Brookfield swallows North American Palladium

North American Palladium (TSX: PDL) operates a mine which has been somewhat profitable, but financing expenses have killed any chances of the overall operation returning money to shareholders.

Balance sheet-wise, they invested $450 million in mining operations, while having a $220 million debt to deal with and a requirement for some cash, which they do not have. A classic case of solvent, but not liquid.

The primary cause of this was doing a deal with the Brookfield devil, where management borrowed US$130 million at a rate of 15% interest in June 2013. The debt was secured by PDL’s assets. Not surprisingly, it has gone financially downhill since then. The debt has since morphed into US$173.2 million as interest has been subsequently capitalized into the loan (and other drama that has happened since that point which I will not get into).

What’s amazing is the corporation somehow managed to find enough suckers to invest in some toxic convertibles in 2014 that significantly diluted the company’s equity but kept enough cash to keep the zombie alive for another year.

Finally, they succumbed to having a quarter of your revenues go out the door in the form of interest expenses and are coming to grips in the form of a recapitalization proposal.

The term sheet (attached) that management came up with to ensure its own survival is quite onerous to all involved.

The salient details are that existing shareholders will keep 2% of the company, unsecured debenture holders will receive 6% of the new company, and Brookfield and partners will keep the 92% after generously injecting US$25 million and releasing their accumulated debt to the firm. Afterwards, Brookfield will float a rights offering where they will raise another CAD$50 million and this will presumably dilute the interests of the then-common shareholders even further if they do not wish to participate.

A holder of 52% of the convertible debentures has been spoken to and agrees to this proposal. They need 2/3rds approval, which is likely considering that the convertible debentures are unsecured and they would receive nothing if the company went through the CCAA route.

Not surprisingly, existing shareholders/debentureholders of PDL took down the price:

PDL.TO share price

PDL.TO share price

PDL.DB.TO price

PDL.DB.TO price

The recapitalization document was released on the morning of April 15, 2015 half an hour before trading opened, so astute traders that could skim through the news release and the actual term sheet would have been able to get out at 19 cents if they hit the opening market trade. If you waited until the end of April 15, you would be sitting at 12 cents.

At 7 cents per share of PDL stock and roughly 400 million shares outstanding, the market is valuing the recapitalized version of PDL at CAD$1.4 billion.

It does not take a genius to figure out that, with $220 million in revenues in 2014, the existing stock price is still significantly over-valued. If I was owning any shares of this train wreck, I’d still be dumping at market. Fortunately I’ve never owned any shares (or debt!) of PDL. Purchasing a mining operation at 7 times revenues is not exactly a value play.

However, the albatross of having to deal with a crushing 15% senior secured loan will be off their backs and the resulting entity may have a fighting chance when it doesn’t have to shell out $50 million a year in interest expenses. You just have to figure out at this point what Brookfield’s incentives are to ensuring they get the most of their 92%+ equity stake in a post-recapitalized PDL.

Q1-2015 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2015, the three months ended March 31, 2015 is approximately +0.7%.

Portfolio Percentages

At March 31, 2015:

40% equities
3% equity options
2% equity warrants
31% corporate debt
24% cash

USD exposure: 57%

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.


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

This was an odd quarter. There was some accumulation of five new names in the portfolio, which to my knowledge is a record for me in accumulating names – I’m usually a little bit more calm. The new acquisitions amounted to approximately 18% of the portfolio. One of them I bought both the equity and debt of the issuer, and I obtained about 80% of the equity position I wanted to in this before it began to skyrocket upwards. Oddly enough the debt remains roughly at the same level where I had bought it – one of the debt or equity markets has to be correct (unfortunately in most cases it is usually the credit markets provide the better insight on pricing simply due to the fact that irrational retail investors rarely trade in debt – they usually deal in the equity).

The portfolio continues to remain concentrated in the name of mainly three issuers. The lead one, which I have still not disclosed, did a successful debt rollover during the quarter and also closed a divestment that resulted in an after-tax gain that will bring its reported tangible book value about 10% higher than what the current market value of the stock is. Although ambient market conditions have not been tremendously good for the underlying business, it is a matter of time before this will turn around and a simple matter of being patient and waiting for the market to take the stock up to a proper fair value. Management is also on-the-ball by repurchasing shares under book value, which results in appreciation of the book value figure. It has been about 18 months since I took my initial stake, and have been twiddling my thumbs and waiting for meaningful appreciation.

The portfolio also holds some equity in Genworth MI (TSX: MIC) that I have written about many, many times before. This company is trading as a proxy for expectations on Canadian real estate in general, and is trading below book value (as of the date of this post, a market value of CAD$31/share, book value of CAD$35/share). Management has been relatively cautious because of the economic frailty of the Alberta and Saskatchewan markets, but I believe it would be well contained. Frankly, they should be repurchasing shares at current prices rather than giving out dividends. Not only would they get a “5% yield” on their investment, but they’d also be purchasing a dollar for 85 cents.

Speaking of 85 cent dollars, I’ve also written about Pinetree Capital (TSX: PNP) and their ongoing saga. I own some of the debt. The debtholders (specifically some Toronto financial institutions that combined have more than 2/3rds of the debentures) have forced an arrangement where they amended the debt agreement to secure the assets of the underlying company and now the new directors face a liquidation challenge to ensure that they are paid off. Management will be required to redeem $20 million (36% of their debt outstanding) by the end of July and up to one-third of this can be in the form of issued (and highly dilutive) equity. There is a very tight leash (covenant) that will be tested on July 31st (50% debt-to-assets ratio) and October 31 (33% debt-to-assets ratio). If management cannot reduce its debt to assets ratio to 33% or under, they will continue to be in breach and debtholders will extract another pound of flesh. The redemption structure will also likely result in the debtholders retaining some sort of equity influence over the company if the company cannot redeem in cash. It is a very interesting incentive structure.

There is a redemption that will occur on April 30, 2015 that will remove 18% of my position in the debt; presumably future redemptions will reduce this fixed income level in my portfolio to a smaller amount. a I am not intending on repurchasing the debt at current market values – I am relatively grateful to be getting my money out at pr plus 10% accrued interest. I will also note that the debt-to-assets ratio at the end of December 31, 2014 was 52%.

There’s a lot of fixed income in my portfolio, and most of it could be considered to be highly speculative debt. In all of these cases, there is a high underlying incentive structure to ensure the debt either gets paid off, or rolled over. Only time can tell whether I have been able to pick needles out of a junky haystack.

Future Outlook and musings

The big news is going to be what will happen to the oil market. It is early in the game. We will likely need to see more consolidation in the oil and gas space before we will see some real appreciation in the commodity price. Strategically speaking, however, companies like Canadian Oil Sands, Cenovus, Suncor, etc., are all very relevant to Canada’s energy security framework and are trading a lot on asset value rather than current underlying cash flows. There has been a lot of equity raises in the oil and gas market and as a result, this will likely have the effect of seeing capacity continue being built and warrants further waiting before jumping in. When hedges start to expire in 2015, it will continue the financial pressure on firms with higher cost structures. Eventually there must be consolidation and a slowdown of production as drilled wells exhibit decaying output.

Companies involved in oil infrastructure (e.g. drillers such as Transocean, Seadrill, etc.) and other related companies (e.g. the servicing industry) have equivalently been hammered due to capacity management issues. There have been some firms that have other businesses not related to oil and gas and they seem to have been a classic case of “throwing the baby out with the bathwater”.

A commodity that has been beaten to death since the last decade is Uranium, especially after the Japanese earthquake. I have been giving this sector a bit of attention as of late. One of the unnamed companies in the portfolio mentioned above is an indirect proxy play on a potential resurgence of nuclear power or nuclear re-armament. It has been absolutely miserable times to be a Uranium producer, but I believe enough capacity has been stripped out of the system that we might start seeing some life in the sector again. This (similar to oil) will not be a quick process, but most of the damage to the sector has already been done. Indeed, when I initially looked around for an ETF, I could only find one.

When Bombardier did its announcement that it was seeking equity funding and suspending its dividend, I thought their preferred shares (specifically BBD.PR.C) was a steal at around $15/share, which would have provided an over 10% tax-preferred yield. The Bombardier family has a huge incentive to ensuring that it does not lose control of its company, and while they have every right to suspend preferred share dividends, I very much doubt they will take that measure unless if everything else has been exhausted first. Unfortunately I missed the boat on this trade.

If you believe interest rates are going higher (I do not), then buying preferred share instruments that have floating-rate characteristics (or at least a rate reset every five years) would appear to be a huge investment opportunity. Most issues are trading at insanely depressed prices from par value and patient investors would likely see yield and capital appreciation in the event of an uptick in interest rates. However, the Fairfax theory of global deflation appears to be the winning theory at present, and indeed, Fairfax itself is trading at such a huge premium over book value that a large part of the market believes them.

I also believe the huge amounts of sovereign debt trading at negative yields (Switzerland, Denmark, Germany, etc.) is a fairly good sign that there are fundamental issues going on within the whole global monetary system. How this ends up breaking will be a good question as there will be plenty of money to be made for the resolution.

I note that China is slowly slipping into the currency exchange markets with the internationalization of the Renminbi. What will be even funnier is them selling a boatload of Chinese paper and then devaluing their currency. Do people ever learn? Also, the Shanghai stock index appears to be a reasonable creation of the 1928 Dow Jones Industrial Average. History may not repeat itself, but it indeed rhymes.

Genworth MI and Canadian real estate speculation

It is fairly obvious by looking at the graph of Genworth MI (TSX: MIC) that institutions are dumping stock in fears that mortgage default rates are going to spike up as a result of economic calamity in Alberta. The CEO of Genworth talking about “heightened vigilance” isn’t helping matters any.

While this might be true, it appears that other real estate metrics are relatively in tune. My cursory scans of the REIT market (e.g. Riocan, H&R, Calloway, all apartment trusts, etc.) doesn’t show any erosion in that marketplace. Banks (e.g. BMO, BNS, etc.) are showing some equity erosion since the middle of 2014, but I’d suspect this is more due to yield curve compression and partially due to the solvency risk posed by syndicate loans to various oil and gas companies.

Other direct lenders, mainly Equitable and Home Capital, have both seen erosion but it is not significant to the point where one would think there is going to be a complete and utter collapse in the fundamentals.

Genworth MI appears to be the whipping boy in the real estate industry. If such fears are warranted, then one would think that REITs and other related stocks would also get proportionately taken down.

So the question now is whether the market is wrong about REITs or wrong about Genworth. Assuming the negative momentum for Genworth MI continues, one would guess that looking at the financial metrics and historical charts (and then-fundamentals of the company at that time) that it is conceivable the stock can get down to about $22-23/share as a floor. This is based on the discount assigned to the stock during the mid 2012-2013 period and the fundamentals of the company at the time.

Today is a little different in that the company has less shares outstanding and has more equity on the balance sheet.

Assuming the Canadian real estate market does not completely nose dive, an investor would still be looking at around 20% downside on existing technical momentum, but fundamentally there is still significant value as the firm is trading deeply below book value at present (right now at a 20% discount). It is like purchasing a leveraged bond fund at a significant discount.

The combined ratio (this is the loss ratio plus the expense ratio) during the depths of the 2008-2009 economic meltdown, did not go above 62%. Delinquency rates never got above 0.30%. Today, it is 39% and 0.10%, respectively. Yes, these numbers will increase as people start defaulting on their Alberta homes, but I simply do not see at present those numbers getting worse than it was in the 2008-2009 era.

I am watching this carefully and may choose to add to my position.

Pinetree Capital – Redeeming debentures

Pinetree Capital (TSX: PNP) today has announced it is redeeming $10 million of its debentures, at par value plus accrued interest, effective April 30, 2015.

As readers are aware by my previous rantings about Pinetree, their debt has been a remarkably good deal, especially around the 70 cent range, but they are still a reasonable risk/reward at 80 cents. The extra security that was arm-wrestled from management once they blew the covenants is icing on the cake.

Debenture holders will be cashed out pro-rata, which works out to an 18% redemption of debt. I’ll be hard-pressed to find a better alternative for the cash, but I’ll be happy to have it sitting in the bank account until such a time.

The market value of the debentures was bid/ask 80/83 cents and considering the cash-out is at par, this will likely result in an increase in the quoted price for the remaining debentures.

Notable to this announcement is that this is going to be funded by cash on hand, which implies that the company has been doing some liquidation of its non-disclosed holdings (these would be less than 10% ownership stakes in various firms). There has only been a minor trace of activity on SEDI on their 10%+ ownership stakes (the two largest that are publicly known is POET Technologies (TSXV: PTK) and Sphere 3D (Nasdaq: ANY)).

Also notable is that this is the first $10 million of the $20 million that is required to be redeemed by July 31, 2015. Up to half of the remaining amount can be done through open market transactions and also the company has the option of redeeming 1/3rd of its debentures in the form of equity, which has not been the case to date.

Finally, Pinetree has not released its 2014 year-end audited financial statements, but one can assume that they will be able to with this redemption notice. The annual statements are due on March 31, 2015 otherwise very bad things happen to reporting issuers that do not report.

Pinetree must have a debt-to-assets ratio of 50% up until October 31, 2015 and then after that it must be below 33% otherwise it will be in default of its debt covenants (once again). We should get a better view of what may occur once they file their 1st quarter report. Achieving 33% is going to be made much easier once they complete $20 million in redemptions and the question is whether debenture holders are going to receive equity or not (which would likely give debtholders control of the firm).

I’m expecting there will be a reasonably decent chance that investors in the senior secured convertible debentures will be made whole and also be able to collect a 10% coupon between now and the May 31, 2016 maturity date.

Some portfolio activity

It has been an unusual month in that I’ve been nibbling and taking some small positions on some reasonable bargains.

I’ve taken a half percent position in a very trashy penny stock that will most likely go permanently unnamed. This isn’t a microcap play, it isn’t a nanocap play, it can only be called a picocap play. Suffice to say it is illiquid, infrequently traded, but I managed to get a reasonable fill on what I wanted to get and we’ll see if it goes to zero or whether it’ll triple on some business developments which I believe will stand a good chance of occurring over the year. If anything, at least there is a corporate shell that can be sold as a quick TSX listing.

I find rolling over options to be a royal pain in the rear for stocks that have infrequently traded options. The only reason why I’m in options in the first place is because I believe the implied volatility is badly underestimated (trading in the 20’s when it should be closer to the 40’s) which makes the options a more optimal usage of capital than the common stock. When trading options the only problem is timing, and dealing with a large chunk of a barely in-the-money option when there is a month left to expiry always makes me nervous. So I’ve rolled that over into the latest dated options which is roughly half a year later in time for a moderate cost of about 4.5% of the equity price. The cost of purchasing delta is quite cheap on this one, especially when it is trading under book value and they are buying back shares, coupled with a profitable business operation. Quite frankly I expect a takeover bid.

The mechanics of dealing with a barely in-the-money option is made slightly easier with Interactive Broker’s option spread utility which will automatically perform a transaction whenever the market allows for it. It prevents you from having to manually leg in and out of positions which comes with huge amounts of execution risk.

The most significant of acquisitions has been both equity and debt of a USA entity that was the stinker that I had alluded to earlier. My timing appears to have been quite sharp in that the equity is actually up over 10% since I accumulated the position. I managed to get a fill on 80% of what I had seeked. On the debt side it has hardly budged, but it is trading at such a ridiculously good risk/reward situation that I had to nibble on both debt and equity. If all goes well (and this is always the big “if”), the income this will generate will be very pleasant to receive over the next few years plus a healthy capital gain if there is a payout at maturity. Time will tell.

I’ve acquired some long-dated out-of-the-money warrants (which are thinly traded but there is daily activity and a patient investor will be able to get fills in at the bid) of a reasonably-known firm. Performing a valuation of the overall entity (which has leverage issues but is still quite profitable and has been paying down debt considerably over the past couple years) suggests that given a moderate trajectory, the warrants should get at least at the money in the timeframe of expiration. There is considerable potential, considering past valuations, that the company will be significantly above that valuation so therefore the warrants present themselves as being cheap leverage. The common shares underlying the warrants are trading close to the 52-week lows. This story will take some time to resolve, but the results will become obvious much more sooner than the expiration date.

There are also provisions concerning change of control in the warrant indenture that would result in some form of payout if there was an acquisition bid under the strike price of the warrants. The company’s debt is trading above par.

The last acquisition has been of a company related to the economic crisis that Alberta will be facing. Their shares and debt have been hammered to death as a result of some exposure to capital spending in the oil fields. While my conviction is not huge (and this is represented by the relatively small stake I took), I purchased some debt relatively recently. Insiders have also been purchasing both equity and debt of this issuer and while financially speaking the company looks like it is going through a rough patch, they do have sufficient time to realign their operations where they can satisfy their bank creditors. Once again, time will tell.

Nothing that I have been acquiring is on any major index. I’ve been avoiding anything on an index that is tracked with lots of money for various reasons.

I’m also down to nearly a 25% cash position. The other component is that over half the portfolio is trading under tangible book value of the underlying companies.

The big picture

Be warned that the following is a very unfocused financial commentary on a bunch of topics.

Everybody is trying to figure out when the US Federal Reserve will raise interest rates.

My own opinion is that they will wait as long as possible and not get caught up in the market mania that is currently projecting a 1/4 point increase sometime mid-year. December Fed Funds Futures say that the year-ending rate will be 0.5%:


While unemployment figures would suggest a rise in rates is warranted (as part of the Fed’s mandate is employment, unlike the Bank of Canada, which is purely inflation-driven), with very obvious global deflation occurring, the Federal Reserve should merely be happy that the markets are buying into the threat of higher rates, rather than having to do the job themselves. This persistent threat, but consistent inaction, of higher USA interest rates will likely be the theme for the rest of 2015.

Absent of World War 3, it does not appear that inflation is rearing its head. Too many central banks are trying to stir up inflation with their versions of quantitative easing programs. Japan and the EU are trading moribund, while even China is lowering interest rates and loosening credit policies (as they do not want to precipitate the collapse of their finance system quite yet).

What does this mean for Canada?

Part of Poloz’s strategy is to wean markets away from forward guidance. I’m not sure what the master strategy in doing this is, but by eliminating forward guidance, effectively Poloz is telling the markets to come to their own conclusion in absence of information from the central bank. Thus, it is likely that the Canadian central bank will lag markets rather than lead them. My guess at this point is that they will be standing pat for the indefinite future to see where all the cards lie. Effectively the quarter point move was a signal to the market that “We’re not going to play the soothsayer game anymore.”

The threat of higher US interest rates can only take US currency so high relative to all others. If the threat is executed on, then the next threat will be even higher rates, etc. Since I do not believe the threat is going to be executed on, it would stand to reason that we will be in a holding pattern in the macro scene for the next little while.

Institutions that have taken advantage of extremely cheap money are likely to pare back their leverage, but non-financials should do reasonably well, excluding US exporters.

The forward curve on crude markets is at an extreme point right now and does not bode well for future prices beyond that of the contango slope. That said, there are a few entities out there that are trading as if the entire province of Alberta is going to shut down and while things should get bad in Alberta, they should not get that bad. So watch for opportunity in that area.

As for Canadian real estate, the calls for its demise are loud and clear, but absent of sudden rises in interest rates, I very much doubt it is going anywhere. There is simply too much capital flooded in the market and still too much availability of leverage (either by bona-fide purchasers or investors, whatever the case may be). One item of relevance in Canada vs. the USA is the heavily urbanized and sectorized nature of the distribution of our country’s population and effectively each population center has its own variables affecting real estate valuation.

There is a good component of foreign investment (whether by nominally “resident” Canadians or whether it is through offshore capital) in Vancouver and Toronto’s markets and I do not see signs of this drying up, specifically from China.

Finally, something that I am looking at but is nowhere close to the point where I would want to be accumulating yet, is an odd choice. Gold.

One of the arguments against Gold is that it does not bear any yield. In economies where you end up paying negative yields to invest in sovereign debt (e.g. Switzerland, Denmark, and a lot of the EU), it actually makes some sort of sense to hold value in alternative vehicles, whether that be paper currency or the world’s historical store of value. At CAD$1480 it doesn’t make too much sense from a risk/reward benefit, but in the odd scenario where this goes down a third like the rest of the commodity market, it will be worth looking at. As always, time will tell.

There is also one other commodity that has caught my attention, not for being exciting, but rather for being nearly dead and having very unfavourable supply/demand economics to the point where nearly all interest in it is gone. In fact, the only ETF I could find is rather undiversified to say the least simply due to consolidation in the industry. Still doing research – although the metrics look horrible, when one looks at the rise of other commodities, nobody ever tells you when things will rocket up. Just look at Potash Corp (TSX: POT) from 2006 to 2008:


Getting the “when” correct is always the big challenge.

Economically speaking, it is rational for oil to get back to a “new normal” at US$70-80/barrel given ever-increasing world demand, but I think it will get there later than sooner. We need to see actual shutdowns rather than simple statistics of drilling counts being gutted. When I see companies like Lightstream still dumping $100-120M in capital expenditures (albeit they are going to drop about 20%-25% in production from year-to-year) this is a relatively good sign for upcoming supply drops, but there needs to be time for this to get worked in the system. Most companies are incorporating US$65-ish prices in their financial models and with those rosy projections, it still means they are going to be overspending on the oil patch.

Better to look for businesses that were disproportionately hammered by the plunge in oil prices rather than the commodity itself at this point. Unfortunately my assessment of the situation back in the second half of 2014 was completely incorrect and I have moved on.

Pinetree Capital Debentures – Buying a dollar for 80 cents

The ongoing saga of Pinetree Capital (TSX: PNP) continues.

After coming to an agreement (after what functionally amounted to a financial game of chicken when management “blinked”) with over 2/3rds of the debenture holders in a very private setting, management has been ousted, and a new agreement has been put in place that grants debt holders security over the assets of the entire company.

There is also a provision to repurchase debentures as follows:

On or prior to July 31, 2015, the Company shall reduce the aggregate principal amount of the outstanding Debentures by at least $20,000,000 by redeeming outstanding Debentures and, at the Company’s discretion, repurchasing outstanding Debentures up to a maximum principal amount of $5,000,000 pursuant to a normal course issuer bid.

There will likely be some market action in the upcoming months as the company attempts to repurchase its debt. Of course by doing so the price will get closer to par value. There is also a redemption to equity feature which has been opened by the debtholders, as the following language was inserted into the indenture agreement:

The Initial Debentures will be redeemable prior to the Maturity Date in accordance with the terms of Article 4, at the option of the Company, in whole or in part from time to time, on notice as provided for in Section 4.3 for the Redemption Price. The Redemption Notice for the Initial Debentures shall be substantially in the form of Schedule B. In connection with the redemption of the Initial Debentures, the Company may, at its option, and subject to the provisions of Section 4.6 and subject to regulatory approval, elect to satisfy its obligation to pay up to one-third of the aggregate principal amount of the Initial Debentures to be redeemed by issuing and delivering to the holders of such Initial Debentures, such number of Freely Tradeable Common Shares as is obtained by dividing such amount by 95% of the Current Market Price in effect on the Redemption Date. If the Company

The company will have the choice of either paying out the debtholders in cash, or by issuing equity, or a combination of both up to a one-third allocation of equity, depending on what the market price is.

Management will be compelled to dispose of securities from the newly constructed investment committee, which consists of two directors that were nominated by the debenture consortium:

The Company shall adhere to the decisions of the Investment Oversight Committee, except in cases where the Company’s board of directors has overruled a decision of the Investment Oversight Committee. For greater certainty, the Investment Oversight Committee has the power to override a decision of the Company’s management to purchase or dispose of any securities and to make a binding decision to dispose of any security now held or that may be held by the Company in the future, provided that such decisions are subject to the approval of the board of directors of the Company.

In addition to having a net asset value above the market value, in addition to an anticipation of an equity conversion, the equity of Pinetree has risen. It will likely rise to a point that reflects a modest discount to NAV, and the company is required to disclose its audited financial statements by the end of March.

Pinetree’s two largest holdings, Sphere3D (Nasdaq: ANY), and POET Technologies (TSXV: PTK), have done quite well and will likely provide cash for paying off debtholders.

Finally, lest the company gets its balance sheet out of position, it is required to have a debt-to-assets ratio of 50% up until October 31, 2015 and then afterwards it will go down to 33% as per the original covenant. This will assure the debtholders will be in the driving seat until they are paid off in full. If the company defaults on these provisions, the debtholders will set terms of forbearance and will likely be in a position to be paid off no matter what, as at this point there will only be $35 million outstanding and being first in line to collect.

The conclusion is obvious: barring a collapse in Pinetree’s (admitting they are less than AAA quality) holdings, the original thesis as presented holds true. Debtholders will very likely get the chance to get out at par and collect a very happy 10% coupon in the meantime. The fact that debtholders now have a general pledge of asset security over the entire company is icing on the cake – it does not give Pinetree any maneuvering room until they are paid off first (i.e. by pillaging debtholders by putting somebody ahead of line with them – see Armtech Infrastructure for the end of that sad saga).

I will discount the fraud scenario as it is perfectly obvious by the February 19, 2015 SEDAR disclosures that debentureholders got a very good look at the corporation as they made their negotiations. I would expect the audited financial statements to be published in mid-month. The only accounting decision of any substance would likely involve a valuation allowance offsetting their currently existing tax asset of $13 million (this would have an impact on their NAV, but this can get unlocked in some other transaction of substance).

The maturity date for the debentures are May 31, 2016, but effectively debtholders will know the game is over by October 31, 2015 and the market will treat the debt at that time as more or less being a done deal (i.e. at least 95 cents on the dollar, if not more for the 10% interest accrual).

With the conservative assumption that debtholders will get 95 cents on the dollar, it looks like from existing market prices (roughly 80 cents), an investor will achieve a 20% capital gain and another 10% interest coupon between now and whenever they get cashed out. I’ll call that a 30% reward for little risk at this stage of the game.

It is really a sad story for me as I cannot think of any other place where capital could be allocated for such a good risk/reward situation. I am riding the coattails of some financial institutions that have their vested interests in total alignment with mine – i.e. taking the reins of the underlying company to ensure we are paid back. Backing up this claim is the following clause inserted into the indenture:

The Initial Debentures are direct secured obligations of the Company, and rank senior to all other indebtedness for borrowed money of the Company. In accordance with Section 2.12, the Initial Debentures rank pari passu with each other. Notwithstanding anything else to the contrary in this Indenture, no additional Initial Debentures and no additional series of Debentures shall be issued under this Indenture or under indentures supplemental to this Indenture.

I have little opinion on the equity other than that it should trade a shade below net asset value, plus some amount for the implied value of the future capital loss carryforwards for an inspiring acquirer of Pinetree. Unlike Aberdeen International (TSX: AAB), new management at least has the ability to show they pretend to care about shareholders instead of using the publicly traded vehicle as a personal enrichment device.

This might be my last post on Pinetree Capital as the story appears to have come to a close, but “never say never” in these very strange and weird capital markets we live with.

Disclosure – Long on a non-trivial position of Pinetree Capital debentures.

Embarrassing investments

Sometimes there are stocks out there of companies that have such bad financial statements, poor execution and operations, and just simply make one wonder “what the heck am I doing investing in this entity?”.

However, in the world of the public marketplace, if you pay a price that assumes a terrible operation and instead the actual performance is simply mediocre, you will make money.

I’ve taken a 3% position in one such company. It is traded in the USA, definitely in the microcap category (although historically it has been well in the triple digit millions category in terms of market capitalization), negative tangible equity, negative gross margin, etc, etc. They are on the threshold of not being able to maintain their NYSE listing, and will likely have to cure that one whenever they release their 2014 audited financial statements.

I’m surprised they haven’t issued a going concern statement yet, although in their 10-Q for September 30, 2014 they did state they have sufficient liquidity for the next 12 months of operations. We’ll see if that changes in the 10-K.

If you look at the stock chart, it looks like the elevation profile of a long dammed river.

Anybody investing in this company is clearly nuts and the stock trades that way.

However, they do have a strategic asset which is not listed on their balance sheet that would cost several billion if somebody else were to do it from scratch. Right now that asset is not profitable, but it is plausible that in the medium term future that it could be (and hence worth a fortune since it would be the low cost producer of this particular item that I do not want to mention otherwise I would give away the story).

Again, the stock trades like it is going to bankruptcy. Financially, it looks like that they are on life support. However, if they spend enough time treading water, it is conceivable that the valuation could be 50 times higher than what it is presently.

A small position is warranted. But I’m too embarrassed to admit what it is I’m investing in.

Genworth MI Q4-2014, Canadian housing market

Genworth MI (TSX: MIC) reported their Q4 results a couple days ago. This report was a little more interesting than previous ones simply because there has been a relatively large shift in sentiment concerning the Canadian housing market due to the collapse in crude oil pricing (and its impact on Alberta and Saskatchewan).

The actual result was less relevant than the future guidance of the company.

Specifically, the guidance was that the loss ratio anticipated in 2015 would be between the 20-30% range, while the long-range guidance was for a loss ratio of 30-35%.

As I have pointed out on multiple occasions, the loss metrics for Genworth MI over the past couple years has been extraordinarily favourable, with the pinnacle of loss ratios in Q2-2014 of 12%. Q4-2014 was moderate, with 26%.

Cited was the economic slowdown in Alberta, but they appear to have a fairly solid grip on the upcoming cataclysm that will be occurring to employment in Alberta and Sasketchewan. Approximately 27% of the insurance written in 2014 was in Alberta, although 17% of the insurance in force is from the province.

By virtue of the fact that zero-down loans are no longer done, direct comparisons to 2008 would appear to be less muted, although there will obviously be an increase in losses coming in 2015 from Alberta and Saskatchewan for the company. The question is how bad they will be.

That said, the company still has an incredible amount of room to maneuver with. Their loss ratio for fiscal 2014 was 20% and expense ratio of 19%.

Realize accounting-wise that all of their cash is collected up-front and then revenues are recognized according to a financial model that allocates premiums written (deferred revenues on cash received) to actual revenues (removal of deferred revenues). The revenue recognized is not cash. Instead, the company must earn cash on future premiums collected (somewhat pyramid-schemish!) but also the receipt of investment income.

Investment income is obtained through a portfolio that is 41% corporate debt, 49% government debt, 3% equity and 2% asset-backed bonds, and the remainder 5% is cash and short-term cash equivalents. The total value of this portfolio is $5.4 billion earning an investment yield of approximately 3.5% and a duration of 3.7 years. As interest rates continue to plummet, this investment yield will likely decrease (although they do have a good chunk of unrealized gains due to the rate drop). Reinvestment will become continually a higher challenge for this insurer and many others.

Investment income for the year was $195 million.

In terms of book value, they ended the year approximately at $35.12/share according to my calculations.

Valuation-wise, they are somewhat below my fair value estimate, but not at the point where I would buy more shares. Market sentiment may take them further down and if it does so, I may consider adding to my position. The company itself may decide to repurchase shares (at a much better price than its previously botched buyback of 1.87 million shares at CAD$40/share) which I would approve of simply because repurchases would cause book value to increase. The company holds a minimum capital buffer of 220% over the regulatory requirements (currently at 225%) and they have indicated that they will hold a modest amount of capital above this percentage. I suspect the majority of excess will go towards a share buyback later in the year.

If the company streamed off its entire net income to dividends, they would be giving a 12% yield at present.

I generally do not believe that there will be a precipitous collapse in the Canadian housing market unless if there is an overall recession that affects more than a single commodity industry. In addition, most equities that I see that have significant exposure to Alberta’s economy are trading significantly lower than they were half a year ago. I do have a name in mind (below book value as well) when I write this, but my inability to predict when Alberta will get “hot” again is not assisting with an investment decision.

Government bond yields indicative of a very ill market

If we are in the Japan-like scenario of what happened after 1989, it would suggest that we will be seeing very choppy equity markets over the next decade (this includes up and down swings of 40% or so over multi-year periods, just look at the Nikkei index) and one should wrap their heads around the ability to make money in the marketplace when the overall indicies are not moving in the long run. Some basic financial theory would suggest that if the market gives equities a modest 2-3% risk premium, the most we will be seeing out of the S&P 500 on an annualized basis is around 4-5% nominal returns. The ultra-low bond yields we are seeing internationally are also a symptom of huge problems.

As a small factoid, Canadian 10-year debt is at 1.3%. Looks relatively attractive when comparing it to Japan’s 0.38%, Germany’s 0.37%, or the wonderfully fantastic -0.1% yield you’ll get by buying Swiss Government 10-year debt.

Smarter people than myself have already figured out that one of the primary arguments against gold is that it has no yield. But gold looks very attractive when viewed in relation to either sitting on a pile of Swiss paper (literally Swiss Francs underneath the bed mattress) as you wouldn’t want to be investing your money in negative-yield debt. At least when your house catches on fire, the gold is reclaimable.

Once all the gyrations in the fossil fuel market work their way through, having a swimming pool of crude oil in the backyard isn’t going to hurt either.