Thursday, November 13, 2008

When Markets Collide (Mohamed El-Erian) 7 comments

Mohamed El-Erian has had one hell of a career. He was a university academic, worked in the IMF for 15 years, went to work at PIMCO --- the world's largest bond fund --- alongside the legendary bond king Bill Gross, left to manage Harvard's multi-billion dollar endowment, then returned to PIMCO to share equal status with Gross as co-CIOs (chief investment officer). He is now one of the most respected investment gurus whom the public seldom hear about, though he is coming more into the public eye, through his regular commentaries on CNBC and the like. His first book thus warrants a read, especially when it comes concurrently with the "greatest financial crisis since the Great Depression" (as the media like to coin it nowadays).

Many books start off promisingly and then start to lose the reader's interest as they ramble on, and I'm afraid that this one is not an exception. The premise of the book is about the growing importance of emerging markets and the possibly turbulent transition process, hence the title "When Markets Collide" (ie. collide with the incumbent dominant Western markets), with the current financial crisis as a potential catalyst. El-Erian speaks authoritatively because he was dealing with emerging markets at the IMF and PIMCO, and the starting chapters are indeed very interesting, as he outlines his observations of various anomalies in the past few years, such as how long-term bond yields rose even as the Fed raised interest rates in 2005. He also highlights the importance of picking up information signals from apparent noise, in order that one may make sense of these anomalies. Then he defines the new destination: emerging markets.

According to El-Erian, the destination ie. the way that the world will evolve into over the medium to long-term, differs from the present in three main ways:
(1) For those seeking to understand global economic and financial developments, it will no longer be sufficient to get the US, Europe and Japan right. It will also be a matter of getting the emerging market economies right.
(2) New pools of capital, in particular sovereign wealth funds (SWFs), will become increasingly important and people need to understand what and why these new investors are likely to buy.
(3) Fundamentals will no longer be sufficient for projecting forward. Financial innovation via derivatives means it is also necessary to understand how the technical dimensions of markets are evolving ie. the financial infrastructure, the interactions between derivatives and underlying assets.

These predictions are justified correspondingly, through descriptions of how consumption of commodities, world trade have become increasingly dominated by emerging economies, how these economies have accumulated huge surpluses, and how securitisation has changed business models forever.

Having defined the destination, the rest of the book then goes on to describe the journey to get there, which El-Erian says he is less sure of than the eventual destination. In short, the medium-term evolution is more difficult to anticipate than the long-term destination. He does point out that there are likely to be "market accidents" ie. undesirable market volatility, given such a historic transition. My attention started to waver from this part onwards, especially when El-Erian talks about "action plans for policy makers and global institutions" and macro suggestions for "improved risk management" ---- topics which are very dry and not very relevant to me as an investor --- hence my earlier observation on the book being interesting at the start and disappointing towards the end.

Some of his views that are pertinent to the investor are interesting to note though:

(1) He advocates equity exposure away from the US and towards emerging markets. He believes there should be strong exposure to commodities, infrastructure, real estate ("real assets") in view of the new secular realities. Interestingly, he seems to recommend underweighting bonds, surprising since he works in bond specialist PIMCO. I might be mistaken.

(2) He sees emerging economies' macro policy evolving in a 4-phase process: benign neglect --> sterilisation --> liability & asset management --> embracing change. In essence, emerging economies that find themselves changing from operating in debtor regimes to operating in creditor regimes tend to be initially conservative in the management of their new-found foreign reserves, but will eventually realise the permanence of this structural change and manage their assets and policies proactively. El-Erian sees bond markets losing favour with these SWFs and equities gaining. Currency regimes could also become more open.

(3) He points out in fact, policymakers around the world already share a consensus on what constitutes a correct macro-policy response to facilitate the realignment of national economies and smooth functioning of the international financial system. This is as follows: the US is to reduce consumption to allow for a reversal of trade and budget imbalances; Europe and Japan are to implement reforms that will allow their economies to increase growth capacity and productivity; Asia and the oil exporters are to stimulate domestic components of aggregate demand. This coordinated response would reduce global imbalances and reduce financial system instability over the long term. However, all this must be done together; no country will want to implement this in isolation as it would be impacted negatively --- a classic "prisoner's dilemma". Perhaps this is what the G-20 are assembling for this weekend and will eventually work towards over the next few meetings.

A word of caution though: already El-Erian's expectation of emerging markets behaving relatively stronger than developed markets has turned out to be apparently wrong so far because in fact the flight to safety plus the deleveraging process has subjected the former to greater stress than the latter. It remains to be seen whether his long-term views will come to pass, but of course they carry a lot of weight.

Those not too well-versed in macroeconomics might find this book a bit hard reading. I myself have a general understanding but feel more at home in sectoral and company analysis, and I did lose interest at certain junctures of the book. I nearly did not buy it but eventually did, because it's this guy's first book and he'd probably have put a lot of honest thoughts into it.



Sunday, August 10, 2008

The Aggressive Conservative Investor (Martin Whitman) 4 comments

This book is actually co-written by Martin Whitman and Martin Shubik; the former is the better-known of the two as he is founder of Third Avenue Value Fund and is well-known in value- and distressed-investing. Offhand I recall that Third Avenue was a key shareholder of Chuan Hup which was privatised at big profits to the holders; it also has holdings in undeniably "value-type" stocks like Boardroom and Yellow Pages, though it seems to have been quieter on the SGX in recent years.

The book was written in the late 1970s, when the stock market was in the pits due to stagflation. The timing of its origination might partly explain its value bent, which might not be evident from the title but becomes clear as one reads the book.

The "aggressive" part of the title actually refers to investors who are "aggressive" within their own contexts because they expect a well-above-average return over the long term, and NOT because it wants to introduce a trading approach to stocks. This is strictly a book on fundamental analysis. In fact, its stockpicking approach is very simple and can be summarised in 4 points:
- Strong financial position
- Honest management that is creditor-aware and shareholder-oriented
- Adequate disclosure of information relevant to the success of the company
- The stock can be bought for less than the net asset value (adjusted book value) of the firm

The conservative nature of the stockpicking approach clearly suggests a bear market strategy (which might be useful currently).

It is refreshing to read a book that is so focused on fundamental analysis (in particular, financial statements) and yet does not go too hard on numbers, which tends to alienate readers. There are many good insights that are made, such as:

- stock investors should analyse a company from a creditor's perspective which would lead them to have greater focus on its financial strength, ability to meet obligations as well as the value of assets on its books.

- audited financial statements are the investor's boon and should be utilised extensively, since they are so comprehensive and the auditors will not risk their professionalism to lie for their clients (unless their interests are extremely intertwined)

- the P&L statement should not be over-emphasised because it can distort interpretation of real economic value if one relies too heavily on it; the balance sheet is just as, if not more, important

- earnings is just one facet of the value-generating activities of a company; value generated from asset conversion (sales of assets, restructuring, even use of tax-loss carryforwards) should not be ignored as well (hence explaining why balance sheet is also important)

- the need for the investor to consider exit strategy via cash bailouts, which could take place not just through open market sales, but also via privatisation potential and cash dividends issued by the company

The asset conversion approach is interesting and worth documenting down here for future reference. Basically, the authors recommend looking for situations where resources in a company can be used in a better manner, creating value in the process. There are several situations which might suggest potential for capital/operational restructuring that could unlock value:

- Overly conservatively financed company -- borrowing money to buy back stock, or issuing a special dividend could unlock value.
- Divisions that are undermanaged, or which would fit better in another company
- Company looks like it could be better off going private
- Analyzing corporate structures for where the value is (eg. holding company structure and finances)

Given Martin Whitman's interest in distressed investing, there is also a chapter on investing in loss-making companies and another one on merger arbitrage, both pre- and post- (read the book to understand what they mean).

This is not a Wiley Investment Classic for nothing. The concepts expressed inside are timeless and the fact that they were conceived in a bear market mean that the investor would do well to incorporate them into his philosophy in his quest to protect the downside. The book, however, is not recommended for those who are less than adept with financial statements because even though the authors are sparing with numbers, the writeups on financial statement analysis assume a certain degree of accounting knowledge of the reader.



Saturday, June 28, 2008

Wealth, War and Wisdom (Barton Biggs) 2 comments

I have covered an earlier book of Barton Biggs ("Hedgehogging") and his latest one is about a totally different subject (albeit still linked to investing). WWW (for short) deals with World War 2 and its effects on investments in the buildup, the course of the war, and in the aftermath.

Barton Biggs is a closet war historian, although his multi-decade career (before his turn to running a hedge fund) was as much-revered global market strategist for Morgan Stanley. This is very clear given his choice of subject for this new book, and the meticulous way he deals with the warring parties, the course of the war, the various narratories on the war on both the Allied and Axis sides, through to the various war anecdotes that makes one wonder how many volumes of World War 2 tomes he must have read to distill all these commentaries.

I personally have read many books on World War 2, many of them thicker than this 300-page volume. But Barton Biggs' approach on how World War 2 affected stock markets in the various warring countries offers a fresh perspective. The two broad themes in the book are:
(1) An uncanny ability of stock markets in general to anticipate turns in military fortune during the war, such as the market bottom in the UK markets at the 1940 Dunkirk evacuation, the market bottom in the US markets formed at Midway 1942, the market top in Germany at Stalingrad 1942. All this despite strict propaganda control, especially on the Axis sides, during the war.
(2) How wars can cause great wealth destruction and transfers between various classes of society. Biggs also examines the wealth-preserving power of the various asset classes, such as stocks, bonds, real estate, gold/jewellery, even art, in the chaotic and often hyper-inflationary environment generated by war and its aftermath (especially for the losers). His conclusion is that land ownership (but not the buildings, which were often bombed out) turned out to be the best assets to hold in most cases for the loser countries, while for the victors like the US, stocks did superbly, especially in the long term, if bought at the bottom. Asset performance was also a function of the political environment; where the authorities in power were liable to looting/plunder eg. Nazi Germany in its occupied territories, the wealth-preserving power of the various assets was simply a matter of luck (eg. whether the jewels could be successfully hidden from the looters or not). Generally, bonds proved to be the worst investment in the loser countries, as inflation soared.

To an investor who reads this book, the value of it is in providing a historical perspective to probably the most significant event of the 20th century, and not just from the viewpoint of investments. Too often, people eyeball the stock prices on their screen from day to day, churning and arbitraging and scalping, attempting to earn "kopi-money" and some even engaging in the petty mudslinging and fear-mongering that is so easily facilitated in today's online world. But the real money is made in the big movements and the secular trends happening in the world around us; miss the forest for the trees and you will be penny-wise pound-foolish. Many great fortunes were lost in the war and new ones made in the great asset redistribution following the war (a significant example being Japan where General MacArthur as occupying commander-in-chief ordered the redistribution of farmland and taxed inheritance heavily). And indeed, once one reads about the sufferings and sacrifices made by our fellow human-beings about 1-2 generations before us, investing and making money seem a trivial, almost coarse, topic, in comparison.

Too often nowadays the popular topic is America-bashing (me also a guilty party) in the wake of the subprime crisis which originated from Wall Street. However, the tremendous soft power that it still wields globally is probably a result of the enormous goodwill it generated from its participation in two world wars, and in particular its handling of the loser countries in the aftermath. America's liberal approach towards Japanese rebuilding allowed the latter to swiftly pick itself up to become the world's second biggest economy, and the latter is unlikely to ever forget it. It also saved South Korea from communism in the Korean War. This political goodwill is part of the reason why in its time of need, the world is likely to be ready to sink its funds back into an ailing US economy.



Wednesday, May 28, 2008

Trend Following (Michael Covel) 2 comments

My first impression of this book was that it was about technical trading, which would have turned me off because I hate seeing charts and the patterns they attempt to decipher out of it. Well, flipping through it subsequently, I found that it was about technical trading based on trend-following systems, but it focused more on the general philosophies behind it as well as debunking a few myths of conventional finance theory. It's one of those books that is more interesting than originally thought.

Trend following is actually a mechanical trading approach employed by many futures traders in commodities, currencies, stock and bond indices. Mechanical as opposed to discretionary: the latter is based on trading decisions at the "discretion" of the trader, whereas the former is based on an objective and automated set of rules. In effect, mechanical systems believe that the harm done by emotional trading outweighs the benefits that experienced human judgment can bring to the table.

I happen to believe in discretionary trading, but then of course part of the reason is because I don't have the skills nor infrastructure nor inclination for devising and implementing an automated trading system. And besides, the difference between the two categories is actually academic: a mechanical trading system must have been programmed using human experience and judgment as well, wasn't it? So it's the underlying trading philosophies that's important.

And the underlying philosophy is actually quite interesting and sound, and I have always felt it's important to get new perspectives on the market and not stick to one single view all the time. The author questions the following conventional views:

1) The definition of risk. Is it really volatility? Are mutual fund managers shunning volatility and adhering to benchmarks when volatility is in fact, natural, and tends to lead to better returns? Large drawdowns is a feature of trend following.

2) Decision-making process. How much of fundamentals is actually programmed into the market price of an asset already? Are the market professionals really chasing the wrong alley by trying to absorb as much fundamental information as possible and then trading on them? Trend following adheres to so-called one-reason decision-making --- and that reason is based on price.

3) Buy-and-hold. That's the approach of unit trust managers, and they point to Warren Buffett. Trend followers scoff at the buy-and-hold approach; they have strict cut-loss rules and attempt to ride the trend, whether upwards or downwards (of course, such a flexible approach is easier to adopt in futures, where one can long or short with equal ease).

The author also makes a distinction between "predictive" technical analysis that attempts to forecase significant market events, and "reactive" technical analysis which is what trend followers adhere to. The idea is that trend followers take trading positions with no knowledge that an event/crisis will occur; they take their positions as markets move. The fact that these particular small, initial price trends lead to big trends that lead to big events is not something anyone can predict. In essence, this approach is a "riding the wave" approach, as opposed to "calling the bottom/top".

I can actually identify with trend-following at its core, simply because it is difficult to see how far a trend can go (just look at oil prices now, for example). This, in my view, is especially so for financial assets which are subject to complex demand-supply dynamics which, like macroeconomics, are composed of a thousand moving parts and might prove difficult to decipher fundamentally and might be more subject to short-term momentum and sentiment. On the other hand, my approach is that my entry into a stock should be fundamentally-driven; it is trend-following as well, except that I follow a fundamentals trend.

At the end of the day, the approach one takes is a function of one's beliefs and the tools availabe at his disposal. There is no single best approach. The book devotes one chapter listing the various successful and well-known trend followers: John W. Henry, Ed Seykota, Richard Dennis etc, probably as evidence of the viability of trend-following. Sure (though we don't know how many have failed using this approach), but if more and more people adopt trend-following, it might lose its viability. Such is how the market operates.



Thursday, March 20, 2008

Hot Commodities (Jim Rogers) 3 comments

Now, whatever what one thinks of Jim Rogers --- former affliate of George Soros and now chief doyen of the burgeoning commodities brigade --- it is worth listening to what he says, for his views on commodities and the dynamics that drive them. He has written a few books but this book is the one that crystallises his worldview on commodities, so it's the best one.

Jim Rogers wrote it in 2004 --- or more accurately, before 2004, since the book was published in 2004. That was probably 1-2 years into the boom in energy and metals commodities, and the agricultural commodities boom would only come 2-3 years later. One would have profited immensely from following the advice in this book, but of course it is all on hindsight.

The book offers a beginners' perspective to commodities so it is not heavy reading. To broadly sketch its contents, it begins by introducing commodities and the means to trading it plus the common terminology, then drives home the key catalyst for the coming boom (China), and then examines a few commodities in detail (Precious metals: gold; Industrial metals: copper, lead; Energy: oil; Agricultural: sugar, coffee). There is a set of very useful appendices at the end listing the main commodity indices and the various commodity contracts. Among the commodity indices are his self-created Rogers International Commodities Index (RICI) --- no harm having a little self-promotion.

To me the meat of the book is in the individual chapters on the various commodities. How Rogers structures the discussion is an indication of how he views the commodity market, and it is clear he see demand and supply as the critical issues to focus on, because he devotes separate sections to specifically discuss them --- the main consumers and applications for the commodity, the main supplying countries, the volatility of supply, what drives the supply volatility, and then a historical overview of the impact of demand-supply dynamics on commodity prices. There are some traders who trade on technicals such as trend-trading (some have been very successful at it); it appears that Jim Rogers is more a big-picture, fundamentals-driven type, my kind of man.

It is actually a very simple book; as I said, good for beginners, not much quantitative stuff. My main grouse with it is that Rogers does not cover more commodities than those mentioned. For those who want in-depth comprehensive coverage on the whole commodities universe, he recommends the yearbook published by the CRB (Commodities Research Bureau) which he snaps up every year and reads through front to back. So that's a tip there.

Inflation is here to stay, so whether one is really planning to trade in futures, or is just strictly a share investor, it will be useful to get a feel for commodities prices, because they are, generally without exception, the main cost components to an industrial business, and sometimes but less often, a key cost component to a service-based operation. Read my recent HotTrendsWatch writeup on Global Inflation for more details.