Q2-2015 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the second quarter of 2015, the three months ended June 30, 2015 is approximately +9.6%. The performance for the six months ended June 30, 2015 (year to date) is approximately +11%.

Portfolio Percentages

At June 30, 2015:

22% common equities
2% preferred shares
1% equity options (net)
22% corporate debt
53% cash

USD exposure: 47%

Portfolio is valued in CAD;
Equities are valued at closing price;
Equity options valued at closing bid;
Corporate debt valued at last trade price;
Portfolio does not include accrued interest;
Cash balance adjusted for July 13, 2015 redemption of Pinetree Capital debentures (I did say this was “very unaudited”, did I not?).

Notification

I am still considering an e-mail subscription service for these updates. When I am in a position to do so, I may give an abbreviated summary of the report on the website, but send something more detailed through email.

Portfolio Commentary and Outlook

Mostly cash! This has to be the highlight of the portfolio. Cash earning zero yield. Instead of dumping the remainder in an index fund or long-term treasuries, I have opted to keep things as simple as possible and hold onto cash for better (or rather, worse!) times.

I am shocked that I am substantially outperforming the S&P 500 and TSX year-to-date. I have been running wildly dry for over a year now, so this quarter was a much appreciated break-out – albeit this breakout will strictly be temporary. I fully anticipate coasting over the year due to having a very high cash component to the portfolio.

The major action during this quarter was the liquidation of a substantial position in common shares as a result of a company’s dutch auction tender. I took the opportunity to liquidate most of the position during this time as the story in question (that I have been alluding to in the past couple years of these reports!) will have to wait for longer before it will turn into massive gains. This company will still be on my watchlist and I still hold a smaller position in it than I have in the past. Most of the shares were liquidated at a profit of about 40% from the cost basis that I acquired them at, but I was quite greedy on this position and thought it could go much, much higher (specifically I was looking for a low-risk double and with the help of some momentum, a triple).

Why not keep holding onto a large position if I still think they have potential? In an (hopefully not mistaken) attempt to time when the market will start to like them again, I do genuinely believe there are some technical matters within their ownership structure that need to be sorted out before they will appreciate. It is quite the piece of information for a tender offer to have all of your significant shareholders offer their shares. If they want to get out at a price that is relatively close to market, what makes one think it will go higher from this point until they’re all done liquidating?

I have probably given enough hints on this website for an astute person to figure out what stock this is.

I did pick up a minor equity position in a company that is now trading below a dollar per share. It used to be well above this and is primarily a perceived victim of the slump in the Canadian oil and gas sector. While I am not married to this position (nor am I married to any position in my portfolio!) the risk-reward scenario, especially when examining the financial statements and doing some basic calculations of what the industry should nominally look like in a normal financial state, seems to be quite favourable for a triple in share price over the next couple years. This is assuming some sort of moderation in the industry. Even if the common shares went 3x from present prices, it would still be well below its average trading price in history. Given the balance sheet leverage (which is not completely leveraged, but I would not call them conservative on debt either) this will likely be a binary situation where it will go to zero on a recapitalization, or stabilize and appreciate. If you get 2:1 odds flipping a fair coin, it is still wise to put some money on the outcome even though you may lose your wager. At present it is about 30% below my cost basis and thus it looks like a losing bet. I will not rebalance until I see Q2 financial statements.

My corporate debt positions have been pared down primarily through redemptions of Pinetree Capital debentures (TSX: PNP.DB). I’ve written enough about it in previous posts, but suffice to say, it is going to be very difficult to replace something with such an insanely high yield at a low-to-moderate risk level. Pinetree debt has been trading in the upper 90’s since the last redemption announcement, but it is far from an optimal vehicle to be parking cash (even though the coupon of 10% looks relatively attractive considering the debt is super-duper senior secured).

I have three other corporate debt holdings which are single-digit percentages. One is senior secured, the other two are senior unsecured and all of them are trading below par and are priced at a higher risk level than what I believe their financial statements warrant.

I’ve been desperately trying to find places to park cash to earn something beyond zero. Other than the obvious (GICs at 1%), I have not found any luck with the risk-reward parameters that I am looking for. There are a lot of creative institutions and securities out there that will tempt you into ways to locking your money, but removing liquidity must demand a higher price for the investment and I am refusing to sacrifice liquidity. In this instance, I am keeping very liquid.

My largest equity position is now Genworth MI (TSX: MIC) once again. Historically I took a large stake back in 2012 when it was trading below $20 and I see no reason why I should change my position at present. I did dump some shares in the high 30’s and low 40’s last year. From a fundamental perspective if it goes below $30/share I might start looking at repurchasing shares again if my perception of how the market is pricing in Canadian housing risk is more severe than my well-informed perception of what the reality is on the ground.

There is an omnipresent risk in the entire Canadian market that isn’t directly being talked about, and that is the upcoming October 19, 2015 federal election. Since the NDP (who have vowed to increase corporate income taxes, amongst other taxes) are in a position in the polls whereby they could conceivably be in government, the markets are going to continue be dicey for government-sensitive corporations out there. In particular this also does not bode well for domestic oil producers (which will likely be under further regulatory scrutiny). The election of an NDP government in Alberta has already resulted in their government promising in the throne speech higher taxes for corporations (the provincial corporate tax rate will go up from 10% to 12%), individuals earning $125,000 and above, and down the line, a probable implementation of a carbon tax.

As a result of the high cash balances, I do not seriously anticipate portfolio performance will be deviate much from -5% to +5% for the subsequent quarters unless if I can find a suitable place to deploy those cash balances.

I have quite a few targets on the watchlist, but they are at prices that are sub-optimal in terms of risk-reward. An example of this is Rogers Sugar (TSX: RSI) which at $4.70/share is not something I’d put in my portfolio, but if it goes below $4.00 I will look at it again.

As for now, at current prices, right now I am out of ideas. So I wait.

Genworth MI repurchases shares

Genworth MI (TSX: MIC) recently disclosed that they repurchased 1,454,196 shares in mid-May for roughly $34.38 per share, a repurchase representing $50 million.

The buyback algorithm they employed was less than subtle, mainly the repurchase of 137,210 shares per day for 10 days and 82,096 shares for the last day. As 57% of the shares outstanding are owned by Genworth (NYSE: GNW), they supplied 57% of the liquidity for these transactions. 620,818 shares were taken out of the public float.

This repurchase was executed at slightly less than book value, which means it will be mildly beneficial to book value per share – my estimates are that based off of end of Q1-2015, the transaction would add 3 cents of book value per diluted share.

Of course, the transaction will be hugely accretive to earnings – the buyback represents 1.56% of shares outstanding, which means this will add a couple pennies a share to the quarterly EPS figures. In addition, the buyback also means that the company will not have to give out an extra $2.3 million a year in dividends.

At the end of Q1, the company had $200 million in surplus of its own internal buffer, which is 220% of the minimum capital test required to operate. The company reported 233%.

As the company typically book about $90 million in income a quarter, the buyback likely represents a “cash neutral” policy of balancing dividends (est. $36 million in this upcoming quarter) and share buybacks, at least with its current market value. If their market value remains suppressed below book value and they keep executing buybacks on a quarterly basis, I foresee higher equity prices in the future.

Long-time readers here will remember that I disagreed strongly with management’s decision to repurchase shares at $40/share back in 2014. May 2015’s repurchase I completely agree with – a shame they could not execute it in March, but still, they (and shareholders) will receive good value for this $50 million repurchase.

I continue holding Genworth MI shares since mid-2012.

Liquidation spree – cash heavy

I have substantially liquidated a large position in my portfolio today and am sitting on an approximate 50% cash position yielding precisely 0.00%. The majority of this is denominated in US currency. I have no interest in swapping it for Canadian currency at this time.

For various reasons, while I have thought about investing cash temporarily in 30-year treasury bonds, at this time I prefer the comfort of plain cash. There are quite apparent liquidity issues concerning US treasuries (on an institutional level) that alerts my brain to a form of tail risk that I can’t quite express in words.

I have substantially completed nibbling on a small equity position in a company that I have not disclosed but since I am aiming for a 2% position and have obtained 1.3% to date, you can guess what kind of conviction I have for the underlying company. Looking for a double in a year for the reasons that the market is pricing in worse profitability than what will actually occur, and the industry the company is in can be described as fairly un-sexy at present.

Pinetree Capital (TSX: PNP.DB) will be redeeming more debentures at the end of this week and this will also result in a further injection of cash. There will likely be another redemption notice coming between now and the end of August which will clear out half of the remaining position, and the last half will occur between October and maturity (May 2016).

My largest equity holding is now Genworth MI (TSX: MIC) that I have held on since 2012. At its current price I am not interested in liquidating or purchasing more shares.

I am completely out of ideas and thus the next seven months may be a very boring period of time for portfolio management. I have a bunch of interesting companies that I have researched, but valuations are nowhere close to the point where I would pull the trigger. Examples include cash generators like Rogers Sugar (TSX: RSI) where I would ideally purchase under $4 a share. Companies like this I have on my watchlist, but are nowhere close to where I would want to purchase them with an acceptable margin of error.

I would not want to be a portfolio manager for a firm that required 100% deployment of capital. The decisions at this point would not be pleasant and I would take an extreme perspective of putting capital in the most defensive equities as possible. Most (if not all) of these have been bidded up due to the low interest rate environment.

For now, I wait and twiddle my thumbs.

Beef prices and demand destruction

Here’s an article on the CBC about the state of high beef prices (and how they are here to stay for years to come).

There are a few lessons here.

One is that these market-affecting events typically have causes that span a timeframe greater than a calendar year. For instance, this spike in pricing can likely be traced back to 2011 when there was a significant drought that affected most of the corn and grain-producing regions in the USA. The drought was a multi-year event.

When cattlemen cannot obtain enough feedstock for their livestock, they switch to liquidation mode. Beef prices paradoxically went to relative lows at the beginning of the drought but have skyrocketed (as far as food inflation prices go) ever since.

It will take some time for the supply-demand balance to restore itself. However, the other lesson here may be one of demand destruction – have steak prices gone high enough that people will permanently reduce their demand for the product, resulting in a reduction of overall volumes?

The analogy to the crude oil market is also fairly straight-forward in terms of things not coming to any equilibrium over the span of a calendar year.

Retail prices of beef (and other food products) over the past few years are available from Statistics Canada. Onions, carrots and white sugar are the only three things that have dropped in price from April 2011 to April 2015. (As a side note, celery is roughly equal in price, and onions, carrots and celery make the staple Mirepoix that is a classic mix for sauteing, so at least I won’t be giving that up in my diet).

A couple ways of playing the beef situation financially that come immediately to mind (although both do not make any sense under the circumstances). One are through food processors, e.g. Tyson Foods, (NYSE: TSN). There are few “pure beef” processors out there, but one that does come to mind, indirectly, is Leucadia’s (NYSE: LUK) very ill-timed purchase of National Beef Packing Company. I have no interest in either company (either short or long).

For those brave souls, however, cattle futures on the CME are the purest play on beef prices. They are not the purest play on beef volumes, however, which would be easier to play than the price of beef.

Anecdotally, I have noticed my own consumption of beef (especially my favourite cut of steak, rib-eye) decline as I generally look at the opportunity cost of the CAD$27/kg price vs. other meats that I am equally competent at cooking. Also there is the other option of buying tougher cuts of beef and a competent cook can prepare these in a manner that are palatable (e.g. thin-cut stir-fry), but it just isn’t the same!

A small note and investing in the lottery!

Almost everything I’ve put bids on (very near the market) have creeped away from the bid. It is also not like I put a ten million dollar limit order in the market either – I break things away into very small sized chunks and scale in as market volatility takes pricing lower (or vice-versa in the event of a sale).

My lead hunch at this point is to simply buy into long-dated US treasury bonds (e.g. NYSE: TLT) and just sit and wait and be patient for other opportunities as they may arise. If long-term 30-year yields go to about 3.2-3.3%, I just may pull the trigger. But if anything is like how things have been throughout the year, it is going to be a very boring year. Maybe I am slightly resentful that had I did the TLT route in early 2014, I’d be sitting on a rough 20% gain at present.

I will also point out that the Lotto MAX is at $50 million plus $33 million bonus draws which means that you have a better than 1-in-a-million probability with a $5 fee to win a million. Although the expected value of the lottery of course is negative, it almost seems like the only real chance of getting a big payout is through this medium compared to what I am seeing out in the markets at present.

Sad times indeed!

Maybe I should have invested in the CPP instead

The Canada Pension Plan reported a 2015 fiscal year-end (their fiscal year goes from April 1 to March 31) performance of 18.7% gross, or 18.3% net after fees.

Over the past 10 years, the CPP has realized a 6.2% real rate of return, while in order to remain sustainable they require a 4% real rate of return. When dealing with a $250 billion dollar fund, two percent compounded over 10 years makes quite a big difference.

I have had my doubts that the CPP would be able to realize increased returns as it grew simply because they are competing with a lot of other big players for the same pool of income. In a smaller scale, individual investors have to scour the beds of the financial oceans in order to find reasonable risk/reward opportunities.

There is likely going to be increased political pressure to either reduce CPP premiums or raise CPP benefits due to the outperformance of the CPP. It is likely such a decision would be a mistake because in the macroeconomic sense, central bank quantitative easing has inflated asset pricing to extremely high levels. It is very improbable the CPP can maintain its current performance and quite probable that they will pull in more “real-world” rates of returns (i.e. single digits).

However, all Canadians should be happy that the CPP is doing what it did – there is this pervasive myth that the CPP will not be able to pay out for existing and future generations and with the existing payment and benefit regime it is quite likely they will be able to pay for the indefinite future. Assuming you have made maximum contributions to the CPP, you would be entitled to a $12,780/year retirement benefit when you turn 65 years of age. While this is not a huge amount of income, when coupled with Old Age Security ($6,765/year) leaves approximately $19,500/year of pre-tax income which, if properly budgeted, will pay for a basic lifestyle in retirement.

Not finding a lot to invest in

Barring any investment discoveries in the next month, the cash balance I will be reporting in June is going to be a considerably high fraction of the portfolio.

While cash is great, it also earns zero yield.

Compounding this problem is the majority of it is in US currency.

Unfortunately I have done some exhaustive scans of the marketplace and there is little in the way of Canadian fixed income opportunities (specifically in the debenture space) that I have seen that warrants anything than a small single-digit allocation. I would consider these to be medium reward to low-medium risk type opportunities. Things that won’t be home runs, but reasonable base hit opportunities.

Rate-reset preferred shares have also piqued my interest strictly on the basis of discounts to par value and some embedded features of interest rate hike protection, but my radar on future interest rates is quite fuzzy at the moment (my suspicion is that Canadian yields will trade as a function of US treasuries and the US Fed is going to take a bit longer than most people expect to raise rates since they do not want to crash their stock market while Obama is still in the President’s seat).

I have yet to fully delve into the US bond space, but right now the most “yield-y” securities in the fixed income sector are revolving around oil and gas companies.

There are plenty of oil and gas companies in Canada that have insolvent entities with outstanding debt issues, so I am not too interested in the US oil and gas sector since the dynamics are mostly the same, just different geographies.

I’m expecting Albertan producers to feel the pain when the royalty regimes are altered once again by their new NDP government. There will be a point of maximum pessimism and chances are that will present a better opportunity than present.

Even a driller like Transocean (NYSE: RIG) that is basically tearing down its own rigs in storage have debt that matures in 2022 yielding about 7.9%. If I was an institutional fund manager I’d consider the debt as being a reasonable opportunity, but I think it would be an even bigger opportunity once the corporation has lost its investment grade credit rating.

Canadian REIT equity give off good yields relative to almost everything else, but my deep suspicion is that these generally present low reward and low-medium risk type opportunities. Residential REITs (e.g. TSX: CAR.UN) I believe have the most fundamental momentum, but the market is pricing them like it is a done deal which is not appealing to myself from a market opportunity.

The conclusion of this post is that a focus on zero-yield securities is likely to bear more fruit. While I am not going to be sticking 100% of the portfolio in Twitter and LinkedIn, the only space where there will probably be outsized risk-reward opportunities left is in stocks that do not give out dividends. It will also be likely that a lot of these cases will involve some sort of special or distressed situations that cannot easily be picked up on a robotic (computerized) screening.

I would not be saddened to see the stock markets crash this summer, albeit I do not think this will be occurring.

The continuing saga of Pinetree Capital

Pinetree Capital (TSX: PNP) announced it will be redeeming another $10 million in its debentures on June 5, 2015. This is on top of the $10 million that was already redeemed on April 30, 2015.

For those of you following the Pinetree Capital saga (history of posts here), I continue to hold Pinetree debentures (TSX: PNP.DB) as I believe it is more probable than not they will be made whole at maturity.

On December 31, 2014 Pinetree Capital had approximately $107 million of investment assets on its balance sheet (at fair value, $75 million level 1, $8 million level 2 and $23 million level 3) and $54.8 million in debentures that are now senior and secured by all assets of the company. They have no other debt. When the debtholders got three of their directors on the board when Pinetree defaulted on their debt covenants in late January, presumably on February they start on their liquidation spree. On March 29, 2015 they had $14.3 million cash in the bank which they used to redeem the first $10 million of debt. After June 5, 2015, they will have $34.8 million in debentures outstanding.

Debentureholders will also receive their semi-annual interest payment (10% annual coupon) on May 31, 2015.

As part of their forbearance agreement (to stave off their debt being declared fully payable with likely CCAA implications), Pinetree Capital was required to redeem a minimum of $20 million face value in debentures by July 31, 2015. They had the option of redeeming the debentures with 1/3rd equity, which they have not done so to date. They are also required to maintain a debt-to-assets ratio of 50% until October 31, 2015 and then 33% afterwards.

When doing a quick and dirty pro-forma with no change in assumed asset value other than the payment of interest and principal on debentures, after the June 5 redemption they will have a debt-to-assets ratio of 40.5%. If Pinetree were to redeem another $11 million in principal by the end of August, this would bring the ratio to 33%. Presumably they would want a little bit of a margin of error to work with, so it is likely before October 31, 2015 that they will redeem around $15-20 million in further principal which would bring them safely below the 33% mark.

Not surprisingly, the market has picked up on this and has bidded up the debentures to 88 cents on the dollar. What has previously been a 75 cent dollar is now considerably more expensive and will likely converge to par throughout 2015 with diminishing market liquidity as the debenture supply dries up.

Disclosure: Still long on PNP.DB, but as the redemptions occur, my portfolio weighting decreases.

WYNN not winning

One of the best commentators on conference calls is Steve Wynn (Nasdaq: WYNN) and suffice to say, he has a few zingers in his last conference call. His company’s stock has gotten hammered some 16% today and over half since early 2014.

wynn

Some notable quotes from his conference call:

It is impossible for us to predict how long [the downtrend in business conditions] that will last. We’re not in a position to answer those kinds of questions intelligently. We’re only in a position to react intelligently to what we see.

He goes on a speech about how the company will always be able to manage its debts and affairs, and also about how dividends will only be given from cash that has historically been earned:

So as we look backwards for the fourth quarter and especially during the last four months, and understand what’s happening, both in Las Vegas because of the Asian impact on Baccarat, and we look back and then we extrapolate and try predict the future, or at least understand what most likely will be the future, it is foolhardily and immature and unsophisticated to issue dividends on borrowed money. We only distribute money that’s free cash flow based upon our earnings that trail.

Dividends are nothing and – we don’t say that because we have a business, that we now have a $0.50 dividends forever. That’s baloney and any company that does that is irresponsible. We distribute the money that we make after we make provisions for capital expenditures and all of our other obligations, to creditors and to our employees. And then we distribute aggressively whatever is free and easy to distribute after that.

The note about issuing dividends from borrowed money should resonate with most oil and gas producers in Canada these days – the only reason why most of them are issuing dividends is simply because they’d get their shares jettisoned from the huge pool of income funds. It would also be an admission of defeat and a negative signal to the market.

On a dialog on the conference call with his own president of the Las Vegas casino (which in my humblest opinion had a dinner buffet that was remarkably worth the US$45-ish that I paid for it):

If you were to ask me, since we’re making forward-looking statements, what will the second quarter look like in Las Vegas? Weak. Do you hear me? Weak. So I’m trying to lower expectations here. This notion of a big recovery is a complete dream. I don’t think Las Vegas is experiencing a great recovery. I think it’s still very patchy and I think that that’s probably our non-casino revenue in the first quarter was flat. I’d be thrilled if it was flat in the second quarter.

It is very rare when you get a CEO making such refreshingly honest statements. There’s a bunch of other commentary here, but I will leave that as an exercise to the reader.

Business notwithstanding, there is a whole bunch of drama going on over at WYNN at the present time, including the divorce of the CEO spilling over onto the business side of things.

Genworth MI Q1-2015 review and analysis

Genworth MI (TSX: MIC) reported their 1st quarter earnings results yesterday. The report can be summed up as a relatively boring, “steady as she goes” type quarter, which is somewhat surprising considering the general predictions that the degradation in the Alberta real estate market would cause considerable stress in the sector.

The bottom line earnings took the book value to $36/share.

While the market is signalling there is going to be further losses later this year, the first quarter result had a loss ratio of 22%, which is generally on-level with prior quarters – the company projects 20% to 30% for the year.

Despite the winter quarter being the slowest quarter of the year, year-over-year statistics show a marked increase in unit volume (23,951 in 2014 vs. 32,760 in 2015) and also the net premiums written ($84 million to $130 million). The Q1-2015 net premiums written was also goosed up by the recent CMHC mortgage insurance premium increases. On June 1, 2015, there is another CMHC premium increase on higher ratio mortgages which will also result in a $25-30 million increase in net written premiums.

The company’s insurance in force exposure is 18% in Alberta for “transactional” type mortgages, which are mostly those with 20% or less down-payment. Delinquency rates continue to be very low (0.11% nationally) without any pronounced increases other than a mild rise in Quebec. Ontario has a 0.05% delinquency rate.

On the balance sheet, the company’s investment portfolio yielded 3.4%, but they had some interesting commentary, stating “At this time, the Company believes that the capital adjusted return profile of common shares is less favorable than in the prior year”. As a result of this and also minimum capital test guidelines, they have increased their allocation to preferred shares. Similar to last quarter, they also went out of their way to specify that 75% their energy company investments (in bonds and debentures) were in pipelines and distribution, and the other 25% were in “integrated oil and gas companies with large capitalizations”. The bond portfolio has a mean duration of 3.8 years.

The company has capital that is 233% of the minimum capital test (currently $1.52 billion required) and the internal target with buffer is 220%. This leaves $200 million available for the company to either repurchase shares or distribute in a special dividend. They announced their regular quarterly dividend of CAD$0.39/share with the quarterly release but did not give any indications as to what else they will do with the excess capital.

At a current market price of (roughly) CAD$35/share, I generally believe the company’s valuation is slightly on the low side of my fair value range estimate. I would not start to think of divesting until CAD$40, but an actual sale decision would likely be at higher prices.

I still hold shares from MIC, purchased back in the middle of 2012. Seeing the recent price drop to CAD$28/share would have been a decent opportunity to add more shares and I doubt we will see that again unless if there is a profound economic malaise that hits Canada. If we can survive US$50 oil, our economy is more robust than most think (noting that the rest of the commodity markets have also plummeted). MIC also continues to be a stealthy way to purchase Canadian real estate and also a proxy for a bond fund at a very low management expense ratio. The yield in today’s income starved market is a bonus.