Monday, August 31, 2009

Monthly Review - August 2009

To my surprise, August was yet another positive month for my investments.

Small net losses on mark to market investments were more than offset by by favourable currency movements, option premiums and supplemented by positive cash flows from my investment properties.

Income from my job was good and expenses were low.

Here are the details:

1.my actively managed funds were very slightly up. 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 slightly down I currently have exposure to Hong Kong, India, Taiwan and Russia;

3. my equity portfolio fell. I currently have meaningful investments in 20 companies listed in either Australia (3) or Hong Kong (17). I took a trivial loss on a small speculative day trading position;

4. my commodity investments were went up slightly 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. I am now convinced that not only do pigs not fly but they are in fact burrowing animals;

5. my ELDs produced positive returns for the month. I had no outstanding CLDs this month;

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 purchased three Hong Kong shares (China Blue Chemical, Hua Han and Cheung Kong Infrastructure) , took a loss on one small cap (Paradise Entertainment) small short term trade and entered into two OTC option contracts writing a put options against Hong Kong Tracker fund and China Construction Bank.

Income was strong (it will be erratic under the new job) and contributed to the gain for the month. My spending was low due to an absence of major items. The increased mortgage payments resulting from the refinancing completed in June adversely affect cash flow but not net worth as most of the payment is principal.

For the month, my net worth increased by a surprising 2.09%. The gains came from the combined effect of a weaker US$, positive rental income from properties and a high savings rate more than offsetting a small net loss on my other investments. The year to date increase is 55.5%. Even allowing for the payout arising from changing jobs, it has been fantastic progress this year. The possibility of retiring at the end of 2011 is, once again, very real.

Options - what are they used for?

Options can be used for a number of purposes:

1. hedging: buyers or sellers of an underlying asset or holders of an underlying asset can buy or sell options to hedge their exposure to future fluctuations in the price of the underlying asset;

2. speculating: an investor can buy or sell an option as a means of speculating on the future direction of the underlying asset;

3. arbitrage: an investor can use options as a means of exploiting perceived current or anticipated future price discrepancies between underlying assets;

4. yield enhancement: the writing of options can be used as a tool for enhancing the yield on underlying assets.

The rule that there is no such thing as a free lunch applies to options as much as it does to all other forms of investment:

(i) if you write an option you receive a premium but have to post security and undertake to buy or sell the underlying asset at the agreed price if the buyer exercises the option. In simplistic terms, the writer is being paid a small but certain sum against the possibility of incurring a much larger loss;

(ii) if you buy an option you receive the right to buy or sell the underlying at your election but have to pay the option premium to the seller. In simplistic terms, the buyer of an option is paying a small but certain cost against the possibility of earning a much greater profit.

As mentioned in my previous post on option basics , the value of an option will depend upon (among other factors), the difference between the market price and the strike price, the volatility of the underlying, interest rates and the time left until expiry.

It is crucial to remember that an option has a finite life. When the expiry date arrives it must either be exercised or expire worthless. This means that (other things being equal) the value of an option will decay as the expiry date approaches. I am told (repeatedly) that the majority of options expire worthless.

There are a wide variety of strategies available to investors which involve options. As a relatively unsophisticated retail investor, I use only two:

1. yield enhancement: I write options as a means of enhancing yield on cash balances;

2. long or short equity speculation: I buy call or put options in anticipation of making speculative profits.

I will discuss each of these in future posts.

Friday, August 28, 2009

One ETF to avoid (for now)

For many years Hong Kong has been plagued by a lack of low cost, no load index funds. Investors were faced with choosing between funds with outrageous front end loads and high expense ratios, searching for overseas products (which would often not be sold to Hong Kong residents) or doing it themselves. The typical equity fund charged around 5% front end load and cost about 3% pa to run - it is no wonder that Hong Kong had a relatively low penetration rate for such products.

Gradually this has changed, beginning with the the Hong Kong Tracker fund in November 1999. Deutsche Bank is the latest institution to list some ETF's on the Hong Kong stock exchange. As an investor, I view this as a very welcome addition to the range of products available to me.

There is one product in the range which I will avoid - the db x-trackers US Dollar Money Market ETF. The problem is simple - the current yield of 0.11% is so low that it cannot compensate for either the effect of the bid ask spread (HK$170.80 - $171.10 or 0.176%) or the typical transaction costs (brokerage, stamp duty etc) , let alone both of them combined, unless you invest for a very long period of time (years). In fact if you invest for long enough for the yield to exceed the spread and the transaction costs, you would probably do better with bank deposits and would definitely do better with short term bonds.

While I will consider adding some of the Deutsche Bank ETF products to my portfolio after I have completed the new property purchase, at current interest rates I will pass on the US Dollar Money Market ETF. If interest rates start rising I will revisit (but may well prefer to prepay mortgages in that scenario).

Options - the basics

In response to a query, I have set out a basic summary of options. The next post will discuss the role which options play in the private portfolio.

How they work

Options are contracts which give one person the right (but not the obligation) to buy (sell) an underlying asset at some point in the future at a price which is fixed at the time the contract is entered into (called the "strike price"). The seller of the option (referred to as the "writer") has the obligation to sell (buy) the underlying asset at the agreed price if and when the buyer exercises the option.

The buyer will only exercise the option if the underlying asset is worth more than the agreed strike price at the time of exercise. If the underlying asset is worth less than the strike price at the time of exercise, the buyer will not exercise the option. At the time the option contract is entered into the buyer will pay the seller a sum of money in exchange for these rights (called the "premium"). The seller gets to keep the premium regardless of whether the option is exercised or not.

Terminology and variations

Call option: the right given to the buyer is a right to buy the underlying asset

Put option: the right given to the buyer is a right to sell the underlying asset

Exchange traded options: the options are traded on a stock exchange. These options will typically allow for buyers and sellers to close their position prior to expiry/exercise by entering into an opposite contract

Over the counter (OTC) options: the options are not traded and represent a private contract between the buyer and seller. Typically it is not possible to unilaterally close out an OTC contract before exercise/expiry

Expiry: options have an expiry date. If they are not exercised or closed out before the expiry date, they lapse. Some cash settled options may exercise automatically if they are in the money on the expiry date

Settlement: on exercise, options may be physically settled or cash settled. Physically settled options will result in the underlying asset being delivered against payment of the strike price. Cash settled options are not settled by delivery of the underlying asset but by payment of the difference between the strike price and the market price at the time of exercise (if this is negative then no payment is made)

American style/European style: an American style option can be exercised at any time prior to expiry. A European style option can only be exercised on the expiry date. Most exchange traded options are American style. Most OTC options are European style

Collateral: sellers (writers) incur future liability. OTC counter parties and stock exchanges which offer exchange traded options will require a person writing options to post collateral before allowing the option to be delivered

Underlying: the asset which is the subject of the option. Underlying may be shares, ETFs, bonds, commodities, currencies or intangibles such as indexes

Premium: the amount paid by the buyer to the seller in exchange for the future right to buy (or sell) the underlying. The seller gets to keep the premium regardless of whether the option is exercised. The size of the premium will depend upon (among other factors), the difference between the market price and the strike price, the volatility of the underlying, interest rates and the time left until expiry (duration)

Strike price: the price agreed today at which the option may be exercised in the future. The strike price may be above, at or below the current market price

Covered option: an option where the seller holds the underlying asset

Naked option: an option where the seller does not hold the underlying asset

Next up - what I use options for and why.

Thursday, August 27, 2009

Equity put option written

Last month's equity put options written against China Construction Bank and Hutchison Whampoa expired unexercised.

I have rolled the money over into an equity put option against the Hong Kong Tracker fund (2800). Given current market conditions, I have gone with a conservative underlying and a relatively conservative price. Here are the details:

Underlying: Hong Kong Tracker fund (2800)
Market price: $20.60
Strike price: $19.58
Valuation date: 25 September
Maturity date: 28 September
Implied yield: 9.44%
Net purchase price if exercised: $19.43

In effect, if the option is exercised against me I will end up purchasing Hong Kong Tracker fund at a discount of 5.7% to the current market price.

Tuesday, August 25, 2009

New property purchased

In spite of the rise in property prices, I have kept looking at properties for investment. With interest rates being as low as they are (below 1% on mortgages and zero on bank deposits), even a modest yield from real estate looks attractive.

I looked at a number of properties before putting in an offer on a property being sold as part of a bankruptcy proceeding last month. It would have been a bargain apart from one small detail - the trustee in bankruptcy (i.e. the government) did not have the title deeds and expressly disclaimed any liability for providing them. In effect I would have no assurance that I would get title to the property, would not be able to get a mortgage and would not be able to sell the property. Needless to say, that offer was quickly withdrawn.

The second property I tried to buy was sold before my offer was submitted.

On Sunday afternoon I looked at some more properties and put in an offer on one which I thought was good value in the current market. After some haggling the offer was accepted last night. The next steps are:

1. get finance - I have started shopping around for a mortgage. Even with a mortgage I will need to sell some of my equity investments to complete the purchase;

2. get quotes for refurbishment - I am asking for quotes for (i) basic fit out and (ii) full luxury remodeling. I will then run the numbers and see which makes the most sense.

As a rental proposition, the apartment may rent best with a carpark (which it does not have). I will look into buying a car parking space separately.

Wednesday, August 19, 2009

Equity Put Option Written

Last month's equity put option over the Hong Kong Tracker fund (2800) expired unexercised.

Once again, I have rolled the contract forward for another month, this time using China Construction Bank (939) rather than the Tracker fund. However. I have been less aggressive and used a strike price a bit further out of the money and accepted a smaller option premium as a result. The reason for using a specific stock is that the premium offered was materially higher than the premium on the Tracker fund.

Details are as follows:

Underlying: China Construction Bank (13)
Market price: $5.81
Strike price: $5.47
Valuation date: 17 September
Maturity date: 21 September
Implied yield: 10.24%
Net purchase price if exercised: $5.43

If I get hit I will have effectively purchased the shares at about a 6.5% discount to the prevailing market price.

Tuesday, August 11, 2009

Book Review: The Match King

The Match King is a short summary of the life of Ivar Krueger (aka "The Match King") and what was the largest financial scandal of the 1920s and 1930s. In inflation adjusted terms, the rise and fall of Krueger and his main companies (International Match, Swedish Match and Krueger & Toll) is comparable with the likes of the current era's Enron, World Com and Madoff scandals. Krueger's activities were a significant contributor to the introduction of the Securities Act.

Krueger either built or purchased many businesses in his lifetime. Of these, he is best known for the match businesses he purchased in many countries. Where possible he preferred monopolies. His standard deal was to offer countries large loans on favourable terms (usually below market interest rates) in exchange for a monopoly on the manufacture and distribution of matches. Such monopolies were illegal in relatively few countries at the time and Krueger succeeded in obtaining the monopolies he sought in many countries, including his native Sweden, Germany, France and Poland.

The catch was that Krueger did not actually have the ability to fund the loans from his own resources so he raised it by issuing securities to American investors (initially on the curb market and later on the New York Stock Exchange). By offering what were some of the more innovative structures available at the time, Krueger was able to raise the funds needed for the government loans. The problem was that he had promised investors higher rates of return than he was getting from his loans and the profits on the match monopolies and other businesses were not enough to bridge the gap. With extensive shuffling of assets between companies, Krueger managed to keep his empire afloat until 1932 when the effects of the great depression eventually caught up with him.

By today's standards, Krueger was undoubtedly dishonest. By the standards of the era in which he lived many of the things he did in the advancement of his business interests were common practice. What made Krueger different was not only the scale of his operations and his international reach, but also the sophistication of his business dealings.

It would be simplistic to simply describe Krueger as a (very much) larger version of Charles Ponzi. Krueger left behind him many valuable and profitable businesses, well constructed buildings and an impressive art collection. There was no evidence that he siphoned off money - he would avoid both his creditors and investigators by taking his own life. It is also worth noting that even at depression era fire sale prices, the assets of his companies realised enough to return investors something like a third or more of of their investment - which was a lot more than many supposedly legitimate businesses which raised capital during the 1920s boom.

Frank Partnoy provides a well written book, but one that left me wishing for a bit more depth on the individuals involved. Some pictures would have made a good addition to the book.

Monday, August 10, 2009

Statistics - PRC style

The latest in the Rio v PRC iron ore soap opera is China's claim that the "spying" by Rio staff have cost Chinese steel industry US$100 billion over the last six years. No explanation has been given for how they reached this number, but given that the total of China's iron ore exports over that six year period also came to about US$100 billion, the sellers of iron ore to China would have had to give their product away for the last six years in order to justify China's claims. Somehow, I just can't see that happening.

For those who have not seen the annual phenomena of the sum of the GDPs of China's 31 provinces and municipalities exceeding the national GDP this makes interesting reading and effectively casts considerable doubt over most statistics coming out of the PRC.

Tax breaks for MPF? No thanks

Fund managers have lamented the low rate of voluntary contributions to the MPF scheme (Hong Kong's mandatory retirement scheme). Suggestions have been made that higher rates of contribution would be achieved if tax breaks were given for voluntary contributions.

The blunt reality is that the MPF scheme is successful at one thing and one thing only - the destruction of investor wealth. The fees are outrageous enough to embarrass Bernie Madoff (not that I have been able to work out what those fees actually are - MPF providers are adept at making it next to impossible to do this) and the performance has been nothing short of pathetic. After (about) a decade of dollar cost averaging into two of the available choices my investment is still worth less than my contributions - a lot less. The same exercise into a comparable actively managed equity fund would have done better (and using low cost index funds much better).

To put it in plain English: MPF sucks.

It is so bad, I do not know a single person who has ever made a voluntary contribution.

Even if I could get 100% tax deduction on voluntary contributions - I would still not put a single extra dollar in. A 15% tax break would not even come close to compensating for the ridiculous fees and lousy performance.

As a taxpayer I support the concept of a mandatory retirement scheme. Something along the lines of America's 401K plan or the Australian model would be worth implementing. But the MPF scheme is has been a disaster for Hong Kong's savers.

Friday, August 07, 2009

Hua Han purchased

This morning I added Hua Han (587) to the private portfolio paying HK$1.00 per share.

Hua Han's main business is the manufacture and distribution of pharmaceutical products and feminine hygiene products. Given the expansion of the the PRC health care sector and the continued growth in the number of middle class households in China, this can be expected to be something of a growth industry. Unlike many other Hong Kong listed companies, management has remained focused on its business and resisted the urge to use shareholders' funds to speculate in the stock market.

The company is trading on a single digit PE ratio (7.2x historically but this will be diluted by the recent capital raising) and has a considerable amount of net cash on hand. A minor negative is that the company has flagged that it is looking to expand by way of acquisition which is not always a good thing. The latter may account for the fact that the company does not pay a dividend.

Wednesday, August 05, 2009

Cash for clunkers - deeply flawed

The cash for clunkers program is a classic example of bad policy. Very bad policy.

No matter which way you approach the program, it is nothing more than a transfer of wealth from taxpayers (or more accurately the children and grandchildren of today's taxpayers) to car users. In effect one group of citizens (taxpayers) are being asked to subsidise the discretionary consumer spending of another group of citizens (car owners).

Unlike many other areas of government spending (e.g. welfare, essential services), this is morally indefensible.

The benefits to the various components of the car industry are, at best, a debatable a side issue.

If the objective was to improve the environment by replacing high mpg cars with lower mpg cars, then the program is flawed. There are much more cost effective ways of achieving the same or better environmental results.

Tuesday, August 04, 2009

China Blue Chemical purchased

This morning I added China Blue Chemical (3983) to the private portfolio paying $4.72 per share. China Blue Chemical manufactures a number of chemical products, including fertilizers. The company has a clean balance sheet with net cash on hand. Recent small acquisitions indicate that the company is looking to grow vertically (presumably with the intention of deriving associated cost benefits as well as securing raw material supplies). The earnings valuation is not demanding (trailing PE of 11.6) although the dividend policy of distributing only 20-30% of profits results in a rather low dividend yield of around 2.3%.

CKI Holdings purchased

This morning I added CKI Holdings (1038) to the private portfolio paying HK$28.60 per share. CKI Holdings is a diversified infrastructure investment company. The portfolio consists of investments in electricity, bridges, toll roads and water as well as companies which supply goods and services to infrastructure companies.

The company offers a solid 4% dividend yield and a decade long track record of steadily rising dividends.

Monday, August 03, 2009

Independent financial advisers - mythical creatures

There is no shortage of people in Hong Kong who tout themselves as "independent financial advisers". They will claim that they are independent of large (or any) financial institutions. This is nothing short of an outright lie. If they are taking a commission (or other payment) from an institution they cannot be independent and should be prohibited from holding themselves out as such.

The only financial advisers who can legitimately claim to be independent are those whose only income from their relationship with their client is paid for by the client as a fully disclosed fee. These advisers are known as "fee only" advisers. Unfortunately, I have been unable to find such a person in Hong Kong and have concluded that, like the Easter Bunny, such creatures do not exist here.

The reason for the search is that, as my target retirement date draws closer, I would like an independent professional to take a good hard look at our finances, our financial projections and our retirement plan. I want an independent sanity check before I join the ranks of early retirees to give myself maximum comfort that (i) I will not have to re-enter the workforce at a later date and (ii) we will not have to compromise on our living standards.

I do not trust the so called IFAs and the wealth mangers at many banks whom I have encountered. With only very limited exceptions, all have essentially offered me insurance/annuity products which only a moron would buy, high front end load funds with high expense ratios (often with long lock ups) and similarly unattractive products which are designed for the sole purpose of making other people rich at my expense. Most of them ask only basic questions about my financial background and objectives (or none at all) and only once I has a so called financial planner talked about asset allocation. Most do not even ask about wills and medical insurance. The last person I wasted time speaking with gave some of the most outrageously bad advice I have come across.

The limited exceptions are people selling specific products (like overpriced off the plan property developments and futures trading accounts) which are typically equally good wealth destroyers. The only piece of rubbish no one has tried to sell me (yet) is a time share.

How hard can it be to find a competent fee only financial planner in one of the world's financial centres?

Saturday, August 01, 2009

Monthly Review - July 2008

July was yet another hugely positive month for my investments. Solid gains in all asset classes were amplified by favourable currency movements and supplemented by positive cash flows from my investment properties. Income from my job was good and expenses were low. From a financial perspective, everything went my way this month.

Here are the details:

1.my actively managed funds were up. 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 equity portfolio appreciated strongly. I currently have meaningful investments in 17 companies listed in either Australia (3) or Hong Kong (14). I also have some smaller residual positions dating back many years and two small speculative day trading positions which, collectively, are not meaningful;

4. 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. I am now convinced that not only do pigs not fly but they are in fact burrowing animals;

5. my ELDs and CLDs produced positive returns for the month;

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). A bill for fixing a leaking pipe did not change this;

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

I purchased two Hong Kong shares (China Gas and Herald Holdings) , took a loss on one (South Sea Petroleum), did two small short term trades at small profits and entered into four OTC option contracts:(i) short GDP/HKD (ii) writing a put options against Hong Kong Tracker fund, China Construction Bank and Hutchison Whampoa.

Income was strong (it will be erratic under the new job) and contributed to the gain for the month. My spending was low due to an absence of major items. The increased mortgage payments resulting from the refinancing completed last month adversely affect cash flow but not net worth as most of the payment is principal.

For the month, my net worth increased by an impressive 5,8%. The gains came from the combined effect of higher asset values, a weaker US$ and a high savings rate. The year to date increase is 52.3%. Even allowing for the payout arising from changing jobs, it has been fantastic progress this year. The possibility of retiring at the end of 2011 is, once again, very real.