A New Theory for the Residential Property Asset Class

Globalization has deepened complexity and allowed seamless investment across the world. This has enabled investors to diversify into ever more asset classes. Our focus here is on the residential property asset sub-class. Typical avenues of investment into property are:

·         Direct investment into commercial property;

·         Direct investment into residential property;

·         Investment in property ETF or listed property company via purchasing shares;

·         Investment in a real estate investment trust.

Property as an entire asset class has historically delivered risks and rewards halfway between equities and bonds. Its benefits include its ability to keep pace with inflation and its usefulness in a portfolio of investments as global property returns have demonstrated a moderately low correlation to North-American and European equities. Its drawbacks are that the asset class is susceptible to bubbles and property can be illiquid.

It is the residential property asset sub-class which we are focused on as it has historically been the most lucrative of the sub-classes. It is not only the largest property asset sub-class, but also the largest out of all investment asset classes, with residential property just in the UK worth over GBP4 trillion. Its benefits include:

·         On a risk-adjusted basis, residential property has outperformed all other assets over the long-term, with a 10-year average weighted return of 10.6%;

·         More liquid than commercial property;

·         Good to be used in diversification strategy as it has low correlation with commercial property (0.70), bonds (0.04) and equities (0.09), as measured by the Pearson product-moment correlation coefficient over the past 40 years;

·         Residential property has the lowest volatility of all asset classes over the long-term;

·         It can be used as a hedge against inflation, partly due to the ability of landlords to adjust rent upwards and partly due to the uptrend of property valuations over time;

·         Depending on the area and type of property, there are chronic supply/demand imbalances;

·         Residential property has intrinsic value through being a tangible investment;

·         Favourable tax treatment of residential property and debt finance has also made it attractive.

However there are some drawbacks to investment in the residential property sub-class:

·         Low liquidity if compared with bond or equities markets trading;

·         High transaction costs and cumbersome settlement and clearing process compared to stocks or bonds as residential property transactions generally require exchanges of physical documents prepared by lawyers;

·         Lack of pricing transparency as most price information comes from prior transactions that may be weeks or months old by the time they are published;

·         Asymmetric price movements as historically residential property prices tend to move up more readily than down (pricing stickiness). This is due to the tendency for sellers who don’t receive offers in their desired price range to resist selling;

·         Significant holding costs of residential property including maintenance expenses and property taxes;

·         Rents are outstripping average incomes, which is sustainable short-term but will be a constraint in the long-run.

More recently within the residential property sub-class, I believe we can discern more distinctions between certain types. This is supported by the difference in price increases between the various market segments – for example prime London property prices have increased 53% since Q1 2009 and 10% just since Q1 2012, whereas comfortable property prices have increased 15% since Q1 2009 and 7% just since Q1 2012. There are several factors propelling this divergence of residential property:

·         The market is now global;

·         Investors hunting for yield have turned to residential property as an inflation-matching income;

·         The wealthy have increased their share of the world’s wealth whilst the middle-class (associated with comfortable and affordable property) have suffered a decrease in their share over the past five years;

·         The advent of larger knowledge economies have continued to consolidate and create more global financial and business hubs.

This divergence can be extrapolated onto the below matrix:

Residential Property Demand Elasticity Matrix

	Super-Prime	Prime	Comfortable	Affordable	Low-Cost
Global City	Perfectly Inelastic demand	Perfectly Inelastic demand	Inelastic demand	Inelastic demand	Elastic demand
Transnational City	Perfectly Inelastic demand	Inelastic demand	Inelastic demand	Elastic demand	Elastic demand
Developing Global City	Inelastic demand	Inelastic demand	Elastic demand	Elastic demand	Elastic demand
Developing Transnational City	Inelastic demand	Elastic demand	Elastic demand	Elastic demand	Elastic demand
National City	Elastic demand	Elastic demand	Elastic demand	Elastic demand	Elastic demand

Looking vertically, city allocation is based on the total capital flows through a city, as the assumption used is that the more international the city the larger amounts of capital that will pass through. However there are many exceptions, such as the Channel Islands, Cayman Islands, Luxembourg, and many more which would feature as global cities if solely based on total capital flows. Therefore, city allocation is a function of total capital flows + population size. The rise of the knowledge economy renders population size for cities an important factor as a greater population can (hopefully) provide a greater number of highly skilled knowledge workers. So for instance:

·         Global City – London, Hong Kong, New York, Tokyo, Zurich, Amsterdam

·         Transnational City – Beijing, Frankfurt, Mexico City, Chicago, Boston

·         Developing Global City – Paris, Shanghai, Moscow, Mumbai, Sao Paolo, Dubai

·         Developing Transnational City – Lagos, Istanbul, Buenos Aires, Jakarta

·         National City – Chongqing, Calcutta, Bogota, Dhaka

Meanwhile looking horizontally, Super-Prime property is property valued at or over US$10 million, Prime property is property valued at US$2 million to US$10 million, Comfortable property is property valued between US$1 million to US$2 million, Affordable property is property valued between US$250,000 to US$1 million, and Low-cost property is property valued up to US$250,000. Low-cost property is that often associated, globally, with the lower-middle class and working classes. Conversely, the middle-classes are associated with affordable and comfortable property, whilst the upper middle-class and global 1% would be associated with prime and super-prime property.

There has been a trend over the past 50 years as a result of a growing world population against a finite supply of land. Super-prime property has increased by 2,690% since 1975 and prime property has increased by 2,580% in the same period. This trend and rising prices will continue, as demonstrated by the demand elasticity matrix.

More specifically, there are several desirable locations to invest in residential property. Using a net of gilt yields measure which compares government bond interest rates to rental growth to demonstrate a comparison of where investors may put their money, suggests there is potential for 30% growth in average New York residential capital values and 40% in Tokyo property by 2016. Moreover, it is suggested that the average price of prime London property will increase to GBP 6million by 2045, up from GBP 1.5 million currently. Rising prices will be most keenly exhibited in the global cities with their favourable legal protection, quality of life, attractive tax regimes, lifestyle, and world-class schools. Research also forecasts London’s average per capita income to grow by more than any other world city between now and 2025, from US$66,000 currently to US$95,000 by 2025, mainly due to booming financial services and increased tourism. By 2025, London will have the fourth-largest city economy in the world (US$821 billion), despite the fact that its population size will remain stagnant. Tokyo will have the largest economy of any urban city (US$1.98 billion), followed by New York and Los Angeles. The other developed city to demonstrate meaningful growth during this period would be Hong Kong, which would also benefit from its world-class financial services industry. These factors will continue to facilitate rising prices for residential property in these global cities.

Ultimately, residential property is a composite good providing many different functions to a buyer – it is an investment asset, a utility as people live in these properties, and as a Veblen good where lifestyle and luxury play a role in the decision. Perhaps the residential property demand elasticity matrix can help illuminate market movements and facilitate investment decision-making in this asset class.

The Ibis Budget of China – Home Inns

The Ibis budget hotel chain, owned by the Accor Group, consists of over 380 basic-service hotels across Europe, Indonesia and Israel. There is a Chinese competitor with a similar model that is beginning to look at overseas markets.

Basic Comforts

Enter Home Inns Group, both the largest hotel chain in China and the first budget chain within China. Founded in 2001 by Ji Qi, this hotel chain managed from Shanghai has swiftly grown to operate 1,682 hotels across 243 cities in China. Much like Ibis Budget, they focus on providing the basics – comfortable beds, free in-room wifi, air conditioning, hot water, and modern bathrooms. The company initially garnered investment from several private equity funds before financing their aggressive expansion through an IPO on the USA’s NASDAQ stock exchange in October 2006. Over the past 12 years, Home Inns have consolidated their hegemony over the domestic budget hotel market by acquiring other major budget hotel chains, including Top Star in 2007 and Motel 168 in October 2011. Home Inns Group have also ventured into the middle and upscale hotel market by launching Yitel brand of hotels in November 2010. Their strategic plan over the next five years is to continue expanding within China to ensure they are domestic tourists’ number one choice as well as selectively expanding into overseas markets.

Hoome Inns' extensive network

Not only is the company itself a good investment, it makes sense to invest within China’s travel industry. China’s hotel market is demand-polarized; this means that consumers are more interested in either the bottom (so-called Starless) market or the top luxury hotel market. There are now around 10,000 starless hotels in China, 9,000 1 & 2 & 3 star hotels, and 2,200 4 & 5 star hotels. Even more stark is the relative growth between these segments over the past 8 years: starless hotels have risen from 200 hotels to 10,000 hotels, the 1 & 2 & 3 star hotel segments have lost roughly 2,500 hotels since 2005, and the 4 & 5 star hotel segments have added around 500 new hotels over the last 8 years. This growth in starless hotels is the result of a variety of factors:

·         More hotels opting out of the China National Tourist Association stars system;

·         Construction of new properties, spurred by rising Chinese domestic income and a greater propensity for travel domestically; and

·         Chinese demand for value for money

Home Inn, Nanjing

These economy hotels roughly correspond to a 2 or 3 star hotel in quality, but have opted not to be classified as they have stripped away many of the hotel extras in order to focus on cleanliness, safety, convenience and value for money. These starless hotels tend to favour a model where they lease property or adopt a franchise model, which lowers their costs and enables them to expand their chains more rapidly.

Home Inn - Wuyi Mountain Resort

Last year starless hotels filled 80% of their rooms, compared to an occupancy ratio of 60% for star-rated hotels. Within the starless hotels segment, Home Inns is the market leader in China with 22% of the number of rooms, followed by 7 Days with 14%, Han Ting with 12%, and Jin Jiang with 8.5%. Moreover, there is still room for growth as nearly 50% of China’s cities have only one hotel and there are only 0.6 hotel rooms for every 1,000 Chinese people compared to 2.5 hotel rooms for every 1,000 American people. With the additional prospect of 221 cities with over a million residents by 2025, buy into Home Inns Group’s shares now and hold for the long-term. Their shares are at US$40.72 currently and have had a stellar performance since January when its shares were around US$24. So buy into Home Inn so that your home can be wherever you are.

All that Glitter Does Not Buoy Gold

The world gold market has undergone a fundamental shift over the past year. This year marks its official end of a 20 year bull run.

 

The last two times the gold market fundamentally shifted were when vast gold deposits were discovered in South America in the 16^th century leading to a sharp drop in gold prices, and when Richard Nixon announced the abolition of the Gold Standard in 1973 as a response to the USA running out of enough gold supply to back all the USD it was printing.

Here is the problem – the supply of gold depends on what can be mined whereas if we use gold to back the economy it needs to bear some relation to the world’s economic needs. Thomson Reuters GFMS produces an annual gold survey with their latest suggesting there is 171,300 tonnes of gold. All this gold would be valued at around US$950 billion totally. We won’t run out of gold anytime soon. Estimates suggest there are 52,000 tonnes of minable gold still in the ground and more is likely to be discovered.

This suggests that the gold price will continue its downward trend. It had been on a bull run from 2011, rising from US$260 to a peak of US$1,920 in September 2011. Since then it has steadily shed more than 30% of its value by falling to US$1,230 currently. The gold price is still well above its price if adjusted for inflation of circa US$900. With no shortage of gold supply in the near future, we would expect the gold price to converge with its price adjusted for inflation. This is a view shared by some notable funds, such as PIMCO, Third Point (run by Daniel Loeb) and Baupost Group (run by Seth Klarman), who have continually cut their gold ETF holdings.

John Paulson up to his eyes in Gold

That is not to say that the gold price won’t, in the long term, revert back to its typical use as a hedge for inflation. The solution for governments troubleshooting most economic problems is to print more money, the corollary of which is inflation. There has always been a strong link between inflation and gold, which no doubt will bring the gold price up over the long term. One of the world’s highest-profile gold proponents is hedge fund Paulson & Co, which made billions correctly predicting the 2009 US housing crash. They have accumulated large quantities of the metal since 2009 and have retained their faith despite the 30% price drop over the past year, backed by the assertion that inflation will raise gold demand.

Therefore the gold price may, historically, move in a cycle in direct correlation to the boom-bust business cycle. As the global economy booms, gold prices diverge from their inflation adjusted price. Conversely, as the global economy contracts, gold prices converge with their inflation adjusted price.

Gold used in USB Flash Drive

The one x factor that may shift the current demand and supply dynamics for gold is one of its relatively new uses. Until now, gold has never gone away but has always been recycled. 12% of the world’s current gold production is being used in the technology industry where it is used in such small quantities in each individual product that it may no longer be economical to recycle it. If this percentage should rise, beware the ramifications for long-term gold prices.

In the extreme short term, gold prices are highly sensitive to expectations of US Federal Reserve tapering. Any reduction in Federal Reserve bond purchases will sharply decrease gold. However, with Janet Yellen taking over from Ben Bernanke as head of the US Federal Reserve, she is likely to err on the side of inflation as she has a penchant for supporting the Federal Reserve stimulus plans, which will provide some short-time support for gold prices. On the other hand, easing geopolitical tensions in the Middle-East have caused demand for gold as a safe haven to decline. Meanwhile, the S&P 500 index’s 30% increase this year has incentivized investors hunting for yield to switch from other asset classes into shares. There is also debate as to whether investment demand is determining short-term gold prices or whether physical demand for jewellery, coins and bars particularly from China, India and the ASEAN nations is driving gold prices. 

The Financial Butterfly Effect

The Butterfly Effect derives from chaos theory; it holds that a small and seemingly insignificant event has the potential to cause a chain reaction of systemic proportions days or weeks later. The Butterfly Effect extrapolated onto financial markets can illustrate the unpredictable nature of risk and the interconnectivity of the world’s financial system.

Many of the economic crises that occurred throughout human history have originated from these seemingly small and unexpected events. Whilst there is an inevitable re-focusing on risk monitoring and mitigation as well as a flurry of regulation aimed at protecting against the recurrence of economic crises, standards drop after a period of time. The problem with this is that in such an interconnected global financial system, it is becoming ever more difficult to anticipate the new risk gaps that surface and the interlinkages that grow between institutions. Furthermore, the internet and greater computer literacy has rendered cybercrimes a major risk to global financial systems, just as the new Basel III regulations and the US Dodd-Frank Act requiring higher capital requirements could give rise to a high-quality collateral squeeze with US$2 trillion in collateral needed just for the first year of implementation of margin rules under the US Dodd-Frank Act alone. In tandem, the IMF has postulated that sovereign credit rating downgrades will result in a reduction in the supply of collateral by US$9 trillion by 2016.

A Financial World of Chaos

Moreover the world's interconnectivity has meant that an earthquake in Japan in March 2013 caused a 6% drop in the shares of a British luxury fashion brand Burberry. And the recent Arab Spring that swept across Egypt, Syria, Tunisia, Libya and Turkey has prompted the patriarchal Arab royal families to embrace English legal concepts such as trusts as wealth-holding structures in order to protect their assets for the next generation.

One financial butterfly effect 'saga in the making' originates from US farmland. US farmland prices have escalated over the past decade as grain prices increased and the Federal Reserve lowered interest rates to historic lows, making it easier for people and businesses to buy farmland. Yet with world grain prices falling as global output increases, US farmers are now suffering from the temperamental weather, limiting their production and diminishing their global market share. Furthermore, the prospect of the Federal Reserve ending its quantitative easing programme is already pushing up the interest rate. These trends could lead to a reversal in US farmland prices. The US Farm Credit System is a government-sponsored enterprise providing federal guarantees for bad loans – similar to Fannie Mae and Freddie Mac providing guarantees for US house prices which helped fuel the US housing boom. Now here many financial companies have exposure to US farmland and may suffer, as do investors worldwide that have poured billions of dollars into US farmland over the past several years.

Seeing the Risk and Reward

Another recent instance is the mere talk of tapering by the Federal Reserve causing financial stuttering in Asian growth markets, particularly Indonesia, Thailand and India. In India's case, its currency has plummeted to record lows despite the Indian Central Bank's recent imposition of capital controls. Meanwhile, world investors are starting to take funds out of emerging markets that they had put there in their hunt for yield and it is now finding their way into Japan's capital markets. This is strengthening the Yen, a contrast to the purported aims of Abenomics.

The global financial industry will never eliminate all risks from the marketplace, and neither should it. Risk and reward are fundamental to markets and the efficient allocation of capital. Yet, it is undeniable that the industry has to beware that the Financial Butterfly Effect means risks can develop and spread faster than ever before. Therefore, protecting against even seemingly minor risks could lead to safer markets and prevent future economic crises. 

Oil Spill Presents Opportunity: PTT

Despite the negative publicity surrounding PTT’s oil spill in the Gulf of Thailand, there are likely to be few repercussions and any damage to their share price merely provides an investment opportunity.

"Cleaning" up the Rayong Oil Spill

On the 27^th July 2013, a pipeline owned by PTT, a Thai majority state-owned oil company, burst while oil was being transferred from an undersea well to a tanker. By the next night, the oil had spilled to the famous resort town of Koh Samet resulting in the beaches’ closure and its tourists being evacuated. The oil spill has caused widespread concern about the environmental and health impact of oil operations in the Gulf of Thailand on local residents. For instance, mercury levels were reported to be 29 times safe limits and the use of dispersants have caused oil to sink to the bottom of the sea and further damage the local environment. Even people swimming in the sea have reported dizziness and there have been reports of oil operation corollaries causing cancers, kidney and liver problems. Official reports said the oil spilled was in the range of 310 billion barrels of oil (50,000 litres), yet critics say the government has downplayed the oil spill’s magnitude as well as the health risks posed from the use of chemical dispersants afterwards. In fact, other estimates from academics have put the oil spill as high as 1,200 billion barrels of oil (190,000 litres). The use of Corexit to clean the oil spill will likely increase the toxicity of oil in the sea by 52 times and can continue to have lasting health impact for many years. One of the main ingredients of Corexit is 2-Butoxyethanol which makes up 60% of the dispersant and is well-known to harm the blood, liver, kidneys and central nervous system.

Turning the CSR Pyramid on its Head

As a result of the negative publicity, PTT shares dived from around THB340 to THB310 overnight. The share price has now settled at around THB320, demonstrating that Asian investors are much less concerned about corporate social responsibility than Western investors.

For PTT and Asia it's all about the Marketplace

Therefore, it seems like a good time for an investors looking for profit to put their money into PTT. It is a share that has increased in value by 80% over the past five years and regularly pays a dividend of around 3.80%. It is also a company that has performed strongly over the past year, bar the oil spill, hitting a high of THB 368 per share in February 2013. PTT is engaged in the whole supply chain of providing oil, petrochemicals and natural gas, from exploration, production, refininery, procurement and transport to distributing through retail sales at service stations and exporting overseas. This business is especially big money in Asia where a Thai producer has advantages in selling to other Asian countries hungry for energy such as Japan, South Korea, Taiwan and China.

The Asian Energy Opportunity - LNG at the Forefront

PTT also has other long-term strengths. Their strategy is focused on long-term investments overseas whilst recent mergers have consolidated their 3 core businesses – natural gas, oil, and petrochemical and refinery businesses. This has allowed them to generate around THB5 trillion revenue per year and could push them into Fortune’s top 50 largest companies by 2018. This is partly because of recognition that PTT will have to seek new energy sources abroad to ensure the company’s continued growth as local energy sources within Thailand are limited and declining fast. In fact, over 50% of PTT’s future investments are slated for overseas with the USA particularly attractive for PTT as they are due to become a major supplier after unlocking shale gas and oil deposits. As one of the region’s major energy companies they also have a headstart on opportunities within ASEAN countries and are one of the first energy companies to start exploration in Myanmar from September 2013. Finally, they have strong financial potentially to invest in these many future opportunities with a debt-to-equity ratio of 4:10.

Asian McDonalds with an MK

Valued at THB 42.35 billion (US$1.4 billion), with 2012 revenues of THB 13.68 billion and profit of THB 1.90 billion, this Bangkok-based company engages in providing cheap quality fast Thai-style Suki, Thai-Chinese-style hotpot with fresh meats and vegetables through its MK Restaurant brand and Japanese food through its Yayoi brand. MK Restaurant Group, this Asian McDonalds upstart has just IPO’d on Thailand’s SET exchange this August in what was the country’s second largest capital raising transaction this year. Currently trading at THB46 (US$1.50), this stock is highly undervalued when compared to its potential Asian competitors such as McDonalds at US$97 and Yum! (operator of KFC and Pizza Hut) at US$68 per share.

Founded in 1989, MK operates 460 MK outlets and 95 Yayoi restaurants in Thailand with ventures in Japan (34 restaurants), Singapore (5 restaurants) and Vietnam (3 restaurants). MK also opened an outlet in Indonesia in September. They are using the IPO proceeds to build a food processing plant, additional outlets and repaying debt. More specifically, they are targeting opening 65 new branches in Thailand as well as 3 overseas within the next two years. Longer term, MK are hoping that their listing on the SET will enable them to tap into faster and lower funding from equity investors and the corporate bond market in order to facilitate their growth internationally as well as open up the possibility of expansion through acquisitions.

The Thai-Chinese Hotpot Experience

The company’s recent financial performance has been exemplary. It has achieved organic growth of 15% over the past five years and have demonstrated innovation by constantly launching pilot brands for development. The latest are Tenjin Tepanyaki, Sakata Ramen and Le Petit. With their restaurant priced at the lower end of the market, and competitively priced with McDonalds and KFC, they are both healthy competition and a good long-term investment. They are also attracting interest from Myanmar, where major local investors are keen to buy into the MK franchise potentially opening up a 60 million population market for the company.

With net profit margins of 15%, strong organic growth, the possibility of growth through acquisitions, and the popularity of its restaurants throughout South-East Asia and Japan, this is a company to watch as a major challenger to Western fast-food giants in the Asia-Pacific region, and who knows maybe the world one day. 

A Universe Apart: China Galaxy Securities

The Sleeping Giant Panda Awakes: China's Securities Industry

The fact that the world’s second biggest economy is two-fifths the size of the biggest economy but has a securities industry a fifth the size relative to its economy, the easiest conclusion to draw is that brokerage opportunities abound in China. With the US$1.4 billion IPO of China Galaxy Securities, China’s largest securities broker by sales, comes the conclusion that this is the company to invest in. Despite being one of the largest securities broker in mainland China, it has just 5% of the market, which suggests there is lots of potential in the industry. Citic and Haitong Securities are other top ten brokers in China. There are 114 brokers in total in mainland China.

China Galaxy Securities HQ

Headquartered in Beijing and founded in 2000, China Galaxy Securities is a nationwide comprehensive securities company. China Galaxy Securities is majority owned by one of China’s sovereign wealth funds, suggesting an ability to curry favour with the Chinese government – an important determinant in the success of mainland Chinese companies. It founded a Hong Kong subsidiary in 2011, China Galaxy International Financial Holdings, which aims to offer investment banking, asset management, and securities brokerage services overseas. Stock broking, part of its securities brokerage business, is Galaxy’s main business. It plans to develop other parts of the securities brokerage business, such as margin lending, using proceeds from its recent IPO, as these areas’ sales have grown 100% in 2012 due to eased regulation. Other businesses include investment banking, asset management, wealth management and proprietary trading. China Galaxy Securities hold a leading position in the country’s securities industry in terms of debt underwriting, ranking first from 2009 to 2011 and second in 2012. Their business will be helped by becoming one of the ten qualified companies to act as lead underwriters for financial debt instruments of non-financial corporations in 2012. Their other businesses are also quite established with financial advisory clients including major corporations such as China Southern Airlines, China Petroleum & Chemical Corporation, Shanxi Coal Import & Export Group, and Mittal Steel Company. Moreover as at 31^st December 2012, China Galaxy Securities had served roughly 29,000 asset management clients, invested RMB 442 million in 8 private companies with the aim of restructuring the businesses and seeking to exit through an IPO a few years down the line, and counted 190,000 High Net Worth Individuals as clients.

Millions of Yuan

However there are pressures due to the heavy competition. Average commission per trade dropped by 20% from 2010 to 2012. The make-up of the securities brokerage industry has also induced heavy competition resulting in the top 10 brokerages claiming only 40% of the market share. One consequence of this is that there is a big difference between the IPO fees pocketed by investment banks in Europe and the USA (around 7% of deal volume) compared to investment banks in Asia (just 2.5%). This points to the need for fewer players in Asia, not more. Yet there may be a danger of more players entering investment banking once regulation allows the state-owned banks (Bank of China, ICBC, Agricultural Bank of China, etc) into the securities brokerage industry, which may further reduce commission and cut into the market share of the current top 10 brokerages. Furthermore, China Galaxy Securities’ business is closely tied to the performance of China’s capital markets, which have foundered in recent years. This is evident when one compares the S&P 500’s 13% increase in 2012 with the Shanghai-Shenzhen 300 index which only rose 8%. Further difficulties are perceived in the backlog created by China’s markets regulator of over 800 companies waiting to IPO in China.

Prop Trading on the Up in China

Despite the pressures, there are many potential opportunities that China Galaxy Securities are at the forefront of being able to capitalize on. Just as Western investment banks cut back from riskier activities as a result of the financial crisis, top Chinese brokers are filling this gap. These areas such as proprietary trading, private equity, lending money on margin to investors buying securities and other alternative investments accounted for around 21% of the Chinese securities brokerage industry’s profits in 2012. These were all areas where Goldman Sachs was or is the world market leader, for example they run the world’s second largest private equity funds under management and the second largest business servicing hedge funds. Yet as the world’s regulators make these riskier activities more costly for banks such as Goldman Sachs to pursue and outright ban proprietary trading, this is an opportunity for upcoming Chinese brokers to break onto the international stage. For instance China Galaxy Securities got almost 7% of revenues and more than 12.5% of profits (US$38.5 million) from prop trading in 2012. They are also making a concerted effort to expand its prop trading assets, which have grown 30% over the past two years.

A long-term Chinese investor

Additionally, since April 2012, the Chinese Securities Regulatory Commission have liberalised rules allowing Chinese brokerages to invest in a wider variety of markets, to lower their capital requirements against these activities and to start issuing their own bonds. In the year following the liberalisation, just over US$13 billion of bonds were issued by Chinese brokers. The aim is to introduce more liquidity into China’s stock and bond markets. Yet the real problem is the lack of a long-term investing culture and the dearth of established institutional investors such as pension schemes, insurers and mutual funds. The moves are part of efforts to broaden and deepen China’s capital markets, and brokerages are already taking the opportunity to boost borrowings and juice up returns. The added advantage is that this is all happening with Chinese brokers having quite low leverage, with the industry’s total net assets just 1.4 times net capital currently.

China Galaxy Securities IPO’d on the Hong Kong stock exchange in May 2013, with its shares rising 11% to settle at HKD 5.62 at the end of its first day. They are currently trading at HKD 5.26 per share. So invest in a company a financial universe apart, invest in China Galaxy Securities. You may be investing in the Chinese Goldman Sachs, which will boost your profits to a universe apart too.