#1 Investment Weekly – What reputation

There is a common saying used by the Hong Kong press that sounds daunting each time it is rolled out, but, unfortunately for the doom and gloomsters editors, has about as much bite as a soft cushion/comfy chair. The offending phrase “damaged Hong Kong’s reputation as a global financial center” was blurted out again last week following news that local banks will buy-back Lehman Brothers minibonds to the tune of 60% (rising to as high as 80%) of their face value. There are several conclusions one can derive from the lack of reaction from Hong Kong’s financial markets to the settlement: first, the decision will not actually impact Hong Kong’s reputation; second, Hong Kong doesn’t have a reputation to damage, or, maybe, investors assume China will continue to bail Hong Kong out.

The Hang Seng Index jumped another 6% last week, while the HK$ remained below the strong side of its official trading range to the US$. I suspect that the lack of reaction to the decision to bail out these persistent and naïve investors is because Hong Kong’s reputation is founded on one basic premise: that no matter how many times we cock things up, China will always come to our rescue. In other words, we have a reputation, but it is founded on an unofficial policy of positive interventionism.

The latest so called “dent to our standing” stems from an agreement that local banks will buy back HK$6.2 billion of an investment product they sold to 62,000 retail investors as far back as 2004. The banks will then sell the underlying assets of the CLNs and return any excess (if any) to these investors. There are a couple of issues that need to be noted following the agreement (some of which could backfire on settlement recipients): first, at some point, the banks that distributed the CLNs will have to report losses (which have not been factored into profit forecasts). For example, Singaporean banks settled with their minibond customers at 30 cents to the dollar after selling the collateral. In some cases, these losses could be substantial and will weaken the capital positions of these banks (by as much as 5% according to rough calculations). This will result in less capital available for loans to Hong Kong individuals (possibly the same people that received the settlements). Second, local banks will be very cautious about selling high-margin investment products to investors for fear of having to take further losses in the future. Local investors will therefore lose the opportunity to take advantage of financial product innovations, thus losing potential income. Local bankers are sure to blacklist settlement recipients from future banking facilities and investments. Ironically, some of the staff selling these products (possibly relatives or friends of settlement recipients) would have been laid off because of the naivety of these investors and the soft headedness of Hong Kong’s politicians. All these outcomes are bad news for the Hong Kong economy, but no one seems to care. Finally, the selling pressure on the underlying collateral (which apparently consists of CDOs, other asset-backed securities and other obligations that are worth far less than their original values) will be severe as the banks scramble to realize cash. The whole selling process will take 90 days (60 days to accept and 30 days after that to sell). Although the amount to be sold is not large compared with the total asset-back securities market, someone out there may not be aware of the reason for the selling and it might spark a panic.

If the outcome is so negative, why has the agreement been ignored by the market? Probably because the list of blunders by Hong Kong’s great and good has become so long and odious that overseas investors have become immune to these policy mistakes and dodgy dealings and assume, with impunity, that, no matter the amount of mess or the size of the dent to Hong Kong’s reputation, mother China will coming running to aerosol over the stench. Last week’s pong was preceded by the waving of the first train into Hong Kong’s Exchange Square terminus (see Investment Weekly – Just what the DR ordered). Last week, China announced subsidies for mass solar panel installation, thus providing a boost to its green credentials and giving an excuse for overseas investors to talk up the green potential of a massively over-polluted fast-developing nation. This newsletter has recently added a fair weighting of green stocks to take advantage of these new inflows into the market before this particular bubble bursts.

The new talk around town recently has centered on possible bubbles in Greater China’s asset markets. It is amazing to believe that only nine months after the world’s financial systems almost imploded that the bulls now have to fend off discussions about double dip recessions and asset prices having risen too high too fast. It has to be said that the bulls are unfazed by such talk, judging by the surge in stock market volume in recent weeks. The bears, such as Roubini and Taleb (notice how Middle Eastern, and therefore ominous and troubling, their names sound now) have been almost completely absent from the business pages recently – although I did see Roubini predict on April 18 that the “bottom is a year away”. These terrible two did see the bear turn correctly, but, because they are constantly depressed, they did not pick the upturn in the world’s financial markets and are now having to cower and eat large amounts of humble pie. Their reputations have been damaged because they did not spot the turn in the world’s financial markets in March and they do not have anyone to hide behind. These mavens will not be listened to again until the top of the next market, when the bubble has been puffed up to full potential and headline writers need some justification to back their claims that the top of the market has arrived.

Unfortunately for the bears, the top of the market is still a long ways off. This means that, although this newsletter will be taking a two week break as the author takes a vacation, there will be no changes to the model portfolio.

#1 Investment Weekly – Just what the DR ordered

There was only one headline worth reading last week, and its effect was a 9% surge (1,551 points) in the Hang Seng Index. The gist of the article on Wednesday was that finance officials in Shenzhen are proposing a new cross-border scheme that would allow mainlanders to invest in the Hong Kong-listed H shares of mainland companies through depositary receipts (DR) traded on the Shenzhen stock exchange.

The initial reaction was equal to 41% of the subsequent gain in the Index, and was powered by a small belief that the headline was reference to some sort of “through train”. This perception was quickly scoffed at by op-eds as a red herring. I suspect that they are wrong, because the markets are saying something quite different as the chart below illustrates.
“Shenzhen through train” performance

The clear outperformance of the H-share-heavy HS Index relative to the Dow or the Shanghai Composite suggests that investors see the DR proposal as a green light to buy. So, while the Dow recovered on strong earnings from US banks, the Shanghai Composite lost ground as mainland investors switched to Hong Kong H shares in anticipation of the introduction of DRs in Shenzhen. This switching explains the relative performances of the usual benchmarks for the HS Index last week. The extra 4-5% of outperformance was purely due to the DR announcement.

The concentration on H shares explains why, unlike the direct investment proposal put forward with the original through train in mid-2007, the only beneficiaries of the DR proposal would be H shares. This explains why overall market turnover did not match the surge in the H share heavy index. The market’s average daily volume actually fell 4% compared with the prior week, but turnover rose 9% due to the rise in higher priced H shares.

As with the mania in mid-2007, mainland investors will be keen to buy H shares because they are trading at a discount to their equivalent A shares. The current AH share premium index is trading at 141%, with many stocks trading at premiums of 70-80%. The AH index fell 3.8% last week, having hit a high of 148 and a low of 135 last month. If the DR story continues, then a continuation down to the recent low is a necessity to confirm the view of the market. The only false signal to appear from last week was the relative strength of HKEx (which matched the index’s 9% jump). Although the stock exchange will benefit from increased demand for H shares if the DR scheme is implemented, investors were probably getting ahead of themselves if they believe that the proposal from Shenzhen will lead to a direct through train (which is when HKEx will truly benefit). As mentioned earlier, turnover actually fell last week.

AH Premium index

Action for the rest of the market last week could be characterized as sloppy, with so much attention paid to the DR story. Boosted by the DR theme, the HS Index reversed some technical weaknesses and bounced back above its 18,300 fair value level and the 20-day moving average was retaken. But breadth and turnover were not indicative of a plausible rally. These indicators will need to pick up strongly this week if a break above 19,000 (which would put the index well into overbought territory) can be sustained.

#1 Investment Weekly – Stocks waiting for capex and stocks

There is a basic formula for determining the profits generated by an economy. It states that profits are equal to: consumption (less wages), capital expenditure, inventories, government spending (less taxes) and exports (less imports). As we head into the half-term earnings reporting season, investors have a good handle on C, GS and trade, but, as usual, have little information about capex and inventories. These should be the key factors that managers should be addressing. Unfortunately, analysts’ questions hardly ever concentrate on these areas – so we may never know the full profit picture. Here are my guesses about what company managers are likely to say about the various components of their profits.

Discretionary consumption has been weak everywhere (except China) and should remain so as long as workers fear for their jobs. However, for the vast majority who are working, wages have been flat or even rising slightly. This means that bank savings are rising or debt levels are falling. In both cases, this allows banks to lend to their retail and corporate customers. This leads to the capex expectations. As global banks have been hording capital, the surge in lending by China’s banks is likely to stand out like a sore thumb. Capex on the mainland is unlikely to have been impeded by bank balance sheet restraints. Only the trade sector would have seen expansion plans put on hold, while using free cashflows to upgrade or replace equipment. The same freedom or tactics would have been applied to inventories, with basic material users stock piling while end-users have made inventory management a top priority in recent months. Overall, the picture on capex and inventories in China would have been better than many had expected, and I suspect this may have been behind recent upgrades in economic growth forecasts for China in recent weeks. Government spending has been well telegraphed during the current downturn, and forecasts are pretty transparent, while trade deficits have been improving (adding to GDP) as discretionary imports have fallen in line with demand. The weak US$ has, at the same time, boosted US and China’s export price competitiveness.

How does all of this translate into next quarter earnings prospects? Banks are always the main beneficiaries of a steady or rising economy as they are likely to record fewer losses (rather than more profits).. They will continue to lead the Hong Kong market higher. Basic material profits will be under pressure because of their inventory build up, while users will be benefitting from more efficient inventory management. Capex intensive industries will be benefitting from available credit and stimulus packages. Retailers will still be producing good profits in China (but not elsewhere) while utilities will be flat and defensive (as usual). Overall, Chinese profitability should be sound, with spectacular pockets of growth. Hong Kong profits should be showing signs of improvement, with asset prices (across the board) rising through the first six months of the year.

With this outlook in mind, one would expect investors to be slightly cheered by upcoming announcements. This doesn’t seem to tally with recent performance of the HS Index. The reasoning for the recent pull back from the high of 19,000 can be traced to two key factors: 1) new supply of stock and 2) seasonal apathy. The new supply will run its course as investor apathy eventually consumes investment banker enthusiasm. Although the latter will continue to serve the growing need for capital in China, the initial quenching of pent up demand for China IPO stories is wearing out. This should redirect some demand back into small cap names, but the main indices will continue to be dragged by investor indifference ahead of confirmation of results. Clarity on capex and inventories should allow justification of at least current index levels.

#1 Investment Weekly – What he made off with

There are two important lessons from the Bernie Madoff Affair (besides the obvious such as: cheaters never prosper, where was the regulator and how did he do it): first diversify and second ignore the rhetoric.

Now that we have closure on the Madoff scandal, it is time to reflect on what went wrong. From an investment manager’s point of view, the overriding lesson is that the investors that placed their trust in Madoff’s promises did so with so much faith that they apparently forgot the first rule of investing: diversify. This is how the press seemed to have covered the story because the testimony delivered at the sentencing seemed to suggest that the investors that spoke had lost everything. If they had done so there would be no mention of “my daughter is holding down two jobs to pay for college” or “we don’t have enough money for food”. Let’s be clear: the people that left their life savings with Madoff had deposited large amounts of money. You had to be rich to invest with Madoff. Even if it was a feeder fund, you had to be wealthy. This was not a scam aimed at retail investors. These were wealthy, supposedly intelligent, people. So, he’s my first fire back at those investors: you deserved everything you got. The greed that consumed you into investing all of your life-savings with one investment manager was foolishness that deserved to be punished. As for the young woman having to work for her college degree, I would not be surprised to hear that she is actually feeling good about herself, almost normal, almost one of the crowd, instead of simply sailing through college knowing that if anything happened, she could always fall back on Mummy and Daddy’s wealth. The type of people that live off their parent’s success mostly grow up to be spineless creatures, who end up putting all their wealth into a ponzi scheme because they have no street smarts. For those that are now working to survive, I would say, great. This is good news for the US economy. It means that people that were very successful during their careers are now suddenly putting their experience and knowledge back into the economy at a time when the US economy needs all the entrepreneurial spirit it can get, as it grows its way out of the recession. These 50-60-somethings may well regret having to go back to work, but I didn’t hear of anyone saying that they couldn’t find jobs (despite the 9% unemployment rate). These people have connections, have done it once, and can do it again, and are more productive now than they were playing golf in Florida.

There is no doubt the press have had a field day covering the Madoff scandal, with headlines screaming about how terrible he was and how much he apparently stole large amounts of money. In a sense, Madoff was partly the Sheriff of Nottingham, and partly Robin Hood. He stole from the rich, but gave back to some other rich people. Remember, no money has actually been “lost”. Only the ones left holding the parcel when the music stopped have not received their capital back. It should also be remembered that those left by the wayside, received returns while they were in the scheme (even last year when the markets tanked). Are they planning on giving these returns back? Not likely. However, there are many, perhaps more streetwise investors, who would have invested and divested from Madoff funds. These investors are no where to be heard, and the press, as usual, consumed with their yelping headlines, have failed to find one former Madoff investor.

There are lots of data about how the scheme worked, some of which can be used (with some assumptions) to determine how the pyramid grew so large. We know that ~1,400 accounts were opened since 1995 and that total flows through the funds totaled US$160 billion, and that ~US$65 billion was active at the time of liquidation. Knowing the top of the inverted pyramid and how many bricks it was made from, we can paint a picture of what Madoff was doing. Assuming very tempting average returns of 8% a year, and after fees of ~US$260 million to himself, one can say the following: 1) he generated 100 new customers a year, each handing over US$10 million in AUM. 2) he must have already had US$40 billion in AUM in 1995 3) outflows could have been as much as US$700 million a year 4) but in the end Madoff’s funds on hand were equal to only 86% of the AUM that was supposed to be in the bank 5) this assumes he was paying 8% but also that he was making no returns – either because he made money in some years and lost in others (particularly in 2007-08). 6) Madoff paid himself a fee of only 0.004% on the AUM. The table below illustrates a best guess scenario.
Madoff’s pyramid

It is possible Madoff could have continued with the scam for quite a while before the coffers were completely empty, but I suspect he was overwhelmed by a tinge of guilt and a lot of panic.

Panic is something the bears are trying to instill into Hong Kong equities. They are talking up local interest rates as a focal point for their argument that equities are overvalued right now. Unfortunately, central bankers have a different point of view and the bears are not likely to win against the keepers of the purse. However, as long as they are trying to force the issue, equity prices will continue their current holding pattern within a narrow medium term upchannel.