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.

dcf

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.

De-leveraging

Leverage is great – only when everything is appreciating. Indeed, if things appreciate, the leverage ratio goes down since the loan-to-equity ratio goes lower. A simple example is taking a $100 portfolio, borrowing $100, which gives you a 50% loan-to-equity ratio. If your portfolio appreciates 10%, the loan-to-equity goes down to 45%, and suddenly you’re feeling more comfortable again.

This basically explains the real estate market – you buy a house, take a mortgage for 80% of the house value (paying 20% down), and when the real estate market goes up 40% (like it has in the Vancouver area), suddenly your loan-to-value ratio goes down to 57% – let’s suck more money out of the house and get that back to 75%! This means borrowing another 25% of your original house value.

This all works, until the underlying asset value falls and you have to pay back your loans. In the instance of an initial 80% loan-to-value, a price drop of 10% means the loan-to-value goes up to 89%.

The same dynamics go for portfolio management – leverage is painful in the down direction because your loan-to-equity ratio becomes more concentrated.

Clearly, the best time to de-leverage is when you’ve made your anticipated gains.

I’ve started to take some money off the table. Specifically, Genworth (NYSE: GNW) and most US insurers have gotten hot because of the probability of the federal reserve increasing interest rates again.

After raising cash, the most difficult part of investing is to wait. The easiest way to lose money is to do something with cash just because it is earning zero yield in the brokerage account.

Genworth MI – Despite housing slowdown, still undervalued

mic

Genworth MI (TSX: MIC) has gone nowhere in the past three months, despite the corporation lowering losses from insurance claims and the housing market being relatively stable to date. The company trades at a 10% discount to book value, and also at a P/E of 9 (realizing that these two metrics are not the only ones that insurance companies should be valued by, but suffice to say, unless if the insurance written is completely bad, it is difficult to lose money when buying something under book and under a P/E of 10).

There are a few cautionary flags – the reduction of their portfolio insurance business (which allows third-party financing firms to securitize and sell their lower loan-to-value mortgages with portfolio insurance) and also the slowdown in housing sale volumes, combined with the attempts by the BC Government to quell foreign ownership with a 15% transfer tax for non-permanent residents or citizens.

In particular, the transfer tax has caused quite a quenching of the roaring housing fire that was occurring in the southwestern BC housing market. This in turn has spooked the various markets linked to residential real estate. However, it is my assessment that as it relates to mortgage insurance, the market has continually over-estimated the impact of the short-term gyrations in Canadian real estate.

What would cause issues is mortgage serviceability and this is a function of employment, not housing prices. Although there is correlation between housing prices and construction-related employment, if there is not mass unemployment it is difficult to see how somewhat lower housing prices would cause difficulties in the mortgage insurance space. Indeed, the $300 billion ceiling for private insurance in Canada seems to be more of a daunting barrier than the state of the actual insurance market.

It is worthy to note that during the depths of the 2008-2009 financial crisis that the loss ratio peaked out at 46% (June 30, 2009) and this still resulted in a profitable book for the firm. The subsequent combined ratio peaked at 62%, which means that for every dollar of revenue booked that the firm recorded a gross profit of 38 cents.

Also, the corporate has increased its quarterly dividend every year for the past 5 years – it is currently 42 cents and if prior patterns continue they will likely raise it to 45 cents per share. Although the yield is not important (cash generation is), there are various market participants out there that only care about yield and this would serve to boost the stock price.

Bombardier debt trading like it is investment grade again

What a difference a year makes for Bombardier’s (TSX: BBD.A, BBD.B) credit profile:

bbd

Their credit profile over the last year has improved considerably – they can now tap debt capital from the market at reasonable rates. Right now the closest comparable is the 8.5 year maturity for 8.5% yield.

The market is clearly believing that their solvency concerns are over. This would likely get cemented (and yields will compress even further) on successful deliveries of CS100/CS300 jets to their customers, of which two are already delivered and 356 are currently in the pipeline.

The more junior preferred share (TSX: BBD.PR.C) with a 6.25% coupon is trading at a current yield of 9% (eligible dividends), which should continue to go lower as confidence increases in the firm’s ability to be financially sustainable with the C-series. The rumours of the pending Learjet sale would also be an injection of capital if it did occur, but it does not appear that this is necessary, nor is the rumoured injection of capital by the Government of Canada (although this might occur to give future customers the impression that the government will not let the company fail).

The common equity remains pinned around CAD$2/share, and there is considerable overhang from the warrants issued from the two Quebec financings. I doubt that there will be cash dividends on the common shares until the turn of the next decade.

Selling volatility works, until it doesn’t

Since February, yields have compressed to the point where I am getting a bit suspicious that we are going to see some spreads widen again whenever we get some sort of credit event that will cause another round of financial distress. I am not forecasting when this will happen, but historically speaking, the lead-up to the presidential election always causes unwelcome volatility. Right now the assumption is that Hillary will win, but between now and the early November election date, things will change when the public actually starts to pay attention again to their two choices.

The markets, however, do not appear to indicate to price in much risk. Following is a chart of the VIX:

vix

The last time volatility got that low was back in the middle of 2014 (remember when oil was at US$100/barrel?).

Volatility is typically anti-correlated to positive price movement. Right now, investors that sell risk on the main index are not receiving much money for what is a piddling amount of yield – an at-the-money option sold a month out on the S&P 500 will only yield an investor about 1.1% on their at-risk amount, which is very, very, very low. Looking out nearly 5 months to mid-January, that same premium is 3.7%.

In the event of a market crash, an investment in put options not only profits due to the pricing differential between market and strike, but also due to the increase in volatility that occurs during turbulent markets. There’s probably never been a better time to invest in a potential market crash than right now, but the phrase that says markets can be calmer for longer than one can remain solvent applies.

Indeed, I am seeing many market prognosticators talk about skepticism of the existing market conditions, that the indexes (which are at all-time highs) are sputtering, that the economy recovery is long in the tooth, etc, etc. This does not bode well for crash conditions, which happen when there is stress and underlying causes to force entities to liquidate at all costs.

I can’t conceive what could cause crash conditions other than a major WMD event to the scale of a 9/11.

I still believe that a cautious approach is appropriate and that the market participants that will get the most out of the market will do so on the fixed income side. However, these opportunities I have noticed have basically vanished from the good risk/reward column to just ordinary. Ordinary valuations are good enough for me to hold onto things, but not nearly enough for me to invest in.

I was fortunate enough to fully participate in this market cycle, but in general at present, I am in a very slow liquidation mode as I do not see much worth investing in. There are a couple portfolio components (fixed income) that are trading at prices that are within 5% of me dumping it, but I am no rush for them to get there – I will keep collecting dividends, distributions and interest to pay down the very low interest margin debt. In general, I see about a maximum capital appreciation of about 15% in the remaining portfolio for still relatively low risk – even if the actual appreciation is zero, the weighted average coupon is 7.9% and I get paid to wait.

If we get some sort of spike that caused a general portfolio rise of 10%, I would have sold enough to have a healthy double-digit percentage cash balance. If this portfolio spike was 15% from present levels, the only things I’d be holding would be my bonds to maturity (unless if those too were trading ridiculously above par value). Then I would go on vacation and wait a long time.

Sometimes I am furiously active on trading, and sometimes there are very dull moments. The past few months have been very dull and I’ve been twiddling my thumbs. My investment strategies have been working and there will be a time to shift gears once my current strategy has run out of gas. Just not today.

An incorrect call made in the past – Whistler-Blackcomb

Everybody likes writing about their winners, but it is equally important to understand why failed predictions end up so.

Many, many, many years ago, I wrote about Whistler-Blackcomb’s (TSX: WB) IPO and about how I was quite leery about it.

With today’s acquisition offer by Vail Resorts, it should end this particular story – and was I ever wrong about the market valuation of the entity! WB went public in 2010 at $12/share, and they closed today at $36.63 a share, which would be about a 21% compounded annual gain for shareholders. I said when they got public “I might think about buying at $5.30/share”, but it never got close.

Why was I so incorrect with my projections? Putting a long story short, their resort operations ended up producing more profitable revenues than I originally anticipated, coupled with the fact that their capital expenditures remained below their ability to rake in cash flow – their net debt situation has been positive (i.e. net debt reduction) since they went public. With increasing profitability and decreasing financial leverage, I believe the partners of the Whistler-Blackcomb entity have done very well financially.

I never liked the fact that a good chunk of the publicly traded entity only represented a partial amount of the full operation – there was a huge amount of minority interest that would have siphoned a lot of economic upside. There were other residual risks (Whistler is quite developed as it is and there is significant political cost to further development in the area) that made me skeptical of the performance of the corporation. There was also the nagging feeling that the company was trying to cash out on the Vancouver 2010 Olympics.

The takeout price (a combination of roughly half cash, half stock in Vail Resorts) is higher than I would have ever expected such an offer to be. The acquisition is strategic in nature, so Vail Resorts should be able to achieve some sort of cost synergy with Whistler. That said, I’d be happy with the price received.

I have never owned nor shorted any shares of WB, and I am glad to have not!

Genworth MI Q2-2016 results review

Genworth MI (TSX: MIC) reported their 2nd quarter earnings results.

The results are reasonably positive for investors and a shade higher than what the market expectation would be.

Diluted book value per share goes to $38.23, up a dollar from the previous quarter (higher than net income minus dividends due to portfolio fluctuations).

Premiums written were $249 million, up significantly from $205 million in the Q2-2015, but this number was artificially higher due to the closing of the July 1, 2016 regulatory window for the issuance of portfolio insurance (i.e. future portfolio insurance issuances are likely to be significantly lower). Portfolio insurance written has been averaging about $24 million for the previous four quarters, but this quarter was $78 million. Transactional insurance (the type of insurance most people associate with mortgage insurance) was down 7% to $170 million.

Portfolio insurance has been quite profitable as the constituents of the loans are low loan-to-value ratio material – although the premiums received by the company are relatively low to the loans insured, these premiums are basically free money exchanged to entities so those other entities can free up the capital to make other loans. The government announced they were going to put a halt to this activity in the 2013 Budget as entities (e.g. HCG, EQB, etc.) were basically using government guarantees to increase their ability to perform higher amounts of mortgage lending. Now the lenders will have to take higher risk, which would potentially dampen the credit market for residential housing.

Other items of note include the following (quotations are from their MD&A):

The Company has reviewed the proposed methodology for calculating SCRIs and observed that Calgary, Edmonton, Toronto, Vancouver and Victoria would breach their respective prescribed SCRI thresholds at the end of the first quarter of 2016. These metropolitan areas represent approximately 35% to 40% of transactional new insurance written in the first six months of 2016.

Calgary, Edmonton and Vancouver would have been in breach of the prescribed SCRI thresholds since 2010 or earlier and are currently more than 15% above the respective SCRI threshold. The anticipated changes from the proposed new capital framework, including the proposed supplementary capital requirement may impact the regulatory capital requirements for the Company however the final impact will not be known until OSFI publishes the supplementary capital requirements. The Company expects that transactional and portfolio insurance premium rates may have to be increased for affected metropolitan areas as a result of the implementation of the new capital framework in 2017.

If the regulatory framework continues to tighten (i.e. more capital required for “hotter” markets), this would result in increased mortgage insurance rates and hence higher premiums written for future transactions – or perhaps premium surcharges for “hot” metropolitan areas. Not surprisingly, Vancouver is the epicentre of this.

During the quarter the Company entered into a $100 million senior unsecured revolving credit facility, which matures on May 20, 2019.

This was very mysterious. Genworth is solvent, their nearest debt maturity is not until June 15, 2020 ($275 million) and they have plenty of capital that they are using as a buffer until federal regulations are finalized. So why go through the bother to open up a credit facility? Odd.

(Update, August 3, 2016: Remarks were made in the conference call:

CFO: “It’s not earmarked at this time for any specific activity. It’s more in light of build-in financial flexibility to ensure that we’re nimble and whether this is core business opportunities in the MI business, for example, you saw the levels of bulk insurance as we did last quarter. If in the future other opportunities were to present themselves in our core business, and it require incremental capital, we certainly have long-term plans to fund that capital. We may use the facility for short-term need but it’s clearly not intended for a long-term portion of our capital structure.”)

The loss range for 2016 has been revised to 25% to 35%.

The company’s initial projections for losses were 25-40% for the year, but the upward range of this was lowered to 35%. For the first two quarters of the year the loss ratio averaged 22%. This is obviously a good sign for investors.

In order to help improve housing affordability, on July 25, 2016 the B.C. government introduced a four-pronged plan that includes an additional land transfer tax on foreign buyers. As of August 2nd, foreign individuals and corporations will be subject to an additional 15% land transfer tax on the purchase of residential property in Metro Vancouver. The company does not expect these changes to have a material impact on its business, as foreign borrowers are typically not eligible for high loan-to-value mortgage insurance.

I will parenthetically add that foreign buyers typically do not take out mortgages for properties either – these are cash payments as the real estate title is the vessel for storing cash offshore. Foreign investors would not have a requirement for mortgage insurance.

Also, delinquency rates have lowered from quarter-to-quarter. While Alberta and Saskatchewan have higher delinquencies, they have lowered significantly in Quebec. I would also estimate that the severity of the real estate market decrease in Alberta was less pronounced than projected.

Not everything is rosy, however. There are a couple other storm clouds worth noting:

1. The company has lost a considerable amount of money on its preferred shares. They have $49 million in unrealized losses as of the end of June on their preferred shares, which is down from $51 million at the end of March, but this is very sloppy pickings by their asset managers.

2. Private mortgage insurers are approaching a $300 billion cap:

The maximum outstanding insured exposure for all private insured mortgages permitted by the PRMHIA is $300 billion. The Company estimates, that as of March 31, 2016, the outstanding principal amount of insured mortgages under PRMHIA was $197 billion for Genworth-insured mortgages and $241 billion for all privately insured mortgages. While the federal government has increased the cap to ensure that the private sector can continue to compete with CMHC in the past as the total of the outstanding principal mortgage amounts has approached the legislative cap, there is no guarantee that this will continue. The Company estimates that the private sector will remain below the cap for the remainder of 2016 and the first half of 2017 based on the current market share of the private mortgage insurers and the forecasted size of the mortgage originations market.

The inability to capture more of the mortgage insurance market beyond $300 billion, needless to say, would be a negative – the company would have to run off the book and only acquire insurance at the rate that it expires. I am also not sure how Genworth would coordinate with the other private insurance company (Canada Guaranty) to collectively stay under the $300 billion mark. This is a line item that would need to be addressed in legislation, specifically the 2017 Budget, and I would not view the current government to be supportive of private industry in mortgage insurance markets.

Finally, I will observe that the company is unlikely to buy back shares or declare special dividends until such a point that the regulatory framework for capital holdings is solidified.

Overall, my conclusion still remains unchanged that Genworth MI appears to be somewhat undervalued at present (trading at 89% of book value, with a strong balance sheet and low loss ratios). The market is clearly pricing them lowly due to the increasing speculation of over-valuation of real estate pricing in Canada, in addition to the balance sheet issues faced by their parent company. Genworth MI appears to be very aware of the Canadian real estate issues at hand. As I have been long-since speculating, given the issues that are going on in the parent company (Genworth Financial), Genworth MI is a likely candidate to be taken over if Genworth Financial finds the correct (and willing) purchaser. The take-out price would most certainly be higher than the current market price.

Mortgage insurance concerns

The provincial government in British Columbia is trying to balance the politics of housing prices in the Greater Vancouver Regional District and the fact that housing and housing-related economic activity is our #1 source of economic activity.

The government knows that if they take policy decisions to snuff out the fire that is currently raging in real estate that they will collapse the economy into recession – our other industries (mining, forestry, oil and gas) have been withering away and this leaves real estate as our number one export.

Managing a “controlled landing” will be an interesting feat. I’m not sure whether the government can do it, but we will see!

CMHC released a report (July 27, 2016) confirming something almost anybody on the ground here knows: in real estate, there is “strong” evidence of problematic conditions in the Vancouver and Toronto regions of Canada.

This has implications for mortgage insurance. While rising prices is great for mortgage insurance (i.e. there is a much lessened chance for mortgage defaults), the residual concern is one of regression to the mean – if insurers write policies for people taking mortgages at the peak of pricing, insurers will have a considerable amount of downside exposure in the event there is a deep decrease in real estate pricing.

The last time that real estate prices fell for any significant period of time in the region was back in the early 1980’s:

June-2016-REBGV-Stats-1977-to-June-2016-Price-Chart-for-Vancouver

Interest rates at that time were in the double digits. Real estate from the beginning of 1981 to the end of 1982 dropped by about 40%, but you would never detect it by looking at the chart above – this is why stock charts use a y-axis that is logarithmic scaled, not linear like the one you see above.