Sunday 30 March 2014

The Stock Market is a Voting Machine

Benjamin Graham, the father of value investing, once said that in the short-term, the stock market is like a voting machine, but in the long term, it is like a weighing machine. Let's take this concept of a voting machine further and explore why sometimes the market can be erratic.

Imagine a city in a far far away land called Far Far Away City. There, elections for the city mayor are held everyday, except on Saturdays, Sundays and Public Holidays. The candidate who wins the election for that day becomes the city mayor, but only for that one day. The city has 10 million citizens, of which roughly 1 million are farmers and support the left-inclined parties called the Lows (L). Another 1 million citizens are descendants of the nobles and support the right-inclined parties called the Highs (H). The rest 8 million citizens support the mainstream parties called the Mids (M). Since elections are held everyday, and because voting is not compulsory, the voter turnout everyday is very low. On average, only about 10 persons go to vote. Most of the days, the mainstream parties would win the election. However, given the low voter turnout, there are a few occasions when either the Lows or the Highs would win the election. Whenever that happens, the international media would decry that the 10 million citizens of Far Far Away City support a leftist or a rightist mayor, depending on the election outcome. Obviously, the actions of 10 voters cannot be representative of the political views of 10 million citizens, but that is how elections work.

Interestingly, although the citizens of Far Far Away City do not like to vote, they pay a lot of attention to the elections. There is even a 24-hour TV broadcast on the elections, interviewing experts on what is the likely outcome of the election and what is the quality of the candidates. As elections in Far Far Away City are held in the open, the TV broadcast would even show a ticker-tape on how the votes are being voted. A typical ticker-type on an ordinary day might run like this: M, M, L, M, M, M, H, M, M, M. Some experts would scrutinise this ticker-tape to search for hidden information to predict the next winner. Other experts would review every statement that the candidates make to make the same prediction. In essential, there is a lot of information generated to keep the citizens of Far Far Away City busy and excited about the elections.

Although most of the days, the mainstream candidates would win the elections, there are occasionally long periods when the elections are won by either the Lows or the Highs. When there is a prolonged drought, for example, the Low supporters would come out in droves to vote for a mayor sympathetic to their circumstances. On other occasion, when there is a royal marriage, for example, the High supporters would be ecstatic and come out to vote for a mayor supporting city-wide celebrations. Yet, during both these extreme occasions, the election outcomes do not represent the political views of the vast majority of the citizens.

Coming back to our lives, similar to the mayor elections of Far Far Away City, the stock market is open every working day. Just as similarly, only a small minority of investors actually buy or sell in the market everyday. Do the actions of this small minority dictate the views of the vast majority who does not trade? For example, if someone were to sell Singtel at $1 and the market closes at that price, does it mean that most investors would lose two-third of their value in Singtel? Even if there is a prolonged market crash and Singtel closes at $1 everyday, does it mean that Singtel's value is worth only $1 for all investors?

The market participants who trade in the stock market are only a very small minority of investors. Their views of the market do not represent the views of all investors. Investors are best served by ignoring what the market does. As Benjamin Graham said, the market is for investors to take advantage of, buying when the market is in a depression and selling when it is in ecstasy.

In my very first post of this blog, I briefly mentioned that the financial market is a "Matrix". The Stock Matrix wants us to believe that we all fall off the building when prices crash. We fall off only when we choose to follow the rules of the Stock Matrix. We can actually defy gravity in the Stock Matrix.

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Sunday 23 March 2014

A Tale of 2 Indonesian REITs

I have 2 Indonesian REITs, both are owned and managed by the same owner, yet, their management of foreign exchange exposure could not have been more different. 

The first REIT, Lippo Malls, collects rental income in Indonesian Rupiah (IDR) while holds debts in Singapore Dollar (SGD). Thus, when IDR falls against SGD, Lippo Malls' rental income and asset value in SGD drop while the debt value stays the same. This results in a sharp fall in both distribution per unit (DPU) to shareholders and net asset value (NAV). In 4Q2013, the quarterly DPU dropped from SGD0.0074 to SGD0.0056, a fall of 24.3%. The NAV fell from SGD0.56 to SGD0.41, a larger fall of 26.7%.

Figure 1 below shows the balance sheet of Lippo Malls as at end Dec 2013. Here, it clearly shows that property valuations as represented by Non-Current Assets fell from SGD1,756.5M to SGD1,415.7M while total debt went up from SGD472.5M to SGD622.5M (there was an additional debt of SGD150M during the same period).

Fig 1: Lippo Malls' Balance Sheet as at 31 Dec 2013

In contrast, First REIT pegs the rental income from its Indonesian properties to SGD and holds debts in SGD. Hence, when IDR falls against SGD, its rental income, asset value, DPU and NAV maintain their values. In 4Q2013, its quarterly DPU rose from SGD0.0172 to SGD0.0197, a rise of 14.5%. Its NAV rose from SGD0.83 to SGD0.97, a rise of 16.8%.

Why does Lippo Malls choose to hold its debts in SGD? The following 2 figures may shed some lights into its decision. Figures 2 and 3 below show the benchmark interest rates of Indonesia and Singapore respectively. 

Fig 2: Indonesian Benchmark Interest Rate

Fig 3: Singapore Benchmark Interest Rate

From the 2 figures above, the Indonesian benchmark interest rate (prior to talks of tapering by the US Federal Reserves in May 2013) was about 5.75%. This is way above the Singapore benchmark interest rate of about 0.03% over the same period. Hence, by holding SGD denominated debts, Lippo Malls stands to save almost 5.72% in interest rate every year. There is a problem, however, which is IDR is constantly falling against SGD to compensate for the interest rate differential. When the fall is gradual, it usually does not pose any major problems. However, the fall in SGD/IDR forex rates after Aug 2013 was quite significant, as shown in the figure below.

Fig 4: SGD/IDR Foreign Exchange Rates

Beginning in Aug 2013, the SGD/IDR fell from 7,800 to 9,600, a fall of 18.8% in a period of 4 months. SGD denominated debts thus became more expensive by 18.8%. The interest rate savings from holding SGD denominated debts is more than completely wiped out by fall in IDR forex rates.

Overall, does it make sense to hold foreign currency debts? Even before the current forex volatility, the Asian Financial Crisis way back in 1997 shows that it can cause a lot of harm in holding foreign currency debts. Lippo Malls apparently have not learnt the lessons of the Asian Financial Crisis.

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Saturday 15 March 2014

The China Wage Story

China is known as the world's manufacturing floor. It produces a whole range of goods for which it ships to the rest of the world. Many companies have set up or relocated their factories to China to take advantage of the large and cheap supply of land, labour and other resources. However, after several decades of explosive growth, China is no longer as cheap as before. The figure below shows the average annual wages in manufacturing from 2003 till 2013, as reported by the National Bureau of Statistics of China.

Annual Growth in China's Manufacturing Wages

In the 10 years from 2003 till 2013, the average annual wages in manufacturing have grown from RMB11,000 to RMB41,650. This represents a nearly 3-fold increase in annual wages over the same period or a Compounded Annual Growth Rate of 14.2%.

Companies with factories in China are feeling the heat of such rapid increases in annual wages. Many companies, including those with headquarters in Singapore, have experienced strong wage inflation that depresses their operating profits. If you read the financial statements of companies with factories in China and are listed on the Singapore Exchange, it is usually not difficult to find references to increases of wages.

On the other hand, the rapidly rising annual wages are a boon to Chinese consumer stocks. Companies that sell to the Chinese consumers tends to benefit from the increasing disposal income. For example, CapitaRetail China Trust recently reported a 3.5% rise in revenue in its latest financial report. Its tenants' sales increased by a greater 9.2% year-on-year. These are evidence that China is slowly shifting away from being a low-cost manufacturing plant to a consumer-oriented market. Investors should take heed of the above-mentioned shift in trends.

P.S. I am vested in CapitaRetail China Trust, CapitaMall Asia, Mapletree Greater China Commercial and a host of companies with exposure to the China market, e.g. China Aviation Oil, Midas, Valuetronics, Yangzijiang, etc.

Sunday 9 March 2014

I Don't Understand China Stocks

In January this year, I received my share certificate from Hongwei Technologies Ltd. This is not something to rejoice, for it means that the shares are now officially delisted from the Singapore Exchange and worth nothing. The main cause of the company failing was accounting irregularities at one of its subsidiaries. What are the lessons that I learnt from this episode?

I first invested in this stock in Apr 2009 during the Global Financial Crisis (GFC) at a price of $0.125. Then, I liked it as it was an undervalued stock. It had earnings per share (EPS) of 28.9 Renminbi (RMB) cents in Financial Year (FY) 2008, making its Price/ Earning (P/E) Ratio a mere 2.2 times. Its net asset value was 145 RMB cents, making its Price/ Book (P/B) ratio only 0.43 times.

With the passage of the GFC, it recovered to a price of $0.285, allowing me to post a paper profit of 128%. I continued to hold on to it, believing that the stock was still undervalued. The last available financial results before its suspension in Feb 2011 showed it had EPS of 26.9 RMB cents in FY2009, making its P/E ratio only 4.8 times. Possibilities of accounting irregularities did not occur to me. The only concern I had was that a significant portion (24%) of its pre-tax profit were trading profits, and in trading, you could make profits as well as losses. It was probably a matter of time before the company reported a trading loss or a smaller trading profit. Nevertheless, I continued to hold on to the stock.

In Feb 2011, the company announced that the auditors had problems confirming the cash balance of one of its subsidiaries. The stock promptly fell from $0.26 to $0.19 and was suspended. Upon deeper inspection of its financial statements post-suspension, I realised that while the group had healthy cash balance of RMB112 million, the holding company itself had only cash balance of RMB71,000. All the cash balances were with the subsidiaries. This was a red flag that I should have picked up but did not. Other indicators were healthy: it paid dividends continuously for 5 years since 2006, although the dividends had declined from a peak of 7.58 RMB cents in 2007 to 1 RMB cents in 2010. From the cashflow statement, it paid income tax of RMB12.7 million in FY2009, approximately in line with its pre-tax profit of RMB76.7 million and Chinese tax rate of about 20%. So, what I learnt from this episode is that if the group is making profits, cash should also accumulate on the holding company's balance sheet. The holding company's balance sheet is something I always overlook, choosing to concentrate only on the group's balance sheet. After all, it is the group that we buy into effectively, even though it is the holding company that we own nominally.

Armed with this fact, I reviewed the balance sheets of all the China stocks and stocks with exposure to the China market in my holding. In total (as at now), I have 6 such stocks, namely, China Aviation Oil, Fung Choi, Karin, Midas, Valuetronics and Yangzijiang. In 3 of them, the holding company's cash balance is less than $1 million in the functional currency (either RMB or Hong Kong dollar). These 3 companies are Fung Choi, Karin and Valuetronics. So, are these 3 companies likely to have accounting irregularities like Hongwei? My guess is probably not. I can only say "I don't understand China stocks".

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Saturday 1 March 2014

Do Drawdowns Matter?

In the last few blog posts, I've discussed that volatility is your friend in portfolio management. The greater the volatility of a particular stock index or bond, the higher is the eventual portfolio value. However, I have not addressed a pertinent point, which is that drawdowns do happen during the course of the portfolio. The figure below shows the performance of a portfolio comprising 70% stocks and 30% bonds over the last 26 years.

Drawdown in Portfolio Value

Although the final value of the portfolio is 3.3 times the initial value and is close to the highest value achieved, it has gone through several drawdowns, the most significant of which occurred during the Global Financial Crisis, when the portfolio value dropped by 44% from the peak. Are drawdowns of importance to investors? It depends on the risk profile of the investor.

For investors who are risk-averse and are fearful that their portfolios lose money, drawdowns matter significantly. They could force such investors to sell out before the portfolio regains its previous value. Such investors would be better off investing in lower-volatility portfolios so that they can see through the drawdowns and realise the eventual but smaller gains in the portfolio.

However, for aggressive investors, drawdowns matter little. Such investors know from history that drawdowns are usually temporary and are necessary for portfolio rebalancing to achieve a higher portfolio value in the future. In fact, they create rare opportunities for investors to invest more in the portfolio. Such opportunities could generate large returns and come only once in several years.

There are some portfolios which are specially constructed to minimise drawdowns so that investors can stay the course and realise the eventual gains. I do not have a good answer to drawdowns. You have to decide whether you prefer a higher eventual portfolio value and hence have to accept higher volatility or you cannot live with volatility and hence have to content with lower portfolio value. You just cannot have your cake and eat it.

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