Looking back at Davis and Henderson

Once upon a time, I had invested some money in David and Henderson Income Fund, which was back in the days when a lot of viable corporate operations were structured in the form of an income trust. I made some reasonably quick capital gains, sold, and never looked back.

Davis and Henderson, similar to Kentucky Fried Chicken, Ernst and Young, PriceWaterhouseCoopers and many other establishments, decided to abbreviate their corporate name to their initials and become D+H Corp (TSX: DH). Considering that their previous business was the printing and processing of Canadian (paper) cheques, diversification of their business was correctly considered and for the most part, they made a fairly good transition into the broader realm of providing financial technology services for big banks.

You can see in the 10-year chart that this has really worked for them, and the market has been on their side, until recently:


What you don’t see is that in today’s trading, they fell 43% on a quarterly announcement (closing at $16.25/share, with a low of $14.97), bringing their stock price to levels frighteningly close to what I had invested back in 2010 with a cost base of $16.10 per unit. This was certainly a case of “back to the future” for Davis and Henderson.

The question of course is whether the six or so years it has been since I had last invested in them, whether they were worth taking another stab at again.

D+H’s fateful decision was the acquisition of Fundtech on March 30, 2015 (which closed a month later). In this acquisition, they issued many hundreds of millions of debt (in addition to doing a secondary offering at $37.95). Unfortunately, while the acquisition was designed to represent a diversification away from their traditional businesses, it has not materialized into anywhere that could be financially rationalized with the price paid. It has also bloated D+H’s balance sheet with the haunted scars of an additional $1.7 billion in goodwill and intangibles, and when considering their pre-existing goodwill and intangibles, they are sitting on a negative $1.3 billion of tangible equity.

Putting this into plain English, their balance sheet is a train wreck.

Train wreck balance sheets can only sustain themselves with positive cash flow, and continued good credit, as the generosity of lenders will be able to see them through.

For the first 9 months of the year, they have generated $167 million in free cash flow. A majority of this goes to dividend payments ($90 million), and the rest of it goes to debt repayment and acquiring other intangibles.

The problem is with the last quarterly result – it is quite evident that the corporation, on a consolidated basis, has flat-lined. While they still generate a very healthy amount of cash, it is obvious that they will be receiving future stress in the form of being able to repay debt as it matures.

They face the following debt situation:


They have an immediate maturity coming in June 2017, which they should be able to pay off with existing cash flow and/or their revolver without issues. The issue is what happens when they start getting into the bulk of their 2021-2023 maturities.

The math is simple – if they continue paying dividends at their current rate, they will have about $100 million a year in cash to acquire businesses (more intangible assets on the balance sheet) plus debt repayment. They will not have nearly enough to pay off the bond maturities without getting another extension of credit from bondholders.

Considering all of the bond issues and the revolving facilities are secured debt, you can be sure that the banks that supply the revolving debt are going to be nervous about using their money which is pari-passu to bondholders – which means that something is going to have to be negotiated in a couple years.

My guess is that the dividend is going to get slashed in half.

In terms of valuation, the balance sheet situation would make me quite uncomfortable as an equity investor. While I see the value in the cash generation potential of the underlying businesses (notwithstanding the fact that cheque processing is a dinosaur industry and is decreasing accordingly), I do not believe a leverage-adjusted valuation of this business is attractive at present prices.

For now, D+H is still a “pass” in my books. I did sell them at $21 back in the year 2010.

Genworth Financial bought out

Imagine my initial surprise when I saw a news feed that Genworth had been bought out. Unfortunately for me, it was Genworth Financial (NYSE: GNW) and not Genworth MI (TSX: MIC).

Genworth Financial is being taken over by China Oceanwide Holdings, chaired by Lu Zhiqiang, who apparently has a networth of $5 billion.

In the press release, there are scant details. They mentioned the buyout price and the intention of the purchaser to inject $1.1 billion of capital into Genworth to offset an upcoming 2018 bond maturity and shore up the life insurance subsidiary, but the release also explicitly stated a key point:

China Oceanwide has no current intention or future obligation to contribute additional capital to support Genworth’s legacy LTC business.

The LTC (long-term care) insurance business is what got Genworth into trouble in the first place, and its valuation is the primary reason why the company’s stated book value is substantially higher than its market value.

The press release also declared that this is primarily a financial acquisition rather than a strategic one, with management and operations being intact.

One wonders how long this will last.

Since Genworth Financial controls 57% of Genworth MI, it leads to the question of what the implications for the mortgage insurance industry will be – and it is not entirely clear to me up-front what these implications may be. Will the government of Canada be comfortable of 1/3rd of their country’s mortgage insurance being operated by a Chinese-owned entity? What is the financial incentive for China Oceanwide’s dealings with the mortgage insurance arms of Genworth Financial (noting they also own a majority stake in Australia’s mortgage insurance division)?

One thought that immediately comes to mind is that if Genworth Financial is not capital-starved, they will no longer be looking at ways to milking their subsidiaries for capital. In particular, if Genworth MI decides to do a share repurchase, they might opt to concentrate on buying back the public float (currently trading at a huge discount to book value) instead of proportionately allocating 57% of their buyback to their own shares (in effect, giving the parent company a dividend). This would be an incremental plus for Genworth MI.

Finally, one wonders what risks may lie in the acquisition closing – while it is scheduled for mid-2017, this is not a slam dunk by any means. Genworth Financial announced significant charges relating to the modelling of the actual expense profile of their LTC business and it is not surprising that they decided to sell out at the relatively meager price they did – there’s probably worse to come in the future.

However, as far as Genworth MI is concerned, right now it is business as usual. There hasn’t been anything posted to the SEC yet that will give me any more colour, but I am eager to read it.

(Update, early Monday morning: Genworth 8-K with fine-print of agreement)

Yes, I’ve read the document. Am I the only person on the planet that reads this type of stuff at 4:00am in the morning with my french-press coffee? Also, do they purposefully design these legal documents to be as inconveniently formatted as possible, i.e. no carriage returns or tabs at all?

A lot of standard clauses here, but some pertaining to subsidiary companies (including Genworth MI), including:

(page 47): Section 6.1,

the Company will not and will not permit its Subsidiaries (subject to the terms of the provisos in the definition of “Subsidiary” in Article X) to:

(viii) reclassify, split, combine, subdivide or redeem, purchase or otherwise acquire, directly or indirectly, any of its capital stock or securities convertible or exchangeable into or exercisable for any shares of its capital stock (other than

(A) the withholding of shares to satisfy withholding Tax obligations

(1) in respect of Company Equity Awards outstanding as of the date of this Agreement in accordance with their terms and, as applicable, the Stock Plans, in each case in effect on the date of this Agreement or
(2) in respect of equity awards issued by, or stock-based employee benefit plans of, the Specified Entities in their respective Ordinary Course of Business and

(B) the repurchase of shares of capital stock of Genworth Australia or Genworth Canada by Genworth Australia or Genworth Canada, as applicable, pursuant to share repurchase programs in effect as of the date hereof (or renewals thereof on substantially similar terms) with respect to such entities in accordance with their terms);

(note: Genworth MI’s NCIB expires on May 4, 2017)

(page 53): (e) During the period from the date hereof to the Effective Time or earlier termination of this Agreement, except as set forth on Section 6.1(e) of the Company Disclosure Letter, or as required by applicable Law or the rules of any stock exchange, the Company shall not, and shall cause any of its Subsidiaries that are record or beneficial owners of any capital stock of or equity interest in Genworth Canada or any of its Subsidiaries not to, without Parent’s prior written consent (which consent, in the case of clauses (ii)(B) and (iii) below (and, to the extent applicable to either clause (ii)(B) or clause (iii) below, clause (iv) below) shall not be unreasonably withheld, conditioned or delayed):

or (z) any share repurchases that would not decrease the percentage of the outstanding voting stock of Genworth Canada owned by the Company and its Subsidiaries as of the date hereof)

(note: Hmmm… this does open the door for repurchases).

I’m still unsure of the final implication on Genworth MI other than the fact that if this merger proceeds that the parent company is going to lean less on their subsidiaries for capital.

Bombardier will get their money from the federal government

It is quite obvious that Bombardier will eventually get some equity infusion from the federal government, which will be the final signal to all market participants that Canada will not let the corporation fail, even if the C-Series turns out to be an economic disaster (it does not appear to be at the moment – the risk at this point is on execution).

The question is what type of concessions Bombardier will have to make, and I suspect the “win-win” agreement will be only dismantling the dual-class structure of stock if the company keeps less than X jobs outside of Canada (mainly in the Province of Quebec).

The Government of Quebec (and the Quebec Pension Plan) invested previously into Bombardier and received common shares and warrants for a half-stake in the C-Series jet and also a chunk of the Bombardier transportation division.

My whole line of thinking was that preferred shareholders and bondholders would be the primary beneficiary of all of this capital infusion. Currently, the Series 4 preferred shares (TSX: BBD.PR.C) is trading at a 9.4% yield, while the Series 2/3 (floating/fixed) shares are at 8.2% and 9.1%, respectively. The next rate reset will be in August of 2017.


The yield curve for debt is quite healthy for Bombardier and they’ll be in a good position to refinance maturities, especially when they receive another equity injection. Yields should continue to compress in this scenario.

Genworth MI: Opposing arguments

Interesting article posted by David Desjardins on Seeking Alpha – he has purchased deep out-of-the-money put options (January 2018 puts with a strike of 18) and is clearly anticipating a drop further in the stock price.

His arguments can be summed up as follows:

1. Vancouver housing prices are ridiculously high, inventories are climbing, and prices are dropping;
2. Alberta unemployment is at relative highs and their delinquency rates should spike to 2010 levels;
3. Ontario housing prices have ascended and when they taper, delinquency rates should rise to averages;
4. Higher delinquencies will result in higher claims, and these claims will have a serious negative impact on the corporation;
5. Increased capital requirements, both as a result of claims but government regulatory changes, will require MIC to issue shares.

My comments:

1. My own overall thesis is that we will see a tapering of pricing demand in the urban real estate markets, but not a crash. The housing targeted to foreign interests will depreciate considerably (my own on-the-ground research has shown this has had a 10-15% impact on asking prices in BC), but these markets have not been eligible for mortgage insurance since July 7, 2012. The spill-over is what happens to the townhouses and condominiums in the Vancouver marketplace – there will be undoubtedly be price compression due to decreased demand as a result of decreased credit availability.

I do agree, however, that BC’s delinquency ratio (currently 0.07%) is abnormally low. Ontario’s (0.04%) is also abnormally low, but the company’s loss ratio guidance has always been above the expectations of what delinquency numbers would imply – original 2016 guidance was 25%-40%, but it is fairly obvious that it is going to be well under 40%, and they decreased the upper band for loss guidance to 35%.

2. If we see the delinquency rates as he suggests in his article (1% in BC, 0.7% in Ontario), then Genworth MI and CMHC will be in very rough shape. You would see a significantly lower stock price and you will be seeing huge political ripples about the whole Canadian housing market going from boom to bust in short order. Genworth MI’s peak delinquency rate was 0.3% in June 30, 2009 during the 2008/2009 global economic meltdown, and their loss ratio was 46%. It is not a stretch that a delinquency ratio larger than that would be the result of another meltdown in equal size, something I do not believe in the offering.

If the author’s worst case scenario of 1.5% delinquency rates occur in the insured mortgage space then you will be seeing crisis headlines that would ripple well beyond the financial state of the mortgage insurance industry.

It is also important to note that lending practices in the USA during 2008-2009 had significant differences than lending practices in Canada today.

3. Genworth MI, in general, has a healthier mortgage insurance portfolio than CMHC (I will leave speculation why out of this discussion). In Q2-2016, Genworth MI’s delinquency rate was 0.1%, CMHC was 0.32%. Any changes in regulatory burdens will impact CMHC’s profitability more so than Genworth MI; while this doesn’t directly impact whether there will be a spike in delinquencies, the federal government clearly does not want to knee-cap its own crown corporation in the process (one that generated about $550 million in net income to the Crown in the first half of this year).

4. Housing prices are the primary driver of claim severity, while unemployment is the primary driver of claims. Insured mortgages in Canada are full-recourse, which means the metric to watch for is unemployment and not housing prices. An unemployment rate of 7% nationally is not concerning for housing.

5. In Alberta, unemployment is anti-correlated with increases in energy prices and has probably peaked around 9%. Housing prices have decreased by 5-10% in the province, and delinquencies have climbed from 0.09% (Q2-2015) to 0.17% (Q2-2016), but this has been well-anticipated by management. Delinquencies peaked in Alberta at 0.62% for Genworth MI in Q4-2010 (the primary after-effect of oil going down to US$33 at the beginning of 2009). My estimate for delinquencies in Alberta should taper off around 0.25-0.3%.

6. The author appears to be misunderstanding the minimum capital test. The new regulations by OSFI introduce a new regime for minimum capital required to retain insured mortgages. While the statutory minimum is 100%, the supervisory target is 150%, and the company typically keeps an internal buffer higher than the supervisory target to ensure that month-to-month operations do not bring the ratio under 150% – the pro-forma at Q2-2016 was 153-156% of the new MCT, while I suspect the internal target will be somewhat higher. Genworth MI will book another $100 million of after-tax income for the second half of the year (after dividends) and this will push it to the 160% level. They do not need to raise capital – they just need to slow down issuing insurance and continue amortize their current book.

In addition, there are transitional arrangements to the new capital levels that will only “kick-in” after they are lower than the old capital test levels. That said, the old and the new capital test levels include a 20% buffer for “operational risk”, and since the new capital test levels are higher, this will also increase the capital required for operational risk (which in the new rules, is the operating capital minus the supplementary capital required for insuring mortgages in “hot” markets). This increase in required capital is transitioned in over a 3 year period.

The effect of these changes, however, will definitely increase capital required for mortgages, especially for lower ratio mortgages:


These changes affect MIC and also CMHC. CMHC is relatively less affected as in Q2-2016, its MCT level was 366%.

As a result of these changes, I expect transactional mortgage insurance origination to decrease significantly (guessing around 20%). As I said before, if Genworth MI stopped writing insurance, their share price would still increase as their liability book would shrink and capital is released for asset distribution.

7. 92% of MIC’s mortgage business is written on loans under $550,000. 8% would be between $550k to $1M. In relation to income capacity of borrowers, this does appear to be reasonable (especially considering the average gross debt service ratio of borrowers is a reasonable-sounding 24% on Q2-2016).

8. Even if home values drop below mortgage values, the option to strategically default in Canada is much, much more expensive due to full recourse rules on insured mortgages. As long as people are employed, they will continue paying their mortgages (albeit be a bit bitter about paying down a debt on a property that is valued less than the debt).

While the author’s “what-if” estimates in the event of a spike in delinquencies is an excellent stress test, they appear to stem from a scenario that is the result of something worse than what happened in 2008-2009. If the 2008-2009 scenario happened, there are far better short sales out there than Genworth MI (candidates that come to mind include HCG, EQB, FN, etc.).

Recall that Genworth MI went public in 2009 at CAD$19/share (the first window of opportunity after the financial crisis) and this was a forced IPO because Genworth Financial desperately needed to raise capital. CAD$19 back then was a fire-sale price and the entity today is larger and more profitable than it was back then (and also noting that they had 117.1 million shares outstanding after IPO, compared to 91.9 million today) – and they IPOed at 10% under book value, compared to 25% under book today!

Mortgage changes and Genworth MI valuation

By now the whole nation has heard of the proposed changes to mortgage financing and insurance requirements for Canadian mortgages.

Genworth MI (TSX: MIC) evaluated the impact of these changes and the payload of this was in the following paragraphs in their press release issued 4 minutes after the market opened yesterday:

Based on year-to-date 2016 data, we estimate that a little over one third of transactionally insured mortgages, predominantly for first time homebuyers, would have difficulty meeting the required debt service ratios and homebuyers would need to consider buying a lower priced property or increase the size of their down payment.

Furthermore, approximately 50% to 55% of our total portfolio new insurance written would no longer be eligible for mortgage insurance under the new Low Ratio mortgage insurance requirements.

The market proceeded to take MIC down from about $34 to $30 in short order, presumably on the basis that a third of their mortgage insurance market is going to get knee-capped due to customer income requirements.


It is important for the reader to understand the difference between transaction insurance (which the typical retail investor is familiar with) and portfolio insurance (which is where a financial institution purchases insurance on its own behalf for the purpose of assembling mortgages and securitizing them for selling in the secondary marketplace).

I am generally of the belief that despite these regulatory changes, Genworth MI is very much undervalued at present pricing. There are quite a few variables at play in this space, which I will go over as follows:

1. On the basis of premiums written, portfolio insurance was 13% of Genworth MI’s business in 2015. There was a regulatory change (dealing with mortgage substitutions and time limitations for portfolio insurance) that is effective July 1, 2016 which caused a one-time spike in portfolio insurance demand in Q2-2016. The portfolio insurance market was already effectively squelched by regulatory change and this further change will dampen it further.

Because portfolio insurance is written on low-leverage mortgages, they are akin to selling significantly out of the money put options on mortgages. In Q2-2016, Genworth MI insured $26 billion in mortgages via portfolio insurance, but this only generated $78 million (0.3%) in premiums (the median loan-to-value was 65-70%).

I would anticipate that portfolio insurance will be a very small part of the future mortgage insurance market – I’d be surprised to see more than $10 million in premiums each quarter going forward.

2. Transactional insurance is the bread and butter of the business. The question is how much of consumer demand for insurance will be eliminated because consumers failed to pass the affordability test (due to using the Bank of Canada posted rates) versus these consumers simply choosing to downsize their financing requirements to fit with the new mortgage insurance parameters.

My initial estimate would be that transaction insurance would slow down by about 1/6th of ambient levels instead of the 1/3rd backward-looking estimate given in the release. The past four quarters had $686 million in transactional premiums written. Going forward, I’d expect this to decline to around $570-ish.

3. Clearly these changes are going to result in less premiums written for Genworth MI (and also CMHC). However, this will not impact the existing mortgage insurance portfolio. If Genworth MI decided to stop underwriting all business and decided to run off its mortgage book, shareholders would still be looking at north of their Q2-2016 book value of $38.23/share as the company recognizes revenues. In a relatively normal environment, the company’s projected combined ratio should be around 45-50% (which is above what it has typically been) and the unearned premiums (currently of $2.08 billion) would likely amortize to another billion in pre-tax income if the book were to be run off.

The terminal value of the operation, with the assumption they decide to shut everything down, would be very well north of the existing book value, and most of this capital would be freed up completely after 5 years (customers would have their mortgages amortized to a point where mortgage losses would virtually be impossible).

There are various ways to value companies, but they all generally depend on a function of income expectation and how much cash can be liquidated from the balance sheet if operations were to cease. In Genworth’s case, there is a huge margin of error between current market value, current book value, and a reasonable expectation of performance in future years.

Simply put, the market is valuing Genworth MI as if it is going to lose money in the future. I do not believe this is a reasonable assumption even though this Canadian government appears hell-bent on pushing us into a tax-induced recession.

4. OFSI has released a draft proposal concerning the capital requirements of mortgage insurance companies, and in general this will require Genworth MI to retain more capital for its existing mortgage insurance portfolio. The reason is that the new capital requirements introduce a supplemental capital requirement for housing markets that are “hot”, which is determined by a price to income ratio. It is likely that mortgage insurers are going to raise premiums in 2017.

Genworth MI’s policy has been to keep its capital base above a certain level above its internal minimum (in the new proposal, the fraction will be above 150% of the revised minimum capital test) and distribute the rest of it in buybacks and dividends. Although the future rate of premium collection will be less, the company will be in a position to repurchase shares at a considerable discount to book value.

5. These changes in capital requirements force mortgage insurance companies to heavily err on the side of conservatism, both in terms of balance sheet strength and insuring customers that are quite strong (via the posted rate interest test).

6. The parent company (Genworth Financial) has stabilized considerably since last year and I still believe a low probability scenario is for them to exit the Canadian mortgage insurance market through a sale of the entity. They could certainly fetch more than CAD$30/share, but the question would be who the buyer would be – there are not a lot of obvious well-capitalized candidates, but I would think of Fairfax or even the CPPIB or a Canadian pension fund doing so.

7. It didn’t take a rocket scientist to realize that the government announcement of October 3, 2016 would be negative for transactional and portfolio insurance volumes, yet the market only reacted when Genworth announced the retrospective impact of the changes. Yes, I should have been there on the morning of October 4th and pounded the bid, but I was asleep at the switch and I would have expected the negative market reaction to be on October 3 and not a day after!

8. In relation to the rest of the financial entities trading on the TSX, Genworth MI is very much undervalued and the market has over-applied the negative effects of the regulatory change on the company by weighting its impact on future premiums written too heavily. Genworth MI could easily give its shareholders a boost by announcing a wind-down of operation and a release of capital as mortgage insurance policies amortize, but they will not do this simply because Canadian mortgage insurance is still too profitable. In the first half of 2016, they make approximately a 60% profit of every dollar of premium they recognize. Why give this up?

Where should Genworth MI be trading? Higher than what the market is currently valuing it. This is a fairly strong buy on my radar, despite the fact that it has been a long-term core holding since 2012 when I first invested.

Dredging the market for corporate debt

I’ve been doing an exhaustive examination of the available publicly traded debt from US corporations. I am specifically looking for debt that has maturity lengths of between 2-8 years, and the underlying issuer is relatively solvent. The actual parameters I used for the screen I’ll leave aside, but there were a lot of issuers to do some quick research on to see whether they were worth further investigation.

The “relatively solvent” criterion allows me to exclude companies that are basically operating entities that are encumbered with a gigantic amount of debt relative to tangible book value. These entities typically exhibit goodwill and intangibles far in excess of what the stated equity is, which means that the entity was likely a result of a previous leveraged buyout or some sort of financial restructuring to extract the maximum capital of the entity.

A good example of this is Toys R Us, a completely leveraged mess of a financial entity as a result of a leveraged buyout years ago. If you like anti-depressants, please take them while you read their last quarterly report. I would not go anywhere near their unsecured debt. Somehow this entity actually warrants a market value of an 11% yield to maturity on their 2-year debt. Amazing.

I am not interested in these entities unless if they were generating a sufficient amount of cash in relation to their debt, and in most cases they do not. This means that refinancing risk is going to be crucial for these entities – while today they might get the financing, tomorrow they might not. It is at those moments where an investor will make the optimal risk/return ratio. Today an investment will just result in a mediocre risk/return.

There were a lot of offshore drillers that are clearly in trouble, and a lot of energy-related entities in trouble. In general, I am not interested in these (in addition to having enough exposure to energy bonds via Teekay debt).

Finally, anything that did seem to be a reasonable candidate had a chart resembling this:


I picked Titan International (NYSE: TWI) just as an example and not something I am interested in purchasing (at current prices). It is an automobile parts manufacturing company and is fairly easy to analyze – $200 million cash in the bank, a $60 million debt issue due in January 2017 that they will pay off, and $400 million due October 2020 (which you see in the chart above). The coupon is 6.875% and the debt is senior secured, and trades at a YTM of about 8.5% at present. The corporation in the first half of this year generated about $11.6 million in free cash flow. Historically they seem to be a cash generation vehicle for management teams.

It doesn’t take a Ph.D in finance to realize that they will likely have to refinance the debt when it comes to maturity in four years. They will probably be able to do this, but who knows?

This same bond traded at nearly a 19% YTM back in February when the whole market was going haywire.

Just because the bond is trading at higher levels (lower yields) doesn’t mean that they are valuable today. But if you did buy today you’ll get a high single digit return in the compensation for the risk that you’ll be dealing with the Chapter 11 proceedings of an auto parts manufacturer that doesn’t have the capacity to generate a huge amount of cash in a very low-margin industry.

Is it worth 19% to take this risk? Absolutely. Is it worth 8.5%? Probably not. Today you can get that debt for about 94 cents on the dollar, but if you got the same debt for 80 cents a year from now, you will get a much better return (assuming the aforementioned default does not occur).

The other question I ask myself is whether we’ll likely see something in the next couple years that will resemble a bond refinancing crisis. While the future is always difficult to predict, there will always be something that will cause panic in credit – and it is in these times that one must dive in deep, just like I did back in January and February.

There are numerous examples like this littered in the bond markets today – lots of mediocre companies with bonds trading at single digit yields to maturity. Even worse are the over-leveraged messes that are just asking for recapitalization when the market sneezes.

So overall, the pickings of my bond market research have been very slim.

The results are quite depressing – out of looking at approximately a hundred issuers, I’m only interested in doing a deep research session on one corporation. Also, my initial take on this entity wouldn’t be for their debt – it would be an equity investment. My initial instinct says that their equity could double in a year, while their debt yields 7.6%. I’m eager to start the research process.

Looking at this whole exercise, I realize this following statement might be the biggest piece of confirmation bias about my own portfolio, I believe the pieces of corporate debt that I currently own represents the best risk/reward available on the publicly traded markets today. I just don’t see anything else out there worth putting capital in the corporate debt markets. It’s a classic case of doing a lot of work but achieving no tangible results for the portfolio.

Q3-2016 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the third quarter of 2016, the three months ended September 30, 2016 is approximately +12.2%. The year-to-date performance for the nine months ended September 30, 2016 is +49%.

Portfolio Percentages

At September 30, 2016:

36% common equities
25% preferred share equities
43% corporate debt
-4% cash and cash equivalents

USD exposure: 41%

Portfolio is valued in CAD;
Equities are valued at closing price;
Values include accrued corporate bond interest, but not that from Canadian exchange-traded debentures;
Corporate debt valued at last trade price.
“cash equivalents” in this instance includes holdings of VSB.TO.

Portfolio commentary and outlook

I keep saying that good performance can’t last forever. Fortunately, the gravy train hasn’t stopped quite yet. Going back from my half-year report, at most I was expecting double-digit appreciation in my portfolio before hitting the sell button. As you can see, I have gone from 21% margin to 4% margin in a relatively short period of time, which means I have liquidated some holdings.

I have been disposing of equity securities (and some corporate debt) and have been using that cash to reduce the amount of margin.

So, I have decided to cash in some chips and wait for worse days ahead. Indeed, if the remaining portfolio appreciates, I will be cashing in even more chips. There are a few things on the horizon that will likely be cashed out, and there is some PGF.DB.B debt that will mature on March 31, 2017, likely at par. Items that are close (via market pricing) to being liquidated consist of another 15% of the portfolio and it is quite likely by year’s end the net cash balance will be positive.

While I can be considered in a cash-raising mood, my invested portfolio fraction is still quite high. It’s not as if I’ve decide to sell everything.

The majority of the portfolio (equity and preferred securities) remains relatively unchanged. I sold some equity components over the past quarter, but otherwise the names are still the same. I tried to acquire an old name that was trading cheaper, but sadly missed out by pennies before the market moved against (higher) me. I got a whopping 100 shares of this thing, which was frustrating since I was seeing thousand-share blocks trade a penny above my bid.

The remaining debt portfolio is invested in companies that I do not realistically expect to incur losses, while providing a steady stream of income. While my portfolio is targeting the best risk/reward ratio, I am rather agnostic about whether this comes in the form of capital gains, dividends, interest or pixie dust, as long as it can be translated into after-tax cash at some point in the future. One such debt investment I disclosed was Teekay Corporation, where most of their debt is in the form of an unsecured bond maturing on January 2020. There are a variety of reasons why bondholders will be made whole and all I have to do is just sit on it. While I bought the debt at roughly a 20% yield to maturity, it still presents a 13% yield to maturity today.

Unfortunately, like the previously stated cases and in most others, the time for superior returns is not now. Indeed, the stock I missed out on by pennies would have actually contributed a performance that is under my historical average, but the risk/reward was simply too alluring to ignore. If you can get a guaranteed 4% and only have to pay 2% interest for the privilege, why not do it?

Despite what most mutual fund marketing says, timing is a very important element in attaining superior financial returns. The theory of market timing is simple – you want to be purchasing things that are out of favour, ideally in panic situations, with the realistic chance of things not being as gloomy as the price might indicate. The actual practice of market timing is far, far different. Fund managers have pressures to be fully invested and attain steady returns for their clients (one reason why fixed income investing has become so popular since the financial crisis). People have itchy trigger fingers and have to “do something” with their money, lest it earn zero percent interest!

It is this reaction, “do something”, that causes capital to be pushed into securities with sub-par returns and as a result, will incur portfolio losses whenever the next crisis occurs.

Indeed, the emotion of seeing the market rise when you are sitting on cash is more powerful than the emotion of loss when you are invested in something going down.

Having a huge performance gain creates its own difficulty. Indeed, since I have outperformed the major indicies, on average, by more than 10 percentage points over the past 10 years, it creates its own performance issue when I decide to bunker down and play defensive. I am not concerned, nor do I face external pressure from clients to maintain a high level of performance. What is hidden in these performance numbers is the risk I took to obtain these numbers in relation to performance.

I am willing to hold onto cash for longer than most people in order to ensure that when the cash is invested again, it is invested in the best risk/reward opportunity that would give me an edge over the market. Sometimes the market presents opportunities (like last February) that are so obvious, and sometimes the markets are completely shut, like I am finding them now. There is no point for me to force the matter – instead, I should just take a long vacation and wait and see.

This is probably why I would never work well in a typical finance firm – telling my bosses that the best thing we can do for now is to entirely invest in cash would get me fired.

Something I find disturbing is that there are similar other prominent individuals, ones with a lot more cash in the piggy bank than me, in the marketplace that are positioned in a similar manner. When lots of participants in the market have cash, it is not a condition that is ripe for a market crash. My general thesis is that markets will remain choppy for the indefinite future and most of the money is likely to be made in yielding instruments.

This is why I’m not too afraid of my existing portfolio structure, which is heavily biased towards fixed-income securities.

In terms of portfolio outlook, I really do not see excessive outperformance between now and the end of the year. At the absolute highest, I’d expect to see another 5% for the quarter, but I think this is a stretch. I also believe there will be volatility caused by US Presidential Election antics. We will see.

The last thing I would like to remark upon is the gross performance figure over the past 10.75 years – there is a chance that this performance is just pure luck. I would not extrapolate 17% into the future – maintaining this type of performance is very, very difficult. I have outperformed 99% of all hedge fund managers out there, albeit I have an advantage with an incredibly smaller base of capital to work with than they do. That said, I am confident that I cannot keep this pace.

Portfolio - 2016-Q3 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
10.75 Years (CAGR):+17.3%+5.3%+7.5%+2.5%+5.5%

Difference Capital

Difference Capital (TSX: DCF) was the venture capital corporation created by Michael Wekerle in 2012 (done via reverse merger of an existing corporate entity). It invested in a whole bunch of private entities in the hopes of making superior returns. While the going was initially good, it has steadily eroded in value as demonstrated by the five year chart.


In its modern incarnation, it has about $79 million invested (mostly in equity, and the rest of it in debentures and real estate) along a smattering of mostly private entities. They did employ some leverage in the form of a convertible debt offering and they did get in a bit of financing trouble as a result of the debt issuance, but for the most part they cleaned this up in 2015-2016 through buying back the debt at a discount, from $47 million outstanding at the beginning of 2015 to $32 million on June 30, 2016. The debt has an 8% coupon.

They also have $16 million in cash, and an extra $3 million in receivables if some of their prior asset sales do not incur claims by the end of 2017.

The math is simple – can they cover the $32 million in debt over the next couple years? Assuming there are no material claims, they have $37 million to pay off in interest and principal (interest expense assuming no buybacks), which leaves them about $18 million short if you completely dedicate their existing cash and receivables against their debt. Their burn rate is also about $3 million a year, excluding interest, offset by about $1 million in investment income.

The equation then becomes a matter of raising $22 million over the next couple years to service their debt, or to obtain an extension of their debentures (with some sort of sweetener). I view the latter to be the more likely scenario, but it is quite conceivable that they could cash out an investment or two and partially chip away at the $22 million figure. The other option is to equitize the debt at maturity, but this would be done at a significant discount to their proclaimed NAV.

The debt is trading at 97 cents on the dollar and given everything I have seen, I would view it as over-valued at present. The market is weighing the probability of a clean maturity to be too high.

No positions.

Petrobakken / Lightstream Resources bites the dust

Lightstream Resources (TSX: LTS), formerly known as Petrobakken (TSX: PBN), was formerly a subject of analysis on this website. Despite the company having excessively high yields and posting (and boasting) about huge cash flows through operations, I remained very skeptical of them. Then the oil price cratered at the end of 2014, and then all the excess leverage the company held came to bite it.

The senior unsecured creditors failed to reach an agreement with the company, and as a result they will be going into CCAA proceedings.

I have never held shares of this company. The entity, once restructured, should be mildly profitable in the current oil price environment, but they need to shed a healthy quantity of their debt. It is a classic case of using too much leverage when the times are good.

Turning down a very likely 12% annualized return

There is a catch to the title – the 12% annualized return is in the form of a 6.6% return over six and a half months.

I have mentioned this before (at much higher yields) but Pengrowth Energy debentures (TSX: PGF.DB.B) is probably the best low-risk/medium-reward opportunity in the entire Canadian debt market today. At the current price of 97 cents (plus 5.5 months of accrued interest payments), you are nearly guaranteed to receive 100 cents plus two interest payments of 3.125% each. The math is simple – for every 97 cents invested today (plus 5.5 months coupon which you’d get 6 months back at the end of September), you will get 103.4 cents on March 31, 2017, the maturity date. This is a 6.6% return or about 12% annualized.

By virtue of Pengrowth’s debt term structure, this one gets the first crack at being paid by their billion-dollar credit facility which was untapped at the last quarterly report.

The only risk of any relevance is that the company will opt to exchange the debt for shares of PGF at 95% of the 20-day volume-weighted average price, but considering that the debenture face value is $126 million vs. the current market cap of $1.1 billion, the equity would not incur too much toxicity if management decided to do a virtual secondary offering at current share prices.

The company did give plenty of warning that at June 30, 2016, current oil/gas price levels and a 75 cent Canadian dollar would result in them potentially blowing their covenants in mid-2017. But this is of little concern to the March 31, 2017 debenture holder. They will get cashed out at par, either in cash or shares.

I own some of these debentures, which I purchased earlier this year when things were murkier and much more attractively priced. Given some recent liquidations in my portfolio, I could have reinvested cash proceeds into this apparently very low risk proposition. But I did not.

So why would I want to decline such a no-brainer opportunity and instead funnel it into a short-term bond ETF (specifically the very-low yielding Vanguard Short-Term Canadian Bond Index ETF at TSX:VSB)?

The reason is liquidity.

In any sort of financial stress situation, debt of entities that are “near guarantees” are traded for cash, and you will suddenly see that 97 cent bid moved down as entities are pressured to liquidate. For securities that are precious and safe, such as government AAA bonds, there is an anti-correlation to market pricing that occurs and ETFs holding these securities will be bidded up in response.

VSB is not something that you are going to see move up or down 5% overnight in a real panic situation, but it will retain its liquidity in stressful financial moments. The selection of VSB is different than the longer-term cousin, which has more rate sensitivity, but something has changed in the marketplace where equity and longer term debt asset classes have decided to trade in lock-step: as demonstrated in last week’s trading in Japan and the Euro-zone. When equities and long-term government debt (nearly zero-yielding, if not negative) trade in the same direction, it gets me to notice and contemplate what is going on.

The tea leaves I have been reading in the market suggest something strange is going on with respect to bond yields, the negative-interest rate policies and their correlation to equities. I’m not intelligent enough to figure it out completely, but what I do know is that putting it into so-called “low risk” opportunities like Pengrowth debentures come at future liquidity costs in cash if I needed to liquidate them before maturity. Six and a half months can be a long time in a crisis situation, and we all see what is going on in the US President Election – markets are once again seriously considering Donald Trump’s election now that Hillary clearly isn’t healthy enough to be Commander-in-Chief of the US Military. The public will ask themselves: If she can’t stand up to attend a 15-year memorial of 9/11, what makes you think she will be able to stand up when the terrorists strike the homeland again?

The markets have vastly evolved since last February where things were awash in opportunities. Today, I am seeing very little that can be safely invested in, which is getting me to change what I am looking for, but also telling me that I should relax on the accelerator, raise cash, and keep it in a safe and liquid form until the seas start getting stormy again. And my gut instinct says exactly that: winter is coming.