Beware the crowded trade

02 Jun 2017

Most investors have seen or experienced a crowded trade -- a security or theme that has attracted an inordinately large number of followers or believers. The problem is that when it is “on”, such a trade often feels like a good bet until it falls apart. MSCI cites the risk of crowded trades thus: an “overlap of positions among managers may result in extreme levels of risk when those investors experience negative shocks in other parts of their portfolios, forcing them to liquidate their positions (selling what they can, rather than what they would necessarily like to.) These ‘fire sales’ may then cause losses for other investors following the same strategy and result in further liquidations, driving stock prices into a downward spiral.”



Crowded trades often go hand in hand with bubbles, and even recognized geniuses are not spared from being caught up in the ensuing craze.

From Business Insider, we learn that “in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he ’could calculate the motions of the heavenly bodies, but not the madness of the people.’ Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price -- and lost £20,000 (or more than $4 million in today’s money). For the rest of his life, he forbade anyone to speak the words ‘South Sea’ in his presence.” Not only did Newton get burnt but, by some accounts, he exited his South Sea position broke.

Is it me or is it just getting too crowded here?

The Philippines has its own colorful history of crowded trades. I’ve met a good number of senior people who refuse to touch stocks today because they lost money on mining and oil stocks in the 1970s.

More recently, the BW scandal of 1999 created great fortunes for a few but left most with nothing more than harsh lessons. One story has it that a group of BW investors had shares that were under lock up and their fortunes rose more than 30-fold into the tens of millions when the stock rose to its peak of Php102. Unfortunately, they could only watch as the bubble burst and BW eventually became a penny stock.

The stock market, however, is not the only arena where crowded trades are born, mature and eventually fizzle. In business, there were the litson manok and Zagu crazes of the 80s and 90s. Eventually, many of these businesses folded simply because there were too many of them.

Meanwhile, some say that art has become a crowded trade with too much money chasing a limited number of actually great pieces. It is one thing to democratize art but some people are buying paintings or sculptures because they want to flip them as soon as possible or because an artist (especially a national artist) looks like he or she is likely to kick the bucket soon.

Going back to local equities, I suspect that we are in the midst of another crowded trade. This is based on several interconnected observations.

First, the first quarter earnings season has just concluded, and the results are not pretty.

Based on core or recurring profits, the weighted average year-on-year earnings per share (EPS) growth for the first quarter is a modest 6.6%. On reported or headline numbers, this figure becomes even more tepid at 5.5%. Meanwhile, the Philippine Stock Exchange index (PSEi) has thus far rallied 15% this year (through May 26), pushing the market’s price/earnings ratio close to a heady 19x on 2017 estimates.

Moreover, PSEi members’ earnings revisions have been mostly negative year-to-date. The notional EPS for the index is currently at P412, two percent lower since the start of the year. Two percent may seem trivial but it is not as it equates to about 160 index points. Finally, foreign investors remain net sellers of Philippine equities to the tune of $15 million year to date (also through May 26). This means the enthusiasm is largely coming from domestic investors. Despite all these, the PSEi has not only been resilient but is actually pushing into bull market territory.

So, what continues to stoke Filipino investors’ animal spirits? There are two factors, with the second (the promised “golden age” of infrastructure) being dependent on the first (comprehensive tax reform).

Everyone acknowledges the need for tax reform. When it is done right, it can indeed be a catalyst for economic growth. In the US, many economists agree that the posthumous passage of President Kennedy’s proposed tax cuts in 1964 helped the economy sustain growth of 5% for nearly a decade. In the same manner, Ronald Reagan’s 1980s tax cuts are also credited for boosting America’s growth to 4%. However, I believe that the current proposals in Congress, embodied in House Bill (HB) 5636 are not the specific tax reforms the Philippines needs.

First, it does not address the strict bank secrecy laws that enable many to avoid scrutiny from tax authorities.

Of course it would be a very contentious issue but no tax reform package would be complete without it. Studies show that bank secrecy results in billions of lost revenue for the government annually.

Second, the ultra-rich comprising the wealthiest 0.1% of families (approximately 23,000 households) may actually see a net tax benefit because estate and donor’s taxes will be slashed. Moreover, since ultra-rich families incorporate their business interests, they will gain immensely when corporate taxes are reduced as part of the Department of Finance’s (DoF) second tax reform package.

Third, the tax reform package does not address the issue of low tax compliance among the self-employed and professionals. Moreover, by raising the top tax rate to 35%, the incentive to evade taxes increases and could even lead to a drop in collection from these groups.

Fourth, as often pointed out by Rep. Romero Federico S. Quimbo, higher fuel and automobile excise taxes are likely to encourage even greater smuggling of these items (notwithstanding the implementation of fuel marking as one of the complementary tax measures). As a result, the projected revenues would be at risk.

Most importantly, the tax proposal from the DoF will result in a net tax increase for the average Filipino consumer. Despite infographics showing an increase in take home pay for teachers, policemen, call center agents and others, the truth is only a small fraction of people in the labor force (around 14%) will benefit from lower tax rates. This is because farmers, OFWs, construction workers, kasambahays, informal sector workers and more are either exempted from income/withholding taxes or are not captured as part of the tax base.

On the other hand, all Filipinos will feel the impact of higher fuel and car excise taxes, a new sugar tax, the lifting of VAT exemptions and more changes to the tax code.

To illustrate this, we begin by breaking down the impact of the major components of HB 5636 by economic class. The following calculations are based primarily on data from the Family Income and Expenditure Survey (2012 and 2015), Bureau of Internal Revenue and others. The table above gives rise to the following observations:

• Only 19% of the projected tax savings arising from lower tax rates will accrue to the bottom 50% of Filipino households. The middle 40% gets the lion’s portion of the tax savings but the top 10% will still get a big chunk.

• Including pass through effects from trucking (which feeds into the cost of manufactured or imported goods) and public transport, the bulk of higher fuel taxes will be borne by the middle 40%.

• The removal of VAT exemptions as well as the new tax on sweetened drinks will also impact the middle 40% the hardest.

• Higher excise taxes on automobiles, as expected, will mostly be shouldered by the top 10%.

Graphically (below), the net effect for each economic class becomes clear: EVERYONE loses.

However, the rich can afford to pay higher taxes while the bottom 50% will receive targeted subsidies. It is the middle class, therefore, that will bear the brunt of the government’s proposed hike in tax collections. And, given that these are permanent tax increases, the impact on consumption, especially discretionary spending, will be significant. This is why I disagree with most when they say that the tax reform pending in Congress will be a boon for consumer discretionary stocks.

Some can see through the smoke and mirrors and have spoken out against the potential negative effects of HB 5636.

As mentioned previously, Rep. Quimbo has warned that increasing fuel excise and automobile taxes may result in increased smuggling of these products. This seems likely given the resulting huge arbitrage.

On the other hand, Rep. Zarate and other left-leaning solons have said that the proposed tax reforms are anti-poor because they will significantly increase the cost of basic goods. Government calculations, indeed, show that consumer prices will rise by about 1.0%-1.5%. As a result, 2018 inflation is likely to breach the top end of the central bank’s target range. The DoF characterizes such increase as “minimal,” though not bothering to mention that those in lower economic classes are more vulnerable because most of their income is spent on food.

Various sectors have also expressed opposition to certain measures in the tax reform bill.

As expected, automobile manufacturers and importers are lobbying for a smaller increase in taxes. The beverage industry, meanwhile, warned that the P10.00 per liter tax on sweetened drinks is too big a burden and will drive up inflation.

For its part, the Cooperative Development Authority (CDA), which has 26,000 registered coops with 14 million members (mostly farmers, teachers, drivers, rank and file employees), has said that removing their tax exemptions would pose a huge challenge. The group notes that cooperatives are people-based enterprises that are not driven by profit and HB 5636 would threaten the viability of small and micro coops that make up more than 90% of their membership.

In short, there are many, but disjointed, voices against one or more provisions of the bill advancing in Congress. Most, though, have been sanguine, believing, for the most part, that the short term pain will be worth it and pay dividends in the long run. More and better infrastructure, they say, will eventually lift the tide for everyone.

According to Sec. Bello and other government officials, the P8.2 trillion infrastructure spending program will create 12 million jobs until the end of the President’s term (an average of 2.4 million over the next 5 years). Both ambitious and impressive but these numbers should not be taken at face value.

While tax reform should pass the House with ease, there will be greater opposition in the Senate and thus the threat of dilution. Even administration senators have expressed apprehension with one or more of the controversial revenue generating proposals and Sen. Drilon has been quoted as saying that passage may slide to 2018.

And even if most of the DoF’s first tax package gets approved, the economy’s absorptive capacity will be an issue. The slack in the construction sector is practically non-existent. Where, for instance, is the government going to find 2.4 million additional workers per year? The country’s population does not even grow by 2.0 million a year and the labor force has expanded by approximately 1.1 million annually over the past decade. It would help if the labor force participation rate goes up several percentage points but it is sticky, ticking up only slightly (if at all) in any given year and is probably being held down by other factors.

Meanwhile, property companies have confirmed there is a skilled labor shortage that is causing delays, mainly for residential condominium projects. The same issue has forced construction firms to be more selective or to reject some projects outright. The problem has gotten so bad that major contractors are paying 50%-70% above minimum wage for skilled labor, up from 20%-30% in the past. They have also had to recruit farmers and fishermen plus invest heavily in training and housing them.

Industry stakeholders agree, therefore, that the government’s infrastructure program will significantly worsen the Philippines’ shortage of skilled workers.

Bringing in advanced technology and equipment (from China, perhaps) can bridge some of the labor gap but this will not change the equation. Neither will banning or reducing the deployment of skilled laborers to Middle East. Filipinos will continue to prefer working far from home because of the huge wage differential. Could we, perhaps, import labor from neighboring countries? This is going to be a stretch. Myanmar has a skills shortage of its own, Vietnam’s unemployment rate is much lower than the Philippines’ and Indonesia’s economy is booming as well.

Meanwhile, issues that plagued previous administrations are expected to crop up.

Right of ways, legal challenges from losing bidders and the snail-like pace of the court system can cause significant delays. New problems can arise as well. Potentially the most serious would be the lack of qualified contractors. DMCI, for example, has said that it has a capacity of P50 billion worth of projects at any single time. Out of this figure, only a fraction is infrastructure related so for the industry as a whole, there may be serious limits as to how many simultaneous projects can go on at once. Foreign (read: Chinese) engineering and construction firms will certainly be invited to participate but again they will be competing for limited human resources.

Most recently, several private companies have begun to air concerns regarding the government’s plan for hybrid PPPs. That is, project construction will be undertaken by responsible government agencies using ODA funding or through budget appropriations and, after completion, management and operation will be bid out to interested parties.

The concern is that ODA funded projects usually take longer to finish. A case in point is the Iloilo airport which took 9 years from start to finish. Another example is SCTEX which was delayed by two years and incurred cost overruns of more than 50%. SMC chairman Ramon Ang, for his part, has said that going the hybrid PPP route risks damaging the government’s balance sheet and warned that the conditions tied to ODA funding are “scary.” Not only this, if the government will take it upon itself to plan and execute major infrastructure projects, the projected benefits for various listed companies are not likely to materialize in the near to medium term.

The worst case scenario, therefore, is that real consumer spending growth slows down due to the impact of a net tax hike and higher inflation while, at the same time, the hundreds of billions in additional tax collection becomes stranded and unproductive because the government’s infrastructure roll out is bogged down by major constraints. This is a key risk that is not being priced in by the market that seems to be “all in” on this crowded trade.

Views and opinions expressed in this piece are those of the writer’s and do not reflect the policy or position of BusinessWorld. This piece is for information purposes only and should not be construed as a recommendation, an offer, or solicitation for the subscription, purchase, or sale of any of the security(ies) mentioned.

Raymond “Nicky” Franco is a Certified Public Accountant and received his Chartered Financial Analyst (CFA) designation in 2000. He is the Head of Research of Abacus Securities and the head of its online trading arm, MyTrade (