Thursday, January 25, 2007

It Pays To Read The Fine Print

This is embarrassing. I'm supposed to be experiencing a mid-life crisis, not suffering from Alzheimer's.

The mortgage loan we used to finance our home is from Bank Of China (Hong Kong) Limited. BOCHK required that we make the mortgage payments from an account held with them as a condition of granting the mortgage loan. So we duly opened an account and arranged for an automatic transfer from an account at our main relationship bank to the BOCHK account to meet the mortgage payments each month. The only two transaction that go through the BOCHK account are the transfer payment in and mortgage payment out. Simple. So simple I never look at the statements and just file them when they arrive each month.

Of course when interest rates were cut last year, you would think that I would reduce the transfer payments to match the reduced mortgage payments. Of it completely slipped my mind. So small amounts of money have been building up the BOCHK account since August last year and just sitting there.

I only picked up on this when I actually read the fine print on a bank statement....the bit that actually states how much money is in the account.

Anyway, a small amount of money that I should have known about has now been used to make a small addition to my investment in silver.

Tuesday, January 23, 2007

A Small Step Towards Greater Diversification

My review of my asset allocation lead to the conclusion that I was overweight real estate and underweight most other asset classes.

I have taken a small step to rectify the situation by investing in a Vietnam equity fund. Vietnam is an emerging market that is several years behind many of the the other Asian success stories such as China and India but is beginning to open up to foreign investors as it slowly moves towards economic liberalisation. The other major attraction that Vietnam offers is its demographic profile - it is a very young country.

As with all emerging markets, some ups and downs can be expected and transaction costs will be higher than for more developed markets. Accordingly, this has to be viewed as a long term investment. I anticipate holding this investment for at least five years and potentially for much longer.

One Down, One To Go

I received an offer to let one of my two vacant properties which I have accepted. I will arrange for the provisional agreement to lease to be signed as soon as possible (tomorrow if I can manage it). The only work the tenant has requested is internal repainting and minor repair work (all of which needs doing and will not cost much). The rent is slightly (3.7%) more than what the previous tenant was paying for the last six months and 12% above the rent set when the previous tenant first moved in eighteen months ago.

This just leaves me with one vacant property - the most recent acquisition which has been on the market since the refurbishment ws completed last week. I also have another property which will become vacant at the end of February.

Monday, January 22, 2007

Demographia International Housing Affordability Survey

The Demographia International Housing Affordability Survey 2007 has been released. Although the survey is limited to markets in the United States, Canada, Australia, United Kingdom, Ireland and New Zealand it still contains a lot of interesting data and commentary.

The survey focues on the affordability of housing in each market, as measured by the ratio of average house prices to median household income in each market. The overall ratios per country are:

1.Australia 6.6 (meaning the average house price is 6.6 times the average income)
2. New zealand 6.0
3. Ireland 5.7
4. United Kingdom 5.5
5. United States 3.7
6. Canada 3.2

The survey states that a ratio of 3.1 or higher is "unaffordable" to some degree or other while a ratio of 3.0 or less is "affordable". Ratios of 4.0 or more were rare before the 1990s.

There are of course huge differences between different locations in each market with Los Angeles Orange County (11.4) being the least affordable market and Fort Wayne, IN being the most affordable (2.0).

The causes of the huge decline in affordability in many markets are largely attributable to increases in the price of land (90%) which has risen at roughly doubly the rate of general price inflation. The reasons for the increase in the price of land are largely supply side factors such as land use resrictions, planning regulations, time and other costs of approval processes and costs of related infrastructure.

The implications are obvious: lower rates of home ownership (especially for younger persons and lower income groups), lower quality housing, denser housing (smaller section sizes and more high rise developments) and a greater portion of household income going into housing (with less left for other forms of investment and consumption).

The survey made interesting reading.

Friday, January 19, 2007

To Flip Or Not To Flip?

I inspected the refurbishment work on my most recent property purchase and was surprised to find that there was nothing that I could identify that needed rectifying. I will of course hang on to the retention money for the full contractual period of 60 days in case there are any problems which my visual inspection did not identify.

Recent sales in the same building would suggest that I should be able to sell the property now at a price that would achieve a net profit after all expenses except tax of about 31% on my capital.

So the question is whether I should take the profit or stick with the plan and rent the property out?

I'm inclined to stick with the plan and rent it out for the following reasons:

1. It is a good property in a good building in a good location. The yield will be attractive (subject to a question on how quickly the fit out will depreciate);

2. Gearing based on current market value is conservative at about 53% and I expect a positive cash flow even with a P+I mortgage;

3. If I sell I may be classified as a dealer for tax purposes which will make it harder to avoid tax on gains on any other properties I may sell;

4. I do not need the capital back (the only circumstance is which I would need capital back is if I wished to invest in a much higher value property);

5. I do not have any other appealing investments into which I could reinvest the proceeds;

6. If I wanted to sell a property, there are others that I would rather sell instead of this one (a case of keeping the best properties and selling the less good ones).

The only reason for selling is to take a profit.

Excess Liquidity And Interest Rates (2)

In my previous post I set out some of the effects of excess liquidity in Hong Kong's banking system and the consequential effect on interest rates for both depositors and lenders.

A related point is inflation. Interest rates have been traditionally viewed as being linked to inflation or, to be slightly more accurate, expected inflation. Lenders expect to receive a premium above the expected rate of inflation to ensure that they get a real return on their loan capital. In practice they do not always get this (especially after taxes and defaults are taken into account). The situation where a lender does not achieve a rate of return at least equal to the rate of inflation is known as negative real interest rates.

Inflation in Hong Kong is currently getting close to 3% per annumn. Deposit rates are generally less than this. For depositors, negative real interest rates are a reality. Depositors are losing money in real terms. For lenders we have not quite got back to the late 1980s and early-mid 1990s when interest rates for borrowers were less than the rate of inflation for an extended period of time. However, with mortage rates currently below 5% (my lowest loan is currently 4.6%) and inflation at 3%, the real cost of borrowing is very low.

I draw the following conclusions:

1. deposits are a bad investment. From a return on investment perspective, deposits are losing money in real terms, so why hold them?

2. the cost of borrowing is very low. So why should I be in a hurry to repay my loans?

The answer to both questions is that I shouldn't. I should not hold money on deposit and I should not be in a hurry to accelerate loan repayments. I suspect that the reason why most people hold money on deposit and try to repay loans as quickly as possible is risk aversion. Deposits are seen as being safe (but not from inflation) and debt is seen as being risky.

Of course, if I do not wish to hold money on deposit and am not going to repay my loans early it raises the question of what will I invest in and what risks am I taking in doing so?

Excess Liquidity And Interest Rates (1)

The world economy is awash with liquidity. Central banks in many countries have been promoting economic growth or staving off an economic downturn by increasing the money supply at very high rates.

Although Hong Kong does not have a central bank as such, the story is no different here. The Hong Kong money supply has kept growing. The combined effects of growth in the money supply and a high savings rate have led to a situation where commercial banks continue to hold deposits greater than the value of outstanding loans. The excess of loans over deposits continues to grow. Put differently, banks are receiving deposits faster than they can lend them out. The most recent figures show the value of bank deposits as being about HK$2.2 trillion greater than the value of loans made by the same banks. Three years ago the excess was about HK$1.3 trillion. This is a huge sum for an economy the size of Hong Kong's.

The excess liquidity has a number of consequences. Banks offer lower rates for deposits and charge less for loans. The mortgage wars discussed in earlier posts is one example of this. Even with the Hong Kong dollar being pegged to the US dollar, both lending and deposit rates are lower in Hong Kong than in the US. The gap is about 1.39% for 3 month interbank offer rates which is creating arbitrage opportunities even for small investors like me. It has reached the point where I can borrow in Hong Kong dollars and earn a small spread by investing in a US dollar money market fund. It is also making Hong Kong an attractive centre for international borrowers to raise debt finance. Lastly, the resulting capital outflows (depositors switching to US dollars and lenders remitting the proceeds of Hong Kong dollar loans) have started putting some very slight downward pressure on the Hong Kong dollar. The latter is a bit surprising given that there was some speculation that the Hong Kong dollar could be revalued upwards on the back of a rising remninbi.

Thursday, January 18, 2007

My Asset Allocation - A Change In Strategy?

At the end of 2006 our asset allocation was as follows:

1. Hong Kong Real Estate: 63.6%
2. Overseas Real Estate: 10.1%
3. Managed Funds: 14.7%
4. Direct Equities: 5.0%
5. Cash and Cash Equivalents: 5.0%
6. Other Investments: 1.7%

The "Other Investments" are my paper silver.

This is not exactly a model portfolio. We are clearly overweight property and underweight equities.

Our financial plan aims to derive roughly half our retirement income from rental properties and half from dividends on equities. The original intention was to acquire the required number of properties as quickly as possible. The rental income would then be used to pay the mortgages off while savings from our jobs would be used to build the equity portfolio.

After spending some time educating myself on the importance of asset allocation, I am considering directing a greater portion of our savings to managed funds now. The additional properties will still need to be acquired, but the acquisition would be delayed until an indefinite time in the future. The advantages of delaying acquisition are:

A. I am finding it difficult to identify properties that show an adequate yield (after expected vacancies, rates, management fees and other outgoings). By delaying the acquisition of the balance of the properties, I give the market more time to generate better opportunities;

B. I achieve a better asset allocation in the shorter term. In 2006 the returns on our investments as a whole, while good, would have been even better with greater exposure to equities. I am trying hard to ignore the effect which greater allocation to equities would have had on our 2006 returns - I do not want to end up in a position where I am effectively chasing last year's top performers (historically this has been a bad strategy);

C. My debt levels will be kept lower. I will only be taking on debt if I buy additional properties. At the same time, all our mortgages except one are on principle and interest terms so the amount of existing debt is being reduced each month. As much as I like debt as a tool to enhance returns, I look forward to the day when we have no borrowings at all.

The only downside to delaying the purchase of the additional properties is that he delay will mean that there is less time to pay off the mortgages used to acquire them before I retire.

Tuesday, January 16, 2007

Decline Of The Middle Class

That was the heading of a piece in today's South China Morning Post. The article draws on a recent survey done by a local think-tank in Hong Kong and Kenichi Ohmae's book "The Impact of Rising Lower Middle Class Population in Japan: What Can We Do About It?".

Some key facts for Hong Kong:

1. median household income is still 15.8% lower than the peak in 1997;

2. between 1996 and 2005 the number of households with a monthly income below HK$8,000 rose by 76.5% to more than 500,000 (representing an increase from 13% to 22% of total households).

The data clearly shows that the benefits of the economic recovery that Hong Kong has experienced in the last three years have been unevenly distributed.

My view (and I am not sure if it is right or not) is that globalisation has been one of the major factors behind the decline of the middle class and the widening gap between rich and poor. Producers and suppliers of goods and services have the ability to source their goods and services from (almost) anywhere on the planet and a very strong economic incentive to use the cheapest source available. Hong Kong is not the cheapest place on the planet to do business. In fact it is, in the overall scheme of things, relatively expensive. Globalisation also means increased competition. Competition has the effect of pushing prices down, including the cost of labour.

The second reason for the growing divide between rich and poor (or at least between high income and lower income earners) is the transition from a manufacturing based economy to a services or knowledge based economy. A services based economy requires different skill sets from manufacturing. What we are seeing is a workers who have certain skills are able to command premium incomes while those who lack the skills most in demand are left to compete for a pool of jobs that require (or at least are perceived as requiring) lesser skills. In effect a large part of the gap between higher incomes and lower incomes is explained by differences in skills.

Absent a return to protectionism or the days of strong unions (neither of which I advocate or expect to see happen), I see little that can be done to address the issue of globalisation and would not, in any event, want globalisation to be reversed. It has brought more benefits than burdens. The skills issue is also unlikely to go away either. Even as workers upgrade their skills (or retiring workers are replaced by younger entrants with new skills), the pool of people around the world with the skills that employers demand is likely to keep growing. In effect keeping skills up to date is unlikely to increase your income as dramatically as it once may have. However, up to date skills may prevent you from sliding towards the lower income levels.

Kenichi Ohmae suggests that rather than aspire to join the middle class people learn to adjust their lifestyles and their expectations. In effect many people may have to forget about owning a car, owing their own home or sending their children to private schools and top universities.

This is not an encouraging perspective.

Monday, January 15, 2007

Budget For 2007

I finally got around to completing my rather simple budget for this year.

On the income side I am predicting that my monthly income for 2007 will be the same as for the second half of 2006 (i.e. slightly higher than the average for 2006 as a whole). It will fluctuate from month to month but I hope it will average out at this level.

Expenses are a bit harder to predict, however I am expecting my monthly household expenses to rise slightly. The biggest increase will be school fees when our youngest child starts school in August. This will be partly offset by the fact that (I hope) the floating interest rate on our home mortgage will average less in 2007 than they did in 2006 . The current rate is less than the average rate for 2006. I am also intending to be more disciplined in my spending on luxuries. Last year I spent far too much on overpriced wine and a couple of paintings - something that I hope will not be repeated in 2007.

The bottom line is a projected savings rate of 42% of pre-tax income. This compares to a savings rate of close to 40% in 2006.

Sunday, January 14, 2007

Savings Rate For 2006

I finished going through my financials for 2006 and was surprised that my estimated savings for 2006 amounted to close to 40% of my employment income. This was just above the high end of my projections after the first six months where I estimated an annual savings rate between 35% and 39%.

Alas, the higher savings rate was not due to any particular virtue on the budgeting front (if anything I spent more than I should have last year). It was almost all attributable to my income in the second half of the year being higher than it was in the first half.

I describe my savings rate as an estimate because I adopt a lazy man's approach to budgeting and do not keep detailed records of expenses. Instead I simply go through my bank statements and add up (i) my income and (ii) transfers out of my bank account which are of an investment nature and work out (iii) the difference between my bank balance at the start of the year and at the end of the year. I then deduct (iv) any expenses which have been incurred but not actually spent (e.g. an accrual for holidays, credit card balance) and (v) an estimate for my tax bill. This exercise took less than an hour for the whole year.

The result is still an estimate in that my tax liability is not known but given how simple Hong Kong's tax system is the number I have used should be quite close to the actual bill (which is late in arriving).

Saturday, January 13, 2007

Looking Back - 10 years ago

The Festival of Under 30 Finances up at The Finance Journey asked the question "Where do you see yourself financially in 10 years?"

It started me thinking about my financial position and goals ten years ago (when I was about 30). 1996/1997 was an interesting time. Like the rest of ex-Japan Asia Hong Kong was experiencing an economic boom. Well paying jobs were plentiful. Housing prices were rising to levels never seen before (or since) and the share market was setting record highs. Hong Kong's reunification with the PRC was approaching.

At the time I was a young man in a hurry and feeling that I was watching the world pass me by. I purchased my second property (a small flat - not in Hong Kong fortunately) and thought that it would be nice to buy one a year so that I would have an even 10 by the time I was 40 (with mortgages to match). Ten was a nice round number - not something based on a properly modelled financial plan. I despised cash in the bank ("cash is trash" was a popular saying at the time) and kept all my spare money in the share market. Like many others I had dreams of making enough money to be able to quit my job and make a living from my investments. Exactly how I expected to beat the market and the professionals was not something I gave much thought to.

The Asian crisis did not put an end to my objectives. However, it did delay their implementation. It also lead to me spending a great deal of time thinking about my finances and my financial objectives in more detail. In effect the severe economic downturn (declining asset values, worries over unemployment) made me much more disciplined about my finances. Having got through the Asian crisis and done reasonably well since 1997, I also have a great deal of confidence in my ability to survive difficult economic conditions.

The wealth gap - an uneven recovery

This week both of Hong Kong's leading English language newspapers published articles about the widening wealth gap between the "rich" and "poor" in Hong Kong.

Like many emerging markets (and I do not think that that description applies to Hong Kong), wealth distribution is far less even than it is in many western countries. This is nothing new. what was interesting about the articles was that they made the point that per capita GDP is still below the levels seen at the 1997 peak. Put differently, it means that eight years after the Asian financial crisis, the income levels of the average Hong Kong employee are still below 1997 levels. Also, income distribution has widened during that time. One commentator made the point that those in the top 10% of income earners had essentially managed to maintain their income levels. The bottom 10% of income earners had experienced a very noticeable cut in incomes (partly offset by the net deflation during that time period).

The widening income gap is largely explained by skilled workers being in short supply and able to command higher salaries. The very clear message is that it pays (quite literally) to develop skills that are valued by employers and to keep them up to date.

How much income is needed in retirement?

An often quoted figure is that most people should budget on needing an after tax income equal to at least 80% of their pre-retirement spending once they retire. Put differently, it is assumed that people will spend about 20% less after they retire than they did before they retire.

Is this assumption realistic?

My initial reaction is that some expenses will go up and some will go down - and different people will have different spending patterns. In our own case:

1. the mortgage will be paid off - this is our biggest expense;

2. the children will still be in school or university so this will not change until some years after I retire;

3. food bills will probably go down as I will do more of my own cooking and eat out locally rather than in the more expensive CBD area but I do not expect the difference to be huge;

4. insurance costs will go up. We currently benefit from subsidised medical and life insurance premiums through our employers. This will stop once we retire;

5. other household costs will remain unchanged except electricity which will go up as we will be spending more time at home;

6. we are likely to go out more, travel more and spend more on hobbies simply because we have the time to do so - there will be a significant increase in spending in this area;

7. I have no idea what will happen to taxes in the future.

In short, if the mortgage factor is excluded, I expect our post retirement spending to be higher than it will be before retirement (at least until our children have finished their education and started paying their own way). At least in our case, the 80% assumption is not justified.

Did I miss anything?

Thursday, January 11, 2007

Property Project - almost completed

The refurbishment of my latest property acquisition will be completed in the next few days. I will do a final inspection either over the weekend or Monday. The agent has already started showing the property to prospective tenants.

As this is one of two properties currently vacant, the mortgage payments currently exceed the rental income (after outgoings). Hopefully I can get both of the rented and return to a healthy positive cash flow by the end of the month or, at latest, early February. The risk is that if I do not get tenants by then we will be getting close to Chinese New Year which is traditionally a very slow time of year for renting. Also, the lease on a third property expires at the end of February. I really need to try harder to avoid having so many leases all falling due so close together (or buy more properties ;-).

Wednesday, January 10, 2007

An Unwanted Emergency Fund

I am not a fan of having an emergency fund (at least not the sort that earns a low rate of return sitting on deposit at the bank) in our personal circumstances.

Unfortunately, I am struggling to identify investments that look sufficiently attractive to justify investment. As a result I am accumulating a modest amount of money which is sitting on deposit at the bank earning a rate of interest which is barely above the official inflation rate (and below the real rate of inflation). At least under Hong Kong law I do not have to pay tax on the interest.

Potential uses for the money:

1. increase my monthly payments into mutual funds (currently divided equally between an Asian small cap fund and a European small cap fund). Valuation considerations make me slightly cautious about this although I am still looking for a Vietnamese country fund;

2. make early repayments on one of my mortgages. This will show a better rate of return than bank deposits but with mortgage rates settling below 5% pa (and all tax deductable except for my home mortgage) this is only marginally more attractive than leaving the money on deposit;

3. be patient in the expectations that better opportunities will arise.

The default option is to be patient - although it is irritating accepting such a low rate of return even on a short term basis.

Sunday, January 07, 2007

Book Review: Anatomy of the Bear

Anatomy of the Bear: Lessons From Wall Street's Four Great Bottoms by Russell Napier is a very detailed and well researched review of four of Wall Street's greatest bear markets over the last 100 years (1921, 1932, 1949 and 1982). The author is a consultant with CLSA Asia-Pacific Markets.

Anatomy of the Bear looks at the causes of each of the four market bottoms and what tools investors could have used to try and identify when the market bottom had occured. The authour also compares the factors that may have lead investors to identify each market bottom and whether the same indicators would have worked in all four bear markets. The author's conclusion was that the most reliable measure of a market bottoming was the q ratio which reached a low of about 0.3x near the bottom of each of the four bear markets reviewed. (The q ratio is a measure of the stock market's valuation of a company relative to the replacement cost of its assets.) One reservation or query which I have with the potential usefulness of this measure going forward is that the markets now include many more companies that have fewer tangible assets on their balance sheets than during the times under review. Does this affect the usefullness of the measure of cheapness?

Other useful indicators appear to have been cyclically adjusted PE ratios and a recovery in the bond market.

It seems evident from the wealth of data contained in the book that identifying the exact bottom of a bear market is something of an exercise in futility. Economic reports appear to have been mixed during each of the four bear markets. Relying on sentiment would not be a useful approach.

Another important point was that equities became cheap slowly, in some cases very slowly taking several years to reach bottom.

The conclusion I took from the book (and I am not sure if this was the author's intention or not) was that investing when equities become cheap following a contraction in valuation multiples will ultimately produce excellent returns, but will require both patience and the courage of conviction to carry a position through what could be an extended bear market.

Two small negatives. The wealth of data at times made for rather dry reading. Also, the book would have benefitted from both a glossary and an index.

Saturday, January 06, 2007

2007 - Reading the Tea Leaves

I am not a fan of trying to make annual predictions of where various asset classes are headed. Financial industry professionals who make such predictions for a living seem to get things wrong as often as they get them right and I have no reasonable basis for assuming that my ability to guess the future is any better than average.

That said, it is impossible to make any investment decisions without making some assessment or assumption as to what may happen in the future. Whether I buy equities, bonds, property or put my money in the bank, I am making decisions on what I expect the future to hold for each of those asset classes.

Rather than make predictions, here is a look at some investments I am currently considering.

1. Russia: the Russian stock market has had a very good run but still looks reasonably priced on fundamentals. A significant portion of the country's massive oil and gas (and other commodity) revenues are being spent developing other sectors of the economy. Consumer spending is growing as a middle class emerges and the negative demographic trend is showing signs of reversing. Russia has also accelerated repayments of foreign debt. Political instability and environmental problems remain of concern. Overall, it looks promising.

2. Vietnam: the next emerging Asian tiger? With a large and very young population Vietnam is beginning to grow as economic and social liberalisation gathers pace. Potentially it is still at a much earlier stage of development than other emerging Asian economies.

3. The Japanese Yen: for no better reason than it has showed significant weakness and I am struggling to find many "experts" who rate it a buy compared with other major currencies.

4. The Chinese Yuan: with economic growth and an improving banking sector, the prospects for upwards revaluations of the Yuan in the years ahead look very strong. The issue is whether those upwards movements will be sufficiently large to justify an investment.

5. Hong Kong Property: this remains my largest asset class (by a long way). However, I still need to make further acquisitions to achieve my goal of having half my retirement income derived from rental income. I am moderately bullish on Hong Kong property and would like to make a further acquisition in 2007 if, and only if, I can find a good deal.

Friday, January 05, 2007

2006 - A quick (and slightly late) review

My review of 2006 is slightly late - I had to wait for some statements to arrive by snail mail to update the balance sheet and to recover from holiday.

In short, 2006 was a great year from a financial perspective.

The strongest financial performance came from my job. The working hours were insane (and I paid a price for them in other areas of my life) but I was appropriately compensated. Savings were strong (close to 40% of pretax income) in spite of some blow outs on the expenditure front (some expensive wine which I occasionally pretend is an investment, a nice painting which I do not delude myself has any investment value and a couple of great holidays with the family).

The property portfolio (which is ultimately intended to provide about half of my retirement income) was expanded. Rental incomes grew in line with expectations. The negative was that vacancy rates were higher than both expectations and previous experience. This may have been partly due to leases expiring close to major public holidays (when the leasing market is traditionally soft). In any event, I have decided that it would be prudent to increase the final size of the property portfolio from my previous target (but only by one property).

My investments in equities (mostly unit trusts) did well on the back of boyant global equity markets (especially emerging markets). The only negative was a thankfully small investment in a Thai equity fund which currently shows a loss of about 7%.

My investment in silver was, in percentage terms, my best performing investment with a return of about 42% over the year.

All in all a great year. I am already having fantasies about bringing forward my target retirement date - a good contrary indicator.