Sunday, April 23, 2017

Sector Diversification

In my ebook The Bedokian Portfolio, I constantly harped on diversification of asset class and foreign financial markets, but I did not touch much on sector diversification. In this blog post, I would share a bit on the sector aspect.

What is a Sector

According to Investopedia, sector, or sometimes called the industry, is “… an area of the economy in which businesses share the same or a related product or service. It can also be thought of as an industry or market that shares common operating characteristics”1. In the degree of diversification for The Bedokian Portfolio, sector comes below region/country, since the same sector could perform well in one country but may not be in another.

There are a few ways to define sectors. One way is to classify them by primary, secondary and tertiary, which are companies related to raw materials, processing and manufacturing, and services, respectively, akin to a source-to-end-user process. Most investors would prefer to use the standard “10 sectors”2, namely financials, utilities, consumer discretionary, consumer staples, energy, health care, industrials, technology, telecommunications and materials. These 10 sectors, in turn, could be divided into sub-sectors. Our local stock exchange, SGX, also has its own sector classification3.

The sector is used and analysed in the second tier of fundamental analysis (FA) known as environmental factors. As I had mentioned in the ebook4, the sector represents the “playing field” of the companies involved. When conducting FA, besides analysing the company in question, you must consider the future heading of the sector in general as well.

Why is Sector Diversification Important

In my ebook, I had highlighted an example using the local telecommunications sector and buying up equities of the three companies does not equate to diversification, for any negative impact to the sector would result in losses5. In a somewhat true fashion, when news broke out on the authorities’ intention to grant a licence for a fourth company back in July 2015, all three existing companies’ share prices took a hit.

On a longer term, the drop in the price of oil for almost the past three years had brought the oil and its related industries to a low. Consumers of oil, however, are benefiting, such as transportation and manufacturing. It is precisely this scenario that, like asset classes, certain sectors will perform better than others in certain economic conditions.

Sector Diversification In The Bedokian Portfolio

It is advisable to have a myriad of sectors and industries for your Bedokian Portfolio, but do take note that a sector could be quite broad and sometimes the sub-sectors within it is not really correlated with one another (e.g. manufacturing of machinery and manufacturing of food). As a rule of thumb, the 12% limit rule (see here) should be used for individual companies and sector-based exchange traded funds, in the case for equities. To a certain extent, sector diversification should be practiced for bonds in terms of the corporate bond issuer’s industry.

REITs are a bit unique on the topic of sector diversification as they are a hybrid of equity and property, hence for simplistic sake it is better to have different types of REITs according to their nature, like retail, hospitality, industrial, etc.


1 – Investopedia. What is a ‘Sector’. http://www.investopedia.com/terms/s/sector.asp (accessed 21 Apr 2017)

2 – Kuepper, Justin. The Ten Sectors of the Stock Market. ETFdb.com. 25 Dec 2015. http://etfdb.com/etf-education/the-10-sectors-of-the-stock-market/ (accessed 21 Apr 2017)

3 – SGX.com. Sectors are: Multi=Multi-Industry, MFG=Manufacturing, CONS=Construction, COM=Commerce, Hotels=Hotels&Restaurants, TSC=Transport, Storage&Comm., FIN=Finance, PROP=Properties, SERV=Services, AGR=Agriculture, MINQ=Mining/Quarrying, EGW=Electricity/Gas/Water 

4 – The Bedokian Portfolio, p88-89.

5 – The Bedokian Portfolio, p12.

Sunday, April 16, 2017

Keep Calm and Ride The Waves

2017 had opened with a big bang for the local financial market. For the period of 3 January to 13 April, the Straits Times Index (STI) had taken a tremendous rise from 2887 points on 3 January to 3169.24 points on 13 April, with reaching a high of 3187.51 points just two weeks ago1; Gold had risen from USD 1158.84 to USD 1287.92 along the same timeframe2; Singapore REITs (S-REITs) had also gone up, with the FTSE REIT Index rising from 714.89 points to 765.43 points3. Even the ABF Singapore Bond Index Fund, one of the main indicators used for the local bond scene, displayed a miniscule rise from $1.135 to $1.1554. In fact, the phenomenon is shown at Bob’s Bedokian Portfolio (here), where you could see the rise of prices of the ETFs representing the various asset classes (except cash, which is not measured).

With all these happening, one question pops into most of our minds; are the asset classes really correlated to one another? Is diversification deemed as unnecessary?

Basis of Diversification

The Bedokian Portfolio and some other investment portfolio books espouse diversification through asset classes due to the different correlation displayed in different economic conditions. The very gist of diversification is to reduce risk and to prevent huge losses to your portfolio. There is no surefire way to completely protect your portfolio 100%, but diversification does help out somewhat, hence my emphasis in bold on the words “reduce” and “prevent”.

Time and again, the past has shown this to be true; bonds held up and gold spiked while equities and REITs tumbled during the Global Financial Crisis (GFC) of 2008-2009. However when boom time comes, equities and REITs pounced up at the expense of the rest.

US Market Correlation

In my first paragraph, I had highlighted the correlation issue from the local Singapore market perspective. Let us take a look at the correlations of the major US asset class ETFs for the same time period (3 January – 13 April 2017)5:



The correlation relationship is denoted with a number ranging from -1 to 1. If the number is close to “1”, the two asset classes are positively correlated (meaning they have roughly the same correlation). If the number is close to “-1”, the two asset classes are negatively correlated (meaning they have roughly a different correlation).

From the matrix above, there is still some correlation difference at work among the major asset classes in the US markets, specifically between the VTI and BND as well as VTI and GLD.

Any Explanation for High Correlation of Asset Classes?

The assumption of different asset classes behaving differently in different economic conditions is based on basic economics and market dynamics; the flow of capital to whichever asset class that is deemed safe and/or provide higher returns at a particular economic and market situation. Explaining in further detail with reference to the GFC example above, capital flowed away from equities and REITs into the deemed safe havens of bonds (especially government ones) and gold. Once the market improves, equities and REITs prices are rising again and naturally capital flowed back to them for greater returns.


There are a few explanations as to why high correlation happens. One of them is the ever-complicating world that we live in, with so many things, events and happenings all entwined together, even if they are remotely related, thus creating multiple push-pull factors on asset class correlations. Periods of market irrationality also play a part in having high correlation6. Another reason is credited to the intervention of central banks in the form of near-zero interest rates and large-scale asset purchases in response to the GFC7.

Conclusion

In my opinion, difference in correlation among asset classes will always exist, just that it would manifest as time goes by. The Bedokian Portfolio investor’s timeframe is at least ten years, so do not be overly affected by this high correlation phenomenon. And my answer to all these would be my title for this post; Keep Calm and Ride The Waves.


1 – Yahoo Finance. STI Index. https://sg.finance.yahoo.com/quote/^STI?p=^STI (accessed 15 Apr 2017)

2 – Bloomberg. XAUUSD. https://www.bloomberg.com/quote/XAUUSD:CUR (accessed 15 Apr 2017)

3 – Marketwatch. FTSE ST Real Estate Investment Trusts Index. http://www.marketwatch.com/investing/index/fstas8670?countrycode=xx  (accessed 15 Apr 2017)

4 – Yahoo Finance. ABF Singapore Bond Index Fund (A35.SI). https://sg.finance.yahoo.com/quote/A35.SI?p=A35.SI (accessed 15 Apr 2017)

5 – Asset Class Correlations, 01/03/2017 to 04/13/2017. Portfolio Visualizer. https://www.portfoliovisualizer.com/asset-class-correlations?s=y&s=y&startDate=01%2F03%2F2017&endDate=04%2F13%2F2017&timePeriod=1 (accessed 16 Apr 2017)

6, 7 – Costa, Filipe R. What does the decline in correlations among asset classes mean? Master Investor. 20 Feb 2017. https://masterinvestor.co.uk/economics/decline-correlations-among-asset-classes-mean/ (accessed 16 Apr 2017)

Saturday, March 18, 2017

Of Rights, Warrants and Your Bedokian Portfolio

If you belong to the active camp of investors of The Bedokian Portfolio, chances are you might see the terms “rights” and “warrants” in your individual equities and REITs counters. For this post, I will share what are rights and warrants, how these would affect your Bedokian Portfolio and what to do about them.

Rights

Rights are entitlements to existing shareholders for the purchase of additional shares of a company/REIT at a typically discounted price. When a company or REIT announces a rights issue, it will include a few numbers that determine how many additional shares are entitled per number of existing shares. For example, a company announces that there will be a rights issue of 250 shares for every 1,000 shares owned, priced at $1.00. This means if a shareholder has 1,000 shares, he/she will be entitled 250 additional shares of the company, priced at $1.00 each.

To make it enticing for current shareholders, the rights are usually priced lower than the prevailing market price. Citing the above example, the current market price may be at $1.20, which means getting the additional shares at $1.00 is a bargain. However, issuing of rights would reduce the shareholders’ holdings, meaning for dividends, the company would have to divide the earnings more over a larger shareholder base. Also, simple math would tell you the market would adjust the price according to this $1.00 rights price.

E.g. [(1,000 shares x $1.20) + (250 shares x $1.00)] / 1,250 shares = $1.16 (price that the market may display immediately after the rights announcement is made, assume all things equal)

There are two types of rights, renounceable and non-renouncable. Renouncable rights allow you to transfer or sell them away, usually in a share market where they are listed. Non-renouncable rights do not allow you to transfer or sell them away.

Rights are not permanent; they have an expiry date. The company would give some time for the shareholder to consider whether to exercise the rights or not. If he/she does, he/she would just (again, using the above example) pay up 250 x $1.00 = $250.00 for the rights. If not, he/she could sell them off in the market (provided it is renounceable) or just let it lapse after the expiry date (and no money transacted).

The main reason companies and REITs issue rights is to get more capital to fund its business plans and operational needs. Although a company or REIT could get loans, on an accounting basis, rights are more presentable in a way that they represent assets in the form of shareholders’ equity, not under liabilities (or debt) in which loans belong to.

Warrants

Warrants are contracts that give you the right, but not the obligation, to buy or sell a company’s share at a certain price on a certain date. Warrants are a form of derivative, and may prove daunting to new investors who do not know how they work.

Warrants have three basic components; the underlying asset that they are covering (usually company shares), the expiration date and the exercise price (or strike price). They are priced at a fraction of the company’s share price, and like their share counterparts, their prices could go up or down depending on their demand, supply and market situations. However, warrants are more volatile due to its limited time existence (they have an expiry date), the exercise price attached to the warrant (with relative to the current share price) and volatility of the share price itself.

There are many types of warrants, but what I am covering here are warrants issued by companies (or company warrants). Owning warrants does not mean you own the shares; they are like a “passport” for you to buy the shares at the exercise price come expiration date. You could also not buy the shares if the exercise price is not in your favour, and just let the warrants lapse. Hence this explains the “right, but not the obligation” part stated above.

E.g. I am issued 1,000 ABC Company warrants at $$0.10 each, giving me the right to buy ABC Company shares at $10.00 each on 31 Dec 2017.

When 31 Dec 2017 comes, the ABC Company’s share price is at $15.00. I exercise my warrants (the “right” part) to buy up 1,000 ABC Company’s shares at $10.00, which is a good bargain. However, if on 31 Dec 2017, the share price of ABC Company is at $5.00 each, which is far below my $10.00 exercise price, I just simply ignore it (the “not the obligation” part).

The above is an example of a “call warrant”, i.e. the right to buy at this price at this date. Another type of warrant, called a “put warrant”, is the reverse, i.e. the right to sell at this price at this date. Put warrants are good in situations where the company share price is falling, so you could sell it at a higher price with regards to the current market price. However, put warrants are seldom issued by companies.

To make things more interesting, most of the time these warrants are tradable, meaning you could just buy and sell before the expiration date. This means if you are issued the warrants, you could just sell them off.

The main reason for a company to issue warrants is the same as that of rights, i.e.  raising capital.

How do These Rights and Warrants Affect My Bedokian Portfolio and What to Do About Them

Though the sub-title above sounds ominous, it is nothing serious as the main effect on your Bedokian Portfolio would be your asset class allocation and classification. The concerns would be; by purchasing additional rights, particularly at the equities and REITs asset classes, might affect your allocation ratio and increase your individual counter holdings to probably more than 12% (see here). As for warrants, having derivatives in your portfolio sounds a bit weird as you cannot determine what to make of them and which asset class they belong to, not to mention about some investors who are not familiar with them in the first place.

My advice is, for rights, just purchase it and buy up to the nearest 100, in case the rights issues are not in a rounded number, e.g. if you have 1,000 shares and the rights ratio is 363 rights per 1,000 shares, just buy up 37 more rights to make it 400. If you are comfortable and/or the asset class allocation is not compromised, you could buy up more. The risk of not buying up the rights is the dilution of your holdings, hence it is better to “keep up” so as your dividends from this particular company/REIT remain sustainable. Use the cash component from your Bedokian Portfolio to make the purchase.

For warrants, unlike rights, there is no immediate dilution effect as no one knows how many shares would be bought by the warrant holders by that expiry date, not to mention the market price of the shares by then. If you are comfortable in holding the derivatives and on the company’s performance, just hold them on, else you could sell them off when the warrants are open for trading. Proceeds from this sale will go to your cash portion of The Bedokian Portfolio.

And as usual, please do your own fundamental analysis and other forms of due diligence before committing to the rights and warrants.


Further reading:

Investopedia. Rights. http://www.investopedia.com/terms/r/right.asp (accessed 18 Mar 2017)

Investopedia. Warrant. http://www.investopedia.com/terms/w/warrant.asp (accessed 18 Mar 2017)