Saturday, May 30, 2015

China A shares: Mistake turned Multi-Bagger

A long time ago, in blog posts far away, we discussed the merits and demerits of ETFs. It was around the earlier posts that time (2009 and 2010) that I bought into the China A share ETF thinking that buying into the country that would conquer the 21st Century made sense. As it turned out, it didn't. The only ETF that one should buy is the S&P 500. ETFs, by and large, did not help investors make money. Investing is just such a game. What looked so right doesn't turn out right after all.

Buying China seemed so right!

Today's story is about how a mistake turned out into a multi-bagger and what are the lessons that we could learn. I must say, this is first and foremost a mistake. It was luck that turned it into a multi-bagger. The whole process was painful despite making money and if I were able to re-make some decisions, I would do things differently. Now, looking back, there were good lessons learnt. It's really through mistakes that we learnt most. So sometimes, we really should thank bad happenings and results and also our adversaries for showing us our weaknesses. To sum it up nicely, I think the three lessons would be:

1. Understand the downside well
2. Long term holding power
3. Move in incremental steps wisely

At the time of buying China A shares around 2009-2010, it was supposedly a high confidence bet. The Global Financial Crisis hit all markets bad, China was down 50-60% from its peak, it was really looking cheap. The investment thesis was that China would continue to grow to become the world's largest economy in time, surpassing the US. It was hard to pick Chinese stocks well, so why not just buy the whole Chinese market. China A shares was trading at low teens PE, really not expensive. Although financials dominated the index but that was normal for most emerging markets so things should be ok. 

What was the downside? Well it was the implosion of all these Chinese banks that made up half of the index. So if these halved, maybe maximum impact to the ETF could be 20-25%? And if that happened, maybe it was time to add more! As it turned out, the banks didn't implode but the whole market just continue to languish. It went from low teens to single digit PE, earnings didn't improve, so the ETF did go down 20-25% and this blogger added more not understanding it was a mistake. There's a term for this, and it's well depicted in the following pic. Haha.

It's called catching a falling knife...

Fortunately, that assumption of maximum downside for China's A shares didn't turn out to be too wrong, the market just did nothing for many, many years which was bad enough as it meant 0% return. But to try to gauge the downside is always important. In good companies with some business moats, usually the downside could be 20-30%. If that happens, the right decision is to buy more. In some cases, the downside is 50%, then one would need to know what is the blue sky scenario, ie what's the maximum upside so as to justify risking losing 50% of capital. In others, the downside could be 100%, losing everything. This is like buying dot.com co.s or small firms with no moat. There is no recovery no matter how long term we are. 

This brings us to the second saving grace which was having long term holding power. So while the A shares did nothing for many years, I wasn't compelled to sell. It was locking up some capital which could have been put to better use but by keeping it to a certain percentage of the portfolio, it was also bearable. What would have been unbearable would be using leverage or making it too big a bet. These are the technical aspects that could have easily changed everything. So always use cash and size our bets wisely. More on this later.

After waiting for half a decade, things suddenly changed in a few months. The catalyst was the Hong Kong Shanghai stock connect. Investors suddenly realized that A shares were "too cheap". If they were connected via Hong Kong, there would be lots of demand for these from global investors. So the whole market started rallying. Meanwhile, domestic Chinese investors saw the wave coming and they didn't want to miss out! Aunties, students, retirees, workers, dogs, cats and their offsprings all started opening brokerage accounts to buy stocks. A shares went from 2,000 points to 5,000 points! For me, it was a mistake turning into a multi-bagger! Woo-hoo!

Snapshot of the ETF's factsheet in May 2015

Lady luck smiled at me more than anything else. It wasn't skill or patience. Although if we calculate the return over 5 years, it would be just 5-9%pa or so. No big deal. I am just glad I got bailed out. I sold the bulk of my ETF while leaving some to participate if there's any more craziness. This is #3: move in incremental steps wisely. Remember that the markets and the future is not predictable. So rather than moving in big steps, thinking that what we decided will pan out as we expect, it is always advisable to move incrementally. Have more than two bullets for each target, we are shooting targets we don't know which way they will move! 

For almost every purchase, it is always prudent to start buying just 1/3 of a full position. If it falls, that we could add. If it runs, then it's just too bad but at least we have 1/3. It is also advisable to phase our buys over time periods like every 6 or 12 months. Market are unpredictable, so never think that we are so damn correct and will be proven right and never put our eggs into one basket. This works for selling as well.

So for the A shares, when it started moving and I was up 50%, I sold 1/3. It then went on to move up another 20% or so and I sold another 1/3. After selling the second tranche, I was left with almost pure profits so A shares could fall to zero, I would still have made money and if it continues to go crazy, I could still participate in further upside. Moving incrementally is one of the most important moves in investing but rarely discussed.

Of course, it doesn't help to cut it too finely or double down unto mistakes. Again, this is an art and it is really hard to come up with specific rules that could work universally. This A share saga was a rare case of a mistake making money. In general, we would be counting on mistakes to help us refine our investment process while hopefully not paying up too much tuition fees to learn basic lessons like understanding the downside well, taking the long term approach and moving incrementally.

A happy Vesak Day long weekend to all Buddhists out there!

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