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Key Investment Themes

By Nicholas Mitsakos

We Didn’t See That One Coming – Sort Of

The coronavirus has created a disruption to our lives, relationships, business, and financial markets. But, as we look beyond the immediate crisis, market trends and investment opportunities can be analyzed and calibrated to take advantage of unprecedented opportunities.

Since major disruptions and market discontinuities occur on a regular basis (every 7 to 10 years is regular enough for this definition), understanding that these opportunities will arise and to be clearheaded about how to best take advantage of them, invest in the long-term, and capture disproportionate returns should be the rule – not the exception. The world may seem riskier, but risk-adjusted returns are much more favorable.

Market Modulation

As we look at financial markets and analyze investing in various securities, we have entered an era of “The Great Modulation,” (as described by Andrew Lo of MIT www.mit.edu) where financial markets will experience heightened and compressed volatility for many years to come. We have been experiencing this effect at an increasing rate over the last several years. Arcadia expects this to be the market’s status quo and the context within which all investors must make their investment decisions from now on.

Current conditions have compressed spikes in volatility, underlining the fact that volatility has always been present, but is typically mispriced. The VIX was priced at 14, then popped to over 70. Each level was mispriced, as we are seeing now. But this is the ever-present inefficiency of the markets. Volatility is with us, regardless of a coronavirus. The market simply found a reason to overreact. There will always be a reason to overreact, and it’s in these circumstances where opportunities can be found.

Related to this, diversification through stock selection, which used to be achieved by investing in various stocks within the S&P 500, is no longer possible. The S&P 500 moves too much in lockstep, and five stocks (Apple, Google, Amazon, Microsoft, and Facebook) comprise over 15% of the index. In order to diversify, an investment fund must invest across asset classes, including fixed income securities, distressed debt, and other asset classes.

Currently, outstanding opportunities exist in fixed income securities. Senior leveraged loans have been sold off to such an extreme amount, that reasonable credit funds (such as those issued by KKR, Oaktree, and Apollo) are yielding over 20%. These securities properly chosen and with appropriate leverage can enhance return substantially while reducing overall risk. The combination of a diversified portfolio of equities and fixed income securities can achieve a better risk/return trade-off.

It is Risky Out There

Risk is enhanced because of this heightened “Modulation,” requiring investors to be more thorough in their analysis in order to separate “the signal from the noise.” Current market conditions make it increasingly difficult to see through this volatility, and an investor’s patience and analysis will be thoroughly tested.

Compressed volatility will also require investors to be more creative – use derivatives and futures as investments and hedges across asset classes – in order to achieve heightened returns, and protect against risk.

This new investment environment is driven by a complex combination of multiple decision-making systems, of which efficient markets are only a component. Globally connected capital markets, technological changes, and emerging economies have up-ended the stability of global financial asset prices. Also, factors such as fear (translated into a disproportionate avoidance of loss or irrational greed for profits) and other human behavior, are now magnified, impacting the market We will no longer be able to escape this volatility because of economies and markets’ global nature and technological connection.

Hang On

We are about to enter the most volatile market we have experienced in over a generation. Long-term investors will probably see high positive returns, but within any multiyear period, there will be extreme fluctuations, described this earlier as “signal versus noise.” We are going to be increasingly impacted by “noise” (market modulation and volatility caused by a variety of effects, from investor fear to government interventions, central bank shenanigans, and assorted other mischiefs), and we should not let that impact our overall understanding of the true “signal” of any investment – its fundamentals.

Strategies can take advantage of the noise to enhance returns (such as short-term options and futures), but do not lose sight of value-based investing ideals – the true signal.

Market modulation will interrupt rational pricing. We are having a moment of extreme downward pricing pressure on assets that are perceived as riskier, and upward pressure on prices for safer assets. This can be easily represented by the pricing differential between government securities and lower investment grade fixed income securities. One security has rallied substantially, while spreads between government securities and high-yield debt have widened dramatically.

A normal allocation between risk and reward seems violated. Human behavior, which impacts all markets and valuations, is a complex combination of multiple decision-making systems, of which logical reasoning is only one among several variables. Investors are mostly rational but quickly descend into irrationality as a reflexive, adaptive response to heightened volatility. At these times, great investment opportunities are created.

Globally connected capital markets mean that, like the coronavirus that quickly spread from a local epidemic to a global pandemic, a potential local financial shock in China propagated quickly to up-end stability in global financial asset prices.

These macro factors will make diversifying risk, achieving the highest risk-adjusted return harder to achieve. Markets may one day return to being efficient, publishing accurate, objective, and timely analysis and prices, but I doubt it. The underlying risk is never really priced appropriately over the long term and it will be even will be harder to fully understand in the future.

An integrated global approach to understand all relevant parameters of an investing environment is essential. An investor must look across multiple asset classes, investing in specific securities within the most attractive asset classes, to achieve the highest risk-adjusted returns.

Central Bank Activity

Central banks have flooded markets with liquidity through QE1, QE2, Operation Twist, and LTRO. What is going to happen when they inevitably stop?

Given the current state of the economic recovery in the United States, while another round of quantitative easing is in the process, the Fed’s own guidance states that loose monetary policy will exist at least until 2015. Europe’s recovery will take even longer, and the uncertainty in Greece will require recapitalization of banks, or perhaps, much more intervention from the central banks.

The central banks’ balance sheets have grown dramatically. Since the Lehman crisis in September 2008, the Federal Reserve’s balance sheet has grown from $900 billion to $2.8 trillion; the European Central Bank’s balance sheet has grown from €1.5 trillion to €3 trillion, and the Bank of England’s balance sheet has grown from $150 billion to over $500 billion.

Inflation has not occurred, in spite of the large balance sheet expansion at the central banks. This is because a much lower money multiplier, and inadequate liquidity, continue to exist. In spite of all this, the central banks will need to exit from this extreme monetary policy at some point. How this is done will be very important, and uncertain.

One consequence for the central banks of continued low interest rates and monetary easing is an inability to respond to further shocks. The second round of quantitative easing was less effective than the first, and less effective in general due to intense demand for liquidity and treasury bonds (the “risk off” trade). It is unlikely there will be much room for rates to move downward for years to come. This, coupled with debt concerns and government unwillingness to act, suggests that both monetary and fiscal response to future crises will be constrained. The other consequence is inflation. Expectations for inflation are still very low, but any rise would constrain central banks, especially those like the European Central Bank and the Bank of England, each with a single mandate to maintain price stability.

These policies, coupled with increased regulation, have had a profound effect on the financial system. Central banks have traditionally expanded the monetary supply by making open-market purchases of government bonds. Intense demand for liquidity and safe assets has pushed rates to historic lows, but they are increasingly scarce, and it is more difficult for banks to comply with new risk requirements.

Arcadia believes that these new banking requirements will constrain growth because banks must divert so many resources to safe assets. Also, if central banks end their provision of liquidity, it is unclear how banks will effectively respond to this policy.

Arcadia believes that central bank activity has created an artificial economic environment. Interest rates are repressed to unprecedentedly low levels, bond markets and general credit markets are not functioning as efficiently as they ought to, and demand less risky assets has been artificially enhanced.

We believe that large money center banks hold more risk than a promise, in this new environment. Arcadia does believe there can be great opportunities in the financial sector for specialized financial companies. That is those companies focusing on consumer credit, payment processing, mobile payments, small business credit, and asset leasing. These will continue to be essential functions that must be fulfilled in many markets around the world. There are several companies that serve these functions well, including MasterCard, CIT, PayPal (a subsidiary of eBay), and AirLease Corporation, among others.

The European Crisis

The European crisis thus far has required bailouts, austerity, and the construction of, so-called, “firewalls.” The overall impact has been to significantly reduce economic growth. Europe is in a downward spiral of budgetary deficit, high debt, high interest rates on those debt balances, and reduced revenue from shrinking economies. This is a recipe for disaster.

However, Arcadia does not believe the Europeans are economically suicidal. There may be great opportunity once there is clarity regarding the debt crises that confront Greece, Portugal, Spain, etc.

Germany prefers a strategy of budgetary austerity combined with lower labor costs and export promotion. One of the keys to German success has been its trade surpluses built up against other European countries, where consumers and governments accumulated significant debt. While Germany has benefited, this strategy is proving disastrous in depressed economies. The only remaining options are significant political and financial reform. Germany must concede this point.

Some of these reforms include aggressive recapitalization of banks, new debt instruments – which may include Eurobonds or other forms of cross-collateralization or other shared credit enhancement, a continued active role from the ECB and IMF, pro-growth strategies, and relaxed labor restrictions in many countries, and the political will to do it all.

Like a bad joke, Europe needs French reform, German extravagance, and Italian political maturity before it can tackle the immediate emergency in Greece, followed closely by Portugal, Spain, etc.

The key is Germany, and what they may be willing to do regarding shared credit or European wide bond issues. So far, the objections have been strong, tight, and rather Teutonic. Even though Germany has substantially benefited from the profligacy of other countries, which they now deride, (publicly) they seem unwilling to compromise on some of these essential issues.

The situation in Europe can go in many different directions, some of which are disastrous and self-defeating. That does not preclude those scenarios from happening. As stated, we feel there can be great opportunity once a reasonable policy is adopted. But, because of the uncertainty and fluidity of the situation, Arcadia is willing to observe now and react when appropriate.

One of the obvious opportunities that we see developing will be to invest in the indexes of Spain and Italy’s equity and debt markets. If reasonable policy is adopted, these indices have been oversold significantly, and represent great potential upside when the “risk off” trade consumes the market.

However, we are skeptical now because Europeans never miss an opportunity to miss an opportunity.

The US Energy Market

The US Energy Information Administration estimates that most of the gains in US liquid fuel supplies will come from increases in natural gas production, along with further development of the Bakken oilfield. In fact, the EIA predicts the US will become a net liquefied natural gas exporter in 2016 and an overall net exporter of natural gas in 2021. Also, the US will be energy self-sufficient by approximately 2030. If true, this is a dramatic development. In 2005, the US imported 60% of its energy needs; today it is slightly less than 50%.

State rules impacting electricity generation, and federal laws on ethanol blending, will have the greatest impact on the country’s shift to renewable resources. However, other technologies, such as solar and wind, are questionable as to whether they will have a true long-term impact relative to sources such as natural gas and new oil reserves developed through enhanced technological methods.

Arcadia believes there is a trend favoring natural gas, and pushing against dirtier and, for now, more expensive, alternatives such as oil and coal. We clearly see the sustainability in use for oil and coal, but we see great growth potential in natural gas.

There is also significant opportunity in the pipeline and energy delivery sector. Traditionally, oil was received via overseas shipment, and pipeline systems produced to direct that oil from ports to its areas of direct consumption. Now, however, an increasing amount of oil is being produced domestically within the United States (the Bakken Field), as well as Canada (Alberta tar sands). Pipeline systems that now network within the United States represent a more cost-efficient delivery system, and a significant economic opportunity.

We do not see a similar opportunity in solar and wind. We think some of these opportunities are overvalued, and their future is uncertain. Delivery onto the grid, and other distribution, is not well developed.

Investment opportunities exist in several areas, including owning natural gas outright, investing in liquefied natural gas transporters and producers, energy generation companies, and energy services and transport companies, including domestic pipeline systems.

The Mobile Revolution

Mobile phones have become the most ubiquitous personal computing technology in the world, surpassing the personal computer, as cellular devices have penetrated previously unreachable landline geographies.

Arcadia believes there is a conversion cycle from the “dumbphone,” that is, the regular cell phone, to the smartphone, a robust computer-like device. We are at the beginning of this conversion cycle, and IDC estimates this cycle is only approximately 20% completed. It expects that by 2015, there will be approximately 1.5 billion smartphones, and 500,000 tablets sold worldwide – compared to less than 500,000 personal computers.

Also, internet-connected smartphones are rapidly becoming the most important computing platform. This is disrupting the traditional PC and technology industries and is creating a huge new opportunity for global competitors.

In 2011, there were 5.6 billion dumbphone users, compared to 835 million smartphone devices. In the US, the conversion from dumbphones to smartphones is about halfway completed. But, the replacement cycle is only just beginning globally.

Manufacturers such as Apple, Google, Samsung, and Nokia are vying for position in this international horserace. Apple’s iOS and Google’s Android operating systems account for 75% of the global smartphone market share, up from less than 50% a year ago. But, we think it’s more than a two-horse race.

While Arcadia believes the race is not over, there are some opportunities that have emerged. Qualcomm is the best-positioned company, because of its sustainable advantage in intellectual property and technology, to benefit from this global trend. Also, the Apple ecosystem (of which Qualcomm is a part) is creating global growth and attractive investment opportunities in companies that are part of the Apple trend, as well as Apple itself. Samsung may be transforming itself into a higher growth and formidable competitor.

Nokia may be a turnaround situation because it has a global presence, and the slightest improvement has tremendous leverage for this opportunity. Microsoft, with its mobile operating platform, has been discounted substantially. Arcadia believes this may be a mistake. We would not count out Microsoft when it comes to understanding and profiting from a global computing trend, eventually. Also, another important technology company, Intel, has been dismissed, as well. We also believe this can be a mistake. While Intel is a formidable presence in the PC market, which we see as diminishing, Arcadia also expects Intel to respond with high quality mobile chip solutions. The “Wintel” platform may still be underpriced in the mobile world.

Big Data

The McKinsey Global Institute states “data have swept into every industry and business function, and are now an important factor of production, alongside labor and capital.” Digital information has grown tenfold over the last five years. That is, information that is created, captured and replicated worldwide. IBM has stated that the amount of data produced from Google, Facebook, Wikipedia, Twitter, and other services where people leave digital traces and deposit data, produces every two days on the web more than all the data available prior to 2004.

This dramatic emergent size and complexity requires new technologies and is creating tremendous opportunity. IDC estimates that big data will be a $17 billion annual market in 2015, up from just over $3 billion in 2010 (a 40% annual compounded growth rate).

Relational database management is a key component of this market. In other words, the real opportunity is trying to figure out what all this data means, and how to use it. It is estimated to be almost 33%, the largest share by far of any data sector.

Arcadia believes that large, global experienced technology companies are by far the best positioned to take advantage of this trend. Companies such as Microsoft, IBM, and Oracle, are best positioned to understand relational databases, and data movement. The infrastructure driving this data movement and usage will be led by Cisco. While we do not dismiss the importance of “the Cloud,” profiting definitively and sustainably is a true challenge. There will be emerging companies that do this effectively, and Arcadia will work to identify them. We believe there will be emerging companies that can create great opportunities within certain sustainable niches. We will identify the specific opportunities as they emerge. Historically, we have seen great opportunities with emerging new companies, such as Riverbed and F5, who understand how to specialize in a clear high-growth value-added niche. They simply are not obvious long-term investments yet.


As retailers are emerging from the 2008 recession, we see dramatic changes in the makeup of malls and big box retailers. Luxury department stores, like Saks, electronics retailers like Best Buy, and mass specialty chains like Abercrombie and Fitch are closing stores, as consumers begin to shift to new channels, many of which are not controlled by the retailers, such as online distributors and flash sale sites.

Retailers understand the digital shift, and many retailers, such as J. Crew, Urban Outfitters, and others, are reporting that over 10% of their sales are coming from direct-to-consumer online channels. However, this shift is magnifying issues associated with physical storefronts. Many stores, like the Gap, are using smaller storefronts to bolster margins, while others, like Best Buy, are shifting product mix in order to survive. Barnes & Noble survived the onslaught from Amazon, for now (unlike Borders), but this is helped substantially by their product mix and tablet offering. Perhaps the market needs at least one large physical bookstore. But, apparently, it does not need two.

Another phenomenon is the flash sale. This is a potential threat to luxury specialty shops and department stores, like Macy’s, Neiman Marcus, Nordstrom, and others. Examples of these businesses include the Guilt Groupe and Rue La La. We believe that, while this threat can be formidable, an appropriately merchandised large retailer can do extremely well.

Arcadia believes that the “store within a store” concept for large retailers, such as Macy’s and JC Penny, can represent a higher margin/higher volume business model that can generate substantial profit growth if implemented effectively. These retailers have a substantial sunk cost in real estate and very attractive locations. They represent an opportunity that can be leveraged to their benefit, as well as to the benefit of the stores that locate within their stores. Essentially, they become a leveraged real estate play and leave the cost and risk of merchandising to others. This is a challenging transformation that, while providing the potential for substantial upside, has great risk and may not prove successful for the incumbents to implement.

Arcadia also believes that there can be a great opportunity in high-growth, specialized retailing chains with great growth potential. While we are cautious, as we have seen from overexpansion at Abercrombie and Fitch, a high-margin, high same-store sales growth specialty retailer, with an easily replicable model, can be a great opportunity. Examples of this include Lululemon, among others.

Arcadia will look at physical retailers that can successfully implement a “store within a store” strategy, a specialty retailer with great growth potential in a defensible market position, and unique online retailers, such as Guilt Groupe.


Commodity prices have generally increased over the last several years. A driving force has been increasing demand from emerging markets, particularly China. Oil prices have generally increased through a combination of increased economic activity globally, reduced low-cost supplies (e.g. Saudi Arabia was typically able to meet any shortfalls in oil supply, but its spare capacity has been declining for years, and demand has outpaced it’s discovery of new reserves), and speculation.

Arcadia believes energy prices will continue to be volatile, especially oil. Even though promising new discoveries may increase proven reserves, this oil is from shale and tar sands and is much more expensive to extract.

Other commodities, such as copper and iron ore, react directly with economic activity, especially growing economies in emerging markets. Once again, China is by far the largest player. Its economy has been slowing from its high growth rate of approximately 9% annually. With that, prices of copper and iron ore have decreased significantly. China has also been aggressive in making its own commodity investments, including copper mines, oil, and other mining infrastructure throughout Africa. Arcadia believes this is a growing geopolitical trend – countries in emerging markets will attempt to secure their commodity supplies essential for growth. We are seeing this in agricultural land, as well.

Arcadia sees an increasing trend where the supply of essential commodities will be squeezed because emerging market countries will seek to lock in supplies, along with mature markets, and will continue to grow and build their manufacturing base. An example of this is rare earth metals. China controls 95% of the world’s supply, used primarily to manufacture electronics. Other sources are beginning to be exploited, but China will still maintain an outsized share, and significant cost advantage. This enables pricing control through strict export quotas, and a near monopoly position, squeezing supply, and creating pricing opportunities from other suppliers.

Increasing competition for commodities can create interesting economic opportunities. Those companies that provide commodities essential for manufacturing input, such as Glencore, MolyCorp. FMC Corporation, and others, may be advantageously positioned to exploit a coming global supply and demand imbalance. Also, owning the commodity directly, through a long or short position, can be an attractive strategy. Also, companies like CF Industries, which focuses on basic minerals such as potassium and phosphates, control and produce minerals of limited supply and increasing demand. These companies represent great investment opportunities in the long-term.


We will continue to see dramatic geopolitical and market impacts from food scarcity and rising prices. For example, while there were many causes of the “Arab Spring,” one catalyst was clearly increasing food prices. Arcadia believes that this is part of a larger trend, interrupted only by the 2008 global recession. The United Nation’s Food Price Index reached its highest level ever in 2011.

Global trends in food supply and demand mean that food scarcity will be a greater problem worldwide in the future. As an example, the Middle East and North Africa import more than 50% of their food, leaving them particularly sensitive to food price shocks.

A principal driver of food scarcity will be global population growth, particularly in the developing world. The global population has doubled since 1970 and is projected to reach 9 billion.

As populations in developing nations are lifted out of poverty, they consume a higher calorie diet, with more meat and dairy. A 10% increase in a Chinese family’s income is associated with an 11.5% increase in spending on meat. It takes 3 kg of grain and 16,000 liters of water to produce just 1 kg of meat.

Water scarcity will be increasingly problematic as agriculture accounts for 70% of water consumption worldwide. China and India are increasingly overpumping their aquifers, and significantly reducing their water tables. Soil depletion from unsustainable agricultural practices is estimated to have reduced productivity in one third of the world’s farmland.

Arcadia believes prices are going higher. The factors mentioned above, along with higher energy and fertilizer costs associated with modern agriculture, and increasing global temperatures creating the potential for increased drought and reduced crop yields, can cause dramatic price increases. As an example, the 2010 heatwave in Russia reduced crop yields by 40%, causing a global price spike.

Arcadia believes there are investment opportunities not only in agricultural commodities themselves, but fertilizer and equipment companies that service the agricultural industry.


Several trends are combining to make opportunities within this sector attractive. There is a growing global middle-class, estimated to reach 2 billion consumers in the next decade, which will have an increasing propensity to spend money on healthcare and related services. Mature economies are aging. The United States, Japan, and even China (who’s economy has yet to mature, but whose one-child policy will cause premature demographic aging over the next 20 years) are aging quickly. A larger portion of the population of these, and other countries, will require additional healthcare expenditure and services. Finally, global healthcare providers are adapting their products and services to reach this larger market through over-the-counter products for emerging markets (versus prescription drugs typical in the West), and specialized products to address aging populations.

Insurance and healthcare industries are set for substantial growth as chronic conditions (such as diabetes) become more prevalent, and the growing middle class can afford to pay for more treatment. Emerging market healthcare expenditures are estimated to increase by 20% annually over the next 10 years. Even though there is a trend within mature markets to reduce healthcare expenditure, there is still great opportunity with more cost-effective therapies, such as generic drugs, over-the-counter products that have come off patent protection, such as Lipitor, and cost-effective medical equipment that will save expenditures from more complex procedures and diagnoses.

Companies well-positioned include Teva, the world’s leading manufacturer of generic drugs, as well as some biotechnology companies developing new therapies that can be distributed globally by the large pharmaceutical companies, and even some equipment manufacturers such as Siemens and Toshiba. Other global branded product companies are well-positioned to access this growing consumer class, including Nestlé, Unilever, Johnson & Johnson, and Sanofi.

US Manufacturing

We have seen the rise of Chinese manufacturing might, and the decline of US manufacturing. The US had an obvious competitive disadvantage versus developing nations, especially China. Other nations had lower wages and looser regulation. However, US manufacturing is resurging with growing payrolls, increased exports, and improved productivity. US manufacturers have added almost 500,000 jobs since 2010. Gains are coming from improved competitiveness, which could bring as many as 2,000,000 to 3,000,000 jobs back to the United States. US manufacturing unit labor costs declined over 10% between 2002 and 2012, a decrease matched only by Taiwan.

Auto manufacturing has been an area of strength, accounting for over 1% of GDP growth – about half of total growth. Other strong areas include computer and electronic products, food and beverages, and chemicals.

Increased productivity, historically low natural gas prices, and natural advantages in chemical and IT manufacturing help, but a weaker US dollar and rising wages in the developing world are central to this trend. For example, regarding China, its currency has appreciated 30% against the dollar since 2005, and wages are increasing by 15% to 20% annually. Considering this, and the immediate access to the domestic US market, US manufacturers are finding basing manufacturing within the United States to be much more appealing.

Emerging market demand is boosting US exports, as well. Exports rose 17% last year, and over 60% of those exports are manufactured goods. Arcadia believes that if costs in the US remain at present levels, emerging-market relationships maintained, and the US continues to produce the workers needed, this sector will be the one to drive the economy forward.

Opportunities can be found in manufacturers that have key advantages within the United States, but can also access global markets. Examples include Cummins, Deere, and some middle-market companies with high growth potential.


China is essential in several dimensions. Its domestic market is growing substantially, and its consumer spending as a percentage of GDP is only about 30%, versus 70% in the US (it’s about 50% in Russia; 58% in Japan). As consumers become increasingly enriched in China, many interesting opportunities will develop for domestic Chinese companies. Another dimension is global manufacturing. China’s labor costs and relatively relaxed regulation make it an essential component to any manufacturing strategy. A counterbalance is that labor costs within China are rising up to 15% to 20% annually. This may impact China’s global manufacturing position. China also exports a substantial number of products globally. 20% of China’s exports come to the US, another 20% go to the European Union, and approximately 10% go to Japan, with almost 50% of China’s exports going to emerging markets. Given all this, Arcadia believes China will continue to play a critical role globally in all trade.

China produces approximately 11 million cars annually, which is expected to rise to over 15 million cars by 2015 (approximately 11 million are produced in the US, down from a high of 15 million a decade ago). China will become (and by some measures already is) the largest auto market in the world. Regarding overall consumption, from 2005 to 2010, retail sales increased at an average annual rate of over 17%. China will be one of the most important global markets not only for luxury goods but for middle market, medium-priced products, as well.

There are many risks to China, including the reliability of any data, and every company is subject to the political whim of the controlling party. While Arcadia believes the government will continue to be pro-growth, and aid in business development whenever possible, the party will ensure that Chinese companies will thrive, even at the expense of foreign entities (e.g. Baidu vs. Google).

Another risk is the banking system. The banks are a state tool, funding state-owned enterprises, starving more efficient and worthy companies of capital. Inefficient capital allocation will always slow growth, and damage any economy, even China’s. The issue is whether or not other forces within China, including a shadow capital and banking system, can overcome these barriers sufficiently. So far, that seems to be the case, but we do not know how long this can be sustained.

The creditworthiness of state-owned enterprises is questionable. The Chinese government has substantial resources and can weather any liquidity or credit issue, but the full impact of any financial crisis – which in China may merely be a slowing of growth – is impossible to truly gauge. However, one of China’s great financial strengths is its extraordinary savings rate – 51% of GDP – even higher than its investment rate. The financial foundation is quite strong, the State’s reservoir of resources vast.

Local government debt is a significant risk. Land sales have been used to generate revenue to fund local budgets, but vocal protests and bad publicity have slowed this process. The local budget deficits remain, however. The State may eventually be required to fund these budgets, but, so far, it has shown no desire to do so.

Political instability may be growing, along with resentment in China of foreigners. There has been a lot of negative publicity about this, and we are uncertain if the full impact is understood. Arcadia believes, however, that China will be more stable than the recent press has indicated.

China’s currency remains a hot political issue. Arcadia believes that the renminbi is not as undervalued as has been reported. It has appreciated more than 30% against the US dollar since 2005, and China’s current account surplus/GDP ratio is below the US treasury’s benchmark level. The currency issue is overblown. Chinese goods make up less than 3% of US consumer spending, and half of that spending goes for services produced in the US.

Given the political issues and economic trends, we believe that China can represent an attractive economic opportunity. We like certain Chinese-based companies that appeal directly to the increasing consumer base within China. The Chinese are also especially adept at online consumption. Therefore, Arcadia will continue to monitor closely companies like Baidu (Internet search), RenRen (social networking), Tencent (online commerce), and Sina (media and entertainment). Valuation levels may be high and will fluctuate. Arcadia will only invest at appropriate levels.

Luxury goods also represent a great growth opportunity within the domestic Chinese market. High-end retailers have found significant growth opportunity selling in China. As the wealth creation engine continues to develop within China, luxury brands, such as Coach, LVMH, and others, along with jewelry retailers and other companies that serve this emerging class, may be attractive. We believe this opportunity has been overblown, and maybe sometime until valuation levels match the appropriate economic opportunity. We will continue to monitor domestic Chinese consumption, and identify undervalued opportunities.

Arcadia believes that China must be a core consideration for any investment strategy, even if we decide not to invest directly.