Abaci's Common Sense Investing

I went to the Berkshire shareholders' meeting this May and I'm glad I finally made the trip after putting it off for a few years for no apparent reason. It was a fruitful experience.

Buffett and Munger are really worth flying 12,000km to see in person. They made the meeting an intense yet fun wisdom sharing experience for anyone who wishes to learn. It's like being near a knowledge fountain on a fully open tap. You'd surprised at times they also taught you how to be a good person and lead a meaningful life. I hope I've become wiser after this meeting.

In the end, I'll leave two quotes from each of them.

"Most people do not have the temperament to be investing their own money."

"In my whole life, I've known no wise people who didn't read all the time - none, zero."

And this is the last post on this blog about investment.

p.s. you can google for the complete script of the shareholders' meeting. there may even be translated versions. the flash spot in the photo is where Buffett was at before the meeting began.

I hope this is useful reference for most who want to do some trades with their HSBC shares and rights during the rights period. If you decide to act now however, I have no advice for you. All I can say is the current HSBC share price is the subject of much speculation and arbitrage, and hence is a bad time for trade (for layman) as the market quote is highly distorted. Things should become clearer once the stock has gone ex-right and more so when the rights start trading on their own.

By now most should be familiar with what a rights issue entails so I'll skip to the core analysis.

(HSBC share price, ex-right price, price of each rights)

P P(ex) Rights*
46 40.7 12.7
45 40.0 12.0
44 39.3 11.3
43 38.6 10.6
42 37.9 9.9
41 37.2 9.2
40 36.5 8.5
39 35.8 7.8
38 35.1 7.1
37 34.4 6.4
36 33.6 5.6
35 32.9 4.9
34 32.2 4.2
33 31.5 3.5
32 30.8 2.8
31 30.1 2.1
30 29.4 1.4
29 28.7 0.7
28 28.0 0.0

* [P - P(ex)] x 12/5 or P(ex) - $28

For example, yesterday HSBC closed in HK at $33, so the theoretical ex-right share price of HSBC should be $31.5 (it's lower than market price because there's dilution from the rights shares issued at $28) and the implied market price of each right (to buy one share) is $3.5.

Note these calculation are only relevant BEFORE before the share goes ex-right after trading this Thursday, after which the rights price (theoretical and not traded until March 20) will simply be the difference between the then HSBC share price and $28.

Between this Friday and the following Friday, Mar 20, only the ex-right HSBC shares will be traded but not the rights. It may be interesting to compare the actual ex-right prices to the theoretical ones over the past week (it's roughly 0.9 of the share price if it's not adjusted automatically by your stock quote provider) but I don't know how one can profit from this, if at all, reliably.

Comes the following Friday, i.e. Mar 20, when the rights start trading, 3 possible scenarios can happen but you only need to pay attention to one.

(1) The share price trades more expensive than the rights price indicates, e.g. share price is $35 yet the rights trades less than $7, which means it'd be cheaper to buy the rights and then subscribe to the share than buying the ex-right share outright in the market. You need not worry about this scenario because I'm sure arbitrageurs would come out and equalize this difference in no time, by shorting HSBC shares and buying the rights. So there's nothing you can do to profit from this scenario as a layman.

(2) The share price trades on par with the rights price, i.e. rights price = difference between share price and $28. Again, nothing you can do as a layman. You many choose to participate in rights or buy new HSBC shares as you wish, or not.

(3) The share price trades cheaper than the rights price indicates, e.g. share price is $35 yet the rights trades more than $7, or in the extreme case where share price is below $28, yet the rights trades above zero value. If this happens and stays for a while, a few hours maybe, then there's something we layman can do about. I don't really know why it may happen but there's no need to understand fully either.

If you hold HSBC shares and have decided to participate the rights issue, DON'T! Instead sell your rights and buy the same number of shares (as you would via subscribing to the rights) in the open market. Rarely will you have the chance to do exactly what an arbitrageur would do, selling high and buying low of the same asset.

If you want to speculate and make a quick buck, buy some HSBC shares, as the higher-than-usual demand for the HSBC rights will soon translate into higher demand for the shares as well. But how the share will perform after this difference has been equalized is anybody's guess.

In summary, do nothing new if (1) or (2) happens, buy some HSBC shares in (3).

DISCLOSURE: I have no HSBC at time of writing.

There's really no way to predict how different currencies will act in this on going crisis, just as nobody could really see it coming or foresaw its magnitude (perhaps except Doctor Doom & the Black Swan). Therefore I can only list out the underlying forces at work. You are welcome to contribute what additional signs to watch out for.

(1) USD buying pressure to ease when de-leveraging is completed
This is easier said than observed. USD should drop when global de-leveraging is completed and most USD loans are reduced down to a safer level. But it's hard to say when. Even though most banks in US and Europe are re-capitalized and less leveraged, this is only relevant if value of assets they hold don't drop further. If we see higher grade debt instruments in US turn sour faster and deeper than expected, e.g. commercial real estate loans, credit card debt, municipal and state loan, etc, we know well this time it's not gonna be a localized problem in the US, as via securitization its effect will be broad reaching. And depending on whether the banks have learnt to hold more than enough USD for contingency, there's possibility for another USD rush when positions have to be closed. In addition, the on-going sell/scale down of foreign operations by US institutions will continue to support the USD as funds are repatriated back.

(2) USD borrowing to ease as interest rate is low everywhere
Companies are less likely to borrow in USD if they can get equally low rate in local currencies. In fact, a lot of existing USD debt will be refinanced with local currency debt. For example, in HK many companies are increasing their exposure to RMB debt to repay USD syndicated loan. This suggests lesser selling pressure for the USD. After witnessing the turmoil in the fx market last year, there aren't a lot of brave souls who would venture off-shore financing anytime soon.

(3) Spread of US treasury yield and corporate bond to narrow
It's happening and is a good sign that the bond market is breathing again, even only faintly. There are talks of quantitative easing everywhere, that the central banks will issue cheap debt and used the money to buy commercial loans/bond to push down the yield (i.e. borrowing cost). Whether that's gonna happen is not really important as investors have chosen to anticipate and act in advance, doing what the central banks want to do in advance and hoping to turn a quick buck when the central banks do move in. This seems neutral to the USD.

(4) US treasury buyer's stance, mostly Japan and China
Japan has no choice but to suppress the Yen, which is good for USD. Japan is an export economy and the US is its biggest customer. Its domestic market is too small to self sustain and it can no longer boast infrastructure spending. As most things Japan produces are human/physical capital intensive and it owns the brands, there's a lot of value adding so higher resources price in terms of a weaker yen is of lesser concern.

China on the other hand wouldn't mind a stronger RMB, for most of its exports are low value-adding and thus more sensitive to resources prices. A stronger RMB also brings cheaper imports (even for goods manufactured locally as resources are mostly imported) and boasts internal consumption, good prescription for the economy. However, China doesn't want to see a collapsed USD either as not only will the value of its USD assets largely deteriorate, Chinese suppliers will suffer badly too as they usually hold no brand, operating in fragmented industries, and have little bargaining power with US importers. A weaker USD will translate to lesser demand for goods and pressure for discount (i.e. Chinese side will need to absorb the loss from USD depreciation). If I were among the Chinese leaders I really wouldn't know which I prefer.

Another emerging trend is China is buying up natural resources everywhere in the world whenever opportunities arise. In time this may affect China's appetite for US treasury but at present there's not enough deals of magnitude big enough to cause such a swift. Moreover I note most deals, including the Russian oil deal and the Australian mine deal, are priced in USD (I suppose the reason being most commodities are priced and settled in USD), so China is only exchanging its USD reserve for something tangible, i.e. it doesn't involve buy/sell of new USD. And those selling countries/companies are in need of those USD to repay their USD debt as part of their de-leveraging. So this is really the other side of the same coin (i.e. factor (1)).

(5) Economic health of US and the others
This one is easier to spot - every economy is sick! And the common prescription is to borrow like crazy, either on the government level like in the US or much of Europe, or on business level via the easing of credit by banks like in China. If the borrowed amounts aren't enough to jump start the economies, there'll be a lot more money coming your way. In the end, it's the same for all currencies, i.e. a lot more money supply than before and nobody can be sure that the new money gets spent wisely. Therefore this factor is neutral as all currencies are not considered safe in this regard, i.e. low interest but no future.

But relatively, US is in a stronger position. If it is already hard enough for Obama to get things done quickly with just fellow democrats and the republicans, imagine how hard it is for Europe to agree on anything with all the different political ideologies. Moreover, the downfall of many smaller economies in Europe (including even Italy and Spain and of course the entire Eastern Europe) will drag down the Euro zone further. And the Russia position looks shaky and Europe as its neighbor is gonna feel the impact. If something drastic does happen in Russia, money will be flooding into the USD.

Summary
All the factors are mostly supportive of USD or neutral. The central theme seems to be if the US is bad, then everywhere else is just as bad and likely worse! Therefore I think the USD strength is logical and gonna sustain. WHEN and IF it does collapse, it won't be against other major currencies but rather against hard currencies, at present I think it's gold and oil (and there may be more). This is because the collapse is likely to be driven by the belief that most developed countries are close to bankrupt and thus paper currencies are no longer trusted. Monetary system takes a step backward and people will revert to holding hard currencies. So it's possible that a gold bubble is forming and maybe oil will follow steps too, and it doesn't require actual anticipated events to take place to support it, just imagination of it happening is enough to fuel it.

This isn't my favorite topic for obvious reason - one pays no interest and the other barely pays interest. But since most people can't be convinced to buy stocks perhaps it's good time for a change of topic

Have you ever noticed that American dollar is only currency that is called 'gold' in Chinese when it's not? You never hear (in Chinese) British Gold or Euro Gold. It seems the USD is the next best thing to gold.

The USD has started an uptrend, just like gold, since the collapse of Lehman last year, and it's stayed strong even when the US economy looked like it's heading into a tailspin, and amid the massive creation of money supply via everyday rescue and stimulus package's' and a close to zero federal rate.

The easy answer to this abnormality is that people flight for security in times of uncertainty. The US economy sucks and is shrinking but still it's the biggest economy in the world, and with the biggest army. The only other nations comparable are Russia and China, both communist and with currency control, hence it's not hard for most to make the choice. What about Euro? Well, as much as the high cost and unionized workforce is plaguing the US, the same hurts even more across Europe. And Europeans also fare generally less well than fellow Americans on creativity and technology front.

But this answer seems too easy and ignores something deeper in the working. I recently read an Economist article that provided better insights and together with my understanding here's a slight more difficult answer.

I'll start with the background. Globalization has lead to more emerging market countries, notably China and others in Asia, earning USD from selling exports. These USD ended up in various central banks' reserves and were not converted back, as most governments were still haunted by past trauma of the Asian financial crisis and the heavy foreign currency debt. So this time around they all loaded up USD as buffer for the bad times. Of course at the same time they also didn't want to their currency to rise too much and thus selling these USD was a big no no.

These USD then found their way naturally in the US treasury bond. As foreign trade increased and reserves soared, more treasury bonds were purchased which drove down the yield. During this time there was the bursting of the IT bubble and Alan Greenspan's monetary easing. I think everyone understood this well. So I'd just say both factors combined and the result was an extra low interest rate in the US, second to only Japan.

Out of cheap financing, a housing boom and a consumer spending boom was born. The housing boom was more devastating because it's also self-reinforcing, as higher prices led to more speculative buying.

Extra low interest also meant extra low return for lenders. American bankers then got creative and repackaged all kinds of loans into AAA securities and started selling overseas to those who had to buy USD but weren't satisfied with treasury return. Local US banks then eased its lending standard because lousy loans could always be sold. This part you now know very well too so I'll skip. I'd just add many US banks also provide USD financing to entice overseas buyers.

The low interest rate also helped grow the eurodollar / eurodollar bond market, i.e. borrowing dollar on non-US soil, mostly in Europe. As more companies/investors took advantage of the lower rate USD borrowing, this became self-reinforced as when borrowers converted the USD proceeds into local currencies to use, this drove down the USD and made borrowing USD more attractive as it's a currency that had low interest and was depreciating too!

So much for the long-winded background! Let's guess what's been happening since last year.

First the US banks got into trouble as the housing market deflated. But this was seen to be domestic only and hence USD fell even more as most people moved to other currencies with a higher interest rate when US was cutting rates. Then it became obvious that all the repackaged loans sold to Europe would go sour too, hence most European banks and investors would suffer as well, and probably as much too. These USD assets became illiquid or substantially worth-less. However much of these securities were financed by USD loan given by US banks at the 1st place (originally a nice hedge and leverage to enrich return). So Europeans suddenly found they were very short of USD. Of course it didn't help the US lenders were all in deeper trouble and needed that USD even more urgently.

Naturally the Eurodollar borrowing market ceased as the lenders, both US and European banks, or actually everyone, was short of USD! Normal commercial lending was affected at this point. So every asset class had to be sold to repay those USD loan, and hence USD had nowhere to go but up abruptly. The case was also worsened as borrowing was gradual over years but repayment was almost immediate. This was similar to the YEN unwinding every once in a while but of much broader scale, and with the difference that the original US lenders were also scrambling for the same USD like the borrowers. That's why we had a very high LIBOR vs US fed rate and the USD swap arrangement between the FED and ECB late last year. There's USD shortage everywhere.

What about all the monetary injection by central banks and the fiscal stimulus packages? I think evidence is the former is not enough to counter the size of the credit crunch, and the effect of the latter is not yet felt. Meaning - credit is still not enough so de-leveraging has to go on. This has been a rise or normalization of long term US treasury yield lately, which suggests maybe inflation or worst insolvency of US. But this is universal as I think credit spread for many European countries are rising as well, meaning everyone is having just as bad prospect.

What does these mean? The strong USD isn't going away soon! It's lucky we are in Hong Kong and most of us are automatically invested in USD via the peg. But I do think the tide will turn. I'll try organize my thoughts and tell you next time, and cover gold too.

I remember it wasn't long ago, maybe in late November or early December, that the 3 month US T-bill yield hitted zero. This sounded absurd as why would anyone invest in something, mind you all investments entail risk, for no return. So now somebody rightfully dubs T-bill as the great 'return-free risk', as opposed to 'risk-free return'. I guess the only reason for this abnormality is that massive amount of capital has flown from everywhere into government bond class, and the bond managers have to do something to earn their fees, just like an equity fund manager who must buy when new fund is received. As longer tenure bond yields are also at historical lows, which implies there's much downside for prices to come down, 3 month bet is the safest option as it can always be held to maturity. And those who bought government bond funds don't know they'll be receiving zero return until after the news, since they don't directly participate in the T-bill auction. They probably bought it because they read the yesterday's news in the marketing materials, that government bond funds had little risk but outperformed equity funds by more than 50% last year. This is one layman's investment idea you can consider.

The 2nd idea is a derivative of the 1st, no, it's not a MBO or CDO kind of derivative, but is an origination of Warren Buffett. His rationale is that zero T-bill yield means lending money to the government is no different from putting money under your mattress, except that the government may default. So the next logical thing people will do is to buy as many mattresses as possible to store their wealth, hence all major mattress makers should see much increased sales. Because Buffett himself bought up a lot of household furniture stores last year, he thinks he's gonna make a killing out of it. This is one pro's investment idea you can consider.

Disclosure: I have one mattress (practically only half) and no government bond.

Early last year I looked at COSL and found out it's less a service company but more an utility with old equipment. Subsequently to my amazement its price rocketed from $5 to over $20 in Oct 07, then it was sold all the way down to a little under $3 last month (i.e. one year later). Now the price is around $4.6. One peculiar thing was that share price this year pretty much moved against the rise in profits and the oil price until July, then it moved further down with the oil price and then entered a free fall zone like every other stock in Sept and Oct.

Meanwhile during this time COSL completed a huge acquisition of a Norwegian drilling company. The deal was announced in July and completed in Sept. So I think it's about time to have a second look of COSL.

The acquisition was huge at NOK 12.7b, which was about HK$20b at time of announcement and the same as COSL's own NAV. COSL's historical highest profit earned was a little more than HK$2 billion in last year.

The assets acquired were a fleet of 6 drilling rigs in operation and 7 rigs in shipyard under construction. These 13 rigs will eventually double the capacity of COSL which is 15 now. The Norwegian company was only set up in 2005 and was barely profitable until 2007 (as the rig was put into operation one by one). Given the lack of track record, this deal could be seen as an asset buy, for I don't believe there's much goodwill developed within the 2+ years of operation.

The deal also came with a lot of debt as those rigs were heavily geared. There was US$1.35b of debt against US$1.8b of fixed assets (including those under construction), making the rigs 75% bank financed. Overall gearing of the Norwegian driller was more than 260% and NAV was only US$515m. So HK$20b was spent to acquire HK$4b of net assets. It certainly looked quite expensive for asset purchase. One reason for the high cost maybe the long lead time (~2-3 years) required for manufacturing rigs, thus creating limited supply in the market. Another reason was of course the now-seen-overheated market for drilling equipment back then when everyone was searching for new oil.

This acquisition was ill timed as the deal was struck at beginning of July when the crude oil price was at its peak. Though luck may have it, the deal got to go through the lengthly approval process of the Chinese bureaucracy and wasn't completed until the last week of September, and during this time the NOK has dropped about 15% against the USD so making the cost slightly cheaper at HK$17b.

COSL intended to finance the acquisition with debt so it will have HK$27b debt to service for the new rigs acquired. Interest cost (say 5%) will be at least $1.35 billion a year. Revenue side is less certain now given the market environment has changed quite a bit, and half of the rigs are yet to be delivered and hence without having secured order. Rentals seem to fluctuate quite a bit and some rigs are only on contracts for a few months, subject to extension pending successful exploration which will then lead to multi-year contracts. I'm not really sure about exact dynamics, except the revenue side is much less stable than desired. Looking at the substantial increase in revenue of COSL over the last 5 years, when its fleet size only increased moderately, only confirmed the instability of the revenue stream.

The most COSL earned with its 15 rigs was $2 billion in last year, but it operated with almost no debt and inside Chinese waters, and paid a low 15% tax rate. How much the new rigs will contribute to the enlarged COSL group is really a question.

As said last time, the average useable life of COSL's existing fleet is only about 10 years (vs. 30 years of a new rig), so COSL will have to continue to upgrade its drillers in the future (think what it will do to dividends and debt level). This Norwegian acquisition alone already took up much more than all free cash flow of past 5 years combined! Future replacement cost may come down as the industry slows down and the raw material becomes cheaper. But having an extremely long capax cycle and great uncertainty in product pricing (which depends on oil price) making running a driller business not less difficult than an airline. Both require heavy and long term commitment upfront but profitability depends much on oil price movement.

The current price reflects a historical p/e of 8 times, which looks reasonable but is a result of last year's favorable industry conditions. This years' results should be even better (assume the newly acquired Norwegian driller can pay off the interest of acquisition debt at least), but it's difficult to work out a longer term sustainable earnings, as this entails a forecast of the oil price level. COSL needs both favorable oil price movement and good timed execution in capax to succeed in the long run.

My initial opinion about COSL hasn't changed. I'd modify it as an utility with unstable revenue stream and old equipment. It's mostly a speculation stock.

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

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.