Tuesday, April 29, 2008

An unhappy tenant

One of my tenants is unhappy and I cannot blame him. When the tenant signed the lease, the building was undergoing the second part of a refurbishment programme that involved putting scaffolding up around the building and temporarily removing the air-conditioning units. The work was expected to be completed in March or, at latest, the end of April (i.e. before the weather got really hot and humid).

Well the work is still going on and the building manager has been unable to advise when the work will be completed. The tenant has complained about the situation to me, to my agent and to the building manager. I have complained to the building manager and have asked my agent to put some pressure on them (the agent manages several units in the building). While the risk of delay in removing the scaffolding and reinstalling the air-conditioning units was discussed as part of the lease negotiations so that the tenant does not have the right to terminate the lease because of the delay, I would prefer to keep the tenant as happy as possible - good tenants tend to do less damage and to pay the rent on time and are more likely to renew at the end of the lease. Unfortunately, beyond making my displeasure known to the building manager, there would appear to be nothing that I can do about the situation.

Banks trying to talk interest rates up

Because the HKD is pegged to the USD, the Hong Kong Monetary Authority has been more or less compelled to follow the US Federal Reserve's interest rate cuts. As a result Hong Kong's interest rates are now extremely low. Deposit rates are close to zero, even for reasonably large retail deposits, and lending rates for mortgage finance are typically in the 2-2.5% range.

Given that deposit rates cannot go below zero (if you ignore bank fees), any further cuts in interest rates in Hong Kong can only happen on the lending side which means that the banks' lending margins will be squeezed. As a consequence, the banks have been quite vocal in claiming that there is no room for further cuts in lending rates and, further, that lending rates may have to rise in order to restore their lending margins - even if the Federal Reserve cuts rates again at its next meeting.

While it is understandable that the banks will attempt to maximise their profits, this time around they are fighting market forces. Firstly, the banks have no entitlement to make a particular margin on their lending activities. In Hong Kong only certain regulated monopolies have such a right. Secondly, deposits continue to build up in the banking system (in spite of rising inflation). Even if the cost of these deposits was zero (it is not), then the banks would still be better off lending it out at reduced margins than not lending it at all. Given that all banks are in this position, in a competitive free market for lending interest rates on loans should continue to fall despite the banks' wish to be exempt from the forces of a free and competitive market.

If every other business in Hong Kong is subject to market forces and competition there is no reasons why banks should be exempt or why borrowers should have to pay a premium above the rate set in a free market to subsidise the banks' already huge profits.

Monday, April 28, 2008

Bank raises some mortgage valuations

HSBC has an on line property valuation tool which enables users to check the mortgage value of a property. The on-line valuation tool has some limitations in that it is not an accurate reflection of market values (it tends to lag the market) and it does not cover all properties (mostly the larger estates and selected individual buildings). However, it is an objective basis for calculating net worth (I use it for our consoldiated balance sheet) and provides a very rough indication of value when looking to buy or sell a property.

Back in January HSBC increased the mortgage values of all our properties. I check the values from time to time, and yesterday I found that HSBC's on-line values for two of our properties have been increased again. This is obviously good news and indicates an increase in our net worth. It is also an indication of what is happening in the market place as investors search for both yield and protection against inflation while home buyers seek to take advantage of improved affordability (low interest rates and rising incomes). In effect, demand is driving prices higher.

Thursday, April 24, 2008

Rent controls demanded

There was a whinging letter in the SCMP this morning demanding that the government introduce rent controls to protect tenants against "greedy landlords".

Leaving aside the tone of snivelling, self interested hypocrisy in the correspondent's letter, history has shown that, like other forms of price controls, rent controls have been a bad thing for all concerned. The usual consequences of rent controls are:

1. poorly maintained properties due to the need to cut costs elsewhere and the absence of incentive to maintain or improve properties;

2. risk of default and foreclosure if interest rates rise above the controlled rent level (which in Hong Kong also results in tenants being evicted);

3. reduced supply of properties for rent as investors avoid the market and deploy their capital elsewhere and speculators revert to the practice of keeping their properties vacant to make them easier to sell and banks make finance for investment properties more difficult to obtain.

Landlords are already assuming significant economic risk when purchasing a property. They have to pay outgoings, maintain the property and meet their mortgage obligations (among other things). As investors in the US can testify, investing in property is not a risk free proposition. Even in HK, one only has to think back to the period from the beginning of the Asian crisis to the end of the SARS epidemic when residential property prices fell by about 60%. Landlords are entitled to a return on their investment to compensate them for the use of their capital and the risks they take by being property owners. Part of that return is rent.

It is tempting to suggest that landlords who suffered horrendous capital losses, declining rentals and high vacancy rates during the downturn are entitled to enjoy the benefits of the economic boom. They are, but that is irrelevant to the point that the free market is the best way of setting the price for all goods and services (other than those in a monopoly situation).

As to the level of return, a small flat in a building of average age in an average area would currently show a net yield of between 4-4.5% after outgoings but before mortgage payments. (More expensive properties will show a lower net yield.) This is less than the earnings yield on the Hang Seng index and, in a place where inflation is above 5%, is hardly exorbitant.

The blunt reality is that rent levels have lagged capital appreciation and are only slowly catching up in response to rising demand for accommodation.

Not only are rent controls economically bad, they are morally indefensible.

Wednesday, April 23, 2008

Inflation hits 5.3%

The headline inflation rate for the 12 months to March 2008 was 4.2%. However, if the effects of the Hong Kong government's "one off" relief measures and rebates is netted out, the underlying rate is 5.3% for the same period.

The biggest contributors to the 5.3% rise were food and rents. Food prices have made the headlines with staples such as rice (30%), pork (60%) and cabbage (50%) all becoming a lot more expensive over the last 12 months. Rent increases accounted for nearly a third of the overall inflation number.

In an environment with low unemployment (3.4%), negative interest rates (2-2.5% for borrowers and close to zero for depositors) and a currency which is pegged to the US$, it is difficult to see much scope for domestic factors to result in lower inflation even if food prices stabilise.

Inflation at 4% is a cause of concern. Inflation at above 5% is a major problem because the required nominal rate of return needed to achieve my financial and retirement goals gets pushed to levels which are difficult to sustain without taking on additional risk. That said, at the moment it is quite painless as the combination of negative real interest rates and rising property values has made the private portfolio a beneficiary of inflation.....so far.

Tuesday, April 22, 2008

Second installment of tax paid

The second and final installment of my tax bill for 2007/8 is due on Friday. As I may struggle to get near the IRD office later in the week, I made the payment today. Since I have fully provided for the payment by way of accruals in my balance sheet it will only impact my cash position not my net worth calculation.

Even with the tax rate at 16%, it still hurts to see such a large amount of money go out at one go.

Monday, April 21, 2008

High food prices - an opportunity for reform

Almost all the press about rising food prices has been focused on the negative aspects. It is obviously right to focus on those who are unfortunate enough to be in the situation where rising food prices are adversely affecting their standard of living.

There are some positives. In many countries (China, to name but one), a huge wealth gap has opened up between the rural poor and the more economically prosperous urban workers. In simple terms, to date the latter have participated in recent economic growth to a much greater extent than their rural neighbours.

With food prices rising, it can be hoped that we will see a more even distribution of the benefits of economic progress than has been the case to date. Equally, I would hope to see much greater attention and resources devoted to issues which directly affect the world's ability to produce food on a sustainable basis: water quality and quantity, greater acceptance of genetically modified crops (with the caveat that more work is done on addressing the health issues), less money and land wasted on organic foods and more investment in farming infrastructure. In effect, the best way to improve food production on a sustainable basis is to do more to protect and improve the environment.

My fear is that, among other risks, food (and water) becomes a political football with every lobby group, special interest group an politician around attempting to use the issue for personal gain (economic or political) at the expense of everyone else. Tariffs, subsidies, quotas, price controls and hypocritical trade rules (often based on non-existent health issues) are the enemies of cheaper and more plentiful food. In the longer term, the risk of soil depletion and destruction of forests, wetlands and other land types in a short sighted effort to boost short term production is a huge risk factor for sustainable food production.

Somehow, I just do not trust the politicians and government administrators not to make a serious situation worse.

Saturday, April 19, 2008

Adopting a cat

I finally caved to pressure from my children and adopted a three month old kitten from the local SPCA. OK, I was keen too.

In spite of being an adoption of a homeless animal, it was not cheap. The cost of inoculations, the adoption fee, the initial batches of food and kitty litter, a litter box, a few medications, a carry bag, scratching post, taxi fares to and from the adoption centre and the deposit to ensure that I bring the cat back for desexing at six months came to about HK$4,200 in total. I will get HK$1,000 back after the operation, but HK$3,200 does not make for a cheap pet.

It took about an hour for the kitten to go from hiding under the sofa to tearing up and down the living room, clawing the sofa (no interest in the scratching post), playing with pieces of paper my children were dangling in front of her and sitting on my keyboard while I was (trying to) type this post.

I'm already feeling like she was worth every cent.

Accumulators - a dumb idea

There has been a lot of press coverage about investors losing money in accumulators. The regulators have chipped in with comments as well (largely to the effect that commercial matters should be resolved between the banks which sold the product and the investors unless mis-selling or other misconduct is alleged). Needless to say, investors facing significant losses and margin calls are alleging exactly that.

During the boom times, accumulators were very popular products sold by banks (mostly private banks) to clients (mostly high net worth individuals). I totally fail to see why the typical investor would have any interest in such products. Here's why. The accumulator is essentially a series of rolling put options written by investors on terms that oblige them to buy shares at a discount to the market price at the time the contract is set. If the market moves sideways or rises only a little bit, it's a good deal in that the investor ends up buying the underlying shares at a discount to market value. However, upside is limited because the accumulator will knock out if the price of the underlying rises by more than a very small amount (a 2-7% was quoted in the papers). In the other direction, there is huge downside risk if the underlying shares fall.

In short, the accumulator offers some benefit in a mostly flat market. It offers little upside. It offers a lot of downside.

It's a dumb product and I do not understand why most investors would be interested.

Thursday, April 17, 2008

How low can they go?

I received interest rate fixing notices on two of my mortgages this week. The latest interest rates are 2.0900% and 1.9957%. Both are HIBOR linked mortgages and, yes, they do set them to four decimal places.

Over the last 18 months (approximately), the interest rates I have been paying on my mortgages have fallen from around 5% pa to below 2.5% with some, as mentioned above, now around the 2% pa level. To put this into context, the reduction in the interest bill on our total debt due to interest rates falling from 5% to 2.5% is the equivalent of more than three months total expenses. Put differently, the equivalent of three months living expenses is being added to our net worth on an annual basis because of the impact of falling interest rates.

There is expectation that the US Federal Reserve will make further cuts in interest rates. While we did not get the same reduction in interest rates here (HK rates are already lower than US rates and deposit rates are close to zero), any further cuts in US rates should put at least some downward pressure on the HK rates.

At the moment it is very difficult to fix interest rates for longer terms in Hong Kong (at least not without paying a huge premium). A pity. If I could lock in rates at or around 2% for the next few years, I would be a very happy borrower indeed.

Sunday, April 13, 2008

Food commodities

MSN carried this interesting article on the relationship between the prices of corn and meat (pork and beef): "How to turn food into money". To a large extent it explains the decline in pork and beef prices as corn (which is the staple feed for livestock) prices have been rising.

What the article does not explain is the rising price of pork paid by consumers in Hong Kong and the rest of China. In Hong Kong it is tempting to attribute the discrepancy to currency movements. However, this would be wrong as the HK$ is pegged to the US$ which means that falling prices for beef and pork should translate into lower prices in the shops. This has not happened. In fact the price of pork in the shops has risen even though the price in international markets has fallen. The same has happened in China where, if anything, the decline in international prices should have been magnified by the rise in the RMB against the US$.

So while the decline in meat prices in the commodities markets is explained (and is hopefully a short term situation), the rise in the prices paid by consumers in Hong Kong and the PRC is still unexplained. The best explanation I have been able to come up with is a combination of localisation of the supply and demand (most pork in greater China is sourced locally) with restrictions on importation (China objects to some of the additives used by US pig farmers).

Given my small, and so far loss making, investment in lean hogs ETC, I hope the situation is a short term one that will reverse itself by a combination of reduced supply and rising demand as the PRC relaxes import restrictions to combat inflation in basic food staples.

Friday, April 11, 2008

Tempted by the carry trade

The carry trade is essentially the act of borrowing in one currency at a low interest rate and investing in a second currency at higher interest rate. The investor attempts to profit from the spread between the two interest rates while taking on the risk of adverse foreign exchange rate movements. Over the last decade or so, carry trade investors who borrowed in Japanese Yen and invested in Australian or New Zealand dollars would have done very well, benefiting from both the interest rate spread and favourable exchange rate movements.

With HK$ deposit rates running at less than 1% and New Zealand deposit rates currently standing at around 8.2% (without shopping around for the best deal), I am very tempted to convert some of my HK$ bank deposits into New Zealand dollars. The theory is that with an interest rate differential of over 7%, I would have to experience annual adverse currency movements of 7% pa to be worse off than leaving my money in HK$. (Yes, I know the maths is a bit more complex than that.) There are similar deals involving a smaller spread with the AU$. Yes, I am tempted.

If I wanted to be more aggressive, I could take out a loan in Yen and invest the loan proceeds in NZ$, effectively leveraging my exposure to both the interest rate spread and the foreign exchange risk. Yes, I am tempted with this as well.

With the HK$ pegged to the US$, a bet on the carry trade is effectively a bet that the US$/HK$ peg will remain in place and that the US$ will not appreciate (or will do so at a rate less than the interest rate spread).

Wednesday, April 09, 2008

Book Review: Investing The Templeton Way

Sir John Templeton is one of the world's most successful and well known value investors. Investing the Templeton Way is a very abbreviated introduction to Sir John's early life and the factors that influenced his development into a value investor and a series of reviews of some of his more significant and successful investment decisions.

The books was written in a way which made for easy reading over the course of a weekend and conveyed a clear message that avoiding the extreme euphoria that accompanies bull markets and seeking for what Sir John describes the "point of maximum pessimism" will not only serve to avoid losing money when bubbles burst but also ensure that investors are well positioned to make positive returns from unpopular investments at times when more popular investments are declining in value.

On the negative side, as a biography the book was sadly lacking. It conveyed almost nothing about Sir John as an individual. (In fairness, the books is focused on investing strategies and is probably not intended to be biographical.) As far as investing strategies are concerned, the book was essentially a summary of a series of successful macro investment decisions. There was a complete absence of situations where investments lost money (apart from short periods when Sir John was waiting for the markets to move in the right direction). I have difficulty that any investor could be so consistently right which brings me to the major weakness of the book: the risks involved in picking individual investments without regard for asset allocation and trying to time the market were either glossed over or ignored.

As a final point the use of "Uncle John" to refer to Sir John became a minor irritation by the end of the book. (One of the authors is Sir John's great niece.) When added to the failure to adequately address the risk factors, I was left feeling that Investing the Templeton Way lack sufficient objectivity.

Book Review: Big Money Little Effort

I wish it was that easy. Big Money Little Effort is the second trend following book by Mark Shipman.

The premise of the book is that the best way to invest in financial markets is to participate in long term trends. Mark Shipman's recommended approach to getting into long term trends and for exiting when the trend ends can be summed up in one sentence: buy when the 30 week moving average moves above the 50 week moving average and sell when the 30 week moving average moves below the 5o week moving average.

The advocated investment strategy (called the "long term investment strategy") is supported by back tested data on the S&P 500 index. Using that data, the long term investment strategy looks very successful.

As with all "systems", I have some reservations - if it was that easy why aren't more people doing it? The obvious weakness of a system like this one is the potential to be whipsawed in a market which is volatile without trending.

Regardless of the merits of the system, Shipman has a concise and easy to read writing style which makes Big Money Little Effort potentially a good choice of reading material for someone looking for a quick and easy introduction to a very simple trend following system. That said, both Shipman's earlier book The Next Big Investment Boom and Curtis Faith's The Way of the Turtle made for better reading and, in my view, would provide a more useful basis for developing a trend following investment system.

Inflation - winners and losers

Economists generally view inflation as a bad thing and for most people and for most purposes it is a bad thing. However, as with many (I would not say most) economic phenomena there will be people who benefit from inflation as well as those who lose by it. Also, people who are aware of the fact that inflation is happening and its effects can (usually) take steps to either limit its adverse effects or even profit from the situation.

The winners

The big winners from inflation are borrowers. Inflation reduces the real cost of servicing and repaying debt. Historically, inflation has often resulted in higher interest costs which has made borrowing either expensive or unaffordable. This time around, interest rates have dropped while inflation has risen. In Hong Kong we now have negative real interest rates which means borrowers are effectively being paid to borrow money.

Holders of hard assets such as real estate have traditionally benefited from inflation as the cost of replacing assets has had the effect of pushing up prices in the secondary market. That has certainly been the case in Hong Kong, China and a number of other places (although there are other factors involved). In contrast, some markets (e.g. the USA) are experiencing declines in the nominal value of real estate and in real terms inflation makes those declines larger. Even then, inflation will push up the cost of developing new properties which will in turn have some limiting effect on future supply. In effect, inflation should limit the longer term downside to holders of hard assets even in a market characterised by over supply.

With different countries experiencing different rates of inflation, economic theory suggests that this has an impact on currency movements. Holding assets (even cash) denominated in hard currencies is one way to preserve or even enhance the real value of those assets. In practice, inflation is not the only factor which drives currency movements.


People on a fixed income.

Salary earners whose incomes are rising at less than the rate of inflation.

People holding assets (like cash) which generates rates of return lower than the rate of inflation.

In Hong Kong the big winners over the last 3-4 years have been leveraged property owners who work in jobs for which there is excess demand (which is most jobs involving at least some skill level). They have benefited from (i) rising property values (ii) reduced interest rates (now around 2.5%) (iii) reduced property rates as the HKSAR government has waived rates in an effort to combat inflation (iv) rising employment income as employers compete to attract and retain staff and (v) for investors, rising rental incomes. The wealth and income effect for people who meet all of (i) - (v) is significant and accounts for a significant part of the growth in consumer spending in Hong Kong.

The losers are people who rent their accommodation, people on fixed income and those who work in most unskilled jobs.

Tuesday, April 08, 2008

The Vegemite Crisis

Amidst all the talk of soaring food prices and possible shortages, Hong Kong is currently experiencing its first genuine shortage of a basic food staple since the last out break of bird flu temporarily halted the importation of live poultry.

The SCMP reported that Hong Kong has run out of Vegemite. The cause of the shortage is reported to be a lack of product available for export from Australia (which I find hard to believe). Consumers of the yeast extract are currently being forced to either do without or fall back on Marmite (yuck!). The more enterprising types have been working the phones and arranging for friends and relatives travelling to Australia and New Zealand to purchase emergency supplies. As a consumer of the sticky black stuff, I will be doing the same.

I'm sure there has to be a business opportunity there somewhere.

Saturday, April 05, 2008

Inflation in basic food supplies

The most significant financial stories in the news this week had nothing to do with sub-prime write downs or credit issues. They were all about the very significant increases in the prices of basic food necessities such as rice.

For people living at the margins between financial advancement and poverty, high inflation in the necessities of life such as rice (a basic food staple for nearly half the world's population), other foods, electricity, transport, water and so on, are hugely material. For households struggling to make ends meet, experiencing increases in basic necessities of up to 30% (or more) within the space of a year is a major problem. It is little wonder that hoarding has become an issue in some countries (India announced it would crack down on hoarding). Suggestions that exporting nations may be forced to reduce exports have also been in the news. As examples, questions have been raised over Australia's rice and wheat exports due to drought) and Thailand's rice exports (domestic demand).

The prospect of food becoming a major political and economic issue as rising demand from a growing population and bio fuels collide with relatively inelastic supply is very real. In many countries food riots are a very real possibility.

It's also a problem which has few obvious solutions. Subsidies (a typically myopic political solution) will do nothing to increase supply as there is very little additional arable land available. Planting more of a given crop is usually at the expense of alternative crops. Also, given how much water gets used up in agricultural production, clearing more land for agriculture carries a very significant cost in terms of both environmental impact and future water shortages. Genetic modification will help and the world may be forced to accept GM foods more readily that at present. Likewise, given that organic farms are less productive that ones which use fertilisers etc, we may be forced to accept that organic foods are environmentally and socially less desirable than many people would like to believe.

Of course, if we really really wanted to address the issue of rising food prices and the risk of food shortages we should all become vegetarians. Somehow, I cannot see that happening anytime soon.

Thursday, April 03, 2008

The Life and Death of a Mortgage

Here is a short story about how I managed to earn a (nearly) risk free gain on some tax arbitrage.

A number of years ago I purchased a property in New Zealand (a small brick and tile house in Auckland). It seemed like a good idea at a time when I was contemplating the possibility of retiring there. Between the appreciation in the value of the house and the appreciation of the currency, it has been a very good investment.

In the course of arranging the mortgage financing, I came across an oddity in New Zealand's tax laws:

1. as a non-resident for tax purposes, I have to pay tax on New Zealand sourced income (rent on the property)subject to a deduction for relevant expenses (interest on the mortgage). The relevant tax rate was 36% and has risen to 39%;

2. as a non-resident, I can invest in bonds and bank deposits and pay only 2% tax in New Zealand.

There are no Hong Kong taxes payable.

By opting for an interest only mortgage and putting the surplus cash flow into bank deposits rather than into principal repayments on the mortgage, I was able to earn myself a small spread.

The maths looks like this (using indicative but realistic numbers):

A. tax deductible interest on mortgage: 10% less tax effect at 36% = net cost of 6.4%

B. taxable income on bank deposit: 7.5% less tax at 2% = net income of 7.35%

Although interest rates have fluctuated a bit, the net spread has generally been slightly above 1%. Given the returns on other investments, I would have been better off investing else where, but it was still a more efficient use of funds than principal repayments.

The build up of the deposits (from rent and other New Zealand income) recently exceeded the principal amount of the mortgage. In addition, the interest expense on the mortgage has risen faster than the interest rates on the deposits, narrowing the net spread, meaning that there is no longer much advantage in preferring deposits to principals repayments. After giving the matter some thought, I gave instructions to the bank to repay the mortgage in its entirety.

So I now have a debt free property and another source of free cash flow. The New Zealand property market is showing signs of a correction. If an opportunity arises, I would consider buying another property there either next year or the year after. It's a nice country and the rent from a couple of houses would easily cover the cost of living there for a couple of months year after I retire. In effect, I would be matching income with expenditure.

Tuesday, April 01, 2008

Monthly Review - March 2008

The best word to describe my investments in March is ugly.

As a group, my mark to market investments declined in value during February. Here are the details:

1. my actively managed funds lost money. Vietnam continues to plumb new depths and the rest didn't do much better. I currently have investments in actively managed funds investing in Thailand, Taiwan, Vietnam, Eastern Small Companies and European Small Companies;

2. my equity ETFs went sideways. I currently have exposure to Hong Kong and India;

3. my residual equity portfolio appreciated;

4. my commodity investments fell during the month. I sold the rest of my silver position and took a loss on a small position in platinum. I continue to hold a commodity ETF and lean hogs and nickel ETCs. All of these declined;

5. my properties are all fully rented and 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). The cash flow and the surplus have benefited from recent cuts in interest rates;

6. currency movements were close to neutral.

The only investment movements this month were the sale of the balance of my silver and my position in platinum.

My income was at the high end of expectations this month. My spending was high due to the payments for a family holiday (no effect on net worth as I had adequately provided for the expense) and the resulting savings helped to offset the losses on my investments.

The end result was an increase in net worth of 0.4% for the month. The year to date increase is 3.3%.