#1 Investment Weekly – Profit expectations must fall

Bear markets are all about contraction, as investors take into account the higher risks to earnings due a slowdown or decline in economic activity. The most visible crunch is the decline in the benchmark index. Yet, as I pointed out in last week’s newsletter, the Hang Seng index is still 10% higher than it was a year ago. Worse, according to consensus estimates, earnings for Index constituents show a 10% increase on a collective basis compared to estimates made last year for 2008, while the index’s PER is actually higher than a year ago at 15.7x (vs 15.4x). This situation must, and will, change.

 

The collective nominal earnings for all 43 Hang Seng Index constituents for 2008 are currently forecast to be HK$765,881 million. That’s a 3.3% increase compared with 2007’s actual income. On a weighted average basis, earnings are actually expected to contract by 1% (mostly due to the 26% decline in earnings expected at heavyweight HSBC). This is the sort of slowdown in earnings one would expect in a weakening economic environment.

 

However, according to data I have collected from a year ago, the forecast for 2008 earnings was HK$692,368 million. That means that analysts have raised their earnings estimates for 2008 by 10% compared with a year ago. Some of this increase has been due to the rise in profits for resource companies. Remove the five resource companies and the increase in earnings upgrade drops to 7.6%. Still, a near 8% increase in net profit from estimates made a year ago, does not seem to jive with the slowdown in economic growth expectations from a year ago.

 

 Analysts could counter my puzzlement by pointing out that China and Hong Kong’s GDP have both risen by 6-10% in the past 12 months. This justifies the increases in their estimates from a year ago. However, economists should understand that profitability and GDP are not particularly well correlated, particularly because of the lags caused by shipments of goods, their pricing, the input costs used, businesses’ fixed costs and other operating expenses.

 

Interestingly, over the years, I have noticed that analysts tend to start bringing their profit estimates down before economists cut their GDP estimates, because of analysts’ ability to monitor sales and margins via their contacts with the companies they follow.

 

Monitoring earnings estimates can provide clues as to which sectors are going to lead the market to its inevitable cycle low, and which sectors should be the leaders on the way back up. In effect, there are four sectors in the Hang Seng Index, accounting for 30 companies, or 70% of the index’s constituents (88% in terms of market value).

Changes in 2008 consensus estimates since June 2007

 

The table shows the average change in estimates for the four main sectors of the index. The stand out increase in estimates since June last year is (naturally) resources, with a 27% increase. Financial and Utilities are level with an 11% increase, while Hong Kong property stocks have seen no increase in earnings estimates in the past year. In fact, estimates for property stocks and utilities (particularly China telecom stocks) have seen their growth rates pared back quite dramatically over the past year, to such an extent that both sectors are expected to report negative earnings growth in the current year. This makes some sense, because, although local property prices have been rising, this has been chiefly due to a lack of supply, while China’s telecom industry is currently undergoing a major restructuring that will disrupt profitability. The MTR (which I consider a utility) also has lower property completions this year. I suppose the surprise in the table is the strength in financials, particularly against the global background. China’s banks are expected to report strong earnings growth in 2008, partly as they use their newly acquired capital, and because they continue to defy Beijing and write loans at a rapid rate. Their strength more than makes up for flat income at Hong Kong banks (lower fees, higher expenses and provisions), and HSBC’s huge American write-downs.

 

As you would expect, the price performance of each sector, exactly mirrors the expectations for earnings. If there is an anomaly, it would appear the utilities have outperformed expectations. This premium performance may be due to the perception that utilities offer defensive downside protection. When the rebound comes, utilities will probably under perform.

 

I have to admit, the price performance of Dore (628.HK – HK$0.45), which has been my only stock recommendation this year due to its strong defensive qualities, has underperformed against a tide of good news. I thought recently that the upcoming listing of Mr. Stanley Ho’s SJM (a direct competitor) had encouraged some switching of funds away from Dore. After all, Capital Research and Management had announced a reduction in their stake in Dore last week. The sale of 10 million shares is small compared with its total holdings of 72 million shares – so this overhang will remain until it is cleared. However, there has been counterbalancing news: 1) Dore is spending another HK$2 billion to increase its stake in the Macau junket business while 2) there appears to be another delay in SJM’s listing. Both these pieces of news should be viewed as price positive, and should lift the stock from its current 12 month low.

 

At the time of writing, the HS Index was still trying to test its 12 month low. It will probably achieve that milestone this week. One should not underestimate the tales being told by the following two charts (one with a long term horizon, the other more short term).

 

The first chart plots the percentage of positive monthly returns in the trailing 12 months for the Hang Seng Index. As June is certain to close lower, the percentage will fall to the normal bear market percentage of 45%. As the current bear market is behaving in line with expectations (at least in terms of the 8 months standard duration) it is possible that the depth of the current down cycle will be in line with the 45% norm. Only if there are bear market extension, will the percentage chart move down to the 32% level. The chart would suggest that, from a monthly perspective, the bottom of the cycle is near.

% of positive monthly returns of HS Index (12 months)

 

The second, shorter-term, chart shows the distribution of turnover at various levels of the Hang Seng Index. What it is saying is that there the Index has been spent very little time in the 21,000 area.

Hang Seng Index price/turnover (HK$b) all time

As such, there doesn’t appear to be any support for the index in the 21,000 area, and a sharp move to the 20,900 neckline seems inevitable.

Part of the reason for the lack of interest in the 21,000 area is due to the fact that the index basically blew past this region in 2007, and spent a small number of days in the 21,000 range when the index hit its year-to-date low in mid-March. That low was triggered by the collapse of Bear Stearns. If the index moves through 21,000 again, it will likely be sparked by liquidation worries as the oil bubble bursts. This may pressure prices into oversold territory, producing the V shaped bottom the index should ideally form.

#18 Macau

My mother’s maiden name was Morales (meaning: Place with abundant blackberry plants), while her mother’s name was Gomeze (meaning: Son of Gome, Gomo or Gomaro, also of Germanic origin), which are relatively common Latino names. However, she was born in the (former) Portuguese colony of Macau, which is a one-hour, high-speed ferry ride, south-west from Hong Kong. So, it was only natural for me (as a filho de Macau) to visit the old place when I first landed in Hong Kong.

 

If you ever visit Macau, there are two characteristics of the place that you should watch out for: 1) the mañana attitude of the locals and 2) the preservation of Catholic/Portuguese architecture.

 

 

You would never see anyone in Hong Kong walking around town in the middle of the road with their hands behind their backs! See what I mean about mañana?

 

The first time I visited Macau was in 1985.  This is when I took the photographs of this post and explains why they look kinda old (sort of sepia-like). The transformation of Macau in the past 20 years has been quite astonishing. Basically, the government of Macau adopted the Broken Windows theory that was highlighted by Malcom Gladwell in his book, The Tipping Point (see page 141). When I first visited Macau, the place was run down and seedy. As the photograph below illustrates, although the buildings were quaintly Mediterranean and the atmosphere was decidedly relaxed compared wth bustling Hong Kong, underneath the denegration, the town was basicly being run by gangs of triads who were fighting for control of the gambling and prostitution rackets that still dominate Macau’s economy.

If you go to Macau today, you will be hard pressed to see a building in this much disrepair. The place has been spruced up, and the crime rate has declined proportionately.

 

The preservation of the Catholic architecture is best illustrated by Macau’s main landmark, the ruins of the Cathedral of St. Paul’s (which was built by Jesuits and badly damaged in a fire in 1835). I have posted two images of the ruins, one of my pictures of the remaining facade, and a sketch from 1834 by Macau’s most famous documentor, the 19th century English artist, George Chinnery (who lived and drew/painted scenes of Macau for 27 years until his death in 1852 – i.e. 24 years before the birth in Macau of my great grandmother Esperanza).

 

Along with the highly visible churches, Macau’s Chinese temples have also been maintained, thus enhancing the East meets West feel of Macau and adding a splash of red to the usual pale yellows and greens. Here are two images of the A-Ma Temple - from my 1985 trip and a sketch by Chinnery from 1833.

As I have familial connections with Macau, I thought it would be appropriate to invest in two sketches by Chinnery (a banana tree and a junk – both of which are inscribed with his unique codes), which I have posted below.

 

#17 Smoker

I’m a smoker: I admit it. I’m a drug addict. I know it’s wrong. But how was I to know? I was 13 when I started, my father and his father smoked. It seemed the natural thing to do back in those days. There were no health warnings, although, on reflection, it seems pretty clear now that inhaling smoke is not a good thing for your lungs. Anyway, all the other guys at school (see below) were doing it.

 

Passing around those little No.6s in the fire escape of the dormitory.

The Jesuit priest who was our head of year at school used to roll his own. We were always impressed when he rolled one, with one hand, and we watched in awe as the thick smoke rose in the air above him. I moved from No. 6 to Benson and Hedges because my father smoked them.

 

 When I first arrived in Hong Kong I had given up smoking. It was mostly an economic decision, although, the process of stopping was something akin to a “moment”. I suddenly stopped while taking in a drag, and asked myself what was the purpose of inhaling in, and breathing out this stuff? As I couldn’t answer, I decided to stop. It worked. I started up again, several years later, because my wife-to-be was puffing away on very light Silk Cut – the ones in the yellow box.

I eventually switched to Salem Lights or Green as they have recently been rebranded.

 

The economics of smoking in Hong Kong are relatively friendly. Cigarettes are dirt cheap at HK$29 a packet (US$3.72 or Stg1.86). In fact, most people smoke duty free cigarettes brought over the border with China or bought at the airport by acquaintances. These only cost HK$11 a packet.

 

Hong Kong has been smoke-free in public places such as restaurants and bars for one and a half years, but you wouldn’t really know it. I haven’t seen a noticeable decline of smokers on the streets. In fact, our numbers have increased, as smokers from offices now congregate in particular areas of the street to pollute the atmosphere together. In the old days, smokers in the organizations I’ve worked for were allowed to smoke in their offices, or in special areas around the office, or in the fire escapes. Nikko had a special room for smokers, because the Japanese have always been the most accommodative of nations when it comes to cigarette smoking (they still have smoking flights). My current company actively encouraged it, with smoking at meetings common practice. The poor non-smokers were often forced into inhaling the smoke on a regular basis, because committee meetings used to take up most of the working day. In effect, they were smokers. The particularly nasty habit of leaving a cigarette to burn away in an ashtray, unattended, made the situation even worse. Some meetings were so bad that it was hard to see from one end of the room to another. The chain smokers didn’t seem to notice, as they were too busy stubbing out their cigarettes and starting up another. I made a point of never smoking in meetings, although, I got my fair share of nicotine just from breathing in the air.

 

Combining my daily nicotine and caffeine addictions should have produced some devastating damage to my insides. But, for the moment, the God’s have deemed that I can steer clear of the negatve effects of these terrible drugs, and simply enjoy the benefits.

 

What benefits? Well, other smokers will confirm that a cigarette after a meal somehow tastes goooood! Although smoking a cigarette produces an elevated heartrate, this could be good thing because the heart is being exercised. However, the effect can be neutralized by drinking coffee.

#16 What exactly do you mean?

The written word is a two way process, it requires a deliverer (the author) and a receiver (the reader). It’s also circular, rather than linear, in that the author is conveying a message which he/she wishes the reader to act on, thereby resulting in the wishes of the author being fulfilled. Unfortunately, as I travel around Hong Kong, I frequently come across examples of translations into English that break these basic rules.

 

The following memo is from the management office of Peninsula Heights, where I live. There is no doubt that the memo is informing people about the discovery of a snake. But, there is some confusion about which tense the memo should have been written in – particularly the use of the past perfect progressive. Also, blaming the unstable weather for the appearance of snakes and insects is a little bizarre. I’m also confused about the connection between the call to the police (had the snake broken the law? trespassing maybe?) and the professional (professional what?). The reminder, at the end, is a little unusual because it is not clear what exactly is the issue (the unstable weather, calling the police/professional or something else). The final paragraph seems to sort of confirms that the discovery of a snake in the grounds of the estate requires the attention of the police, rather than the Agricultural and Fisheries Department.

 

Here is another memo from our estate managers about driving slowly in the car park. Again, I understand what the memo is saying, but the grammar is awful, and the repetition of the message is tedious.

I’ve also added this latest missive from the management office of Peninsula Heights, which asks residents to wrap glass objects before throwing them away. It’s not as badly written as the others examples posted here, but the grammar is annoyingly almost correct.

The sign in the photograph below is delivering a message, but it’s very clumsy. The Chinese says “please do not damage the plants”, but the English can be intepreted as “do not damage various parts of the plants” or “there is no damage to the plants” (please make sure it stays that way).

 

Now, you may point out, quite correctly, that I should be grateful and I should consider myself fortunate that these notices/signs etc have been translated into English. I am grateful, and I’m not trying to be pedantic, but I believe that anyone that attempts to translate something into English should spare some time to consult with someone who can write English to a reasonable standard, if there is a doubt about the accuracy of the translation. Otherwise, something bad could happen: for instance, if the notice on a broken park bench said “No damage of bench” would you sit on it? Possibly! Could you sue the sign maker for putting a misleading sign on the bench if you hurt yourself? Possibly. Although the sign was supposed to warn people not to damage the bench, the English reader assumed that the sign was declaring that the bench was safe to sit on, when, in fact, it was not.

 

The following notice from Peninsula Height’s management is an annual treat for me because of the weirdness of the concepts as well as the terrible grammar. I am not sure what the author believes Halloween to be, but he seems to thing that children should pretend to be a Western idol (whatever that is) and dress bizarrely and that they should then make an “appointment for candy”. As with all the other notices I receive from the guys downstairs, I just about understand what he means, but it’s written in such a bizarre way.

 

Here’s another notice from the management of my building, warning people not to drop things when leaning out of their windows while cleaning them. I don’t have an issue with the content, which I (amazingly) understand, but the descriptions of: securing your cleaning equipment (“tighten up their domestic cleaning tools at a fixed point”), leaning out of a window (“body over-projection”), and the warning (“please don’t try it”) are a) confusing b) overly technical and c) accusatory (it suggests that people having been trying it out) and provocative (“now that you mention it, let’s throw cleaning objects out the window to see what happens”). None of these descrpitions were entirely intentional, but badly constructed English notices can cause these effects.

#1 Investment Weekly – One down, two to go

I need to clarify a couple of points relating to last week’s rather radical ideas (that the ECB should cut interest rates and the Chinese should remove its oil subsidies) to revive the dollar, prick the oil bubble and reduce global inflation. It would appear, at first glance, that cutting interest rates and removing subsidies would be inflationary, and are thus counter-intuitive under current circumstances. Not so. Simply put: EU/global inflation has not spiked recently because of demand push (unemployment rates are too high and consumer confidence is too low for this to be true), and, higher oil prices in China would reduce the demand and, therefore, eventually, reduce oil prices.

 

There is another possible contradiction: liquidity is still too abundant to be cutting interest rates. However, as I mentioned last week, the ECB has been sitting on its hands rather than providing liquidity support. Also, although US/European loan growth appears to be elevated, this has been almost entirely driven by the calling of banks’ contingent liabilities, that were written ages ago by some rather loose bankers, rather than due to genuine “new” demand. Therefore, the current increase in money is not contributing to inflation.

 

Further, the French economist, Jean-Baptiste Says, declared in his “Says Law” that money is neutral within the workings of an economy, because it is irrational for consumers to stash it away (particularly when prices are rising quickly). Instead, it is the production of products and the demand for those products that determines the pace of economic activity, price inflation and the creation of wealth. Apply this thought to today’s inflation and China’s new consumers are creating demand as they bring their cash savings into the real economy.

 

Finally, the US Federal Reserve has already stated that it will not keep its emergency liquidity facilities switched open for ever. Therefore, as a modification to what I believe to be the necessary steps needed to strengthen the US$ (and therefore lower oil prices and inflation), I would advocate some tightening of the current liquidity facilities, that were erected as emergency measures to soften the effects of the US housing derivatives crisis. There is a general consensus that the mark-to-market crisis at US and European investment banks is almost over, as the banks have written down the value of these investments to almost zero, and have recapitalized their balance sheets.

 

This triumvirate of actions by the ECB, China (already implemented) and the Fed should be sufficient to achieve the aim of deflating the oil bubble. However, there are always repercussions to radical financial actions. The most notable this time around will be the losses some investors are going to feel when the oil price falls as dramatically as I expect. These losses could be so great that some will go out of business. Unfortunately, the banks that are funding these investments are going to get smacked too.

 

When the bubble breaks there will invariably be some liquidation pressure and general asset prices may fall because of it. But I would see this as a buying opportunity – particularly if the selling becomes acute. It may mean, for instance, that the bottom of the current bear market will be V shaped, with the Hang Seng Index only spending a couple of sessions in oversold territory in the 19-20k range.

 

Locally, investors have moved to the sidelines, as they watch the inflation story unfold, with turnover hitting a 12-month low last Tuesday, with only 19.7 billion shares traded in Hang Seng Index stocks. This apathy has also been reflected in the decline in gross open interest on the June futures to below 100k contracts. Generally speaking, low volume and low participation signal misery ahead.

 

Certainly, if investors are looking for precursors to a precipitous drop in equity/asset prices in Hong Kong, then they might look nervously at the chart below. It’s a 1970s classic, the Misery Index (unemployment rate and CPI – in other words it’s a real unemployment rate). As local unemployment has been low for quite a while now (below 3.4% since the year started), the recent surge in the index is totally due to the rise in oil and food prices. The index did predict the 1997 bursting of the local property and equity markets, but sailed through the tech bubble because asset prices in Hong Kong were still deflating. The recent surge hasn’t hit the highs of 1997, but it certainly appears to have some upside potential. Any further rises could signal a major problem, which is why action to trim inflation pressures is so urgently required.

Hong Kong’s Misery Index (unemployment rate + CPI) (%)

Here’s another chart, which shows the relationship between real PER of the Hang Seng Index and CPI over the past 10 years. There is a clear de-rating of the index’s real PER as inflation rises, with Hong Kong’s long bout of price deflation allowing a ballooning of the real PER during the 2000 internet bubble.

HS Index real PER vs CPI levels (and # of months)

 

At the moment, the index’s real PER is ~10x, with inflation at 5% and the PER at 15x. This is a little high, because the index’s real PER has been as low as 5x, and used to trade at 7-8% before 1997. The average real PER since then has been 15x, which is about the same as the average nominal PER of 16x (in other words, five years of price deflation in Hong Kong almost wiped out five years of price inflation). Unless more urgent action is taken to deflate the oil price bubble, persistent inflation will deflate Hong Kong’s real PER, with the inverse being a rise in the Misery Index.