Revisiting a warning

29th December 2006

The Malta Independent - Friday Wisdom

On 24th February 2006, I had given this stark warning, through the medium of this column, to investors of Maltese shares quoted on the local Exchange. It is a warning worth revisiting:

“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.”

The timeliness of this warning can be gauged with the benefit of hindsight, The share price of HSBC Malta is 28 per cent off its end February 2006 value and 35 per cent of the highs reached in March 2006. Bank of Valletta share price is 22 per cent off its end February 2006 value and 28 per cent off its peak in March 2006. Lombard is marginally still above its end February 2006 values and off only 11 per cent the peak reached in March 2006.

In spite of this sharp correction in equity prices in the second half of 2006 there is still evidence to suggest that, in comparison with their international peers, local equity prices still carry an unjustified premium, keeping value investors away from the market.

What is puzzling is why the share price of Lombard Bank seems to be living in a different planet from the share of the two bigger banks. There could be several reasons for this. Firstly the share price of Lombard Bank had not reached the dizzying heights reached by the other two Banks so the correction needed could be less pronounced.

Secondly Lombard could be commanding a premium in its price through a development which occurred during the second half of 2006 whereby Lombard acquired a strategic equity stake in Maltapost.

The market could well be pricing in the growth which Lombard could experience if this strategic acquisition is turned into an effective delivery channel to challenge the broad branch network of the two larger banks.

Yet Price Earnings Ratios of 15.24 for Bank of Valletta, 23.27 for HSBC Malta and 18.90 for Lombard still represent a substantial premium over the average of 12.58 for international financial services companies. The higher the price earnings ratio the more expensive the share price is in comparison to the profit generated by the organisation whose share price is being assessed for value indicators.

There is no rule that local equities should not justifiably command a premium over international peers but when such premium gets way out of anything that may be considered reasonable, then it is inevitable that sooner or later the market will have to adjust.

The question for 2007 is whether the price adjustment process has been completed or if there are pains yet to come as this process continues into next year.

As years go by

22^nd December 2006

The Malta Independent - Friday Wisdom

Another Christmas, another year! Time flies away so quickly. The year 2006 will soon be consigned to history. Sports enthusiasts will remember it as the year of the World Cup in Germany where Italy defied most odds and won a coveted prize from the clutches of Brazil that were considered as unchallengeable favourites.

Yet 2006 will probably be remembered for much more serious issues of life and death, war and peace, poverty or prosperity. In particular two new realities came to be in 2006 which will undoubtedly influence the developments of international relations for the years ahead. Both events are somehow related. Firstly 2006 was the year when Americans joined the rest of the world in the long held view that the war in Iraq is un-winnable for the US and allied forces. It is the year where the US has been frozen in Iraq in a quasi desperate situation where they know that they cannot reach their invasion objectives, but at the same time they cannot afford to leave without risking that Iraq tears itself apart in a religious civil war which will increase Iran’s influence in the region and threaten the stability of oil exports so indispensable for the world economy.

It is the year when Americans finally realised they elected the wrong president who led them into a cul-de-sac in international relations and brought to the fore the limitations of the undoubted military superiority power of the world’s sole superpower. It is the year when the Americans were forced to abandon their policy of staying the course in Iraq whatever the consequences, to the realisation of the imperativeness of seeking a more tolerable diplomatic solution by engaging Iraq’s neighbours in such negotiations.

The other major development is related. The 33-day war of Israel on Lebanon again exposed the limitations of using military power to obtain diplomatic concessions from non-state organisations like Hezbollah, whose value of life, even their own, is much lower than that of organised state powers and can therefore afford human shields, suicide bombers and other such like strategies to cultivate international pressure against the organised military force being used against them.

With the effective use of America’s international military power and Israel’s regional war capabilities substantially dented by these two events and with Iran strengthening its influence in the region not least through the use of the substantial money flows from its oil resources, it is fair to wonder whether Iran, and Syria, are not the real winners of wars they are involved in only by proxies.

There is nothing to suggest much confidence in the thesis that if Iran and Syria are engaged in multilateral discussions at diplomatic level to influence a negotiated settlement on the issues of Iraq and Palestine, the price they would expect for such engagement would be one that the international community should be prepared to pay. Iran will probably insist on its right to become a nuclear power in the region and Syria is likely to insist on its continued hegemony over Lebanon.

America’s impotence through the loss of the deterrent value of its military force, coupled with that of Israel’s following the unsuccessful Lebanon invasion, which has failed in all its major objectives, is leaving a dangerous void in the Middle East which does not augur well for future stability in the region based on the continued democratic development of its single constituents.

This void must be filled and it is the duty of the European Union and other European states not to allow this void to be filled by those whose values are not anchored on democratic principles and who think they can impose their fundamental religious beliefs on the entire Middle East region and then proceed to fight an oil war against western democracies.

A solution to the oil issue is an indispensable chip in the equation for a lasting solution in the Middle East. We are presently caught in a dangerous spiral where the more instability anti-western oil states create, the richer they become as the oil prices start reflecting a premium for the prospective instability of future supplies. This circle needs to be broken.

Inevitably the prize for breaking this circle is the re-emergence of Russia as a power at world level. As a non-Opec member Russia will be a crucial provider of energy exports to stabilise supply disruptions that could result from Middle East instability. Engaging Russia at international level and accepting that democracy in Russia cannot achieve perfection instantly and that occasionally lapses into autocracy are unavoidable in order to keep controlled development towards a working democracy, are essential for smoothening international relations.

But the bulk of the void needs to be filled by the EU. The success of engagement of former communist states into full membership is remarkable. In spite of short-term pain the long-term gain is there for all to see as the EU economy is now growing and is more competitive than it would have been without the enlargement to the East. Without fixing unrealistic time schedules the enlargement to the east must continue. The process of engagement itself would bring stability among neighbouring states. Without such stability the EU will have socially upsetting waves of illegal immigration and conflicts with bordering states.

May this Christmas bring peace to everyone. May world leaders reflect during this Christmas break on the need to lay down arms and work for peace through long-term diplomatic engagement. May they come to realise that the road for peace in Baghdad passes through Palestine and Israel rather than the misguided Bush strategy that the road for peace in Palestine passes through Baghdad. Tony Blair was always right; he was simply not forceful enough to make George W. Bush see the light and is finishing his career paying a price for a misguided policy he intrinsically never really believed in.

Cautious Optimism

15^th December 2006
The Malta Independent - Friday Wisdom

Economic data is continuing to show a general improvement in Malta’s economic performance. Provisional estimates for the third quarter of 2006 indicated an annual GDP growth in real terms of 2.7 per cent. International trade statistics for October 2006 have shown a small narrowing of the trade deficit for the month compared to the same month last year, with a 17 per cent increase in exports and a 22 per cent increase in imports of industrial supplies. The latter is indicative of further potential for export growth in the pipeline.

None of this should necessarily lead to the euphoria expressed over the weekend by the Prime Minister during the normal Sunday ritual of economic bulletins within the strange confines of local political party clubs, where people are more interested in beer than economic statistics.

However there is scope for cautious optimism; so much so that the opposition’s criticism of the government’s economic performance is rapidly losing its punch.

A 2.7 per cent real annual GDP growth is to my mind way below our natural potential for growth which is nearer to five per cent. We do in fact need much higher growth rates nearer to our indicated potential if we are to make progress to catch up on the EU average of GDP by 2013, after which period we will experience a substantial reduction in EU grant revenue. But considering that we are coming from a negative outturn of –2.3 per cent in 2003, a meagre 0.8 per cent growth in 2004 and 2.2 per cent in 2005, the progress is noticeable.

What gives scope for cautious optimism for 2007 are several factors which seem to augur for a stronger economic performance for next year. The economic growth recovery in our main export markets of the EU is remarkable and all indications are that economic growth in Europe will overtake that of the US next year. Strong economic growth in overseas markets leads to stronger demand for our manufacturing exports and in fact we are witnessing substantial growth of pharmaceuticals and microchip exports.

The 2006 performance is encouraging considering that one of our major industries, tourism, was working at half throttle. Nobody should doubt our potential to re-achieve strong growth in our tourism sector and if we manage to do it in 2007, then by and of itself this could add between one and two per cent to the GDP growth for 2007.

If on top of this we could be favoured by a more benign environment for international energy prices, even if this were to mean merely that oil prices would stay at around the current $60 level and the US dollar stays at around 1.32 to the euro, then the government could justify converting such cautious optimism into real registered growth that could lead to pre-election euphoria.

Clearly the government is banking on this sort of scenario as a favourable background leading to the general elections, hoping that the feel-good factor resulting from such economic growth will be enough to persuade the electorate to stay the course with whom they know rather than opt for change for change’s sake.

The government also knows that infrastructure projects to be financed by the EU grants under the 2007-2013 financial programme, will add further impetus to economic growth and resultant feel-good factor.

Yet there is no doubt that among the electorate, the government is suffering from fatigue and perceived arrogance. Many I meet doubt whether any amount of feel-good factor would be enough to overcome the desire for change after more than 20 years of the same faces in power, excluding the largely forgotten interlude of 1996-1998.

It would take a very high dose of such feel-good factor to give the PN scope for euphoria about their prospects for re-election.

On the other hand, the PN knows it has more than the feel-good factor to aid them in winning the electorate’s favour.

The point that Labour has been fossilised under an unsuccessful leadership for 15 years is being made with forceful persuasion.

Pity Labour could not find the courage and wisdom to present itself for the electorate’s choice not only with new policies but more importantly, with new candidates who do not carry the baggage of the misguided policies that changed the freshness of the1996 victory into failure of not being able to hold on to the executive power delegated by the electorate for even half a legislature in 1998.

Labour is not helping democracy to express itself through practical alternation of power.

Over Compliant

8^th December 2006
The Malta Independent - Friday Wisdom

 

Is it just an impression or are we really changing, and from a laissez-faire society we are fast turning into an over-compliant one? Are we becoming Swiss in the Mediterranean, giving up our sense of improvisation and turning into a regimented society?

What sparked off this strange thought was an experience I had last Monday evening. Just before six in the evening while at my office, my scheduler set off an alarm reminding me that I had to pick up my son from a football nursery at St Andrews.

I rushed for the usual road towards St Julian’s and when it was too late to turn I realised that I had put myself into a traffic bottleneck due to works started on the Manwel Dimech Bridge, which reduced this main thoroughfare to a one-lane road. Notices with deviation signs had sprung all over the place and warnings have been duly issued to avoid this traffic juncture while works were going on. I could only blame myself for negligently forgetting about these warnings.

I drove on and could not believe my eyes when I managed to sail through the tunnel approach and the tunnels themselves in a one-lane stream without any problems. My trip to St Andrews proved much smoother than usual when traffic arrangements are normal.

Evidently so many cars had followed the deviation routes that driving through the feared congestion proved totally smooth and effortless.

The conclusion can only be that when we were made to perceive compliance as less burdensome than non-compliance, irrespective of the real thing, perceptions prevail and people willfully comply. Nobody forced anybody to take the deviation. But warnings were duly given that if the normal route is chosen the congestion delay could exceed the delay for following a divergent route. And it worked so well that the feared congestion did not result at all.

Can we transfer this analogy to other areas where compliance is still deficient? How can we use it to achieve better compliance in our tax systems?

This is an area where compliance is important not just to ensure that the burden of financing the working of society is carried as intended by the tax planner, but also because a high degree of tax compliance is essential to ensure that social transfer payments are made on the basis of real needs. Unless we achieve a fairly high degree of tax compliance, many of the means-tested social benefits go to those that do not really need them and are denied to others who have a genuine claim for such social assistance.

Tax compliance obviously depends on the quality of the enforcement mechanism. Human nature being what it is, people generally try to avoid paying taxes if they see that the enforcement mechanism is lax.

In a lax enforcement scenario the cost of compliance is perceived to be higher than the cost of non-compliance and those who have a choice opt for the cheaper route.

However it is realised that enforcement needs resources and could become quite expensive in deviating a large amount of scarce resources to enforce taxes rather than to create wealth. It is not in the national interest to do so.

So before enforcement can be upgraded we need to find a natural balance where the marginal tax rate is low enough to tip the balance of choice. It has to be a rate where the cost of compliance is perceived to be equal to or less than the cost of non-compliance.

Once this fine balance is achieved the compliance ratio increases so much that the scarce enforcement resources could be applied vigorously onto the much smaller residual base that continue to avoid compliance. This would reinforce the culture of compliance as it increases the cost of non-compliance.

I know this is easier said than done. There are all sorts of implications that need to be taken into consideration but one must at least have a sense of destination of where we have to go with our tax systems. And I have no doubt in my mind that we need to arrive at the destination of creating a frame of mind similar to the one created for the traffic deviation system of the Manwel Dimech bridge. A frame of mind where tax compliance is perceived less taxing than non-compliance.

A frame of mind where tax-compliance is cheap enough to permit compliance so that we can use our traditional creativity and flair for improvisation for the proper use, both for consumption and investment, of the bigger residual value of the tax paid earnings, rather than to avoid tax and having to stash the tax liable funds idly under the mattress.

That December Feeling

1^st December 2006
The Malta Independent - Friday Wisdom

 

Unbelievable how time flies! Eleven months of 2006 are history and today we start the last month leading to a James Bond year.

Government is softly, softly slipping into an electoral mode and is doing all that is possible to create that feel good factor which has been missing since soon after the last election we discovered that rather than having government finances on a strong footing much more belt tightening was needed to come into euro shape.

Now no opportunity is lost to inform us that, inflation permitting, we are already in euro shape. This is however not the same as saying that we are in good economic shape. Having public sector deficit, public debt, interest rates, exchange rate and inflation within or moving gracefully towards the Maastricht criteria, is not necessarily synonymous with an acceptable economic performance.

The true criteria for the latter are much wider. They have to include employment creation, labour participation, balance of payments situation, level of investment and overall size and nature of economic growth always benchmarked to that of our main competitors which in our case ought to be the new members of the EU rather than the old ones.

Yet there is no denying that achieving a smooth fusion into the euro monetary system is an important economic milestone which could be a catalyst for the achievement of the wider economic objectives. The euro project will dominate the economic calendar of 2007 and will no doubt be used by the government to generate a sense of pride and achievement which will generate a feel good factor for an election which could be held with a few months on either side of the actual euro entry in January 2008.

This December, possibly being the last Christmas month before the next election, will be a good launching pad for the government to stimulate such feel good factor so essential for the electoral democratic test. Facing the run up to Christmas with budget discussions well behind us will no doubt help to focus people’s attention on increased consumption which is typified by the quantity of people in our best shopping streets and malls.

The new traffic and parking arrangements for Valletta, which are only suffering the consequences of their success in that the car park at Blata l-Bajda gets full too early each morning, should make more people rub shoulders in our Valletta streets and in the process rubbing on each other the feel good factor which comes from the joy of Christmas shopping.

International events are also helping to permit the government some latitude to engineer an immediate increase in the spending power of the population without involving budgetary measures. Free parking for Valletta shopping is a small but significant contributor in this regard. Shifting the wardens’ focus from negative fine levying disciplinary attitude to more positive supervisory and environmental duties also eases a drag on the feel good factor.

However it is the happenings in the international energy and foreign exchange markets which are the best harbinger of good news to the local consumer. With oil prices stable at around 60 dollars well off the peak of 78 dollars hit earlier this year, and with the US dollar sliding back in value against the euro, and consequently against the Maltese lira, to the lowest levels last seen this time in 2004, will permit the government to announce on this very same day a substantial reduction in the surcharge on utility bills and reduction of fuel prices at the pump.

All these things falling together at the right time seems to be a coordinated effort, aided by a stroke of international luck, to generate what the GRTU has proclaimed as having the prospect of being the best Christmas for a very long time, from a commercial point of view.

Other measures of a more social nature should also help in having a better Christmas than last year. Certainly the curtailment of open bar parties is an overdue step in moderating the binge drinking culture among our youth.

Yet even while enjoying a good December and a peaceful holiday season we must not think that all is fine and dandy. The fact that the economic situation is better than it was in the first half of this decade is not the same thing as saying it is fine and where it should be.

With tourism, one of our most forceful economic engines working at half throttle, we can never be satisfied with our economic performance. What can sustain or wither away the December feel good factor for the rest of the run up to the general elections is the performance of our tourism sector where we have long been operating well below our capacity.

If we can put our house in order from a (hard and soft) quality point of view and render Malta as a cool destination on the European tourism map, possibly aided by the availability of flights on newly operating low cost airlines, next year we can possibly have the best performance in tourism since the turn of the millennium. No other industry can have the same multiplier effect generating a sustainable feel good factor than tourism, where the value added stays locally given the domestic ownership of most tourism outfits.

Our performance in the tourism sector next year could make or break the feel good factor which this December could help set in motion.