Thursday, September 01, 2005

BARRON : Niche Player

[Think-3 : China / Asia in eyes of foreigner investor ..... so called "Niche Player" ]

Monday, August 29, 2005

Interview with David Riedel, President, the Riedel Research Group

NOT ONE TO MISS A CHANCE, even under trying circumstances, securities analyst Riedel found his niche a few years ago, providing global investors with independent coverage of what he considered a neglected area -- Southeast Asian equities.

Fluent in Chinese and Thai, Riedel has been working in the region since 1992, including eight years with Salomon Smith Barney as a telecom analyst in Thailand and small-cap analyst in New York. When the tainted-research scandals hit the securities industry in 2002, thousands of analysts, researchers and other Wall Streeters lost their jobs, including Riedel, even though his work wasn't under question.

Subsequent events proved fortuitous: Massive legal settlements mandated that investment managers spend more money on outside research to protect investors. The 38-year-old researcher-turned-entrepreneur decided to take advantage of the opportunity and formed his own company, specializing in Asian equity research, in 2003. The New York City-based Riedel Research Group now has 11 analysts throughout the region and plans to add another three this year. Riedel recently spoke with Barron's about Asian equities and the current state of Wall Street research on the region.

Barron's: You started your business with analysts based in Indonesia, Malaysia and Thailand -- and only recently added China and India to your coverage. That sounds like a odd way to begin an Asian stock-research firm.

Riedel: When investors think about Asia, not including Japan, they usually look at it as one large area. But Northeast Asia tends to be more developed than Southeast Asia, and markets in Jakarta and Bangkok are very different than those in Seoul or Taipei. Also, the bulk of my experience as an analyst was in Southeast Asia, where the potential for discovering undervalued companies with solid fundamentals and promising growth opportunities seemed superior to those already discovered in countries like South Korea or Taiwan. Plus research coverage of companies in South Asia was almost nonexistent. So it was a natural starting point for me.

But you will add Taiwan and Korea, right?

Of course, and soon. You have enjoyed a rather quick start. Does that reflect a hunger among mutual and hedge funds and other financial institutions for alternative sources of information about these areas?

We don't have many hedge-fund clients yet, but that is definitely the case with our mutual-fund clients and institutions, especially those investing in emerging markets. They tell me that the research they are getting from the big brokerage firms is inadequate in terms of detail and perspective and heavily skewed toward promoting investment-banking deals and generating brokerage business.

Having researchers stationed in the Asian markets they cover is crucial to investment success, Riedel argues.

How good is Wall Street research on developing Asia?

The quality, as well as the volume, of equity research on Asian firms has dwindled in the past three years as a result of the research scandals of 2002. Analysts have become much more constrained by regulatory concerns. There are now a lot of hoops they must go through in order to get information out to their clients because of the new compliance issues. The inability to collect information like they used to has also narrowed the field of research for many sell-side analysts, forcing them to focus on a much smaller list of companies.

And the decline in commission income for the big brokers has crimped a lot of research departments, right?

The decline in commission income has indeed been dramatic. The commission rates that are being paid in the U.S. for stock trades have gone from nearly 5 cents a share in 2002 to 3.2 cents today and they are expected to go to about 2.2 cents next year, which will represent a 50% decline in the per-share commissions. As a result, the pressure on the big brokerage firms has been tremendous. They simply don't have the money to grow their research departments, much less finance offices in Jakarta or Bangkok or New Delhi.

Why has Southeast Asia been so poorly covered in the past?

Because it is expensive and difficult to run a large network of offices throughout the region. It also involved compliance and regulatory issues. So people have retreated to just having a few people in Hong Kong covering certain sectors and then parachuting people into Jakarta and Delhi and other cities to meet with companies without actually being on the scene.

Our analysts are locals who get much more and better information than someone based in Hong Kong, Boston or London. I hire only experienced analysts who have been following companies and sectors for a long time. They're well-connected and they may have family connections that let them get good information. Generally, access isn't a problem.

What about the quality of information you receive ?

About a third of the 100 or so companies we follow have American depositary receipts issued in the U.S. While this isn't a fool-proof guarantee of accuracy, issuing ADRs does force them to maintain higher disclosure standards. If you get quarterly updates of the balance sheet and of the cash flow, you will be able to catch a problem situation before it deteriorates.

How do you see Asia's growth prospects generally?

It's just amazing. If you look at the top five countries in the world in terms of population, you are talking about China and India, which with populations of 1.3 billion and 1.1 billion, respectively, are No. 1 and No. 2, and Indonesia, with 242 million people, is No. 4, and Brazil, which is not in the region but is in our coverage area, is No. 5 with 186 million. China and India's economies are expected to grow by 8.8% and 7% this year. So there you have two economies with combined power of nearly 2.5 billion people growing at 7%-plus. It is virtually impossible for a stock market not to provide opportunities when you have that kind of growth.

So worries that China's heady growth days are over are greatly exaggerated?

Very exaggerated. It is astounding to me that some people have been worrying about a China collapse. The country is growing 8%-9% at the official rate, but in reality is expanding more rapidly. Imports are increasing, new construction continues unabated and exports remain strong. Chinese officials are under too many social, economic and financial pressures to allow any deceleration of their economy. China's growing economy, like that of India and Brazil, continues to provide above-market growth for fund managers.

Can you give me an example of a company you found early?

In Indonesia, we had been covering for some time a shipping company that controls 12% of the tanker capacity in Asia. It is Berlian Laju Tanker and trades in Indonesia under the ticker symbol BLTA. Suddenly, it was discovered by other analysts and started going up. It soared by 20%-to-30% as brokerage firms started adding more coverage and bringing it to their clients' attention. The stock eventually became overvalued, and we recommended that our clients get out. But some other companies kept promoting it until the price collapsed.

What about China?

Our Beijing analyst noticed a quiet but steadily growing telephone and broad-band-services provider in northern China called China Netcom. We found most of the numbers out there on the company were far too low. Our estimates are 50% above the investment banks' consensus. We believe they are missing incremental broadband revenue which will prove very profitable. As Netcom increases its penetration in northern China and the Beijing area, this will drive earnings. Even after recent strength, valuation is still very reasonable at a P/E of under 10 times forward earnings. It's a great play on increasing broadband penetration in China.

What else do you like in China?

Tom Online, a leading provider of wireless value-added services, is a strong performer. It has assembled a very impressive array of companies and services through a series of acquisitions. It recently formed a partnership with Warner Brothers to be its exclusive distributor of Warner Brothers media online in China. It also has a promising co-branded service with Skype -- the VoIP [voice-over-Internet protocol] provider. The shares haven't done much recently, as a result of concern over the direction of short-message and other wireless services in China. But we believe investors will be surprised by the strong contributions from Tom Online's other niche markets.

We also have been adding quite a lot of U.S.-listed Chinese coverage. We currently follow 22 companies with ADRs like Sina [ticker: SINA], Shanda Interactive [SNDA], China Mobile [CHL] and Ninetowns Digital [NINE]. And, at the behest of clients, we plan to add another 15 or 16 in the next year or so.

Is that because it's easier to trade American depositary receipts than the underlying shares?

Exactly. ADRs are registered with the SEC, their reporting materials are in English and easily available to investors, and they are quoted in dollars. Also, they tend to be better-quality companies, with better performance. Our buy recommendations of Chinese ADRs are up 21%, year-to-date, compared with 11.7% for the Hong Kong/China Enterprises Index, a benchmark for just China plays. That includes names like Nam Tai Electronics [NTE], which is up 23%; China Netcom, plus 23%, China Mobile, ahead 28%, and NetEase [NTES], up 37%.

But some of the better plays are available just in local shares?

Yes. For example, in India, we have had great success this year with a company called Ashok Leyland [AL in India], the country's second-largest commercial-vehicle manufacturer. The government is trying to upgrade the quality of trucks and buses on the roads in India. There are emission and safety problems and all kinds of reasons why they want to have higher-quality commercial vehicles and diesel engines. So they've started doing things like requiring vehicles that were registered in certain municipalities to meet certain emission standards. To have this and really enforce it is a first for them. Ashok shares have appreciated more than 50% since we got interested in the company, so we have recently downgraded it. But our clients did quite well.

We also like Motor Industries [MICO in India], an Indian subsidiary of the German auto-parts manufacturer Bosch. MICO makes specialized pumps for diesel engines. They increase efficiency and lower emissions, and they're benefiting from this new law in India.

What else do you like in India?

We think people have been a bit too quick to sell off the IT outsourcers in India. But major players like Infosys Technologies are well-positioned. It's well-run, well-capitalized and has the scale to succeed longer term, where some smaller players might be pushed out. The company's operating margins are under pressure because of wage hikes, but it is offsetting this by moving into higher-margin businesses, such as consulting, engineering services and package implementation. The shares aren't cheap, but with earnings expected to show 25% average annual growth over the next five years and a return on equity currently around 33%, we believe the valuation is more than justified.

You don't seem shy about making negative calls on Asian stocks.

Because we are small and independent and not involved in trading or underwriting, we don't face the potential conflicts of mainstream brokers or investment managers. About 30% of our recommendations are Sells. About 40% to 50% are Holds and 25% to 30% Buys.

What are some recent Sells?

We recently made Sell calls on two Chinese stocks. One was ASIAInfo, the country's leading software and IT provider to telecom companies, which has been suffering from government-mandated delays in telecom infrastructure rollout. The company's recent acquisition of the Lenovo consulting division puts more pressure on margins.

The other call was on China Southern Airlines -- an airline seeing tremendous growth in revenue and passengers but whose operating-expense growth is outpacing revenue growth. The company is suffering from higher jet-fuel prices and also from poor management. We don't believe it will survive the growing competition in the airline market, following liberalization.

Any other pans?

Patni Computer Systems, an Indian IT-services provider with a $1 billion market capitalization, would be one. The company is suffering from mismanagement and could be a victim of the higher wage rates and competition in Indian IT outsourcing. It's suffering higher-than-industry-average staff attrition. And its U.S.-listed stock is quite illiquid.

Since you focus on Asia, why did you add Brazil to your investment universe?

Brazil is very interesting. At the beginning of this year, it became a cheap way to play China. Brazil has a lot of commodities, especially agricultural commodities, that China imports. Brazil is a huge producer and exporter of soybeans. The Chinese went to Brazil this year and signed several multi-year contracts to secure supplies of soybeans, minerals and fuel from Brazil. So Brazil is a bit of a China play.

What do you recommend there?

We are high on Braskem [BAK], the Brazilian petrochemical provider. We also like Brasil Telecom [BRP], which will soon be taken over by Telecom Italia [TI], which will provide the Brazilian telecom with a strong combination of fixed-line and wireless network. BRP will be able to offer fully bundled telecom service -- wireless, fixed-line and broadband. The shares currently trade at 2.3 times cash flow and one times book value.

What don't you like in Brazil?

We're negative about Gerdau [GGB], the big steel company, which is suffering from a downturn in the steel industry and is, in our opinion, overleveraged and overvalued. We also don't favor Embratel [EMT] a telecom with long-distance service but no cellular or local fixed-line component. It's in a very poor competitive position.

Thanks, David.


David Riedel's Picks...
China Netcom CN $31.87
Tom Online TOMO 13.90
Braskem BAK 18.11
Brasil Telecom BRP 33.55
Infosys Technologies INFY 68.63

...And Pans
Gerdau GGB $11.38
Embratel EMT 9.11
ASIAInfo ASIA 4.94
China Southern Air ZNH 14.25
Patni Computer Systems PATNI IN 382.45 INR


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