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O'Keefe: Cautious on China

Greg Carlson

Greg Carlson: And you can touch on emerging markets, particularly China. I think that's an area that a lot of investors have been excited about recently, including in the mutual fund world. Your funds, on the other hand, don't have a big presence there, and I wonder if you could expand on the risks that you see in that area?

Dan O'Keefe: Well I think there's an interesting phenomenon that work here; as we all know from reading the newspapers and watching TV and seeing what happened in Greece, we all know that the governments around the world, in the developed economies of the world, are under fiscal strain. They have significant budget deficits, and they've accumulated unsustainable level of indebtedness relative to their GDPs. And Greece was the first example of a government being forced by the market to actually have to retrench, to have to cut the deficit, start to reduce the amount on the debt outstanding.

Yesterday, we had David Cameron in the United Kingdom, issue what is the first austerity budget that the United Kingdom has had in many, many, many years. It's one of the first in Europe, but it's certainly not the last. We are clearly facing a period of austerity, as governments reduce deficits and start to address this unsustainable level of indebtedness.

So we know that this is a relatively unhelpful environment for economic growth in general. And so as people face this, as investors face this, the immediate desires to try to find some type of safety valve, in other words, where can you go where the economic growth is better and where the prospects look better. And people have found a safety valve or perceived to have found a safety valve in the emerging markets. I think, well, they're less indebted, there are younger economies are developing, they can still grow, and of course the largest emerging market is China.

However, I would be very cautious on China, and I would argue that the risks that we face as investors in China are arguably not significantly less than the risks we face in the developed parts of the world. China has been on a long and unsustainable capital spending boom, which has driven its economy. It has recently embarked on a very, very rapid expansion of credit within its economy. Over the last 18 months, Chinese banks have lent US$2 trillion out into their economy. This is on an $8 trillion GDP in China. They've lent $2 trillion of loans for building infrastructure and building housing. There's now almost 2 billion square meters of residential housing under construction, and this is in an economy where arguably the amount of living space per capita is not meaningfully less than some other developed economies in Asia.

So there appears to be building up within the Chinese economy, the excesses of that capital spending boom and the excess capacity, and also loans that have been made that arguably are not necessarily of the highest quality, since they serve the purpose of not necessarily making a strong underwriting decision, but they reflected policy decisions on the part of Beijing to continue to grow that economy.

So these excesses, I think, will play out over the next several years, and should, as they resolve themselves, bring the growth rate of China down. And moreover, the valuations in China in our view are not particularly attractive. So we don't really see China as – is a viable -- to go back to the metaphor, is a viable escape valve to get away from the difficult conditions that we face in many of the developed economies.

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Carlson: Are there other areas within emerging markets where you're more interested?

O'Keefe: Well, we look, we are always looking. I just got back from Brazil. I was recently on a trip to India, and I would say that the valuations within the context of what's going on in those economies are not necessarily attractive to us. Even in an economy where there is healthier growth in my view, in India for example or in Brazil, certainly healthier relative to China. Just because there is growth, does not necessarily mean that it can translate or will translate into attractive returns for equity owners, and that's a function of valuation. As I said before, the valuations are not particularly interesting in those two markets. And number two, it's a function of relatively undeveloped corporate governance structures and management cultures and structures, such that even if the economy grows and the companies grow that doesn't translate into capital generation, cash flow generation and returns for shareholders.

A great example is in India, where you have the booming telecommunications industry. In that, there are still many people who do not have cell phones, and as people under the middle-class, they're spending more and more money on cell phones. And so that industry is booming in the sense of the revenue available to it. Now that is actually translating into significant value destruction for owners of telecom companies in India perversely so or un-intuitively so, and that's because there are regulations within India that have allowed the proliferation of telecommunications licenses for in excess of what the market can bear. So pricing is being destroyed by irrational investment in network capacity, which is driving prices down. And as a result, all the telecom companies' profit margins are being squeezed. The returns on capital are being squeezed. And again, because of some very un-sensible regulation, you're not able to consolidate the industry to get rid of the weak competitors, and so it's a problem that is persisting. So again, you have growth, but it's not translating into value. So for us on balance, we are unable to find anything interesting in those markets today. That could change.

Carlson: Very interesting. Thanks very much for joining us today, Dan.

O'Keefe: Thank you. It's my pleasure.