#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.