A Newly Bullish Russell Clark Likes Emerging Markets And China

For Horsman Capital Management’s Russell Clark, investing is a game of patience. After changing strategy horses in March, Clark, whose global hedge fund was down -2.01% in April, looks at a 9.54% year to date loss and preaches patience to his flock of investors. In April Horseman Capital Management losses were found in the long portfolio, particular from the mining sector, while the short portfolio was a winner, particularly the US REITs sector.

The market cycle for emerging markets is going to turn, Horseman Capital Management tells investors

Markets are cyclical, Clark told investors in an April letter to investors reviewed by ValueWalk. Market moves can, in part, be explained by business and profit cycles, credit and investment cycles, interest rates and related currency values.

China’s “overinvestment cycle” coming to an end will likely impact commodities such as steel, coal, aluminum, but the impact can be a net positive.

“Cutting this over-investment allows global margins to rise, and to allow investment outside of China to increase,” he wrote. “The Chinese government is actively looking to curtail capacity, and to raise interest rates to reduce over-investment.”

Often cycles from around the world move into different stages at different times. While China’s commodity usage might be faltering, an emerging market such as India is beginning to accelerate. Looking at weakening Chinese demand that appears priced into the market, there is India, where growth had not been properly priced in to the same extent. Clark thinks commodities could experience a “demand shock” which could push commodities higher, impacting commodity-centric markets.

This explains one side of his new strategy: investing in emerging markets. Clark writes:

The strategy that we have had in place for the last five years or so has ended. We are now moving to a new strategy for the next five years or so. Its principal tenets are emerging market growth, commodity undersupply, and excessive corporate credit in the US. The positions for this strategy are mainly long emerging market, short US dollar, and short US stocks.

The benefit of this view is that most people would disagree with the view that China and commodities look great and the US looks expensive, but the investing cycle is turning and capital will be created where people are not invested, and destroyed in the names where they are invested. This is the nature of markets. Your fund is long emerging markets and short developed markets.

Horseman Capital Management notes:

In a book entitled ‘Capital Cycle’, Edward Chancellor explains: “Typically, capital is attracted into high-return businesses and leaves when returns fall below the cost of capital. This process is not static, but cyclical – there is constant flux. The inflow of capital leads to new investment, which over time increases capacity in the sector and eventually pushes down returns. Conversely, when returns are low, capital exits and capacity is reduced; over time, then, profitability recovers. From the perspective of the wider economy, this cycle resembles Schumpeter’s process of “creative destruction – as the function of the bust, which follows the boom, is to clear away the misallocation of capital that has occurred during the upswing”. In our opinion, in the commodity sector, the capital expenditure (‘capex’) cycle is key to understanding when prices are reaching an inflection point.

And….

Supply capacity has now been reduced extensively. The top 40 mining companies reported impairments of $53bn in 2015. As at last year they had written-off the equivalent of 32% of capex spent since 2010. (Source: PWC). Capex spend by Australian miners fell from about AUD 25bn in 2011 to about AUD 10bn last year and debt was reduced. Glencore cut its long term debt from $40.7bn in 2014 to $23.2bn in 2016.

He concludes the section stating:

In the meantime China implemented reforms to cut over-capacity in the steel sector, which in our opinion will have a positive effect on China’s demand for iron and other metallurgical ores, and on the overall economy. The Bloomberg Industrial Metal Price Index is still some 42% below the 2011 peak, the fund has a 30% long exposure to the mining sector and a 32% long exposure to the Australian dollar versus US dollar.

The other side of Clark’s Long / Short strategy is the US, which he sees overpriced on several levels.

“The other side of lower commodities and lower interest rates has been huge profit growth in the US,” he told investors. “Businesses that have thrived on the combinations of lower commodity prices and lower interest rates have been many.”

But when market cycles change so, too, do the fortunes of those that benefited. He thinks the auto financing, commercial real estate and retail are examples where a change in the commodity and interest rate markets “spells doom” for such investments.

As interest rates rise, any business that is feasting on cheap capital will be hurt, such as US shale drillers, whose plans could “derail” with higher corporate borrowing rates, making this industry “unattractive.”

Putting this macro thesis into practice, Horseman Capital Management is long mining and metals in a big way, long defense, industrials and consumer staples to much smaller degrees. The fund is short REITS along with autos and airlines to a significant degree, while slightly short financials.

From a regional perspective, which is not often an overt targeting component of the strategy, most of the London-based hedge fund’s action is in the US, where it is significantly short, along with notable short positions in Japan and the Eurozone. The fund is long in Asia, Latin America, and the UK.

The hedge fund’s famously short Long / Short ratio dial is slightly negative, at net -22.48% net short in stocks while net long 23.66% in bonds.