Momentum and Value Investing

24^th February 2006
The Malta Independent - Friday Wisdom

If you are investing in the quoted shares of our three main banks (HSBC, Bank of Valletta and Lombard), you have to be a momentum investor.

Momentum investing is the antithesis of value investing. Whereas value investors search for the intrinsic underlying value based on fundamentals and only invest where they see that the market price discounts such fundamental value, momentum investors do not care much about fundamental intrinsic value.

Instead, momentum investors base their investment decision almost exclusively on the psychology reigning in the market. If there is a momentum building round a particular share or a particular market sector – even if this creates serious and sometimes awesome gaps between the market price and the underlying intrinsic value which would make such investment totally inconsiderable for a value investor – the momentum investor joins the pack and simply assumes that market momentum will continue to push share price(s) forward.

History shows that money has been made under both investment philosophies. The difference is that while value investors may have to wait quite some time for the market to discover the value discount and thus produce the capital gains they desire only on a long term basis, momentum investors can generally reap their returns within a relatively short time.

The problem with momentum investing is that when the momentum peters out, as it unavoidably will once the price surge runs out of steam, there would be nothing left to support the wide gap between the market price and the intrinsic value and the value argument will have to come back into the equation. And just like a rocket that runs out of fuel it cannot keep hanging in the air; if it cannot surge forward it will have to fall back to a reasonable distance of the intrinsic value pulled by the investment value gravity.

There is nothing wrong in being a momentum investor, provided one knows what one is doing. Whoever chooses such an investment strategy must however realise that if it is too good to be true, then it is generally not true, and when the whole process would have run its course, there will be winners and losers – but the sum of the parts will be the same. Such investors have to make sure that they leave the party when the champagne is still flowing – as, the moment the champagne stops, there will only be tears for the road.

Managements of our banking sector ought to know better than all analysts that the prices of the shares of their organisations have gone out of all reasonable ranges and they have a moral duty to calm down the party before it finishes in tears. The following figures need no additional persuasion as they speak for themselves:(Table 1)

Table 1

                                         P/E                                  Price//Book                          Dividend

                                        Ratio                                  Ratio                                   Yield

Global Financial Sector    13.3                                     1.8                                     3.1%

HSBC Malta                      33.0                                     6.0                                     3.5%

Bank of Valletta                30.0                                      3.7                                    2.3%

Lombard Bank                   25.2                                     2.8                                     1.6%

Note; Global Financial Sector compares to 2006 estimates whilst Malta Banks compares latest 2005 result except for Lombard Bank which takes 2004 results as 2005 results not yet published. Ratios based on local share prices as at 20^th February 2006

        

The only ratio that is comparable is HSBC Malta dividend yield and only because HSBC Malta is not only distributing all generated profits, but is even distributing past reserves.

Consider now how equity prices of the main banks have been performing on the Malta Stock Exchange: (table 2)

 

Table 2

Share Price Movements

                                              2004                  2005            YTD                   Cumulative

                                                                                             2006                2004-YTD 2006

HSBC Malta                           46%                 100%             36%                        297%

Bank of Valletta                      83%                   65%             30%                       292%

Lombard Bank                        15%                  111%               7%                      160%

Note: above excludes dividend distributions and is based on equity prices closing 20^th February 2006

I would have thought that this stellar performance in share prices could have inspired prudence in dividend distribution policy and share splits and bonus issues, which in the current context is like putting out more alcohol at a party that has gone wild.

Such policies are encouraging momentum investing at the expense of value investing. In the interest of long-term orderly development of our financial markets, prudence should have prevailed over cheer-leading.

But prudence is also unknown to our political class – who is ever so ready to clutch at every shred of positive news to take credit for its performance in office.

The Prime Minister is repeating the gratuitous assertion that the performance of the banks in reporting record operating profit is indicative of resurgent economic growth.

This does not make economic sense to me, as it could well be that economic growth is in fact being suppressed by the oligopolistic profits being returned by the banking sector. This deserves a thesis on its own some other time.

 

A tale of two cities

19^th February 2006

The Malta Independent on Sunday

No, I am not referring to the Charles Dickens classic. I am referring to what happened in Malta (Valletta, if you want the city) and New York where two pieces of market-moving financial news last weekend made it to the front pages of the Sunday papers in the respective cities.

The Malta Independent of Sunday carried a front page article titled “Investors ‘may get hurt’ by Maltacom’s spiralling share price”. Even if the article did not contain anything substantial, which of course it did, the title was enough to move a thin market like ours, so much so that up to the time of my writing this piece, the market in Maltacom shares turned down, protected only from sharper falls by the trading range set daily by the Malta Stock Exchange.

It is not the purpose of my contribution to agree or disagree with what the editor of The Malta Independent on Sunday carried on this matter as front page news. However, it is important that certain questions be asked in the pursuit of and in the interest of transparency in Malta’s financial markets.

The whole rationale of the article was based on a premise that “it is generally thought the share price (of Maltacom) at the beginning of the privatisation process (Lm 1.39) was a ‘fair price’… (but) the present price (Lm2.20) does not reflect the real worth of the company”. The article goes on to quote an unidentified source, which states that although “Maltacom made significant progress in curbing expenditure and re-structuring its efficiencies, it has invariably not registered any major or strategic breakthrough which can justify such dramatic increase in its share price”.

I find this quoting unidentified sources more than a bit unorthodox and to my mind goes against the letter and spirit of the stipulations of the Prevention of Market Abuse Act 2005, which came into effect last year. This places on journalists the obligation to be prudent when expressing opinions on market valuations and to disclose clearly their source and ensure that it is qualified and licensed to express such opinions. Quoting unidentified sources could lead to hidden agendas that could involve market abuse, especially in the process of privatisation where bidders have every interest to acquire Maltacom on the cheap to the detriment of government and the nation at large.

In fact, what amazes me and gives rise to further suspicion on the genuineness and objectivity of the opinions of the unidentified sources, is that what has been said about the Maltacom share price applies many numerous times more forcefully to the share prices of most financial services organisation quoted on the Malta Stock Exchange. Yet no word and no front page articles how investors ‘may get hurt’ from such investments as was done in case of Maltacom.

I think that in the interest of transparency it is imperative that the privatisation process of Maltacom be conducted with less secrecy so that investors can make their buy, sell or hold decisions on the basis of official information, prudently placed in the public domain, without jeopardising the competitive bidding process.

Now let us compare this to what happened in the other city. Google shares have been a hot story in the financial markets. Since its initial public offering at $85 in August 2004, the price skyrocketed to a peak of $475 per share late last year from where it retracted to $365 by the end of last week.

At the end of last week, Google sported a market capitalisation of $110 billion, rendering it the 18th largest company in the US stock markets exceeding the market value of such long-established brands like Coca-Cola. The market price consequently discounts substantial earnings growth for Google from $5.70 per share in 2005 (up from $2.79 in 2004) to $8.85 in 2006 and $12.06 in 2007.

Last weekend, a very respected investors’ magazine, Barrons, carried a special feature on Google and expressed doubts on the feasibility of such market expectations (collected by Thomson Financial after polling financial analysts, as Google itself, unlike the normal practice, does not issue any market guidance about its future earnings).

Barrons consequently hypothesised a scenario where Google’s reported earnings in 2006 and 2007 will be below market expectations and consequently its share price could be scaled back down to earth to a range between $188 and $257.

On Monday, Google shares reacted by falling five per cent to $345 and reaction to the Barrons article was as usual split between the bulls, that maintain a price target of $500 for Google in 2006, and the bears who went along with Barrons views. What was sure however was that no one quoted opinions expressed by unidentified sources. On the contrary, every opinion was not only fully attributed to an identified source, but such sources had to disclose all interest they can have in Google shares.

It is one reason why I always sign my name when expressing an opinion about market valuations and try to give technical reasons for my judgement. And also why, as a matter of principle, I refuse to have a personal interest in the local investments I advise on to ensure that my opinion remains objective and not motivated by any market movements that could result from such opinions.

Privatisating Properly

7^th February 2006

The Malta Independent - Friday Wisdom

There is no doubt that following the way that Mid-Med Bank was privatised through one-on-one private negotiations without due process of transparent bidding, the privatisations that have been effected since, have been much better organised to secure the best price in what appears to be a fit and fair process.

The main privatisations since the Mid-Med debacle have been MIA and the Pubic Lotto. The Freeport has also privatised its operations with the project title remaining in the hands of the Malta government, although I never understood the logic of favouring a shipping line with such an award rather than a port operator.

P & O port operators of the UK were recently up for grabs and the main contenders were the Singapore and the Dubai port authorities – eager to extend their global coverage to offer a real challenge to Hutchinson of Hong Kong, the largest global port operator. The price in the acquisition contest from P & O got so high that Singapore Port Authority had to withdraw when an international rating agency put its rating on negative watch for fear it might over pay and prejudice its financial strength.

Maltapost was also privatised in a haphazard way by involving New Zealand interest as minority equity partners and technical operators. It is widely acknowledged that the Maltapost deal was badly designed and is evidently being somewhat undone – at least in so far as the technical operations contract is concerned, although it is still not clear what the intentions are regarding the equity position. In any event, Maltapost is in context small fry.

Now we are on the verge of another major privatisation, this time Maltacom. What is different from recent privatisations and is again back to the model of the privatisation of Mid-Med Bank is that this time the government is privatising a controlling stake (60 per cent) of an organisation whose remaining shareholding (40 per cent) is in the hands of the public and is traded freely on the Malta Stock Exchange.

The process of privatisation must therefore take into account the need to protect sensitive information or making it public officially, in order to avoid the risk of creating false markets where information is leaked unofficially – producing an unlevelled playing field in the financial markets.

Certainly, no one has suggested that to avoid this from happening, we should adopt the Mid-Med model of privatisation through secret one on one negotiation. It has been proven that such a model does not produce the best price for the vendor, as it restricts competitive bidding that is the surest way to secure a fair price. In any event it fails basic and elementary governance tests.

However, jittery market movements in the share price of Maltacom – since it was announced that the process has entered the final phase for submission of binding offers by identified short-listed bidders – seem to suggest that the chosen method leaves something to be desired by way of market transparency.

Such jitteriness is not uncommon in equity markets and the fundamental principle should be that all market participants are to be in the same position with the same level of information available to everybody. Furthermore, at such a delicate stage of the privatisation process, licensed analysts who choose to an express an opinion on the appropriateness or otherwise of the share price determined by the official market should do so directly and not anonymously. They should also give technical reasons for their opinion and disclose any conflict of interest in the matter or certify that no such conflict of interest exists in order to remove all doubts regarding the objectivity of their opinion.

Maybe to assist the functionality of a proper market the Privatisation Unit should consider being more transparent in the final phase of its selection process.

Presumably, the fact that a few bidders have been short-listed to submit a binding bid means that the other terms setting minimum standards of acceptability have been met. These, no doubt, would include the bidders’ financial standing, technical ability, investment commitment, and general business plan showing an acceptable deployment of the human resources that will be taken over through the acquisition of Maltacom.

Having come to this stage, I think that in the interest of financial transparency, serious consideration should be given to making the price setting process fully visible by means of bids opened in public or in a beauty contest type of bidding.

In this way, not only will the public be satisfied that the privatisation process is due and proper, but the investing public would not need to stay second guessing where the privatisation price is heading in making its decisions whether to buy, sell or hold Maltacom shares.

Obviously, it is important that such an open bid process or beauty contest be conducted after market hours – in order not to disrupt the operations of the Exchange during its normal trading hours.

These are delicate issues which need to be handled with utmost care and sensitivity. At this time, the Malta Stock Exchange and the Regulator of Financial Services should be extra vigilant to guard from manoeuvres which could condition the market price to the bid price in any way other than through official information placed in public domain as quickly as possible for investors to be guided in their judgment by real things not imaginary hypotheses.


   

A Tax to Reconsider

10^th February 2006
The Malta Independent on Sunday
 

The government has finally indicated its readiness to reconsider the airport departure tax which was increased by Lm10 last year and which on evidence has materially impacted on the residents’ aptitude to travel. Travelling, being a discretionary sort of spending, is very sensitive to pricing and the tax has acted as a serious disincentive, which added to increased security charges for airport use, could in effect be counter-productive as a revenue generating fiscal measure.

If government accepts such logic one wonders whether the promise to reconsider such airport departure tax if current year’s fiscal objectives are met has a smack of electioneering in it. In terms of revenue generation it has been proved as largely counter-productive so its revision need not impact the fiscal performance to any material degree. Or is it more politically opportune to review such tax in 2007 as it would preserve the feel good factor for the electoral test of 2008?

Bad as it may be the airport departure tax is at least not discriminatory. If one is a resident in Malta and one opts to travel through the airport one pays the tax whatever one’s circumstances. However we have other fiscal measures still in discussion stage in front of parliament through the bill to implement measures announced in the 2006 public budget which are much more discriminatory and which needs to be re-thought before we bring confusion to our tax system.

This relates particularly the proposed change of taxation regarding profits, and even non-profits, from sale of immoveable property which this week gave us quite an uncommon experience in parliament of a government measure being severely criticised by a government’s own member. Former Finance Minister John Dalli, who is the architect of the current tax structure including VAT, FSS and withholding tax system on investment income, was highly critical of the measure hotchpotched at the last budget and amended soon thereafter to change the tax system of sales of immoveable property. And with good reason!

Because you cannot include a fiscal measure under our direct system of taxation, i.e. the Income Tax Act, which could involve the possibility of tax being due even where there is no profit on the transaction. Legislation cannot just take recent commercial experience into consideration and simply assume that all property sales are conducted at a substantial profit so that imposing a withholding tax on the declared sales value translates to a straight forward way of taxing profits from such sale. There are, and in future there could be much more, instances where a sale is conducted at a loss even if sold a at distance of more than five years from its acquisition.

The new tax system of imposing a withholding tax of 12% on the sales value of immovables that are sold after five years from acquisition is wrong in principle as it discriminates against taxpayers conducting a perfectly identical transaction. Take the case of A and B who are selling an identical property under the proposed legislation for the same sales price of Lm100000 and which they both bought for Lm80,000, all expenses included, thus each making a profit of Lm20000. However whilst A bought his property within the five year time limit imposed by the proposed legislation, B bought his just beyond such time-limit.

A has the option to be taxed at 35% on Lm20000 profit incurring a tax charge of Lm7000 whilst B is compulsorily obliged to pay withholding tax at 12% of the sales value of Lm100000 incurring a tax charge of Lm12000. What tax logic and tax equity can sustain a tax system that structures such discrimination in its application?

Taxes are generally abhorred but accepted, with or without protest, when they apply indiscriminately amongst taxpayers. But when taxes start discriminating amongst taxpayers conducting a perfectly identical transaction because of some backdated artificial line of demarcation, than they become unacceptable as a matter of principle.

And what about sales of commercial property which by all practical measures has not experienced the same price rises as residential property over the last few years. How sensible is it to tax at 12% the sales value of commercial property that has been carried for more than five years incurring substantial interest charges and has to be sold under pressure from the banks who demand repayment of their loans as the margin between the accumulating debt with interest and the market value get too narrow for their liking? A clear case of being constrained to pay taxes even where there is no profit and without the possibility of using the resultant loss against future business profits.

The new tax on sales of immoveable profits also brings havoc to the long – term plan to build audit trails to achieve better tax enforcement through complimentarity of the various tax systems. Through the proposed withholding tax on property sales the inbuilt need to justify costs under the former system is being washed away opening a disincentive to adhere to VAT legislation in property development with consequent loss of audit trail on profits declared by contractors and other building services providers.

The measures seem to be a case of the tail wagging the dog. The wish to give fiscal incentives to facilitate the sale and development of long held property is leading to measures that discriminate against more active property owners and compromises the enforcement process of the whole system of taxation through lack of complimentarity between direct and indirect taxation.

And this when the need for giving incentives to property hoarders has been very unconvincingly made. What these people really needed was elimination of the provision introduced in a previous budget where the mechanism to tax capital gains made since 1992 when the capital gains provisions were first introduced was washed away and rendered all capital gains taxable since origin – another piece of nonsensical retroactive taxation.

It would do well for the Finance Ministry to take stock of the situation and the parliamentary debates again before deforming our tax structure through irreparable harm of cash carry instant cooking legislative changes.

Finding a soul for our Euro

 

The Malta Independent on Sunday

So now we have a face for our Euro. The real challenge is finding a soul.

It is important to get the symbolism of the change-over from Maltese Lira to Euro out of the way as early as possible to permit proper focussing on the ‘soul’ issues of the matter. I am pretty sure we can handle all the logistics of the change-over, from the replacement of notes and coins to the shift of all accounting and reporting, including past historical figures for comparative purposes, without undue stress. I am sure that we can quickly adopt to retailing under Euro pricing and to valuation of existing contracts and investments denominated in Maltese Lira in new Euro terms without any major mishaps. Six months into 2008 all this would be behind us and the Maltese Lira would be little more than a historical relic.

What I am not so sure we can handle is the need to re-structure our economy to remain competitive and achieve fast economic growth in order to make the adoption of the Euro a positive experience when we would be sharing a monetary union with other countries whose economy is much more flexible than ours and much better poised on growth trajectories we can only dream of. That is the challenge of finding a soul for our Euro!

It is a source of apprehension for objective analysts that we seem to be approaching such a monumental and irreversible decision with an air of nonchalance. We seem to be in a mind-set that converting to Euro is a ceremonial event not dissimilar to the experience we had when we had converted from shillings and pence to decimal cents and mils.

It is quite different. What will happen when we convert into a monetary union is that we will be giving up one of the few levers we still have for economic management and get locked into a fixed exchange regime which would be a shared structure with other countries in the monetary union. Our survival and enrichment within the new structure will depend on rendering our economy competitive and flexible as much as that of Estonia, Lithuania, Latvia and Slovenia who are basking in the economic sun as we merely survive in a seemingly interminable economic winter.

The administration seems to believe it can address our economic ills by merely talking positively about them and harping nauseatingly that we are on the right track. The issue is not whether we are on the right track. It is how fast are we moving forward along it.

And more than that. Not only how fast but also how stable. The truth, if it is to be said,is that the little economic growth we are registering is very unbalanced. We do not have economic growth spread across all sectors. Growth in manufacturing and tourism is notable by its absence. Our growth is focussed on construction and real estate development which strangely enough demands labour resources which are already in scarce supply and for which we have come to depend on illegal immigration.

We have a very strange phenomenon which is stretching into uncharted economic territory. How durable is the economic equation where retail inflation remains subdued whereas asset prices keep rolling forward like an unbridled horse? Can we underwrite a system where wage growth remains restrained whilst consumption continues at superior levels as consumers wind –down their savings feeling comfortable that the reduction in savings, or in some cases the higher level of consumer debt, is well compensated by the increase in their overall wealth through higher real estate and exploding equity prices quoted on the Malta Stock Exchange.

These are the issues that have to be discussed and addressed if we are really to find a soul for the Maltese Euro. Otherwise we would be rendering our future as a hostage to fortune.

One of the things that people do not seem to realise is that package of the monetary union in the Euro comes an obligation to have the same domestic interest rates as that applicable for the entire monetary union. The level of such interest rates are decided that the European Central Bank who have to take into consideration both domestic ( i.e. Euro area - wide issues) as well as international issues. Certainly the state of the Maltese economy will have very low priority and practicality no influence whatsoever on the level of interest rates for the Euro.

Growth in the real-estate and construction sectors are very much dependent on low interest rates, the sort of we have been experience since 2001. If the market turns, as it has a habit of doing over an economic cycle, and Euro interest rates move to much higher levels than we seem to be taking for granted, this could very well puncture the only areas which are producing some growth. We could see sharp correction in asset prices which deflate the economy unless in the meantime we can render it flexible and competitive to put new verve into our manufacturing and tourism sectors.

The real challenge is finding a soul for the Maltese Euro, a challenge which we are disregarding at our own peril.

Be Careful What You Wish For

3^rd February 2006

The Malta Independent - Friday Wisdom

It might come true. So goes the old adage. Wishes tend to appear more desirable and attractive when they stay as wishes rather than when they turn into reality. Disappointment and confusion can well result – leading to regrets that the wishes did not stay as wishes.

Two contemporary events are testing the wisdom of this old saying: one from the international scene and the other from the domestic.

Let me reflect on the surprise landslide victory of Hamas in the Palestinian election. That Hamas would do well in the election was easily predictable. However, that it would win an overall majority with a landslide was beyond all predictions, even those of Hamas itself.

It is clear that Hamas has not prepared itself for the responsibility of governing through an outright and clear democratic mandate, as it was expecting a substantial increase in its share of the vote, but not to the extent that it would overtake Fatah and gain an overall majority.

Wishing for electoral success might seem stimulating and motivating. Out of government, it is easy to promote policies without actually having to prove them and be accountable for their practical implementation. From the opposition, it is easy to challenge and criticise government’s policies and it needs little more than demagoguery to inspire the crowds with promises and aspirations.

Tasked with the responsibility of governing, reality has hit home, as Hamas now has to prove that it can translate its promises into a tangible action programme that delivers a better life to the Palestinian people. All the indications are, however, that Hamas itself is as surprised as the rest of the world and that it is ill-

prepared to meet the test of reality rather than continue with mere demagoguery.

And the suddenness with which events have unfolded, and the evident lack of preparation for such a new reality, adds further complexities to a situation that was already very difficult. Hamas has placed itself in strong contradiction, where the room for manoeuverability that they allowed themselves is pretty well zero.

Hamas has been elected on a vision of firstly pushing Israel back to the pre-1967 boundaries, leading to the eventual reversal of the 1948 UN decision for the creation of the State of Israel on Palestinian land.

Obviously, such a vision is easy to fan from opposition, but with the responsibility of government it is clear that it would isolate the Palestin-ians at a time when they most need international political support and financial aid. All people of goodwill can only continue supporting the Palestinians if they undertake a sharp revision of their objectives and accept the reality of the State of Israel and commit themselves to a policy of peaceful co-existence in a two-state solution.

On the other hand, such an instant sharp revision of policies that have been cycled for decades would weaken the very democratic base that produced the mandate to govern. In difficult circumstances such as these, it takes a huge dose of scarce leadership to find a delicate way out an impossible situation by gradually changing long-held visions as concessions are made against securing material aid which can alleviate unbearable miseries.

The more likely and unpromising development is that, in response to Hamas election to government on the Palestinian side, the forthcoming Israeli general election will elect someone like Netanyahu, thus killing all hope of a negotiated settlement.

Such conflicts often arise as a result of different interpretations as to when history starts.

For the Palestinians, history starts in 1948, when their land was taken away to create the State of Israel under a UN charter. For the Israelis, it was a homecoming to the land they had occupied when Moses took the Jews out of Egypt and across the desert to the land of milk and honey, which had hitherto been occupied by the Canaanites. According to the Israelis, only the no longer existent Canaanites can legally claim title to the land of Israel, and for them, history starts more than four thousand years ago.

Coming closer to home, we also have to be careful about wishing to strike oil in the Australian geological research being conducted. Rumours has it that the research is producing promising results. I seem to be one of the few who harbours grave doubts over whether finding oil in commercially exploitable quantities and conditions will be to our long-term benefit.

My worry is that what is commercially exploitable, when crude oil comes with a price tag of nearly $70 per barrel, might not remain so when oil eventually reverts to more normal price levels.

And if it so happens that we adjust our economy and our expectations and start behaving prematurely like small sheiks, we could find that growth in the oil sectors displaces rather than adds to other economic sectors and that oil sector growth may not, in the long term, be as stellar and sustainable as it has been these last three years.

We should be careful about wishing for riches through winning the lottery of oil exploration. We have come a long way through exploitating our abilities rather than our luck. I would much prefer that we continue to believe in our abilities and our winning in the global world through efficiency, ingenuity and innovation rather than rely on material resources, the value of which is subject to sharp fluctuations way beyond our sphere of influence.

We should be careful what to wish for.