetary policies. Since the Chinese are keeping the yuan artificially low relative to the dollar, they are in essence importing our expansionary monetary policies. It is a little scary to think an entire country the size of China could become a bubble, but I believe that is likely what will happen over the next year. How to play this bubble is going to be challenging since the Chinese government could allow the yuan to rise, increase interest rates, or some other centrally controlled effort to tamp down prices. So far, I'm betting the government lets the good times roll any way possible, which means encouraging domestic consumption and trying to actively manage prices through controls. These policies should make my investments in CHOP and EDS perform well, but when to get off the train will be a critical decision.

December Performance - Up 8.5%

For December the balance increased 8.5%, after all fees and dividends received. The performance exceeded the increase in the SP 500, which increased 6.5%. By the end of the month I moved to a more conservative portfolio with almost 30% in cash. For the quarter the value of my IRA increased 13.4% relative to the 10.3% increase in the SP 500.

The largest position remains the inverse 20+ year Treasury ETF (ticker TBT) at 14%. Commodities also account for a significant portion of the portfolio, with the agricultural market basket (ticker DBA) at over 11% and palladium (ticker PALL) growing to 6%. The geographic positions each account for over 4%, with Matthews China Fund (ticker MCHFX) at 9%, Chile (ticker ECH) at just under 5%, and Hong Kong (ticker EWH) at just over 4%. For individual stocks the largest position is Citigroup (ticker C) at just over 4%. The weightings highlight an on-going belief that debt costs likely continue to rise in the U.S., benefiting banks, and commodities and inexpensive manufacturing likely outperform the market, in general.

Every position but two increased during the month, highlighting the breadth of the market rally during the month. GT Solar (ticker SOLR) bounced back after a weak November, increasing 33% up until I sold the position on December 22. American Axle and Manufacturing (ticker AXL) and MKSI Instruments (ticker MKSI) both increased almost 20%.

My positions focused on China underperformed during the month, which I believe is largely due to concerns about a rising interest rate environment. While a short-term concern, I remain confident these positions should perform well due to healthy trends in the Chinese economy and increasing pressure to allow further appreciation in the yuan relative to the dollar.

After such a strong run in December and spotty U.S. economic indicators (notably housing and unemployment causing concern), I expect somewhat of a pullback in the market in the first half of January. I plan to use this anticipated pullback to re-enter positions at more attractive prices.

		31-Dec	Dec.
Name	Ticker	% Portfolio	Chg
RF MICRO DEVICES INC	RFMD	0.0%	11.3%
KULICKE and SOFFA INDS INC	KLIC	0.0%	12.1%
HUNTSMAN CORP	HUN	0.0%	1.3%
FREEPORT MCMORAN COPPER and GOLD INC.	FCX	0.0%	15.9%
GT SOLAR INTL INC COM	SOLR	0.0%	33.3%
DUOYUAN GLOBAL WATER INC SPONS ADR	DGW	1.4%	2.1%
JEFFERIES GROUP INC NEW	JEF	2.9%	10.3%
CA INC COM	CA	1.8%	6.8%
LYONDELLBASELL INDUSTRIES N V COM CLASS A	LYB	2.6%	17.8%
CHINA GERUI ADVANCED MATERIALS	CHOP	3.5%	5.4%
PERKINELMER INC	PKI	1.9%	10.8%
AMERICAN AXLE and MFTING	AXL	0.0%	19.5%
CITIGROUP	C	4.3%	7.7%
EXCEED COMPANY	EDS	3.1%	(7.8)%
MKS INSTRUMENTS	MKSI	2.8%	20.3%
MULTI SECTOR COMMODITY TR PWR DB AGR	DBA	9.7%	11.2%
ETFS PALLADIUM TR SH BEN INT	PALL	6.0%	14.5%
PROSHARES ULTRASHRT LEH BROS 20+ YR TREAS	TBT	13.9%	6.5%
ISHARES INC MCSI CHILE INVESTABLE MKT INDEX	ECH	4.5%	3.9%
ISHARES INC MSCI HONG KONG INDEX FD	EWH	4.3%	0.2%
MATTHEWS CHINA FUND	MCHFX	9.0%	(2.1)%

Established ~3% Position Exceed Company (Ticker EDS)

Established a ~3% position in Exceed Company Ltd, ticker EDS, at $8.95.

Purchased the position for the following reasons:
(1) Exposure to growing middle and upper class young Chinese who are enjoying rising incomes and increasing interest in living healthy.
(2) Strong 2011 sales fair with a 25% y/y increase in wholesale order values relative to 2010. "One of the strongest growth rates in the industry."
(3) Exceed has been aggressively opening new stores, increasing the number of units by 15% over the past year.
(4) Rising prices for footwear and apparel improving gross margins with management's expectations of continuing to expand margins through economies of scale.
(5) Expansion of apparel and footwear product lines increasing interest from consumers. This expansion is backed by an aggressive marketing campaign around a "happy lifestyle," with a popular Taiwan music group - By2.
(6) $95 million net cash on balance sheet (over $3 per share),  with healthy CFO of $19 million last quarter.
(7) EDS is trading at 4x the C11 consensus estimate, which includes only one estimate for an under-followed stock.

Concerns:
(1) Low visibility into demand trends, business and reporting is not up to U.S. standards.
(2) Currency and country risk.

This is an investment considered quite high risk, but the cash on the balance sheet and low P/E makes the rick-reward tolerable, in my view.
 

Company Description
Exceed Company Ltd. (Exceed) designs, develops and wholesales footwear, apparel and accessories under the Xidelong brand name. It has three principal categories of products: footwear, which mainly comprises running, leisure, basketball, skateboarding, canvas, tennis and outdoor footwear; apparel, which comprises of sports tops, pants, jackets, track suits and coats, and accessories, which comprises of bags, socks, hats and caps. In October 2009, Exceed Company Ltd. announced the completion of the acquisition of Windrace International Company Limited. The Company sells the products mainly through the Xidelong retail stores. Exceed’s 22 distributors own and operate all Xidelong retail stores. As of December 31, 2009, there were 3,694 Xidelong retail stores, of which 1,000 were operated directly by distributors and the remaining were operated indirectly through authorized third party retail store operators.