Rent v Buy

A lot gets written about whether it is better to rent or to buy your home. Some people seem to hold very strong views on the subject - often coloured by personal experience or recent declines in asset values. My own view is that there is no universally correct answer to that question - each case must be considered on its own merits. As an exercise, I ran the numbers on whether it would make sense to buy or rent our home based on current market conditions.

I assumed:

1. that the purchase price was the same as a comparable unit which was sold in mid-May;
2. that we would spend the same amount on fit out as we did when we actually purchased in mid-2005;
3. stamp duty is at 3.75%;
4. agency is the standard 1%;
5. legal fees and registration costs were HK$20,000 (probably a bit high);
6. interest cost was 1.0% pa (yes, you can get mortgages at that rate in Hong Kong at the moment - but they are floating);
7. I used the most recent rental of a comparable unit in our building (also in mid-May);
8. I used actual management fees, rates and government rent numbers (ignoring the recent waivers).

I then ran the numbers for zero gearing, 50% gearing and 70% gearing. To make the maths easy, I assumed financing was interest only and that I would be a long term occupant of the property.

The results were interesting:

(i) at zero gearing: the return on equity was 2.6%;
(ii) at 50% gearing: the return on equity was 4.1%;
(iii) at 70% gearing: the return on equity was 5.7%.

While these are unexceptional and unexciting numbers, at least they are positive and, with these sorts of numbers, you either have to assume that there will be some sort appreciation in the value of the property or that you want to have some money invested in real estate for reasons other than maximising your return on investment. That said, so long as interest rates remain low buying with these numbers is unlikely to cause you any financial harm.

Needless to say the results are highly sensitive to assumptions as to future (i) changes in prices (ii) changes in interest rates and (iii) changes in rental levels. They also change significantly if you can negotiate any kind of discount off the price I used in my calculations. In effect, investing in property (including an owner occupied home) is no different from any other investment - you have to make guesses about the future in order to evaluate the financial merits of buying and the price you pay is crucial in determining your return on investment.

As a general proposition, the cheaper the property the more the numbers favour owning over renting. At the luxury end of the market, the reverse is true.

Monthly Review - May 2009

May was a spectacular month for my investments. The majority of my investments were up strongly. The exceptions were few and, in absolute terms, insignificant. Currency movements were positive as I benefited from the weaker US$. In addition, I continued to enjoy full rental income from my properties.

Here are the details:

1.my actively managed funds all appreciated during the month. I am still holding losses on many of them. I currently have investments in actively managed funds investing in Thailand, Taiwan, Eastern Small Companies, European Small Companies and Vietnam;

2. my index tracking funds were up. I currently have exposure to Hong Kong, India, Taiwan and Russia. The Indian election result was a huge boost to the value of my India funds;

3. my legacy equity portfolio depreciated slightly;

4. my embryonic portfolio of Hong Kong stocks showed holding gains in the first month;

5. my commodity investments were went up (with an increase in the price of nickel and a rise in my commodity ETFs more than offsetting a further decline in the price of lean hogs;

6. all my properties are all fully rented and the tenants are paying the rent on time. I have both a positive cash flow and a surplus of income over expenses (which represents an increase in net worth);

7. currency movements were positive as the US$ declined.

I increased my investment in a commodity ETF (2809), purchased several Hong Kong shares (Hutchison, Fairwood, Sichuan Express, Jiangsu Express and Hang Seng Bank) and entered into four OTC option contracts:(i) short NZD/USD (ii) writing a put option against the HK Tracker Fund and against China Construction Bank and Hutchison.

Income was steady (it will be erratic under the new job) and contributed to the gain for the month. My spending was high due to (i) indulging myself during the en primeur season and (ii) paying a deposit for our holiday at Christmas. I already make accruals against my net worth for holidays, luxuries and tax, so the latter items did not affect the net worth calculation.

For the month, my net worth increased by a staggering 7.45%. Most of the gain came from the combined effect of higher asset values and a weaker US$. The year to date increase is 28.39%. Even allowing for the payout arising from changing jobs, it has been fantastic progress this year.

An unstimulating stimulus package

The Hong Kong government unveiled a very underwhelming stimulus package this week. Given the size of the government's reserves a package worth about HK$16 billion (less that USD 2.0 billion), is a relatively trivial effort towards combating recession. That said, it is refreshing to see a government which does practice a degree of fiscal responsibility (unlike many).

At a personal level, we will benefit from an extension of the waiver on rates (property taxes) for another two quarters and an increase in the tax waiver from HKD 6,000 to HKD 8,000 per person. All in all, it is better than nothing but is not otherwise meaningful. To put this into context, the combined effect of the two measures is about equal to 60% of one monthly mortgage payment on our home.

Now if only the government would take some meaningful action to (i) address pollution and (ii) reduce the cost of the bloated and overpaid civil service.

USD/NZD FX contract entered into

My previous FX contract matured today. Being short the NZD against the USD turned out to be a bad call as the USD depreciated sharply during the contract period. I would have been better off holding the NZD. However, a combination of setting a strike price which was out of the money and the premium received means that in USD terms, I actually came out ahead on the trade (although not by much).

I have entered into a new FX contract:

Currency pair: USD/NZD
Strike rate: USD1.00 = NZD 0.6100
Spot rate: USD1.00 = NZD 0.6214
Annualised premium: 14.265%
Calculation date: 26 June 2009
Maturity date: 29 June 2009

Equity put options written

One of my equity put options written against the Hong Kong Tracker fund (2800) expired today. As the valuation price was below the strike price, the option was not exercised and I pocketed the option premium.

After spending a considerable amount of time doing research, I decided to be more aggressive and wrote put options against Hutchison Whampoa (13) and China Construction Bank (939). In addition, I selected strike prices that were slightly closer to the prevailing market prices than I have done with my previous contracts. Details are below:

Contract #1

Underlying: Hutchison Whampoa (13)
Market price: $50.55
Strike price: $48.65
Valuation date: 23 June
Maturity date: 25 June
Implied yield: 20.58%

Contract #2

Underlying: China Construction Bank (939)
Market price: $4.76
Strike price: $4.57
Valuation date: 23 June
Maturity date: 25 June
Implied yield: 16.548%

In both cases, if I get hit I will have effectively purchased the shares at about a 5% discount to the prevailing market prices.

Hang Seng Bank purchased

I added Hang Seng Bank to the private portfolio paying $97.10. The HSBC subsidiary stock offers an attractive dividend yield of 6.4% (although I expect this to decline a bit this year), pays dividends quarterly (which is unusual for Hong Kong companies), has very little exposure to sub-prime or other toxic products, is showing signs of benefiting from reduced asset impairment issues and is likely to benefit from growth opportunities in the PRC. Importantly, Hang Seng did not have to dilute its capital base in order to maintain a strong Tier 1 capital ratio (unlike its parent). The broker reports I have managed to track down have generally been positive and show valuations meaningfully above the current share price.

Bank deposits drop to 0.001% pa

HSBC announced that the savings rates on Hong Kong dollar deposits would be cut from 0.01% pa to 0.001% pa. That's not a typo - a $1000 deposit will pay $0.01 in annual interest.

The reason for the reduction? Too much money flowing into the banks. For most of us that would be a nice problem to have. But not if you are a bank who has to pay interest to your customers on the money (as well as the cost of administering the account).

The surge in bank deposits and the consequentially ultra low (almost non-existent) interest rates on deposits explains:

1. why the banks are tripping over themselves to make mortgage loans at very low rates (1 month HIBOR + 0.7% currently works out at 0.95% pa on a home loan);

2. why money is flowing into the stock market (the HK Tracker fund currently yields around 3.8%);

3. why the residential property market has bounced back so strongly since the beginning of this year (and why I was unable to find any motivated sellers);

4. why HK$ bonds have such low yields (blue chip HK listed companies bonds with 5-6 year maturities will pay around 2-2.4% - if you are lucky).

In this sort of environment, it is really easy to make a case for putting every spare dollar into equities - on condition that you are prepared to hold for a period of several years if necessary.

As a humorous aside, legislator Chan Kam-lam described the reduction as "outrageous" and urged banks to "take their social responsibilities seriously". All I can say is that this clown has absolutely no clue about anything to do with banking (or any business) and demonstrates why democracy would be bad for Hong Kong.

India's Sensex Index Jumps 17.3%

India's Sensex Index jumped 17.3% this morning before trading was halted. Usually markets halt trading to deal with very large declines. This has to be the only time that I can recall an entire stock market being shut down because of a massive upward movement.

And the cause of the jump? Politics. Prime Minister Singh effectively won the Indian election by taking enough votes to form a government without including the communist party. The expectation is that this will give Singh the ability to implement some much needed reforms - reforms which should have been adopted decades ago.

Needless to say, commentators and analysts are tripping over themselves to predict how much further the market will run when it re-opens tomorrow.

As for the private portfolio, I hold both of the HK listed India ETFs (2810 and 2836) and benefited nicely from today's jump in the underlying index. :-)

Refinancing mortgages

With the mortgage wars having resumed, there are some very cheap financing options available. The best we have come across is from Standard Chartered Bank which offers 1 month HIBOR + 0.7. At current HIBOR rates this equates to about 1% pa. By any measure this is very cheap.

We reviewed each of our mortgages and decided to refinance three of them. In each case we were paying around 2.2 - 2.25%. Reducing the interest cost to about 1.0% will, over the lives of the three mortgages, produce some very significant savings - pretty much enough to pay the school fees for one of our children. Happily, two of the three mortgages are with DBS which has agreed to match SCB's terms so we can refinance without having to involve our lawyers.

We decided that the remaining mortgages were not worth refinancing. A couple are at rates that are even cheaper than what is currently on offer. The remainder are either too small or, in one case, have such a short remaining term, that the benefits of refinancing were negligible.

Debt is a good thing (in moderation)

Many people rant about the negative aspects of being in debt. Where the debt has been racked up to fund an unsustainable lifestyle (overly large mortgages, credit cards with carried balances, payday loans etc), viewing debt as an absolute bad thing is, perhaps, understandable.

I do not share that view. In most cases, the culprit is not the debt but the decisions which led to the debt being incurred. I view debt as a wonderful tool for promoting wealth creation. Here are some examples:

1. borrowing money to finance successful investments can greatly enhance returns. For those with an eye on early retirement, using leverage can add years to the time spent doing more meaningful things than sitting in an office cubicle;

2. credit cards provide a wealth of convenience - saving many trips to the bank or ATM, reducing the costs of spending in foreign currencies, discounts, points etc. And they cost nothing;

3. student loans can fund an education that would otherwise be unaffordable;

4. governments around the world would not be able to afford the stimulus packages they are currently implementing (of course, if they had wasted less of the tax payers money in the good times they wouldn't need to borrow nearly as much).

The other big benefit of debt is that debt enables investors to put money on deposit with banks and buy bonds, CDs and other interest bearing instruments. If debt did not exist, then neither would any of these forms of investment - and for most investors, deposits, CDs and bonds are the least risky part of their investment portfolio.

Of course, unless you are a civil servant, there is no such thing as a free lunch. Debt has a cost (interest) and comes with an obligation (to repay it). Without the interest cost and the obligation to repay, no one would lend money.

As much as I like debt and view debt as a positive thing, the obligation to pay interest and to repay the loan mean that too much debt can be dangerous. In some respects, borrowing money for investments is a bit like drinking red wine: a little is good for you - too much can be detrimental to your (financial) health. The latter is a point that governments who are busy racking up massive amounts of debt should pay more than lip service to - at some stage the money has to be repaid.

Hutchison Whampoa purchased

I added Hutchison Whampoa to the portfolio on Friday paying HK$50.20 per shares. Although the projected 3.4% yield is sub optimal (actually, slightly below the expected yield of the Hang Seng Index as a whole), Hutchison is one of Hong Kong's blue chip stocks with a diversified portfolio of businesses some of which are likely to be relatively unaffected by a recession. From a trading perspective, the stock has lagged the recent rally and, I hope, will play catch up. As an aside, Goldman Sachs placed a buy recommendation on the stock with a price target of HK$61.

Fairwood Holdings purchased

Yesterday I added Fairwood Holdings (52) to the portfolio paying an average of HK$6.65 per share. The restaurant chain offers a high yield (about 9%), although I am not convinced that this will be fully sustainable. However, given that restaurant takings rose slightly in the first quarter, Fairwood has a well established brand in the low cost end of the market place, and a balance sheet which is not overly leveraged, I am comfortable that this will provide a yield comfortably above my expected 5%.

Equity put option rolled over

One of my two outstanding put options written against the Hong Kong Tracker fund (2800) expired today. With the market down nearly 600 points the premiums for writing put options were quite high so I have rolled over the contract:

Strike: $15.56
Market: $16.54
Underlying: Hong Kong Tracker fund (2800)
Implied yield: 13.94%
Determination date: 11 June
Maturity date: 15 June

Of course, if the market goes into free fall, this will be an expensive mistake. That said, the underlying is an index fund - I am enough of an optimist to believe that all I would have to do is wait to recover the money.

As an aside, there are some large cap stocks which look attractive as individual investments. Next time around, I may be more aggressive and write a close to the money put option against an individual stock on the theory that if I get hit, I will have purchased at below the prevailing market price and if I do not get hit, I will have pocketed a much larger option premium.

Underspending

Is there such a thing as underspending? When it comes to personal finance, definitely when it comes to essentials such as health, children's education etc, but otherwise probably not. That said, it is nice to "live a bit" and part of my budget is allocated to luxuries - non-essential things which I allow myself to splurge on without worrying about blowing my savings rate. Examples of spending over the years have included paintings, en-primeur wine, hand woven carpets and an "L" lens for my camera.

Each month I accrue a fixed sum to the luxuries account. (I have a separate accrual for holidays.) Whenever I spend something on luxury items, the cost is deducted from the account. I have been operating this system since 2005. However, with the exception of 2007 when I overspent on wine and carpets, I have consistently failed to spend all of the money which I have put aside. As a result, the balance accrued in the account is now more than double the annual budget for luxuries (even after what I have just spent on this year's en-primeur campaign and replacing my increasingly unreliable iPod classic).

The temptation to make a single handed attempt to stimulate the economy with a spending spree is something I can resist easily enough. If I do spend the money, it will be on something which either has lasting value or which will generate a memorable degree of satisfaction. However, I am struggling to think of anything else other than, possibly, another painting. The reality is that I have most (if not all) of the things I need/want which would fall within the budget. (The Ferrari is, sadly, outside the budget and likely to remain so.)

Of course, I am in no hurry - I can just keep the accrual running and wait until I find something that I want to splurge on. Of course, I could just ask mrs traineeinvestor.....

Investing in indivdual stocks

I have not dealt in individual stocks for nearly ten years due to staff dealing restrictions at my previous employer. My current employer is less restrictive in that I am largely free to deal subject to clearing with a compliance officer first.

My retirement model is based on using income from investments to meet my expenses (i.e. no draw down of capital). This requires that most of my capital be invested in assets which yield a cash flow sufficiently high to meet my living costs. Ideally, there should also be enough assets which have the potential to produce yields that grow over time to keep up with inflation.

Individual stocks have a role to play in the retirement asset allocation in that it is possible to construct a portfolio of stocks which have higher yields than index funds, sovereign bonds, short or medium term corporate bonds or bank deposits. Given that dividends have the potential to rise over time, it seems reasonable to allocate part of my retirement savings to individual stocks.

Of course, there is no such thing as a free lunch (with the possible exception of diversification), and it has to be recognised that individual stocks carry higher risks than investing in bonds, index funds or real estate. For that reason, I have set myself some parameters:

1. no more than 20% of my target number should be invested in individual stocks;

2. I should not invest more than 1% of my target number in any one stock;

3. there is little point in investing less than 0.5% of my target in any one stock;

4. I am investing for longer term yield. It is unlikely that many stocks with yields below 4% will make the final cut and I most stocks should be expected to reach 5% yields within two years of purchase;

5. I should avoid stocks which have high gearing ratios. What amounts to a high gearing ration will depend on the business of the company (compare banks with software companies as an example);

6. if a stock disappoints on yield, it should be disposed of. I do not wish to end up holding unsuccessful investments for long periods;

7. unlike index funds, I will avoid illiquid stocks.

I expect that most of the stocks I end up owning will be mid-caps outside the Hang Seng Index.

I have six stocks which are a legacy of the portfolio I held prior to the previous dealing restriction taking effect. Two of these meet my investment criteria . The remaining four are worth trivial amounts and do not meet my criteria. Three were small holdings that were the result of spin offs from other holdings or life insurance policies and one is a company that came close to insolvency. I will dispose of these four by the end of 2009.

My initial research produced four Hong Kong stocks which meet my criteria. One was on our restricted list. The other three were all PRC toll road operators. Not only do these three companies offer attractive current or prospective dividend yields, but the continued rise in the number of vehicles on China's roads gives reasonable expectations that those yields will rise in the future.

Accordingly, I purchased shares in Jiangsu Expressway (177) at $5.57 and Sichuan Expressway (107) at $2.11. Both are expected to produce yields greater than 5% going forward. I held off purchasing the third stock (Zhejiang Expressway (576) as three stocks in one industry is a bit much at this stage.

Russia ETF purchased

I completed the purchase of an investment in the Russia ETF (2831) today at $20.60. My previous purchases were at $18.10. Notwithstanding the relatively illiquid market resulting in a wide spread, I would have done better to accept the spread and buy more aggressively when I first began accumulating a position in this ETF. Of course, this is only with the benefit of hindsight - if the market had tracked sideways or gone down, my tactic of placing tight limit orders would have been vindicated.

Commodity tracking fund purchased

This morning I added to my investment in the Lyxor Commodity ETF (2809) at $17.42. The purchase was partly motivated by the very early and tentative signs of recovery in manufacturing in China. The greater, but more speculative motivation, was a realisation that the huge run down in inventory levels should be reversed (at least in part) as demand for manufactured goods bottoms out.

An arbitrage opportunity?

I am in the process of refinancing two of my mortgages. The best rates currently on offer work out at about 1.2% pa (1 month HIBOR + 0.7%) which is, by any measure, extremely cheap money. Many investments will offer yields which are materially higher than 1.2% including:

1. the Hong Kong Tracker fund: 4%

2. HSBC long dated bonds: 7.2%

3. many Hong Kong listed shares: dividend yields of 5% or better

4. residential property: net yields of 4% or better

There is at least some temptation to draw down against the equity of some of our properties to take advantage of the yield gap. Of course, this is not a risk free proposition. Taking the HSBC long bond as an example:

A. interest rate risk #1: the mortgage finance is priced at the short end of the money market. The long bond is priced at the longer end. If interest rates rise, the cost of the mortgage will rise while the yield on the bond remains the same;

B. interest rate risk #2: rising interest rates will lower the market value of the bond - meaning there would be a capital loss on resale;

C. credit risk: if HSBC became insolvent (or if its credit rating deteriorated) the market value of the bond would decline;

D. bid offer spread: even if B and C did not eventuate, the Hong Kong bond market is relatively illiquid, meaning that the bid offer spread is wide and a loss would be taken if I decided to sell the bonds;

E. cash flow mismatch: the bonds pay interest only. The mortgage will be P+I which means that there will be a negative cash flow to maintain. (Interest only mortgages are hard to come by in Hong Kong.)

Given that I have a significant amount of cash in the bank, this is somewhat academic but the possibility of taking advantage of the yield gap would otherwise be very tempting.

Monthly Review - April 2009

April was another good month for my investments. Just about every investment I hold appreciated in value. Currency movements were neutral. In addition, I continued to enjoy full rental income from my properties, although lower rental levels started applying this month on some properties.

Here are the details:

1.my actively managed funds all appreciated during the month. I am still holding losses on many of them. I currently have investments in actively managed funds investing in Thailand, Taiwan, Eastern Small Companies, European Small Companies and Vietnam;

2. my index tracking funds were up. I currently have exposure to Hong Kong, India, Taiwan and Russia;

3. my residual equity portfolio appreciated slightly;

4. my commodity investments were static (with an increase in the price of nickel offsetting a decline in the price of lean hogs. I have small positions in the Lyxor Commodities ETF, nickel and lean hogs;

5. all my properties are all fully rented and the tenants are paying the rent on time. I have both a positive cash flow and a surplus of income over expenses (which represents an increase in net worth);

6. currency movements were neutral.

I increased my investment in an India ETF (2836), made a small investment in a Russia ETF (2831) and entered into two OTC option contracts:(i) short USD/NZD (ii) writing a put option against the HK Tracker Fund. At the end of the month I made a further small investment in the Russia ETF and purchased some RMB and USD denominated bonds. The end of month investments have not been included in the balance sheet as the have not settled yet.

Income was low (it will be erratic under the new job) but sufficient to make a small contribution to the gain for the month. My spending was high due to our overseas holiday at Easter. I already make accruals against my net worth for holidays, luxuries and tax.

For the month, my net worth increased by 2.68%. The year to date increase is 19.49%.