Difficult Times for Longs

FALLS CHURCH, Va.—Investors are still evaluating the impact of the credit crunch on the US economy, Europe is showing early signs of a slowdown, and Japan is yet to establish itself as a viable alternative. Meanwhile, the selloff continues.

Once again, China and India are expected to carry the burden of growth, although now the circumstances are more difficult.

The emerging Asia giants may be able to deliver again in terms of economic growth. But the local financial markets are still tied to their developed peers. Global markets have been synchronized for some time now, and it will take years for Asian markets to truly decouple from the US (see Silk, 5 December 2007, Roll with the Bear). Nevertheless, I expect Asia to outperform the US this year.

During this period of weakness, stock and country selection is even more important. The Fresh Money Buys list below is a useful starting point.

The Silk Portfolio’s returns provide a cushion, and the way it’s constructed should allow it to withstand the weakness, just as it did during the three big selloffs of 2007. But if the market has something nastier in store for us, expect more bleeding.

The hedges I’ve advocated for some time now provide additional protection against a downturn, and the permanent ones should always be in place. See the portfolios for details.

The Short Trade

During the November market turmoil, I recommended shorting the Chinese insurers for extra protection. See Silk, 13 November 2007, Flash Alert: Hedging the Portfolios.

My US trading recommendation was to short China Life Insurance Co (NYSE: LFC). The profit was 15 percent as of 8 December 2008. If you’ve shorted China Life Insurance Co, stay with the position and set your stop-loss at USD83. This is a hedging trade for a long-only portfolio, and this is why the stop-loss is so loose.

Selective in Hong-Kong

The Hong Kong economy has been strong of late and continues to make improvements that started in 2003. The unemployment rate is down to 3.6 percent, and according to the census and statistics department, the median household income has risen to a new peak around USD3,000 per month.

Source: Bloomberg

Retail spending is also rising because people feel more secure about the future. As the chart below indicates, retail growth is also strong.

Source: Bloomberg

As inflation rises, Hong Kong will have negative real interest rates for sometime. Because of the currency peg, Hong Kong will most likely follow the US rate policy, which will lead to a large amount of funds flowing into the local economy, particularly because Mainland China remains strong.

But the real estate market should benefit the most, and there are good reasons for that.

Real estate is a cyclical industry. In Hong Kong’s case, there’s strong pent up demand because of the low transactions in the past two years, particularly in the low end of the market. The last time Hong Kong experienced a structural upturn in housing prices was from 1985 to 1997. Prices rose every year, except in 1995, and gained 720 percent.

Prices have been stabilizing for two years, and the market’s now ready for the next leg up. After a disappointing 2006, last year was much better with residential prices increasing by around 10 percent. See the chart below.

The strength in the stock market also seems to help; locals are known to gain more confidence when their market goes up. Historically, the residential market follows the stock market with a time lag. This process is now underway.

Source: Bloomberg

Housing supply was low in 2007, and the same is expected for 2008. During the real estate downturn from 2002-04, land sales were cut back. They resumed in May 2004. And since then, the process has been quite slow because of new regulations. As a result, inventories remain quite low, as the chart below indicates. And I don’t expect that developers will sell at discounts while the market remains tight.

Source: Bloomberg

The influence of the mainland also shouldn’t be underestimated. According to executives at Portfolio holding Cheung Kong (Hong Kong: 1, OTC: CHEUY), 20 percent of the buyers in its latest residential development, Central Park Towers, which will be completed in the first quarter of 2008, are Mainland Chinese. Other property developers have reported similar trends. Such interest will boost local sentiment regarding real estate, even though the initial numbers will be relatively small.

Demand remains genuine and is also picking up at the lower end. Speculation is still in its early stages. A Confirmor transaction–in which a buyer sells its unit before completion of the purchase–is a highly speculative activity and has always been present in great real estate cycles in Hong Kong.

The practice hasn’t yet picked up in earnest, as the following chart indicates. On monthly basis, the number of confirmors has been as high as 10 percent of primary transactions in the past. Currently, it’s at around 2 percent, up from very depressed levels.

Source: Bloomberg

The Silk portfolios are well positioned to benefit from these developments.

First is my long-term favorite Cheung Kong. The stock has done well since I added to the portfolio more than a year ago; it’s up 70 percent.

The company has one of the biggest residential land banks in Hong Kong: 17.3 million square feet. It’s a respectable player in the mainland, too. The stock trades at relatively cheap valuations, especially compared to the more leveraged construction plays. Cheung Kong is a conglomerate and has more room for upside and better downside support. Cheung Kong is a buy.

A more recent portfolio addition, Bank of China Hong Kong (Hong Kong: 2388, OTC: BHKLY) is the number one mortgage bank in HK and as such is well positioned to benefit from the pick-up in the property sector. It strong deposit franchise also gives it funding flexibility. It also offers a solid and sustainable dividend yield of 4 percent. Buy Bank of China Hong Kong.

For more leverage to the theme, I recommend Henderson Land Development (Hong Kong: 12, OTC: HLDCY). Although the company has a smaller residential land bank of 5.8 million square feet, it also has 31.7 million square feet of agricultural land that could be converted into residential land. (In comparison, Cheung Kong has 15 million square feet of agricultural land). According to industry experts, this will take place gradually in the next few years.

Henderson also has around 150 million square feet in mainland land bank, one of the largest among Hong Kong-based developers. Even with short-term drawbacks in the Chinese property market, long-term growth will be an additional kicker for the company.

Valuation wise, Henderson is also one of the cheapest developers, and I expect this gap to close this year. Henderson Land Development is the new addition to the Alternative Holdings Portfolio.

As always, it’s better to purchase Hong Kong stocks locally. The majority of serious brokers now offer this option for US-based investors. Liquidity is a plus in both up and down markets. Alternatively, you can buy the stock over the counter in the US.

Fresh Money Buys

The investment process is constant. So if you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the Portfolio pages on the left-hand side of your screen for details.

  • Russia (energy, telecommunications)
  • Hong Kong (real estate, banking, infrastructure)
  • South Korea (banking, electric power)
  • Philippines (telecommunications, real estate)
  • India (pharmaceuticals)
  • China (consumer, coal, e-commerce, oil, water)
  • Singapore (banking, telecommunications, industrial)
  • Malaysia (ETFs)
  • Taiwan (technology, telecommunications)
  • Europe (industrials, communications equipment)
  • Japan (banking, industrials)
  • Macau (gaming)

How Silk Works

The Silk Portfolio has been constructed around the view that domestic economic demand and investment are driving Asia’s economic ascent.

The Portfolio should be viewed as a whole rather than an assortment of stocks. It’s my hard-earned assumption that investors seldom follow such advice, so I also offer some direction in an effort to assist with the decision-making process in the Fresh Money Buys section.

In this section, readers can find a guide as to how I rank countries and sectors at any point in time. The ranking changes often, so pay attention.

The ranking starts with the countries I prefer and then lists specific sectors you should look into. When I mention a sector, it’s assumed that the first pick will be from the Long-Term Holdings. Then, if more exposure is warranted, additional picks will be from the Alternative Holdings. Of course, if a country isn’t represented in the Long-Term Holdings, refer to the Alternative Holdings for a selection (which is the case for Macau).

Portfolio recommendations should be taken at face value. For instance, if a stock is recommended as a buy and trades below the price indicated in the Portfolio tables, the recommendation stands for newcomers as well as longer-term readers.

Occasionally, I recommend that long-term readers take profits off the table by booking any gains while letting the initial capital invested.

In other words, I expect investors to look at their profits (i.e., how much money they’ve made above the initial investment) and then calculate how many shares they needed to sell in order to take those profits off the table.

If you’re not a long-term reader, chances are you probably don’t have profits to take from the specific stock; you’re unaffected by the recommendation. The fact that I haven’t advised selling the stock outright indicates that it remains a good, long-term holding.

Silk has one main portfolio, the Long-Term Holdings, and an alternative, the Alternative Holdings-Permanent Hedges. Look first to the Long-Term Holdings for asset allocation in the markets covered here.

In the Alternative Holdings-Permanent Hedges Portfolio, readers can track permanent hedges and shorter-term recommendations. It also includes companies I’ve recommended for longer-term or more fundamental reasons, and they represent additional exposure to favored investment themes. For example, Lukoil (OTC: LUKOY) provides extra exposure to a favored theme: Russia and energy.

On the left-hand side of the Web site’s main page, under Portfolio Performance, you can get a snapshot of the Portfolio’s return compared to other major indexes.

On the Portfolio page, you can click on the asterisk next to each holding to review the original commentary and recommendation. I plan to enhance the portfolios with extra features and welcome comments and suggestions.

Many new readers have also asked, “What do we do when the market drops substantially?”

Since Silk’s inception, I’ve been skillful and lucky enough to have booked profits before precipitous falls, in which case I recommended sitting still through the turmoil. I’ll also get word to you via Flash Alert if events turn too quickly.

Silk is built around a set of core themes. I often revisit those themes or certain analyses through a link to a previous article or by reproducing relevant paragraphs. You can also read previous issues in the Archives to gain an understanding of the investment philosophy of the publication.

Or you can ignore my advice and try to find the next big hitter the Portfolio will produce. You may succeed, but be aware that I don’t play that game; “fast guns” are wasting their time with this publication, as well as Asia and the rest of the international markets as an asset class.