Den of The Lion Investor

A few days ago, I attended a preview of an options trading seminar conducted by Ron Ianieri. Ron was supposedly one of the best option traders in the United States. He is also the co-founder of The Options University, and has trained many new trader trainees.

Before Ron Ianieri gave his presentation, Adam Khoo came on to cover some fundamentals of options. He used an example of a property purchase to illustrate what an option is.

A simple definition of an option is that it gives you the right (but not the obligation) to buy or sell the underlying asset at a particular price. This price is called the strike price.

Most of you will probably be quite familiar with the many call and put warrants that are traded on the Singapore Stock Exchange. Both these instruments are examples of options with stocks as the underlying asset.

At the preview, we were given a nice little notebook which contained the 7 deadly sins of options trading. They are:

1. Not fully understanding the independent effects of time and volatility on your option.
2. Forcing a pre-selected strategy on every opportunity.
3. Not fully understanding the proper meaning of leverage as applied to trading.
4. Not fully understanding the foundations or building blocks of option theory.
5. Thinking that cheapness or expensiveness of options is determined by dollar cost.
6. Overcomplicating otherwise simple strategies.
7. Not knowing how to pick the correct option for the selected strategy.

Trading options without first understanding the mathematics behind it is a sure recipe for disaster.

I won’t be going into too much details about the technical aspects of options in this post. Instead, I will focus more on some of the strategies that I pick up from Ron Ianieri.

A) Stock Replacement Strategy (Bullish Play)

This strategy involves buying call options instead of buying the stock directly. The advantage is that a lower capital is required to get the same amount of exposure. You get leverage and if done correctly, your loss can also be controlled.

A rollup play involves selling your long call with a lower strike price while simultaneously buying a new call with a higher strike price in a 1 is to 1 ratio. This trade helps to lock in your profit with a credit which is money received.

B) Stock Replacement Strategy (Bearish Play)

This strategy is an opposite to the above strategy. Put options are used to get a short exposure instead of shorting the stocks directly.

C) Earning Monthly Income (Covered Call)

For this strategy, basically you just sell call options on stocks you own. This is a premium collection strategy and not a directional play.

D) Stock Replacement Covered Call

This is a combination of strategy A and D. This strategy is far superior to a basic covered call but the price of superiority comes at a potential cost.

Morphing

This refers to the switching of your position from one direction to another in just one trade. Example:

1. Buy a call.
2. When stock retraces, short the share.
3. Cover the short and then collect more profit on the upside.

And finally ….

The Big Secret

Most amateurs trade backwards. They learn a few tactics and then go out to find stocks that fit this strategy. Sometimes, they force a situation to meet their strategies.

Ron says that we should recognise the opportunity, and then apply the correct strategy from our trading arsenal to meet that scenario instead.

It was a rainy morning as I headed over to the AGM for Babcock and Brown Structured Finance last week. The place was fully packed and the organisers had to bring in more seats for the shareholders.

The chairman, Sylvia Ann Wiggins, started the proceedings by doing a review of the fund’s performance compared to the IPO prospectus projections. There was a significant outperformance in all the categories shown. (projection indicated in brackets)

• Gross invesment income of 483.9m (396.7m)
• Cash economic income of 44.8m (34.6m)
• Revenue of 96.3m (44.2m)
• Profit before tax of 68.8m (26.6m)
• Profit after tax of 68.7m (27.2m)
• FY 2007 dividend of 10.70 cps (9.54 cps)

Strategic Review of Debt Level

In view of the current volatile market, the company will reduce the corporate debt from US$105m to US$35m or about 10% of gross investment value of S$483.9m.

No asset sales will be required to achieve the lower debt level as it will be funded from maturing debt assets. As a result, earnings and cashflow will drop.

Also, it will be a period of consolidation for the company so no acquisitions are expected in the near future.

Corporate debt facility maturing in December 2009 from UOB and Commonwealth Bank of Australia have been secured and being finalised.

Outlook

Market volatilty and uncertainty is expected to continue and the company will be closely monitoring its assets.

The 1H08 dividend guidance fo 5.2cps has been confirmed. However, the company is unable to give an estimate whatsoever of the 2H08 dividend guidance. This is due to the uncertainty (and possible volatility) from the income streams of the company (particularly of the loan assets).

Selected Questions and Answers

1) The net asset value/share dropped from $0.85 to $0.79 because of the issuance of additional shares. Will this continue to happen?

At the present time, we do not have firm plans to issue additional shares other than for the payment of management fees. The other item that has affected the net asset value is the mark-to-market adjustments of certain assets.

2) Looking at the three asset classes, we have a significant portion in the loan portfolio and securitisation assets.

We share your concern and this is the asset class we think most about. Currently, these assets are still performing and providing the income. The US subprime has some ripple effects to the UK and Australia, where our holdings are. What will happen in the future is unclear as it will depend on interest rates and real estate values.

3) Your alternative assets of $70m+ only produced an income of $1.46m. Can you clarify?

These copyright assets were bought in April and December, thus there’s some distortion to the income reported.

4) Since you mention the impairment is only due to mark-to-market accounting, can we assume that the income stream to remain unchanged?

While the assets are still performing, we will continue to watch them. Economic conditions might affect the income as the cashflow is dependent on interest rates and pre-payments.

5) Your assets are in various currencies. Some of them are in weak currencies like the US dollars and British pounds. Can you explain how you protect the fund against currency movements?

The structure of the fund is to be a global one with investments in various currencies. The dividend distributions are hedged but not the principal amount. As long as the maturing assets are reinvested into another investment of the same currency, there won’t be a realisation or impact on the net economic income at that point.

6) In this current uncertain climate, we would like more information from the company. Can we request for more regular updates?

Yes, we will certainly be doing that. We will be providing regular quarterly financial updates of how the fund is performing and its asset value. Once we can predict to a certain degree of comfort for the 2H08, we will be doing that.

7) Speaking of quarterly updates, can we have quarterly dividends as well? Just like the REITS. We can put it to a vote and I’m sure we can get 100% acceptance.

Laughter from the entire room. No response from the management.

Other Matters

There were a few other questions on whether the company would restructure its investment portfolio to have more assets that would bring a steady cashflow. (One representative from Oilpods even started to pitch his product!)

The asset allocation will be considered as part of the strategic review but given the current consolidation phase, it is unlikely that there will be any acquisitions in the near term.

Overall, I get the feeling that the uncertainty from the loans portfolio is very high. How these will turn out remains to be seen.

Last week, I managed to attend the AGM of Anwell and Babcock and Brown Structured Finance. The discussion for Babcock was quite lively so it will take me a while to compile the notes. Once I’m done, I will post a summary.

In the meantime, here’s the schedule of the AGMs this coming week for your reference.

Monday 28 April 2008

• Adampak
• Allgreen Properties
• Asia Environment Holdings
• BBR Holdings
• Breadtalk Group
• Broadway Industrial Group
• China Bearing
• China Fishery Group
• China Precision Technology
• CSE Global
• Eucon Holding
• FDS Networks Group
• Firstlink Investment Corporation
• Global Ariel
• Global Voice Group
• Greatronic
• Guthrie GTS
• HLN Technologies
• Honguo International Holdings
• HTL International Holdings
• Huan Hsin Holdings
• Indofood Agri Resources
• ISDN Holdings
• JK Yaming International Holdings
• Liang Huat Aluminium
• Luzhou Bio-Chem Techonology
• Medtecs International Corporation
• Nippecraft
• Ocean International Holdings
• Ouhua Energy Holdings
• Pacific CenturyRegional Developments
• Penguin Boat International
• Pharmesis International
• Sarin Technologies
• See Hup Seng
• Shanghai Asia Holdings
• Shanghai Turbo Enterprises
• Sino-Environment Technology Group
• Sinopipe Holdings
• SM Summit Holdings
• Sunpower Group
• Synear Food Holdings
• Telechoice International
• TMC Education Corporation
• Tri-M Technologies
• United Pulp & Paper
• Wheelock Properties
• Zagro Asia

Tuesday 29 April 2008

• ASA Group Holdings
• AEM Holdings
• A-Sonic Aerospace
• Asia Food & Properties
• Baker Technology
• BRC Asia
• Bright Orient (Holding)
• C & G Industrial Holdings
• CapitalLand
• Changtian Plastics & Chemical
• China Great Land Holdings
• China Infrastructure Holdings
• China Petrotech Holdings
• Courage Marine Group
• Eagle Brand Holdings
• Eastgate Technology
• Ezion Holdings
• Fastech Synergy
• Financial One Corporation
• Food Empire Holdings
• Full Apex (Holdings)
• Golden Agri-Resources
• Ho Bee Investment
• Hup Soon Global Corporation
• IPC Corporation
• Jardine Cycle & Carriage
• Jiutian Chemical Group
• Kian Ho Bearings
• Lee Kim Tah Holdings
• LHT Holdings
• Lizhong Wheel Group
• New Toyo International Holdings
• PT Berlian Laju Tanker TBK
• Samudera Shipping Line
• Singxpres
• Star Pharmaceutical
• Swissco International
• Texchem-Pack Holdings
• Yongnam Holdings

Wednesday 30 April 2008

• Advance Modules Group
• Advance SCT
• Berger International
• Chuan Soon Huat Industrial GP
• Chunghong Holdings
• ComfortDelgro Corporation
• DMX Technologies Group
• ECS Holdings
• Esmart Holdings
• Federal Int (2000)
• Hotel Grand Central
• Hotel Properties
• Innotek
• Junma Tyre Cord
• K Plas Holdings
• Lindeteves-Jacoberg
• Lizhong Wheel Group
• Midas Holdings
• Noble Group
• Pacific Shipping Trust
• Penton International
• Pemasteelisa Pacific Holding
• Reyoung Pharmaceutical Holdings
• Samko Timber
• SBS Transit
• SNP Corporation
• Sunmart Holdings
• Swiber Holdings
• Tastyfood Holdings
• TSH Corporation
• Top Global
• UMS Holdings
• United Overseas Bank (UOB)
• United Overseas Insurance (UOI)
• Yong Xin International Holdings
• Youcan Food International
• Zagro Asia

When I opened up the newspapers today, I saw the headline “HDB Flat Buyers Pay Less Cash Upfront” screaming at me on the front page. I got pretty annoyed about the article after I finished reading it.

That same headline could have been rewritten as “HDB Resale Flat Prices Continue to Rise“, and it would have fit the original article just as well. In fact I think it fits it even better.

The article states that the median cash-over-valuation (COV) prices in many popular estates have gone down. This is due to the increase in the market valuation of the flats.

“With valuations going up, the COV is coming down and this makes it more affordable”, someone was quoted as saying.

How misleading.

Granted, the lower COV means that buyers need to fork out less cash upfront. However, they are going to pay more for their flat and this is going to make them financially worse off in the long run.

Able to fork out the upfront cash does not equate to being able to afford a flat.

If I tell you that you can buy a Porsche for no money down compared to paying a 10% deposit previously, does that make it any bit more affordable for you? Whether you can afford it or not will also depend on whether you can service the monthly installments.

There was an example given in the article about a five-room flat in Bukit Batok.

In the fourth quarter of last year, the median valuation was $389k, the median COV was $41k and the median price was $430k.

Barely 6 months later, the valuation is $420k, the COV is $30k and the price is $450k.

This is an increase of 20k or about 4.7% of the flat’s price in less than half a year.

If you read the entire article, you will realise that the author, Jessica Cheam, is trying to paint an optimistic picture about the affordability of HDB flats - despite the increase in their prices.With rampant inflation, the national newspaper is probably trying to do its part to reassure the public. Seriously, I think they can do much better than this.

Ironically, another section of the newspaper shows the cost of three HDB resale flats in the Holland area.

The 3-room was going for $378k, the 4-room for $465k and the 5-room for $680k.

The (rapidly) rising property prices is a real cause of concern.

If left unchecked, how are the lower income families going to be able to afford basic housing for themselves?

About a month ago, I didn’t get a chance to attend Thomas Matthew’s talk at the Smart Expo event. However, I did managed to listen to Thomas Matthew give a short seminar at an event organised by IPP Financial Advisers today.

I consider the talk a foundational one in impacting some of the basics of financial planning. The concepts are neither unique nor are they rocket science, but having a understanding of them should put anyone in good stead.

What probably made the talk more interesting are the many personal stories shared by Thomas. He certainly knows how to engage the audience and inject humour at the appropriate time in his presentation.

Thomas defines financial independence as having a fully paid home, sufficient savings and an income generating asset (IGA).  When you start off, you will use your employment or business income to build and grow this asset. An appropriate income allocation could be 50% for family expenses, 30% for savings and 20% for the home mortgage. The IGA can consist of:

• Dividend paying stocks
• Investment properties
• Investment portfolio with ROI of 5-8%
• Tactical portfolio

However, while we are building this IGA, things could happen that could disrupt our plans.  These shocks could be:

• Timeline shock
• Market shock
• Self funding shock
• No income generating asset shock

Therefore before you even think about growing the IGA, you will need to first construct a risk management portfolio. This is basically insurance to protect yourself and your family from unexpected events. In today’s context, everyone would probably need at least $1 million worth of insurance cover for himself.

Overall, Thomas Matthew shared a number of concepts and ideas. If I could sum it up in a few lines (steps), it would probably be this:

1. Start with a goal in mind.
2. Buy sufficient insurance.
3. Do not overspend. Make sure you save sufficiently.
4. Invest your savings wisely with diversification to achieve consistent and decent returns to beat inflation.
5. When you leave this world, you take nothing with you. Plan in advance how your assets should be distributed.

Will all these really make you a millionaire?

Many people don’t realise that if they keep every dollar of the money they earn throughout their entire working life, it is probably enough to make them a millionaire many times over. Yet many people accumulate very little wealth even after working for many years.

When you take charge of your financial life and plan ahead, yes - it can and will make a very big difference.