Alloy Steel, Altman Z-Scores, China, and Vertical Branding

Connecting the dots between some recent topics:

- Alloy Steel International (Nasdaq: AYSI.OB) is the sort of company that is benefiting from China's New, Self-Propelled Economy.

- The Altman Z-Score model can be used by equity investors to evaluate current long holdings for signs of financial distress, as we did with Alloy Steel most recently back in May. When the model predicted that the company was not at risk of bankruptcy at that point, we added more to our position (at about 23 cents per share), despite the weak quarter the company had just announced.

- The Altman Z-Score model can also be used to look for potential short ideas, as in the previous post re BAGL. We'll see how that one works out.

- Vertical Branding (Pink Sheets: VBDG.PK), retailer of such fine, made-in-China products such as this,



is an example of the sort of company associated with China's pre-self-propelled, more export-dependent economy. When China's exports of these sorts of products started to drop precipitously as the global economy sunk into recession, one of the concerns pundits raised was the plight of the migrant workers from China's rural West who were getting laid off. China decided to address this via its stimulus package by increasing investments in Western China, including job-creating infrastructure projects there. Infrastructure requires steel, and to make steel you need iron ore. Companies that mine for iron ore need wear plates to protect and increase the efficiency of their mining equipment. Alloy Steel International makes best-of-breed wear plates.

China's New, Self-Propelled Economy

A few months ago, we mentioned James Kynge's 'China Continental' thesis. In that post, we excerpted an essay Kynge had written in the Financial Times explicating his thesis for China's continuing growth in the wake of declining exports. This was the excerpt we quoted from Kynge's essay:

China is going continental. Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China’s case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world’s fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to “China Continental” – the transition of the world’s most populous country into an increasingly self-propelling economic force.

A couple of items that appeared earlier this week in the Financial Times suggest that Kynge's thesis may have been correct. This item from Monday's Lex column, "China's Stimulus" is one, and Martin Wolf's column from Monday's FT, "Wheel of fortune turns as China outdoes west", is another. Here are a couple of brief excerpts from both.

Lex:

There is no precise breakdown of stimulus spending by geography. But $366bn falls under the heading of infrastructure and post-quake recovery; another $113bn under public housing and rural development. Only a small slice – $54bn to stimulate “technological innovation” – seems to explicitly favour developed regions. Output in 12 western provinces grew an average 8 per cent in the first half – a whole percentage point better than 11 provinces in the east.

This structural shift was evident in first-half figures from ICBC, China’s largest commercial lender. Its year-on-year percentage increase in operating income in the Yangtze and Pearl river deltas fell, but rose in central and western regions. In short, China would rather finance roads in Chengdu than sweatshops in Guangdong. Many private, export-led companies in coastal areas, lacking collateral in the form of land or government relationships, are still struggling for funds. Trade data on Friday showed exports and imports falling for the 10th month, year-on-year. Weak external demand is not the only cause; this is an unabashed internalisation of growth.

Martin Wolf:

China has emerged as the most significant winner from the financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?

Cushioned by its more than $2,100bn (€1,440bn, £1,260bn) of foreign currency reserves, huge trade and current account surpluses and a robust fiscal position, Beijing has been able to deploy all its levers over the financial system and the economy.

[...]

Three immediate questions arise. How has China responded to the crisis? Is its resurgent growth sustainable? How far will its recovery help the world economy?

The answer to the first question is: astonishingly. According to data reported at the end of last week, industrial output expanded 12.3 per cent in the 12 months to August, up from a 10.8 per cent increase in July. This is the fastest growth for a year.

[...]

Is this growth surge sustainable? In a word, yes. Inevitably, the torrid growth of bank credit and money is spilling over into asset prices, particularly equities. But there is little danger of excessive inflation in an economy with an appreciating currency, fully embedded in a world economy still threatened more by deflation than by inflation, at least in the near term. Moreover, the government is solvent. As premier Wen Jiabao noted in Dalian, "we . . . kept budget deficit and government debt at around 3 per cent and 20 per cent of the GDP respectively". Should bad loans increase, China is well able to recapitalise its financial system.

This is good news, of course, for companies selling raw materials to China, for vendors to those companies (e.g., Alloy Steel International), and, more broadly, for countries such as Australia and Brazil that export significant amounts of raw materials to China.

James Kynge's Thesis: "China Continental"; John Authers's Follow Up

James Kynge laid out his thesis for China's continuing growth in the wake of declining exports in a recent Financial Times column, "China Continental". Excerpt:

China is going continental. Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China’s case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world’s fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to “China Continental” – the transition of the world’s most populous country into an increasingly self-propelling economic force.

Kynge lists a few different specific metrics to back up his case, including increases in China's retail sales and domestic cargo traffic, and survey results on consumer spending intentions, before addressing China skeptics in his conclusion:

Sceptics argue that China’s performance this year has come through huge but ultimately unsustainable government intervention. Such spending, they say, will boost growth for a time but achieve little but industrial overcapacity in the longer run. These arguments are not without merit, but they miss a newer, more interesting prospect; that Chinese growth is increasingly self-generating and continentally driven.

Recent moves in the commodity markets support Kynge's thesis, as John Authers noted in his Financial Times column today ("China's health gives rise to fresh growth theory"):

Industrial commodities, that benefit most from economic growth, have surged, with lead and copper up more than 50 per cent in three months. Gold, an inflation hedge, has barely gained.

Authers went on to summarize the debate about China's economy (both sides of which have been fleshed out by Kynge and Zeihan, respectively):

As a whole, even before yesterday's strong headline to the US jobless report, world markets were plainly working on the assumption that China has saved the world from Depression. Is the market right to do so?

There are two camps. The optimistic side, laid out by James Kynge in the Financial Times last week, is "China Continental"; like the US in the late 19th century, China can turn itself into a great economic power, by building links to its interior and unleashing its buying power.

The pessimistic side suggests China has poured money into the public sector, and will merely form excess capacity. The huge demand for industrial metals may be artificial.

Electricity generation is down year-on-year. Supply managers surveys show new export orders are barely expanding. So maybe China is caricaturing the US in the 1930s, and paying some people to dig holes and others to fill them in.

If so, the gains could soon be in for another ugly recoupling. Either way, nothing just now is more important than the health of the Chinese economy.