#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).

#1 Investment Weekly – Tips to insure profits

This might be a backronym, but according to a programme I just watched on the history of coffee, the word “tip” stands for “to insure (sic) profits”. Apparently, it was the inscription on pots into which coffee house patrons of 17th century London would throw their spare coins. Appropriately, these shops were congregated around Jonathan’s Coffee House in Change Alley. It was from those coffee shops in the square mile surrounding London’s stock/commodity/shipping exchanges that insurance giant, Lloyds of London, sprang, as well as many of the old fund management houses/brokers of Europe (Cazenove, Schroders, Rothchilds etc). Hong Kong has a fine tradition of generating plenty of stock tips (contrast this with conservative American investors, who buy Treasury Inflation Protected Securities (TIPS)). I’m not sure if Hong Kong’s stock punter class are aware that tips was originally suppose “to insure profits” for the owners rather than the patrons, but they have certainly had an easy ride making profits of late. Can the punters get on their bikes and peddle hard enough to keep the momentum going? Or will corporate owners take their profits?

I passed on a big tip last week that the market was not about to tip over because of a rating outlook downgrade by an unreliable credit rating agency. The tip was correct, although the surge in US consumer confidence and fresh giveaways by Hong Kong’s Keynesians on Battery Path were slightly surprising. I say only slightly surprising because, as I explained last week, Hong Kong officials are past masters at timing market intervention with an eye to maintaining/lifting consumer/punter confidence.

The Hang Seng Index has now reached the point where the momentum from the low is nearing exhaustion. Imagine that the market is like sitting on a bicycle (with no brakes) on a never-ending rollercoaster. After tipping over the edge, the bicycle travels, almost unaided (gravity/inevitability), to the bottom of the down slope, and continues upwards, again, almost unaided (momentum/certainty) back up the next upslope. However, as the momentum begins to dissipate, investors are forced to start peddling to keep the bicycle moving further up the slope. The Hang Seng Index has produced its best performance in the month of May since my records were started in 1985. The last time the Index recovered on a scale of the magnitude of the past three months was in 1998, when Hong Kong looked over the financial/economic precipice as the HK$ came under attack. Back then the Index recovered with a momentum rally of 39% from September to November. The free-wheeling momentum rally of the past three months has been similar in scale at 37%, after the whole world looked down the barrel of financial Armageddon and decided it didn’t like what it saw. The 1998 rally stalled for two months, because investors had to figure out how to peddle the new bike they were on (usually, after each cycle, the bicycle is changed). The same should be true again this time. Investors need to read the instructions about how to ride the new bike or they’ll tip over the handlebars, with damaging results. This, in effect, means a greater dependence on stock tips will be required from now on in. I’ve already hinted that the alternative energy sector will be a growing theme as the current bull market unfolds, but I would add Hong Kong property (a long term favourite of this newsletter) and China’s banks as other areas for leadership in this new uptrend.

This newsletter is not a tip sheet, but when a certain situation presents itself, I will make a point of describing it to readers. Hence, the Bank of China (HK) recommendation of April 1 has generated a 42% return, while the two green tips of a fortnight ago have jumped 19% and 50%. You’ll be happy to know I have another tip, which will be added to the model portfolio. It’s the start of the rainy season here in Hong Kong/China, with heavy monsoon downpours interrupted by brief spells of hot sunshine for the next few months. These tropical conditions will extend as far north as Beijing, and will provide the drinking water for China’s massive population during the dry winter months. China Water (0588.HK – HK$2.02) will be gathering as much of this scarce and precious resource so that it can quench the appetite of both the populations it serves, as well as meet the requirements of the Central government.

I am quite sure that China’s central authorities are aware that the HS Index is close to reaching its long term neckline. This is a line drawn from the top of the dotcom bubble on March 28, 2000 (i.e. the previous all-time high) of 18,300. It is also the level that the Index closed at after gapping down on September 16 last year after the Lehman bankruptcy news. The resistance line from the peak also passes (conveniently) through this 18,000 area. Breaking both would need sustained turnover in the HK$90 billions a day. There are a couple of signs of technical fatigue last Friday, with the put/call ratio falling to 74 from elevated levels of 85 in recent weeks, while warrant turnover (a proxy for extreme risk-taking), as a percentage of turnover was only 6%, much lower than the 12% seen as recently as May 22. My tip for this week is for further advances, but in a more horizontal plane than of late.