Sunday, January 31, 2010

The Volcker Rule

Despite the mostly good corporate earnings, with many beating analysts' estimates, couple with a surprising GDP perk up in 4Q2009, the markets had trouble turning around the bearish trend. Methinks it has a lot to do with the uncertainty with respect to the Volcker Rule. Although you will find pundits giving many other reasons for the current downtrend. The market got hints that Obama was mulling some banking reforms, and you could see the south ward bent from then onwards.

The NYT had a good article on the Volcker Rule, my comments in colour:


New York Times / Dealbook: Obama is pushing hard for stricter financial regulation, promising in his first State of the Union address that he would not sign a bill that “does not meet the test of real reform.” This has left Wall Street wondering how much Mr. Obama’s regulatory proposal, known as the Volcker Rule, will cut into its profits.

The proposal, named for Paul Volcker, the former Federal Reserve chairman, would limit a bank’s ability to trade on its own account and would ban banks from investing in hedge funds and private equity funds. It could put an end to the huge Wall Street profit machines that emerged in the last decade since financial deregulation. Some analysts are already offering estimates about how costly the Volcker Rule could be. (Limiting banks' ability to trade on its own account IS GOOD, we are not going to see total prohibition, just a more sensible guide on exposure with respect to capital - now tell me that is not a good thing, but markets tend to discount absolute profits straight away... here we are talking about better quality and less volatile profits.)

In general, most analysts feel that Goldman Sachs has the most to lose if Congress passes some form of the Volcker Rule. David A. Viniar, Goldman’s chief financial officer, told analysts last week that the firm derives about 10 percent of its revenue from proprietary trading.

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As such, Citigroup estimates that the Volcker Rule would cost Goldman $4.5 billion in revenue based on its 2010 estimates, translating to a $1 billion drop in profit. Analysts at JP Morgan Chase said the Volcker Rule would knock about $4.67 billion off Goldman’s future revenue stream, but they came to their projection a different way, estimating that the firm would experience a 20 percent decrease in its overall trading revenue.

Meanwhile, analysts believe that Morgan Stanley has less to lose than Goldman, as it shuttered most of its proprietary trading units after it was hit with huge losses in those divisions during the financial crisis. The firm has only two small proprietary desks left, one of which the bank is considering spinning off.

(Well, lessening the power of Goldman Sachs certainly cannot be a bad thing... seriously ... if they are allowed to do as they like and grow even bigger they can dominate the capital markets even more, in particular over the past 12 months where they showed their ability to bounce back a lot faster, but also because they read the markets well and largely avoided the subprime mess. In fact they made money from the mess. So, lessening the power that is Goldman Sachs is not a bad thing - if not, they can be a lot bigger too fast and we are back to the same thing of having something that is too big to fail.)

Factoring in losses from Morgan’s private equity and hedge funds business, Citigroup estimates the firm’s future revenue could decline 3 to 4 percent. Meanwhile, JPMorgan analysts estimate the firm could take a 15 percent hit to its overall trading revenue, about a $2 billion reduction in earnings.

JPMorgan, like Morgan Stanley, also got rid of most of its proprietary trading units after experiencing big losses, so it, too, is not expected to suffer as badly as Goldman on the trading front, but it will still take a hit from pulling out of its $7.3 billion in private equity investments.

Citigroup estimates that JPMorgan’s private equity business generates earnings of 15 cents a share for the bank. Meanwhile, analysts at Morgan Stanley estimate that JPMorgan would have a 3 to 5 percent hit to its earnings over time based on reduced trading and private equity investing.

Citigroup would likely take most of its hit from its proprietary trading units, as the firm is already in the process of getting rid of most of its hedge fund and private equity fund investments. Morgan Stanley estimates the bank’s overall revenue could be reduced 2 to 5 percent if it suffers a 5 to 15 percent decrease in trading revenue. Put in perspective, Morgan Stanley estimates that Citigroup could lose $134 million to $534 million from its bottom line in 2012, based on the bank’s making $3.5 billion after tax in trading that year.

Bank of America is expected to take minor hits from its private equity and proprietary trading businesses. Citigroup estimates that the bank has about $16.6 billion in private equity investments that it may have to get rid of, but that is small compared with its balance sheet. Citigroup estimates that Bank of America generates only 2 percent from that investment anyway, so the hit would be minor. Meanwhile, analysts at Morgan Stanley estimate that the bank’s bottom line would fall 3 to 5 percent through reduced trading activity and private equity investments.

(The reforms would include barring these banks from funding or seeding hedge funds. This incestuous relationship is one that is full of conflict of interests, and will usually result in "insider information trading fomenting", riding on coattails of mega trends, thus enlarging volatility.)

But all the analysts warned that their estimates were based on factoring out earnings from the banks’ wholly owned proprietary trading units and not taking into account trading the banks perform to facilitate client trades.

If the Volcker Rule is narrowly defined to count just trades done purely with the bank’s money, then the analysis would likely be correct. But if the Volcker Rule is broadly defined to encompass all trading that might put the firm’s balance sheet at risk, the banks could face higher costs.

That’s because 90 percent of the banks’ proprietary trading activity is linked to trades made on behalf of clients as the banks make markets to facilitate trades, Goldman recently said in a note to clients.

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For example, Morgan Stanley and JPMorgan are large commodity traders, so they take on a lot of principal risk on behalf of clients because of the illiquid nature of that business. If the Volcker Rule is broadly defined to encompass that kind of proprietary trading, the two firms would have to stop performing that service, translating to a big loss to their bottom lines that would be far above analysts’ estimates.

If broadly defined, firms like Goldman and Morgan Stanley could simply give up their bank holding company status and operate without the government safety net — even though both have said they have no plans to do so. But for banks like JPMorgan, Bank of America and Citigroup, which have huge retail banking operations and cannot give up their banking charters, the Volcker Rule fallout could be very expensive in terms of lost profits.

Of course, the Volcker Rule may look very different once Congress gets its hands on it. It is not yet part of either of the financial regulatory packages in the House or Senate, and much will depend on committee hearings on the proposal in the weeks to come. The Senate is expected to take up the issue on Tuesday.

– Cyrus Sanati


I believe the markets have tried their best to discount a worst case scenario for the Volcker Rule, hence downside will be limited from here. Seriously, the corporate earnings figures coming in have been pretty good and the 4Q09 figure tells us a lot of things are panning out better than expected. You may get the markets focusing on some other issue temporarily, but they will always go back to earnings and growth and jobs. Unless you are talking about a bubble or a financial crisis, the markets won't be down for long. The Volcker Rule is not a crisis or a bubble of any kind, its the right things to do to rein in excessive risk taking and bring about better quality earnings, and getting banks to do what they were SUPPOSED to do. Its good, but knee jerk wise, they have wiped almost 5% already and that is already too much no matter how you cut it.

p/s photos: Macy Chan Mei Si

Friday, January 29, 2010

Must Watch This: The Blind Side

In our cynical world and hardened hearts all around, it was gratifying to watch a movie that lifts our senses. Its a feel good movie but never milks the audience for tears. What makes this so wonderful is its a true story. The other bit which makes it so enticing was that it was based on the book by my favourite author Michael Lewis - yes, the same guy who wrote Liar's Poker, Moneyball and The New New Thing.

Sandra Bullock was amazing in the dramatic role and should finally win the coveted Best Actress Oscar this year. Remember to wait for the credits as they will show photos and video snips from the real life family members of the characters. Quinton Aaron was spectacular too as he brought sensitivity and allowed us to empathise with his character.

The story was all the more amazing as it wasn't just Sandra's character that did the right and noble thing, but that all of her family members got on board as well - and that is not a common thing.

Its a very good movie when it not only entertains but it makes you think about our value system. What is charity, what is empathy, what one person can do to completely change the path and destiny of another, why so many of us only have good intentions but is cowered by what others might think .... Its a very very good movie.


Review From Inquirer: ADAPTED FROM MICHAEL Lewis’ 2006 true-to-life book “The Blind Side: Evolution of a Game,” the film “The Blind Side” tells the extraordinary story of an impoverished young boy who is adopted and subsequently brought up by a wealthy couple to become a potential star in the National Football League. Although initially perceived as a rags-to-riches story, the film effectively positions itself as a heartfelt yet humorous drama, minus the common themes and elements found in most inspirational stories.

Michael Oher (Quinton Aaron), a homeless African-American young man who comes from a broken home, is adopted by Leigh Anne (Sandra Bullock) and Sean Tuohy (Tim McGraw), a wealthy white family who helps him develop his true potential and character. Oher’s presence in the household leads to several self-realizations by the Tuohy family, including their two children, Collins (Lilly Collins) and Sean “SJ” Jr. (Jae Head).

At the same time, the teen, while living in his new environment as a student and football player, faces an entirely different set of challenges to overcome. With the help of his newfound family and teachers, he works hard to hurdle the obstacles in his life and become a professional offensive left-tackle.

Genuine, nontraditional

In many instances in the film, you may feel the story of an African-American boy being taken in and raised by a wealthy white family may seem too good to be true. But it is this reason—and the fact that character relationships in the movie center around a poor yet innocent young man—that makes the film more magical than the book. One of the factors that make the film special is that Oher, played by Quinton Aaron, is undeniably likeable. Aaron’s seemingly pure and innocent demeanor onscreen enables us to connect with him more in the film than in the book. His relationships with his new family and his genuine amazement at his new environment are believable.

Bullock as Leigh Anne, on the other hand, is able to effectively flesh out a role in which she strikes an amazing balance between a feisty iron maiden and a loving and compassionate mother to a complete stranger —all capped with a convincing accent. But in the film, Leigh Anne’s relationship with Oher goes beyond the premise of a white person rescuing a black man from poverty and despair, which viewers may also perceive.

Their chemistry and bond onscreen result in an authentic mother-and-child relationship which you can easily identify with. What’s truly unique about this film is that it has no clich├ęs or traditional scenes usually found in inspirational and rags-to-riches stories. There is no true villain in the story as the main conflict is Oher’s struggle to overcome his weaknesses, and eventually succeed in life.

While loaded with drama as in the book, the film is genuinely funny, too. For instance, the sudden yet snappy quips of “SJ” are welcome breaks in between Leigh Anne’s emotional self-realizations. As a result, you do not tend to be completely drowned by its heavy drama.

Overall, “The Blind Side” is truly a film that strategically plays on your emotions and genuinely makes you feel good as the credits roll.

Thursday, January 28, 2010

What A Speechmaker ... What A Leader

As I am writing this, Obama is only halfway through his State of the Union address. At a time when Americans have kind of lost track of Obama's vision and "change" mantra, they have a kind of disconnect to the whole thing. At a time when the media cast doubts over Obama's plans to tax the banks, impose new regulations to control them, at a time when Main Street thinks the government is losing its fight to reprimand and teach Wall Street a lesson ... it wasn't easy for Obama.

Choi Ji Woo

I have posted on how and why Obama is such a great speechmaker - you can learn most of it, but you cannot learn how to connect. He is not only charismatic, he does not seem artificial at all. In the end, you trust him more because he connects all the dots of your concerns.

Obama's speech is genuine sounding, he made sure that he connected to the everyman in smaller towns, just count the number of small towns he mentioned. He also did not gloss over the realities, that he knows things are not all that rosy, that things put in place are working and that all should be in the same boat.

We have to remember that the media is still largely controlled by Republican-leaning people. In one simple sentence, Obama's contentious tax on big banks gains huge acceptance - when these banks asked for bailouts, and in less than a year are preparing to reward themselves with a huge bonus pool... Obama's tax on them does not seem so bad, especially when it is going to support a jobs bill to create jobs and sustain lending to small businesses.

He did not alienate the Republicans but will put them up to be on the same side to lift the US out of their difficulties. More importantly, Obama has showed all that HE is still very much in CONTROL, that he is still on top of the matters that concerns all, and that he is still addressing the major issues effectively, decisively and continuously.

He punctuates his speech with strong convincing ideas, logic and persuasiveness that is hard to shake off. Well, you can cast a lot of market doubts on Obama government's thrust to reform banking, ability to create jobs, the ability to lift the economy out of the doldrums, and the ability to maintain a stricter fiscal prudence to eliminate deficit ... in one fell swoop, Obama has literally dusted all those concerns off with aplomb and credibility. He reminded all on the cohesiveness of his government's every step and that all actions are working towards many bigger visions for all Americans. I think all market shorts will be running to cover their positions FAST...

Yes, I am in awe again ... this speech is even better than those he made in the past ... even when you know he has the gift of gab, even when you know he is already charismatic ... you still go away feeling you can trust him even more in spite of his natural abilities (which many may use to deceive and con others with).

p/s photo: Choi Ji Woo

Wednesday, January 27, 2010

How Do I 'Bear' Thee ... Let Me Count The Ways

Let's look at the current issues scaring the equity markets:

a) Stronger USD, lower commodity prices - Technically, we all want lower commodity prices, but somehow that does not work so well in equity markets. They seem to favour higher commodity prices so that bullish equity markets could continue. Its a matter of where we are in the recovery, as we have bottomed, any hike in commodity prices is deemed as heightened demand and vice versa. When economic activity is bubbling, lower commodity prices is welcomed as that reduces inflationary expectations and help improve margins. Yes, its investing is a strange world. Anyway, the lower commodity prices is not really a reflection of lower demand but rather a carry trade play on the USD. It is more a factor of where USD is headed which causes commodity prices to be inversely correlated. More importantly, a strong USD send shivers to investors because of heightened risk aversion among investors.

b) China's Applying Brakes - The fact that China has asked banks to stop or reduce bank lending in January naturally caused some to exit the markets. You cannot win on this. Everybody talks about how China is allowing a too easy monetary policy, and when they do something about it, markets get nervous. Its a temporary nervousness rather than a major sell off in the making. By acting now, that is preserving the longevity of the bull run, not putting an end to it.

c) Obama's New Medicine Bag - Attempts to regulate banks more closely will be OK and welcomed. Attempts to stop or tax proprietary trading is bad but not debilitating so. Even so, it will take a whole lot more to even pass any of the regulations. I would like to see caps on leverage on capital deployed by financial firms. Its the uncertainty that is rocking the markets as I believe most of the additional measures should be welcomed for the longer term.

d) Bernanke's Confirmation - This is so unnecessary, just go ahead and confirm, don't drag it out. Will be confirmed as there are no better visible candidates, and Zeti's not an American.

e) Sovereign Credit Rumbles - Deteriorating public finances of some eurozone countries such as Greece , and you can throw in the UK, have sent shivers on advanced nations' debt rating situation (read Black Swan #1 Japan posting). The euro has fallen 3% over the last 2 weeks, and the pound has tumbled following weak GDP figures yesterday.

f) Big company earnings from the US have come in at or above expectations but markets are ignoring all that for the time being. However, these data flows cannot and should not be ignored as it grounds the undertone that we are in a healthy equity market phase rather than an over-exuberant one.

Dangers of tightening too soon - not happening in the US, UK or EU. Even in China's case its an acceptable effort to rein in liquidity velocity there now. I have never seen a meaningful correction (i.e. more than 20%) happening while interest rates are at near record low levels everywhere. This is more a period of nervousness to reassess the overall parameters, and after a while we all will realise that interest rates are still low, things are mostly still recovering with pockets of difficulties in various countries, but liquidity is still seeking a place for better returns, back into the markets we go.

Technically HK has had a 10% correction already from its peak. Brazil is off 7% already from its peak. As all markets have gained more than 50%-100% over the last 12 months, its only fair that a 5%-10% correction be allowed for digestion purposes, even at a buffet you have stop a while before gorging yourself again and again.

Obama's state of the union address tonight following Bernanke's likely confirmation should set a new path uptrend again, provided Obama's address does not whack on taxes and the banks too debilitatingly.

p/s photos: Fala Chen Fat Lai

My #1 Black Swan In 2010

While the whole black swan thing sounds interesting, how are we to make a conscious effort to incorporate it into our analysis? Let's look again at Taleb's thesis:
... the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations. Taleb regards almost all major scientific discoveries, historical events, and artistic accomplishments as "black swans"—undirected and unpredicted. He gives the rise of the Internet, the personal computer, World War 1, and the September 11 2001 attacks as examples of Black Swan Events. To a large extent, the subprime crisis is another prime example of a Black Swan.

"What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives."

Taleb contends that banks and trading firms are very vulnerable to hazardous Black Swan Events and are exposed to losses beyond that predicted by their defective models.

Taleb's Ten Principles for a Black Swan Robust World

Taleb enumerates ten principles for building systems that are robust to Black Swan Events (my comments in brackets):

  1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. (We cannot allow financial firms to get so big that they cannot be allowed to collapse on its own. We cannot allow a domino effect owing to firms getting too big. Big financial firms need to be broken down into smaller units. In that respect, Obama is taking a leaf from Taleb's book by trying to reform some of the banking practices - consumer banking to be separated from investment banking. IBs to have a strict guideline on leverage to be used for proprietary trading and deal management.)
  2. No socialisation of losses and privatisation of gain. (US banks, insurance firms and automakers are prime examples of this. Malaysia and many other nations have been guilty of this as well. If companies were badly managed, they should be allowed to fail.)
  3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. (The funny part was Taleb putting in the phrase "and crashed it", because if a person drove a bus blindfolded and did not crash it, that person must have very special abilities and hence can be trusted to further drive buses. This rule of thumb points to decision makers who have acted recklessly, e.g. CEOs of many mortgage companies; the rating agencies; even Greenspan ... to be never considered for a similar position. In Malaysia, so many CEOs have proven themselves to be inept, thankfully most were not reckless, but still we need to be more vigilant to engage suitable performers and not to always give greenhorns a go at the top job without a good track record managing smaller units.)
  4. Do not let someone making an "incentive" bonus manage a nuclear plant – or your financial risks. (This one is key. We always give incentivised bonuses to managers based on profits or ROE. Take the investment bankers, their bonuses are linked directly to profits generated, and not accounting for the amount of risk and/or leverage deployed. I give you an even better example, which financial firm in the US had the best ROE in 2007 .... you'd never guess it, its Lehman Brothers. We have to rethink how we reward employees, not just in profits generated but also on "safety measures" i.e. no time bombs being created - hence we should include a hefty penalty on cost of capital and leverage deployed on profits generated, plus I would want bonuses tied more closely to "net margins improvements" and staff turnover ratio.)
  5. Counter-balance complexity with simplicity.
  6. Do not give children sticks of dynamite, even if they come with a warning. (Many local councils, even government bodies have been left holding lots of derivative contracts which puts their firms at a very high risk, without a proper assessment of the gravity of the exposure. Even firms like Citic got trashed. More regulations should be put in place on the kind of contracts companies can enter into, maybe some firms should never be allowed to even enter into any new fangled instruments unless board approval has been obtained. Accounting rules should have more detailed reporting standards enforced on all companies who have entered into these derivative contracts, so that investors can better assessed the risks.)
  7. Only Ponzi schemes should depend on confidence. Governments should never need to "restore confidence". (This one, I do not agree with Taleb. When consumer confidence is dented to a pulp, we need to have the "spender of last resort" come in to keep the velocity of money going. Confidence is a huge thing, the lack of it translate to risk-aversion. Governments and regulating bodies are not there to always maintain a bullish market, but they are there to ensure that things do not get whacked to both extremes of the pendulum. You have to restore confidence when things got so hairy following the subprime crisis, if not, the social cost could be too enormous to recover from.)
  8. Do not give an addict more drugs if he has withdrawal pains. (Taleb must be quite against the amount of bailout funding given to firms. I do agree certain firms have gotten too big to fail but there were many that should be allowed to fail.)
  9. Citizens should not depend on financial assets or fallible "expert" advice for their retirement.
  10. Make an omelette with the broken eggs.
So, what's my #1 Black Swan so far for 2010? I have a few, but I will share with you the one on the top of my list. Japanese yen may go in for a huge devaluation in 2010. During the risk aversion period, many people flocked to the yen currency. Seriously, for an economy still grappling with the excesses of the late 80s and early 90s, and going into a deflationary mode, you don't need a strong currency.

Why is this a black swan? Most people assume that Japan should not have a strong currency. Its zero interest rate policy has not been working but most will assume that it may go back from 90 to 100 at the most vis-a-vis the USD. The biggest catalyst has to be the mega government deficit that Japan has. Japan being Japan is doing tai-chi on that issue. The tons of fiscal stimulus pumping over the last few years have not budge the economy. The budget deficit is unsustainable.

S&P: The outlook on Japan was revised to negative on diminishing economic policy flexibility, and ratings were affirmed at AA/A-1+. At a forecasted 100% of GDP at fiscal year end March 31, 2010, Japan’s net general government debt burden is among the highest for rated sovereigns. The ratio of gross government financial debt to GDP is already around 170% on a general government basis (i.e. central and local government and social security funds) and is the highest by far among developed countries (OECD average was 75% in 2007). Moreover, the policies of the new Democratic Party of Japan (DPJ) government point to a slower pace of fiscal consolidation than previously expected. Combined with other social policies that are not likely to raise medium-term trend growth and with persistent deflationary pressures, Japan’s net general government debt-to-GDP ratio may peak at 115% of GDP over the next several years.

Many think that the yen carry trade is done by big hedge funds, but there are a substantial number of Japanese individuals who have borrowed in yen to invest overseas. A weaker yen will reverse that trend.

The key here is many think Japan's fiscal deterioration is a given but also note that Japan has a AA long term rating. A catalyst could come from a few rating agencies downgrading Japan, or Bank of Japan engineering (or allowing) the yen to fall. A major catalyst should be if/when they decide to make a landmark decision on how to tackle their outstanding debt. Its a time bomb because the yen's un-natural strength is largely due to the subprime mess but is dragging Japan into a recession if its allowed to continue. The shock could be exogenous (e.g., a rating agency putting a major AAA-rated country on negative watch) or endogenous (e.g., failure to match supply and demand on a major sovereign issuance). These fears actually emerged on several occasions in 2009, but were not amplified by massive sell-offs as occurred in 1994, despite far higher volatility this time around. The actual catalyst may not even have to come in a downgrade of Japan's ratings, it could be triggered by a major downgrade of another country's sovereign rating.

In 2009, downgrades and debt auction failures in countries like the UK, Greece, Ireland and Spain were reminders that advanced economies are not immune to being reprimanded for "poor fiscal fundamentals This year, the "pervasive negative big issues" should be: a weak economic recovery and an aging population, translating to a focus on the increase of the debt burden of many advanced economies, including the U.S., UK, Japan and several eurozone countries.

The weaker yen should happen because Japan does not have foreign currency debt, and the "devaluation" would not hinder their debt absolute value. Key implication of all estimates of Japan's debt is that without increasing the national tax burden (i.e., tax and social security costs)—which is relatively low compared to other major countries—it is impossible to sustain public finances. Unfortunately, raising taxes would curb already weak domestic demand.

Wafer-thin interest rates make it cheap to issue bonds, but the Japanese have decreasing incentive to invest in Japanese government bonds. If Japan must start selling more debt to the foreign market, interest rates may rise to attract any investors. If the market demands an interest rate of anything more than 3.5% then Japan will not have the [tax] revenue to service its debt. Even without a weak economy, Japan's debt numbers are set to get worse because of its aging population and underfunded public pension fund.

Not all black swans are negative events, and in this case, I think the yen can go back to 120 level, literally overnight. When that happens, we will have a chain reaction:
- Japanese stock markets will boom as exporters benefit immediately and companies can be a lot more competitive
- A sharp rise in FDI both short and long term into all types of Japanese assets
- Many Japanese exporters have come to terms with the strong yen over the last 10 years by expanding overseas. The net effect of this yen weakness will reverse the trend and cause more Japanese companies to reinvest in Japanese operations and manufacturing
- BOJ will start to raise interest rates, which will be a good thing really all around
- Exporters in same competitive categories in other countries could see a temporary sell down in their shares

p/s photos: Angelababy

Tuesday, January 26, 2010

The Hype Surrounding Black Swans

No, we are not talking about the beer. Investors who read a lot would have come across the quite audacious yet thought provoking book by Nassim Nicholas Taleb. You can summarise the book with the line: The Impact of The Highly Improbable.

The Nobel Laureate Daniel Kahneman proposed the inclusion of Taleb's name among the world's top intellectuals, citing "Taleb has changed the way many people think about uncertainty, particularly in the financial markets. His book, The Black Swan, is an original and audacious analysis of the ways in which humans try to make sense of unexpected events."

Before the discovery of Australia, poeple in the Old world were convinced that all swans were white, an unassailable belief as it seem completely confirmed by empirical evidence. The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the coloring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single black bird.

Consider these factors: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. We amble through life, in our careers, personal life, investing, etc... and these are punctuated by "black swans" - the humdrum would not kill you or make you rich and wealthy, its the black swans that turns everything around, be it in relationships or investing.

The central idea of this book concerns our blindness with respect to randomness, particularly the large deviations. In other words, we do not see the big picture but base our decision making process on what has happened in the past.

For those of you who attended my talk, I have spoken on how most of us make decisions: anchor & adjust. That in effect is one way to make sure we will never see or predict black swans in our analysis. When you anchor & adjust, you fixate on what happened recently and make your guesstimates from that point of reference. When Malaysia's GDP growth last year, say was 3%, to predict GDP growth the following year, we would anchor at 3% and make adjustments according to how we view FDI, unemployment, currency, interest rate differentials, blah-blah... Hence 99% of the predictions would be plus or minus 100-200 basis points from 3%. A black swan effect would be tantamount to something like two major banks collapsing in Malaysia overnight, and the resulting GDP growth was a contraction of 8% - now, that's a black swan effect - most did not see it coming because they never figured in our calculations.

Its not just in investing, you can be dating a girl for 5 years and planned to marry next year, and wham, she turned into a lesbian - turning your world upside down, what a black swan.

It is easy to see that life is the cumulative effect of a handful of significant shocks. It is not so hard to identify the role of Black Swans. Consider the significant events, the technological changes, and the inventions that have taken place in our environment since you were born and compare them to what was expected before their advent. Look into your own personal life, to your choice of profession, say, or meeting your mate, your sudden enrichment or impoverishment. How often did these things occur according to plan?

Taleb appeared to be vindicated against statisticians in 2008, as he reportedly made a multi-million dollar fortune during the financial crisis of 2007–2008, a crisis which he attributed to the failure of statistical methods in finance. Universa, where Taleb is adviser, made returns of 65% to 115% in October 2008 in its approximately $2 billion “Black Swan Protection Protocol.”

While most human thought has focused us on how to turn knowledge into decisions, ... if you follow Taleb's reasoning, we should be more interested in how to turn lack of information, lack of understanding, and lack of “knowledge” into decisions. That is because the world is always a place where information and understanding are lacking in most areas. Knowing that we will never be able to grasp all critical issues is important. The question of "what if" carries with it graver consequences when we know how to ask "what if" properly.

The LTCM collapse, with two finance gurus in the company (Nobel prize winners no less), was very Black Swannish. Using standard deviations and pricing models, they try to extract price differentials when certain factors move in a certain way. They looked at correlation between various asset classes and instruments. Well, the best minds could not explain when things that are supposed to correlate, starts diverging in a big way.

Our system of rewards is not adapted to black swans. We can set up rewards for activity that reduces the risk of certain measurable events, like cancer rates. But it is more difficult to reward the prevention (or even reduction) of a chain of bad events (war, for instance, the recent subprime crisis is a major example).

When our system of risk-reward is not geared towards detecting, spotting or preventing black swans - that put everything at risk. We can get into a very theoretical debate on black swans, but for us who are in investments, how does Black Swans apply to our senses?

The impact of black swans has been enhanced many times over due to the globalisation of markets, as well as financial firms getting a lot bigger and international (and fewer of them as a result). You can be owning very safe stocks with splendid dividend yields in Timbuktu, but due to over speculation in certain asset classes in Eastern Europe, or a maniacal over leverage by some Icelandic banks, you could have a cascading effect which hits at banks, markets, confidence ... leading to a de-rating of emerging markets, smaller currencies ... i.e. risk aversion, nobody wanting to own stocks. Hence your so called blue chips could be halved in value, to no one's fault.

The Black Swan thing should alert us to reflect that we really CANNOT adopt a buy and hold forever type of investing mentality. The markets are so different now, many things are the same, but there are critical nuanced differences now. Black Swans in investing will usually be found in over-leveraged situations, bubble type situations in certain asset classes, sovereign debt defaults, the collapse of a major financial firm, ... You may be just investing in stocks, but now you have to read and follow closer on what's happening or bubbling in other areas as well. Their bubbles will affect you in the end.

There are things we cannot control, that is external to us. We need to stay tuned to potential black swans, even though we may be laughed at initially. Take any industry or markets, think of a few really "upsetting things" can whack them out of the water - these are your potential black swans, then you start ticking things off in your research and analysis to see of any of these potential black swans are about to morph into something sinister.

Do not take things at face value, learn to ask better "what if" questions even when they appear to be silly sounding. Beware of leverage, beware of things like "value at risk" because nobody really knows VAR in reality.

p/s photos: Gu Chen

Monday, January 25, 2010

Getting A Hold On Market Weakness

Now that the US markets have been down 3 straight days, I get a lot more queries on "what the hell is happening" ... "is this going to continue" ... Well, first of all, in my lifetime, I have never seen a major correction whilst interest rates are near all time lows, have you??!! We are so used to a robust equity market for the last 12 months, that we lose sight what is a normal dip.

The trouble is exacerbated when fundamentals cannot explain these 3 days of weakness, we go searching for reasons, and usually they are the wrong ones. Some will cite that Obama's health care plan faces a setback with a Republican taking over the late Ted Kennedy's seat... some will say its Obama's thinking of implementing a tax on "traders or firms taking prop positions" ...

The whole thing is further exacerbated by people looking to charts and technicals to explain the situation - this is the best part, when all other reasoning fails, let's look at charts ... well you might as well consult a fengshui master. Charts are not so bad really, they are tools which can help us.

I came across a pretty straight forward guy looking at technicals of emerging markets, pretty OK.
Richard Shaw is the managing principal of QVM Group LLC, a fee-based investment advisor based in Connecticut. QVM manages portfolios uniquely designed for each client on a flat fee basis through the client’s own accounts at Schwab, Fidelity or Vanguard.

The BRIC countries are a mixed story. Brazil and China have clearly broken support, while Russia and India are still in rising patterns. Brazil may be a Sell. We think China is a Sell. Brazil has broken three conceptual support levels — its trend line connecting recent bottoms, its 21-day lower price channel and its 100-day moving average (in red). The 200-day average (in blue) is about 15% away.


As of January 21, China has broken four of four conceptual support levels, including its 200-day moving average, which is generally held to be a major significance.


Russia is in a rising pattern, but is testing a support level created by two recent highs that had formerly provided resistance. That support level is above the price channel and moving average support levels.


India is still in a rising pattern, but is close to a level where three conceptual supports converge (trend line, lower 21-day price channel and 100-day moving average).


The other countries within the emerging markets index are also a mixed bag.

Chile and Turkey are the two with the strongest current price patterns.



The Middle East has the weakest price pattern.


Taiwan and Malaysia are in OK price chart conditions.



Mexico is still in a rising pattern, but has pierced its bottom connecting trend line and its 21-day lower price channel. The 100-day moving average is not far away.


Thailand did not exceed its high achieved in October and is now at critical support formed by the convergence of its trend line connecting bottoms, its 21-day price channel and its 100-day moving average.


My concluding view is that we are just in an adjustment mode, I do think the markets will resume its bullishness very soon. I also see some markets drifting away from each other as the domestic liquidity conditions and monetary policies are diverting. Many are trying to rein in excessive lending and excessive property price speculation. I do think Malaysia is less affected by these issues. You should also read the recent posting on PEG ratios to get a better view that not all markets are similar, we are all going up using different routes.

Saturday, January 23, 2010

BFM Interview - Breakfast Grille, Monday 25th Jan 8am

Finally caved in to agree to do the interview on BFM 89.9 ... Catch it when you are driving to work or listen to it live on the internet from their site:

Friday, January 22, 2010

Leader Universal's Transformed Fortunes

Leader is an integrated cable and wire manufacturer with subsidiaries involved in the Independent power plant and property businesses. Recent developments have warranted a reassessment of their prospect and platform.

Song Hye Kyo

Lets look at it as their business model now where the bulk of the revenue is from cables and wires, with less than 20% from power plant. However the contribution to net profit is about equal from both divisions.

For the year ended December 2008 revenue dipped about 10% from 2007 to RM2.54bn and net profit was RM65m. For 2009, it looks likely to put up revenue figures of just RM1.95bn owing to weaker selling prices for cables and wires. That was due to a steep decline in aluminum and copper prices last year. However, net profit is still going to be respectable at RM65m or an EPS of 15 sen. That would make the stock trade at a very low 6x at 90 sen a share. Already for the three quarters combined for period ended Sep 2009, the company has registered a revenue of RM1.42bn and a net profit of RM55.4m. If you take the net profit for the third quarter alone, its net profit contribution was already RM20m, which could very well mean that the full year's figure could surpass the anticipated RM65m easily.

If you read the UC Rusal prospectus you will find that the outlook for aluminum prices is looking much better in 2010 and 2011 and that should secure a large deal of comfort. One of the main reasons why Leader Universal is still so cheap after rallying a bit over the past few weeks is the very very large free float.

Major Shareholders (%)
Zun Holdings 12.0
LTH 6.2
Gold Connection Assets 6.1

Paid up is 436m shares. There are a lot of shareholders holding less than 5% but herein lies the problem, it is not a widely followed counter, thus prohibiting funds from making it as part of their portfolio. However, that is gradually changing. Right now, there is only OSK which has been following the stock. The Cambodia project was signed back in 2008 and took a long time to come into frituion. Hence you can say that at below RM1.00 a share investors are still just paying for its existing business and not for their Cambodia project.

There is a lot to like about their new project. It is substantial, and will elevate the company to be a lot less dependent on its cyclical cable and wire business.

Leader Universal Holdings Bhd has secured a 25-year deal with Cambodia’s state-owned Electricite Du Cambodge (EDC) to develop a 230kV power transmission system on a build-operate-transfer (BOT) basis. In a filing with Bursa Malaysia yesterday, Leader said its wholly owned Cambodian Transmission Ltd had signed an agreement to undertake the project, which is estimated to cost US$107 million (RM359.52 million). The project would be financed by internally generated funds and bank borrowings.

The project involves the construction of two substations and 110km of overhead transmission lines joining the substations, in Kampong Cham and Phnom Penh. The project fulfils part of the planned development of the Cambodian grid system and provides for future 230kV extension to other parts of the country around Tonle Sap, the largest freshwater lake in Southeast Asia, in Siem Reap. The Kampong Cham substation was expected to be completed by July 2011 and the one in North Phnom Penh by March 2012, with commissioning and commercial operation expected by Dec 31, 2013.

Song Hye Kyo

Leader, through its 60% subsidiary Cambodia Utilities Pte Ltd, currently owns and operates a 35MW power generation plant in Phnom Penh and supplies electricity to EDC under an 18-year power purchase agreement (PPA). The power plant has been in operation since 1997.

The company is also developing a 100MW coal-fired power plant in Sihanoukville via its 80% subsidiary Cambodian Energy Ltd. The electricity generated will be supplied to EDC under a 30-year PPA.

This development for positive Leader as it marks the company’s second major breakthrough in strengthening its power division's presence in Cambodia. According to OSK, the PPA could well provide an estimated IRR of around 11-14% (very decent). This stems from cost savings arising from parts sourced via Leader’s cables and wires division and possible lucrative rates provided. The project is likely to be financed at a 70:30 debt-equity ratio.

No early impact. The project shall comprise 3 stages. Based on the Bursa announcement,
the excerpts state that:
(i) The first stage of the project will be the new Kampong Cham Substation expected to be completed by July 2011;
(ii) The second stage will be the new North Phnom Penh Substation expected to be completed by March 2012; and
(iii) The completion of the entire Project with the commissioning of the approximately 110 km transmission line from North Phnom Penh Substation to Kampong Cham Substation, from whence the commercial operation date of the Project commences. This is expected by 31 Dec 2013. Given that the project shall span 4 years to full completion, OSK reckons that the earnings shall stream marginally starting from 2011 only. Thus there is no impact on this year’s earnings.

Prospects are booming. There has been a slew of positive developments involving Leader, which is growing the presence of its power division in Cambodia. We see near-term catalysts for Leader's wire and cables business as cable and wire demand improves in the SCORE region. Nonetheless, OSK estimated that there is a potential RNAV of around RM100m from this PPA - or 22 sen a share.

You have the UC Rusal listing factor, which will lift interest in Leader Universal and maybe Press Metal. You have the huge Sarawak thing in SCORE which will up the interest in Leader Universal's core products. Now you have a pretty substantial and viable Cambodia project, which will create a much better quality of earnings (power plant), thus lifting the and countering the cyclical nature of earnings, thereby moving up its valuations.

Its hard to put a target but even on existing business, its cheap below RM1.00. With all the catalysts mentioned, we might find Leader Universal as the new market leader in volume and market interest.

p/s photos: Song Hye Kyo

Thursday, January 21, 2010

Country PEG Ratios

The folks at Bespoke Research have put up an attractive piece on PEG ratios. Ratios are very useful especially when comparing things across countries and industries - it makes them comparable.

The PEG ratio is the P/E ratio over the growth rate, and a PEG of less than one is generally considered good, according to Bespoke - however, guys, that is almost none existent. For example if a country is looking at GDP growth of 20%, can we safely try to find the markets at just 20x PER. Generally if you can even get a figure of 3, that is very decent already.That is we are talking of GDP growth rates and not company earnings growth rates. Even the very robust China markets only showed 10%-12% GDP growth in their robust years, so the 1/1 things never will exist.

In this regard, they have created "PEG" ratios for a number of countries using the P/E ratio of each country's main equity market index along with 2010 estimated GDP growth rates. Just as with stocks, the lower the country PEG, the more attractive.

click to enlarge

India ranks as the most attractive, followed by China and Brazil. Save for Russia, that's the whole BRIC trump card. Now, what's even more interesting is that Malaysia ranked near the top as well together with Singapore and HK. Foreign funds have been avoiding Malaysia like a plague for the past 18 months, will that trend continue. Many research strategists seem to think foreign funds will continue to underweight Malaysia. I have shifted tack and I think the Malaysian market may actually outperform most Asian bourses for the first half of 2010. The second half is still a bit unclear to make a confident call.

Worries over political stability should be ebbing now that Najib seems to have stood the "uncertain first year" in the office. Many funds were adopting a wait and see attitude with respect to Malaysia as many were thinking that many issues and factors were very "volatile" and fluctuating in the first few months. I think that stage has passed.

Bank Negara has managed very well, not letting the economy dwindle and keeping a lid on pessimism. The catalyst for Malaysia will be the ringgit outlook. I do think Bank Negara will be allowing the ringgit more leeway going forward, and that is a major attraction to funds. Valuation wise, its not demanding. The domestic economy is flushed with liquidity, just go to any new property launches. These are all a potent mix.

p/s photos: Jarah Mariano

Wednesday, January 20, 2010

Bernanke's Likely Weapon Of Choice

This is my prediction for Bernanke. He will raise fed funds rate very very soon. Just because of that, it does not mean that it will be bad for equity markets.

But lets go back to why it will happen very soon (by February I think). Most developed nations' central banks have been reluctant to move the low interest rates regime up because the Main Street has been showing nascent growth. What Bernanke wants to see are corporate spending on R&D and hiring - both not really evident yet. Despite the tons of liquidity being poured into markets, many banks are just sitting by idling.

The Fed has had to maintain a low fed funds rate for obvious reasons, but look at the chart, banks are earning very decent net interest margins by lending to the system, and not to clients. High ranking officials have been calling the banks to lend more aggressively, but that does not seem to be working.

Erika Sawajiri

Bernanke's hands are being tied a lot more now that many of the banks which received funds from the government are returning it - that means the government will have a lot less leverage to "move the banks" toward certain persuasions.

It looks like Bernanke will have little choice but to close the gap and raise fed funds rate. When net interest margins start to shrink, then the banks will have to put the money to work. The summary from all this deduction is that don't be worried when Bernanke raises fed funds rate, in fact it is a new bullish sign.

p/s photo: Erika Sawajiri

Tuesday, January 19, 2010

Why I Like London Biscuits

London Biscuits is engaged in the manufacturing and trading of confectionery and other related food stuffs. It markets products in Malaysia and 65 other markets, worldwide. The group primarily operates in Malaysia, where it is headquartered in Johor.

Its main overseas markets include China, Hong Kong, Macau, Indonesia, Singapore, Taiwan, Thailand, Vietnam and the Middle East. London Biscuits’ products are divided into two categories, corn based snacks; and cake products such as swiss rolls, pie cakes and layer cakes.

In addition, the group also manufactures range assorted chocolate confectionery including
chocolate-coated peanuts and biscuits, pancake cookies, jelly and puddings, wafer sticks, cup sticks and snack noodles. Some of the London Biscuits products are marketed under the brand names: Lonbisco, London, Kinos, Gega, Caca, Mizu, Hiro.

The group recorded revenues of RM138.2m in the fiscal year ended June2008, an increase of 17.9% over 2007. The group's operating profit was RM18m in fiscal 2008, a decrease of 26.4% compared to 2007. Its net profit was RM10.5m in fiscal 2008, a decrease of 47.2% compared to 2007. For the year ended June 2009, the company's fortunes rebounded well to RM184.3m, and net profit jumped from RM10.5m to RM13.68m.

On a paid up of just 78m shares, that worked out to be 17.5 sen. A share price of RM1.17, that translates into a historical PER of just 6.68x.

London Biscuits was acquired by Liew Family in 1994. In the following year, the group purchased a new building. In 1998 London Biscuits purchased its second factory and diversified their operations into pie cakes and confectionary segment. The group purchased its third and fourth factory and expanded into producing London roll and London layer cakes in 2000. Two years later, the group was listed on the main board of Bursa.

In 2004, London Biscuits expanded its production capacity for cakes conversion to usage of pasteurized liquid eggs for production completion of a custom built office cum warehouse facility. In the following year, the group purchased its 6th factory and acquired Kinos Food Industries with its two factory premises. London Biscuits acquired 25% stake in Lay Hong, an integrated poultry farming company, in 2006. In 2007, the group acquired a majority stake holding in Khee San Berhad, a manufacturer of sweets and candies. The company launched its London choco roll and milk roll cake products, and purchased its 9th factory in 2008. London Biscuits launched its potato bites range of potato chips in 2009.

Even during the crisis, they managed to record a growth of 33% topline and 52% bottomline. Turnover in 1QFY10 (for the quarter ended Sep 09) vs 1QFY09 grew 18% to RM46.6m and net profit grew 45% to RM3.522m. NAV stood at RM2.12, which means the company trades at just 55% of NAV. Hmmm... coupled with the fact that the company expanded its plant in 2009, we should be looking at a significant bump up in revenue and net profit figures for the next few quarters.

Here is the funny thing. Their supplier for plastic packaging. Daiboichi trades at 9.9x FY09 and P/NTA of 1.7x. Its not too much to ask that London Biscuit should be closer to its NAV of RM2.12, is it? For a company that has expanded gradually and carefully, noting that their margins and net profit figures have climbed steadily. Certainly not a fly by night operator. Of course it should trade a lot closer to its NAV.

Before the financial crisis, they used to pay half of its earnings as dividends. We may expect that to continue again.Assuming we annualise its net profit to RM15m, that will mean a dividend of RM7.5m / 78m or 9.6 sen per share. Its retained earnings is around RM73m, almost enough for a 1-for-1 bonus.

Dato’ Sri Liew Kuek Hin was appointed to the Board of LBB on 27th December 1993 and was subsequently on 26 October 2007, re-designated as the Non-Independent Non-Executive Chairman of the whole Group. He studied in Nanyang University, Singapore and thereafter, he joined his family-owned businesses, which includes logging, transportation, sawmilling, plywood manufacturing, plantations, palm oil mill and hotel operations.

DATO’ SRI LIEW KUEK HIN, SSAP, DIMP, PJK, JP Chairman of the Board, in his statement in the latest annual report: Outlook and Prospects The smile is slowing returning to the face of many Malaysians Manufacturers and Exporters, which were directly or indirectly affected by the global economic crisis, which led several countries to a worst recession that they had experienced thus far. Fortunately, many feel the worst should be over and recovery is in sight. The Board, is once again optimistic and confident that LONDON would be in a good position to end the financial year 2010 with a “bang”.

It is unusual for the chairman to issue such an "emotional tinged" statement at the end... "with a bang". Hmmm... I agree too. I have been highlighting some of the often overlooked smaller companies, that does not get proper coverage from the research community. It is sad because we need to reward and encourage the smaller companies by getting more early investors into them, so that we all can share in their growth and expansion. That's what investing is all about. A credible business model and a strong management team that executes well.

NOTE: The above opinion is not an invitation to buy or sell. It serves as a blogging activity of my investing thoughts and ideas, this does not represent an investment advisory service as I charge no subscription or management fees (donations are welcomed though). The content on this site is provided as general information only and should not be taken as investment advice. All site content, shall not be construed as a recommendation to buy or sell any security or financial instrument. The ideas expressed are solely the opinions of the author. Any action that you take as a result of information, analysis, or commentary on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

p/s photos: Carmen Soo

Press Release By Notion Vtec

(Company No. 637546-D)


Nikon endorses the Notion Group by Buying a Substantial Stake

KLANG, Selangor 19th January 2010 – Notion VTec Berhad (Main Market -Technology: Notion & Code 0083) is pleased today to announced that Notion group have placed 13,844,694 NVB shares representing 10% of outstanding shares prior to the new stock issue to Nikon Corporation ("Nikon") at an issue price of RM 2.44 per share.

The issue price of RM 2.44 which was priced on 6th January 2010 represents a discount of 10% of the weighted average market price for the five(5) market days immediately preceding the said price fixing date.

Nikon commands a high global standing in the manufacture and sale of camera-related products, such as digital cameras, as well as binoculars and other optical products for consumers, such as ophthalmic lenses. These items complement Nikon’s diverse array of industrial precision equipment that includes semiconductor-related equipment, IC and LCD steppers and scanners, microscopes and measuring instruments. Headquartered in Tokyo, the Nikon group recorded global sales of Japanese Yen 879.719 billion (equivalent to RM33.4 billion) for the year ended 31 March 2009.

The NVB group has been a major supplier of cam barrels (for the SLR cameras) to Nikon since 2005. The camera segment currently contributes approximately 43% of the NVB's group revenue. Having Nikon as a strategic investor should further strengthen the business relationship and create additional opportunities for both the groups. Nikon’s concern on the strong Japanese Yen is also seen as a strategic move by the Group to obtain essential supply of camera components from an efficient supplier such as Notion in non-Yen currencies.

The proceeds raised of approximately RM33.78 million will be used for the expansion plans in Thailand which will create an extra floor space of 200,000 sq ft to the group's facilities. The Notion Thailand plant will in the initial stage mainly cater for Nikon (Thailand) Co Ltd which has indicated that there will be additional orders for camera parts and also possible sub-assemblies in the near future.

The investment by Nikon Corporation in the equity of Notion is indicative of the strong confidence placed on the Group and should not affect any other camera business that we have,” said Mr Thoo Chow Fah, Executive Chairman of Notion VTec Berhad.

“It is a sign that the Notion group is a key player in the supply chain management of a top notched SLR camera/Interchangeable Lens maker in the world. The camera segment will remain a key contributor to the Notion group’s revenue and profitability.

(Company No. 637546-D)

“There have been discussions on training of Notion’s staff in Japan and possible future collaborative R&D in the optical and imaging segment which opens up further opportunities for skills development, technology and new business.”

About Notion Group

Notion is a large scale global supplier of high precision parts for the hard disk drive, SLR camera/Lens and Industrial/Automotive industries and amongst its customers are multi-national companies who are market leaders in these industries. Its strength is in product development, engineering, quality assurance, in-house tooling and jigs & fixtures capabilities. Notion will continue to invest in new technologies to stay in the forefront.

Notion was established in 1995 as a precision machining company. Please visit the Investor Relations section of the company website (} for additional investor and financial information.

Disclaimer Regarding Forward-looking Statements

This press release material contains forward-looking statements including expectations, judgment, plans, and strategies. The forward-looking statements are based on management’s assumptions and belief in light of the information currently available. Certain risks, uncertainties and other factors could cause actual results to differ materially from those discussed in the forward-looking statements. Such factors include, but are not limited to: fluctuation of currency exchange rates, overall supply and customer demand, product development and production capabilities, performance of affiliated companies, and other risks and uncertainties. Notion undertakes no obligation to update forward-looking statements to reflect events or circumstances that occur after the date the statements are made.

Notion VTec Berhad, Lot 6123, Jalan Haji Salleh, Batu 5 ½ Jalan Meru, 41050,

Klang, Selangor DE. Tel:03-3361 5615 Fax:03-3392 8482

Making Sense Of The Risks & Rewards Of Owning UC Rusal

None of what's written below is original. All have been culled from various business publications:

... at the core of Rusal’s pitch to institutions is this claim on how it wants to invest in its $2.6bn flotation proceeds:

Rusal has deliberately positioned itself to exploit the urbanisation and industrial growth of China and now claims that it can put aluminium on to the docks at Shanghai more cheaply than its Chinese rival, Chalco.

Rusal’s secret weapon over rival producers, says the paper, is an abundance of “stranded” hydroelectric power in Siberia that cannot be moved far afield and is sold cheaply to local industry.the indebted company sources nearly 80 per cent of its energy requirements from hydroelectric power in Siberia, unlike its rivals which are dependent on fossil fuels.

That means Rusal’s flagship smelters, which generate nearly 80% of the company’s total output (an estimated 4.3m tonnes in 2009), do so at an average cost of $1,338 a tonne.This puts the company in the 1st quartile of the cost curve by exploiting availability of abundant, low cost, stranded hydro power in the region. Power costs constitute only 26% of the company’s total production costs compared to 36% for the industry in H1 2009.

We estimate power consumption in Siberia is running somewhere below 50% capacity right now. Given there are few other power intensive industrial activities in the region, we the potential for aluminium production to double before it become constrained by the availability of cheap power.

So Rusal, which owns 18 aluminium smelters, 12 alumina refineries, 8 bauxite mines and some other mines, is basically a Siberian power play.

But that’s not all. Rusal’s smelters are close to the world’s biggest aluminium consumer — China. This, it is claimed, gives Rusal a transport advantage of circa $40 a tonne over the weighted average of China’s trading partners.

At the moment, Rusal sells only 14% of its output to China, according to the report. But that could change given anticipated increases in carbon regulations in China and the intention of the Chinese government to restrict new aluminium supply.

The report eventually arrives at a valuation range of $20bn-$26bn, using discounted cash flow and peer group valuation multiples. (That implies a PE range of 14.1-18.3 times 2010 earnings, apparently).

Below are excerpts from the IPO prospectus, released on Thursday through the Hong Kong Stock Exchange, the first time ever that RUSAL has given key financial and company details. Russian aluminum giant UC Rusal won backing for its US$2 billion Hong Kong initial public offering from Asia-based tycoon Robert Kuok and two prominent hedge funds, two people familiar with the matter said Tuesday.

The backing could lend credibility to an IPO that got off to a rocky start, after Hong Kong regulators forbade retail investors to participate amid concerns over Rusal's $14.9 billion in debt.

According to the people familiar with the matter, the investors include Mr. Kuok, also known by Chinese name Kuok Hock Nien, whose Kuok Group includes Hong Kong-listed Kerry Properties Ltd. and English-language daily South China Morning Post; blue-blood hedge fund manager Nathaniel Rothschild, through his NR Investments; Paulson & Co., the hedge fund run by John Paulson; and Russian state development bank Vneshekonombank, or VEB.

The four will serve as cornerstone investors, these people said. Cornerstone investors buy into a company during the pre- IPO stage and agree to hold their stakes for a certain period of time, in this case six months.

Rusal plans to raise about US$2 billion from selling around a 10% stake as part of efforts to repay debt. The company is set for a primary listing in Hong Kong and a secondary listing of its depositary receipts on Paris' Euronext stock exchange on Jan. 29.

We believe that Rusal should trade somewhere between Chalco and Western peers considering its low cost, tier 1 assets, the Russain risk and the Chinese premium for the Hong Kong listing.

Although it could be worth more.

UC Rusal is scheduled to repay some $5bn of debt to its lenders by the end of 2013 under the proposed debt terms (excluding the VEB loan). Even after considering this, we estimate free cash flow to equity increase at 7% CAGR creating a value of $36.5bn by 2012, a 40 per cent upside to the top end of our valuation range.

There are other risk factors, however, such as the fact that US Rusal is net short bauxite (it purchased 8.8m tonnes of the stuff in 2008) and also the rather mature age of its assets.

Its smelters and refiners, according to the report, have an average age of around 42 years and nearly 75 per cent of the group’s aluminium production comes from “Soderberg technology,” which is said to be power intensive and pollutive compared to “pre-technology” (whatever that is).

So its just as well that cheap power is on hand.

Rusal also has a very low effective tax rate of 13%, compared to the corporate tax rate of 20% in Russia, the report states.


Rusal's restructured debt is $14.9 billion. It includes $7.4 billion to international lenders, $2.1 billion to Russian and Kazakh lenders, $4.5 billion to state-run VEB bank and $895 million to Onexim Group, owned by tycoon Mikhail Prokhorov.

RUSAL, under the terms of the restructuring agreements, may be forced to dispose up to all of its 25 percent stake in the metal giant Norilsk Nickel .

RUSAL is prohibited to pay dividends unless the Group's debt to banks, except for VEB's and Onexim's debt has been repaid by at least $5 billion.


Moscow-based Norilsk Nickel is the world's largest producer of nickel and the world's largest palladium miner. Norilsk's main shareholders are billionaire Vladimir Potanin and RUSAL, each with a 25 percent stake.

RUSAL has pledged 25 percent plus one share in Norilsk as collateral to secure its indebtedness to VEB.

VEB agreed to switch collateral and will now accept a 5 percent stake in RUSAL itself instead of a 25 percent stake in RUSAL's Bratsk and Krasnoyask aluminium smelters.

EN+, Deripaska's investment vehicle, is expected to pledge 15 percent of the issued share capital of RUSAL to the lenders of EN+ in connection with EN+ $1.04 debt restructuring.


By 29 October 2010, unless RUSAL obtains an extension, it must repay a $4.5-billion loan from VEB.

RUSAL plans to seek a further extension of the amounts outstanding under the $4.5-billion loan, dated 30 October 2008 between the company and VEB. RUSAL's directors believe that, if requested, VEB will extend the loan maturity for successive one-year periods through the override period to October 2013.

RUSAL can also request state-controlled Sberbank to assume all rights, claims and obligations under the VEB debt following a request from RUSAL, and to extend the debt to Dec. 7, 2013.


From the prospectus: RUSAL does not meet the profit test to qualify for listing on the Main Board of the Hong Kong Stock Exchange Limited. The company has been admitted on the basis of a large market capitalisation, revenue of more than HK$500,000,000 and positive cash flows from operating activities.

If the repayment of the whole of the group's indebtedness is accelerated... or if the Company should be unable to extend or refinance or repay the VEB loan as and when it falls due, RUSAL may cease to continue as a going-concern.


Deripaska has confirmed to RUSAL that he had an application for a U.S. visa denied in 1998 pursuant to Section 212 of the U.S. Immigration and Nationality Act, which relates to aliens deemed ineligible for U.S. visas based on security, unlawful activity and related reasons, and this position was reiterated in 1999 and 2000. Deripaska has consistently challenged these denials as being unwarranted and unsupported.

He has also confirmed to the Company that he subsequently visited the United States lawfully a number of times. The most recent visits were in August and October 2009.

Deripaska has also confirmed to the company that, to the best of his knowledge, he is not under investigation by any U.S. authority.


In its prospectus, Rusal said if the Michael Cherney case were to prevail on its merits it could require a payment in excess of $4 billion from Oleg Deripaska. The company cautioned, however, that the case is still in the early stages and that it is too early to say what the final amount might be. [ID:nGEE31QV]

If Deripaska were forced to use his UC Rusal shares to fund the payment, his influence over the company would be "significantly reduced", the company said in its prospectus.

According to the company, Deripaska "strongly denies and will vigorously resist Mr. Cherney's claims."


After the placement, Deripaska's EN+ will have 47.59 percent of RUSAL shares; Onexim Group of tycoon Mikhail Prokhorov will hold 17.09 percent; SUAL Partners, controlled by tycoons Viktor Vekselberg and Len Blavatnik, will have 15.86 percent; and Swiss-based commodities trader Glencore will hold 8.65 percent.

RUSAL will place 10.81 percent of its shares, of which VEB will buy 3.15 percent and International lenders 0.17 percent.

The company's Global Depositary Shares will be also listed and traded on the Professional Segment of Euronext exchange in Paris. Each Global Depositary Share will represent 20 shares. The company will be renamed as United Company RUSAL plc.

p/s photo: Marsha Milan Londoh