Abaci's Common Sense Investing

The CNOOC 2006 results were out yesterday and there's no surprises. It was as good as people had expected under very favorable environment of last year. Management was also very upbeat about new oil finds, citing the replacement/production ratio reached 200% last year, and they expect the oil reserve will continue to grow and hence are investing heavily into E&P equipment. This sounds good to the driller.

I had a quick look at the 5-year operation summary in the 2005 annual report. There I found the r/p ratio has always been over 100% over the period, meaning more oil was found than produced. And at the end of 2005 the reserve life was 15.3 years, almost same as the 2006 figure, reflecting higher production level last year.

But one has to be careful that the excellent results of the past few years was a combination of rising product prices (rental) and increase in utilization rate, which steadily increased from 70% in 2002 to over 90% of capacity last year, as opposed to increase in capacity, ie. production from new oil wells. Utilization will become less of a growth factor in the future and as costs will definitely be going up due to the replacement of the fleet, whether future rental can be raised enough to compensate for it (so far the margin has been stable) is unknown and will be an internal matter between CNOOC and the driller. If the driller has to bear the cost then it might earn 20% less (see my last analysis).

Business for certain will continue to be robust but I'm just not so sure if earnings will be. At 22x p/e and less than 1% yield, I'd take a pass on the driller and rather look for real service companies that have less reinvestment burden and more distribution.

DISCLOSURE: I don't hold 2883 at time of writing.

The last few posts were a little long and complicated which wasn't expected, nor was it my usual style. That's why I usually hate reading into too much details, because it only draws you to more calculation and guesswork but not necessarily accuracy. And it tends to masks you from seeing the big picture too. I'll try to go back to being brief and simple for the coming ones.

Below is breakdown of the two halves' figures of China COSCO.

Port 1H: $0.54b; 2H: $0.61b; Total: $1.15b
Shipping 1H: $0.44b; 2H: $0.44b; Total: $0.88b

The shipping side showed no improvement in the 2nd half despite cheaper fuel and supposedly higher freight. As OOIL management correctly put it earlier, too many lower-priced contracts locked in the 1st half when everyone was too eager to find business for the new vessels had a lingering effect on the 2nd half. Of course you won't find this mentioned by the COSCO management.

In my first analysis of the shipliners in Dec last year, my work was based on the principal assumption that all three shipliners with roughly equal-sized fleet and similar routes should demand similar valuation. That's how I came up with the pick on China COSCO and OOIL at that time. Three months later and with a bit of luck the valuation gap is now pretty much filled. But when I come to think of it again after seeing these results, I think execution skills should factor in and OOIL is clearly superior in this regard.

After deducting the market value of COSCO Pacific*, the shipping division is worth $23b, which is about what I gave to the OOIL shipping division, 8x p/e of a $3b earnings. I'd be really hesitate to give China COSCO the same valuation, when it only made 30% of OOIL's earnings last year. Maybe half of it is more appropriate and 2/3 will be very generous. So I'd say the current price is fair at best, you may add it's a little rich, but that's because all eyes are now on the injection of the parent company's dry bulk fleet, which is the largest in the world, and the A-share listing, and China COSCO is the only ticket to the show so this premium won't go away anytime soon. I hope it'll be a good show.

Don't buy at this price unless you are a speculator, a good one, but hold on to your shares if you have it.

DISCLOSURE: I hold 1919 at time of writing.

* i'm not not worried about the ports since its business nature is utility-like and defensive, and the current price isn't stretched and actually shows restraint compared to a lot of other china shares.

Today I did some more digging into the equipment cost issue where I left off yesterday.

According to the prospectus the fixed assets were revalued twice, once in 1994 and once before listing in 2002, under the replacement cost method. Whatever that was the book cost shown should be reasonably current, which is comforting. The discomforting part is that while these revaluation surplus nicely showed up as reserves, there's no cash set aside for replacement. The driller will need to incur debt or sell shares to finance these replacement, which unlike capital expansion won't generate new earnings (but one can argue the new rigs should be more efficient and have lower operating costs). Either way is gonna negatively affect per share earnings by higher interest or dilution.

In 2002 there were $10.2b of fixed assets (cost basis) supporting operations of 12 rigs, or $8.5b per rig. In 2005 the book cost was $13.9b and there were 15 rigs, so the unit cost was increased to $9.3b per rig. The 2005 annual report showed just the rig alone to be delivered at the end of this year would cost $11.5b, another 24% increase. If all rigs are to be replaced then eventually depreciation should go up by similar proportion. My estimate shows this will cost 20% of future earnings, if these increases can't be passed on to customers.

Most importantly and before costs, are there enough oilfields to be drilled? What's the use of having new rigs if there are not enough discoveries? Almost all the rigs now are on sites that are just as old as the rigs itself. What's gonna happen after these wells are done with. I got from the prospectus that in terms of E&P activities, China off-shore seemed much less developed than the Mexico Gulf of the US. So that seemed to suggest the China off-shore oilfields would have a long life. Anyhow, this is such a fundamental issue but I only raise it in the end of my analysis! I guess this shows I still have a long way to go.

I'll try to make a conclusion after I read CNOOC's results tomorrow.

DISCLOSURE: I don't hold 2883 at time of writing.

This morning on reflex I bought some shares in Henderson Investment (97), mainly as I saw it as a cheaper way to buy into Hong Kong and China Gas.

Having said this, this is not a new discovery as there's been two privatization attempts in the past for the same objective. But this time there's a new twist as HI's interest in HKCG is untouched whilst almost everything else inside HI will change hands. This will make holding HI no different from holding HKCG directly. Even dividends are said to be fully distributed dollar for dollar in the future, until and unless HI takes on other acquisitions (this is the tricky part and you'll have my guess later).

Quick math shows after two dividends (interim & special) HI will be worth 2/3 of its value or about 32b. The market value of its 38.5% interest in HKCG is worth 37b. So there's a 15% difference which one can pocket, or as I saw it an invitation to buy HKCG cheap. Of course my assumption is this time the deal will get the greenlight from the minority shareholders. I'm confident Mr. Lee after two hard lessons should have figured a way out already. So I'll let him worried about it and do his job.

Now the fun part of guessing what's behind all these and what'll happen next. But beforehand you should be warned that as I hold a position all these arguments won't be impartial and my wishful thinking will dominate.

(1) Privatization of HI
Many suggest this will be the eventual path and the current step is to clear the necessary hurdles for it to happen. This sounds very logical but doesn't make much sense. Unless Mr. Li has lost his sense this will mostly likely not happen. Privatization is only sensible when the assets can be bought cheap, which can be caused by market inefficiency or a divergence of view between the market and the owner on future prospect. But I see neither of this. After the shuffle, HI will hold nothing but HKCG's stocks. With this much of transparency, any future buyout will have to be made on market price (at least) to succeed. If this was what Mr. Li was willing to pay, this deal could have been bundled together this time, or would have been done long time ago.

(2) Future role of Panva Gas
Some say this reshuffle will cement and expedite Panva Gas's role as the flatship of HKCG's China business. It's a bit stretched on imagination to say the least how these two can be related. I'd just say I'm not sure if Mr. Lee would want to share the captain seat of his flatship with someone else. Nevertheless Panva Gas may get more assets down the road and let's watch the space.

(3) Future role of HI
This part draws my interest the most as I can't really figure out why HI is kept. There's got to be a purpose for its listing or a story to sell. The official reason is to have an more efficient operating structure for the Henderson group and to unlock the value inside HI. My logical guess is Mr. Lee and HI are thinking about selling new shares, otherwise why he would care about reflecting the real value of HI. Now if I tie in this to the part about HI paying out all dividends from HKCG until and unless there's new acquisitions, a picture starts to emerge - HI may have big acquisitions in the pipeline which will need equity financing. I'll look no further than those in HKCG.

HKCG has 4 pieces of assets: HK gas business, China gas business, China water business, and IFC interest. There's some HK development properties which will turn to cash so I'll ignore it here. The IFC interest looks a better fit to Henderson Land and I won't be surprised to see it go first. The HK gas business has nothing exciting so the candidates can only be the China gas and water business.

But why buy something one already owns? First, one need to distinguish the level of effective interest. Henderson Land owns 68% of HI but only 68% x 38.5% = 26% of HKCG. Wouldn't it be nice for Henderson to hold 68% of those China projects on the HI level than 28% on the HKCG level? Second, after the shuffle HI will only be 1/3 the market size of HKCG and hence its share price should respond faster to the growth in the China business. It'll be easier to raise capital too. HKCG also benefits from having a clear identity of a local utility play.

How soon will these happen? I'd say patience. HKCG won't be selling now as these assets are green and need funding (which it's got plenty from the HK gas business). Remember Mr. Lee has said he expected the China business to flourish anywhere between now and in 3 years' time. My guess is it'll happen when the assets start to mature but not overly ripe.

DISCLOSURE: I hold 97 at time of writing. I don't hold 3, 12, 1083 at time of writing.

This is a nice detour from the tough job of reading the Sinopec financial statements.

COSL announced yet another pleasant results with 37% increase in 2006 earnings. And it doesn't appear the momentum is slowing down. COSL has plans for major capex and will be raising both debt and equity, but more on that later. Since listing at the end of 2002, COSL has had a EPS compound growth of 32%, or a triple over 4 years. Even taking out the effect of the tax break it's gotten since 2003, when its income tax rate was reduced from 33% to 15%, pre-tax earnings showed 29% compound growth. Making this record more impressive is that COSL has had no debt for most of this time until last year, even then debt level was still held at very manageable level (d/e: 23%).

COSL looked to me like a perfect beneficiary of the oil boom. Even real estates of Calgary and Edmonton, two oil cities in Canada, have gone skyrocketing again after many years of drought since the end of last oil boom in the 80s. With the US not having much success on international affairs and its influence fading, COSL with its Chinese background is looking more attractive in the eyes of lesser developed oil countries in the Middle East, Africa, and South America. Don't forget Russia is also China's long time buddy.

Moreover, COSL being a fee-based service company, as opposed to an oil producer, has the added advantage of not having to worry about the rise and fall of oil price too much. Just in case you don't know what COSL does, in simplest terms it does everything an oil company requires to find oil and to produce oil on sea. In more difficult terms it does geophyiscal services, drilling, well management, marine support and transportation.

At first I thought of COSL as a Li & Fung or HAECO type of service organization, those that require great skills but little hard assets to operate on. Afterall aren't we told it's getting harder and harder to find and produce oil? But one look at the historical financials suggests otherwise, rather something to the opposite. ROA for each of the past 5 years were surprisingly low at mid-to-high single digits and ROE weren't much better barely reaching 10%, except for last year when it was 13% with some debt in place. So it's a pretty darn capital intensive business. The question next came to my mind was why I'd want to pay over 3x p/b for assets that yield so little. What am I buying into if it's not great service?

Could this national franchise* to drill, as long as it's above water, be worth so much? I'll simply call COSL the driller from here. I think it's a carved out bit from the E&P unit of CNOOC (this explains the heavy capital requirement), who has been its biggest customer for over 60% of its business every year since listing. Clearly the driller can't survive on its own. But equally there's no ground to suggest CNOOC will ditch the driller, for it's detrimental to both its daily operation and 62% equity investment.

How's the fee to be determined between CNOOC and the driller? The official line is to charge no less than the current market rate. But whether that's entirely accurate is another issue when the two are intermingled and CNOOC takes up so much volume of the business. And I doubt cost difference, if any, will be apparent enough to an outsider given the the complexity and technicalities of the matter. However having observed how listed state-owned companies operate for some time, I'd say they are actually quite fair in their dealings. So I guess the fee would approximate a reasonable return on the assets employed, making the business model look like an utility, in particular that of a power company. Another similarity is that once a rig (drill tower) is in place and production starts, it'll probably stay there until the well has been depleted, which will be many years down the road.

Following this logic cost containment should be the focus since revenue is relatively stable. I want to find out if the driller, like other oil companies' E&P units, also faces the problem of increasing costs. But if it's on the receiving end, i.e. it can pass on the costs to CNOOC, then the current situation is actually conducive to its businesses.

Both the daily rate (price) and the utilization rate of the rigs have increased over the past 5 years. The pre-tax profit margins, however, were more or less 20% during these years (save for last year's higher margin of 22.8% due to the use of leverage), so operating costs had increased but it appeared to have been passed on to customers. Expansion provided further earnings growth as 3 rigs were added to the lineup which is now 15.

Unlike the power companies, the driller hasn't make good use of its balance sheet by borrowing as much as it can. Management has stated it's gonna increase its gearing from 23% to somewhere between 50-100%. This will probably lead to another 10-20% growth in earnings assuming the new assets won't yield less than the present ones.

Up to now the driller's p/e of 21x appears justifiable or even to the low side for a high growth utility.

This final bit is the spoiler. Don't read further if you are keen to buy now. Like Sinopec, capex has been multiples of depreciation for each of every year since listing. Rough calculation showed the remaining life of all productive fixed assets at the end of 2005 was only 7.3 years! This was already improvement from 6.8 years at the end of 2002 but still short by any measure. If you look at the lineup of the self-owned rigs you'd be impressed that only one belongs to the 90s and the second youngest has already 24 years in its service. So over the next few years the driller will have to replace its fleet, and at higher current costs too (read: higher depreciation and lower dividends). I tried but couldn't quantify the earnings effect. But if the driller could pass this cost too to CNOOC and other customers, then my worry is overdone. Now I'm undecided.

Don't let that name fool you, this aint' a service business but rather an utility with old equipment.

DISCLOSURE: I don't hold 2883 at time of writing.

* it's been the government's policy that CNOOC be responsible for all China offshore and overseas oil exploration and production activities, whilst Sinopec and PetroChina be restricted to that on land only. but this distinction could get blurry when everyone is fighting for oil now.

This is the 1st part of an I-hope-not-too-long series on Sinopec, a business which is both huge and diverse. If this is not difficult enough, the rapid movement of oil price creates further headaches to those who try to analyze and properly value Sinopec. Nevertheless oil, like coal, is the mother of energy, but it's cleaner. Oil, like gold, serves as a hedge against war and instability of this world, but it has much greater industrial use. So my first impression is oil is a better investment than either coal or gold.

While there'll always be plenty of buyers for oil, the unanswerable question is price, which could be US$70 per barrel last year or only $25 per barrel 5 years ago post 911. And for this reason I'd prefer Sinopec over PetroChina and CNOOC for its downstream operations and stability, relatively speaking. Others though might prefer the other two when making a hedging bet in a portfolio.

Sinopec runs a fully vertically integrated operation from exploration to refinery to petrochemicals to distribution of oil products. Looking at the asset breakdown each division is roughly equally sized at $106-135 billion, which is a surprise as the exploration and production (E&P) unit is perceived to be biggest because of its earnings (contributing 3 quarters of total operating income). The refining unit made a loss and the rest made up the balance of the earnings.

E&P

Looking at the operational data from 2001-2005, I noted that both the production output and the proven reserves stayed pretty much the same, at about 270-280m barrels and 12 years of production. So far Sinopec has been able to replenish its reserves by finding new wells and squeezing extra mileages from existing wells using more advanced technologies, though it seems not much can be done to increase production level. This is consistent with my observation that for most oil producing countries production can't be rapidly raised to meet demand even under a higher oil price.

With oil prices hovering around high level it's said many old wells and untapped reserves previously deemed not commercially viable have become productive because oil companies can now afford using more expensive technologies in extraction. Explorations are probably getting more costly as well since new findings are few and far between. The case is probably similar for Sinopec so I expect to see increasing costs over time and I've tried to verify this in the following ways.

I extracted that the total operating cost of E&P per barrel of production output increased by 18%, 15%, and 12% over the last 3 years, an definite up-trend though the magnitude of increase was getting smaller.

5 years' average capex of $21b a year exceeded amortization (i.e. depreciation of fixed assets plus write-off of dry well cost) by 74%. This was against the background of no growth in either reserves nor production.

Indeed, the carrying value of E&P fixed assets kept growing by $10b a year for 3 out of past 4 years and has grown by 47% since end of 2001, but depreciation only grew by 35% over the same period. Maybe there's some giant infrastructure being built that's yet in operation, like say long distance pipes to bring oil/gas from Russia. But there's no figures or description in the annual report to give any useful insight.

Which way I choose look at it, it suggests reducing margin for E&P over time.

At the back of the report though, there's a supplemental disclosure prepared under US accounting standard which showed the discounted value of the oil and gas reserves at $360b (calculated based on 2005 year-end oil price of US$60 per barrel and a discount rate of 10%). Amortizing this over the reserve's production life of 12 years gives an annual expense of $30b a year, 3x of last year's depreciation. I then plugged in US$50 in the calculation, the amortization expense was a rough $22b a year still $12b more than last year's depreciation. All these are very imprecise estimate I must say. And I've not thought it through that whether it's necessary to take such amortization from an investor's point of view, in lieu of the company provided amortization.

Finally there's the new 'oil' tax put in place that weighs down earnings. But I'll wait until the release of the 2006 results for further analysis. I think what I have now is already complicated enough.

To sum up, costs are up, additional amortization might be needed, and taxes are higher, but all these won't matter if oil price is high enough. So it all comes down to oil price again, which no one can foretell. Here's a quick look at the E&P profits of the past 5 years and the average oil price.

2005; US$55; $46.9b
2004; US$38; $25.6b
2003; US$29; $19.2b
2002; US$25; $14.8b
2001; US$25; $23.4b

I'll come back to the valuation after I'm done with other parts of the Sinopec business.

DISCLOSURE: I hold 386 at time of writing.

The 2006 results came up last night and offered no surprises, market price though jumped up by more than 3% this morning, quite a movement for an utility. Maybe the market is really excited about the China unit's 60% jump in operating profit to about $400m, which was now over 10% of total earnings (excluding property). Gross investment in China, which includes gas and water projects, grew by some 40% to $10.5b, starting to catch up with that in HK of $12.6b.

Growth in China earnings apparently lacked behind the speed and scale of expansion (ROA at only 4%) but Chairman Lee offered no insights into when these investments are gonna give meaningful return other than that "these projects are projected to thrive within the next three years". Since Chairman Lee is known to be a very long term investor, it could be in 2009 when the thriving really happens.

The problem seems to stem from a lack of supply of natural gas as the giant west-to-east gas pipe can't cope with the rapid conversion from coal to natural gas taking place in many cities. This is because coal price has gone up whilst the natural gas price is still under strict government control to promote usage. Hence supply has run tight and HKCG is tackling this by establishing its own upstream projects. It remains to be seen how long will this situation resolve itself. I'll probably need to dig deep into the PetroChina and Sinopec reports to find out more.

Using the same valuation yardstick last time, the China part is worth 3x p/b at $30 billion. If we assume the supply situation can revert to normal, which will eventually, and the return on investment can reach 15% (with gearing), then the valuation will be about 20x p/e, certainly justifiable but in what year? $1.5b is about 5x of last year's China earnings after some adjusting for profits tax. It'll take more than 3 years if profit growth can be maintained at 50% annually. Alternatively if a 30x p/e can be accepted in light of the growth potential, then a mere $1b earnings can support the valuation. Either way Chairman Lee's words 'thriving within 3 years' comes to mind again. To be any more aggressive than this really requires imagination, which I never have much in disposal.

The performance of the HK gas business was as predicted lackluster. No detailed figures were given but earnings should be a little less than $3b. The partial switch to natural gas is said to create cost savings which will be passed on to customers. But I think it's equally likely and understandable that some savings will find its way to the bottom line. For now I'd stick to the same price tag of $48b.

HK properties including the IFC had a book value of about $10b, since the IFC has been marked to market and the Grand Promenade was largely sold, I'd say it's worth $12b which allows for one or two more years' profit. HKG also held some cash and investment worth about $3b on book.

The total valuation of HKCG is $93b, about the current capitalization. Downside risk at this price is little to none. Personally I'd prefer to wait for one or two reports to see if the China earnings can really take off, or wait for some market signal given by other gas companies. Since many brokerages have already issued buy calls with bullish forecasts, soon I may be left behind in dust regretting my inaction. However I'm not afraid to buy at a higher price if it becomes a sure bet.

DISCLOSURE: I don't hold 3 at time of writing.

The subject has attracted so much attention and press coverage that I almost felt guilty not to write something about it. However I'd not repeat what you probably have heard but instead fill-in a few details which I hope will help you understand the situation better.

The mortgage market in the US is the most advanced in the world and it's long evolved from a pure lending market, where banks and homeowners are the participants, into a free-flowing capital market where everyone can be a part of it, be it commercial banks, investment banks, mutual funds, pension funds, wholesale and retail investors. For this day we have the US academics to thank, who came up with the exotic math to tackle all kinds of uncertainties in this world, and property market is only one area of application.

Anyone who'd want to know more about the inner-workings of the mortgage market, but not too much technical details, can read Liar's Poker by Michael Lewis. It's a hilarious story about the daily life of a group of greedy and over-aggressive mortgage bond traders. The fictional story took place in the 80s but I don't think things have changed much since, other than that there are now more exotic products.

Like HSBC management has explained, Household Finance was too eager to lend to sub-prime borrowers as, like everyone else, they thought they could always securitize and sell those mortgages to others. Nobody was expecting to hold the mortgage for long, in spite of its higher interest. They all aimed for making capital profit, i.e. lend/buy mortgages at say 10% and then securitize and sell for 8% (similar to what HK developers did with REIT to get rid of its rental properties). After the mortgages have been sold the process repeats itself, like a wholeseller selling and restocking. If they 'turnover' the mortgage book often enough they'd sure make big bucks in the end of the year. Mortgages have become a merchandise, a hot one indeed with the rising and buoyant housing market. The overall market grew by the day and that attracted more liquidity. Of course, the low interest cost environment throughout the world also added fuel to the campfire.

Once a big enough pool of mortgages is obtained, you can slice it anyway you want and start selling, as far as your imagination can go. It can be done by location, e.g. Westcoast, Silicon Valley, or even beachfront (my wild guess); by average maturity, e.g. 5 years, 10 years, 20 years; by timing of cashflow, e.g. interest only (IO) which a holder only receives interest throughout, and principal only (PO) which works like a zero coupon bond; by level of credit protection which works sort of like preferred and common shares (higher class bondholders have priority over lower class bondholders in receiving interest). Closer to present there's a new market for credit derivatives where insurers underwrite default risk for a fee and then, guess what, further securitize those policies, bringing in yet more investors. In nice words it's said mortgage securitization allows every John Dole to participate in the growth of the US housing market, and in investment opportunities that didn't exist before, and that all the different varieties merely reflect investors' needs and tastes. Most importantly, the originators should be rewarded for their ingenuity. Soon came the convenient disregard for the classic listing question: 'should' the issue be floated as opposed to 'can' the issue be floated.

With the mortgage market functioning much like a stock market, it's no surprise there will be extended bull and bear runs. Obviously now is a bear market where liquidity has dried up and sellers/lenders are fighting for the nearest exit. And probably some witty traders, if their hands are not burnt yet, are trying ways to further 'short' the market knowing most participants don't have the capital to defend their positions. This will cause an oversold market which don't reflect longer term fundamentals.

What are the fundamentals?

A property market dropping by say 15-20% can result in many negative equity homes and many more near worthless bonds, but these don't necessarily lead to massive default, just like a listed company can go by its business without minding its share price. The key factor remains repayment ability. How fragile are the sub-prime borrowers? Are there more property-flippers or those making lower but honest income? Is the job economy gonna be affected eventually? These are all important considerations, and there are many more, but my lack of timely knowledge of the state of US market has precluded me from writing further.

Chalco reported earnings of more than RMB11b on strong sales on alumina and recovery of the aluminum market. On the face of it p/e is now only 8x which suggests cheapness but can it be sustained?

For those not familiar with Chalco and its attraction to me can visit my past post. (http://abaci-investing.blogspot.com/2007/01/buy-china-buy-chalco.html) This post is more about the latest results.

I'll start off with the aluminum business because that's where Chalco has been expanding in order to lessen its reliance on the more volatile upstream alumina market. Aluminum is an essential construction and industrial material (in my view it's better than steel for its lighter weight and better strength) with uses in construction (think buildings), transportation (think cars and parts), packaging (think consumer goods), aviation, aerospace. These sectors will all grow with China even over the long run. I think these all you already know.

Figures wise, capacity was up 65% to 2.5m tonnes and production volume was up 84% to 1.93m tonnes (vs national output of 9.35m tonnes). National demand was slightly lower estimated at 8.67m tonnes but did show faster growth than supply. Management's 2007 target previously stated was 3.4m tonnes or 1/3 of the domestic aluminum market.

I'm not particularly worried about the supply/demand situation of the downstream market, for now, because last year was only the 1st year of recovery when everyone started making money again. Operating margin (before interest & tax) of Chalco was 13.5% vs 1.6% in 2005. And a 13.5% margin did not strike me as being excessive. I don't think a new round of price war will be near the top of the agenda for most smelters.

Figures wise, Chalco's smelters made operating profit of 4.5b, 20x better than in 2005 but still only 1/3 of the upstream alumina business.

I couldn't help but notice the downstream smelters were bought cheap, at only perhaps 4x p/e and discount to the fair value. These bargains might have come as the result of luck as Chalco happened to buy when the industry was at a bottom, or the result of government policy which forced smaller smelters to merge into bigger ones. Though these new businesses only contributed 5% of the net profit last year, it's a good start and I'd like to see this trend of 'cheap' acquisition to continue.

The alumina business contributed 3 quarters of the operating profit, or 13.3b. There isn't much to analyze about this market as so far no one can quite predict the pricing. There was a series of price cut in the 2nd half of last year but then a sudden 50% spike this year. This coupled with Chalco selling forward too making it even harder to understand. So I'd leave this task to the specialist and I offer you no comfort on the stability of the alumina price. But it's worthwhile to note the national supply, though grew by 61% and reached 13.7m tonnes (Chalco produced 8.8m tonnes), still fell behind of the national demand of 19m tonnes. Internal consumption ratio of alumina also grew to 40%, and increasing, which should provide more stable earnings stream.

On capax, Chalco spent 8.7b last year and 8.4b in 2005, proportion spent on downstream increased to 50% from 33%. Management mentioned 3 major alumina projects with combined capacity of 2.8m tonnes, and some expansion of smelters, nearly all located in central/southwest China (opportunities?). These would probably be financed by further bond issues as financially Chalco was very strong with net debt of 6b (against equity of 44b) and interest expense was insignificant at 800m.

Last year's result was exceptional and could be hard to repeat. In a normal year, I'd expect Chalco to earn maybe 8b a year, with equal contribution from upstream and downstream, and a potential to earn up to say 10b as downstream business further expanded. I wouldn't attach too much hope on the alumina business just to be conservative and to save myself from any future embarrassment (but I do assume selling price will not drop by more than 20% from 2006 average of 3,600 per ton). But I do believe it shouldn't be too risky when one is buying the largest vertically integrated production chain of aluminum in China, for China is far from done in building its dynasty.

In terms of valuation anywhere between 10-12x p/e would be fair, that translates to a price range between roughly HK$7-10, though one can never correctly gauge the appetite of the market at any one time, and judging from past observations large over-shooting in either way does seem to occur frequently.

DISCLOSURE: I hold 2600 at time of writing.

The FY results were more or less in-line with expectations and that of the 1st half. Segmental profit of the shipping division in the 2nd half showed some 10% improvement, although I had hoped for a higher figure with the sharp drop in crude oil price.

Management cited the cause of the sluggishness was other ship-liners being far too eager to reduce freight in the 1st half to secure orders, for fear of over-capacity in the industry (which did not materialize), and hence OOIL was reluctantly dragged into this price war. And the damage done to the freight, which were contracted months ahead, will take time to recover. There may be some truth in the statement as both China COSCO and CSCL did so much worse in the interim (with shipping profit dropped by 75% and 99%!). So don't expect their full year results will bring much surprise. And salute to the OOIL management for riding out this very tough year.

Going forward management's tone is positive and expansion of fleet is still going strong with about all free cashflow (shipping) reinvested. There was mentioning of a drop in shipping volume of furniture and housing related goods due to the softening of the US housing market, but that was well compensated by increase in goods of other categories. This is pretty much what I have thought, as more of everything is now made in China and people just can't buy it elsewhere. For 2007 so far the freight has increased by an average of 10% though the crude oil price has also climbed back to the level of US$60 a barrel. My optimistic view is the shipping division will earn about HK$3b net each year and be worth HK$24b.

There wasn't much contained about the property division in the press release, other than the old news that property income will be kicking in starting 2008. The Wall Street Plaza though could be sold to provide further funding to the China property projects, as it's another piece of non-core asset.

The port business was classified as discontinued operation so maybe the California and Taiwan ports are now included in the shipping and logistics division.

The biggest disappointment came from the size of the special dividend (80 US cents), which was only a quarter of proceeds from the sale of the North American ports. The official reason was that completion will take place in 1st half of 2007, not 2nd half of 2006, and therefore there's still the possibility of further special dividends down the road. But I guess the real reason is management is either not willing to let go of the money yet, or they have something cooking in the kitchen. This will probably trigger some profit-taking when the trading resumes on Monday. But to me a dollar is still worth a dollar, in my hand or not, as I have confidence in OOIL's management and their execution ability.

So my rough estimate of the company's worth is HK$24b for the shipping business plus HK$18b cash plus say HK$10b on the properties, or HK$52b in total. This is about HK$82 a share. I'd say the current price while still has some attraction isn't the tremendous buy as it once was. I'd hang on to my holding but wouldn't add more.

DISCLOSURE: I hold 316 at time of writing.

I usually update my portfolio status (i.e. gain/loss/%/etc) after each Friday's close. I reckon it's probably done too frequently but in return I do get a feel on the 'beta' or sensitivity of my portfolio and more importantly, I need to monitor the gearing as I do borrow against my holding. But after yesterday's fall I also did an asset allocation review, which on the other hand was something rarely done but should've deserved more of my attention.

Although I'm not a believer in the efficient market theory, I do by experience come to appreciate the virtue of some diversification, based on what's called academically the efficient frontier (which suggests within certain parameters diversification can actually both increase return and reduce risk!), unless you have superb sense to correctly pick the 'hot' industry year after year, in which case you are already immensely rich and I hope you are doing the society some good now.

I had to update my positions again yesterday even it's a Monday because I saw myself really 'stretched' after the fall (during which I bought some too). It turned out my gearing wasn't too bad and could absorb further shock. For self-record this is what my asset allocation looked like at yesterday's close.

Industrials 24.4%
Container Shipping / Port 18.4%
Banking / Insurance 13.4%
China Property 12.9%
Resources 12.9%
Utilities 6.6%
Construction 4.8%
China Retail 2.7%
Others 3.9%

There's so many good stocks to buy, with every one of them holding an equally credible story and promises. Sometimes it's easy to get distracted and lose focus. In my case while I believed I had done enough since last year to trim down my small cap positions, I was surprised I still held a bundle of them, especially the industrials though they are my sentimental favorite having brought my first success in stocks. Now it's clear I'll have to drop an existing holding if I happen to find yet another bargain in this sector, or this may be a proof that they are not really bargains and there's something wrong in my selection process. I don't wanna become a nail-hitting hammer only!

Other categories look fine though I'd prefer more exposure to the China power and retail plays. And maybe holding more resources as a strategic hedge isn't a bad idea too. I'll probably add some should this correction go deeper since the prices still weren't attractive enough and I only have one or two rounds of ammo left, so I'll wait for my chance and if possible until the release of last years' results. But who knows if the market will simply take off from here and never come back? But a 6-day correction, if it's over, will be one of the shortest in recent memory, even it managed to create as much damage as the last correction in May 2006 which lasted 6 weeks! I think this is too far off today's topic.

Another useful thing I did during a review is to count the number of stocks. I usually hold about 20-25 at any one time (excluding those IPO allotments which are too small to matter). I've tried hard enough to keep it under 25 but my target is 15-20, which should suit my portfolio size and risk appetite well. Reducing the number of stocks in a portfolio can really stress on one's stockpicking ability. That's why if you read an annual report of a typical mutual fund you'll find hundreds of holdings but little return! This is in sharp contrast to Tony's portfolio in the Next Magazine which holds like more or less a dozen stocks but has delivered 25% annual return since 1999! I guess the morale is: you can't hold too many good stocks because there aren't that many good stocks around!