Running on Empty

This post is at least a week late. Various committments had conspired and led to what should have been a late October post to turn into a 1 Nov one.

About ten to eleven months ago, we asked whether "we can have a last flutter?". Many readers were astounded and questioned our sanity. Fortunately, equity markets have heeded our request and delivered one of the most stunning recoveries since the Great Depression. The recovery in price performance is so strong that it seems detached from the underlying economic and market fundamentals. So it is worthwhile to check back to ascertain whether this is inherently sustainable.

First, it is important to understand why we wrote that in Dec 08 that we "cannot rule out the possibility of the largest ever January effect taking place". Our call was made on the back of the direct consequence of the monetary easing and fiscal expansion; actions coordinated by all global economies. Hence, the strong subsequent surge in equities was due to the flood of liquidity or easy money in the system, not an actual recovery in fundamentals.

Fast forward nearly a year. Things are indeed looking up but it would be foolhardy to think that we are out of the woods yet. A debt deleveraging crisis is inherently debilitating and countries like the US still have a ton of debt, including that in commercial property space that remains yet to be tackled. However, a lot of emergency stimulus measures put in place last October at the height of the crisis expired in end October this year. Whilst the market does not require some of these measures such as those designed to restart money markets, due to the inherent recoveries, liquidity in the system cannot be said to be as abundance as before.

Likewise, in China, whilst Premier Wen may be asserting that headline monetary policy stance remains loose, folks on the ground are reporting otherwise. Bank lending in 4Q09 are not as easy as that of the record RMB 7 trillion extended in the first nine months.

Also, certain governments such as that in Australia are mindful of inflation, and have started hiking rates.

We write this with the STI closed at 2651 and S&P 500 at 1036. At these levels, we feel that the downside risk outweights the upside potential because (a) liquidity conditions are not as strong as before, (b) fundamental recovery has not taken root to support current equity valuations. In plain English, MOS expects markets to correct in the months ahead.

Despite the bold assertion in the preceding paragraph, we have to stress that we do not possess any magic crystal balls. It is just an outcome we believe should happen given our analysis of fund flows and market dynamics. If we are right, MOS will be in a much better position to capitalise on the resulting carnage. As net buyers in the long run, we welcome any correction in the market as we plough through company after company in search for fundamental value. This is also not a recommendation to short markets as they can stay irrational for longer than one can stay solvent. It however should represent an opportunity for an investor to trim or unload any fundamentally weak positions into this period of strength, given that we expect rougher waters ahead.

We had a good time last night, indulging in the various "Trick or Treat" festivities that characterize Halloween. But without future government intervention, we leave the month of October with a niggling suspicion that the haunting and spooking of markets could linger on for much further, into the weeks and months ahead.

The Wayward Son?

In February last year, Margin of Safety pointed out the special situations opportunity in Lion Asiapac Limited (LAP). LAP was trading at S$0.265 then. The value proposition was that if LAP were to dispose of its stake in Shanghai listed Anhui Jianghuai Automobile (AJA), the NET CASH on its balance sheet will swell to S$0.44 per share, a whopping S$0.17 above the then market price.

The ensuing financial crisis meant that LAP failed to dispose of the AJA shares above the price floor of RMB7.50. However, the recent recovery in global, in particular, Chinese equity markets have given LAP much cause for cheer. AJA has traded back up above the floor price, thereby allowing LAP to partially dispose of its stake.

As on 15 Sept, LAP has disposed approximately 2% of its 6.16% stake in AJA. The sales netted total consideration of Rmb189.46 million.

By our updated estimates, the net cash per share on the balance sheet increases to S$0.21 per share (assuming the 2% were all conservatively sold at S$0.21). Completing the entire disposal program means net cash per share of at least S$0.41, still way above today's market price for LAP at S$0.32 a share.

Enthused by the recent strong property sales in Chinese market, LAP had proposed to go into property development in China. The mandate, however, was wisely (in our opinion) thrown out by minority shareholders at an EGM yesterday. This effectively leaves the possibility of LAP being a company trading under net cash when the remaining stake in AJA are progressively disposed in the days ahead. Whilst management do not have a track record of doling out special dividends, there is little reason for a company to trade under its net cash value when it is not under any particular duress.

In recent meetings, minority shareholders have increasingly made their presence felt and views ahead. Besides vetoing the mandate to do property development, many have also loudly articulated the need for a special dividend. We expect increasing media focus on this tussle in the days ahead as the small investor turns up the heat on management for a special dividend from a company which will soon trade under its net cash value. Perhaps if you are convinced about the merits of our argument, you may wish to pick up several lots of LAP and make your voice heard too.

A Return to the Gold Standard

October beckons and what an amazing twelve months it has been. Vindicating our golden call since July to go into S-REITs, we note that S-REITs as a basket are up about 17% in the past month, 36% in the past 3 months, outperforming both the property developers (+3% and +14% respectively) and STI index (+6% and +21% respectively). In July, we had lamented that "it is surprising that the S-REITs have not re-rated more strongly." In early August, we maintained our similarly bullish stance saying that S-REITs, "despite the run-up, still offer a very healthy spread to the risk free rate." and REITs are, "by and large, still very cheap".

The performance in last month was indeed robust as S-REITs are benefiting from a chase for yields. If fixed deposits are yielding a paltry 1% tops, perhaps CMT at 4.5% yield is still attractive. So there can still be upside remaining but we don't like to bet when the odds are only marginally in our favor. So choose judiciously if you still want to play this game because going forward, rates can only go up from here.

We continue to be bullish about high yielding equities in the near term. US rates are likely to remain on the floor as the authorities attempt to revive employment. Consequently, this results in a lot of cheap and easy money in the global system seeking returns. The run up in asset prices in HK is a case in point. A rich businessman has reportedly paid HKD40,000 psf for a one bedroom unit in Kowloon (not HK island!). The monetary policy mismatch brought about by the HK dollar peg is certainly fuelling a bubble in HK. Easy money from China is also flowing into HK. The situation is certainly worrying the local authorities who have warned the HK banks to tighten their lending standards. We suspect the pleads will continue to fall on deaf ears. So, in the next few months, residential prices will continue to rise in HK, Singapore and key gateway Asian countries, despite the currently half hearted efforts by the authorities to rein it in. Looking ahead, we wonder whether the HK property bubble would result in a de-pegging of the HKD to the USD? After all, both economics are structurally different today as night and day. No inflation will ensue in the US because they are still battling deflationary monsters. But in Asian countries like HK and China, it is inflation worries that is keeping us awake at night.

North of HK is of course China, the country touted as the new locomotive of the world. It is such a misnomer to label them a communist country when their citizens are probably amongst the most capitalistic and enterpreneurial in the world. It is also here in China where we find the comment made by the CIC chairman Lou Jiwei in late August most fascinating: “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose."

Certainly reminds us of the title of one of our past posts - Forever Blowing Bubbles, isn't it? Judging from CIC's recent investments into Noble Group, Poly HK, etc, his view also ties in to the lament in our last post: "Yes, the market is irrational. It may not really matter if we don't have understand why it is irrational. We just want to be able to profit from it."

So in the paper currency system, it is plain obvious that it is possible to monetize our way of problems. But will everyone raise their hands up and say they have had enough with the USD and Euro in the longer term? If the Yuan is still not ready to step up to the plate, perhaps what's in store for the world is a return to the Gold Standard. So perhaps it may be wiser to persuade your loved one that gold jewellery would make a better gift with the cash made from your S-REITs investments.

We will all laugh at Gilded butterflies

Come, let's away to prison:
We too alone will sing like birds I' the cage;
When thou dost ask me blessing I'll kneel down
And ask of thee forgiveness; so we'll live,
And pray, and sing, and tell old tales, and laugh
At gilded butterflies...

-- King Lear to daughter Cordelia, King Lear, Act V, Scene 3

Following our positive call on S-REITs on 20 Jul 09, the sector has continued to re-rate strongly. It is our belief that we are now in a bull leg of a bear market. It is not hard to figure it out why equities are the default asset class for investors today. Are we convinced that there will not be a double dip? No, but alternatives to equities are yielding close to nothing. Cash returns close to zero. Ten year Treasuries give a pathetic two per cent and one bears the risk of capital loss if yields move outwards under inflationary pressures. So, its our view that equities will continue with its sizzling run.

As our title posits, we may all laugh at gilded butterflies. But we still cannot help and admire their beauty nor resist touching them. So for investors who missed out on the strong surge which we pointed out could happen as early as Dec 08, the small and mid cap space should be where opportunities remain. As usual, the strategy would be to buy value and move nimbly.

Also, REITs are, by and large, still very cheap. M-REITs are trading around 9 per cent yield and S-REITs, despite the run-up, still offer a very healthy spread to the risk free rate. Likewise, the property funds in Thailand still offer double digit yields. We continue to be positive on them.

Prim and Proper Property

If two investments are similar and one is trading at a higher yield, what is likely to happen to the one with the higher yield? Price compression is likely to ensue. With the direct property market burning red hot, it is surprising that the S-REITs have not re-rated more strongly.

Investors are chasing condo projects in the residential market at yields of apparently 3%. Note the word apparently because rentals are likely to come under pressure due to the supply of 20,000 units coming on stream in the next two years. A Singapore minister alluded to the same per annum supply figure recently. S-REITs on the other hand, are yielding at least 6%. Their yield spread to the risk free rate is probably the largest on record ever. Take A-REIT for example. If you think its quarterly DPU can be annualized, one is looking at an investment which is liquid and tradable and yielding 8%. The indicative yield on a 10 year SGS is about 2.3%. So that's over 6% yield spread. Of course, you are taking on equity risk premium and yes, some REITs are pricing in blue skies scenario and investors have ignored balance sheet/credit risk. But that is not to say that there are good REITs going for a song in the market today. Another benchmark was when CMT first went to the market in 2003. Then, the first incarnation of CMT failed. A revised offer, from memory, of a 7% yield helped get investors attention and thus, planted the seed for our S-REIT industry. With yields where we are at today, are we back at the same spot in the 6-7 year cycle? We are vested and do not want to offer names. But any serious yield investor who ignores this segment of the market, we believe, would be missing out on an opportunity to get yield with upside potential.

At this juncture, we also would like to clarify our comments on the Singapore residential market. Whilst we will not participate in the queues, it is not to say that the rise in prices and buying activity will abate anytime soon. So is this a bubble? Maybe so. But there could be rational reasons underlying the frenzy.

If one were to take a step back to examine the Singapore household balance sheets, you may come to a similar conclusion. Do not quote us on this but the cash and housing investable savings are about 140% of our GDP and our medium household income is approximately S$7000 per month. Unlike the US and UK counterparts, Singapore households have no deleveraging issue and are not net in debt. So to put a downpayment for a S$1 million property and service its monthly interest is comfortable for many households. Loan servicing may only become a challenge if jobs are lost. But lo and behold, isn't the papers reporting that banks are hiring back investment bankers and private wealth managers again - the same segment of the market who are likely to buy these units? So although the huge supply in the coming months ahead should put a dampener on capital values and rental prospects, the price may find support at a level that may not represent fire-sale prices. If you need to buy, buy into unique projects with good location. Its amazing how the 2 room or studio units get sold so quickly these days. Yes, the absolute ticket size is small but I really wonder how many occupants want to live in such small confined places? An expat family wants a sizable unit, not a tiny 60 sqm compound which sees Junior running into the family's domestic help at every turn.

Yes, the market is irrational. It may not really matter if we don't have understand why it is irrational. We just want to be able to profit from it.

Nobody is thinking in the Herd

We write this 100th MOS post in late June when the Asian property markets are on the verge of boiling over. Today, showrooms are crowded and property viewing is weekend sport. Queues have also started to form overnight, and agents are working in overdrive again.

Whilst the economic fundamentals in many Asian countries such as Singapore and China are better than that in the US, the recent rush back into the residential property market suggests too much misplaced optimism.

The inventory in markets such as Shanghai are low, but the same cannot be said for cities like Singapore and Malaysia where, in the case of the former, close to 10,000 new units could well be made available in the next two years. And in certain Malaysian states like Johor, the supply overhang has been a historical challenge.

Indeed, the low savings rate and rock bottom mortgage rates (such as sub 2% for the latter in HK) brought about by the easy monetary conditions globally has unleashed money into alternative asset classes such as residential properties. But these investors search for yield without paying sufficient regard to the possibility that rentals could fall in oversupplied cities. Also, the other oft-cited argument that physical property is an inflation hedge is only partially true. One usually forgets that the effectiveness of the hedge actually depends on the lease structures in place and inflation actually pushes out the nominal discount rate. Furthermore, the terrible recession today has caused an output gap of 7% and prices are unlikely to run away until this gaping gap is closed out possibly, at the earliest, at the start of the next decade.

So, we find it apt to leave readers with a quote from English economist and logician, William Stanley Jevons (1835 - 1882) - "As a general rule, it is foolish to do just what other people are doing, because there are almost sure to be too many people doing the same thing."

Life in Hamelin

It was only a few months back in December when we wrote the piece titled Death by a Thousand Cuts (But can we have a last flutter?). In that post, we stuck our neck out with a prediction. And with economic predictions, one will inevitably get it wrong:

"If we succeed in getting the credit creation process going again (probably more likely than not), another rally in equities would be inevitable. This is not totally tongue in cheek but I cannot rule out the possibility of the largest ever January effect taking place next month! "

Well, we were partially right, save for the timing. The "inevitable rally" has occurred since the March 09 low. And boy has it been a strong one. One of the strongest post crash rallies ever. This has left everyone split and debating whether this is the birth of a bull or a suckers' rally?

As we take in the plaudits, we also take time to compile a list of FAQs which we have been asked and heard discussed regularly in the last few weeks. And we offer our best guesses to each of them.

(1) Birth of bull or suckers' rally?

Call it a suckers' rally, a dead cat bounce, a codicil or a last flutter at the casino. Call it whatever you like but the fact is that the market took off on a tear. We somehow saw it coming in 2009 because of the unconventional and the "do it at all cost" will of the measures undertaken by authorities. That resulted in truck loads of cash sitting at the sidelines and, when sentiment improved a little, led to them being pored into equities again. After all, near money supply growth, M1 and M2 measures are very good leading indicators of subsequent stock market performance.

Also, let us not lose sight for a single moment that we are in the business of buying cheap stocks. And a lot of equities were very cheap in March. They were really oversold. Some were trading at sustainable double digit dividend and free cash flow yields. These should have gone into your shopping basket. So, a rally from those levels is also inevitable.

(2) What to make out of the green shoots?

We think the low lying fruits have been plucked. The economic data is less ugly than before is because the US economy cannot contract at the same negative six percent every quarter. There is also a limit to the savings a corporate can generate through cost cutting. What happens to the next quarter's numbers when there are nearly 9% unemployment rate out there? Will these workers spend? And what in turn happens to corporate earnings then? Economists of a better ilk call it the paradox of thrift; in that, more savings is not necessary good for the wider economy. Paul Krugman had weighed in similar words recently too.

(3) Is the deflationary beast slayed and we are back on track?
It was a massive, do it at all cost boost given by the US authorities. Unlike Japan which used quant easing after the economy sanked into the pits, USA is using it before it really went into the quagmire. So, herein lies the crucial difference. The massive quant easing after Oct 2008 may well have plastered a lot of band aid over the sputtering machine to keep Pied the Piper going for a while more.

Its true that a lot of the quant easing programs have a short time span to it, ie, they will expire in the next 12 months or so. But we could totally see the authorities extending it again if it was necessary to prop things up.

(4) So what's next for the world?

We all knew the eventual destination of the rats in the town of Hamelin. We may be able to avoid hyper inflation. But higher inflation also seems like another inevitable too. So net net, the world could be a low growth and higher inflation place. Until maybe China changes its economic structure. So whilst focusing on cheap stocks, it will not hurt if you prepare for this next inevitable of higher inflation in the medium term because all the quant easing measures to fight deflation may well bring about higher inflationary pressures in the medium term.

In a few years out, asset inflation may also be inevitable then with real rates possibly being negatively currently. Shrewd investors may wish to consider how to hedge or position oneself to profit from this inevitability.


(5) Last Words, MOS?

If you have taken a monster coaster, you will know that the best way to go about it is to either look far out into the horizon or have your hands firmed gripped around the handle bars or do both.

Markets unfortunately are going to be very volatile from this point onwards. Participants in the market will find that they are almost like riding a monster coaster. To get over the fear of it, you should look out into the horizon - at the medium and the long run of the business. And by holding onto your handle bars or seats, the parallel would be having a strong grasp of fundamental valuations of your investee companies. That's has been and is the only way to "survive the ride".

Feel free to drop comments with your opinions.