Friday, May 15, 2009

How To Make Money in Stocks Part 7: Pick Low-Hanging Fruit 255 comments

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Allied to this theme is: don't try to understand the whole world! (actually that was the original title, but I thought the low-hanging fruit thing sounds more professional)

Actually in my view, investing is a very simple process compared to most other forms of work in the world. Not making money from investing, mind you, but the process in itself. All the talk and academic theories about structuring portfolios, optimising risk-return etc, does it really do anything but add two or three percentage points of return over the market (if one is lucky)? But people actually make a good living out of this, not just fund managers, but also service providers like financial consultants, market forecasters, systems providers, and a myriad of financial-related cottage industries. I look at engineers and the gargantuan structures they come up with: aeroplanes, software, building systems .... and I wonder .... it's incredible that the financial industry is paid so much for coming up with so little! (albeit they have the uncanny ability to blow these little achievements up into monumental state-of-the-art triumphs).

The point to all the above rambling is that we are all exposed to, and have generally accepted, a certain line of thinking: that to achieve good market returns, we have to accumulate as much knowledge as possible about as many industries and countries as possible, so that we can find and take advantage of potential misvaluations. That is how the output of the broking industry has been structured: daily market research, continuous company reseach reports, economic strategy reports, etc.

While there is nothing wrong with building a competitive advantage based on superior knowledge, it makes more sense to identify a few key trends, what I call inevitabilities, that have a higher-than-average probability of materialising, and then focusing on them.

The alternatives are what many people tend to do: (1) try to read as many analyst reports as possible, end up being overwhelmed with the info and betting on the popular themes/sectors of the day; (2) try to enter or exit based on different analyst interpretations of the market outlook ie. market timing; (3) buying and holding stocks based on analyst recommendations of their potential. For (1), the investor tends to be late into the buying process, while passive buying into recommended themes based on day-to-day reports will tend to lead to a bloated and overly diversified portfolio. For (2) market timing based on reports has historically led to being whip-sawed by Mr Market. For (3) the buy-and-hold approach is fine but one must think deeply about the stock and be comfortable with holding it for a couple of years (or else you will end up in the value trap, like Temasek with Merrill Leech/ Bank of Assholes).

One can be inundated with all the information in the world, but there is no point if it cannot be converted into useful knowledge. Different economists, for example, can utilise the same facts and come up with diametrically opposite and yet equally plausible conclusions. Who to believe?

Investors should recognise that economic outcomes, like investing, is really a game of probabilities. There is nothing definite that will happen in the future, it not only depends on the structural issues, but also responses such as governmental reactions, corporate maneouvres and that most elusive of all --- public sentiment. Who knows what would have happened if Lehman had not been allowed to fail last year, for example? A different governmental response would have generated a different outcome.

Perhaps it is best to visualise things in this way: at every point in time, there is a range of possible outcomes that could develop in the future, but with different probabilities of happening. The investor's responsibility is not to understand all these possible outcomes, because it will tire him out trying to monitor all of them. Rather, the optimal approach is to pick out the outcome that has the highest probability of happening, and then invest according to that outcome.

All this sounds very mathematical, so let's illustrate with an example. At the start of 2009, the whole world was very nervous with the possibility of economic breakdown, with reports of problems surfacing in the US, the UK, Russia, emerging markets. Contrarians, however, noted that given the depressed valuations, potential returns could be very good should the situation clear up. So, invest or not to invest? Rather than leave the decision to a matter of faith, a better approach would have been to avoid trying to forecast how the entire world economy would pan out, but rather to identify who the strong players were and the actions they were likely to do. Who were the strong players? Only governments were able to borrow at low rates, so they were the strongest. What were they likely to do? They were under popular pressure to save the world, so obviously they had to apply stimulus in large enough quantities to replace dwindling export demand. The remaining research to be done would then have consisted of identifying which governments were in the best fiscal position to apply aggressive stimulus, and then identifying which industries would have been chief beneficiaries of such stimulus packages.

Half a year down, those who had been invested in China infrastructure builders, like China Communication Construction, China Railway, China National Building Materials etc, would have seen their money double or more. The infrastructure builders of China were the low-hanging fruit in January 2009, because China was in a strong fiscal position to finance a stimulus package, and was under strong political pressure to replace weak export demand with a domestic stimulus to keep its target growth rate up. Injection through infrastructure construction was a natural choice because China had a need for it, and traditionally this had one of the best multiplier effects.

I want to bring the issue of market timing into the discussion. Readers of my blog will know my long-standing philosophy: returns from stocks are typically driven by the market/sector/company in general 40/30/30 proportion (this is a philosophy because I have no statistics to prove this, it is more a belief/rule-of-thumb based on experience and logic), but rather than focus on the market, my approach has always been to focus my attention to deriving useful returns from the balance 60% based on sector and company. That's because I have always felt it's impossible to decipher a system of 1000 moving parts ie. the economy.

Well, the belief on the difficulties of deciphering a complex creature like the economy still remains, but I have modified my approach after watching the sychronised selldown in all asset classes (except Treasuries) in late-2008. The "pick low-hanging fruit" approach also works for the economy. Indeed one of the most inevitable outcomes of 2008's subprime crisis, in retrospect, was the danger of collapse facing the financial system. Hence, not only banking stocks, but indeed a risky asset class like stocks, should have been avoided studiously if one identified this macroeconomic inevitability. It was the "low-hanging fruit" of 2008.

What low-hanging fruit are available as of now? Maybe we could start with thinking about what is inevitable based on trends so far. I can think of two. For one, with low interest rates it is becoming difficult to implement monetary policy stimulus further except to print money, and that implies currency devaluation. Two, governments will continue to apply stimulus but they will have to find ways to finance it. That implies they will have to increasingly borrow from capital markets. This has implications on currency and bond markets. The above two will eventually happen, there're no two ways about it; governments have to take measures along these lines in order to reverse the potentially destructive effects of deleveraging. The low-hanging fruit will probably be found in these two markets.



Sunday, April 12, 2009

Thanks Thailand, you screwed up the show again 40 comments

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Why some people love to shoot themselves in the foot I will never understand.

I am talking about the current political chaos in Thailand, which has forced its months-old government to call off the ASEAN summit in Pattaya on Saturday, and to declare a state of emergency in Bangkok just earlier today. There are rumours of yet another coup that could see yet another government change. My guess is that if it comes to this, it won't be as peaceful as the last few bloodless ones because the Abhisit essentially has the implicit blessings of the Thai king and the Bangkok elite and these power brokers will not let their man go quietly.

This is not the first time I'm saying this, but essentially it is tragic that Thaksin had to be forced out just when Thaksinomics was beginning to have a broad-based improvement on the lives of ordinary Thai citizens. I am not sufficiently clued-in on the depth of his corruption, but general consensus was that his reign from 2001-06 had steered Thailand from the abyss of the Asian financial crisis through stimulation of domestic demand and lessening the country's dependence on exports and volatile global demand. The rural regions had also benefited from Thaksinomics, which placed them as the primary target of its policies.

What is generally agreed, as well, is that there were green eyes over the rising popularity of Thaksin. Thus there was clear and strong motivation to remove him, and the means was available as well, for those green eyes allegedly belonged to the tradtionally powerful elite in Bangkok; that included the military, the rich and politically connected, the royalists. These people had the most to lose from a dilution of political tradition.

And so Thaksin was gone. From one who had led Thailand to the brink of being the de facto leader of ASEAN given a still recovering Indonesia (in 2005), Thaksin has fallen badly. He has been hit hard by the global recession since there's nowhere to hide, and there're now no political connections to leverage which could have cushioned his fall. His assets in Thailand are frozen. A desperate man makes a determined man --- the way the Thai authorities have cornered Thaksin has boomeranged back on them in the form of this latest attempt to re-take power in order to unfreeze those assets.

Since Thaksin left, the political situation has been in a state of limbo up till today. An army general took over in the interim, and during that period the Thai monetary authorities screwed up by imposing capital controls and then backtracking within a week. Then they had an election through which a Thaksin loyalist party took power. Samak became Prime Minister. However, he didn't last long as somebody figured out a way of removing him --- for receiving fees for his cooking show outside of his office. Then he was replaced by another Thaksin relative, who didn't last long either. Sheer farcical political theatre.

There are apologists who will argue that this is how modern democracy works and this shows that the people are free to express themselves. They are missing the point. Any political system should be judged by the way in which they can align the majority to pull together in one single direction; hence different political systems can be optimal at different times in a nation's development. The way political change has been enacted gives foreign investors and tourists increasingly little confidence in the stability of the country. Petty issues are used to remove governments, such as Samak. The way in which the yellow-shirted PAD was allowed to take over government buildings and then, horrifyingly, the airport, had shown how the broad national agenda could be hijacked by private ones. King Bhumibol was seen previously seen as a unifying figure that could stabilise the country, now the aging monarch is used by factions as an excuse to take power against majority will. And when he goes, I can't imagine how things will deteriorate.

Frankly, I wouldn't even care about how things go, except that this country is in our vicinity, and its political developments will affect how investors and people from other parts of the world will see our ASEAN region as a whole. And now you have this ASEAN summit which was supposed to be a platform to discuss economic stimulus for the region. The heads of six countries were to have joined the discussions: China, Japan, South Korea, India, Australia, New Zealand. Wen Jiabao, leader of the fastest emerging nation in the world and eager to be a benefactor to its neighbours in order to build its soft power, was to have been in Pattaya. The world was focused on the summit.

And Thailand has to screw it up. Yet again. Of course, this time it's the red-shirts' turn. But the blame is on the Democrat government for failing to ensure the security of the summit. Is it really so difficult to cordon off the supporters for ONE summit lasting just a few days??

I read online that China planned to sign an FTA with ASEAN members and announce a $10billion aid package during the summit. I don't know how true it is. We will never know. And you know what, I also read that the summit will now be held in August, a full 4 months away.

Thanks Thailand, you always have a way to make us feel superior.



Friday, February 13, 2009

Technical Analysis- A somewhat scientific look 26 comments

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I like reading the Review segment of the Straits Times because there are occasionally interesting analysis, and Andy Ho sometimes has interesting articles. This guy writes extensively on a variety of topics ranging from health to science to philosophy to political systems to economics ... all of which interest me (save maybe for health). Saturday's article in ST is the inspiration for this latest blog entry.

I had read a book on chaos theory some years back, which is the subject of Andy Ho's article, but had not really made the connection to stock market dynamics then, probably because my market experience then was not too extensive for me to make that connection. But some years later, on reading this article, it struck me how economic and stock market behaviour can be described by chaos theory's derivative, complexity theory (if it can even be called a theory, since there're no real quantitative equations).

The story goes that classical mechanics can describe the interaction between two bodies, such that if given a set of initial conditions (eg. position, speed) for both bodies, the equations can predict their future trajectories for all eternity. This is known as a deterministic system (ie. its future is predictable). However, things get much more complicated for a system of three bodies. Where initial conditions vary by a little bit, the subsequent behaviour of the system can vary by a lot. This finding forms the basis for complexity theory, which attempts to describe complex systems.

Imagine what happens when you have n bodies! The system will be too difficult to characterise, it appears at first glance. The first thought that comes to the stock market player's mind will be the parallels to the stock market where you have n millions of players interacting with one another.

However, one of the key findings of complexity theory is that, rather than throwing our hands up in despair, it is possible to find so-called "emergent" properties within such systems. Basically the idea is that although "their futures cannot be predicted, such systems exhibit patterns, so their stability is bounded" (I couldn't have described it better than Andy Ho, hence the quote).

The example of the graceful flocking behaviour of birds is given, where even though there is no preconceived coordination the herd movement appears elegant when viewed as a whole. In fact, the only rule that has to be followed individually is for each bird to keep constant the distance between itself and the one in front while flying in the same general direction. Extending it to anthropology, the way that people congregate in urban areas and interact gives their cities emergent personalities ie. small-scale interactions among many individual parts can lead to large-scale order.

You can see where all this is going. If we characterise technical analysis as an attempt to identify such emergent patterns within the interaction of millions of bodies ie. a complex system, it may not be too far off the mark. Note the word ---attempt --- that suggests discretionary judgment and interpretation and hence practitioners should always remember to exercise prudence in implementation.

I used to be more sceptical of technical analysis, primarily because of the lack of true scientific logic and its lack of quantitative rigour. My doubts were expressed in an earlier writeup in 2006 on the subject --- Technical Analysis --- where I attempt it describe it as a technique for the short-term while fundamental analysis is more effective for capturing market-beating returns over the longer term. I also expressed my views that since the market often priced in breaking news swiftly, it tended to be efficient over the short-term and hence it was more advisable to assess companies fundamentally and position for the long-term.

Today I'm not so sure. First reason: market volatility has increased since mid-2008, as described by the VIX index which shot up from its traditional 20s to as high as 80-90 (it is currently in the 40s). In the past reversal signals were triggered whenever the VIX breaks 30 .... so this current situation is out of the ordinary. A volatile market becomes a short-term oriented trading market, so anyone hoping to make money may have to pay more attention to TA. Secondly, one cannot fail to notice how simple TA rules would have got an alert investor out of the carnage in late 2008, or even early 2008. First example --- the double top pattern, which was exhibited in most stocks and all major country indices that I know of, would have signalled an exit in late 2007 right at the top. On retrospect, it stares at us right in the face. Second example --- moving averages --- once all the short-term averages for the S&P started going below longer-term averages one after the other in Sep 08, what followed was a rapid collapse that spread across the globe. Just two very simple TA indicators .... and the rules for interpreting the signs they carried were established long beforehand, and not on hindsight.

So how do they work? I used to think the self-fulfiling prophecy provides the major mechanics that describes how TA drives the market; that may well be true as its acquires a critical mass following who act according to its signals. But this is not the sole mechanism. If we go back to the example about flocking behaviour, simple trading rules observed by market players can result in patterns that repeat themselves time after time as graceful emergent behaviour ---- which is then lumped together under TA as chart patterns. For example, practice of simple cut-loss rules individually, eg. cut at 10% loss, can drive its own momentum that is naturally reflected in dips of near-term prices below their moving averages and provides a TA sell signal. Likewise, the likely behavioural pattern that culminates in a classic double-top signal can be characterised by many individuals thinking to themselves "damn, failed to sell it at the high the first time, next time it goes back up I'll make sure to sell" ..... hence resulting in strong selling resistance the second time round leading to a double top that never recovers. Thus, individual behaviour that follows simple rules, just like the flocking example, can lead to a herd behaviour that seems coordinated when viewed from the outside, as described by complexity theory. There is this saying "history never repeats itself, but it rhymes" which further illustrates how a study of the past and of TA patterns can foretell likely herd behaviour.

And of course, coming back to the example of the 2008 collapse, there is a third reason why short-term price behaviour is extraordinarily important: reflexivity theory is extremely relevant when the critical issue is banking, whose assets are marked to market and hence solvency is market-dependent. For further reading, here is my article "Reflexivity Revisited".



Saturday, February 07, 2009

On Temasek Holdings 16 comments

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I do not often like to comment on political issues too vehemently but sometimes I feel so strongly about certain subjects in which I feel I have a reasonable overall grasp, that I have to blurt it out. Temasek is still a political organisation as of now, no matter their claims about how commercial they are (tell me how commercial you are when the former CDF can go straight from the SAF to Head of Portfolio Strategy of the organisation), and I think it will be difficult to shake off the political links. I mean, how can it possibly do so, unless it wants to deny that the money it is handling does not belong to the citizens and the state of Singapore???

So, Madam Ho Ching's resignation has signalled a recognition of the need for a change in the power structure in the organisation, and hopefully this will lead to a change for the better in all senses. My views about Temasek's execution through the financial crisis starting from 2007 are as follows:

1) Let's start from the most recent issue. I have nothing against Ho Ching. In fact, I have respect for the timing that she chose to step down, ironically because it was bad timing. People would more often than not choose to step down when things turn for the better, so that they can look good and save face. The fact that she did not do so and chose to let go to the next better player at this time says something about the lady.

2) But of course, that does not exonerate the mismoves of Temasek from late 2007 onwards when the subprime crisis first broke out. The purchase of big stakes in western financial groups started with Standard Chartered in 2006, but the real missteps were when it invested US$5.8bn in Merrill Lynch and US$2bn in Barclays as the first tremors of the global financial crisis were being felt. As of March 2008, the time of its last financial report, its portfolio was 40% loaded in financials. That stake is set to be trimmed drastically, mainly due to market movements, when its next report is due in March this year. I personally have never understood why fund managers are so captivated by financial stocks. I mean, unit trusts yes, they have to track their benchmarks so it is more understandable, but why SWFs like Temasek? Are banks the best way to play economic growth? I don't think so. Sector-for-sector, financials are the lazy man's way to play on economic growth, who claim that it offers diversification. I say that it's better to identify individual themes, say healthcare, consumer brands, infrastructure etc, and then go for the best-of-breed in each identified category, with an emphasis on not overpaying for the business. Financials should have been the one category to avoid in late 2007, given that the subprime crisis was just breaking, with possible contagion (which has become reality unfortunately). Leveraged institutions like banks would have been hard hit, not to mention the fact that they were in the eye of the storm in the first place. So why?

3) To be sure, Temasek did divest some financial institutions. It actually sold its stakes in some Chinese banks, at a good profit, in late 2007, in order to control its banking exposure. This is something that some foreign papers fail to highlight and I think we should be fair to Temasek and not just focus on its losses. Unfortunately, it turns out that it would have been best to have stuck to these Chinese banks while avoiding the Western institutions in the first place ie. we should have sat on our hands through 2007-8.

4) The most disturbing thing, in my view, is what Temasek actually sees as its role. This is what was written in a Financial Times article (link is here). (quote):"We felt, along with other [sovereign wealth] funds, that we had to do something to help stabilise the global financial system,” said a senior Temasek official, referring to the Merrill investment.(unquote). Ok, so the mission of Temasek is to save the world? Is that why its sister organisation GIC also bought heavily into Citigroup and UBS? This is disturbing because we have always seen the reserves we have built up over the years as one of our key national assets, and while these assets are substantial, they can hardly be adequate to support the national economies of developed nations with multiple times our GDP .... let alone the world. I agree with the view that SWFs should play a greater role in the world financial system, but I do not agree with the type of role ..... are SWFs supposed to provide dumb first-round recapitalising capital that have greater risk/reward profile (ie. downside risk is greater than upside potential) before the individual governments come in with the second, third rounds etc? I would've thought it works the other way.

The fact is that bigger nations with greater resources, perhaps China or Germany, can do that. These are the nations that have run a consistent trade surplus and the implicit understanding of the world system is for trade surplus countries to do more to reverse this surplus, through stimulation of domestic consumption or exporting their capital. That is to make up for their exporting their excess capacity to global demand. But in the words of our own PM, Singapore is a small sampan floating in international waters, subject to its waves and various propensities. Sure, we have one of the largest reserves in the world, but that was through painstaking accumulation. It would grieve me more if it was political pressure driving the decision-making process to buy into those Western institutions in 2007-8, more than if it was sheer foolishness or ineptitude.



Sunday, January 04, 2009

Developing An Investment Philosophy Part 5 25 comments

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A friend joined a fund management firm recently and was amazed at how the analysts were expected to cover multiple geographical markets simultaneously, since the firm managed several Asia-Pacific funds. How was he supposed to do it, he wondered, since he previously was only familiar with the Singapore market. Indeed, was it even humanly possible for a person to cover many markets at the same time?

To me, there are three distinct aspects to developing one's expertise and effectiveness in the stock market: depth, breadth and philosophy. Be deficient in one aspect and he will be a much less effective investor by an order of magnitude because of it.

In fact there are many analogies that I can draw between this and kungfu (which I like watching, and in the mood to indulge in today because of the movie Ip-man) so I'll use the analogies liberally here. Depth is easiest to understand. If you master a certain kungfu style eg. Snake style or Eagle Claws (in that old Jackie Chan movie), you will know all the intricacies and be in a great position to fight all comers. Ditto for the investor who knows a market (usually his home market) or an industry really well; he will understand what drives it, the industry dynamics and cycles, the key market players etc, from which he can make money with more than even odds. This is what my friend had: depth of knowledge in the Singapore market. Often, depth of knowledge in one market can serve as a good launching pad for expansion into the next aspect --- breadth --- because the groundwork has been done; one knows what to look out for the second time round.

Just like the single-style kungfu expert who encounters other schools of kungfu. He will find it easier to learn them because he has the basic understanding gained from his mastery of his first kungfu style. And as this exponent encounters more and more different schools of kungfu, he gains breadth of understanding and knows their various interactions and how to deal with and counter each and every school. In the same way, breadth of knowledge of different markets will move the individual investor up another level because it will reinforce his knowledge of how sector peers in different countries operate, and relative valuations provide a guide to whether the particular stock he is holding might still be undervalued or is merely fairly-valued. Personally, I follow a "buy local, monitor global" approach given my limited time; at the same time I recognise the importance of expanding breadth, hence my "monitor global" emphasis ("My Research Routine").

But a lack of breadth, I said to my friend, could be made up for by excellence and consistency of application in the third aspect, which is sound investment philosophy/principles. A kungfu analogy will be the "internal strength" that shields top martial experts from serious damage by opponents eg. the ultimate Jiuyang Zhenjing in Jin Yong's Heaven Sword Dragon Sabre. Or how about Zhang Sanfeng's tai-ji ("no style is the best"). Once one has internalised certain values, he does not need superior knowledge across many markets or insider news to succeed in the market. Intangible facets of investment philosophy, such as an appreciation for value, decision-making based on upside potential vs downside risk, a balanced understanding of the key parts of business value, consistent and logical thinking and discipline in application, trading philosophies such as cutting loss and when to average down/pyramid up .... if one can internalise a philosophical framework within his investment approach, he will indeed be more effective in that most important measure --- market profit --- than the professional who is continually scrambling to expand his breadth of knowledge (sometimes at the expense of depth, I understand).

It will indeed be the most desirable to attain expertise in all three, for one can then claim to have achieved Investment Nirvana (and then spend the rest of his life peddling away to stay at the same point). Then again, for want of time, it is often important to prioritise, in which case I would advocate a clear investment approach anchored by frameworks of thinking, and depth of understanding in the various sectors that one is interested/vested in. One will then be confident of his position when he faces his counterparty in the transaction.



Saturday, November 29, 2008

Reflexivity revisited 3 comments

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Let's review the various perspectives about the relationship between stock prices and "business fundamentals" as most people understand it. First, there is the advice given by the Sage of Omaha about Mr Market being manic-depressive and that the prices he/she/it quotes can have a disconnect with underlying fundamentals. Then there is the typical technician's/efficient market theorist's view that price reflects underlying fundamentals, even though it might not seem so at the time to the outsider. And then there is George Soros, who advocates that market prices can actually actively influence fundamentals. The last view is known as reflexivity, a term coined by Soros.

Despite Soros' celebrity fund manager status, reflexivity has never really caught on in popular investment literature, partly because it does not really have mathematical grounding. It is more of a philosophy than anything else, in its recognition of the two-way feedback between price and fundamentals, instead of the traditional view that fundamentals drive prices. But in the aftermath (I hope) of this credit crisis, it deserves serious all-round consideration and recognition now.

First of all, by virtue of the fact that Soros was among the first to recognise the seriousness of this crisis, calling it the greatest financial crisis since the Great Depression, his market ideas and philosophy deserve special elevation. Now everybody knows the current crisis as .... yes, "the greatest financial crisis since the Great Depression". Talk about parrots. But more importantly, the mechanics and evolution of this financial crisis indeed has the feel of a price-induced death spiral about it.

The most obvious linkage is market confidence. There is nothing that unnerves the self-assured long-term "fundamentals-driven" investor more than to watch the market value (and his net worth) of his investment drop day by day; it has the effect of shaking his conviction to the point of changing his perspective from "Mr Market is wrong" to "Mr Market might know something". The same applies to the bond investor of course, who will be driven more by credit concerns than earnings concerns (bond investors also tend to believe in market efficiency more). This is all fine if the stock is trading on the secondary market and the business is self-sustaining without funding concerns, because the business doesn't really care what price it's worth according to Mr Market, as long as its suppliers and customers continue doing business with it. Operations-side partners tend to be less market-sensitive; however financial-side partners are hyper market-sensitive, and this is where declining market valuation can feed into faltering confidence. If the company is constantly dependent on financing cashflow (not necessarily from stock market or bond market) to sustain its operations, or if indeed (in the case of banks) market trust is integral to its business model, then the reflexivity effect is particularly influential. Indeed, in Soros' original illustration of the reflexivity effect, he highlighted the case of REITs, which often funded new property purchases through issue of new units and therefore depended heavily on high market prices of their units to purchase these new properties at above-average yields ..... sort of a Ponzi scheme in my opinion. Today, REITs face a different market confidence-related concern .... they have trouble rolling over their current debt.

Another linkage is the interaction between market valuation and regulatory requirements. For the current crisis, the most obvious example is the mark-to-market rule which requires financial institutions to mark their financial assets at current market prices; given the collapse of mortgage securities and almost every other kind of financial asset except Treasuries, banks and insurance companies have taken a severe hit on their balance sheets. Regulatory requirements (eg. Basel 2 accord) requiring them to be sufficiently liquid or solvent then force them to have to raise cash, either by issuing new shares or bonds, or deleveraging through selling assets on the open market; any such measures are undertaken at unfavourable prices and adds further to the deterioration in market confidence.

Although I have pointed out earlier that operational-side partners tend to be less market-sensitive than financial-side partners, they will eventually be affected if asset prices correct significantly across entire markets. This is what is happening now as the financial crisis spills over to the real economy. Corporate customers unable to obtain trade financing have difficulty paying for ship charters, so ship owners are hit. Retail customers unable to obtain easy home loans or auto loans stop buying homes and cars, while those that hold significant paper wealth have effectively had their net worth halved or more, hence retailers are hit together with their previously free-spending customers. This is the capital market-to-economy linkage that presents another facet of reflexivity.

Such a positive-feedback spiral can feed on itself in the way that panic does. What are "fundamentals"? At the end of the day, it is hugely dependent on confidence. Without confidence that the future can be better, consumers will not consume. Without assurance that future consumer demand will grow, businesses will not invest. The demand curve is actually heavily dependent on sentiment, security and other intangibles; demand is what generates growth; it IS the fundamentals.

That is why the government has to come in to intervene, the way Keynes advocated and the way Soros believes has to be to break the reflexive spiral. It has to inject confidence through being the capital provider of last resort, revise regulatory requirements (or at least ease them), and provide counter-cyclical demand. Those who believe in letting the markets cure themselves, such as the Austrian school, the market fundamentalists and even Jim Rogers, are just hallucinating. Especially for Jim Rogers, I cannot understand why he was working with George Soros for years but does not seem to understand the government's role in breaking this crisis?

Those who want to read further about reflexivity should read Soros' book "The Alchemy of Finance" (link to my book review) where he expounds on his pet theory in greater detail.



Monday, November 10, 2008

Stockpicking in a bear market 14 comments

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Stockpicking in a bear market can be a hazardous business, because going long in deflationary conditions is by definition an attempt to pick a bottom (whether intermediate bottom or long-term bottom) on the stock price. It is easy to be bloodied by the falling knife, especially if one attempts to catch it naked (eg. contra, no ability to hold). One could thus simply choose to avoid risk and not hold stocks altogether, which is the reason why we have a bear market at all --- risk aversion leads to lower volumes and the stock prices drop by gravity due to lack of support. But yet, if we define risk as the potential loss on investment over say 3-5 years, rather than the standard textbook definition of price volatility which I have always maintained is more appropriate for short-term leveraged players than for long-term investors (see my article on risk), then buying stocks during a bear market could be a low-risk proposition indeed (because you are buying at a lower base and hence risk of losing is lessened over the long term), assuming that the bear cycle reverses in several years.

I feel that a good model for picking stocks in a bear market would be to examine the cash bailout potential of a stock over the medium to long term. I build my ideas based on the "cash bailout" concept as espoused by Martin Whitman in his book "The Aggressive Conservative Investor", which was written in the late 1970s when stagflation gripped the US. The general idea is to view a stock with regard to its potential to allow the holder to eventually bail out; under this umbrella of "cash bailouts", selling in the open market for capital gains is but one of the bailout exits; other potential exits include dividends and privatisation.

This way of viewing a stock is especially useful in a bear market where most small-cap stocks may be thinly-traded and selling out of them may be difficult. Yet, illiquid small-caps often offer the best potential gains. I adopt a two-horizon approach to picking these stocks in a bear market.

The two horizons refer to the medium-term horizon (6-12 months) and the long-term horizon (3-5 years). Under each of these horizons, I examine the cash bailout potential of the stock. For the medium term, I naturally demand lower potential returns as opposed to the long-term horizon.

Under the medium-term horizon, two main factors to look out for are privatisation potential and dividend yield. These are the two main cash bailout avenues in a recession/bear market where liquidity and capital gains opportunities might be limited. Dividend streams tend to be more easily predictable especially for older companies, and high dividends, perhaps in excess of 5-10% yield, would be a good clearing mark for potential stockpicks. Privatisation potential is harder to judge, but on top of the usual "good earnings/business" criteria, I would expect that tight ownership under a strong cash-rich owner, an operating niche or desirable brand name and steady free cashflows (operating cashflow minus investing cashflow) would attract potential privatisation offers from parties such as the main shareholder, business competitors or private equity funds.

Under the long-term horizon, capital gains look like a more viable, and probably the most profitable, cash bailout avenue. This is of course the preferred bailout avenue of the long-term growth investor. Two main issues must be considered with respect to stockpicking for this horizon: firstly, how many times can the stock price appreciate; secondly, can the company's fundamentals survive the recession unblemished. For the former, I would consider that if one is targeting 3-5 years down the road, he should be picking a stock with the potential to be at least a 4-5 times multibagging potential. That would translate to about 30-40% annualized gains --- quite ambitious but nonetheless a good way to filter out the real bargains among the many cheap pennies floating around in a bear market. Of course, the devil is in the details: the judgment of appreciation potential is critical and clearly the selected stock might not fulfil its hoped-for potential. For the second issue, it boils down to an examination of the company's accounts and operating business. I would say that the balance sheet (complete with footnotes) is the single most important source of information to make the judgment. Things to look out for would be heavy debt, contingent liabilities (under footnotes), consistently negative operating cashflows and insider selling. As Warren Buffett says about car racing, to finish first, you must first finish.

Ideally the selected stock would be satisfactory on all counts, both medium-term and long-term. But it may be difficult to find one that has multi-bagger potential and yet has clear indications of being taken over, say. Or it might pay miserly dividends. In my view, the dividends and the fundamental strength of the business to negotiate through the recession override the other two factors in terms of importance. Ultimately, they are the ones that are most easily judged from current and past data, can be judged objectively, and provide a clear operating basis to fall back on should privatisation or capital appreciation not work out. In short, they provide a floor for the stock price. Look out for these two parameters most of all.



Saturday, November 01, 2008

Structured Products fiasco- What's reasonable, what's not 5 comments

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It is surprising that this storm has still not abated about one month after it initially started following Lehman's failure which ignited so-called "credit events" in many structured products offered around the world, most prominently in Hong Kong and Singapore (I wonder why these two countries in particular). With all due respect to the victims, my conclusion is that in Asia, money (and the loss of it) strikes at the raw emotions (and the corresponding activism) of people much more than anything else (eg. intangibles like democracy, politics, environment).

As this issue is covered almost every day in the papers, I cannot help but be saturated by all the reports. And I cannot help feeling that while there are obviously certain points that buyers of these Lehman minibonds/DBS Hi-Five/Merrill Jubilee notes (to name three of the most prominent) have strong reasons to be indignant about, there are other points that were raised which do not really hold any ground. I discuss a few of each below:

What's reasonable (ie. the investors have reason to be indignant about)

Terminology used: The misleading terminology used to market these products is one of their biggest bugbears, and rightly so. As I've said before, I never would have understood that there was a difference between capital-protected and capital-guaranteed until the shit hit the fan in the last two months. And calling the Lehman products "minibonds" certainly hints of an intention to lull the target audience into complacency. A rose by any other name is just as sweet (and the reverse applies for a pile of shit), but certainly the name is supposed to convey a certain first impression and underlying meaning.

Lack of understanding of products by sales personnel: For the level of complexity of the structured products which had even some experienced finance professionals struggling to comprehend the prospectus, it is highly debatable whether they should even have been made available to the masses. One thing is clear, and that is that many of the sales personnel were not equipped to explain their complexity to retail customers. There is anecdotal evidence on the part of the aggrieved customers, and partial acknowledgment of this fact on the part of the selling financial institutions. In my view, the caveat emptor principle is more valid when the investor is the one actively sourcing for investment targets to purchase; it is reasonable then to expect that he should do his own research. However, where the seller is conducting aggressive selling tactics, I feel it is their responsbility to explain the upside and downside of the product to their customer to give a complete picture. Most agree that it is doubtful that the sales personnel were even in an enlightened position to explain the risks of these products.

Poor financial advice: In the old days, the easy money was to be made in "widows' and orphans' money" --- it was easy to target the money of the most vulnerable. Anecdotal evidence suggests a key target for these structured bonds were the elderly looking for fixed deposits. This is not wrong in itself, except a key tenet of prudent investing --- diversification --- was ignored when a big part of these customers' money (several hundred thousand dollars for many) was eventually funnelled into one or two structured products. However safe a product might be deemed to be, surely it was unwise to put all the eggs in one basket? Perhaps the money could have been spread among several structured products?

What's not reasonable (ie. the investors shouldn't complain)

The yield and risk involved: Now this is one argument that I don't agree with. Some investors have pointed to the admissions of the banks that the structured products were risky ("probably a 8 or 9 on a scale of 10") as evidence that these were high-risk products that were mis-portrayed as safe products when they were marketed. Others claim that they had mistaken the products as being safe because they looked at the promised yields of 5% and thought that such low yields would surely mean that the products were low-risk ("high risk, high return" and vice versa). But people have to remember that at the time of issue, many of these instruments were rated AA or thereabouts, comparable to or even better than many emerging market sovereign bonds. The banks have a reasonable case that nobody expected then that the credit would deteriorate so fast. What the banks could have done better, though, was to regularly update their customers on the riskiness of these structured products, including any downgrades by the ratings agencies.

Role of the government: Some feel that our government has largely adopted a hands-off/passive approach to administering this issue and want them to offer more protection to the victims. Personally I feel the official reaction has already been quite active judging from the numerous comments from the authorities on the mass media, though people are apt to compare with other countries, notably Hong Kong. I don't really think taking too strong an official position on either side will be prudent, especially when one is wary of setting a precedent that could have implications down the road, or where it could cripple some financial institutions at a time of great crisis, and when our business reputation has always been built on fair governance without letting economic issues being corrupted by politicisation. For this issue in particular, it's really better to cross the river by feeling the stones.



Saturday, September 27, 2008

Screening S-stocks 5 comments

DanielXX's intro: The below is extracted from the Nextinsight share investors' site, a no-nonsense website whose founders include a former business journalist and a head of a well-known local investor relations agency. The article is written by Sim Kih. The writeup was in turn based on a lengthy JP Morgan report on the dangers of S-stocks.

The reason for my highlighting this article is that it offers many key insights on what things to look out for when stockpicking S-chips, or so-called "warning alerts". An article worth archiving for future reference. It is my belief that once you know what red flags to spot and what stocks to avoid, you will have controlled your downside pretty well. Why else do you think JP Morgan is one of the survivors, or some might even say a key beneficiary, of the current credit crisis?

One thing to note: the valuation screens used can be moving targets. There is no reason to claim that say, a PE<10 means a good stock pick, if most other peers are trading at <5X. In other words, one has to watch the relative valuations available on the market and cannot use rules-of-thumb blindly.

(P.S: The following were extracted from another source and is not my original work.)

Considering the risky nature of S-chips, what are some potholes to avoid when stock-picking from the “bargain department”?

There are 10 barometers that suggest to seasoned investors there’s more than meets the eye. Many of these include detailed checks on cash, which is harder to manipulate than earnings.

Does your 'bargain gem' fail any of these 10 warning alerts?

Readers should note there could be sound reasons behind some of these “warning alerts”, so the discerning investor would investigate further before writing any stock off.

10 warning signs for troubled stocks

1. Extremely low deposit rate for cash

This is a major warning alert.

Using China’s annualized cash rates as an example:

0.72% Demand deposits
1.8% 3-month time deposit
2.5% 12-month time deposit

It is thus reasonable to expect interest on bank deposits for S-chips to exceed 1%.

JP Morgan screen:
Deposit rate for cash <1%
Total cash/market cap > 5%

2. High cash reserves, but high debt

A high-cash and high-debt scenario indicates poor financial discipline since companies can logically cut finance costs by paying down their debt with excess cash.

Investors begin to wonder there is “balance sheet management” around the book closure date, or in the worst case scenario, a possibility of fraud or embezzlement of cash.

JP Morgan screen:
total debt/market cap > 30%
total cash/market cap > 30%

3. Much higher capital expenditure for the same capacity

If a company's fixed asset investment per ton of production capacity increases sharply over its expansion schedule, investors begin to wonder if the increasing depreciation expense that shows up on the profit and loss statement could in fact be excesses in other operating expenses.

Inability to sustain growth

4. High gearing, high working capital requirement

High working capital requirements, low net margin and high gearing will slow growth.

JP Morgan screen:
High net working capital to sales ratio (>20%)
High gearing ratio (>35%)
Net working capital to sales ratio – net margin > 15%

5. Frequent fund-raising

JP Morgan screen:
Issues of new shares or convertible bond more than twice during 2004-2007.

Changes with key officers

6. Hit-and-run

When a controlling shareholder dilutes its stake to below 50% within a few years of listing, there may be reason for investors to ask questions.

Another situation would be a passive investor holding the controlling stake.

7. Resignation of key managers, directors or auditor

Most auditor replacements in Asia are related to unsettled disputes on accounting practices.

Investors should be alert if senior managers resign without a proper reason.

If the company was doing well, why would they leave instead of enjoying the corporate spoils?

Often, the resignations potentially indicate corporate governance issues that investors were unaware of before, said JP Morgan.

Poor corporate governance

8. Acquisitions that do not make sense

Investors require acquisitions to show synergy, and a fair acquisition price.

This is especially so if the seller is an interested party or an affiliated company. Volume and size of transactions could mask sharp unwarranted jumps in certain accounting items.

9. Lack of sufficient disclosure

This could include failure to disclose large payments related to subsidiaries acquired from a related party, and such payments were subsequently highlighted by independent auditors.

10. High cash reserves, but low dividend payout

JP Morgan screen:
net cash/market cap > 10%
rising cash level in the past two fiscal years
dividend payout ratio < 20%

(The above was extracted from Nextinsight with their kind permission)



Monday, September 08, 2008

Understanding stock valuation 14 comments

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To me, understanding valuation, or why the stock is priced the way it is over an extended period, is one of the, if not THE, key risk management method for the stock investor/trader. This is as opposed to the approach of many traders who use technical analysis, momentum trading, cut-loss etc. Indeed, if I may generalise, the upside gains from an investment comes from astute understanding of business dynamics and growth potential, but management of downside risk comes from understanding of the valuation.

There are several issues on valuation that I'll discuss here. First of all, understanding what type of valuation technique drives the price of a stock is winning half the battle. The favourite technique is PE (price earnings) but I am incredulous when people quote PE for companies which should more accurately be valued by their balance sheet assets eg. property stocks. PE is more relevant for companies which enjoy steady and sustainable growth in their core earnings because it is predicated on projecting a certain level of earnings growth into the future, and hence it's imperative that these earnings are predictable. Indeed, it's worth noting that often the best time to buy cyclical companies is when their PEs are high or even negative, because it will be at the bottom of the business cycle when this happens (ie. the market-timer can catch it at its bottom).

It's also interesting to observe how valuation technique can change at different points in the market cycle. In an up market, PE is often used because earnings are seen to be on a steady growth trend in the foreseeable future. The more cynical individual might also postulate, with some truth, that PE valuation offers a lot of latitude for the market analyst who wants to push a stock to derive a very high target price, through surreptitious methods like using high PE ratios (can anyone honestly explain why a stock should be worth 15X instead of 20X PE?) or using earnings 2 or 3 years later as the basis for the PE calculation. When the market turns, like now, suddenly analysts base target price at NTA (net tangible assets). It's worth guarding mentally against such skulduggery.

An associated issue is the elasticity in price valuation that each valuation technique produces. There is great amount of discretion that has to be exercised with respect to the PE ratio used, whether it should be 5X, 10X, 20X. Hence this method often can be dangerous in the event of a PE compression when liquidity is tight or sentiment weakens, simply because price targets can decline by multiples without earnings even changing. Valuation on the basis of NTA might produce a more solid base, because balance sheet assets don't just melt away; the analyst might decide, however, at different times to assign 0%, 10%, or 30% discount to NTA, or even premiums to NTA, when calculating fair value, depending on his or Mr Market's "mood". That is why one should perhaps buy both asset plays (valuation based on NTA) and growth plays (valuation based on PE) if he wishes to control the degree of price voilatility in his portfolio.

The last issue is to do with assessing the components of valuation. This could best be illustrated with the example of a conglomerate. For example, consider Keppel Corporation. Conglomerates' values are calculated on a SOTP (sum-of-the-parts) basis, where the value of various divisions are summed up. According to a recent GKGoh report on Keppel, I can observe that its offshore division constitutes >50% of the SOTP total value, its property division and Keppel T&T constitute >10% each, with its infrastructure division and SPC stake making up the balance. This provides a general reference for where the main price driver of Keppel lies, whether or not the target price eventually derived overshoots or not. Hence the valuation of Keppel will be most affected by changes in the offshore segment --- this is the one to watch if one is holding the stock.

This approach can be extrapolated to most companies as well to assess what drives their valuation. For example, my Hotstocksnot assessment of Lian Beng in October last year concluded that a large part of its valuation derived from its property developments with its construction segment forming the minority, and this formed the basis for my hotstocksnot conclusion because I felt then that property prices might have peaked which meant Lian Beng's heavy exposure in this segment would render it a substantial victim of a property downturn. Although Lian Beng had hitherto been known as a construction player, an in-depth assessment of its stock valuation would have rendered useful insights and prevented a disastrous entry into the stock.

That is why I consider valuation knowledge probably the most important aspect of an investor's toolkit. At the same time, it is important to recognise and keep in mind the fluid and dynamic nature of valuation approaches, so that one constantly evaluates the market and its interaction with the mainstream valuation approach.



Saturday, September 06, 2008

The biggest bubble in the world 16 comments

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No it's not the US housing bubble or even the UK housing bubble. Though definitely quantitatively more substantial, the amount of euphoria and the way that prices were being chased up are nothing compared to the greatest one of all -- the English Premier League.

When player wages are inflating at an increasing rate even as global fundamentals are declining you either call that a growth industry or a bubble. Some statistics: in the first Premier League season the average player wage was £75,000 per year, but subsequently rose by an average 20% per year for a decade (source: Wikipedia) and in 2006 a survey by The Independent and the Professional Footballers' Association found that salaries of EPL players had jumped by a massive 65% within one year to an average basic pay of £676,000. Based on anecdotal evidence from 2006 onwards, I would think that rate of growth has continued to sustain itself, with the influx of wild money from abroad.

When you combine this with the fact that only eight of the 20 EPL clubs recorded an operating profit in 2006/7 - half the number which did so a year earlier (source: BBC news), you have to conclude that this is a bubble rather than a growth industry.

Two decades ago, cash-flush Japanese benefiting from a massive real estate and export boom at home combined with a greatly-appreciated yen post-Plaza Accord (see " Japanese bubble economy of the 1980s") went on an overseas asset buying spree, with the most infamous being their purchases of Impressionist paintings at absurdly high prices of tens of millions. When the economy bust, so did the market and prices for paintings. So today we see the phenomenon being repeated with petrodollar-rich Arabs and Russians, whose names have been so oft-reported in recent times that I need not repeat them here. Crazy liquidity chasing illusory status symbols.

While we're at this game, I might as well list down the various clubs and their possibility of extravagant takeovers/makeovers, and who SHOULD be buying them, in terms of personality fit etc. In the order that they currently occupy in the table:

Chelshit - Only Putin can take this one away from Roman. I hope he does and this biggest bubble of all gets relegated.

Liverfools - Admittedly, they're already a brand name with great tradition. That's why the filthy-rich won't buy them, because the idea is to flaunt your wealth and show how your money can transform a piece of rubbish into gold. Maybe a Spanish buyer might be interested, so that the Spanish transformation of this club will be complete. They can rename it La Fools.

Man Shitty - Already done. Might be attempting a trillion-dollar takeover of Man-U next, through buying their entire team over starting with the crying one. No-brand/house-brand manager Mark Hughes won't survive past half the season.

Arsenal - What's the point of takeover? Give him billions of dollars and the Frenchman prefers to spend millions (or thousands if possible) at most. If Anwar takes over the Malaysian government, he might like them. But Malaysia can't afford to buy this arse.

West Ham Utd - London address. Managerless. Excellent for a takeover with minimal opposition and freedom to install one's choice of management. With their tradition of violence, maybe Iran might be interested.

Middlesbrough - Currently going nowhere which makes it a good choice for remaking. Maybe some Japanese fund will buy it since they share similarly-coloured flags/jerseys and share similar recent histories of underperforming.

Aston Villa - Big club, middling performance. Prime target. Some kind of value buyer, say a bank or private equity, that can hype this into a speculative and exciting club and then hawk it to the Arabs amid the euphoria.

Bolton - You really don't want to buy a club that is in danger of relegation. Any makeover has to be extreme.

Man Utd - They are so profitable that they are going to be difficult to take over. As said above, Man Shitty's strategy is to empty them of their players. If anyone is going to buy them, it will be China --- a symbolic gesture (Chinese are big on these) of China's imminent world domination.

Blackburn - With a name like that, I think black-hearted hedge funds who will burn in hell might be interested.

Newcastle - Anil Ambani of Reliance rumoured to be bidding. For a club not known to be reliable on consistency, this is indeed ironic.

Hull City - CMI. Straight back down.

Wigan Athletic - Any club with Emile Heskey and Titus Bramble needs an extreme makeover. But I cannot fathom who will give it to them. This one will never become a Monet or a Renoir.

Fulham - The Harrods boss probably has loads of Middle-East connections so he might sell, but only at a huge premium. Saudi Arabia or Kuwait, maybe.

Stoke City - CMI. Straight back down.

Portsmouth - Dirty Harry allegedly loves to buy and sell players because he takes cuts out of each transaction. I cannot think of more appropriate buyers than another of those Russian oligarchs.

Everton - I hope Temasek or GIC buys them, so that I can claim to be patriotic when supporting Everton.

Sunderland - Should get a jersey makeover before anyone will consider bidding for them. Maybe one of those shady Al-Qaeda funds might like to buy them because they have a gigantic stadium and nobody visits the stadium, so they can use it for all kinds of training purposes.

Tottenham - Premium London address. Premium tradition of excitement, but mainly when going one-on-one rather than in group matches. Perhaps the US might be interested in going for them.

WBA - Can anyone tell me what these initials stand for??



Monday, September 01, 2008

My Investing Journey: Hurricane Katrina 5 comments

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If late-2004 and early-2005 are remembered for the corporate debacles of CAO, Citiraya and ACCS, the later part of 2005 will be remembered for the attention that centered on oil and refining. The catalyst was Hurricane Katrina, which was the worst-ever storm to hit the Gulf of Mexico and caused extensive damage to the refining facilities in the region, exposing the deep global capacity crunch in refining capacity.

Katrina formed over the Bahamas in late August 2005 and due to the unpreparedness of the authorities, caused severe destruction along the Gulf of Mexico coast from central Florida to Texas in the form of a Category 5 storm, with the most severe loss of life and property damage occurring in New Orleans. Of more interest to oil traders was the damage to the oil production/refining infrastructure in the most important offshore oil production area of the US, where numerous oil platforms were destroyed and refineries were forced to close; approximately half of the Gulf's oil production was shut over the subsequent 6-month period.

Oil prices making new highs had been the talk of town throughout 2005, but Hurricane Katrina brought into focus the glaring global tightness of refining capacity. Simple and complex refining margins spiked up several dollars per barrel after Katrina which bloated the profits of refineries across the world for 2H05.

Allied to this tale is the story of SPC. The story is told in my writeup on "Bull stock: SPC". Struggling with razor-thin margins and stagnating revenues in its refining business in the late 1990s when oil prices were in the pits, it was a massive beneficiary of the burgeoning demand for petroleum products after 2003 that translated in steadily rising refining margins from 2004 onwards. Net profits for SPC jumped an astonishing fourfold from S$60M in 2003 to S$250M in 2004, and within the year 2004 alone the stock shot up from 1.50 to 4. Remember that 2004 was a relatively tame, mildly bullish year, so this was a meteoric rise, reflecting the rewards that can be reaped when the investor recognises a single trend and bets on it.

Unfortunately, I did not see the trend, and so missed out on the bulk of the gains. There was plenty of talk online about this though, but I only read through the threads after the bulk of the price gains were done. Nonetheless, I got into the stock in early 2005 at $4 because of what I felt was an under-recognised strength of SPC: its being a complex refinery which meant it could handle heavy sour grades from the Persian Gulf countries, which were in abundant supply, while simpler refineries in other countries could only handle the more expensive sweet light grades. You can really learn a lot through good analyst reports especially those that cover an industry on the whole; typically such reports have less of a "sales" agenda compared to reports on individual companies: I learnt all the facts from several such reports on the refining industry before parlaying my bets in early 2005.

The stock did relatively well throughout 2005 but really spiked up post-Katrina when it shot from the high 4s to $6, when the tightness in refining capacity was revealed in its entirety and Singapore complex refining margins shot from US$5/barrel to US$15/barrel. In fact, it had been tight throughout 2005, with US and Asian refineries operating at above 90% capacity. Katrina was merely the catalyst that pushed it over the edge by knocking out spare capacity (and then some). The dramatic reaction of refining spreads is a manifestation of how prices for commodities can surge when demand just slightly tips over the thin margin previously existing between it and supply capacity.

It also is an example of the moral dilemma that often surfaces when one invests in stocks whose potential price catalyst could be some disaster that exposes the deficiencies in the industry and brings market attention to the particular niche that the stock serves. Offhand, I can remember stocks that benefited from such phenomenae such as Medtecs (which sells gloves, facial masks and medical consumables) during SARS and defence stocks during the US-Iraq war. Some might even see the glee that short-sellers exhibit in every new bite of bad news hitting the US banks currently as an example of such morbid moral ambiguity. How does one reconcile one's morals with one's market position?

I reckon the crux lies in whether one is actively hoping that a disaster will happen which he perceives will benefit his stock as a consequence. For SPC I had never bought in with such hopes so I never suffered any guilt pangs when Katrina struck and had a positive uplifting effect on prices of refining stocks across the board. However, I have seen people who, for example, bought Medtecs after the SARS crisis blew over and then hinted that SARS might come again, with the subtle hope that it WOULD indeed strike again. That is contemptible behaviour which is akin to building your happiness on public misfortune. On the other hand, it does not mean that the investor/trader cannot position himself in a fundamental trend which he feels is going to persist, even though this trend might be generally detrimental to society. The investor/trader might be betting on the inevitability of a development, and there is nothing morally wrong about that. Or he might be hedging his portfolio, which is even less reprehensible. But once he crosses the line between dispassionate betting based on return/risk/odds calculations to an active desire that something bad will actually happen to humanity, he will have lost the essence of being a human being in itself. Never put money above your own humanity.

For the record, I eventually sold SPC at the end of 2005 at about $5, when the stock retraced its steps back from $6 and I found other better stocks to switch to. I had also come to the view that the continually rising oil prices would not be good for refiners, because although in the early stages they reflected strong end product demand which basically pulled the entire supply chain (including refining margins) along, high crude prices in fact constituted high raw material prices for refiners which would actually harm their margins eventually if end product demand stagnated (see my writeup on refining margins). Ultimately, of course, SPC would reach $8-9 in 2007-8. But that would be more due to hopes for its upstream segment plus a bull market for commodities --- another thing altogether.

Katrina was the precursor to the annual August/September hand-wringing over potential hurricane impact on oil prices/refining capacity ever since, and the world have had scares now and then over approaching cyclones in the Gulf of Mexico, with the latest one being Gustav (which has turned out to be a mouse). In my view, the fact that people have worked themselves into a frenzy already guarantees that these storms will never again likely have the same impact as Katrina, because they will have prepared themselves to handle any crisis emanating from these storms (eg. shut down facilities, evacuated the coast). A bit like the stock market, where selldowns lead the real event, whether it does eventually transpire or not.



Saturday, August 02, 2008

How To Make Money In Stocks Part 6: Identify spread divergence 6 comments

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As a fundamentals-based investor, I am always looking to find bargain buys on the basis of value and I often try to spot trends (see my blog Trendspotting) which could lead to a re-rating of particular stocks. Once one has identified a particular trend, he can find companies which have particular leverage to that trend. A useful framework for finding good companies is identifying a divergence in its revenue-costs spread, which is of course an elaborate way of describing the income.

The spread is simply the numerical difference between A and B (ie. A-B). The spread will widen/diverge if (1) A goes up while B remains the same; (2) A remains while B decreases; (3) A rises more than B or declines less than B. The most divergence is of course when A rises while B drops. A concept that is easily applied to the earnings framework for companies.

The key benefit for thinking about earnings as a spread between revenue and costs is that it compels the investor/trader to think about the components of income individually insofar as they contribute to the spread (which is also the profit margin). Often, the fundamental factors driving revenue are independent of that driving costs. Identifying stocks where certain trends favour revenue growth while other particular trends point to cost decrease ie. a form of spread divergence, could suggest a stock with potentially explosive profit margin growth.

The most obvious example would be banks. The business model for commercial banks is to borrow funds at a lower interest rate (depositors, inter-bank loans, wholesale market) and then lend it at a higher one (home loans, business loans, credit card loans etc), thus capturing the spread (see "Financials/Business Model"). Typically the borrowed funds are short-term while the bank loans offered are longer-term, because long-term interest rates are usually higher than short-term ones --- thus enabling the bank to make spread profits. In the early 1990s, when America was recovering from a recession triggered by housing-induced banking failures (sounds familiar?), the Federal Reserve lowered federal funds rates (short-term rates which it controls) aggressively, enabling banks (and many speculators) to benefit enormously by borrowing cheap and investing in higher-yield instruments like long-term Treasuries, stocks etc. The financials turned out to be among the best performers as a result of this Fed policy-driven spread divergence.

There are so many such drivers of revenue-costs spread divergence around, depending on the industry. For refining companies, it would be the refining spread, which will widen if petrochemical product prices (a function of refining capacity and product demand) grow faster than crude oil input prices (often subject to supply-side pressure). For manufacturers, revenue could be driven by industrial or consumer demand (which is in turn a function of trends that should be identified) while costs depend on raw material prices. An article I had written about stocks to buy to ride on the global inflation trend illustrates an application of this approach: capital-intensive businesses could be a way to go, since depreciation costs are flat, while selling price (revenue) could be adjusted in-line with inflation; this in effect transforms the inflationary environment to the company's advantage.

Another reason why thinking in terms of spread divergence is useful is because it can be applied to other areas other than the P&L statement. Specifically, it can also be used for balance sheet analysis, particularly for those industries whose stock valuations are more driven by NAVs (Net Asset Value) than by earnings --- for example, property. A favourable asset-liability spread divergence, driven by, say, rising property prices (culminating in higher asset valuations for holding properties) even as inflation rises (hence lowering the real value of debt liabilities), could mean higher NAVs than recorded on book. This model can easily be applied to other industries, such as shipping companies, steel traders, mining companies.

At the end of the day, what is important is that individual investors/traders need a consistent framework for crafting buy/sell decisions in a disciplined manner. Identifying possible outperformers on the basis of potential spread divergence is, in my view, as good a framework as any.



Friday, August 01, 2008

What wage-price spiral? 18 comments

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Inflation is in the air, and Singapore has not been spared. Indeed, as one of the most open economies in the world, we are seen as particularly vulnerable, even a precursor to what the rest of the world will experience several months later due to our lack of subsidies for many common products that typically shield consumers of other countries from immediate price impact.

Given the price pressure faced by people in their daily necessities as a result of imported inflation, it has become necessary to communicate the linkages between wages and prices. No less than two full ministers have come forward to explain the intricacies of inflation and why a wage-price spiral must not be allowed to develop --- which means wages must be controlled.

I sympathise with them because it must be politically difficult to explain to people that their income cannot rise in-step with their expenditure. Before we go further, let's briefly look at what wage-price spiral means. Essentially, it is a classical inflation phenomenon where wages are allowed to chase prices upwards. Prices, in turn, will be positively influenced by rising affordability (rising wages) and hence its upward momentum is not checked, leading to a positive reinforcement cycle. In a sense, inflation begets further inflationary expectations.

But let's look at it more closely. I am in no position to discuss it quantitatively, but let's reason things out qualitatively. Two key points on why I doubt a wage-price spiral will occur even if wages are allowed to rise: firstly, this is widely seen as a cost-push inflation; and secondly, Singapore's inflation is largely imported. A cost-push inflation is caused by drops in aggregate supply due to increased prices of inputs. For example, the 1970s inflation is widely seen as due to a sudden decrease in the global supply of oil due to the formation of OPEC which started to exert control over supply, which in turn increased oil prices. Currently, we are seeing prices of agricultural products, metals and energy commodities rising due to increasing tightening of supply and this is in turn feeding into rising prices of goods/needs that they're used to manufacture/fulfil. Meanwhile, Singapore's consumption expenditure is largely on imported goods because our manufactured goods are largely exported while we produce minimal agricultural goods. Piece the two together and it suggests that inflation is a function of largely external factors where prices are fed from interactions of world demand/supply dynamics directly into the country.

The classical reason on why a wage-price spiral must not be allowed to develop is that the demand-curbing effect of higher prices, which automatically checks and stabilises price inflation, is lost when wages rise in the same proportion to the effect that rise in expenditure is balanced by rise in income. But what if prices is independent of wages, as described above? A part of the argument for not raising wages for fear of a spiral will be lost. Indeed, life can get difficult if prices which are uncontrollable (domestically) rise faster than wages which are negotiable.

In such a scenario, provided that many other countries start to negotiate higher wages for their workers to cope with rising inflation, a country that has a stringent wage inflation policy will gain in competitiveness and become more attractive as an FDI (foreign direct investment) destination. That might also be another reason for not letting wages rise in proportion with inflation. Ultimately it might be a win-win situation too. However, this rationale has not really been presented strongly so far. Anyway, to preserve competitiveness through lower relative pricing does not seem a viable long-term strategy for a developed nation; creating higher value-add should be the way to go. Perhaps we are not ready for it yet?

Of course, wage pressures in certain industries should be checked lest they affect end-product prices, particularly when they are key to the development needs of the country. For example, in the construction industry which is crucial to the remaking of Singapore and where construction material cost pressures are already rampant, it may be important to control wage pressure such that the end-product (the building) does not become so expensive to build that it drives away developers and potential buyers, upsetting the long-term plans of the country. But surely, the control measures should be specific rather than broad-based (and anyway, there're ways of controlling wages --- by lowering regulations for foreign supply, for example)

Caveat: as a non-economist, all my rationalising above might be faulty. Any indignant economists seeing the fault, please kindly point me out in the right direction.



Thursday, July 24, 2008

How much is one billion? 23 comments

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Not a lot if it is in Zimbabwean dollars (maybe could buy a loaf of bread), but really, are we getting numbed by billions being thrown around, being lost here, being written off there? Is this *gulp* an inflation phenomenon?

I guess it is a matter of context. For example, for a bank to write off $1B in the midst of the bull market last year would have been one hell of a shocker, as did indeed happen when banks started writing off amounts of that magnitude when the subprime crisis started and turned the bull market. But clearly people have become numbed as the crisis stretched and now the markets rally because banks "only" wrote off $1B.

It is also partly a psychological thing. Just as a $1 loss on a $20 blue-chip sounds more impressive than a $0.005 loss on a $0.05 penny stock (even though the percentage loss on the latter is double that of the former), $1 billion dollars just does not have the same aura as $500 million even though it is double that amount. Perhaps, it is because common people have always strived for that magical MILLION, and hence they can be impressed by SEVERAL HUNDRED MILLION. One billion, on the other hand, is something not many can intrinsically warm to unless it is framed in the context of ONE THOUSAND MILLION --- which we are seldom impressed upon.

How much is one billion also rests on the context. I am not going to go into the classic demonstrations of how many houses or cars or egg sandwiches that $1 billion can buy, but rather I will highlight three factors that would affect both perception and real impact.

First would be the absolute level of wealth. Clearly one billion as a fraction of one trillion, say, would be insignificant. If lost, it may merely be regarded as an expense of operation, a frictional loss, something that can be "learnt" from so that the future may be better. The source of that wealth is also important of course, for it makes a difference whether it is purely personal wealth or fiduciary funds that one is managing on behalf of another party, or whether the funds come from a cash-cow business or is simply non-renewable (in which case the one billion is ALL THAT ONE HAS).

Second would be the application for which the $1B is used for. Two broad categories of expenditure would be consumption and investment. Consumption is for the present, and any necessary consumption expenditure has to be undertaken no matter what the amount, though it tends to add no value beyond the period in question. Investment is building growth capacity for the future, and abstention from unnecessary consumption to invest for the future is a virtue and should be seen as such. The worst form will be bringing the money to a casino for gambling, in which case one billion dollars is a huge amount.

Thirdly, the time frame over which one billion is consumed/invested/expended. This is self-explanatory. One cannot expect to consume $1 billion over one year and not see it as huge unless he is Mike Tyson. In the same way, a return of $1 billion over one year is fantastic while a similar return over one century is still fantastic, but less fantastic. Ermm, the reverse applies of course.

Fund managers and corporate officers should keep these in mind when they manage billions of dollars and not lose the money perspective. It brings to mind the dehumanising process/system that facilitated German officials of World War 2, all ordinary citizens, to grow to see Jewish prisoners as simply "digits" to be handled when they all played a part in the supply chain that sent the prisoners to their doom.



Friday, July 11, 2008

Why Market Downturns Are Not All Bad 39 comments

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Yes yes, we are in a market downturn and it's depressing to see Mr Market's valuations of your stock portfolio (and your own valuation of your stockpicking abilities) going down and seemingly bad news all round with seemingly no hope of recovery in the next five years, but things are not all bad. No, this is not an article encouraging short-selling (think you'll be an idiot to short-sell the Singapore market at current levels) nor is it a tongue-in-cheek writeup where I don't mean what I say nor is it a shining example of ah-Qism (I hope not). It's not even meant to be chicken soup for the investor's soul because if one just sips it without acting on it, it's simply no use --- conviction is worthless unless it is converted into conduct. Here are my views:

(1) You can't have a market rally without a market downturn. Translating to something more intimate to our hearts, you can't have big profits without tolerating substantial drawdowns. Why does this always work? For one, the valuation goes from overvalued to undervalued, and valuations always regress to the mean. For another, in downturns the scrip moves from weak holders (margin, contra, institutions with investor mandate that could face redemptions etc) to the strong holders (pension funds, investors managing with no heavy liability considerations, wealthy people, other cash-rich fund managers) and setting the stage for a compressed spring effect.

(2) Certain things are controllable and one should not be beset by a sense of panic and helplessness. Aren't there some stocks that you always wanted to buy because they had all the elements of a Buffett-type long-term stock with economic moats and honest management and high returns on equity and all that, except that their valuations were too expensive? The good news is that in market downturns, the baby gets thrown out with the bathwater.

(3) The ironic thing is that one doesn't have to worry too much about the price-fundamentals linkage in down markets. In bull markets, one should take note if the price is weak despite apparently strong fundamentals; it might signal something wrong. In down markets, more often than not it's due to a rush for liquidity and institutional risk aversion. Of course, this conviction must be supported by an understanding of market dynamics and that the company is not going to be genuinely hit, especially in the long-term, by the declining real economy.

(4) It's an opportunity to swap the weaker companies in one's portfolio for stronger ones. If you bought Ipco at 10 cents in July 07 when Celestial Nutrifoods was at $1.50, you have the option of swapping one for the other now at no relative loss (they have both halved since then). Isn't it great, you can wash away your stockpicking mistakes in a down market?

(5) Market downturns offer validation of a stock's underlying potential, something like stress-testing. It offers you a chance to see the price action of the stocks you hold/are interested in under a market downturn scenario. Often it offers many insights on resilience of price supports, trading volume in weak markets (indicative of institutional interest), and of course fundamental earnings performance in a weak real economy. Very valuable information that either strengthens your conviction or removes it.

(6) For the investor, it allows him to practise value averaging effectively. If one is certain of the (non-cyclical) fundamentals of the companies he holds, market downturns offer the best justification for averaging down because often the stock's price decline has little to do with its core operating strength. Just as pyramiding in a bull market allows one to build on gains exponentially, averaging down in bear markets can work (big caveat: know the fundamentals with conviction).

(7) There are always certain sectors that will do better, or even flourish, stock market-wise. Check out William O'Neill's book "How To Make Money In Stocks" for a listing of the bull sectors even through the stagflation years of the 1970s.

(8) If not price-wise, there are always certain sectors that will do better operations-wise, while remaining quiet on the moribund stock market. So one will be able to get emerging champions at a good price in a market downturn. For the 1970s, an example of a new bull sector that would come to the fore and subsequently enjoyed a secular run over the next two decades was the electronics sector, specifically, computers. The important thing is to stay alert by tracking the news so that you can spot these sectors.

So there you have above, 8 reasons to huat from a market downturn. Of course, if in doubt, remain in cash. Risk-taking is a function of one's stomach, one's conviction, one's liability considerations and one's time horizon. There is no one-size-fits-all.



Saturday, May 17, 2008

How To Make Money In Stocks Part 5: Learning to sell 295 comments

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It is my belief that if the retail investor does his research properly and bases his buying decisions on long-term business fundamentals coupled with a reasonable valuation, his downside is limited and he can expect the stock to eventually rise, whether on market realisation of the business potential, or on the margins hitting a sweet spot of the business cycle, or on management/fund buyouts reflecting insider/institutional awareness of the intrinsic value of the business. The key word is "eventually", because the time the investor has to wait for the stock to rise is unknown. But my point remains --- the patient investor will eventually see the stock gain some buying interest.

When that happens, another aspect of time becomes important for the investor: how long will the stock enjoy its place in the sun? Will it be just a short pump-and-dump operation by the big holders, or could the stock become one of those rare Cinderella stories and live happily forever?

There is a new branch of finance, known as behavioural finance, which essentially recognises the "humanness" of market participants that adversely affects their decision-making (as opposed to standard finance that assumes a "rational" investor). Behavioural finance sheds some light on human tendencies when faced with the above scenario. People tend to be overly-optimistic and have a fear of regret (ie. the stock soars after they sell) which leads them to hold rather than make any active decision to sell.

Hence, it is important to be aware of our own human nature and to consciously lean against its biases. In the case of what action to take when a particular stock holding rises substantially, sometimes it's better to let the profits run, sometimes it's better to lock in the profits, again there is no fixed rule, but it is my experience that selling is the most difficult thing to do for many people --- which is why patient investors might not make money in the end. Therefore an element of selling discipline is important to lock in the profits when they arise.

There are several other key factors why learning to sell is important, besides the abovementioned psychological bias.

Firstly, fundamental cyclical effects. This is a real danger of holding on too long to a stock that has risen substantially, and is particularly relevant for cyclical stocks like shipping, property, commodities, technology ...... or indeed in most sectors where product demand is discretionary and pricing is commodity-like (ie. the business is a price-taker rather than price-setter). Where profitability is highly dependent on industry prices which are in turn determined by demand-supply dynamics, the entire sector can come in for strong market attention when the pieces come into place at a particular part of the business cycle eg. technology at the early stages of recovery when inventory is low, production capacity is thin and consumer demand is growing at an increasing rate. The stock surges in response. But as manufacturers ramp up capacity and squeeze the margins, the product ASPs (average selling prices) can quickly fall even as raw material prices rise. If one misses selling at the sweet spot, he can be stuck for ages when the stock normalises. This is because capacity, once increased, is difficult to reduce until there is painful industry restructuring where smaller players exit ie. when losses become too hard to tolerate. The problem is that the level of tolerance of many business owners is very high.

The second main issue is market liquidity. How many times have we seen this: stock A, previously illiquid, gains some market attention on initiation of broker coverage (perhaps because the company is placing out new shares). The stock rises on optimism about the strength of its prospects, and fundamental investors accumulate. As volume picks up, the stock breaks past all resistances, attracting technical traders. The momentum carries it on day after day. Then it peaks, strangely on a day when good news came out and the stock failed to react. Classic "buy on rumour, sell on news". The stock retraces all the way back to where it came from, and liquidity dries away leaving the stock to the effects of gravity. And soon it becomes anonymous again as a new wave of market favourites take over. The loss of market liquidity, sometimes unrelated to intrinsic fundamentals but nearly always linked to sudden market-wide realisation of expensive valuations plus withdrawal of strong-hand support, is another reversion-to-mean effect that is often difficult to reverse and exacts high opportunity cost for the late-to-sell investor.

The devastating psychological effects on the investor should he endure an up-down cycle without anything to show for it cannot be ignored either. Those who have experienced it will know what I mean. Failing to sell at the peak, he will find it harder to sell at 10% down, even harder to sell at 20% down and hence arises the terrible situation where the more the stock drops, the more unlikely the investor will sell. That is because he had already mentally anchored his wealth at the peak of the stock's valuation. It is important not to let this happen too often, because it can eat into one's confidence and affect future decision-making.

The above reasons suggest that profit-taking, though not always leading to an implementation decision, should always be at the back of the investor's mind when a particular stock holding surges. Quite often, the most painful thing to do is the right one. Introducing some selling discipline, such as selling a portion of one's holdings once the stock reaches a particular valuation waypoint, say 15X PE (or whatever one deems a fair valuation), might be useful in altering the psychological state-of-mind and facilitate further liquidation on perceived peaking of fundamentals and/or momentum etc. This is in recognition of the fact that selling is as much a psychological issue as one based on financial evaluations.

And then again, letting the profits run might be the best thing to do in some cases. Without adding to the confusion, I will just point out that it happens less often and also that some find it prudent to set some moving sell-point that is say, 10% below the peak, so that even if one intends to ride the long-term momentum, he will be stopped out by a sizeable adjustment from the peak. The level of tolerance, and hence the maximum drawdown limit where one sets his sell-point, varies from individual to individual and from stock to stock, depending on the level of confidence about its long-term strength.