#1 Investment Weekly – Currency unwind, the last in the garden

I’ll be candid with you: I’m a born-optimist. Consequently, I’m feeling very sheepish right now, as everyone turns so pessimistic and so Candide-like. If only the general public had more information, perhaps they would not be quite so fearful, perhaps all would be well in the garden. So here’s the latest financial news – without the hype.

Money market rates have been steadily falling in recent days as central bank assurances have calmed the interbank markets. After the decline in interbank rates around the world, one would have thought that selling pressure on equities would have eased. However, the pressure seems to have actually increased. The bears have plenty of ammunition, but I reckon they are near the end of the clip. The latest weapon is the unwinding of the Yen carry trade (particularly by hedge funds facing huge redemptions and investors that are getting knocked out as downside levels are broken), and the damage to corporate profits caused by the unraveling of structured products.  

Remember, the dealers that wrote the structured products would have had a plan to make money if the products they were selling went sour. This is called hedging. I am quite sure that the investment bankers that were creating “power reverse dual currency notes” (the main medium for executing a Yen carry trade), were also short the Nikkei and the A$ (hence the close performance of the two recently – R2 is 0.93 since A$ all-time high of 15^th July). As the carry trade unwinds, Japanese exporters are getting hammered by the rising Yen, providing more short selling opportunities for the traders. The same could be true of the US$8 billion in Knock In: Knock Out currency products sitting on South Korean SME balance sheets. Here’s the point: although the newspaper headlines are reading doom and gloom, as prices fall, remember, someone is making money as prices plunge into bubble territory. The financial garden is finely balanced, with the same amount of hedges and bushes and trees on both sides of the arbor.

Nikkei vs A$

 

For instance, I am sure the bankers that wrote the A$ accumulator (a.k.a. I kill you later) for CITIC Pacific asked the company’s finance people several times: are you sure? when the terms of the deal were being thrashed out. “You don’t want to be knocked out on the downside?” they would have asked. Are you sure? “what if the A$ falls when the carry trade eventually unwinds? Don’t you want to hedge against this, because, I’m telling you: if you don’t: I will”. Surprisingly bearing in mind the size of the deal, the investment bankers did not query why the managing director, Henry Fan (Exco member, SFC and HKEx board member) did not sign off on the contract (or maybe he did, but he did not know what he was signing). Either way there was clearly some sort of failure in how the deal was approved, and with the global unwinding of the currency trade CITIC Pacific is clearly in a perilous financial position. If the A$ hits US$0.50 by year-end, the mark to market loss on the accumulator would wipe out the company’s HK$50 billion in capital. I’m betting that China will step in to rescue CITIC by taking it private (or maybe implement a share buy-back deal as it did in 1998, when CITIC’s share price was being valued as if it were about to go bankrupt). The current take-over price being talked about is HK$10 a share (Cathay, DCH, the tunnels and CITIC 1616 are worth HK$10 a share, the value of the rest of the businesses (the mines and special steel businesses) have been wiped out by the currency trade from hell. One intriguing fact about HK$10 a share is that Mr. Larry Yung, CITIC’s largest minority shareholder bought his 15% stake in early 1997 for HK$22 a share. As he has received HK$12.50 in dividends since he bought his stake, he will not be out of pocket.

CITIC Pacific is currently trading at 4x 2009 earnings (assuming it takes its medicine and covers the outstanding accumulator in 2008). This looks cheap (both for CITIC’s parent and for non-owners of the stock). However, even if stocks look cheap, that is not a signal to buy them for a short term rally. If your investment time horizon is two years, then current valuations will bear fruit (hence the decision to add ICBC and Esprit shares to the Model Portfolio recently). However, buyers now are fighting against a down trend. As I have being bleating recently, although I’m optimistic, the trend is not your friend (unless you can borrow stock). The players have exited the garden in a panic.

One trend that has changed is the year-to-date 30% outperformance of HSBC relative to the Hang Seng Index. HSBC always outperforms on the downside, and another recent indication of a change in trend for the overall market is the heavy switching out of HSBC shares last Friday. The change in trend started on October 8^th, when HSBC seriously broke below HK$120 for the first time since July. If HSBC continues to underperform, investors can take this as a signal that the market’s trend has changed.

Investors may have sold HSBC shares for liquidity purposes or on concerns of weak earnings when the bank announces 3Q results next Monday. However, I have found little evidence of this. Instead, I would bet that short sellers of HS Index futures were behind the 10% sell off in the bank last Friday. As most futures traders are funded by HSBC, and as HSBC officials continue to talk down the market and raising mortgage rates, they should not be complaining now that their share options are worth considerably less than they were before.

HSBC relative to HS Index YTD (rebased to 100) 

As for the recent addition to the portfolio, Esprit, recent analyst comments were quite alarming. First, its cash pile and rising same store sales means that it will probably pay the same dividend as last year, meaning a secure 10% dividend yield. But one analyst’s comment was: “shut your eyes and buy”. I’m glad he’s done his homework and spoken with the company, but recommendations like that are what got us in this mess in the first place.

#1 Investment Weekly – Chicken Licken fall

I was on holiday during the “Great Fall” of the week of October 13, when, apparently, the sky fell on Chicken Licken (HS Index -16% the largest WoW decline since January 22nd this year, the week the bear market officially started – see January 21st newsletter – Welcome to the bear market). If you are unaware of the fable of Chicken Licken, Wikipedia’s description should suffice: “A chicken jumps to a conclusion (that the world is ending, even though it was only an acorn landing on her head) and whips the populace into mass hysteria, which the unscrupulous fox (short sellers, permabears etc) uses to manipulate them for his own benefit, some times as supper.” Here’s a piece of advice for regulators/governments/investors: if you fall in quicksand try not to move. The more you struggle, the greater the suction effect. The greater the downward pressure the worse your panic becomes. Hopefully, the markets will be given a few weeks of non-intervention by our well-meaning politicians – so that the measures they have introduced can be given the time needed to unfreeze the financial markets (with a fall in Libor leading the way). Eventually, we will be pulled out.

Because of the gap in the publication of this newsletter I need to belatedly clarify a few points. First, when I pointed out in the last newsletter that current economic conditions are not as bad as 1997-98, I was referring to Hong Kong, not to developed economies (which are in a right mess). Sure, Hong Kong will feel the effects, but it will not be to the full extent as elsewhere, and it will not feel as direct as 1998.

As far as I‘m aware, no one is attempting to break the HK$’s peg to the US$, HK$ interest rates are elevated, but no where near the panic levels of 1998 (overnight hit 3,000% on one particular day), asset prices here have risen, but more moderately than pre-1997, suggesting that a correction in local asset prices is not going to be as severe as 1998-03. Unemployment remains low; while real interest rates are negative (although this should revert to positive as import-price inflation eases over time). The only major correction in asset prices has been in Hong Kong/China equities, which, although an important confidence indicator, are not intricately linked with Hong Kong’s real economy. China’s economy is still growing at 8-9% and both Hong Kong and China have huge surpluses to spend.

The early-year decline in Hong Kong equity prices, which have always been heavily owned by overseas institutional investors, reflected global risk aversion (not a deterioration of local economic activity). However, the story altered to a scramble for cash after the fall of Bear and accelerated with Lehmans’ demise. This pash for cash sparked the massive declines in global equity prices in the past two weeks.

The series of events in the past two weeks went something like this: on October 2nd, Lehman’s US$200 billion in outstanding bonds were auctioned to the highest bidder as part of its liquidation. The auction valued the bonds at 9 cents in the dollar. The following day the Dow swung 1,000 points intraday, completing its worse weekly decline in history. Why? Because, written against the US$200 billion in Lehman debt, are US$400 billion in credit default swaps (CDS). These “insurance” policies are due to be settled on October 21st. In other words, the market believed that someone had to find US$364 billion to settle these contracts. Unfortunately, CDS’ are transacted over-the-counter; there is no market; nobody knows who has what. One thing is for sure, the market was worried that someone was about to win big, and someone was about to lose big. In fact so big, they could go under. This was the underlying fear that has gripped the world’s financial markets since Lehman went under, and why large global banks/insurance companies are hording/raising cash. In fact, we are now learning that only US$6 billion in CDS contracts actually need to be physically settled on October 21st. The rest have been netted out, according to the Depository Trust and Clearing Corporation, the body that registers CDS trades. The setting up of exchanges for both CDS and interbank markets can avoid such transparency issues in the future.

My second point is that the current banking crisis is not entirely a “global phenomenon” as newspapers and analysts keep clucking on about. Other than some issues with Korean banks’ short term debt, some CDO/SIV write-downs (HK$8 billion vs total capital of HK$520 billion = 2% in Hong Kong) and a bank run on Bank of East Asia, the region’s banks have performed admirably. They have not needed saving and have not asked for or needed government capital/liquidity (although they are being offered it just in case). Remember, China’s banks are state-owned, just like banks in Europe and the US. If it did nothing else the Asian Financial Crisis instilled risk discipline into Asia’s banking systems. Although some banks were tempted into enhancing their net interest margins when interest rates were unprofitably low (2004-2006), there has been a strict adherence to the basic banking principle of know your customer with loans priced and extended on the basis of the forecast cash flows of the borrower (something that will be embedded into western banker’s by their new owners in the years of recovery to come).

My final point is that taxpayers have always supported the banking system, and that government injections of liquidity and capital into the broken banking systems of the US and Europe are merely an extension of the implicit support for the system by all depositors. By depositing your hard-earned cash (after you’ve paid your taxes) into a bank, you are providing the capital required by the bank to allow it to extend loans to you personally or the company you might work for. Banks and the so-called villains that run them are also tax payers (I don’t have the data for anywhere else, but Hong Kong’s 12 listed banks paid HK$30 billion in taxes last year – 22% of all direct taxes received by the government). Finally on this point, it should be remembered that nationalizing banks also ensures that the financial system stays in domestic hands, rather than some foreign entity. Nationalizing is a political as well as practical decision – thus limiting Sovereign Wealth Fund investments. How ironic, though, that 20 years after the fall of the centrally-planned economic models of the Soviets and China (and by extension the triumph of ReagoThatchernomics/Chicago School) they are making a comeback!

Lastly, I have to take umbrage with Hong Kong’s biggest tax payer, HSBC, and its behaviour in the past two weeks. My recent observations of HSBC suggest it has been short Hong Kong equities. Its decision to raise mortgage rates just when mortgagees were preparing for an interest rate cut is a classic short sellers’ strategy – hit ‘em where it hurts and when they least expect it. Then immediately follow up a rate increase with a downgrade of Hong Kong’s economic performance and several scary warnings about the “sky falling” and “the end of days”, and you could hear the truck full of profits reversing into 1 Queen’s Road. The final straw was comments from HSBC that there was no need for full deposit protection in Hong Kong because depositors had complete faith in the system. I don’t know where Mr. Sandy Flockhart has been sucking his eggs recently, but I’m sure he would have seen the increase in cheap deposits into HongkongBank after the bank run on Bank of East Asia. He would also know that his competition has to pay well over HongkongBank’s costs to get those deposits to return. In his defense, he will no doubt point out that Hong Kong operates a free market economic system. This is true, but if he looks overseas, he will see that this economic model is currently in intensive care and cash has been migrating to banking systems with deposit guarantees backed by the state. This partly explains the decline in Hong Kong dollar deposits in recent months. The other reasons for the worst dip in HK$ creation since 2005 range from: funds locked up in investments (like the Lehman mini-bonds) that are under water, slowing trade and a preference by depositors to hold higher yielding US$ rather than HK$.

HK$ deposits change YTD – 2005-08 (rebased to 100)

Market action for the week ahead will likely be choppy, but generally, local equity prices should continue to remain in their oversold position until some sense returns to investors’. The current conditions have all the hallmarks of an extension of the current bear market (in other words, we are repeating the January sell-off). This is a worse case scenario, only there is a small problem: I hate saying it, but we are in unprecedented times: not because of the actions of governments, or the saving of banks – there are precedents for all these events – but because the downturn in equities has been driven by a collapse of confidence in the financial system, rather than due to some economic event, which is the usual trigger for market crashes. The long-term chart for the Hang Seng Index points to a strong support point at 13,000.

Hang Seng Index monthly chart (log scale)

In the meantime, the best advice right now is not to look and don’t panic. This crisis will pass, either through sheer exhaustion (note the light volume last Wednesday and Thursday), or through a complete capitulation (at 13,000?). By not taking any notice, you will be joining the retail investment community, which has been sitting on the side lines since June (when the index broke below 24k). Since early June there have been only four occasions when there were more than 3,000 decliners in a day. Considering where we are, the declining trend of stocks that are falling indicates that the market is now in the hands of institutional futures traders.

#33 Hong Kong girls

Before anyone jumps up and down in protest at the following post: I will protect myself with the following disclaimer: I love Hong Kong girls: actually just one in particular. I think that should cover any possibilities of any Hong Kong girls that read on from here: but if by any chance a Hong Kong girl reader recognizes any of the traits that I am about to describe, here are some tips: 1) don’t change 2) it is possible that the foibles I describe could be universal and therefore don’t feel like your different and 3) these are only my opinions and they could be completely wrong or I might be in a minority.

Talking is something that immediately stands out when describing the Hong Kong female. They just love to do it. They do it so much that sometimes it’s infuriatingly annoying. However, on other occasions, the ability of Hong Kong girls to talk no stop about whatever it is they are talking about brings generates in me a great deal of admiration and wonder. How is it that the Hong Kong female is so well versed in whatever subject they decide to talk about (remember I have no idea what they are talking about, but I assume that they are not talking nonsense because the listener appears engrossed and interested). How is it that they are able to converse at such rapid speeds? How is it they can talk, and listen at the same time? And, most interestingly, how is it they can talk…….without breathing? Answering these questions requires a little bit of background into Cantonese. The native language of Hong Kong people is a verbal language – it’s a dialect of the general language of Chinese. As such, it is designed specifically for speaking – something that Hong Kong girls have perfected to such an extent that it facilitates their great love of speaking. The rapidity of speech is a function of the Cantonese dialect. If the BBC allowed Just a Minute (a radio show where celebrity guests attempt to talk about a subject for sixty seconds without hesitation, repetition or deviation) to be conducted in Cantonese, they would have to alter the name of the show to Just Five Minutes, because a minute is not long enough to test a Cantonese speaker. Watching two Cantonese girls talking to each other is a wonder, because they seem to be talking at the same time, yet they will understand what their partner is saying, process the information and reply instantly. This skill is only eclipsed by the ability of Hong Kong girls to speak without breathing. I suspect that this trait is due to the fact that speech has no punctuation, so spoken sentences tend to run into each other.

I understand that talking may not be applicable to all Hong Kong girls, I am sure that many are very quiet and shy and withdrawn. It’s just that I have never actually come across one. If any Hong Kong girls are reading this and don’t recognize themselves as a rapid talking, multi-tasking, oxygen depleted converser, then maybe you might recognize yourself as a mirror-loving admirer. I can guarantee you that if a Hong Kong girl walks passed a reflective surface, she will look at it. Under normal circumstances this would be construed as being a bad case of vanity, but it could also have a practical purpose. First, Hong Kong girls are obsessed with their hair. I can challenge anyone to show me a Hong Kong girl with unkept hair. There is no such thing. However,  Hong Kong girls’ hair are subjected to huge amounts of pressures ranging from air-conditioning, fan blowing, wind and pollution, as well as big swings from hot and cold. With all the money they have invested in looking after their hair, it is necessary to constantly monitor the state of their primed bonnets.

If they are not talking or looking at themselves, Hong Kong girls have another pre-occupation – carrying things. For some unknown reason, most women in Hong Kong carry more than just their handbags. Usually, it will take the form of a shopping bag (not the supermarket version – only mothers, domesti helpers and old people carry plastic bags). No, the Hong Kong girl’s second bag is always paper, must be coloured, and is imprinted with the name of a shop. Why Hong Kong girls can’t put whatever is in the second bag in their (now) massive handbags is a mystery. This is particularly interesting because of another rather important habit of Hong Kong girls – hanging on to each other. Hong Kong girls are quite practical, if you want to talk to a girlfriend in crowded Hong Kong, grab hold of each other, that way you can’t be separated in the crush.

And, finally, there’s my favourite characteristic of the Hong Kong girl: its the wiggle. Although it is fair to say that Hong Kong girls are physically challenged because of their relatively short legs (in relation to the rest of the bodies, their legs are well short of the Vitruvian ratio), they make up for this inherited shortfall with “the wiggle”. For some reason, Hong Kong girls are fabulous wigglers. I have a theory that the hip swaying is due to the shortness of the legs and the shape of the pelvis. However, I can’t find any empirical evidence of this, so I can’t be sure. Regardless, Hong Kong men, who have a penchant for a wiggling derriere are not short of examples, because I have never come across a Hong Kong girl that doesn’t wiggle when she walks, or giggles when she talks, or makes the world go round, round round.

#1 Investment Weekly – Not as bad

September was the fifth worst monthly performance for the Hang Seng Index since I began watching the market in 1985. That means that 2008 has managed to produce the fourth and fifth worst monthly performances. I was quoted on the front page of the SCMP in October 1997 (see Claim to fame post): “I was here in ‘87 and for Tiananmen Square, but this ranks as number one”. If was asked to produce a quote again, it would probably say something like: “I was here in ‘87 and for Tiananmen Square and SARs, as well as the Asian Financial Crisis, but this US banking crisis is no where near as bad because the markets have been prepared and governments have acted swiftly to contain the pain of this latest financial correction.”

Top five worst months of Hang Seng Index and why

Where as previous bear markets in Hong Kong started with a big bang, as the bubbles burst in spectacular fashion, this time, price deflation has been slow and orderly because the last bubble (the through train) was short and confined to equities. Although the housing/banking crisis in the US has knocked the profit performance of some local banks (even super conservative Hang Seng Bank), the impact has been negligible on Hong Kong/China company profitability with overall earnings only 14% lower than a year ago (mostly caused by weak financials). The Hong Kong economy is still expected to grow 4-5% in 2008-09, with inflation coming under control (on lower commodity prices) and interest rates set to remain low for quite some time (this is more certain now that the HKMA has finally stepped in proactively to provide liquidity and support for the HK$ interbank market). China’s economy will still likely grow by 9-10% – aided by infrastructure spending, lower interest rates, tax breaks and consumption.

Influences of PER and earnings on HS Index

The recent decline in Hong Kong equity prices has been mainly due to risk aversion (PER contraction has accounted for 71% of the change in prices) and the liquidity needs of foreign fund managers/banks. Now that the dust has almost settled, this has left Hong Kong stocks are trading at cycle-trough valuations in reducing turnover velocity.

Hang Seng Index PER and turnover velocity

It would appear, therefore, that medium-term-thinking equity investors have only upside to look forward to, with recoveries from previous lows ranging from 24% to 85% in the following 12 months.

HS Index trough recoveries – 12 months on

As the current downturn is less severe for Hong Kong than the three local/regional events, the only recovery performance worth considering at this time is the slow march upwards after the 1987 financial markets crash. There is a feeling in Hong Kong that if the US, that bastion of free-market capitalism, can force its government to intervene to save its financial markets, then cashed up socialists in Beijing can do the same with no threat of any backlash. A small indicator of this optimism is the performance of the A50ChinaTracker. This ETF closed 1% higher last week, providing a shadow indication of how the Shanghai market would have fared if it had been open last week. Its performance compared with the 4.2% dip in the Hang Seng Index.

Probably the only possible spanner in the works is the 25% monthly decline in the open interest of the HS Index futures contract. This big shift of interest away from the contract (worth ~HK$32 billion) could be due to: 1) reduced mainland participation due to China’s Golden Week holiday 2) short sellers are leaving 3) a lack of interest in Hong Kong when there’s so much to handle elsewhere and/or 4) the cutting of credit lines to futures traders. If it’s the latter, then this is the first indication that the credit crunch has directly influence Hong Kong equities.

The local banking system has held up quite well through the crunch (the run on Bank of East Asia was self inflicted and pointless, but a good reminder of how low the situation has reached) because a) local bank’s fund their loans with retail/corporate deposits (systemwide loan/deposit ratio is only ~60%), and the average CAR is still respectable to 14% (although this is much lower than the 18% of 2001).

This newsletter’s model portfolio has been inactive through most of the current bear market (except the clearing out earlier in the year and the unfortunate addition of Dore – which has just paid a 1.5 cent dividend but also placed shares at 16.6 cents). The passivity of the portfolio is about to change with one value and one growth pick. The first addition is retailer Esprit (330.HK – HK$46.25). The stock is currently trading at a 7x PER and a dividend yield of 9%. When these two price indicators cross, it usually signals deep, deep value. The company has net cash (so it has opportunities to buy market share, buy back its stock or give it back to shareholders). At HK$46.25 (-65% from its high) it’s a bargain.

When people are greedy, be fearful: when people are fearful, be greedy. I’ve also decided to get a bit greedy and add ICBC (1398.HK – HK$4.36) to the portfolio. Admittedly, the stock is not crushingly cheap at 10.7x earnings with a 4.7% dividend yield. But I believe the China banks will lead the overall market higher in the months ahead, with their superior profit growth and involvement in a growing economy. In other words, China banks will be a growth story rather than a value proposition for the next 12 months. ICBC’s shares are trading close to their long term uptrend support line.

As I plan to hold both stocks for at least two years, I will not provide a target price, but I will say that neither stock will be generating dividend yields double or sextuple what I can get in a HK$ fixed deposit right now. 

Premium of dividend yield of Esprit/ICBC over 3 month Hibor (%)

 

#32 At your service

The level of service in Hong Kong is as wide as the city’s gini coefficient – sometimes fantastic: sometimes down right appalling.

My wife and I used to regularly eat at a Shanghainese restaurant called Yat Pun Heung on Kimberley Road in Tsimshatsui, not so much for the food, which was alright, but because the waiters were terribly old (most were Shanghainese that came to Hong Kong after 1939 to escape the Communists), and were also very rude to their customers. As they were very ancient, regular customers put up with their inability to take a correct order, or their ability to almost throw the food at you when delivering it, with that sort of scornful look usually reserved for angry young men when they were doing either. I’d love to be present at the start of day prep talk to these old biddies. I’m sure it would be something like: “you were way too nice to your customers yesterday, if someone wants to place an order, you are supposed to ignore them, when bringing the plates of food, make sure you throw them as hard as you can, passing the plates is not good enough, and your order taking is too accurate, customers will not come again if the orders are always 100% correct! “

Contrast the complete disregard of the Yat Pun oldies with with the usual clothes shopping experience in Hong Kong, which usually involves being mugged from the time you enter a shop to the time you leave. Having some youngster follow you around a shop while you are browsing is highly disconcerting for me. The pressure to buy is intense. Nothing can shake the vultures off you, so its best to make an exit. Unfortunately, leaving can not be done quietly because someone will make sure every one in the shop knows you are leaving (empty handed), because the assistant will declare this event with some gibberish about “coming again”.

Something I that I believe is quite unique to Hong Kong are the Government’s public service announcements. According to the Government’s website (www.isd.gov.hk), there are 146 of these classic pieces of television. These are broadcast mostly on the local English language terrestrial channels, as fillers, because they don’t attract any advertisers. They are unique because of the nature and deliverance of their content. Mostly these service announcements relate to public hygiene, such as warning citizens not to cough and spit everywhere, or to wear a facemask if you are ill (a remnant of the SARs epidemic) or if you are travelling overseas beware of being bitten by mosquitoes or eating exotic foods or some such nonsense. The government is even reminding us to wash our hands after going to the toilet. There are others reminding the public not to set our country parks alight, or not to burn down our cemetaries during Chung Yung festival. Another announcement promotes polite behaviour to shoppers, which apparently entails being annoyingly friendly and helpful to the point that shoppers would be horrified and run out of the store. The announcements about landslides are as about as stupid as any. The announcement usually shows an anxious wife wondering if her husband is going to make it home because its raining. Her curtain grabbing is quite ridiculous, while the husband’s irratic driving heightens the action. Eventually, he stops in front of a fallen tree and makes it home safe. Generally speaking, the Government acts both condescending and rather nanny like with these announcements, which are produced on shoe string budgets and are very tacky. They are therefore very annoying and most people do not take any notice. Their objective has therefore been destroyed and in fact may even encourage more spitting and loud coughing and sneezing, as the populace revolts against such pandering.