#1 Investment Weekly – What he made off with

There are two important lessons from the Bernie Madoff Affair (besides the obvious such as: cheaters never prosper, where was the regulator and how did he do it): first diversify and second ignore the rhetoric.

Now that we have closure on the Madoff scandal, it is time to reflect on what went wrong. From an investment manager’s point of view, the overriding lesson is that the investors that placed their trust in Madoff’s promises did so with so much faith that they apparently forgot the first rule of investing: diversify. This is how the press seemed to have covered the story because the testimony delivered at the sentencing seemed to suggest that the investors that spoke had lost everything. If they had done so there would be no mention of “my daughter is holding down two jobs to pay for college” or “we don’t have enough money for food”. Let’s be clear: the people that left their life savings with Madoff had deposited large amounts of money. You had to be rich to invest with Madoff. Even if it was a feeder fund, you had to be wealthy. This was not a scam aimed at retail investors. These were wealthy, supposedly intelligent, people. So, he’s my first fire back at those investors: you deserved everything you got. The greed that consumed you into investing all of your life-savings with one investment manager was foolishness that deserved to be punished. As for the young woman having to work for her college degree, I would not be surprised to hear that she is actually feeling good about herself, almost normal, almost one of the crowd, instead of simply sailing through college knowing that if anything happened, she could always fall back on Mummy and Daddy’s wealth. The type of people that live off their parent’s success mostly grow up to be spineless creatures, who end up putting all their wealth into a ponzi scheme because they have no street smarts. For those that are now working to survive, I would say, great. This is good news for the US economy. It means that people that were very successful during their careers are now suddenly putting their experience and knowledge back into the economy at a time when the US economy needs all the entrepreneurial spirit it can get, as it grows its way out of the recession. These 50-60-somethings may well regret having to go back to work, but I didn’t hear of anyone saying that they couldn’t find jobs (despite the 9% unemployment rate). These people have connections, have done it once, and can do it again, and are more productive now than they were playing golf in Florida.

There is no doubt the press have had a field day covering the Madoff scandal, with headlines screaming about how terrible he was and how much he apparently stole large amounts of money. In a sense, Madoff was partly the Sheriff of Nottingham, and partly Robin Hood. He stole from the rich, but gave back to some other rich people. Remember, no money has actually been “lost”. Only the ones left holding the parcel when the music stopped have not received their capital back. It should also be remembered that those left by the wayside, received returns while they were in the scheme (even last year when the markets tanked). Are they planning on giving these returns back? Not likely. However, there are many, perhaps more streetwise investors, who would have invested and divested from Madoff funds. These investors are no where to be heard, and the press, as usual, consumed with their yelping headlines, have failed to find one former Madoff investor.

There are lots of data about how the scheme worked, some of which can be used (with some assumptions) to determine how the pyramid grew so large. We know that ~1,400 accounts were opened since 1995 and that total flows through the funds totaled US$160 billion, and that ~US$65 billion was active at the time of liquidation. Knowing the top of the inverted pyramid and how many bricks it was made from, we can paint a picture of what Madoff was doing. Assuming very tempting average returns of 8% a year, and after fees of ~US$260 million to himself, one can say the following: 1) he generated 100 new customers a year, each handing over US$10 million in AUM. 2) he must have already had US$40 billion in AUM in 1995 3) outflows could have been as much as US$700 million a year 4) but in the end Madoff’s funds on hand were equal to only 86% of the AUM that was supposed to be in the bank 5) this assumes he was paying 8% but also that he was making no returns – either because he made money in some years and lost in others (particularly in 2007-08). 6) Madoff paid himself a fee of only 0.004% on the AUM. The table below illustrates a best guess scenario.
Madoff’s pyramid

It is possible Madoff could have continued with the scam for quite a while before the coffers were completely empty, but I suspect he was overwhelmed by a tinge of guilt and a lot of panic.

Panic is something the bears are trying to instill into Hong Kong equities. They are talking up local interest rates as a focal point for their argument that equities are overvalued right now. Unfortunately, central bankers have a different point of view and the bears are not likely to win against the keepers of the purse. However, as long as they are trying to force the issue, equity prices will continue their current holding pattern within a narrow medium term upchannel.

#1 Investment Weekly – Summertime blues

We are heading into the usual summer doldrums, and indicators are showing a lull in activity on the Hong Kong’s stock market. The two main liquidity gauges are starting to show signs of fatigue, while short selling is on the up and the number decliners is on the rise. Capital inflows have artificially lowered interest rates and are distorting the near term outlook. This should keep the index moving around the 18,300 fair value mark.

The first chart shows the rise and decline in recent weeks of stock market turnover and volume. The decline has been sharp and short. The second chart shows the money flow of the total market.
Hong Kong stock market turnover (HK$b) and volume (b shares)

Hong Kong stock market money flow (Price change * shares traded)

As turnover has dwindled, the index itself will start to oscillate less. The chart below shows the daily difference of the HS Index compared with its 21 day average. The straight line is two standard deviations of the average.
HS Index daily change vs 21 day average and 2x standard deviation

The z score indicator breeched two deviations at the March low and was one of the many signals of a cycle low. The peak in short selling in February also flagged the low. One reason why the Hang Seng Index has been so volatile on the downside recently was due to the lack of short sellers in the market. This situation suddenly changed last week as the chart below illustrates. The percentage of short selling jumped to over 8%.
Short selling turnover vs total market turnover (%)

So, who have left the market? Although the number of declining stocks is not necessarily an important indicator of activity, it is a good proxy for the nature of market participants. The recent surge in stocks that are declining on the Hong Kong stock market has been noticeable, with the daily tally getting into the 3,000 plus level on a regular basis. This is an indication that retail investors and small cap fund managers have exited the market. This has probably accounted for the decline in turnover and (in particular) volume, especially as the recent jump in IPOs and placements are high volume events.
HS Index and number of declining stocks

So what it causing: the decline in turnover, the rise in short selling and the increase in declining stocks? There is a large clue coming from the futures pits.

Since global interest rates have been declining, the HS Index futures contract has been trading at a discount to spot. This discount reflected the fact that the cost of borrowing on a levered futures contract has been all but zero. Prior to the emergency interest rate cuts of the past 18 months, futures contracts traded at a premium to reflect the cost of holding borrowed money. However, in the past two weeks, Hang Seng futures contracts (all months) have been trading at a small premium again. This reversal reflected an expected rise in local interest rates. At the moment, local interest rates and the HK$ are being kept artificially low/high by IPO and capital raising activities in the buoyant equity market. Also, demand for HK$ is always higher than usual at quarter end. But futures traders are wary of this and have been pricing in higher funding costs. The question that has changed the complexion of equity markets is whether, after the IPOs are complete and the quarter end passes, local interest rates will remain at current levels or will they spike higher. The prospect of permanently higher funding costs, albeit at still very low levels, is a new dynamic that local equity investors will need to navigate (it’s one of those items that makes the current bicycle different from previous cycles). While this question has no answer, equity prices (and their value relative to interest rates) will remain in a tight range, with short covering supporting the downside and the lack of retail buyers capping the upside.

#1 Investment Weekly – Prepare for risk

In 2002 I was involved in a decision that drastically altered the risk profile of an organization. My involvement was to formulate an independent view on a trend that was going on, almost unnoticed, within the local banking scene. The question that was posed was this: as Hong Kong’s economy continues to mature, how can local banks generate returns on equity commensurate with their recent past performance?

The answer was simple: instead of relying on asset growth to generate returns, local banks would have to widen their net interest margins by increasing the risk on their balance sheets. In order to achieve this, banks would have to take a view on the future direction of interest rates and bet on that forecast. As it turned out, this was a recipe for disaster if the organization (read: investor) was not geared to formulate decisions and act on them.

After several memos explaining that local competitors were widening their margins by actively managing their surplus funds, the decision was taken to change the bank’s Treasury operations into a profit-making unit. The bank’s board agreed, the bank’s regulator did not object (because it was going on anyway), and management were convinced that it was the right direction to take. After all, there were plenty of tools available to foresee the direction of local interest rates (Fed Fund futures, HK$ swap rates etc). Instead of just rolling over a HK$ government bond portfolio, why not buy blue chip company paper, at ratings similar to government debt, but with a slightly better yield? After all, the bank had lent money to the same corporate, and had a pretty good handle on its financial situation. This sort of reasoning made perfect sense and it was working. A Morgan Stanley report (titled “Treasury – deflation and recession buster”) at the time pointed out that local bank profits would have fallen 12% compared with the actual decline of 2% in 2001 but for enhanced Treasury profits. The authors of the report were right about several things: first, Treasury was misunderstood (most investors/bank managers at the time assumed that Treasury business referred to bond gains and proprietary trading). However, the authors were dead wrong to assume that Treasury profits are countercyclical relative to the rest of the banks’ business and, consequently, reduced banks’ overall income volatility. In a sense, the authors were selling in writing the toxic products that active Treasury managers were just starting to snap up.

After a couple years, I was asked to write a follow-up memo on whether the bank would have generated better returns by continuing to run an inactive Treasury division compared with the actual outcome. Although there were many assumptions to determine the result, my conclusion was that a passive Treasury would have outperformed the active version we had put in place. How could this be? There were two major mistakes in the set up of the active Treasury model: 1) wrong people and 2) wrong attitude. Management decided to recruit a senior Treasury executive from a rival bank. This was the correct decision: someone senior was required to run the active Treasury team, but an executive requires a strong second string and people, and it was this layer that was lacking. There were some hirings: but they did not last long. As a small bank, the bank could not attract the talented individuals needed to take the extra risks. In the meantime, the staff that had run the passive Treasury were slowly pushed out into other areas of the bank. This was the correct decision – to a point. But the previous managers were still hovering around the scene: waiting for the trading mistakes which could allow them to bounce back into the limelight with their “I told you so” attitudes. I remember sitting next to the former head of the passive Treasury as I delivered my verdict on the passive/active Treasury performance. He felt vindicated and went off and spread his “I told you so” attitude further into the bank’s people network. The final “people” mistake was the introduction of pay incentives based on the performance of Treasury. This introduced a new level of risk that management had failed to completely recognize.

Of course, the passive/active argument could not be decided by a couple of years of performance, and there were so many variables about what decisions the passive Treasury would have taken that the result of the argument will never to known. However, knowing what I know now, seven years on, it is certain that a passive Treasury department would have not bought the CDOs and SIVs that the bank has had to write off in the past two years. Passive works: active doesn’t.

This newsletter runs a passive, long-only, equity investment portfolio that has produced annualized return of 8% since inception in 2001. The strategy has been simple enough: the market’s cycles eventually flatten out returns. The shortest position the portfolio has taken is three months, the longest is the Café de Coral position which was included at inception. The idea of riding out the long term cycles is not a foreign concept, but sometimes investors and company managers get too focused on the present. This has certainly been the theme for equity investors in the past week, where the HS Index fell below the 18,300 benchmark. Just in case readers need reminding, the index is currently just below its 20 day moving average for only the fourth time since the March low. The parabolic just turned down, but the Ichimoko cloud is far below current levels. This week’s action will probably determine the direction of the market for the summer, so it is important for the bulls that the week and month close around current levels.

#1 Investment Weekly – The Law of the Jungle

Most investors and primary school-aged children have poor discipline. Their lack of experience and short memories make them prone to indiscipline and unpredictable behaviour. I’ve been reading Kipling’s The Jungle Books to my youngest son each night as a means of establishing some sort order into his life before bedtime. It’s been working, as Kipling’s characters, Mowgli, Shere Khan, Bagheera, Kaa and Baloo are fascinating and, as it is usually quite late my little one is usually asleep before I finish the third page (which is why this newsletter is usually no longer than three pages).

Discipline applies to all types of business investment strategies, with banks among the most rule-based of all. This might explain why bank bosses are often described as tyrants. They need to instill strict parameters on their staff and balance sheets. For instance, banks are required (by law) to maintain a minimum capital adequacy ratio of 8% and a liquidity ratio of over 25%. However, banks are also subjected to a series of Management Action Triggers (MATs) on their assets/business strategies. Two in particular relate to the profit and loss and the Value at Risk of their investment portfolios. The bank’s treasury risk managers are supposed to monitor these MATs and report any breaches to senior management. Reporting is usually done officially at Risk Management Committee or ALCO. At that point committees are supposed to act to lower the impact on the portfolio. In other words, the MAT is a sort of cut-loss strategy. Unfortunately, cutting loss is as unnatural as a man-cub talking intelligently to jungle animals. Therefore, quite often, as the MAT is only a flag and is not cut in stone, management often chose to ignore the warnings and would rather wait out the storm – in the hope that the losses on the portfolio or the increased VaR will eventually abate. However, if the regulator/risk mangers get their way, the consequences can be catastrophic. Reducing risk usually means selling the riskiest assets, which are also usually the least liquid, so the final price achieved can be lower than the mark to market value that triggered the MAT in the first place. This process was partially behind the forced selling of late last year. For individuals, MATs are not in issue, but cutting loss is more than often a better strategy than hoping for a rebound.

Two examples stand out in this newsletter’s model portfolio – Dore and Wing Lee. The portfolio has hung on to these positions in the hope of an eventual recovery. This is probably never going to happen. On a personal level, I recently acted on a stock tip from a not-very-reliable source last week. Following Clement Freuds’ horse racing advice: I acted on gut feeling, backed up the hunch with a couple of recommendations from reliable tipsters, and then plunged in with a big wager (“Small bets are a waste of time; if it doesn’t hurt you to lose, winning cannot be sufficiently significant to cause happiness”). However, as soon as the buy order went through, the selling pressure was intense and at the close, the large orders on either side had disappeared. This was a bad sign, and it was confirmed with an open below the previous day low. There was only one thing left to do – cut loss, as fast as possible. The stock has since fallen 10% since I sold, in a rising market and in no volume. Although this is a little late, I’ll be looking to unload Dore and Wing Lee early in the current bull market, with the expectation that the removal of loss-making positions will improve the profitability of the overall portfolio and reduce the VaR.

As recommended last week, the model portfolio added Daphne at HK$4.00. The addition of Daphne added HK$17,828 in VaR to the portfolio and lifted the portfolio’s beta to 1.47x. The model portfolio has a book value of HK$2.16 million, with a potential profit of HK$438,584. The portfolio’s VaR is HK$218,174 (to be precise). As an individual with HK$2.6 million invested in equities, I think that a downside risk to the portfolio of 8.4% is reasonable. However, for a bank, with, say an equity portfolio of 100x the size, and potential loss of HK$20 million could be too much to contemplate relative to net profits for the entire bank of say HK$400 million (assuming HK$200 million is 5% of equity and the bank’s ROE is 10%). Selling two positions (Dore and Wing Lee) would result in a loss of HK$236,619 or 9% of the portfolio (half of the book profit) but would reduce the VaR by only HK$14,692 or 6% of the risk of the portfolio, while the beta (or expected performance relative to the benchmark HS Index) would actually rise to 1.49x. At this stage, the sale of Dore/Wing Lee would not make much sense, and, although one could argue that the portfolio is not apply much investment discipline, but Kipling’s Law of the Jungle states: “Now this is the Law of the Jungle – as old and as true as the sky; And the Wolf that shall keep it may prosper, but the Wolf that shall break it must die. Cave-Right is the right of the Father – to hunt by himself for his own. He is freed of all calls to the Pack; he is judged by the Council alone.” In other words, laws are important, but individuals have the right to make their own decisions.

Individual stocks may come to the fore in market action this week as the breadth of the market has changed. Although volume will remain elevated (over 120 billion a day), advancing stock fell while decliners rose last week, and this trend will continue. The index itself will continue to vacillate around the 18,300 level as consolidation continues, with share placements putting pressure on individual stocks.

#1 Investment Weekly – PMI mystery

Equity investors have been very alert recently to the readings of surveys of purchasing managers around the world. This has been a curious change in emphasis away from the usual economic indicators such as unemployment, inflation and retail sales. As far as I’m aware, business surveys in the past were given very little credence by the markets either in bull or bear markets. So why has there been this sudden change in focus?

Part of the reason can be put down to an underlying conflict. Traditional economic indicators are ineffective at providing clues about the future intentions of businesses/consumers because economic data are a lagging indicator. This contradicts the function of the stock market as a leading indicator. Some could also argue that investors have lost faith in economists because they failed to adequately warn of the problems that manifested themselves in the great bear market of 2008. However the greatest reason is that equity investors want to hang on to something different because of the failures of the past. Purchasing Manager Indices currently fit the bill because they are relatively timely, they have an element of future expectations and they involve a certain degree of human interaction.

However, there is a major flaw with the PMI data from China (which was the first survey of a major economy to show signs of moderating and rising). According to acquaintances I know that work for or own manufacturing businesses in Guangdong, the 700 questionnaires that are sent out each month are skewed towards the electronics industries (which have benefitted the most from re-stocking by their overseas customers). There is also a degree of skepticism about responses from companies that are state-owned or are influenced by the state (which is effectively everyone). Quite often the responses reflect state policy rather than business conditions. Take, for instance, China’s stated policy of stock piling basic raw materials. It has been well known for a while that China has been buying basic metals on spot markets (particularly copper) in recent months as a hedge against future higher prices as the global economy recovers. How much of this stockpiling is reflected in the China PMI survey is unknown.

China’s PMI and HS Index

The correlation between China’s PMI and the Hang Seng Index is quite tight at 0.54, but it gets closer (0.63) if there is a one month lag. This fits with the general view that the PMI offers some sort of lead for Hong Kong equities and that the HS Index is heading for a couple of months of consolidation.

A leading indicator for the financial health of a bank is any decision to sell off core parts of its business. Bank of East Asia has always highlighted the strength of its overseas Chinese businesses, particularly those on the west coast of North America. So it came as a real surprise that the bank has decided to sell a majority stake in its Canadian business to state-owned ICBC for US$72 million. This is not a non-core business. BEA set up its Canadian business in 1992 to tap the mass immigration of middle-class Hong Kongers to Vancouver and Toronto ahead of the 1997 changeover. These migrants have firmly settled in Canada and have formed a large pool of banking assets that BEA has gleefully tapped.

Why has BEA sold this little gem? It may because of the attitudes of two external agencies. The HKMA, like all regulators, has been getting tough on local banks, urging them to increase their capital ratios. BEA’s Canadian subsidiary had paid up capital of C$58 million and grew its balance sheet 10% in 2008 (compared with a 9% decline in its Hong Kong business). Rating agency, Moody’s, downgraded the outlook for BEA to negative in early March and it downgraded ICBC (Asia)’s outlook to negative due to its relatively low CAR last week, so the pressure is on to avoid a credit rating downgrade at heavily-indebted BEA (the bank has debt of HK$18 billion against equity of HK$58 billion). Selling a majority stake in the Canadian business does two things: it frees capital and brings cash back to its balance sheet. Good news for BEA, but why would ICBC buy this asset? It is almost certain that BEA’s customers (whose mind-set is suspicious towards the Mainland (why would they have immigrated if it wasn’t)) are likely to leave in their droves at the prospect of their money being held at a Mainland controlled bank. There is likely to be massive destruction in the value of the franchise, and the size of the business is so comparatively small, that ICBC would not benefit financially in the short, medium or long term. The only explanation is that BEA needed the money. Countering this is BEA’s decision to buy-out ICBC’s 75% share of local investment bank, ICEA, for US$48 million. However, this business absorbs a lot less capital than an overseas commercial banking subsidiary, so the argument still stands.

Investment advice in cases like this is problematic because, although it appears there is an issue, it could be glossed over in a rising market. It is unlikely that BEA’s share price will deviate significantly from the overall market, but I would expect the share price to underperform and would suggest switching out of the stock.

My stock tip this week is a company that is a million miles away from a blue-chip local bank with capital issues. Daphne (0210.HK – HK$4.00) is not likely to receive a questionnaire for China’s PMI survey as it retails footwear on the mainland. However, its suppliers probably do. They would point out that conditions for export are weak and that buyers are demanding lower costs and are selling lower priced items, but that local demand is still showing positive figures. I would only recommend the stock below HK$4.00, with a target price of HK$5.00 (note I did not tag target prices on the three previous recommendations because they are for holding, while Daphne is a bit of a punt).