The Greatest Real Estate Deal Of All Time?
The “Mighty” Mississippi River is born a mere trickle in Lake Itasca, some 1,500 feet above sea level in the northern U.S. state of Minnesota. From there> READ MORE
The “Mighty” Mississippi River is born a mere trickle in Lake Itasca, some 1,500 feet above sea level in the northern U.S. state of Minnesota. From there> READ MORE
It’s been a while since I brought my readers an example of one of my own personal car-crash investments! This edition of My Top 5 Worst Investments doesn’t> READ MORE
In late September, a true lion of Asian business died after a long illness. He was 91 years old. Typical of many Chinese billionaires, his success came from> READ MORE
A couple weeks ago I was back down in Auckland, New Zealand for my 50th high school reunion. Of course, as regular readers will know, I don’t go anywhere> READ MORE
It was a warm, clear afternoon over this year’s Easter weekend. I was sitting on the breakwater of a small rural fishing village situated around 275 kilometres> READ MORE
I joined the derivatives structuring desk of a European investment bank straight out of university. I recall having to google search the term ‘derivatives’ the> READ MORE
Wherever I go in the world, for business or leisure, I always ask myself two basic questions… The first question; what’s happening in the local property market?> READ MORE
There are developed markets. There are emerging markets. After that we have frontier markets... And then there are emerging frontier markets. Earlier this month I> READ MORE
The “Mighty” Mississippi River is born a mere trickle in Lake Itasca, some 1,500 feet above sea level in the northern U.S. state of Minnesota.
From there it meanders its way south, gathering volume as the increasing flow from tributaries swell it into the fifteenth largest river in the world (and fourth longest, at 2,320 miles).
The river creates some of the most fertile agricultural terrain in America, along with navigable rivers, forests, prairies, and mineral riches.
These bounties led France throughout the 17th century to explore the Mississippi River valley creating settlements across the region.
By the middle of the 18th century, the French held sway a length of terrain from New Orleans in the south, to Montana in the north.
To be clear, this ‘Louisiana Territory’ was enormous… covering some 828,000 square miles.
That’s nearly three and a half times the size of France today.
The territory came to be, as historian George Herring puts it, a “pawn on the chessboard of European politics”.
France ceded control to the Spanish at the culmination of the Seven Years’ War in 1762 under the Treaty of Paris… however, Napoleon Bonaparte regained ownership from Spain in 1800 under the secret ‘Third Treaty of San Ildefonso’ between the French and Spanish.
Around the same time, President Thomas Jefferson demonstrated considerable foresight and downright smart thinking by agreeing to increase American presence in what was a politically unstable area of North America.
However, he was concerned that political instability in the area could undermine efforts to occupy these lands and lead to further conflict with the American state.
Word filtered that that France had entered into a secret agreement with the Spanish to take back control of the Louisiana Territory.
Soon thereafter Napoleon’s France was facing revolutions across its colonies, most notably Haiti and Hispaniola where French forces suffered thousands of casualties from war and yellow fever.
Napoleon’s visions for the French colonies in the western Atlantic were in tatters.
His plans to use the Mississippi basin as a base for food production and trading activities to support French colonies in the region now made little sense.
The colonies were breaking… and French forces would be inadequate to protect the Louisiana Territory.
Moreover, plans were afoot for conquests closer to home in Europe. But he needed money to fund those military adventures.
Jefferson offered to purchase some of the territory from Napoleon. Specifically, they were prepared to pay up to $9.375 million for New Orleans its surroundings.
Napoleon countered, offering Jefferson a deal of incalculable value…
He proposed the sale of the vast Louisiana territory… in its entirety… for $15 million (roughly a quarter billion dollars today).
The Americans couldn’t believe their luck. The offer was completely unexpected. They were stunned.
In a single stroke the newly emerging America could almost double its total land area. And at a cost of less than 3 cents per acre.
Signed in Paris on the 30th April 1803, and aptly announced to the American public on the 4th of July, this deal became known as the Louisiana Purchase.
America went on to become the most powerful and wealthy nation on earth… as predicted by founding father Robert Livingstone, who said at the time…
“We have lived long, but this is the noblest work of our whole lives…From this day the United States take their place among the powers of the first rank.”
In my decades in finance and real estate, one thing I’ve learned is this: the core underlying principals of investing rarely change.
You see, the fundamentals aren’t new. Technology, computing, speed of information dissemination and transparency… sure, these have all helped change the game.
But throughout the span of recorded human history, the same lessons are there in plain sight, again and again… they are timeless.
Bear in mind, the Louisiana Purchase was more a political deal than an outright real estate one.
But still, there are a couple of major lessons that still ring true today.
Firstly, motivated sellers offer value.
If you’re a buyer, the best sellers of real estate are ones who need to get out, and fast.
Distress equals opportunity.
There are hundreds of reasons why an individual might need to sell: maybe they need cash to bail out their business, maybe they’re leaving the country, it could be a divorce, it could be a case of over-leverage… who knows?
Regardless, a motivated seller usually gives you negotiating power… in other words, the opportunity for a lower price.
And hopefully, you can pounce… which brings me on to the next lesson…
…the ability to act quickly can be critical.
Take the Louisiana Purchase. The deal was completed on the 30th of April… yet Napoleon’s offer of the entire territory was only made NINETEEN days prior to that!
Had the Americans not acted so quickly, who knows what could have happened.
We do know that Napoleon’s two brothers were trying to talk him out of the sale!
Some of the best real estate buys I’ve made have been done quickly… sometimes completely on the spot.
Combining a speedy transaction with a motivated seller will give you a better price. Period.
But critically, you have to know your market inside out.
A seller looking to offload quickly often wants to sell you more than just his property… he wants to dump you with the problems that come with it!
Maybe there are structural issues, a leaky roof, asbestos… a new sewage plant to be installed close by! You get the picture…
The final lesson from the Louisiana purchase is this: don’t sell real core assets to fund spending.
It’s one thing to sell assets and reinvest, it’s quite another to do what Napoleon did…
He frittered the entire proceeds on senseless wars and military incursions, squandering one of France’s greatest financial and economic assets.
Some time later Napoleon was reported to have said, “America is a fortunate country. She grows rich by the follies of our European nations.”
I couldn’t agree more!
It’s been a while since I brought my readers an example of one of my own personal car-crash investments!
This edition of My Top 5 Worst Investments doesn’t relate to any specific investment per se.
I’m talking here about a broader type of deal that everyone will be tempted by at some time or another.
I know with certainty, that for some of my readers, this edition of Peter’s Perspective will save them tens if not hundreds of thousands of dollars…
Tama and I often get approached by all sorts of people looking for investor dollars.
It could be venture capital (a new concept/idea from an entrepreneur or a small company looking for financing).
Or it could be private equity (perhaps a more traditional business where you are buying into more mature companies).
At one end of the spectrum, we have the more modest business ambitions.
Maybe it’s a food & beverage play, someone looking to import and distribute a product or service, a small tech startup, a new app… the list goes on.
[A reminder here why you should never invest in F&B!]
These meeting requests typically come through friends, old acquaintances, former colleagues and the general grapevine.
Normally you’re looking at an investment size of anywhere from US$25k to US$100k.
At the other end of the spectrum, we have the more ‘professional’ grade of private equity. It could be a Chinese factory, a European bioscience private equity fund, an appliance manufacturer… anything.
In these cases, the ticket size is larger (think US$100k to US$250k) and the opportunity is wrapped in a more standardized private equity vehicle.
I’m pretty sure that in the past twelve months you’ve been approached by someone pitching you an opportunity somewhere in the spectrum described above.
[Let me point out here that I have some experience with raising capital myself. I spent a lot of time raising money for the real estate hedge fund (since closed) that I set up in 2004. And I continue to spend a lot of time raising money for our local real estate private equity vehicle today.]
Now, what I’m about to say will make me highly unpopular to many people… and I could be shooting myself in the foot as well, but let me be clear:
Most individuals have absolutely no business whatsoever ‘investing’ in either of these types of private enterprises – either the small deal, or the larger traditional private equity deal.
I’m absolutely serious. And here’s why.
Imagine your total personal wealth asset allocation pyramid.
At the bottom of the pyramid you have things like cash, savings accounts, vanilla life insurance… money market accounts.
Low risk. Low volatility. Your foundation.
Moving up you have fixed income… bonds, maybe some preferred stock.
Low-ish risk. Income.
[I’d also put real estate (that you live in) in this category as well.]
Higher up the pyramid come your big blue chip stocks… and gradually moving to emerging markets, currencies and smaller cap equities… and finally things like options, maybe futures.
Our allocations of wealth to each part gets smaller as we move up the pyramid.
And right at the very top… in the ‘highest risk with lowest liquidity’ category… you have venture capital and private equity.
Now, I think you know that part of the pyramid should have your lowest overall allocation!
Deep down it makes total sense to you.
I asked a Financial Advisor friend of mine, Todd Pallett at EXS Capital, what he recommends as an allocation to this part of your pyramid.
“You should limit your VC or PE investments to no more than 5% of your net worth at a maximum.
That means if you’re going to write a fifty thousand dollar cheque, you shouldn’t have anything less than a million bucks in net worth.
If it goes to the moon then great, you might wish you did more!
But in my years of experience with clients, it’s much more likely it won’t. And you’ll be very happy you kept a sensible risk limit.”
When you stop and think about it for a moment, just take a look at what characterizes these kinds of private capital investments.
They’re Totally Illiquid
If you sign a US$50k or US$100k cheque, you better believe you’re not going to see that money again any time soon.
It will be YEARS before there’s any kind of exit for you. That cash is tied up.
Unless the company IPOs or gets bought out, then you’re stuck. You might book some paper profits if there are later funding rounds at higher valuations.
But rest assured, you need to be willing to sit, watch and wait.
Take it from Warren Buffet. Cash is King. And he keeps plenty of it on hand.
We keep a lot of cash on hand “so that we can both withstand unprecedented losses and…quickly seize acquisition or investment opportunities”
If too much of your wealth is tied up in illiquid investments, then you can’t move quickly when the really great opportunities come along.
As they say, when “there’s blood on the streets” it’s time to buy… (or sell mops).
Say No to the “FOMO”
Let me guess, the opportunity sounds great. It’s exciting. All your friends are all piling in.
You get a little adrenalin rush thinking about how you’re going to spend your newfound riches…
You DO NOT want to be that one guy who didn’t buy the winning lottery ticket. The guy who missed out on the big score.
How will you live with yourself if you’re still sat behind your desk while your buddies are sitting on their yachts sipping Mai Tais?
Please, ignore the Fear Of Missing Out (FOMO).
We all get it… myself included. But it’s a terrible, terrible reason to invest.
Your Odds Are, By All Accounts, Terrible
The media loves stories about the folks who bought in to Twitter or Facebook in the early days. The investment buccaneers who struck gold…
But rest assured, for every unicorn, there are at least 99 donkeys who end up at the knackers yard…
For the vast majority of us, it ain’t gonna happen.
Don’t get me wrong, your winning numbers might come up… but that doesn’t make buying a lottery ticket the right idea.
I could go on and on… the lack of control, corporate governance issues, transparency…
The point I’m trying to make here is this: there IS a place in your portfolio for these kinds of investments, but the biggest single mistake I see people making is allocating way too much money towards them.
I know plenty of people who don’t own a stock, or a bond, or even real estate… yet they’ve put low to mid six-figures into venture capital and private equity!
Remember: these investments are the LAST thing you look at, not the FIRST!
Get everything else in place to begin with.
Make sure your pyramid is properly structured.
Then, and only then, dive into the illiquid stuff… and get your allocation right.
And when it comes to these investments, there’s a long list of things you need to check off before you hand over a single dollar.
I’ll share my check-list with you another time.
I’ve had plenty of painful experiences and hopefully sharing my mistakes will help you avoid making the same ones.
In late September, a true lion of Asian business died after a long illness. He was 91 years old.
Typical of many Chinese billionaires, his success came from humble beginnings. He started in the jewelry business in Macau in the late 1930’s. He later inherited the family business and grew it substantially.
From there he moved, like so many of his generation, into property in Hong Kong in the 1960’s.
Forget diamonds and gold… real estate is where real money was made.
Cheng Yu-tung was a highly regarded businessman who extended his reach beyond property and jewelry into various forms of infrastructure, retail, and hotels.
Having watched and followed his core company, New World Development (17 HK, US$10.5 bn market cap), and jewelry company Chow Tai Fook (1929 HK, US$7.6bn market cap) for more than thirty years.
In my investment banking days, I was part of the team that took New World’s China property business public. It was one of the earlier China property sector IPO’s.
New World was a pioneer, showing how foreign companies could take on China’s fledgling property markets in a big way.
Asian property investors and developers have often struggled when entering foreign markets, but one example of a ‘win’ involved the Cheng family and a fellow Hong Kong tycoon, Vincent Lo of Shui On Land (272 HK)… and as it would happen, Donald Trump.
This particular deal initially dates back to the 1970’s. But it really took shape in the mid-1980’s. It involved the Manhattan West Side Yards, a 77-acre site on Manhattan’s west side.
The owners went into bankruptcy and the site fell into the hands of banks. Trump’s part in this began in 1985 when he acquired the Yards from another distressed developer for US$115 million.
But of course, as we have seen from Trump’s frequent incursions into bankruptcy and financial distress, it was only a matter of time before this asset would fall into the “distressed” bucket again.
It duly did so…
In the early 1990’s, the site, under Trump’s control, was bleeding cash like a stuck pig. The New York property market was undergoing a correction at the time which didn’t help.
Trump’s bankers forced him to relinquish control of the site.
The new owners? Yes, you guessed it. The Cheng family of New World fame in Hong Kong and Vincent Lo another property tycoon with big real estate interests in Hong Kong and China.
In 1994 they paid US$82 million, and assumed the roughly US$250 million debt that the Donald had accumulated.
The new owners set about developing the site with up-market condos and other uses. Trump was entitled to a share of the profits from property sales and took management and construction fees during the build.
His interest in the development post-sale was reportedly 30%.
Come 2005, the Hong Kong team agreed to sell the development for around US$1.76 billion.
And that’s when the fun started. Trump screamed blue murder.
This, as so often seems to be the case with America’s possible new President, ended up in the courts.
Trump tried to sue the pants off the Hong Kong partners. His argument? They should never have sold it for that price. It was worth much more he said.
He refused to accept his share of the proceeds of the sale.
Over the next four years the case dragged on, producing 166,000 pages of documents for the court.
Trump accused his Hong Kong ‘partners’ of all sorts of infringements… from tax evasion to fraud.
His compensation was a minority interest in the New York and San Francisco Bank of America Buildings (which are worth around US$640 million today according to Bloomberg).
He now of course trumpets that this was a great deal that he won! One of those times he “beat China”…
The Hong Kong group won their case in court but at great expense and great effort.
Recently, referring to the Trump litigation, Vincent Lo was quoted as remarking, “Well, that is him. To file a lawsuit is nothing. It’s just like having lunch”.
Probably not too many people outside of Hong Kong followed this story.
But it does, once again, serve to illustrate something of the character of the man who could be the next President of the U.S.
[I also spoke to a wealthy European family office earlier this year who had done business with Trump and reported that the experience turned unpleasant.]
This deal though shows that at least some investors from Asia have faced the notorious court process in the U.S. and won.
And it also demonstrates the importance of retaining control over investments where possible.
Trump was a minority shareholder in the project and couldn’t drive it as he wanted. Despite having his name on the buildings, he was a passenger.
Fourth, I have long opined that Asian real estate investors are not adept at investing outside their home markets. This story is a good example of me being wrong… although the Hong Kong partners sure had to work hard for their win!
In the next 24 hours there’s a good chance we’ll know the name of the next President of the United States.
But there’s one particular sector of the economy that stands to benefit regardless of who wins…
Because BOTH of these candidates have pledged to increase spending in this sector massively … and we outlined a simple investment to take advantage of this in a recent edition of The Churchouse Letter…
We call it “Phase 4“.
A couple weeks ago I was back down in Auckland, New Zealand for my 50th high school reunion.
Of course, as regular readers will know, I don’t go anywhere without kicking the tyres on investment opportunities.
This trip was no different. But it gave me a great opportunity to look back at the inaugural edition of Peter’s Perspective, sent out in July of 2013… “What’s Happening in the Land of the Long White Cloud”.
To save you time, here are some excerpts from that letter:
“This trip was a case of rolling up the sleeves, burning the shoe leather and getting the low down on investment prospects in the residential market there…
I liked what I saw…
Auckland housing prices are definitely on the up…
Supply is currently tight…
Mortgage rates have never been lower. There is little to no motivation for the central bank to push rates up anytime soon…
Auckland will be the first port of call for most [Asian] newcomers…
The role of foreign buyers in the market right now should not be underestimated. They are a significant force, and most are Asians. A meeting with a long established lawyer friend this week said that his practice is dealing with 20 plus property transactions per week for Asian clients. He has taken on a small team of Chinese speakers to deal with this flow, and the deals are not just families buying a small apartment for own use or investment…
The majority of people checking out the bricks and mortar at “open homes” that I visited in the last week were Asian. That will become a familiar pattern to many major western cities if it is not already…
Having completed three trips in the past nine months to do my homework in this market, I am convinced that it is providing decent opportunities in a market that is recovering from the global financial crisis…
Right now I am buying residential property in Auckland”
Like I said, I bought Auckland residential real estate. The chart below gives you an idea of where’s it’s gone since mid-2013…
I’m not interested in bragging. I’ve been actively investing in real estate for over three decades across the globe. And this is far from the best real estate trade I’ve ever made.
But rather I want to share two key lessons with you today.
Lesson Number 1: Do what you can to front-run Chinese money.
There’s a lot of speculation these days about MSCI including China into their stock market indices and the potential inflows of money into Chinese stocks.
That’s great and there will be opportunities for sure. But for the time being I think people are looking in the wrong direction completely…
Let me explain.
China was the world’s second largest outbound direct investor last year behind the United States.
Mainland China actually became a net capital exporter for the first time ever.
Around two-thirds of those outflows were from the private sector. This is the first time that China’s private enterprises have overtaken the state-owned enterprises.
Huge amounts of money are simply pouring out of China.
And where is it going?
Companies and Real Estate.
NONE OF THIS IS NEWS TO US!
I’ve been telling subscribers of The Churchouse Letter about this for years (See the November 2014 edition “A $35 Trillion Dollar Bonanza”).
“If you think you’ve seen a lot of Chinese money pouring into Western markets so far, then think again. You ain’t seen nothing yet. A dribble is about to become a torrent…”
Our conclusion there remains unchanged.
Chinese businesses and individuals remain hugely underweight overseas assets. This tsunami is far from over.
There will continue to be hiccoughs along the way. We saw what can happen when some markets say “enough is enough”. Vancouver’s recent 15% tax on foreign property purchases was clearly aimed at Chinese buyers and has triggered a subsequent correction.
And we’ve seen some M&A deals blocked here and there (for anti-trust or ‘strategically important’ reasons). But these outflows are far from over.
So go ahead and figure out where the Chinese are headed… and get there before them!
From everything I’ve seen and continue to see, Chinese buyers are cash rich and happy to overpay.
Lesson Number 2: Follow My Rules for Buying Real Estate.
The Auckland property market is up around 45% since mid-2013.
I paid NZ$440,000 for an apartment in downtown Auckland back then. And I put about NZ$150,000 into giving it a full makeover.
Given recent transactions in the building along with conversations with agents, I could likely get north of a million for it today. [And believe me, it would be sold to a Chinese buyer!]
But what’s my point here? Well, this property has returned closer to 70%. Not 45%.
Why the out performance?
Because I followed the same basic real estate investment rules that I’ve been using for decades.
I use these rules everywhere.
[“Peter’s Rules for Buying Real Estate – Lessons From The Trenches….” is a bonus report that comes free with a subscription to The Churchouse Letter.]
I use these rules for my own investments.
We use them in the Hong Kong private equity real estate vehicle that I help manage and own a share of.
And these are the same rules I talk about to investors today as we go about raising money for our second private equity real estate vehicle here in Hong Kong.
They’re not overwhelmingly complicated!
In a nutshell, just think:
Note: using 50% leverage, combined with my rules, is what transformed my return-on-equity in this case from 69% to 170%.
There’s a bit more to it than that of course, but I’m giving you the high-level essentials here.
It was a warm, clear afternoon over this year’s Easter weekend. I was sitting on the breakwater of a small rural fishing village situated around 275 kilometres south-east of Manila.
My daughter and I were visiting the hometown of my domestic helper… a Filipino lady whom I employ in Hong Kong.
My daughter was off playing with the local kids. So I sat there on a little plastic chair, shooting the breeze with the local fishermen.
In major cities, most Filipinos have a good grasp of English. But out here communication was problematic, so I was using a dialect that guys the world over speak fluently: beer.
I bought a couple of cold cases of San Miguel and a few cartons of cigarettes to pass round, and we sat there enjoying the breeze. One of the guys fetched his guitar and strummed out a few tunes.
What on earth was I doing here?
Well, I’d made this trip specifically for my eldest daughter. She’s six-years old.
I wanted to take the opportunity to show her people living different lives in different places.
I wanted to give her a quiet reminder that Hong Kong is a bit of a bubble… that there is a much wider world out there… and that she has it far better than most.
It can be easy to forget that nearly half the world’s population live on less than US$2.50 a day. In Hong Kong that doesn’t buy you a cup of coffee.
There are a billion children globally living in poverty, according to UNICEF, and over 20,000 children die every day from its effects.
I figured there’s no harm in my daughter spending some time with kids who have far less than she’s fortunate enough to have been given.
And make no mistake, the Philippines is a poor country. These kids lived in cinderblock huts with dirt floors. They didn’t have much…
This kind of experience won’t make much impact now necessarily. But as she gets older I know it will help ground her and give her some perspective on life.
Now for me, this trip provided some fascinating insights into trends far, far bigger than this small fishing village of 2,000 people.
Let me explain.
You see, I can read all the investment bank research I want. I can dig through pages of statistical reports from the Asian Development Bank. I can go visit companies with Peter in Manila.
But trips like these offer something far more valuable. A chance to observe what’s really happening on the ground in the thousands and thousands of villages like this all over the country…
After all, villages like this are where half of the Philippines’ 100 million people live.
There are two observations I want to share with you.
The first struck me on the day after our arrival.
One of the kids was throwing a tantrum. (I have three kids myself so nothing new there!)
The tantrum died down and I wandered over to the hut (nosily) to casually enquire from my helper what was wrong.
She pointed to him, sitting cross-legged and now silent, on the floor of the hut.
In his hands he held a large smartphone. He was playing games on it. Hence the peace!
I hadn’t noticed before, but it suddenly struck me that everyone had a smartphone.
Here we were, miles from anywhere, with few modern conveniences… but everyone had incredibly powerful internet-connected handheld computers in their hands.
Surely, this really was absolutely transformative?
I am still wondering what these devices will ultimately mean for countries like the Philippines… being mobile, fast data, powerful devices, online banking, facebook… but in fact it was the second observation that was more profound to me.
And it provides a small window into the huge opportunity that Peter is talking about in this month’s edition of The Churchouse Letter.
Back to those beers on the breakwater… A few more guys had turned up.
Word had spread that the foreign visitor had opened up a couple cases of beer. I was more than happy to oblige.
One of the guys, the local priest, spoke good English so we chatted.
Nearly all of the others were fisherman. That was their livelihood. I’d seen them bringing in their catch that morning.
I asked my new friend a question.
“What is the most dramatic change in the past 10 years that has benefitted this place?”
I already knew the answer. Mobile phones, smartphones and the internet.
It couldn’t possibly be anything else…
I was wrong.
My friend just answered “the road”.
Surely it couldn’t be that basic? But it was.
You see, in recent years a concrete paved road had been built, connecting the village to a much larger network of roads further inland along with the major road running up the island.
Previously, access to this village had been via dirt track. I took a ride on a section that was still dirt. I have to say… both speed and comfort immediately fell by 80%.
A simple concrete road…
It put the village on the map.
It allowed the fishermen to dramatically extend the marketplace for their perishable products much further afield.
It allowed easier and faster delivery of consumer goods and food to the little market shops that dotted the village.
It brought opportunity and improved lives.
A road… the most basic form of infrastructure there is. And it had made all the difference in the world to this tiny fishing village tucked away on the shores of the Ragay Gulf in the south of Luzon, Philippines.
In the latest edition of The Churchouse Letter, we’re exploring this theme of infrastructure growth in Asia. And in one particular country, the Finance Minister recently announced plans to connect 700,000 villages just like these with infrastructure.
The opportunities these plans will create are just tremendous. Both for the villagers, and for you and I.
For me, this three-day trip served as a humbling reminder of just how powerful and effective even the most basic public conveniences can be…
I joined the derivatives structuring desk of a European investment bank straight out of university.
I recall having to google search the term ‘derivatives’ the day before my interview.
That pretty much sums up my degree of expertise on the subject at the time.
At the end of a pretty grueling interview (which involved having someone come and interview me in Mandarin), I was offered a job.
They asked me what I expected as a monthly salary. I told my interviewer and future boss what an intern friend of mine at UBS was earning.
He offered me just under half that amount.
My first day was in August of 2004. There was no training program… no scheduled classes, presentations or anything like that. On that first day my boss put a stack of around a dozen financial textbooks on my desk and just said “learn those”.
As an area of finance, derivatives are seriously technical. I however, was not.
No matter. I persevered, and three months later, in November I structured and sold my first structured note.
I remember drafting the product term sheet. I christened it a “Bermudan Callable Three Times Leveraged Inverse HIBOR in-arrears Resettable Step-up Snowball Note.”
No, I’m not kidding…
The notional value of the note was HKD100mn (around US$13mn), and we booked around EUR100k of profit. It was a relatively short-term note, hence the low profitability.
But it was my first trade so I was happy. My boss ceremoniously cut my tie off below the knot when the trade was done.
I still have the tie… or what’s left of it. It’s hideous. In retrospect my boss did me a favour.
I won’t go through how the structured note coupon was calculated… but the only thing you need to know is that if Hong Kong interest rates rose, the note holder would be screwed.
You can probably guess what happened next (see chart below).
Okay, so that one didn’t quite work out as expected but live and learn… (The client did. As far as I know they never did another structured note with us. Although I should point out they didn’t lose any of their principal).
The thing is, even if rates had stayed low we’d probably call back the note after three months.
In that event the client would get a nice coupon for three months and then his money back (which he would now have to reinvest in a lower interest rate environment).
You get the picture… either way, perhaps there were better ways the capital could have been put to work…
I went on to spend nearly 9 years on derivatives desks at investment banks (I got better!).
Anyway, I was reminded of this story today when I read an article on Bloomberg entitled “Brexit Blows Up Currency Derivatives Sold to U.K. Businesses”.
The article describes how an increasing number of U.K. firms are facing massive losses after entering into leveraged derivative transactions to “hedge” their foreign exchange exposures following a sharp post-Brexit decline in the British pound.
The article states: “The derivatives subject to misselling claims have names like “seagull” and “two-times leveraged accelerated knock-out, knock-in forward.”
To many, this sounds like complete gibberish, but the story is a wearily familiar one by now…
And it brings me to some very simple rules I learned in my time on the structuring desks which I want to share with you now.
Beware of any derivative product with more than one adjective in its name.
I mean, in all honesty a “two-times leveraged accelerated knock-out, knock-in forward” is unlikely to be a ‘hedge’ against anything.
If it sounds ridiculous, it probably is.
Complexity = Profitability… for the banks and brokers.
This should be pretty straightforward. The less a client understands about what he’s buying, the more money you can make.
Of course, the fine print always has the disclaimer that the client knows all the risks etc…
But unless you have the pricing model yourself (which, let’s face it, small businesses aren’t going to have), then you really don’t have any idea what you’re letting yourself in for.
Complex Structured Derivative Products don’t get bought… they get SOLD.
Believe it or not, there are relatively few corporate treasurers who wake up on any given morning with an urge to buy a “Bermudan Callable Three Times Leveraged Inverse HIBOR in-arrears Resettable Step-up Snowball Note.”
Likewise for your average retail or high net worth individual.
They get ‘sold’ to you because they are profitable for the seller!
Don’t confuse “hedging” with “speculating”.
The entire purpose of a hedge is to offset any potential gains or losses you might incur in another position.
It’s not hard! It should be straightforward.
Done correctly, hedging provides certainty and reduces risk.
If you ‘hedge your bets’ and end up with more risk than when you started… chances are you’re not doing it right.
An example. If you know you are going to receive Japanese yen and buy U.S. dollars in 6 months’ time, you can enter into a simple FX forward.
This locks in your forward FX exchange rate and that’s it! You’re hedged!
Now, over the next 6 months that FX forward contract can gain or lose in value depending on what happens to the currency pair, but it’s irrelevant!
In 6 months’ time you receive your yen, buy the dollars and settle the forward contract.
Regardless of what happens, net-net you’ve gotten the FX rate you knew you would.
What’s more these kinds of ‘vanilla’ hedging products exist in every financial asset class…
FX, equities, interest rates, commodities… and they are transparent and liquid.
Which is why banks and brokers won’t be rushing to sell you these… because transparency isn’t a word they associate with profitability!
Why sell an FX forward when you can sell a “two-times leveraged accelerated knock-out, knock-in forward”.
The bottom line is this: the vast majority of individuals and companies have absolutely no business whatsoever in doing anything more than the most vanilla derivative products… if those.
Maybe you sit on the board of a small business which is being sold these kinds of products… the kind of one the Bloomberg article talks about.
Or perhaps you have some financial advisor trying to sell you some kind of structured product.
My advice? Be warned!
And good investing,
Wherever I go in the world, for business or leisure, I always ask myself two basic questions…
The first question; what’s happening in the local property market?
Are prices trending up? Down? How’s supply looking? What about vacancy? Is anyone building or redeveloping?
I’ll pop into local real estate agents. I’ll ask around whoever I’m with (people love talking about their real estate markets).
The second question; what’s happening in the local economy?
What do people actually do for a living here? What do income levels look like? How about unemployment? And on it goes.
This may sound a bit geeky… but the answers to these questions are fascinating to me. And people are willing and very enthusiastic to tell you what they think
And it doesn’t matter where I am. Whether it’s Oregon like last week… or when I’m back in New Zealand next month… or visiting Las Vegas the following month… or touring Zambia the month after that…
I always look for answers to those two basic questions.
So I spent the past week in Gold Beach (population 2,253), on tucked away on the west coast of Oregon, about five and a half hours drive south of Portland.
The skies were blue. The air, fresh and clear… fishing the great outdoors of the Rogue river and Pacific Ocean.
I’m fortunate enough to spend a few days here every couple of years with some great financial minds… fishing, barbecuing, the occasional glass of wine… and a lot of conversations with my friends as well as the locals… getting answers those two questions I mentioned.
Talking about jobs and the local economy in Oregon, it struck me that the government employed a heck of a lot of people.
But it was one particular aspect that kept cropping up again and again… it was the number of government workers (city, local, state, and federal) who had already, or were just about to retire… and the amount of pension money owed them.
It was astonishing. And as the days went by this story kept cropping up again and again…
One particularly vivid example (of many): A friend based in California who told me that the Chief Firefighter at his local town had recently retired.
He’d put in 20 years. He was at least a decade younger than me. And he’d be enjoying a very substantial six-figure salary… for the rest of his life… which could easily be another 20 or 30 years…
When the Americans had left the room, Tama and I would just say to each other… “How the HECK is the government going to afford all this?”
And it got even worse.
We met a guy who had hit retirement, was getting a fat government pension cheque… and had immediately been hired back at full pay by the exact same government agency!!!
I’d heard of this concept of ‘double-dipping’… (taking retirement, getting your pension, and then immediately taking the job you’ve just vacated!)… but, seeing it first-hand, for ourselves… in a small, modest? relatively poor town in rural Oregon… it’s why I spend so much time travelling.
In all honesty, I’m perfectly familiar with America’s social security funding crisis. It’s been talked about at length for many years now.
But large, slow-moving problems are often pushed back to the ‘worry later’ part of the brain… but when you see the reality on the ground… it really hits home.
The realization just hits you like a brick.
The United States will face an almighty day of reckoning.
This isn’t ‘doomsday talk’. It’s just numbers… plain and simple. Sooner or later the money will simply run out. Maybe ten years. Maybe more, maybe less.
As credit-rating agency Moody’s put it just a few months ago:
The unfunded liabilities of the various federal employee pensions systems, covering civilian and military employee benefits, amount to about $3.5 trillion, or 20% of US GDP. Additionally, Moody’s estimates that unfunded state and local government pension plan liabilities are of the same magnitude, bringing the total shortfall to 40% of GDP.
The bigger challenge to the US comes from the unfunded liabilities for the Social Security and Medicare programs. The Social Security funding gap is estimated at $13.4 trillion, or 75% of GDP, while the shortfall from the Hospital Insurance component of the Medicare program amounts $3.2 trillion, or 18% of GDP.
Does anyone expect the U.S. government to address this problem?
Will any politician ever stand-up and take responsibility for this social security/pension ‘third rail*’ (see below)?
And even if they did, would the U.S. electorate even vote for them?
The voters of this country are not interested in doing anything about it.
*The third rail of a nation’s politics is a metaphor for any issue so controversial that it is “charged” and “untouchable” to the extent that any politician or public official who dares to broach the subject will invariably suffer politically. It is most commonly used in North America.
What can you do about it? Well, I’ve been saying for many, many years now: DO NOT RELY ON ANY GOVERNMENT TO TAKE CARE OF YOU IN OLD AGE.
Folks my age will probably be the last generation who enjoy the kind of ‘double-dipping’ shenanigans I’m talking about.
If you’re younger, you better start thinking about building your long-term wealth today…
But right now I’m sitting here at Salito’s restaurant here in San Francisco looking out at the bay.
My fish and chips should be on the table soon. My flight home to Hong Kong is later tonight.
San Francisco and its people provide a great metaphor for the problem I’m talking about.
Ask anyone here, they’ll tell you they KNOW a big earthquake is coming.
They expect it soon.
And they expect it will be devastating…
Do they worry about it today or even talk about it?
But they know it’s coming.
And I know that an even greater, national, full scale financial crisis will strike as well.
Peter & Tama
There are developed markets.
There are emerging markets.
After that we have frontier markets…
And then there are emerging frontier markets.
Earlier this month I spent a few days revisiting and pounding the pavements of a true “emerging frontier market”.
Can you make money in an emerging frontier market? Yes… but it’s tough. I made around 800% on an equity investment in this particular market, but more on that later…
My first visit to this country was around six years ago. I joined a trade mission exploring the potential for business opportunities as the country was emerging from decades of closed military dictatorship.
At that point the basics of financial life as we know it simply didn’t exist. There was virtually no mobile phone system in the country. And it would set you back around US$3,000 for a mobile phone and SIM card.
(To put that in perspective, although we don’t even have the data, I’d estimate that annual GDP per capita was less than half that amount!)
Electricity supply was dire. To this day it remains woefully inadequate.
Owning a car was a pipe dream for ordinary folks. A rusty 20-year old Toyota banger would set you back about US$30,000. That’s assuming you could find someone who had one and was willing to sell it.
Billboards carrying names of any kind of foreign brand were unknown. Coca-cola, McDonald’s, Visa… they just didn’t exist.
The transformation has been extraordinary, the speed of which I don’t recall having ever seen in this region.
In terms of mobile phone penetration, just take a look at the chart below.
And these are predominantly smartphones. In the space of a couple years, millions of people have gone from nothing to having a world of information and connectivity in their hands.
Legions of drivers are using these same phones and google maps to navigate around the city. Wi-fi is available everywhere… often free in cafes, hotels and restaurants. Internet speed isn’t too bad either.
And there are cars everywhere now. Too many some would argue. Japanese car makers have had a field day here.
Evidence of foreign brands is all around. Korean and Japanese names are dominant, but Rolex, Mercedes, Land Rover, Illy coffee, Apple and the like are piling in. About a dozen foreign banks now have a small presence in the country.
On my first trip there was only one modern office building I could see, just nearing completion. Five years later there are many more, and they are full. Rentals in prime office buildings are now similar to those in well located grade B/C buildings here in Hong Kong.
High rise apartment blocks are now a common sight, with a good many more coming out of the ground.
While this is not a building boom of the levels we have seen in countless cities in China over the past 25 years or in Thailand say in the 1990’s, the amount and pace of change is impressive.
But at the same time, there are commendable efforts to preserve much of the historic urban architectural fabric of the city.
While this transformation is not at the breakneck pace we saw in China, it is nonetheless impressive to see the extent of change that has taken place in a mere five or six years. You get the sense that this is just the beginning.
The country I am talking about in Myanmar, and the city, Yangon.
It is emerging into the world after decades of being shut off from it by a hard core military regime that largely sealed its borders to outside capital, investment, goods and services. The military is stepping back (slowly!) from their total control and an elected civil regime is now taking its place for the first time in decades.
The country is rapidly opening for business.
And yes, it does actually have a stock market!
In fact, the size of the market in terms of listings has doubled in the past couple of months… to two, although even that number may triple by the end of the year (to 6).
Going back to the big question… how do you make money in markets like these?
I’ll be honest, it’s tough. More often than not, you need to rely on your gut, have a bit of an inside track and the ability to move quickly….
I took a position (since exited) in a company called Yoma Strategic Holdings Ltd (YOMA SP) in late 2011. We wrote about it in our publication that would later become The Churchouse Letter (“The Road to Mandalay: Myanmar Looks to be for real” – The entire issue is available to read).
Why did I buy an emerging frontier stock?
The macro and political side of things was important. Myanmar was just beginning to open up. Hilary Clinton was about to visit the country, the first U.S. Secretary of State to do so in 50 years. Aung San Suu Kyi had been released from house arrest a year earlier.
But the ‘local’ knowledge? Well, I had been acquainted with the Chairman, a Burmese man, since the mid 1980’s. In addition to that, a good friend of mine was appointed as CEO of the company. I’d known him a long time. He was an extraordinarily skilled investment banking and private equity expert with a pedigree background.
It also helped that the company’s main line of business is real estate; an excellent place to be when a country is starting to modernize and open up.
Much of the low-hanging investment fruit has since been picked in Myanmar, but it’s always good to keep an ear to the ground… and there’s no substitute for pounding the pavements yourself to see what the state of the economy is like.
It may take time, but Myanmar will no doubt offer us more profitable opportunities down the road…
At the end of the day, trades like this are small and speculative… there’s the potential for huge gains if you’re aware of the opportunity to get in early. But you also need to be prepared to endure some potentially stomach-churning rides.
I rarely invest in these kinds of opportunities, and right now there are better emerging market Asia investments to be had (see The Churchouse Letter recommendations in the members’ area).
Tama and myself are off to San Francisco and Oregon tomorrow for a week. I’m hugely looking forward to catching up with my friends from Newport Asia (large long-only Asia focused fund managers) along with plenty of other old hands… There’s plenty to talk about, especially on the political front.
But with the S&P500 now trading at its highest valuation since the dotcom bubble I’ll be spending plenty of time assessing equity market prospects as well.
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