Whether or not we are in a bear market rally remains to be seen. I must admit I’ve been rather passive throughout the rally, and I’ve held on mostly to my positions with the exception of CIMB which I feel is getting overdone. The CIMB story has run ahead of the earnings and at 4.5x Net Tangible Assets, so has the share price I feel.

If the market does take a dive, the stocks that get hit the hardest will be the large caps on high multiples – CIMB, SIME etc. Be that as it may, I could be wrong. But why take the chance when there are other better buys in the market?

I did do quite a bit of thinking in the past months and I believe Jim Rogers is right when he says:

“Anytime you think you’ve become a financial genius – when, in fact, you simply have had the good luck to turn a profit – it is time to sit back and do nothing for a while. If you stumble upon success in a bull market and decide that you are gifted, stop right there. Investing at that point is dangerous, because you are starting to think like everybody else. Wait until the mob psychology that is influencing you subsides.”
Jim Rogers, A Gift to My Children, P74-75

It made good sense to me, and I re-adjusted my portfolio a little to position better for dividends, bought a few shares in higher dividend and financially strong companies such as Plenitude, NCB, Manulife and Petronas Dagangan.

Who knows whether Charles Nenner will be right this time? But what if he is? Anything is possible! And we as investors need to allow for that possibility.

It is at this point that we would do well to remember Benjamin Graham’s margin-of-safety principle, which is that favourable difference between price on the one hand and appraised value on the other. The margin-of-safety will help us to absorb “the effect of miscalculation or worst that average luck”.

That said, are you ready if we are looking at a 40-50% market decline? If this turns out, a 20-30% decline in your portfolio may not be such a bad thing as it could present the “Intelligent Investor” with another opportunity to make more money. Of market fluctuations, Benjamin Graham has this to say:

“In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third ore more from their high point at various periods in the next five years. A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer.”

Sound advice indeed. So does it matter if Charles Nenner is right or wrong?

The Baltic Dry Index is a price index compiled by the Baltic Exchange in London. Each working day, the Baltic Exchange canvasses hundreds of brokers around the world for prices to move dry bulk cargo, for example iron ore, coal, copper and grain (there are 26 such items). The prices are then combined to form the Baltic Dry Index (BDI), which appears in shipping publications such as Lloyd’s List.

I’ve come to learn that the BDI is an excellent indicator for economic growth and production.

Why?

BDI doesn’t deal with container ships carrying finished goods.

It deals with the precursors to production – ships carrying iron ore, building materials, cement and coal … raw materials so to speak.

If shipping rates for dry bulk are low (as they are now), it means less cargo is being moved around. We are in for declining global production.

Check out the BDI chart below.

(Source: Bloomberg, click picture to enlarge)

See the spectacular rally from 2006-08? The index peaked at just under 12,000 points.

To give you a feel, the cost of chartering a Capsize bulk carrier was around US$235k per day in May 2008. Now it is less than US$10k!

Up until 2008, China was importing huge amounts of raw materials and churning out exports.

But now the world’s factory is in trouble. Raw material imports have collapsed as a result, and so have shipping rates for dry bulk.

When will the Baltic Dry Index Recover?
The shipping industry relies heavily on Letters of Credit (LC). As liquidity tightened worldwide, so has the issuance of LCs. To cope with this, the market is beginning to see an emergence in export credit (exporter issues a loan to the buyer via export credit agency).

But this will not make much difference to global trade because Export Credits are risky for exporters compared with the traditional LC.

The deflation in commodity prices is now causing companies to use up existing raw material inventories rather than replenishing stocks. Why buy today when it will be cheaper tomorrow?

Eventually inventories will run low and factories will replenish.

As this happens and as global credit markets unlock, we will see stabilization and a marginal recovery in shipping costs.

But is unlikely we will see the Baltic Dry Index anywhere near its peak in the near future.

BDI is Highly Responsive to Shipping Demand
The supply of bulk cargo ships is tight and inelastic – it takes two years to build a new ship. A demand increase can push the index higher quickly. Even more so, significant increases in demand can push the index sharply higher. That was pretty much what happened between 2006 and 2008.

Furthermore ships are not taken out of circulation during slow periods (due to the high cost of docking). A drop in cargo rates does not change the number of ships in operation.

Even a slight change in the demand for dry bulk shipping results in a significant change in the BDI.

BULL or BEAR? Look to the Baltic Dry Index
I don’t know why they don’t teach BDI in economics. It could have saved me a lot of money!

If you’re looking for a clear indication of a market bottom, forget about GDP, Unemployment, Inflation etc. Just this morning we hear of US unemployment reaching 7%. There are still massive layoffs so don’t be surprised if it trends higher. Bottom line is that all the major economic indicators are backward-looking.

If you want a forward-looking indicator to know when business earnings will trend higher, look for the Baltic Dry Index to start trending noticeably higher. I suspect it will be quite a while yet.

Unlike the stock market, the BDI does not have any speculative element. People don’t book cargo ships unless they have cargo to move. Furthermore BDI is not a “tradable” index and that makes it devoid of any speculative element.

The BDI reached its record high of 11,793 points on 20 May 2008. Just 6 months later in Dec 2008, it had dropped to 663 points (down 94%). Current rates are cutting close to operating costs (vessel, fuel, and crew). But it does look to have stabilized at 700 – 800 points.

I have included the Baltic Dry Index in our Indices page.

Has the market bottomed out?

I’ve just read a pretty good report by CIMB Research. Can’t say that I agree with everything they said but there are some good observations.

The report looks at the six major bear markets that Malaysia experienced in the past 30 years. The observation is that each bear market lasted 15-17 months on average (from peak to trough).

As you can see, the average decline from peak is 53%. Using this figure, CIMB derives a floor of 707 points for the KLCI. Based on the average period, it says the market may bottom out around May-Jun 2009.

Positive Political landscape
Deputy PM Najib Razak is set to take over as Prime Minister around Mar-Apr 2009. According to the report, investors typically give new leaders the benefit of the doubt and this time should not be different. In the 6-7 months before Dato Seri Abdullah Badawi took over from Tun Dr Mahathir in Oct 03, the KLCI rallied 29%. Three months after the handover, the Malaysian market went up another 13%.

Weak Corporate Earnings
The recent quarterly results in 2008 have been generally poor and this is expected to continue for at least another 1-2 quarters. Malaysia is a net oil exporter and the world’s largest exporter of Crude Palm Oil. The recent plunge in these commodities will filter through into lower earnings. Many brokers have downgrades across the board especially for sectors such as plantation, construction and property.

The flip side is that lower petrol prices will reduce operating costs for businesses. Here’s a good illustration of our petrol prices over the last 8 years.

Source: CIMB Research

Price fall for coal and steel will also mean lower energy cost and raw material costs for industries such as construction and property. We are now in for a period of stable prices and low inflation and hence stable interest rates. This may be the slowdown Malaysia needed so it’s really a blessing in disguise.

Foreign Shareholding
According to CIMB Research, foreign shareholding in Malaysia is still relatively high at 21% which is 5-6% higher compared with the previous trough.

Foreign shareholdings in some heavyweights remain high and there is a risk of further sell down. In Jan-Sep 2008, portfolio outflows amounted to RM41 billion. In 1997 to 1999, portfolio outflows totalled RM71 billion. According to CIMB Research, similar outflows would wipe out a further 10% of market capitalisation.

Corporate Strength
Except for the utility and infrastructure companies, net borrowings in top Bursa Malaysia companies are low. Malaysian banks are looking strong. However among the small to mid-size listed companies, quite a number that have a Net Gearing ratio of more than 100% (i.e. Net Borrowings more than Shareholders Funds).

Individual Wealth
Unlike the bull markets of the mid-1990s, individual investors now have low exposure to the stock market. Wealth lost in the stockmarket collapse in 2008 is much less than in 1997-98. Property prices continue to hold firm although transaction volumes are much lower.

According to CIMB Research, total household debt is now higher at 67% of GDP as at end 2007. My guess is that these days, people are borrowing more to buy more expensive houses and cars because they have more disposable income. A low interest rate environment helps to keep this sustainable.

As I am writing this article I am in Kuching, Sarawak and the economy has never looked better. Although there is talk of job losses (such as Western Digital retrenching 1,500 workers), the economy in Sarawak has been riding on years of growth and favourable conditions. So a lot of wealth has been created. Furthermore Sarawakians are a conservative lot, many are cashed up and misers when it comes to spending.

But I believe Sarawak is changing fast. The younger generation are starting to spend more and the consumer profile is changing. Good restaurants continue to mushroom and many are well patronized despite charging KL prices. I attended banquet dinners and each time the restaurants were unbelievably packed.

If there is anything that epitomizes the modern consumer, it is the modern shopping centre. Go to The Spring in Kuching and you will feel like you are shopping in Mid Valley, 1Utama etc. You have the convenience of everything under one roof, brands that look familiar – Parkson, Giordano, Starbucks, HSL, MPH, FOS, Padini, Vincci etc etc. Truly, Sarawak is playing its catch up game seriously! And I really should mention some of the cars I saw – Aston Martin Vantage, Ferrari 360 Modena and a ton of other latest model Mercedes and BMWs. OK enough rambling … basically Kuching is in great shape going into the slowdown and should do more than its fair share for the Malaysian economy.

There should be some good opportunities to accumulate stocks in the coming months. Some companies with conservative balance sheets and solid market positions are trading at low PE multiples. Rather than being too defensive in your Portfolio, maybe it’s time to identify companies that are reasonably priced and can take advantage of the coming downturn to build their business further.

Maxwell recounts the story of Anne Scheiber, an elderly and thrifty lady who lived in New York and worked for the Inland Revenue Service. When Scheiber retired at age fifty-one, she was only making $3,150 a year. She was treated poorly by her employer and was never promoted. Yet when Anne Scheiber died in 1995 at the age of 101, it was discovered that she left an estate to Yeshiva University worth US$22 million!

How did a public service worker with minimal salary accumulate such a staggering wealth? Here’s Maxwell’s take on it:

“By the time she retired from the IRS in 1943, Anne Scheiber had managed to save $5,000. She invested that money in stocks. By 1950 she had made enough profit to buy 1,000 shares of Schering-Plough Corporation stock, then valued at $10,000. And she held on to that stock, letting its value build. Today those original shares have split enough times to produce 128,000 shares, worth $7.5 million.

The secret to Scheiber’s success was that she spent most of her life building her worth… When she earned dividends – which kept getting larger and larger – she reinvested them. She spent her whole lifetime building…. When it came to finances, Scheiber understood and applied the Law of Process.”

The above story of Anne Scheiber was actually used by leadership guru Maxwell to illustrate an important leadership principle. But it can be equally applied to investing. I’m not sure if Maxwell got the facts right, but we can certainly learn a couple of important principles here:

1. Time in the Market
It is now how you start that is important. It is what you do day to day, and how you finish that counts. Sure it’s nice to time the market correctly but if you’re looking to make some serious bucks, time in the market counts.

Patience and consistency is everything!

2. Focused Investing
Most of Scheiber’s wealth was in a handful of stocks, the largest one being Schering-Plough. Like Warren Buffett, Scheiber is a Focused Investor. A Focused Investor puts meaningful amounts of money in a few things. Scheiber liked companies which are leading brands in their market.

Anne Scheiber

Most of us will not have the experience of picking one company which will ride on a tsunami wave. If you had bought a piece of Microsoft or Berkshire Hathaway when they started business, you would have the same ecstasy… but how many companies are like that? What are your chances of picking such companies? Nevertheless it is not impossible… imagine if you had bought and held on to Public Bank since inception. Now isn’t it worth a little time and effort to research and identify the next Public Bank?

3. Compound Growth
Whether the stock went up or down, she never thought, I’m finished building; now it’s time to cash out. She was in for the long haul, the really long haul. We are told that Anne Scheiber reinvested all of her dividends. She didn’t say lets take out some money and buy the latest LV handbag.  In fact Anne Scheiber was frugal to the point of being miserable. She lived in a rent-controlled apartment, wore the same clothes year in year out, didn’t own a car and even went to shareholder meetings so she could take home bags of food.

Don’t get me wrong… I’m not saying you shouldn’t reward yourself once in a while. In fact I would say there is a thin line between extreme thrift and greed. If you are blessed with so much money, spend some of it, give it away or whatever. Not only will you bless others, you release yourself from the trappings of greed

“Keep your lives free from the love of money”
Hebrews 13:5 (NIV)

The important lesson here is to realize the power of regular investment and compound returns. When you invest in good things and you invest regularly, your wealth will eventually multiply.

Remember attending one of those Unit Trust presentation and the Agent puts up that Regular Investment & Compound Return chart? Then everyone’s jaw would drop because your RM100/month savings can turn into a six figure sum when you retire? Start early, invest and have the discipline to keep re-investing…

Anne Scheiber loved stocks for her whole life and it is likely that she started investing much earlier than 1943 (the time she retired). Although she met with limited success initially, she came out tops in the end.

4. Hard Work
Anne Scheiber worked on her investments. She studied the companies she invested in, attended shareholder meetings and asked many questions to satisfy her curiousity and passion. Hard work with laser-like focus usually pays off.

“Successful leaders are learners. And the learning process is ongoing, a result of self-discipline and perseverance. The goal each day must be to get a little better, to build on the previous day’s progress.”
John C. Maxwell

Replace the word leaders with investors. Makes sense, wouldn’t you agree?

Hmmm… it still looks quite expensive compared to our Malaysian market which is probably well below 10x PE for our household names.

OK granted that the above names are global players with global revenue base. And also Warren Buffett’s recent remarks that he’s piling back into US equities.

So it doesn’t take a genius to figure out that we are comparatively cheap … and arguably with a better economic outlook compared to US and Europe. I believe we will see some serious wealth creation over the next 10 years for those who brave the stock market turmoil and drumbeat of bad news that is all over the place right now.

On 16 October 2008, the New York Times published an op-ed letter contributed by Warren Buffett. The message of the letter was clear–Buffett is a buyer of US stocks.

In the letter, Buffett offers a few words of wisdom which has made him perhaps the greatest investor of all time.

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”

Buffett says that people who are high in cash have opted for a “terrible long-term asset”. Personally Buffett is planning to move towards 100% in US Equities.

“If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.”

Buffett draws some analogies between previous recessions/depressions and how the stockmarket usually runs ahead of the economy. When we look at the carnage even in Malaysia, it does make sense. Fundamentals have not changed much except that we are looking at a global slowdown which will affect us somewhat. However liquidity is ample, exports are stable, ringgit is low and interest rates are low.

“In short, bad news is an investor’s friend.”

So what Buffett said can be equally applied to Malaysia!

You can read more about the article here:
http://www.nytimes.com/2008/10/17/opinion/17buffett.html

The US initiative follows announcements in Europe that France, Germany, Spain, Austria and the Netherlands have committed US$1.8 trillion to guarantee bank loans and take stakes in lenders.