The Capitalist Survivor

Includes: DIA, FXI, QQQ, SPY
by: Keith McCullough

“The human body can take damn near anything. It’s the mind that needs training.” (Instructor Reno)

For those who took our book recommendation on May 26th, you’ll know that quote above is from a drill instructor depicted in The Lone Survivor, Marcus Luttrell’s first person account of the 2005 SEAL operation in Afghanistan that resulted in the greatest-ever single-day loss of life in the elite unit’s history.

Instructor Reno says this during the infamous SEAL ‘Hell Week,’ which puts the candidates through unthinkable mental and physical stress with the purpose of eliminating all but the toughest warriors on the planet. The part of this quote that I can’t (and don’t want to) shake is that towards the end of Hell Week, if someone expressed the desire to quit, the drill instructors would offer them a second chance before they officially ‘rang the bell’. A seemingly kind gesture, but one offered with indifference. Why?

No one who takes the offer actually ends up finishing the program – ever. Once the thought of quitting manifests itself into action, it’s pretty much ‘game over.’ It’s like trying to uncrack an egg. Those that complete the program and join the esteemed ranks of the Navy SEALs were truly in control of their own destiny – mentally and physically -- throughout the entire torturous initiation.

I know… you’re probably thinking “Thanks, but I’d love to see how you’re going to actually tie all that in to an investable theme.” That theme is something that you’ve seen us write about time and time again – proactively building and managing a process that allows you to always be on offense, and in control of your destiny.

Trust me; I’d love nothing more than to tie-in the armed forces theme with bullish comments about US markets as Independence Day draws near. But I cannot.

The real survivor in this interconnected macro web is China. China is in control of its own destiny, and if it ever feels the desire to ‘ring the bell,’ it certainly does a great job of hiding that from outside observers like me. China is always on offense – always in control – always a capitalist.

Check out the third most read story on Bloomberg this morning. “China Allows Yuan Trade Settlement, Offers Tax Breaks To Shift From Dollar.” China’s official statement includes the following verbiage…

Companies in China and neighboring countries are facing relatively huge risks of exchange-rate fluctuations because of big swings in the U.S. dollar, the euro and other major settlement currencies during the global financial crisis.

Need I say more? Probably not. But I will anyway…

Let’s also take this to the industry level -- apparel/footwear retail for example (86% of our footwear comes from China alone).

There’s a lot that controls the margin inputs for any company. For a company tied to this supply chain, one of the majors is the FOB cost of the goods. In plain English, this is Freight On Board, and represents the all-in cost to land a product on US shores. From 2000 through 2007, this cost came down precipitously as capacity in China grew to fulfill a change in WTO regulations that allowed it to scale up production. The timing and magnitude of this change allowed so many US players to garner more margin dollars than they deserved.

But then China changed its offense. In 1Q07, with the Olympics looming, China cracked down on sweat shops, mandated back-pay for factory owners to employees for unused vacation time, and pulled the ultimate lever to reduce capacity – it lowered the VAT rebate. The VAT (value added tax) stands at about 17% in this category, and the government rebates a given portion of it to encourage exports vs. local consumption. In early-’07 this rebate stood at about 13%, and subsequently came down into the single digits.

Think about it…if you are a factory with a profit margin of 3% (about average over the past 10 years) and then not only do your labor costs go up, but your VAT rebate goes down by 500bps, that turns into a pretty catastrophic event. The result? In ’07 and ’08 the factory count in China’s Pearl River Delta went from about 12,000 down to about 6,000. No joke…

The trajectory of exports fell like a stone – bottoming at -23% in 1Q. So how did China react? Yes, the VAT rebate is headed up again – and now is at 15% (above ’07 peak). Other countries such as India, Malaysia, Indonesia, Pakistan, and others have followed suit. We’ve seen around 1,500 factories reopen in China, and there’s more to come.

How’s that for proactively managing growth? Most US retailers don’t even have a clue as to this dynamic. I’d argue that we’re entering a period where they earn what China wants them to earn.

The bottom line is that the companies that really ‘get’ China are the real survivors. That’s the long-term call. There are the ones that have been investing there over the past 10 years. Not those that started last week because the manic media said that they have to.

Have a terrific long weekend with your loved ones, and thanks to all those courageous men and women who are unable to do so as they fight to protect the freedom of this wonderful country.