Sunday, July 30, 2006

Save Money - Do Not Buy From Amazon

I read a lot of books, although not as a many as I used to do before we had children. Amazon has a lot to offer, most notably an inventory which is much much bigger than any book store in Hong Kong. Frequently, the discounted price of the books on offer will be competitive. However, it is expensive once the cost of shipping is taken into account.

When I find a book that I want which my local book store (Dymocks) does not have in stock, I simply ask them to order it for me. I do not have to pay for shipping. Delivery time is similar to Amazon and the price is less than Amazon's price + the shipping I have to pay when ordering through Amazon.

Saturday, July 29, 2006

Principle #6 - Challenge Assumptions and Beliefs

All financial plans and investment decisions are made on the basis of a number of assumptions and beliefs. Assumptions and beliefs are not facts. They cannot be taken for granted. With the benefit of hindsight they may be proven wrong. They may be just plain wrong and, with a little thought, can be seen to be wrong even without the benefit of hhindsight. A little time spent identifying and evaluating the assumptions that are being made (expressly or implicitly) and the beliefs held can prevent costly mistakes from being made and help identify opportunities.

Several examples can be found in calculating the amount of money a person or couple will need in order to support themselves in retirement. The calculation is usually based on the following factors (among others):

1. your life expectancy;

2. your cost of living (typically being either a budgeted amount or a percentage of current expenditure);

3. the rate of return on your investments;

4. the rate of inflation.

Each of these factors contains a number of assumptions including:

1. your life expectancy: you could live longer than the actuarial tables suggest - they are, after all, average life expectancies. With advances in medical science and some healthy living,you could live a lot longer;

2. your cost of living: many plans assume that your cost of living will be less in retirement than when working. This will not be true for everyone. Medical expenses will probably be higher. You may take up some new hobbies or travel more and so on;

3. the rate of return on your investments: most plans assume and average rate of return based on historic rates of return. This is a seriously flawed way of preparing a financial plan. An average is just that - in some years the return may be above the average and in some years it may be less than the average (or even negative). If a plan relies on draw down of capital, then below average returns (even if still positive) in the first few years can destroy the plan. Money that would have lasted 30 years if the average return had been achieved every year can run out in 20 years or less with just a year or two of below average returns at the beginning. Above average returns later on will not rectify the problem;

4. inflation: even if you believe that CPI numbers represent the true rate of inflation, why assume that your personal living expenses will rise in line with the average inflation rate? Medical expenses, rates, utility charges and travel expenses (all big budget items for retirees) have risen faster than the official rate of inflation in recent years.

As worst case example, if life expectancy is underestimated, cost of living is underestimated, the return on investment is over estimated and your personal inflation rate is underestimated, the combined effect on the amount needed to fund retirement is huge. Given that we cannot predict the future with any degree of certainty, this is one of the reasons why I have opted for a "no draw down" retirement plan.

A similar analysis can be made for individual investments as well.

One of the problems with this sort of thinking is that it can lead to decision making paralysis. It is helpful to remember that challenging assumptions and beliefs is intended to help make better decisions, not to provide and excuse not to make any decisions at all.

Thursday, July 27, 2006

Principle #5 - Understand the Meaning of Time

Time is a commodity that affects almost every aspect of financial planning and investing. At times time is an ally and at times it is a remorseless enemy.

Time affects our financial planning and investments in many ways. For some purposes it is a commodity that can be purchased and sold. Think of a time deposit. You are lending your money to the bank for a period of time. The time which you commit to let the bank have the use of your money is a commodity as much as the money itself. The longer you leave your money on deposit the more interest the bank pays you. Usually the rate of interest will be higher for longer term deposits as well - reflecting the longer time commitment made. Similar considerations apply to the pricing of many other investments including bonds, stocks, options and futures contracts.

Time affects financial planning in many other ways as well. Compounding is one example. The more time investments have for returns to compound the greater the value of the final investment. Compounding is largely a function of time - the longer the time period the greater benefits of compounding are likely to be.

Another example is our lives. The amount of time we have to accumulate savings for retirement and the amount of time we expect to spend in retirement are two of the six critical factors which define how much we need to save for our retirement, when we can retire and what standard of living (financially) we will have in our retirement. (The other four critical factors are our savings rate, the return on our investments, inflation and expected income from other sources such as Social Security). Ultimately, it is time that dictates the advantages of starting to save for retirement early in life.

Thinking about how time affects my financial planning and my investments has had a significant influence over my investment behaviour and financial management.

Principle #4 - Avoid Unnecessary Erosion of Value

Investments are vulnerable to many evils. Among the most insidious are fees, charges and other things which, at first glance, appear to be small and insignificant. In reality, they are neither small nor insignificant and can have a massive negative effect on the value of investments. Ultimately these "small" things can have a material adverse impact on when and how you retire and your standard of living.

Let's look at some examples.

1. Front end load. If anyone tries to sell me an investment that has a front end load, my immediate reaction is to invest somewhere else. If you have a choice between two investments: Fund A and Fund B. Each fund is projected to earn 8% per annum compounding monthly. Fund A has no load. Fund B has a 1% front end load. You decide to invest US$500 per month into each fund. The amount of your investment will be increased in line with inflation of 3% per annum. That sales charge doesn't look too bad does it? It's only $5.00 per month. Fast forward 30 years to retirement and we see that the value of your US$180,000 investment in Fund A has grown to US$1.225 million while the value of Fund B has grown to US$1.017 million. That US$5.00 per month made a big difference in the end. Similar principles apply to management fees and any other charges that are being deducted from your investments. Fight these things.

2. Idle money. I am frequently guilty of leaving money lying around. No, not in stacks for my children to play monopoly with but in bank accounts that either earn sub-optimal rates of interest or, worse, none at all. Money comes in from a variety of sources and ends up in various bank accounts in different currencies (one of the joys of being an expat). Eventually it gets utilised, but often it takes time - typically months - before I get around to using it and even longer before I use it in the most productive manner. In one case I found I had several hundred dollars sitting in an account earning no interest for nearly a year. None of the amounts are large (possibly excepting my salary and term deposits at sub-optimal rates). However, if I add them all up, take into account the time the money is sitting unutilised or underutilised, look at what the money could have done had it been applied more productively and factor in the effects of compounding, the numbers are very meaningful. In my particular circumstances, I worked out that over a ten year period more efficient management of cash balances could have reduced the term of one of my mortgages by a several years. Over a twenty five year period I could just about have purchased a (very) small investment flat and repaid the mortgage. How much difference to your retirement would the income from an additional investment property make? That's decent holiday in Europe each year for Mr and Mrs Traineeinvestor.

I now regularly spend time reviewing the small stuff. I sweat the small stuff. Take a few small gains here and there, add the power of compounding, and the results can be truly impressive.

Monday, July 24, 2006

Principle #3 -Understand the Risks

When it comes to making investment decisions many people (including the traineeinvestor) are apt to focus on the potential rewards. To an extent this is only natural - there has to be a belief that an investment will prove to be profitable before we will part with any of our hard earned money. In analysing investments, risks generally get less attention than rewards. This is often a mistake. Professional wealth managers try very hard to produce portfolios that have low volatility (i.e. limited risk).

The old saying that there is no such thing as a free lunch applies as much to investments as it does to other aspects of our lives. One of the most basic rules of the investing universe is that economic rewards can only be achieved by accepting exposure to economic risks. (The relationship is not necessarily a linear one.) Also, the higher the potential rewards the higher the risks which must be accepted to try and achieve those rewards. Even the most secure of investments carry risk. As an example, Treasury bills (often used as a surrogate for the risk free rate of return in financial models) carry risks that are not properly understood. These include:

1. reinvestment risk: the risk that interest rates will drop and it will not be possible to reinvest in securities that will offer the same return;

2. inflation risk: the risk that inflation will erode the real value of your investment;

3. currency risk: if your "neutral" currency is not the US$;

4. opprotunity cost: the cost of not being able to invest the money invested in this investmet in a better investment.

All investments can be analysed in these terms. The next step in the process is to consider the probability of each of the risks occuring and to quantify the extent of the capital at risk should the relevant event transpire. My personal experience is that this is more art than science - maybe smarter people than me can do a better job - but I find that I am often guessing (especially on the probability of occurance question). I do pay very close attention to investments which carry certain risk characteristics:

1. gearing (e.g. leveraged property) ;

2. wasting assets (e.g. options);

3. long lock in periods (e.g. term deposits);

4. high exit or entry fees (e.g. property).

Planning how to respond to certain risks should they eventuate is a key part of any investment decision. Sometimes it can be as simple as setting a stop loss order on a trade when it is entered into. Other investments may require a more sophisticated approach.

A last point about risk is that it needs to be considered in terms of both individual investments and the potfolio as a whole. Professional investors and managers love to include investments which show returns which have low correlation with the general direction of the markets in their portfolios as a means of managing risk.

Sunday, July 23, 2006

Principle #2 - Have a Back Up Plan

I previously wrote that having a plan was a fundamental part of financial planning and investment. Even with the best plan in the world, things can and will go wrong. The blue chip growth stock you purchased ends up in Chapter 11 (Enron) , the market drops 20% in a week (October 1987), the stock market experiences a 14 year decline (Japan) etc. Bad things happen in the world of finance just as they do in other parts of our lives.

Spending some time thinking about things that could go wrong and having a back up plan to deal with contingencies is also a good idea. Having a back up plan serves at least three useful purposes:

1. it preserves self confidence. When your investments head south, it is not only the balance sheet that suffers. If there is one thing that investors and do it yoursef financial planners must have, it is the confidence to back their own judgement. Without that things get a lot harder. Stress levels would probably go up as well;

2. if the back up plan is good, then your ability to react quickly and appropriately will be enhanced. It is easier to make sound decisions when you are not experiencing the stress of an investment turing out badly than when it was all gone horribly wrong;

3. preparing a back up plan forces you to look hard at the risks associated with your financial planning and investments before you put your money on the table.

An example of a back up plan for a long range financial retirement plan is here .

Saturday, July 22, 2006

Principle #1 - Have a Plan

Having a plan is a fundamental part of personal finance and investing. Financial planning without a plan can be chracterised as good intentions resulting in random investing. The absence of plan will often lead to a loss of focus. Specifically, without the discipline imposed by having a plan (and executing it) there will be delays. Given my view that time is one of the most critical influences on financial planning and investing, delay (or procrastination) is usually a bad thing.

Financial plans come in all shapes and sizes. Some are good and some are bad. Some are simple and some are complex. Even the most simple of plans can be sound. For someone who does not want to spend more than a token amount of time on their personal finances, a simple yet effective plan could be to automatically have a fixed percentage of monthly income paid directly into a life cycle fund. Its a plan and in the right circumstances it could be a very good one.

A plan should be in writing.

My own approach to planning is:

1. keep a balance sheet of assets and liabilities. This should be updated on a regular basis. My earlier post on this stage of the planning process is here;

2. work out what the long term goal is. A common goal is putting aside enough money to maintain a desired standard of living in retirement. An earlier post on evaluating long term goals is here;

3. work out a strategy for getting from the current position to the desired future position. An example is here . A budget should form part of this stage of the process as will an investment strategy;

4. conduct periodic reviews of 1-3 above including each of the assets and liabilities contained in the balance sheet. One of the most important part of a review is to take a good hard look at the assumptions underlying your plan. If the assumptions on which the plan was made have proven to be incorrect then the plan may need to be revised.

A plan will not be static. It will need to be updated from time to time.

One important point to bear in mind is reality. A plan that is overly ambitious has a much greater probability of failure than a more modest plan. My own plan written in January of this year runs for 13 pages. It could easily be reduced to half that length. It is also now six months old and needs to be reviewed.

My earlier post on planning is here .

Friday, July 21, 2006

Investment principles 1-20

As an active investor I spend a lot of time reading about, well, investments and personal finance. There are many theories and approaches out there. Some are obviously better than others. Some of the material that gets published is rubbish. Some is excellent. I reached the conclusion a long time ago that one of the most important things about investing is to formulate some clear principles to use as guidance in managing my investments. While I had a lot of thoughts about what worked and what didn't, I never attempted to put those thoughts in writing. In an effort to be more disciplined in my financial planning and to improve my investment decision making, I have now done so. Here they are:

1. Have a plan. Saving and investing should not be a random process.

2. Have a plan for when things go wrong. Murphy's Law applies to investing as much as it does to everything else.

3. Understand the risks as well as the rewards for each investment and the portfolio as a whole.

4. Understand the costs, charges, fees and other ways in which the value of your investments can be eroded.

5. Understand how time affects you and your investments.

6. Rigorously challenge all assumptions and beliefs.

7. Stress test your investments and your portfolio.

8. Understand the role that external and internal influences play in your decision making.

9. Be passionate about investing, not your investments.

10. Remember that small things are meaningful. A penny saved is $0.01 * (1+((100-marginal tax rate)/100)) earned. A penny saved and invested each day for 40 years is....well, you get the picture

11. Listen to other people, but do your own thinking.

12. Nobody is as interested in your financial well being as you are. Be vigilant. Scams abound.

13. Be open to new ideas.

14. Be willing to admit that mistakes will be made...and must be dealt with sooner rather than later.

15. Procrastination will usually cost you money.

16. Invest in your education.

17. Stay focused when things are going badly.

18. Diversification is mostly good.

19. Keep good records.

20. Every investment should have a purpose, an objective and a clearly understood basis for its selection.

I did come up with a lot more but decided to limit the list to 20. I did try and rank the principles in order of importance, but decided that it was a task that was too subective to be meaningful. Consider the order random. Also, some of the principles overlap or a closely related with each other. An attempt to group the principles fell into the "too hard" basket and was quickly abandoned.

In a fit of enthusiasm, I intend to say something about each of these in future posts.

Thursday, July 20, 2006

Gold - not a logical investment

Many advisers advocate having a portion of any portfolio invested in gold. I fail to understand why.

Over the longer term, gold has underperformed most of the mainstream classes of assets. Shares, property and bonds have all been better places to keep your money than the yellow metal.This is based on data going back to the 1930s. Sure, there have been occasions when gold has outperformed many other asset classes - but these have been rare (1979-1981 and 2003-2006) and the returns during this time have failed to compensate for the dreary return the rest of the time.

Gold is supposedly a hedge against inflation. Gold advocates point to the depreciating value of paper currencies as reason for buying gold. Often the arguments compare the price of gold against the value of a currency and adjust one or both numbers to reflect changes in purchasing power due to the effects of inflation. However, the analysis is often flawed as it does not make allowance for the return that would be earned on the paper currency in the period under review. Even a relatively modest return would show the paper currency doing better over the very long term (although taxes for some investors would affect the comparison).

Using selective time periods it is possible to produce numbers which show gold doing better than interest based investments - sometimes by a big margin. Using other selected time periods, you could show cash under the mattress outperforming gold. The point being that if gold is supposedly a store of value, it should be a reliable store of value. This is a test which gold fails. People who had the misfortune to invest near the peak of the last gold bull are still waiting to get their money back. They also would have missed out on the massive bull markets in stocks, bonds and real estate that served investors so well for most of the next two decades. People may wish to protect the real value of their investments, but over very long term periods, there are better options than gold. Over shorter periods, returns on gold are highly variable.

Gold's lacklustre performance over the last few weeks also calls into question gold's reputation as a safe haven in a crisis. At a time when world oil supply is barely keeping up with demand and a number of key supply sources are vulnerable to disruption, a shooting war in the Middle East should have given the price of gold a lift. It didn't - gold actually dropped. Instead investors flocked to the US$.

Most assets derive value from the fact that they can be used for something or produce a stream of income. So what gold is actually used for? The answer is not much. A huge portion of the gold produced annually is simply hoarded for investment purposes. Very little is used for industrial purposes. Add to this the fact that most of the gold ever produced is still in existence (a lot of it sitting in bank vaults) and I have to wonder why gold is priced as highly as it is? It seems to me that gold derives much of its value from the fact that people think it is valuable or because they find it pretty to look at. I certainly cannot see gold has having an intrinsic value which justifies its current price.

Maybe I am missing something here, but I really just do not understand why so many people advocate gold as a core investment.

Sunday, July 16, 2006

Studies in Wealth - John D Rockefeller

This is the first of a planned series of posts about people who make interesting (at least in my view) studies in the creation or destruction of wealth. I have chosen John D Rockefeller as the first subject for the simple reason that he amassed what in real terms was probably the largest personal financial fortune of the modern era. By some estimates, his inflation adjusted wealth exceeded US$200 billion - almost 4 times Bill Gates' current worth.

John D Rockefeller is, in a word, a controversial figure. There are things to admire and things to revile. Whatever else may be said for or against this titan of the American industrial age, the impact he had on business in America was unprecedented during his life and has not been matched since.

Born on 8 July 1839, John D Rockefeller started life poor. At the age of 16, Rockefeller gained paid employment as an "apprentice bookkeeper" in Cleveland. After a series of promotions, Rockefeller left to establish his own produce commission business in partnership with Maurice Clark. Business profits were invested in other local Cleveland businesses. In 1863, he made his first investment in the oil industry - specifically a small oil refinery. At that time in history, the oil industry was a chaotic place characterized by many small operators and intense price competition. Within a short period of time, Rockefeller's business interests had become focused almost exclusively on the oil industry and in 1870 Standard Oil was formed as a partnership. Apart from John D Rockefeller himself, Henry M. Flagler was the most significant figure in the transition of Standard Oil from a small partnership into an industrial giant that so dominated its industry that it lead the United States Government to introduce what is now known as "anti-trust" legislation.

Standard Oil's business methodology could be described (perhaps overly simplistically) as having two objectives. The first was the relentless reduction in costs (something it had in common with other industries of the time). The second was the systematic removal of competitors - either by buying them out or forcing them out of business. Rockefeller himself believed strongly that competition was waste and this appears to have been a key driver behind his pursuit of a monopoly in the oil industry. The relationship between Standard Oil and the railway industry (which spent decades destroying shareholder value through intense competition) is itself a fascinating aside to the Standard Oil story. By the late 1800's Standard Oil effectively held a level of pricing power that enabled it to dominate its markets in refining, transportation and distribution of oil within the United States. By 1911 Standard Oil effectively controlled an estimated 64% of the oil industry in the United States. The rise of Standard Oil was followed by a period of decades of political and public opposition that eventually cumulated in the 1911 Supreme Court decision that required Standard Oil to be broken up into 34 separate companies. It is an indication of the sheer scale of Standard Oil that several of the companies created by the break up were among the largest companies in the United States - including Conoco, Amoco, Chevron, Exxon, Mobil, Sohio.

Independently from his career as a business man, Rockefeller was a deeply religious man. He became a deacon of the Baptist Church at the age of 19 and, at an early age tithed 10% of his income to charity. Religious (baptist) and educational causes dominated his philanthropic endeavors. At a personal level, Rockefeller lived a simple life free of vices. He was noted for his abstinence and his generally active and clean lifestyle. Another point which stood out was that he married once only and generally lived a quiet life away from the society pages.

As an investor, the two most significant lessons I took from the story of John D Rockefeller were that anyone can succeed financially with a willingness to work hard, save money and to take the risk of investing their savings. The second is that there is considerable advantage in investing in businesses that are able to command a degree of pricing power.

For further reading: Titan The Life of John D Rockefeller, Sr by Ron Chernow.

Saturday, July 15, 2006

Book Review: The Next Big Investment Boom

I started reading this book with a certain degree of scepticism. A book advocating commodities as the "next big investment boom" is a little bit dated after the way commodity prices have surged over the last three years. Also, the fact that the author advocates a trend following approach did not impress me either given my distrust of technical analysis (too unreliable). I was pleasantly surprised.

The author (Mark Shipman) is a successful investor with a lengthy track record of doing what he preaches: essentially identifying a trend and following it as long as it continues and exiting when the trend ends. Mr Shipman writes in a tidy concise style without the waffle that many other investment books seem to be padded with. The chapter on the psychology of successful long term investing made some very good points and was the most useful material. The book also contains a smattering of useful insights into the way markets move. As an example, he makes the point that there really is no such thing as a steady return. This is a point which anyone planning to live of their investments simply has to understand if they want to be confident that their money will last.

By the end of the book Mr Shipman had just about persuaded me to add some commodities to my portfolio and to do so through the futures market (spead betting on commodities is not yet available in Hong Kong). More significantly, I am now taking trend following (also known as momentum investing) more seriously and am reading a second book in the subject. For those interested in reading more, Mr Shipman has his own website: Trend-follower/

Friday, July 14, 2006

Savings rate - known for the first time

I spent a romantic evening with a bottle of shiraz and my bank statements. It took a couple of hours but I know know how much I have saved in the first six months of 2006 and have a projected range for the year as a whole.

The good news is that I saved about 42% of my pre-tax income in the first half of the year. The projected savings rate for the year as a whole will be less than this because (i) I will spend more on holidays in the second half than the first half and (ii) the wine bill (en primeur) was paid in July. My estimate for the year as a whole is somewhere between 35% and 39% of my pre-tax income. The range is largely due to the fact that my income is slightly variable and the cost of our Christmas holiday is unknown at this time.

I realise that there is room for improvement in these numbers and will look at ways to try and lift the annual figure to the upper end of the projected range (without compromising the planned holiday).

The calculations are based on pre-tax income and after-tax savings. They do not take into account income from sources other than my job.

My record keeping is a shambles

When I set out to review the abillity of the private portfolio to withstand an economic downturn, the first part (the review of the Hong Kong property portfolio) was easy. However, when I sat down to review the rest of the private portfolio I had a problem. I have an incomplete picture of what I own, only a rough idea of my exposure to various asset classes and could not remember what some of my investments cost. It also occured to me that I do not know how much I save each year (or month) both in dollar and percentage terms and have not done a net worth calculation since the end of 2005.

This is not acceptable. So over the next few days I will be going through the bank statements etc and creating a few spreadsheets to work out some of these matters.

Frustration with Funds

I am finding that the range of low cost no-load funds in Hong Kong is extremely limited. In fact, so far I have identified precisely three such funds. All the other funds which are available to retail investors are actively managed funds which charge a front end load. MERs are typically in the 1.5-2.5% range and the front end load is usually 2% (if you negotiate down from the advertised 5-5.5%). To make matters worse, many also charge exit fees. This is pretty outrageous and is a sad reflection on both the Hong Kong fund management industry and Hong Kong investors' understanding of the effect of such charges on their wealth. This may also explain why the penetration rate for funds in Hong Kong is low by developed market standards.

I have looked at the no load funds which are available (TraHK which tracks the Hang Seng Index and China Tracker and A50 China Tracker which track indicies relating to China shares). I hold TraHK. The other fund is the AHL Diversified Futures Fund which has no load but a quite steep MER and a trailing fee for the first 3 years. The AHL fund has averaged about 13% pa after fees and the returns appear to have a low correlation with general share market movement. I am having a close look at this one.

I have looked into some of the low cost funds which available in other countries and run into a brick wall - the fund managers will not sell to me because I am resident in Hong Kong unless I invest a very large sum of money in each fund (typically US$100,000). I have never been given a reason for the refusal. I will keep looking but I am starting to get rather disillusioned with the whole exercise.

As much as I hate the front end load and the high MERs, I feel that I need to invest in some of these actively managed funds. The alternatives leave me with too little diversification in the private portfolio.

In an ideal world, I would invest directly in stocks and create my own index or theme portfolio. Unfortunately, the terms of my employment prohibit dealing in listed securities (index tracking funds excepted).

Thursday, July 13, 2006

New Tax - a correction

A correction to yesterday's post about the proposals for a goods and services tax (GST). The proposals exempt both the sale and the leasing of residential accomodation from the proposed GST regime. So my expectation regarding the impact of GST on housing values is at least partially incorrect. I say "partially" because I did not see anything that exempted the components used to construct housing. So, unless this changes, there will still be a partial GST impact on the cost of constructiong housing and, logically, some follow through for secondary market prices.

Wednesday, July 12, 2006

New Taxes - yes please!

The Hong Kong Government has released proposals for a 5% goods and services tax (GST). This will be controversial but I really hope it does go through. My reasoning is as follows: will result in a broader and more stable tax base - during the Asian crisis this was a factor affecting confidence in Hong Kong's ability to deal with the crisis; will enable the income tax rates to be cut, potentially to 11% (the standard rate is now 16%) - this will make Hong Kong more attractive as a place to do business (with some offset for higher rentals on office space etc); will encourage people to save more (I can hope);

4. more people (almost everyone) will be brought into the tax net. At present only a very small fraction of Hong Kong residents pay income tax which I view as being something of a moral hazard. Also, if more people have to pay tax we can hope that it will put the government under a bit of political pressure to make some long overdue cuts to its bloated payroll and silly spending projects.

GST is form of tax which generally favours savers over consumers. It is often introduced with the promise of matching cuts in income tax. Experience in other countries has consistently shown that the amount of tax raised by GST is always a lot higher than the tax revenue lost through the income tax cuts. In effect, the taxpayers lose out rather badly when GST is introduced. However, as I save a reasonable portion of my income I should be personally better off - if the tax rate is reduced to the proposed rate of 11%.

Hong Kong's greatest sustainable comparative advantage is its low tax rate for businesses and individuals who work for multinationals. This will help to build on that advantage and reduce the risk of losing it through future tax increases. The gains here may be partially offset by the increased accomodation costs for businesses (residential rentals should be exempt but I need to check this).

If the proposals become more definitive, it should provide a short term boost to economic activity as people rush to buy goods ahead of the tax (and a slow down after?). One longer term consequence is that housing prices should experience some permanent upward pressure. New properties will be subject to GST making them more expensive relative to existing properties and therefore boosting the price of the latter (at least that was the experience in other countries).

Tuesday, July 11, 2006

Stress Testing the Portfolio #1

A slightly dramatic heading, but with the equity markets being highly volatile over the last few months and, as I concluded in my last post, the case for investing in Hong Kong property being less compelling than it was 12 months ago, now is a good time to think about how the private portfolio would perform in a bear market. I started by looking at the investment properties which are located in Hong Kong. Hong Kong property makes up the bigger part of our assets.

1. Diversification: the Hong Kong investment properties are all residential apartments on Hong Kong Island. All are either small or medium sized units. Ages range from 4 to 30+ years. This means that there is no meaningful diversification in the portfolio;

2. Location: location is a positive. There is less scope for new developments on Hong Kong Island (especially in the Mid-levels) than in, say, New Territories or West Kowloon. In the longer term, two of the properties have the potential to marginally benefit from the proposed MTR extension.

3. Vacancy risk: lease terms are typically two years with the tenant having the right to terminate on two months' notice after the first year. Our termination dates are well spread out which means that the risk of having multiple vacancies at the same time is quite low. All tenants have paid two months rent as a security deposit which we hold. We have a small number of properties (very small, alas). This means that the impact of a single vacancy on our cash flow could be quite significant (depending on which property was vacant).

4. Debt: using borrowed money is great when things go in your favour and a disaster when they don't. Most of the property investors who have got into financial difficulties have done so because they have been unable to service their debts. So how robust is our debt servicing capacity? In this area we score quite well:

(i) Cash flow: assuming all properties are leased to paying tenants (one is currently vacant), we have positive cash flow on the portfolio as a whole - the rents will meet the mortgage payments and other outgoings. The excess of rent over outgoings is currently sufficient to cover some further interest rate increases (I need to work this out properly, but roughly at least another 1.5%). However, due to the small number of properties, a single vacancy would result in a negative cash flow;

(ii) Maturity profile: all mortgages are on P+I terms. The residual terms range from 6.5 years to 16 years. This means that we are paying more in principal each month than we are in interest. Our position improves with each passing month and, if things got tight, the possibility of rescheduling to interest only could be looked at;

(iii) Gearing: our highest gearing level (loan to value) is about 49%. The weighted average is about 35%. We have generally taken a conservative approach to the use of debt. At times this has held us back (we could own more properties and have a higher net worth had we been willing to gear higher) but it leaves us much less vulnerable to a downturn.

In summary, the risk of vacancy is a greater risk to the private portfolio's ability to service debt than the risk of higher interest rates. (If we had a bigger portfolio this would be different.) This risk can be adressed through either (a) changing some of the mortgages to interest only or (b)making early repayments or (c) meeting the shortfall from salary should the need arise. However, in general the Hong Kong investment properties are well placed to survive a moderate downturn without causing too much anxiety.

Monday, July 10, 2006

Property less compelling

I recently took another look at the Hong Kong housing market in the light of new statistics which have been released over the last two months. Specifically:

1. primary (i.e. new) apartments were selling a premium of, in some cases, 20-30% above comparable secondary (i.e. existing) apartment prices. Why anyone would pay a significant premium for a new apartment is beyond me. However, the developers have been cutting their prices and the premium is now appears to be much smaller (although I have not been able find any accurate data on what the current premium is);

2. property prices have softened in the first half of 2006 by 3-4% across the board (with the biggest falls in parts of the New Territories and the West Kowloon Reclamation area). Rising interest rates is the most widely quoted reason for the decline in prices;

3. the volume of property transactions has fallen in the second quarter of this year. Most notably, the number of transactions involving confirmors and other speculators has experienced a major decline. Declining volume is never a good sign;

4. there have been a reasonable number of defaults by purchasers of apartments in primary sales. Most of the defaulters are said to be speculators who purchased off the plan with the intention of reselling for a quick profit before the property was completed. With the premium for new apartments shrinking and the market as a whole experiencing flat or slightly declining prices, there were no gains to be had so they have been cutting their losses by defaulting on the completion (forfeiting their deposit).

There is also some suggestion that rising interest rates are starting to have an effect on consumer spending. This has yet to show up in any official statistics. Also, the volatility in the stock market in May and June would have affected confidence. Lastly, the days of having a positive carry on property investment are long past.

On the positive side, employment remains strong, both nominal and real interest rates are not that high (competition among mortgage lenders is still intense), there is upward pressure on wages, Hong Kong still has very high liquidity, real estate is still reasonably affordable by historical standards and China's economy is still growing rapidly. In other words, the economy looks sound.

Reports of problems with the US housing market (or at least parts of it) do not seem to have had any effect here. Nor has the implementation of austerity measures by China to cool its property market had any noticeable implications for Hong Kong.

In summary, the case for property as an investment vehicle of choice is not as compelling as it was 12 months ago and there could be better opportunities to invest later rather than now. Not a great conclusion given that I completed my latest purchase last month.

Thursday, July 06, 2006

Shares v Property - which is better?

I have read many books and articles advocating shares as being better than property or property being better than shares. Harrison at Journey to Financial Freedom recently drew my attention to one such claim .

Often these claims are made by people who have an interest in promoting services (e.g. grossly overpriced seminars) relating to the form of investment that they advocate.

My view is that saying that one is universally better than the other is just plain wrong. There may be times and circumstances where one asset class has greater attraction as an investment than the other, but I do not accept that one will always be superior to the other. Each asset class has its advantages and disadvantages. Shares and property are no exception.

At least some support for the proposition that both shares and property are attractive investments can be found by reviewing the Forbes 400 list of America's richest people - there are examples of people who made their fortunes by investing in real estate and examples of people who did it by investing in shares. More fundamentally, if one asset class was universally "better" than another in terms of risk adjusted expected returns, then investors would bid up the price of the preferred asset class and shun the less popular asset class forcing vendors to lower their asking prices. Eventually, the relative prices of the two asset classes would reach the point where the risk adjusted expected returns were similar.

The following is a comparison of the key features of investing in shares and property.

Diversification: very easy with shares and harder with real estate (unless you have a large portfolio or invest in REITs)

Liquidity: shares are highly liquid. Property is not

Yield: net rental is generally better than the yield on shares but this may be offset by depreciation, maintenance and tax treatment

Potential for yield to grow or decline: yes for both

Capital gains and losses: yes for both

Potential to add value: property generally has some potential to add value. Shares do not

Time commitment: highly variable, but generally more with property

Gearing available: yes, but usually on more favourable terms for property

Outgoings (excluding debt service): only for property and these can be significant

Volatility: both can be volatile, but shares are generally more volatile than property

Risk of total loss of asset (ungeared): companies can become insolvent and do so with depressing frequency. Property is much less likely to go to zero value but it is still possible in extreme circumstances (e.g. flood, earthquake, war)

Transparency/availability of information: generally high for shares and moderate to poor for property (this one is highly debatable)

Transaction costs: very low for shares and very high for property

Taxes: depends on personal and property specific circumstances

Other risks and issues for shares: corporate misconduct, unfunded/undisclosed liabilities, removal from index, competition, lawsuits, overpaid executives, dilution. Any others?

Other risks and issues for property: vacancy, outgoings rising faster than rent, bad tenants, depreciation, changes to neighbourhood. Any others?

Personally, I find both asset classes attractive and prefer to diversify my assets with a mix of shares and properties.

Tuesday, July 04, 2006

Book Review - The Coming Economic Collapse

In The Coming Economic Collapse by Stephen Leeb (writing with Glen Strathy) sets out the case for a potential economic collapse triggered by a shortage in oil that may be a lot closer than is generally accepted.

The basic case for an oil shortage is in two parts. The first is rising demand, not only in emerging large economies (especially China and India) and emerging markets generally but also in developed markets and the oil producing nations themselves. The second is production levels which are already, or will soon begin, declining in many oil producing nations (including the USA, Norway and the UK) and the failure of the oil industry to discover new oil fields.

The author makes the point that, unlike the oil shocks of the 1970s, the oil price is being driven by supply and demand factors and not by political factors - meaning that the problem will be a lot harder to solve. In addition, surplus production capacity is very limited meaning that any supply disruption in a major oil producing nation could have an immediate impact on oil prices.

The section of the book dealing with alternative sources of energy makes interesting reading (he believes that wind power is the best long term alternative source of energy) as does the discussion on the choices which must be made at a political level to deal with the shortage. After noting that political leaders have been making all the wrong decisions to date (nothing new or unique there), the key conclusion is that political leaders have no choice but to accept a high inflation environment as the alternative to economic collapse. The greatest risk to correct political decisions to deal with the shortage is effectively the ballot box - political leaders may bow to pressure from lobby groups and consumers.

The final substantive section of the book looks at invetsments that will either thrive or will suffer in this high inflation environment. While it is difficult to quibble too much with most the conclusions I am slightly uncomfortable with the fact that the recommended course of action is generally based on the experience in the 1970s inflationary period. Instinctively, I am nervous about assuming that history will repeat itself. If we have another bout of high inflation, I would expect there to be some differences to the 1970s. Examples would include the fact that many developed nations have much higher levels of debt (at national, corporate and individual levels) than they did when the first oil shock took place and the effect of the retirement of the baby boomers.

The key recommendations are (i) gold and gold mining stocks (ii) stocks in Chindia or which have exposure to Chindia (iii) oil and oil service companies (iv) alternative energy companies (v) TIPS and (vi) real estate. He shies away cash, bonds (other than TIPS) and stocks generally (including small cap stocks). Leeb also recommneds investing in zero coupon bonds in case the inflationary scenario does not eventuate and we end up with a 1930s style deflationary experience.

There is a lot of thought provoking material packed into this short (196 page) book - the author cannot be accused of waffling. I do not agree with all of the conclusions or the arguments that he uses to support those conclusions. One major issue which the author does not mention is what I term "inflation by stealth" where the inflation numbers (CPI) are manipulated to produce official levels of inflation which are below the true levels. If this eventuates, then TIPS may not be such great investments and using more debt to enhance returns may be a sound strategy (so long as you can service the debt).

One weakness in the case for an oil shortage is the treatment of contrary opinions. In many cases the author does not properly refute opnions which diverge from his own - he simply dismisses the opinion holders of being guilty of "groupthink" and moves on.

Monday, July 03, 2006

Kicking myself - twice over

Markets in Asia have rebounded strongly since the sell off last week. So have commodity prices. By way of example silver has jumped from US$9.72 per ounce on 14 June to US$11.12 at the time of writing.

I am kicking myself for not taking advantage of the opportunity to buy some assets and kicking myself twice over for letting myself be so easily influenced by short term market movements and indulging in "should have" retrospective thinking. I think it is time to add some books on physcology to my reading list.

Sunday, July 02, 2006

No interest rate rises here!

Hong Kong banks did not follow the Federal Reserve in raising interest rates this week. Given that the vast majority of mortgage debt in Hong Kong is at floating rates this is good news for me and good news for the the property market.

The previous increase in interest rates by the Federal Reserve also failed to have a follow through effect on interest rates in Hong Kong. Given that the Hong Kong dollar is pegged to the US dollar, I have to question whether the emerging yield gap between deposit and lending rates for Hong Kong dollars and those for US dollars is sustainable? My conclusion is that at this time Hong Kong does not need higher interest rates because:

1.Hong Kong's economy is still booming but shows no signs of over heating;

2. while property prices and the share market have had a good run over the last three years, there is nothing that could be described as a bubble;

3. Hong Kong as a whole is a very liquid economy and one that is not highly leveraged (either at the corporate level or the individual level). The laws of supply and demand currently favour of the borrower.

For information, while many markets have fixed rate mortgage products, in Hong Kong, fixed rates are less common and, generally, quite expensive.