#1 Investment Weekly – Central to bankers

It used to be, in the days of colonial rule in Hong Kong, that if ever there was a problem that required an answer, Hong Kong officials could pick up the phone and call someone in Whitehall for help. Quite often, the answer was simply a repetition of what was already the practice in the UK. Hong Kong’s soon to retire central bank chief, Joseph Yam, would have been privy to many of those exchanges, particularly those relating to the banking system. As a career civil servant, he would have understood the rationale behind the decisions and would have been coached in their interpretation by the likes of John Bembridge, Piers Jacobs, David Nendick, David Carse and, of course, his current boss Donald Tsang.

Having never worked in the private sector, Joseph Yam was never directly influenced by the pressures of shareholder activism (although he was under constant pressure to produce returns on Hong Kong’s fiscal reserves), and he was an appointed official – so he was never directly accountable to the public. This lack of scrutiny has been a real plus for Hong Kong and the management of its financial system. Yam could plan long term secure in the knowledge that he will be given time to see his policies and actions come to their natural conclusion.

For Yam, being a natural Keynesian/non-monetarist, he should feel quite content in his retirement knowing that his economic philosophy has been justified by the recent actions of the Anglo-Saxon monetarists. However, there is, again, a need for him to take some time to declare a longer term victory. The jury is still out on whether the liquidity pumping currently going on around the world (Hong Kong included) has produced the right conditions for an economic recovery.

Joseph Yam’s tour de force of course was the intervention in the local equity market in August 1998. The plan was simple – knock out the shorts by buying US$15 billion worth of Hong Kong stocks. Attacking the Hong Kong dollar and naked shorting the Hang Seng Index futures contract was a simple enough strategy by the hedge funds. They had that saw a chink in Hong Kong currency peg’s armour. Yam’s response was also simple, buy back spot shares, and cause the hedge funds to lose so much on their futures contracts that they could at best break even, or, mostly take losses. The strike was done with brilliant stealth (for a town built on whispers and tips) no one was aware of the plan until half way through its execution. I remember watching the event unfold from a trading desk as rumour surfaced that the Hong Kong Jockey Club was buying shares. His rumour eventually morphed into direct government intervention. My initial reaction was the same as everyone else – this is madness. However, in hindsight, the timing was perfect. In this case, discretion ruled over rule, although Hong Kong’s ruled based currency peg and small government have always seemed like major contractions to the Keynesians running the economy.

A little less well known was Yam’s involvement in helping to secure a “lifeboat” for the futures exchange when Hong Kong’s stock market closed down for four days after the crash of October 1987. Although his role was minor (Sir Piers and Nendick were the chief instigators), I suspect, judging from his fond memories of that event, that it had a lasting impression on him and, to some extent, cemented his credentials for future interventions.

Yam’s successor has some big shoes to follow (many people do not realize that Yam stands well over six foot, which for a 61 year old Chinese is quite a feat). The front runner appears to be Norman Chan, who is currently vice-chairman of Standard Chartered Asia. If Chan was still with the HKMA, I believe he would fit the bill, but he has been tempted by the dark side of the commercial world, and surely could not revert back to a career civil servant in a hurry. Chan knew that Yam would retire soon, so why did he leave if he wanted the job? Instead, I believe the HKMA will promote from within, and pick one of the three current deputy chiefs. As banking supervision is a key area for the HKMA in current circumstances, YK Choi would be the natural choice. However, YK is probably too old having started his career in 1974. Eddie Yue looks after the reserves, while Peter Pang deals with external matters. Both are similar in age, so I would plum for Pang – the diplomat. All three have been groomed for the job, and are Yam protégés.

As close confidants of Yam, the three internal contenders should be fully up to speed on the efforts by the HKMA to ensure an adequate supply of Hong Kong dollars in the banking system. The Aggregate Balance is currently standing at record levels of HK$250 billion. It is this liquidity that is the most visible proof of the rise of the Hang Seng Index in recent weeks. In the debate about whether the rebound from the low on March is liquidity driven or fundamentally driven, the liquid angle wins, as the chart below shows.

Equity volume vs earnings growth change (re-based to 100)

Yam’s successor should be watching developments in the local equity market closely to ensure that there is the right balance between a liquidity driven rise in equity prices, compared with a rise in values discounting a realistic upturn in the fundamentals of the China and Hong Kong economies and therefore the profitability of listed companies.

Unfortunately, it would appear that this David Beers analyst at S&P has not been paying much attention. The decision to downgrade the outlook of the UK’s debt at this time suggests his vision has been blurred by too much self esteem and not enough self assessment. For one thing, if the decision was based on the budget deficit data which was released on Thursday, then the downgrade was done in haste. This is a perfect example of a wounded, major duopoly, attempting to regain credibility when there is nothing it can do to restore its reputation. S&P has always been late in its assessments of everything because of a flawed system of “rules over discretion”. The rule is: when the debt of a country reaches 100% of GDP, downgrade the outlook. However, if the S&P analyst had bothered to check out of the window, he would have seen signs of a restoration of consumer confidence. By downgrading, he has just shot down those signs, just so he can 1) get on TV 2) restore his credibility and 3) put the fear back into his ratings (i.e. the threat of a downgrade has the potential to bring the world’s financial markets back down on its knees). His timing was impeccable because credit markets had shown strong signs of recovery, with indices actually higher than they were prior to Lehman’s demise (equities in fact have only been playing catch up with credit). However, I have to wonder why global asset markets initially reacted so violently on the downside (they have since recovered from the lows). Yes prices were a little elevated, but one has to wonder how solid is the current recovery. Certainly the permabears would have rejoiced at the reaction, but they will get their comeuppance when prices recover this week. As the saying goes: investors are only good at one thing: forgetting. One hope locally is that the government remembers that a career civil servant has held Hong Kong’s financial system in check for over 16 years, and that his successor should continue this trend.

#1 Investment Weekly – The divvy on dividends

If a bank in Hong Kong wants to do almost anything, it must first either inform or ask permission from its regulator – the HKMA. This includes hiring and firing senior members of staff or appointing someone to the board of directors. In other words, bank dividend payments are decided by Government vetted/approved directors/executives. I’m not sure what all the fuss is about because US bank directors are also approved by the Government, aren’t they? They can be removed as easily as they are approved. The same system of oversight is true of China’s state owned companies. In this part of the financial jungle, the Government has always had a big say in what goes on within corporates – including who pays taxes on what, where and when.

Unfortunately, there appears to be some investors who are not aware of this lack of laissez faire in Hong Kong (or for some reason they believe the Heritage Foundation’s annual rubbish rankings). If there are investors out there buying shares of mainland companies because they offer premium dividend yields, I have news for you: 1) China is an earnings growth story. Chinese companies need capital, so after tax profits will be mostly retained for re-investment 2) investors should be aware of this, so H share dividend yields are relatively low compared with yields on offer in other, more established, economies (I will refrain from using the developed/developing tags following recent economic/financial events).

News that China Mobile has changed its ex-dividend date to allow foreign investors more time to prepare for withholding tax payments on mainland company dividends may have come as a bit of a surprise. But this should not materially alter the investment view of foreign investors towards China Mobile shares – unless, of course, the investor had bought the stock for its dividend yield. These investors need to reassess their initial reasoning for investing in China shares and should probably sell. However, they should take into account a new development which should go some way to counterbalancing the new tax on dividends.
HS Index and HSCEI dividend yield (%)

China’s leaders are acutely aware of the importance of investor confidence. Balance and harmony are very important Confucian influences on mainland policy decisions (e.g. guide the people with edicts or virtues). If there is a negative policy issued, there is usually a positive counterbalance somewhere close by. So the withholding tax is the yang to balance the renewed yin which was been manifested through the surge of optimism surrounding Hong Kong and China’s stock markets recently. Closer ties with Taiwan (and Hong Kong through new additions to CEPA), and an uninterrupted flow of funds from the mainland into related, external asset markets has been briefly dampened by the tax announcement. The recent optimism has pushed stocks into overbought territory and blown short sellers out of the market, so any pull back was bound to be sharp due to the lack of any short covering. This partly explains last week’s 3.5% decline in the Hang Seng Index.

China is still a growth story and local equity markets perform a function of allowing companies to raise new capital to support this growth. China’s banking system has been recapitalized through the stock markets, and, now, it would seem, even large foreign financial institutions are aware of the potential of tapping China’s surplus capital. HSBC’s hint that it would like to raise new capital by listing in Shanghai was an alternative this newsletter recommended in March. Of course this may not have been an option then, but it has become more of a reality now, as China continues to lure Taiwan financially closer to its bosom with sweeteners such as foreigner access to China’s capital markets. A cynic might argue that Goldmans Sachs’ decision last Tuesday to put HSBC on its conviction buy list is linked in some way to the possible lucrative fees and prestige associated with leading a Shanghai listing for HSBC (after all it lead the recent rights issue). The analyst could counter that suggestion by pointing out that since placing the stock on its top recommended list the stock has fallen by 4.4%. AIG’s Asian operations, AIA, have announced plans to raise US$5-10 billion on Hong Kong and /or China’s stock markets. This is yet another example of a global financial institution looking to tap China’s vast store of wealth, while returning to its roots. Overseas investors should take note of this potential. Las Vegas Sands is also considering a Hong Kong IPO to tap the Chinese penchant for a flutter. Bank of America’s gamble to sell its stake in China Construction Bank was the most telegraphed placement in years. The fact that China State and its friends bought back the stake softened the impact and sent a clear message to future foreign investors: no more! These mega-deals have obscured the increase in fund raising on the Hong Kong market in recent weeks by small cap companies, and, again, this recent uptrend may have accounted for some of the pull back in equity prices last week. Investors would have started putting aside cash or took profits to ensure they have enough liquidity to meet the flood of fund raising, while investors interested in buying into the Hong Kong/China growth story were discouraged from entering any further for fear of dilution or a draining away of inflows due to the share placements (whether they be large or small).
Share placements in Hong Kong (HK$b)

Usually, small cap stocks outperform at the end of a bull run, but there has been some rotation into small caps recently with the HS Small Cap Index up 49% in the past two months, compared with 38% for the HS Index. This was mostly rotation of profits out of blue chips into something with a bit more spice, but the buying was conducted sensibly, with themes dominating the flows. This newsletter runs a model portfolio that uses a buy and hold strategy, and this week’s two new additions are early purchases of a theme that will grow in importance as the bull market unfolds. Both China Windpower (0182.HK – HK$0.54) and Solargiga (0757.HK – HK$2.39) are mainland green power technology companies. They are small in size at HK$2.4 billion and HK$4 billion respectively that don’t pay much in the way of dividends, and will probably require new capital in the future as their businesses expand. It may also be possible to buy the stocks at lower levels than they are currently. Therefore, the portfolio will take half-weightings in each, with a view to putting them at full weighting (which is HK$100,000) at a later date (either at a future placement or a significantly lower traded price). Their inclusion in the portfolio is a reminder of 1) China’s huge growth potential 2) because of this potential China stocks do not pay dividends of any note and are capital hungry 3) small caps are the potential big stocks of the future.

#1 Investment Weekly – No contradicton here

If you are confused about the conflicting financial markets information you are receiving, let me help you clear things up.

The most obvious confusion currently circulating is that equity markets are rallying while the economy is contracting. This is a process that economists find very hard to understand and for newspaper editors to decipher. Economists cannot accurately model sentiment. They make forecasts, but they are always wrong at turning points because their models cannot accommodate human behaviour and the impact that a change in confidence can have on economic data. Newspaper editors are in an even worse predicament, because they only report what they saw yesterday. This leads to terrible disconnections, with headlines screaming both positives and negatives at the same time (Stock markets rally as unemployment rises). Then there is a small set of people who gather information from both the market and the economy and put the two data sets together. Unfortunately, for most investors, their views are private and come at a price (unless they are like me and don’t care about the money). For stock market commentators, what is happening now is completely rational and highly predictable (in hindsight). As this newsletter pointed out on April the stock market’s traffic lights turned to amber. Now that the Hang Seng Index closed in April above 15,100, the long term Coppock Indicator has turned upwards, confirming the return of the bull market. There is no contradiction here. If Hong Kong equities turn lower from current levels, this will be a short term aberration within the long term cycle.

Here’s another contradiction: investment banks are raising their target prices of stocks but still rating them “sell”. The reasoning for the price target upgrades range from: the improved economic situation, to cost savings, or lower costs of equity etc. Actually, most of the upgrades are because prices have run well ahead of previous targets. This is because analysts are trained as economists and suffer the same flaws as mentioned earlier. The sell tag could be justified because the recommendation is based on the stocks’ relative performance to a benchmark. This benchmarking is something that the bears are completely ignoring. The bears (who have recently gone back in hiding) are saying that stock prices have decoupled from earnings and that equity prices are now expensive. It is really important that bear commentators stick around, because they will keep prices in check and within the realms of reality. The relative valuation arguments being put forwards are simple enough: a price earnings ratio for the HS Index of 12x is not justified relative to earnings expectations, with growth currently pegged at negative 10-15% for Hong Kong equities. However, 12x-earnings translates into an earnings yield of 8.3%, which is 6% higher than HK$ long bond yields. An earnings yield gap of 6% compares with the average of 2%. As the future economic climate is still somewhat uncertain, a 4% premium over the long term average could be justified.

The spark that started off the recent rally in the Hang Seng Index was another contradiction – the news that China Mobile is to take a direct stake in a Taiwan telco. Although the size of investment is not significant, the deal was a massive boost for the island’s economic future. For too long, Taiwan had been underinvested. Entrepreneurs were more interested in setting up shop in China and had neglected the island’s domestic economy. Foreigners had been restricted from fully investing in the country until recently. Paranoid-infected politics had dominated the island’s economic development. The threat had always been that China would retake the island by force. The China Mobile deal means that the Taiwanese will allow the mainland to take over by economic stealth instead. The deal should have been a warning signal to Hong Kong-based equities that China’s benevolent eye could be shifting its glance towards Taiwan rather than Hong Kong (remember CEPA, relaxing of travel restrictions etc). Closer ties with Taiwan will reduce Hong Kong’s importance as a bridge across the Taiwan Strait. However, to counter the possible loss of confidence in Hong Kong, China’s leaders have turned a blind eye to money flows and have allowed mainland cash to enter Hong Kong’s equity and property markets unhindered. This explains why the HK$ has strengthened below its trading band in recent days, why property and equity prices have moved 20% higher, why the aggregate balance has continued to climb to record levels, and why overnight Hibor is currently 0.0001%.
Of course, no one in the media or even those confused economists have mentioned the fact that China’s investments in Hong Kong could pull investment dollars away from Hong Kong. In fact no one is talking about the impact on Hong Kong if Taiwanese business is pulled from our shores. This maybe due to the need to preserve the fledgling upturn in confidence, or it could be because commentators find it difficult to understand the contractions of equity markets and economic fundamentals.

There has been no confusion about recent market action which can best be described as bullish. Volumes have been rising, the advance:decline ratio remained in favour of the former, while utilities have lagged terribly (except green technology stocks like Solagiga and China Windpower). Technically, the index is trading above its 100-day moving average, is above its parabolic and close to the top of its Bollinger band. Activity is starting to rotate into small caps and covered warrants, as profits are being reinvested into high beta stocks for extra leverage. These are normal bull market activities and will continue to run so long as the volume tap is switched on (watch currencies – HK$ and yen – for clues on this). Naturally, companies will be taking their chances and raising new capital, so stock selection will become imperative for investors wishing to avoid any sudden shocks. If there is anything to be concerned about right now, it’s the lack of short selling. When the market eventually corrects lower, there will be very few forced buyers.