Abaci's Common Sense Investing

Last month I was in an accounting standard update seminar and the speaker, who might have lost a lot of money and thus turned a complete cynic, kept making lame jokes every few minutes about mini-bonds, Citic Pacific, HSBC, and other names I've forgotten. But he repeated more than once, in a serious tone, of his gloomy prediction of HSI falling by 90% and reaching 3,200. His reason was two-fold: (1) this crisis is most severe since the great depression of 1920s, since there's no HK stock market at that time, he could only surmise the HSI fall will be at least as bad as in the 1973 bear market; (2) one of his manufacturing client in Foshan made the exact same gloomy estimate when they discussed the market condition.

Reason (1) is actually not his origination but a popular bear belief in the market, and I don't understand why reason (2) can be considered a reason at all, maybe his client is the unknown 'Foshan Buffett'.

Then I read from Tony Messar's daily column last week and he mentioned something about the 1973 bear market, when the index fell from 1,775 in Mar 1973 to 150 in Dec 1974.

"The 150 on the Hang Seng Index during 1974 was extraordinarily elusive. On that day it had fallen for less than 10 minutes, and 600 points was about its real bottom, and that was hardly attainable for more than a day or two."

This certainly sounded encouraging, but I wasn't satisfied. So I started my own research on the great 1973 bear market, and found out unfortunately Tony's memory was a bit too rosy, although I don't blame him especially given his age now why shouldn't he be keeping only pleasant memories.

There wasn't much on the internet about the crash, mostly anecdotes about how people went mad and then crazy (or the other way around) in the great bull/bear cycle in 1973/74. I have little confidence in the accuracy nor representativeness of those stories, given the tendency of the media to spice up things for attraction.

I did manage to find some data about the index. 1st, the real bottom wasn't 150 but much lower, but it's an intra-day low and probably happened in what Tony referred to as the 10-minute selling. But he's wrong in saying 600 was the real bottom. In fact, the index did fall by 90% in Dec 1974 and stayed there for quite a while before rising again, to 209 on Jan 27 1975, and then to 279 on Mar 27 1975.

Another useful bit of information was found about the super bull market before the crash, on Nov 13 1972, the index was 673, 3 months later on Feb 9 1973, it was 1,450, 1 month later on Mar 9 1973, it was 1,775. I don't really have a starting point for the bull run because of poor data collection. But if I use 673 as a base, then it was up 263% in only 4 months. It was indeed quite a gold rush! [Update: From less reliable source I got that HSI was 113 at beginning of 1969, so in 4 years and 3 months (until Mar 1973), it's risen by 15.7 times! The Economic Journal wasn't even published until sometime in late 1973 in the middle of the crash.]

Next I tried to compare this to the last bull run we had, I used 32,000 as the finish line and calculated backward, arriving at 12,167 in order to give the same 263% increase. It was a time around Aug 2003. The total time was 4 years and 4 months.

So it was 4 years+ vs 4 months!

You should realize the intensity of these two bull runs wasn't quite the same. If you believe that the extent of a bear market fall has some thing to do with the previous bull market run, then you should perhaps give some more thought before casually linking the two bear markets.

[Update: A quick summary

From 1/1969 to 3/1973 (51 months), HSI was up 1,570%
From 8/2003 to 11/2007 (52 months), HSI was up 263%

From 3/1973 to 12/1974 (20 months), HSI was down 92%
From 11/2007 to 10/2008 (12 months), HSI was down 66% (using 11,000 on 10/27 as floor)

For additional info, the bottom of 150 in 1974 was still 33% higher than the starting point of 113 in 1969, while the 11,000 bottom last month was 10% lower than the starting point of 12,167 in 2003.]

Anything can happen for the 1st time, the HSI may fall by 99.9%, or it may rise by 100 times. History is not a reliable predictor of the future, for you will continue to witness 'new' piece of history. (idea of Black Swan author Taleb)

p.s. one should also bear in mind the composition of HSI is very different now with the addition of Chinese companies. therefore to assume a HSI of 3,200 is similar to making an end-day prediction of the China economy. well, if that day does come then that accountant probably has a lot of other things to worry about than the HSI.

This is taken out from quamnet after yesterday's trading, which was probably a typical falling day.

Best performing HSI members
#1 Sino Land 1.1% down
#10 HKE 3.2% down

Best performing midcap members
#1 Lifestyle 3.8% up
#10 Chinese Estates 1.5% down

Best performing smallcap members
#1 Samling 5.2% up
#10 K. Wah 4.3% down

So far so good, all HSI members were down and some mid/small caps went up, not too unsurprising. Below is the more interesting bit.

Worst performing HSI members
#1 Pingan 12% down
#10 HLP 6% down

Worst performing midcap members
#1 OOIL 10.8% down
#10 Shun Tak 5.3% down

Worst performing smallcap members
#1 Kowloon Development 10.2% down
#10 Polytec 3.6% down

In short the bigger the company the larger the fall. De-leveraging you may say, which can explain almost anything now. Because small caps have inherently lower credit quality in eyes of banks, their shares were less lent against in the 1st place and hence can't be de-leveraged as much now. Another explanation is we're near the end of the selling circle, when the best managed companies get sold too. But we can't use recession or depression as a reason, because in that case bigger companies should fare better and hence decline less. The market is indeed acting funny lately.

To conclude, larger companies are more defensive yet cheaper, favorable combination.

Below are a list of high yield plays I've looked at these few weeks. I think it's wise to hold a certain percentages of one's portfolio in this sector as these are fundamentally stable businesses with good distribution, a nice complement to the high flying chips that you plan to profit several times over cost in the eventual rebound (if there is). Fat dividends also keep one's mind sane in a protracted down market.

I won't bore you with the financial details. These are all reasonable buy for holding (read: not trading) with adequate yield and even considerable appreciation potential. In my view these are much better buys than bonds. However I have little confidence if these can outperform putting money under your mattress, over the next quarter or even next year.

Local consumption
GD Investment (270)
This should be the most resilient even in a recession because 80% (or more) of its profit is from selling water to the HK government. Extension terms have just been agreed with a 15% increase in tariff. GDI has some miscellaneous businesses heres and theres but none of them is interesting enough to warrant attention. GDI still has a lot of debt carried over from its last financial trouble and it'd be nice if management is more active in reducing those debt. However now that GDI has gotten in better financial shape, management seems more eager to do acquisitions to demonstrate their competency, but it is this area where GDI really has nothing to show for confidence. Profit should be comfortably above $2b and 09 prospective p/e should be around 7x or less. Yield is adequate but not as attractive though, which kind of reduce the attraction of buying in the 1st place.

TVB (511)
Champion of anti-IQ programming and broadcasting, surprising effective in capturing local viewers for more than 40 years. TVB has such dormant market position you all understand 1st hand. It is also a great business machine. It has little fixed outlay and almost no need for reinvestment (for future earnings). The only capax is the studio which is real estate and hence keeps value. 5 year average earnings are about 900m which suggests 10x p/e. Yield should be around 6/7%. Future generations may abandon TV altogether but I'm sure that'll be beyond my time. Future advertising revenue will contract certainly but share price is already at SARS level and not much above that at worst of Asian financial crisis, making any further fall rather limited.

Oriental Press (18)
Annual profit should be comfortably above $250m. The exceptional move to half the price of its 'Sun' newspaper which badly affected profits in FY06 and 07 probably won't repeat, as it didn't seem to achieve anything. Surprisingly, in the year of SARS OP actually had the most revenue and profit over the past 5 years. Maybe the internet and other new media is really having its effect slowly. This 1st half should have been tough as oil price (which seems to affect newsprint and ink cost) was high and advertising might have slowed. But it should see some relief in 2nd half when costs have come down. There's almost no debt and net cash is $1.75b after selling out its head office in Kowloon Bay. Do you know the market cap now is also $1.75b? Since the Ma family has been reluctant to distribute anything more than current year earnings, I guess overtime the market has basically written this 'cash holding' off. God knows how long you have to wait before you get to see this cash. And you need to pray daily that OP won't buy any of those funny financial products from its bankers. But even without this cash cushioning OP is still attractive at current price. It probably has the highest yield too.

REIT
GZI (405) and Champion (2778)
Both are commercial and retail REIT but at different locations. Main attraction of REIT is regulation, there's a cap of the amount of debt raised (45% on asset) and most importantly 90% of earnings have to be distributed. So you don't have to worry management getting too ambitious with your money. These two offer similar yield and face similar problems, possible falling rental. I'm not sure about the Guangzhou property market although I believe it may be more resilient than HK, but I don't know much about its property portfolio so I'll pass. Champion is more tempting with a 75% discount to NAV ($7), but I have great reservation about that figure because when new units were issued earlier this year, the issue price was only $3.6. Yet, the current price is only half of that at $1.7. The two buildings of Champion, ICBC Plaza and Langham Place are prime enough to me and both are in great locations. If I take 50% off current distribution as long term average (this implies no distribution in really bad years), the yield is about 7% over time of holding, not bad for grade A commercial properties. The return is also sort of inflation-protected too as rent should increase with inflation. However if you want deflation protection then you should probably stop reading from here and forget all stocks mentioned above.

Ports
Cosco Pacific (1199), Dalian Port (2880), China Merchants (144)
These seem interchangeable as they all have had the same dismal share price performance, even their earnings stream are quite different. CP is about 1/3 container terminal, 1/3 container leasing (mostly to parent company China Cosco), and 1/3 container manufacturing. DP is half crude oil terminal and half container terminal. Only CM is a pure container port play.

CP is most complicated in operation and in short too uncertain for a yield play. The container leasing and manufacturing look bleak at the moment, although I tend to believe share price discount is big enough. The worrying bit is actually the port side, where CP is increasing its investment in at least a dozen ports, along the coastline of China and overseas. I'm not really sure if the golden age of port operators has past and whether China can really support that many ports without oversupplying it, like it did in any other sector maybe except oil. CM is more focused and with less expansion, mostly because it started early. But it also has the highest valuation making its attraction average. I wouldn't count on the high earnings growth and 25x plus p/e ratio seen over the last 2 years to reappear in future. DP looks most attractive as half of its earnings is from the more profitable yet stable crude oil terminal business, which will actually benefit from the fallout in oil price. Its container port business targets the northeastern region trade which should be less developed and hence have more potential. I also like its lack of explosive earnings growth like CP and CM which means any adjustment should be slight. The only big negative is that DP invested in some funny interest rate swap in 2007, similar to those sold by Deutsche Bank and covered by David Webb already, I calculated the maximum downside to be about some $22m annually until 2015, which is not much compared to annual earnings of $600m. However in today's market if this is made known the punishment will probably be out of all proportion. That may become the opportune time to enter.

DISCLOSURE: I hold 511 at time of writing.

Around this time last year there were plenty of stock market experts sprung out from everywhere in town. We all heard and read about how they picked the right stocks and made fortune out of it. They were maximum bullish and they put money where their mouth was. They were the stars of the time with huge followers.

This year we have a new group of stock market experts - those who made fortune (relatively) by literally putting money where their pillow was, i.e. under a mattress! Very soon they'll become superstars too. They'll hold investment talks and write books with titles like "Top 10 mattresses to keep your wealth in 2009" or better yet "How I made my fortune by just sleeping on my mattress".

Today's superstars despised stocks so much, just as much as yesterday's superstars despised cash.

Last year it was buy stocks and get rich, this year it is do nothing and get rich! I think both defy common sense, unless you believe the world is only in black and white.

Watching all major central banks are busy printing money and lowering interest rate, injecting more and more money in the market, this reminds me like in a game of monopoly, when one player is about to go bust, he would usually suggest 'why don't we all get $500 each so I can continue the game and everyone is $500 richer?'

Except that this time the sum is a lot more than $500 and everyone is asking for it at the same time. Well the lucky break is unlike in Monopoly there's unlimited supply of $500 notes in central banks.

Yet I'm confused because in Monopoly you can't have all losers without a big winner? So I tried to imagine myself in a game of Monopoly.....................

In the beginning every player is buying properties with cash on hand and cashflow received each round, nothing fancy. After a few rounds someone with a bit of luck will have built up a connecting block of land. Houses and hotels are erected to increase rental but more importantly this block can be mortgaged to the banker or other players to get new loans to continue expansion. This is still within normal boundary of business, for players have to be careful about cash-flows received each round is enough to pay off the interest.

Then for some reason the banker lowers the official interest rate, perhaps a bit too low, and that alters the dynamics and risk appetite. Players begin taking up more loans for 'rents' collected from land can increase with development but interest cost has gone lower. So in theory one can gear up indefinitely to increase return, hence properties are bid to higher levels. Rent soon gets higher too for more properties become fully developed into hotels. At this stage there are happy buyers who look forward to continual appreciation and happy sellers who are willing to sell off and hold on to the profits.

Then comes another big event, suddenly there's whole bunch of late comers with a large pile of cash and desire to become monopolies too! The reason for their late arrival is not known but unimportant. They bring up the pace of buying and the property price. At about the same time all land and properties have been mortgaged to the banker and there isn't enough cashflow each round to support the buying. So all players figure they could invent a 2nd mortgage market at a higher interest, given prices have appreciated by much. So rules are changed and new rounds of refinancing are done to support new buying. And markets for 3rd and 4th mortgages are soon becoming the norm. Early sellers are buying back too because they reckon they'd out of the game soon, eaten alive because of the ever increasing rent. There isn't an exit mechanism, for monopoly is played until there's only one man left standing.

What about bankruptcy risk which are supposed to counter irresponsible financing? Some smart players who are holding more cash than properties figure he could make some extra income by insuring against the default of other players, so rulebook is changed again. Lending become more rampant because of the 'safety' of insurance. Very soon the amount insured is greater than the cash and assets the insurer has, and worse, those assets reserved for claims are properties too! But he reckons players can't go bust together so he's safe. A few other players get envy in this new business and start to insure others too, figuring this can increase income and reduce its own insurance cost. Very soon we have a situation where player A insures B, B Insures C, C insures D, and D insures back A, yet in essence they all insure against a fall in price of an asset which they all hold themselves.

Then one day one player wants to sell down, for no reason, perhaps he suddenly finds reducing debt is a good idea, and then he can't find one buyer in the market. Everyone has run out of cash and borrowing capacity. And during this time the banker has increased interest rate for various time already so all the properties have become cashflow negative. When price can't increase any further, down it goes. and it goes down hard.

Property price plunges and that forces more selling. Those holding on aren't faring better because cashflows are draining each round. Players suddenly find out properties prices are elusive while loan balance is rock solid! Before long all players are into negative equity territory. All 2nd, 3rd, 4th mortgages become worthless. Bankruptcy now is a real threat, but at this important juncture the 'insurer', finds the impossible happening, that all players are bankrupting and it backing assets are vanishing too. Counter insuring also becomes a joke as neither can pay off the claims of the other nor survive himself.

So in the end we have all players owing large sums to the banker (and to each other too), with collateral grossly insufficient in value and technically bankrupt. The banker in order to allow the game continuing then has to convert a large part of that debt into equity, hence becoming a player himself. Next is the cancelling or offsetting of all those inter-player debt and counter insurance contracts which are now proven useless and senseless (i.e. A releases B, B releases C, C releases D, D releases back A). In other words, eliminate all liabilities against losses. With sufficient time all players are largely back to a position where they begin. Meanwhile interest rate is lowered again to its beginning low level so properties become cashflow positive again to induce buying. Players will soon react because no matter how scared they have become, they are still in the game of monopoly, and their job is to win this game. In short, let's start another game ASAP!

I really wonder if this game creates wealth? If this is negative then perhaps the resultant loss of wealth is just one part of the game, for the thrills. And we're all part of this game.