Sorry for being a bit late with this, I decided to include Korea as well and discuss my general method for evaluating economic development, out of which my LBO market analysis is simply a derivative.
I will begin by discussing the state of an economy in general through the corporate degree of lateralization and/or diversification versus corporate specialization. Then I will try to explain my thinking on when an economy should transition from one to the other as well as the implication for LBO opportunities. Finally, I will discuss where Japan and Korea can be said to be in this spectrum and what conclusions and forecasts can be made about them. I will also include a quick review to support my argument in the post on China and Taiwan, as the conclusion reached herein will superficially push back the forecast time for the LBO blooming in China.
Definition of Terms
First, it is useful to define terms, since I don’t know if these are accepted terms in economics writing. I’ll just ask you to bear with me for this one article of 2500 more words. Lateralization is what I call the process of a company taking control of its supply chain, up or down. Notice the word “control”, not “ownership”. One example to illustrate this would be Chinese metal re-rollers (a finishing process): they buy bulk metal from a major smelter/hot roller company elsewhere in China, roll it, and sell to either wholesalers or directly to clients who demand major quantities of finished goods. Some of the more successful ones have recently started trading in the scrap metal version of what they sell. Doing so allows lowered total freight costs, and they are able to sell the scrap to the smelter/hot roller. This significantly reduces the margin these middle companies are able to secure because the re-rollers provide a stable order flow on both the input and output side. Thus, these companies have lateralized and taken greater control of their supply chain. Diversification is a rather more common term, and essentially means taking on large corporate operations in an industry outside of your core industry for whatever reason. A few of these reasons will be discussed later. Specialization on the other hand is the reversal of both these processes, to streamline and focus on a more defined industry and set of products and processes therein to do these well and distinguish your company from the competition.
What does it mean for an economy to be in the lateralization and diversification (hereafter: LD) phase? Simply put, economies of scale are not yet realized, and current management or business acumen is not widely meeting the demands of the market. Taking greater control of your supply chain allows you to eradicate margins of your suppliers/clients and claim them for yourself, and your skills in generally running a successful company are so scarce that the experience itself will make you successful nearly no matter what the industry. LD is a process that most exporting economies seem to go through and enables them to build the corporate giants that have recognized brands and therefore also gives them access to the domestic cash flow that would be necessary to undertake massive overseas activities and take on the associated risks. If one charts the economy as a ladder, with huge conglomerates on top and grassroots entrepreneurs and specialists on the bottom, the mid-cap companies essentially disappear since their operations are undertaken by the conglomerates climbing down to lateralize. This process generally runs for a very long time. However, towards the end of this period, the demands of these conglomerates will be for more specialized products that are more likely to be filled by the entrepreneurs and small businesses at the bottom, causing this step of the ladder to become wider. Thus, this is where an economy can gain a lot of its technical know-how, as the growth that created the managerial know-how continues and specifications become ever tougher down the supply chain.
When does the LD phase end? After a rather long period of this grassroots business growth that supports the conglomerates and economies of scale can no longer be accomplished by means of growing bigger, and value is instead added through development in specific steps of the production process or parts of the product. (Value adding over cost cutting mechanisms.) This instead leads to the specialization phase, where companies spin off non-core assets and processes to focus on a smaller portfolio of activities and aim to add as much vale as possible to these products or services.
One example of the specialization process occurring would be in the Nordic countries, where Sweden and Finland are prominent examples of companies like Nokia and Volvo greatly diversifying and creating a “conglomerate culture”. After a while, however, their companies became ineffective at everything they did since they could maintain focus on nearly nothing, and spinning off units (and if needed buy the products off these independent companies) would create greater benefits. Nokia, having originally started with manufacturing rubber boots, spun off the tire business early on which then became Nokian, and Volvo sold off its entire corporate portfolio outside of trucks and heavier construction vehicles (including everything from cars to tobacco) following the stepping down of acquisition-amoured CEO PG Gyllenhammar. This later morphed globally into the M&A craze in the car industry that gave birth to both Mercedes Benz and Daimler-Chrysler under the name of economies of scale and synergies. Several giants still remain in the Nordic countries, but they are supplied by a multitude of smaller manufacturers and are strictly focused on their core activities, thereby acting as a catalyst and enabler for accumulation of know-how and SME’s. These in turn can grow by trying to expand the client base, which could for example be found in the pool of other supporting SME’s, internationally or with a slight tweak to the production process. I am of the strong belief that this is one of the contributing factors to the Nordic region having fared rather well in the recent financial crisis, as companies were able to able to add value to- or cut costs of their products and thus maintain an agile, dynamic domestic economy with few casualties.
Both the LD- and specialization phase is essentially enabled by exports combined with strong growth domestically as it enables the national champion companies to grow fast and feed the spoils into the domestic economy through different channels. Many of the Asia-ex-Japan countries fulfill these criteria, and the next area of investigation then becomes the more challenging question of when the LD-to-specialization transition begins. In principle, this should correlate weakly to the education levels and general output of the countries in GDP per capita terms. If we entertain the thought that the LD phase is easy – given shareholder pressures to increase revenue, the cheer of takeovers, claiming economies of scale and strong synergies, increased political backing etc., coupled with the survival-of-the-fittest ideas that the successful claim the market – then the very same ideas that we can use to argue that such in fact is the case turns against us in the start of the transition towards specialization. GDP per capita projections and education levels can help us somewhat here. As the example of Japan will show, drawing an upper threshold on when this transition will begin may not be possible, since its initiation may be related to cultural factors or domestic economic factors not covered by the scope of this analysis. However, the interesting idea would be to evaluate when this can happen rather than when it will happen, and ask what enablers are needed.
Indicators of Phase Change
Research has shown that growth tends to taper off once GDP per capita reaches roughly 2005 US$ 17 000 (http://www.nber.org/papers/w16919.pdf), but be careful to adjust for specific factors and domestic considerations in the markets where you apply this to. (Furthermore, read the paper, it is very good and may provide you with deep insight into the future of growth.) Let’s assume that this level is in export driven economies consistent with the end of the “valuable” LD phase. Momentum in the markets and pressures to do the tried-and-true way of growth may persist, but here is likely where the economy no longer derives utility from the increase in lateralization or diversification. Will the specialization phase start immediately? I find this unlikely. What seems more likely is a maturity phase, where the operations of the larger conglomerates grow, albeit slowly, and educated workers leave these companies to open sub-suppliers that can do things efficiently on a smaller scale, thereby growing the grassroots area of the aforementioned ladder. However, stock market prices and general corporate valuations will likely lag the economic reality and maintain expectations for continued growth. This would over a matter of years create a valuation-to-value gap that is likely to be pricked in a stock market crash or economic recession, and generate the impetus to fully dismantle the larger corporate giants and force them to focus on core activities, which is a tougher process than LD by the discussion above. To put the discussion on firmer footing: the enablers of the specialization phase to occur would according to this train of thought be 1. the hurdling of the GDP per capita fast growth ceiling, 2. growth beyond this level, 3. overvaluations leading to a mild corrective move that 4. simultaneously forces and allows companies to restructure significantly and separate non-core business activities. With the numbers provided by research in hand, we can effectively begin to loosely discuss when the LD phase value addition ends, which would be the high-growth ceiling.
However, before we begin, a quick note on why this is when the LBO market in an export-based country will see its heyday if you have not already figured: The need to manage these business units in a different climate, without the strong capital backing of the “parent” company coupled with a more developed exporting economy makes both the company-specific and economic factors surrounding the development highly suitable for an LBO. The company unit will need to specialize to provide value as opposed to cutting costs, there will be less natural access to cash, and it is internally responsible for its own profit situation. So, forecasting the specialization process in an economy and preparing for it would allow one to be at the forefront of the LBO market. Simultaneously, the companies that ascend towards the middle of the corporate-size ladder from the entrepreneurial level will face new challenges which outside management and capital could be highly likely to provide solutions to. With that, some countries can be put through the paces:
Initially, to adjust for inflation, I make the rough estimate that US$ 17 000 in 2005 is US$ 20 000 in late 2011. The researchers have already done the analysis for China, but it is interesting to place Taiwan and Korea in this frame.
South Korea nominal GDP for 2010 is US$ 20 600 and Taiwan GDP ditto is US$ 18 500. (World Bank estimates.) Thus, Korea would be poised to begin this transition imminently, and it proves to be one of the more exemplary economies with companies that have gone through lateralization and diversification, and have yet to specialize. I guess saying “Samsung” or “Hyundai” should be enough to convince you of this. Again, this may take a few years, partially to adjust for the different factors outlined in the paper mentioned, and partially to adjust for the necessary time to grow beyond this ceiling. Given a ~5% annual average GDP growth rate (http://www.tradingeconomics.com/south-korea/gdp-growth-annual) it would then have a rough nominal GDP of 24 000 in today’s dollars by the end of 2014, before which a new global slowdown could be highly likely. But assuming that this is the level at which growth will taper off, and the specialization phase opens up huge opportunities for LBO’s as former units of the Korean conglomerates (chaebols) spin off and are in urgent need of new management.
Taiwan would by this methodology be behind Korea by 2 years (about average growth of 5% as well) but it has less of a prevalence of larger conglomerates. Thus its economy may be more agile, and it will instead see a large slew of companies that provide LBO opportunities for their organic growth and to do increased business with the competition of companies assisted by the larger domestic market in China. I would say that the average corporate structure is thus an accelerant for the Taiwanese LBO opportunity, but not a magnifier, in fact I find it likely that there will be less (and less attractive) LBO targets in Taiwan compared to Korea.
Looking to Japan, in the frame of this analysis, the double systems of cross-ownership known as keiretsu and conglomeration structures known as zaibatsu have effectively “locked” Japan into the end period of the LD phase although its GDP has long passed the fast-growth threshold. This passage is partially attributable to the export wonder which the zaibatsu created in the 1980’s, but so is the stagnation that has occurred since. Japanese business culture simply does not at the moment (or has never since the formulation of a culture in the 1920’s) allow the specialization phase, and its integral spinoffs to occur. Instead, its economy has been stagnant with the continued attempts to cut costs in line with the development methods of a developing country, which has contributed to deflation. The March 11 Tohoku earthquake showed another side effect of this conglomerate culture: instead of growing through middle sized enterprises (made up by by former conglomerate units and organically grown start-ups), it has stalled deflation through grown enterprises from the grassroots-up, and thus has immense amounts of highly concentrated skill pools sitting in small companies. As these have branched out, it is interesting to note just how important these have become for the global supply chain for everything from household appliances, electronics and cars. It is a guessing game just what (if anything) could allow Japan to go through the specialization phase as it is normally done. Though, a “back door” has been opened courtesy of the smaller companies in its corporate sphere. These could likely grow very much given the opportunity, impetus and the realization that the processes they use and products they provide could have immense value worldwide, particularly as other regional economies grow to be in greater need of these products. Again, the LBO market in Japan has been rather unsuccessful in the past, partially because of a culture that strongly favors the zaibatsu system, but in the light of a possible second worldwide recession within the span of five years off the start of the first and the need for change that has been highlighted both by China passing it in nominal GDP numbers and above mentioned earthquake, this may just be the time to attempt to enter Japan for LBO firms. Growth could still be rather stable in the regional economies, and thus provide for the opportunity to vastly reorganize the sales of Japanese products away from the west and towards Asia, something I think that outsiders are more suited to do than the Japanese themselves.
Finally, looking at China, my prediction for significant LBO market growth and opportunities would be pushed back if indeed this ceiling of US$ 20 000 would be a definite. The paper furthermore highlights the dangers of a managed exchange rate. At least that looks like it is changing however, but I would be in muddy waters. Beyond the initial argument of the underlying structure of Chinese companies and the support they can claim from infrastructure, as well as the phase they are in (LD), I would argue that China has an X-factor that throws this analysis into the air: Enormous inhomogeneity. This is constructed from a compounding of its enormous size in terms of population, geographical size and geographic challenges, and that the economy of Shanghai is almost incomparable with that of Kunming! Guangzhou is incomparable even with its own suburbs! So many different economies and local factors make up the Chinese business world that it is misleading to speak of it as a single economy except for statistical economic purposes such as GDP comparisons/trends, current account developments and so forth. Indeed, the GDP/capita of Shanghai (of 22+ million people, enough to make it larger than many measured countries) would push up against the limit very soon, especially as the GDP growth is disproportionately centered in cities along the eastern seaboard. Thus, all economic processes undertaken in China will span a series of years more than their equivalents anywhere else as it moves from the east of China to its centre and westwards! Initially, the LBO market may grow quickly in cities, and therefore grow the domestic market to create other LBO-ready companies.