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The Christmas Pick
18th December 2009

As many regular readers of Webb-site.com will know, once per year at Christmas we have published a stock recommendation, the only "buy" recommendation we make each year.

Market overview

On 16-Sep-07, we published an article called Incredibubble, commenting on the bubbles in Chinese stock markets, both in the mainland and HK. With the Hang Seng Index (HSI) then at 24,898 and the Shanghai Composite Index (SCI) then at 5,312, we asked our readers in an opinion poll, what is the lowest level at which the two indices will ever trade at again? We closed that poll at the end of 24-Sep-07, and more than 59% of responses said the SCI would trade below 2,000, while more than 50% said the HSI would trade below 14,000.

Well as we now know, the SCI reached a daily low of 1,707 on 4-Nov-08, and the HSI reached a daily low of 11,015, as 28% of our readers said it would (only 14% said it could ever go below 10,000). Appearing on local radio on 28-Oct-08, the morning after the HSI hit its daily low, we remarked that on valuation measures, the HSI was getting near historic lows and would probably bottom out in the 10,000-12,000 range. In last year's Christmas pick on 17-Dec-08 we wrote:

"the subsequent 40% rebound has been irrational and we would expect the market to revisit that range as the recession bites in the first half of 2009."

Spot on! The HSI closed on 17-Dec-08 at 15,461 and did indeed revisit that range, closing at 11,345 on 9-Mar-09, the day the US S&P500 also bottomed at 676.53. Nine months on, the market has rebounded sharply, running on a double-whammy of record-low interest rates and a flood of money spilling over the border from mainland China. You see, while Western governments were busy partially nationalising their banks, China was already in majority control of all its major banks and did what central planners do best - it directed them to go forth and lend. This will eventually result in a huge pile of bad debts, and the need to recapitalise the banking system. Indeed, even without bad debts, the credit binge is already leading to some smaller bank capital-raising to increase capital adequacy ratios.

Meanwhile in HK, property yields and mortgage rates are at record lows - so when rates eventually rise, either rents are going to rise sharply (unlikely) or property prices will have to fall.

The big guessing game has been how long the world's central banks will keep rates so low, and how much inflation they and their political masters will be willing to tolerate in consequence. The longer rates stay this low, the more money will get piled into low-yield assets, including commodities. And the thing about commodities is that they eventually show up in the price of finished goods. Governments have managed to cushion the recession with profligate stimulus spending, often on things which will provide little long-term benefit to their economies but will leave them with much higher debts. For example, cash-for-clunkers simply advances some car sales now at the cost of lower sales in the next few years. The temptation to allow markets to inflate away those governmental debts must be enormous, and the public acceptability of a good burst of inflation, in terms of support for home prices and shrinking the real value of mortgages is similarly great, provided that wages rise too.

Governments can't keep the stimulus going forever, so we would expect a second dip in the global economies and a period of classic 1970s-style inflation without growth, or stagflation.

Turning to the HK market, in general valuations are much higher than a year ago, indicating expectations of a great rebound in profits which may not be fulfilled. In terms of corporate activity, we have seen a return to the frothy days of 2007. It seems that hardly a day goes by without another little company becoming a back-door listing vehicle for the next big thing in some obscure Chinese or Mongolian natural resources play, all on the back of flimsy due diligence and typically dealing with a BVI company probably owned or obtained from some shady former official with an ill-gotten exploration license. There have also been some rather desperate-looking IPOs recently. A lot of the larger Chinese consumer plays are also overheated - their P/Es have run way ahead of their growth prospects.

It's the end of a decade, so party while you can, because we would expect the traditional new year's rally to fizzle out as spring arrives.

Last year's Pick

Last year's pick was Alco Holdings Limited (Alco, 0328), a maker of consumer electronics, including portable DVD players, flat panel TVs, iPod/iPhone-ready audio systems and set-top boxes. Well if you joined us, and became an "Alco-holic", then you did well. We picked it at $1.21. It reached a daily low of $1.03 on 20-Mar-09 (so you had the opportunity to get it even cheaper than when we picked it), and it closed yesterday at $2.99. It also paid dividends of $0.23, representing a dividend yield of 19.0% on the pick price. So overall, our pick gained 166.1% for the year, compared with a 42.3% total return on the HSI (dividends reinvested).

As we wrote in last year's article:

"in our fishing ground of small-caps, valuations are at least as cheap as in 1998. We are spoilt for choice, with some companies trading at close to their net cash, at steep discounts to net asset value, with consistent dividends yielding in the teens, and with P/Es below 4. Indeed, your editor's entire portfolio is tonight on a trailing 12-month P/E of 3.67 and a price/book of 0.41. The metaphoric glass is not half-empty, it is one-third full. If you understand the businesses you are investing in, and if you trust the management, then you probably won't get such attractive valuations for another 10 years. So making our 2008 Christmas Pick has been a difficult choice with so many deserving stocks to choose from."

As a consequence, we made two other "honourable mentions", Fujikon Industrial Holdings Ltd (0927), which was our 2005 pick, and optical frames maker Sun Hing Vision Group Holdings Ltd (0125). Including dividends, Fujikon returned 57.8%, and Sun Hing Vision did even better than Alco, gaining 190.8%. All 3 stocks beat the Hang Seng Index.

Your editor, David Webb, still holds over 5% of Alco, over 7% of Fujikon, and over 7% of Sun Hing Vision (which we increased through the 6% disclosure threshold on 4-May-09 at $1.60 and through the 7% threshold on 28-Aug-09 at $2.765).

The 10-year history

What a decade this has been! Our pick has made money in 8 out of 10 years, out-performing the total return on the Hang Seng Index 8 years out of 10. Here's the track record:

What this table shows is that if you put $1,000 into the first pick, and rotated into the next one each year, you would have made 1,118.1% and would have about $12,181 by now, a compound average gain of 28.4% per year. By comparison, if you invested the same amount in the Hang Seng Index 10 years ago, and reinvested the dividends, you would now have about $1,866, a compound average gain of 6.4% per year. So our picks have out-performed the index by 552.8% over 10 years. Both the stock and index calculations exclude transaction costs.

We're also going to reveal that your editor's entire portfolio, if converted into a hypothetical unit trust (but without charging ourselves any management fees), has "only" returned 1057% per unit in the same decade (or a compound average 27.7%), so you really did get some of our best-performing picks, which gained 1118%.

The Christmas Pick

Webb-site.com never set out to pick stocks. We started doing it as a seasonal gift to readers, a free ride on our research, but it has become something of a distraction to our main goal of raising the standards of Hong Kong's corporate and economic governance.

After 10 years, and a rather respectable track record if we do say so ourselves, we think this is a suitable time to call an end to this before it gets out of hand. So that's it. We will continue to issue warnings about listed companies which may often be considered as "sell" notes by those who own them and "don't buy" notes to those who don't, but the good stuff we will keep to ourselves, and you'll just have to figure out which stocks we like by looking at dealing disclosures when we are above the 5% threshold.

How about a fund, then?

Over the years, may people have asked whether we would consider setting up a "Good Governance Fund" in which anyone could invest. This is something we will keep under review, and it would certainly increase our firepower in corporate battles, but it would have to be a "closed-end" company in which holders can trade their shares but not redeem them. This could either be a new special-purpose investment company, or an existing listed company converted into an investment vehicle, rather like Berkshire Hathaway was converted from a textiles company, only smaller of course, at least to start with!

Being closed-end would allow us to hold the contrarian line and invest in stocks, or at least hold them, when everyone else is selling, as we did during the depths of the financial crisis (and the ones before that). Last year, we were like a kid in See's Candy shop, picking up cheap stocks while institutional investors, facing redemption pressure from fund-holders, were selling.

However, running a public company would require a lot more attention than we currently give to our portfolio, and may reduce the time we can spend pushing for other areas of governance reform, such as government transparency and regulatory improvement, so that's a drawback. But there is one other big reason why we would not launch a fund, which brings us on to:

HK's missing closed-end fund industry

Hong Kong could have a flourishing closed-end investment company sector, and all the economic activity that goes with it, but Hong Kong's ambivalent taxation policy prevents this, and it's one of the big things which deters us too.

The Stock Exchange does have a special chapter of its Listing Rules, Chapter 14, for closed-end investment companies. However, very few companies are listed under this section, and of those which are, many are just perpetual value-destroyers run by people we would never trust. Since such charlatans don't expect the fund to make gains, they don't need to worry about whether the gains will be taxable.

If a fund is authorised by the SFC, then it has specific exemption from profits tax under Section 26A(1A) of the Inland Revenue Ordinance, so it is beyond doubt that its gains on investments are tax-free. However, to get such SFC authorisation, under the Code on Unit Trusts and Mutual Funds, a fund must be open for subscriptions and redemptions at least monthly, not closed-end. It is a completely arbitrary Government policy that SFC-authorised funds are tax-exempt but other onshore funds are not.

Overseas investors in HK stocks are also exempt - so a closed-end fund, investing in HK stocks but managed from overseas, would not be taxable in HK. HK has never tried to tax the gains of funds managed by overseas managers, and this provides a clear disincentive to those who might otherwise open an office in HK and run the fund from here.

For onshore investors which are not authorised mutual funds, the Government's policy on taxation of gains is an ambivalent "it depends". That is, it depends on whether the investor is making a capital gain, or a trading gain, which depends on whether they are selling a "capital asset" or not. What's the difference? Nobody can say for sure. The Inland Revenue says it depends on the "intent" of the investor - was the investor buying the shares "with the intent of disposing of them at a profit" or as a "long-term investment"? Are they "in the business" of buying and selling shares? This is an exercise in retrospective mind-reading and of course, the Inland Revenue has a bias in favour of tax-collection, so they can hardly be objective about such a subjective exercise. The rule of law depends on certainty and starts to break down when things are so grey.

It is hard for managers to market a fund if they have to tell investors that the fund might or might not be taxable, particularly when there are alternative ways for people to invest in the markets without taxation.

Gains or losses on a company's shares are nothing more than changes in the perceived net present value of future earnings, and those earnings will eventually be taxed if they are sourced in HK. So a tax on those gains would represent a form of double taxation and would also bring non-HK-sourced gains into the tax net - for example, taxing the gains on an investment in Petrochina H-shares when almost none of that company's profit arises in HK. It would also disrupt the efficient allocation of capital by deterring re-allocation through sales.

The practical reality is that, given this ambiguous position, the Inland Revenue almost never tries to tax individual investors on their gains. For example, it does not tax the gains made by individuals who subscribe shares in an IPO with the "intent" of selling them on day one for a quick profit. Nor does it tax individuals' gains on cash settled-warrants and other derivatives, even though, by definition of their relatively short maturities, the investor expects to make a pretty quick gain. By comparison, the Inland Revenue might well try to tax the gains of HK-based investment funds which buy and sell HK-listed securities, which is why there are very few onshore funds.

For a few years, respected local manager Value Partners Ltd had both a closed-end investment company listed in HK under Chapter 21 (Value Partners China Greenchip Fund Ltd), and an open-ended SFC-authorised mutual fund, investing in similar stocks. The listed company had to make provision for HK profits tax, even though after 3 years it eventually succeeded in clearing its tax and reversing the provisions, presumably by arguing that it was making capital gains and not profits. Meanwhile, the mutual fund was tax-exempt. Eventually, in 2007 the listed fund was delisted and converted into an SFC-authorised open-ended mutual fund, but for a while it provided a perfect illustration of the absurdity of the law.

The Government should remove this ambiguity by legislating to make any gains on HK-listed securities exempt from taxation, regardless of the owner. It would initially not make much difference to tax revenues, since very few traders currently come onshore and knowingly expose themselves to that tax, but it would greatly expand the scope of the onshore fund management industry in Hong Kong by giving certainty that their funds will not be subject to tax on their gains.

That fund management industry would create employment in its own sector and through its fees, creates taxable profits. There would also be jobs and profits in the accounting, legal and broking sector created by the presence of such managers. So even if Webb-site.com never sets up a closed-end fund, a change to the law would facilitate many other funds. We're not saying we would launch a fund, because we rather enjoy spending our time on non-profit pro bono governance activities, but the deterrent of a taxation battle is one reason why we wouldn't and why other's don't.

Webb-site.com, 2009


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