Look for Free Options

Those who have knowledge, don't predict. Those who predict, don't have knowledge - Lao Tzu

Investing is not about predicting the future. Predictions are usually not accurate. We heard the famous ones: Bill Gates predicting nobody needed no more than 640KB of memory, Dow Jones 36,000, who needs cars when we have horses blah blah.

Yeah, how right. So what do we do if we do not want to predict?

We want to be prepared. This post serves to illustrate how.

First we must accept that the future is unknown. It is a set of probabilities. We want to make sure that whichever future pans out, we will be okay. In mathematical terms, it means that the expected return is positive. In investing, we want to look for free options, or near-free options. In layman terms, it just means be prepared, don't anyhow bet.

It's easier to use an example, so we go back to Singapore's property market, my favourite topic. As of now (mid 2014), we can probably trace 3 paths that our beloved property market would follow in the next few years:

1. It will crash and burn, ie prices collapse, falling 30-40%, most speculators fall into deep shit and every Tom, Dick, Harry and his wife and his dog totally shun this market. That's when value investors come in.

2. It will continue to cruise along, doing nothing much at 2% rental yield or an average of $1,500 psf ie 90% of Singaporeans would not be able to afford anything any time soon and foreigners continue to nibble on some of our high-end stuff.

3. It will rise and rise as Singapore becomes the Monaco of Asia. Prices rise to $2,500 to $3,000 psf or higher and stay there forever. 99% of all Singaporeans and their children and their children's children will never be able to afford anything and have to resort to living in Iskandar.

Iskandar. Not too bad. Who wants to retire there?

I have posted in the past about why I think Singapore's property market should not continue to rally. But it's not supposed to be a prediction. It's merely a view I hold which I would attribute say a 70% probability that this future is likely to come true.

As for the other possible futures: 2 and 3 above, I would attribute say a 20% probability that our property market would do nothing and a 10% probability that we would become the Monaco of Asia and we will all have to move to Iskandar some day.

So the way to invest here is to make sure that no matter which future pans out, you would be ok. And if one of them happens to be right, you make a lot of money.

Now obviously if you have bought 5 properties on leverage and is paying interest instalments out of your salary, you are betting on Future 3. But if you believe my probabilities, then if Future 1 pans out. Good luck! See you in Iskandar, sorry I mean your makeshift cardboard at the void deck this weekend while I bring my kids to Legoland! That's way too much prediction and too little preparation.

On the other extreme, if you have sold your home and your mum's and in-laws ones as well and on top of that you go short $500k of Singapore property stocks, then you are heavily betting Future 1. But if Future 3 pans out, then jialat liao (ie in deep shit!). Not only you have no place to live, your short would probably be losing close to a million dollars. Makeshift cardboard at the void deck all over again. Again, that's not rational investing.

In investing, most of the time, it's very difficult to make free money or in investing lingo - to find arbitrage opportunities. You have to take some risk to make some good return. But that's just not very efficient. So the lesson here is really to just keep finding those arbitrage opportunities or what I would call "free options".

A free option or a near free option is a bet that would give a good payout if a stipulated event happens in the future but the cost is either free or almost zero. It could be said that one of the goals of investing would be building a portfolio of free options or near free options.

I must stressed that this is not going to be anything easy. The market is efficient and arbitrages are easily profited away by the professionals. Arbitrages are like dollar notes that fell out of people's pocket accidentally on Orchard Road. It would be picked up in a blink. So it's really not like money would fall from the sky. In investing, some of these free options are hard to come by.

But there are times when "free options" come about. We just have to be savvy enough to spot them. In the Singapore market, ironically, one example would be the property play Ho Bee. In early 2012, Ho Bee's share price fell to $1 as it was becoming clear that Sentosa's luxury properties might struggle to find buyers and Ho Bee was the Sentosa developer. It was clear that Ho Bee could have some serious issues as lower sales meant its cashflow would get tight but it had to finance its huge capex for its residential projects and its crown jewel commercial building: the Metropolis.

The Metropolis is a mega-deal for Ho Bee, at 1 million square feet of rental space right outside Bueno Vista MRT, this property alone is worth more than $2 when converted to Ho Bee's share price and even after netting all its debt, there is still $1.5 left. So when Ho Bee traded at $1, the market was saying Ho Bee's entire Sentosa plus other projects are worth nothing and its prime Metropolis could either be marked down drastically because Ho Bee might have to do a fire sale of this prized asset to survive.

Now I am doing this analysis with the full benefit of hindsight. I didn't invest in Ho Bee then and I am drawing conclusions now just for the purpose of illlustrating what's a free option.

The market is not stupid. Remember markets are usually efficient and I believed that there was a likelihood that Ho Bee needed to sell a part of Metropolis cheap to keep itself going in 2012, hence the market priced it below Metropolis valuation. But at $1, the market priced in the worst possible scenario. If it had gotten any lower, someone would have taken Ho Bee private. In fact, the management could just bite the bullet, partner with some private equity and took itself private at say 80c since the company and its management owns 70% of itself already.

So there was a free option on the table when Ho Bee was at $1. I would attribute say 20% probability that it could still fall another 20% which if it did the prudent decision would be to buy even more Ho Bee. But in another scenario, there is an 80% probability that it could rise 50% back to Metropolis minus debt at $1.5.

As things turned out, the upside was 100% and more. Today Ho Bee trades at $2.20. 

So ironically, despite my negative view on the Singapore property market, a prominent property play called Ho Bee was a free option regardless how the whole Singapore property market performed.