The easy trade is rarely the best one

Canadian Oil Sands (TSX: COS) had a wild day after their year-end report and upcoming projections for 2015.

2015-01-30-COS.TO

Traders clearly were panicked at the beginning of the day and when they all cleared the exits, the stock rocketed upwards.

The amount of volatility we are seeing in the Canadian oil and gas sector is indicative of the volatility typically seen in down points in the market (see 2008-2009 for a good example of this), but these scenarios typically take months to finish and not days. Of course you have to be there exactly at the day the S&P 500 hits 666 in order to catch the absolute bottom, but the right trade at the time should feel painful.

Right now buying into oil seems like the right thing to do, but the trade doesn’t feel painful to make. This makes me very cautious and I will continue to wait.

The other item I am looking for is that audited financial statements are due on March 31st, although companies typically report them earlier. Loan covenants are going to be tested against these numbers and it will be obvious which players out there will be over-leveraged.

The other comment I will make is that most producers seem to be in a waiting game – even Canadian Oil Sands projects a WTIC price of US$55/barrel in their 2015 overall projection. Right now WTIC is at US$47 (the December 2015 crude future is at US$56) so we are not too far off that projection, but the financial modelling of all of these companies (and even the Government of Canada) has an upward bias to commodity pricing. What if this doesn’t materialize? As company hedges (note that COS does not engage in hedging) start to expire and companies have to really start digging into their balance sheets to remain operating at existing production levels, eventually you’re going to see production decreases. Only until then it seems the fundamentals will sufficiently shift toward higher oil prices.

The trade at that time, however, will be painful. Only then will investors see a superior reward on their investment.

The same applies to currency markets. Right now going against the US dollar seems like stepping in front of a freight train at full speed. I’ll be unwinding some US currency exposure if the Canadian dollar depreciates a little more.

Inverted yield curve

The Canadian bond market is exhibiting a very minor instance of an inverted yield curve between short term and 2-year money. You can view interest rates here.

This is a good an indication as any that we’re going to touch upon a zero GDP growth cycle coming later in 2015 and perhaps negative. Pull out the textbooks to see what industries are good to invest in a recessionary climate.

Canadian dollar

The Canadian dollar crossed the USD/CAD 0.8 (reciprocal 1.25) mark for the first time since the economic crisis. Part of this was a sudden reaction down to the US Federal Reserve’s statement basically saying they are waiting and seeing.

cdw

Eventually there will be a time to shift out of US currency and into Canadian dollars, but now does not feel like the right time.

Last second agreement with Pinetree Capital

I thought Pinetree Capital was going into CCAA, but clearly there was enough arm-wrestling behind closed doors to come to the following agreement (which should hopefully be posted in SEDAR fairly quickly):

In connection with the execution of the Forbearance Agreement, each of Messrs. Roger Rai, Sheldon Inwentash and Marshall Auerback will resign from the board of directors of the company. As well, Mr. Inwentash will resign as Chairman and CEO of the company. Richard Patricio, the company’s Vice-President, Corporate and Legal Affairs will assume the responsibilities of Interim CEO.

Management is gone, plus three (of seven) directors, all of which can be considered to be heavy insiders in the company. Needless to say, considering past performance, this can only be a plus.

The CFO and corporate counsel is still on board, presumably to keep continuity in the overall operation.

I had speculated in my earlier post that the reason why Pinetree did not come to any agreement with debentureholders was because they demanded that management be removed, and it looks like management blinked. The reason for this is perhaps because they did not want to be associated with an entity going into creditor protection. This has to get disclosed in any subsequent documents (such as annual information forms) if management is associated with any publicly traded entities.

the Supporting Debentureholders will have the right to nominate up to three directors to the company’s board of directors; two of whom will constitute an investment oversight committee to be established by the company;

The current board (including the three directors that will be leaving) is of seven people; while this is minority representation, one can presume that they will bring in actual investment expertise to ensure that the interests of the debtholders are respected in future decisions. In particular, the hiring of a new CEO will be the most important decision the reconstituted board will make.

the company will grant security over its assets in favour of all holders of the Debentures;

This will ensure that debenture holders will receive proceeds of any sale of the company, including the value of the deferred tax assets. It will also restrict the company from borrowing more money unless if subsequent lenders understand they are subordinated.

the company will utilize at least $20 million to reduce the aggregate principal amount of the outstanding Debentures by July 31, 2015, and will be subject to a debt-to-assets ratio of 50% (in lieu of 33%) for the three-month period of July through September;

$20 million will be utilized and whatever discount there is to market value will result in a higher par value retired by the corporation. At the current quotation of 70 cents, this would retire about $28 million in par value, or about half the current issue.

the Indenture will be amended to remove restrictions on the company’s redemption rights, subject to the approval of the Toronto Stock Exchange; and

I am not entirely sure what this alludes to, but we will see whenever the agreement is posted on SEDAR.

the trustee and the Debenture holders will refrain from exercising any rights or remedies that they may have against the company under the Indenture or otherwise, as a result of the current default and any subsequent default in respect of the Covenant occurring up to October 31, 2015.

This is functionally a 9 month grace period. The maturity of the debentures is May 2016.

You will have the debtholders working to ensure an efficient liquidation of assets coupled with the possibility that they might end up with a significant equity stake if there is a redemption to equity on the May 2016 maturity. The October 31, 2015 restriction is designed to ensure that debtholders have effective control of the company if Pinetree’s debt-to-asset ratio is not less than 33% by October 31, 2015.

Some remaining questions:

1. Will Pinetree be able to liquidate its holdings efficiently? Reported NAV was 46 cents in November 30, 2014.
2. Final year-end statements must be received and filed publicly by March 31, 2015. At a minimum, it will probably look like their $13 million in deferred tax assets will be vanishing and a valuation allowance put into place. The level 2 and level 3 assets will have to be carefully examined to see if they are worth anything (this was $55 million of the reported $161 million in assets at the Q3-2014 statement).

Finally, the asset remaining on the books that is not going to be seen on the statements will be the half-billion dollar capital loss tax shield. This will get sold, the question is for how much and to who. You would think that the debtholders, compromised mainly of financial firm people, will have a way of getting this into one of their own closed end funds for utilization – funds that generate capital gains to offset such losses.

Currently the equity is getting trashed (at 7 cents per share, down from 11 cents when it was halted), while the debentures are roughly level. My initial suspicion would be that with the removal of management, you would have an increase in valuation, but I guess I was wrong there too.

That’s about it for Pinetree Capital

History: Pinetree Capital previous postings (link here).

January 23, 2015 was the date that Pinetree Capital (TSX: PNP) had to cure a covenant breach of its debt-to-assets ratio (being 33% or less). Unfortunately for them, they failed to obtain a waiver or apparently cure the default.

Before the ordinary time of opening, IIROC put a trading halt with news pending. There hasn’t been any news published so it would lead one to believe that management has failed to cure the breach.

Section 8.1 of the indenture states:

ARTICLE 8
DEFAULT
8.1 Events of Default

(x) in each and every such event listed above, the Trustee may, in its discretion, and shall, upon receipt of a request in writing signed by the holders of not less than 25% in aggregate principal amount of the Debentures then outstanding, subject to the provisions of Section 8.3, by notice in writing to the Company declare the principal of and interest on all Debentures then outstanding and all other monies outstanding hereunder to be due and payable and the same shall thereupon forthwith become immediately due and payable to the Trustee.

One can presume that given the rather speedy notice that was given to the company of the default that the trustee is going to get notified of this breach fairly quickly and on the first business day, January 26, 2015, the principal and interest will become due immediately. Since there is an event of default occurring, the company cannot trigger the common share conversion feature.

My guess at this point is that the trading halt will continue until Pinetree officially declares itself unable to pay its debenture and goes into CCAA. Then TSX rules will suspend trading and eventually delist the company. The subsequent proceeding will involve the bankruptcy trustee being instructed by its creditors (the bulk of which are the debenture holders of which the major players will form a committee) to liquidate and put an end to the terminally ill patient.

My other observation is that Pinetree Capital management should have received the hint back in 2013 that they needed to reduce debt by purchasing debentures off the open market while they were given a 9-month grace period by its debtholders. They instead went recklessly purchasing other penny stock securities and ultimately got what they deserved.

My other guess is that behind the scenes the debtholders told management the only condition they will accept for a waiver is a complete overhaul of the board of directors and management. Clearly management did not agree, nor is it in management’s best interest to re-capitalize their company with fresh equity (i.e. cash) since this cash would most likely end up in debtholders’ hands.

I originally thought management had better self-preservation instincts, but apparently even this was too much for them to handle.

Skimming their last quarterly report (September 30, 2014), we have the following entry:

For the nine months ended September 30, 2014, the Company generated net realized losses on disposal of investments of $334,412, as compared to $14,921 for the nine months ended September 30, 2013. The net realized losses in the current period was a result of the disposition of approximately 68% of the Company’s investment portfolio.

Realize these numbers are in the thousands, so just in the first nine months alone they managed to go through 1/3rd of a billion in realized losses (a lot of which I am sure have been on their books for ages). They also have another $118 million in unrealized losses their portfolio, which will inevitably get liquidated for less than fair value as stated on their financial statements.

My idea for Pinetree’s inevitable exit strategy was that they would sell their corporation off to some hedge fund actually capable of making money. The acquiring fund could use Pinetree’s accrued capital losses as a massive tax shield. There are quite complex rules concerning CCAA (if things get there) and utilization of operating and capital losses that I will not get into this post about, but suffice to say, my original idea for their exit strategy has not materialized.

Somebody give me management’s $1 million a year salary job and I’ll do better, I promise. Heck, I’ll do it for a 10th of that with a bit of an equity incentive.

First few causalities of US$50 oil – and who’s next?

Industry Canada maintains a list of companies going into creditor protection (CCAA).

Other than Target Canada (which is for wholly different reasons than the oil market!), GASFRAC (TSX: GFS) has the dubious distinction of going into CCAA first. Their insolvency can be described as operating losses (helps to have a permanent CEO running the company to execute a turnaround!), combined with lack of liquidity (their operating line of credit was nearly exhausted in their Q3 report).

gfs.to

They had a debenture issue which was still trading at a relatively high level (36.5 cents on the dollar) when they finally pulled the plug.

gfs.db.to

The debentures were supposed to mature on February 2017, and had a 7% coupon and were convertible at $10.50.

The debentures are not that badly far behind in the capital structure – the credit facility is $28.6 million and the debentures are a $40 million issue. Debenture holders may get a few pennies from the firesale.

Another recent CCAA filing is Southern Pacific Resource Corp (TSX: STP). They are a pure oil and gas producer and markets were predicting the demise many months ago:

stp.db.to

This was an issue maturing June 2016, 6% coupon and if you purchased it at its 52-week low of 0.1 cents on the dollar and the bond matured, it would eclipse making a leveraged bet on the CHF/EUR pair before the Swiss bank announced it was removing its Euro peg.

Other companies I’m waiting for to hit the CCAA bucket include:
– Arcan Resources (TSX: ARN);
– Argent Energy (TSX: AET);
– Armtec Infrastructure (TSX: ARF) – this patient is being kept alive and bled slowly to death by Brookfield, so the actual time of death may be prolonged;
– Connacher Oil and Gas (TSX: CLL)
– Exall Energy (TSX: EE) – On or around February 13, 2015!
– Ivanhoe Energy (TSX: IE)
… and others.

There is significant opportunity here to pick up players (none of which have been named yet anywhere on this site) which appear to be going down but should be able to weather the storm. When companies with December 31 year-ends have to report audited financial statements by March 31, bank covenants are likely to be breached and the negotiations between now and then will be very unpleasant for all involved.

Even big players like Penn West (TSX: PWT) are publicly talking about covenants.

Speaking of covenants, Pinetree Capital (TSX: PNP) has today (January 23, 2015) to cure a debt-to-assets covenant or face default. If they can’t, then they’ll be forced into insolvency by debtholders on January 26, 2015. This would end one of the saddest, yet fascinating, episodes of capital management.

Genworth MI year end earnings preview

This is part of a long-continuing series covering Genworth MI (TSX: MIC). I will give the changes that I see salient over the past few months.

The past two months of price action has seen an approximate 20% decline in common share price:

mic

This is likely due to market perception of increased default rates in mortgages, especially in the Alberta and Saskatchewan markets (the two provinces in Canada with the most negative bias to lower oil prices). At the Q3-2014 report, Alberta has 17% of the insurance in force, while Saskatchewan is 3%. Both provinces have very low delinquency rates (0.09% and 0.12%, respectively).

This will undoubtedly climb up as property will flood the market in the wake of layoffs and capital expense reduction of the oil majors.

The frequency of mortgage defaults is strongly affected by unemployment rates, while the severity of defaults is determined by property valuations. I would expect management would touch upon the impact of Alberta and also the impact of a potential recession in Canada and how it would affect mortgage defaults. As I have mentioned in the past, Genworth’s loss ratios are at all-time lows and this is an abnormal condition.

The other item of note is that management has repurchased $32 million in shares (799,345 shares) between mid-November to early December, at an average of $40.04/share. This was probably the worst example of market timing I have seen in quite some time and was a transaction above book value. In other words, this will be a negative value transaction to shareholders.

Normally management has been a little more cautious with shareholder capital (demonstrated by their willingness to give a sizable special dividend of excess capital in the previous quarter), but this decision is relatively questionable.

Company management had a shift which I deemed relatively minor – the CEO is resigning and becoming the executive chairman of the board; while the COO is now becoming the CEO. This continuity in management would suggest no major strategic changes in the pipeline.

Tangible book value, pro-forma to the buyback, will be around $34.50/share at Q3-2014. This also includes other accumulated comprehensive income and also deferred policy acquisition costs (which is effectively an intangible asset that represents cash paid to acquire business).

At Q3-2014, they did have exposure to $32 million in energy equities and $253 million in energy fixed income investments out of a $5.6 billion portfolio. It will be interesting to see if they got hit during the quarter on energy.

On a positive note, their fixed income portfolio will very likely accrue an increase in fair value as interest rates have continued to drop over the quarter. Indeed, with the Bank of Canada’s interest rate drop, they will be experiencing even higher gains in Q1-2015.

This will pose reinvestment risk, however. Most insurance companies (and pensions) are really struggling to find high quality investments that give out yield. In the low interest rate environment, this will suppress portfolio yields and will result in more expensive policies.

A slowdown in the Canadian real estate market would have an adverse effect on premium generation. That said, with last year’s price increase by CMHC, and little in the way of market competition, I would view the company as generating more premiums than recognizing at present. For the first 3 quarters in 2014, the company took in $461 in premiums and recognized $422 million in revenues. The decline in revenue recognition should reverse in 2015 and beyond.

In balance, considering the risks in the Canadian real estate market, Genworth MI’s position, and current market valuation, I believe Genworth MI at CAD$32/share is slightly undervalued. While it is not at a low enough price for me to add shares, it is something I am comfortable holding at existing price levels. I do not see Canada’s real estate market imploding, although it is certainly going to be rough going for those that have bought million dollar homes in Alberta and finding they have been laid off in the oil patch.

Disclosure: I have been long on MIC.TO since July 2012. I sold a good chunk of my holdings in 2014 but still hold a reasonable amount today.

The global race to the bottom

While not as dramatic as the recent decision by the Swiss Bank to forgo keeping its currency at a lower than market value level, the Canadian dollar was the recent victim of a central bank action when the Bank of Canada decided to drop interest rates by 0.25%. The Canadian dollar is down 2 cents to about 80.7 cents USD (or about 1.24 CAD/USD).

BAX Futures were not anticipating this decrease – today, they are are all trading up about 0.3% as a result of the Bank of Canada’s actions.

My general thought is that the Fairfax theory of the global economy is showing itself to be true – deflationary forces are forcing export-driven economies to devalue their currency. The next leg to drop will be the European Union officially announcing their version of quantitative easing, of which has already had negative implications to their own currency. Japan has already been in this mode for a couple years (Abenomics).

The remaining leg will be when/if the US federal reserve decides to implement interest rate hikes. On today’s decision by the Bank of Canada, federal funds futures are relatively unchanged; they anticipate the US federal reserve will raise rates a quarter-point by the end of the year.

This will also create an interesting dilemma for the Chinese government – their economy is highly export oriented and their competitive position continues to be eroded by the macroeconomic decisions of other countries. Whether they choose to slowly deflate the Yuan in reaction to this remains to be seen.

While the cause of the Bank of Canada’s decision is related to the very sudden decline in the oil market, I am wondering whether the country is simply getting carried away in the geopolitical currents that seem to be affecting every developed country at the moment.

Right now I am over 50% exposed to US currency (the rest of it being Canadian), so I am not minding this trend. What I am regretful for, however, is that this will have a material impact on my willingness to go down to the USA for recreational purposes.

End of the line for Pinetree Capital?

I’ve written about Pinetree Capital in the past (TSX: PNP) (previous articles), but it appears that management is cutting it really close with a debt-to-assets covenant on their convertible debentures. The indenture document, as amended (amendment 1, amendment 2), broadly stipulates that the debt-to-asset ratio cannot exceed 33%. If the company cannot cure this condition within 30 days of being called on it by the trustee, bondholders can declare the company in default and demand immediate payment (which would clearly result in Pinetree going into creditor protection).

The relevant clauses are quoted as follows:

7.10 (c) Until the earlier of May 31, 2016 and the date when no Initial Debentures remain outstanding, neither the Company nor any of its Subsidiaries shall incur any Designated Indebtedness or issue any Debentures if, after giving effect thereto, the aggregate amount of all Designated Indebtedness and Debentures would exceed 33% of the aggregate value of the total consolidated assets of the Company and its Subsidiaries as at the end of the immediately preceding month, as reflected on the unaudited consolidated balance sheet of the Company as at the end of such month.

(d) Until the earlier of May 31, 2016 and the date when no Initial Debentures remain outstanding, the Company shall not, as of the 15th day of each month, permit the aggregate amount of its Designated Indebtedness and Debentures to exceed 33% of the aggregate value of the total consolidated assets of the Company and its Subsidiaries as at the end of the immediately preceding month, as reflected on the unaudited consolidated balance sheet of the Company as at the end of such month.

According to a November 24, 2014 press release, Pinetree has until January 23, 2015 to cure the existing default condition as their debt-to-assets ratio was 38.8% as of October 31, 2014, based off of a net asset value of 47 cents per share (disclosed November 11, 2014).

On December 2, 2014, Pinetree also breached a debt incurrence covenant by accumulating $3.3 million of margin debt subsequent to the debt-to-assets ratio breach occurring, but this was subsequently cured on December 12, 2014 when presumably they sold securities to cover this amount.

Scouring SEDI, Pinetree Capital disposed of the following securities from November 24, 2014 onwards, of which they are required to disclose in the event of them being 10% or greater owners, or an insider of Pinetree is also an insider of the following issuer:
Canadian Orebodies Inc.
Caracara Silver Inc.
Gold Canyon Resources Inc.
Macarthur Minerals Limited
Manitex Capital Inc.
Mega Uranium Ltd.
Sanatana Resources Inc.

The dispositions of these securities alone do not account for $3.3 million, so there are other companies in the portfolio where Pinetree is not a 10% owner that must have accounted for other cash raised.

There is a major complication at this stage with Pinetree Capital and their ability to obtain a waiver or cure the default.

On November 26, 2014, they filed a notice with SEDAR that an extraordinary meeting will be called on January 22, 2015 for debentureholders on record as of December 18, 2014. The relevant regulations concerning notification to securityholders is through NI 54-101, Communication With Beneficial Owners of Securities of a Reporting Issuer; Section 2.12 (which applies to securityholders in this particular circumstance) states that proxy materials need to be sent 3 business days before the 21st day of the scheduled date of the meeting. The deadline for this was December 24, 2014, which means there can be no brokered agreement with debentureholders as there is no time left for the January 23, 2015 default date.

This leaves them with the following options:

1. Purchase debentures, approximately $11 million face value at 80 cents of par value, which will bring them relatively close to the 33% level. The complication with this is that there is little liquidity in the marketplace, coupled with a lack of time, and the inability to execute on a dutch auction in such a short period of time. They would need to find a private seller of debentures and make a private purchase from them off-market. This is not a trivial amount of debt to be repurchased in a short period of time.

2. Issue equity – given that their stock price is in the toilet, it would be highly dilutive. At a share price of 13 cents, they would need to dilute the existing firm about 40% in order to raise enough in assets to get below the 33% debt-to-assets mark. Pinetree would have to apply to exempt themselves from TSX rules and have this classified as a distressed situation that does not need shareholder approval in order to proceed.

3. If by whatever miracle their assets appreciated by December 31, 2014 to the point where the debt-to-assets ratio went below 33%, they bought themselves at least another three months, depending on what happens to the assets.

Note that simply selling securities in their portfolio would not help their situation – even if they received fair market value for their securities (which is unlikely given the illiquid nature), the debt-to-assets ratio would still remain the same. In order for the ratio to change, their asset value needs to increase significantly, or they need to repurchase debt.

There have been no reported debt repurchases by Pinetree, nor any other insider activity other than insider management issuing options to themselves consisting of approximately 1.76% of the outstanding shares of the company, with a strike price of 16 cents per share and a 2019 expiration date.

How this is going to play out over the next couple of weeks is going to be very, very interesting. There is also a distinct possibility that the company will opt for going into creditor protection via the CCAA (Companies’ Creditors Arrangement Act) and restructure their debentures through that route. This would presumably be a sub-optimal route for management, however, since they would most likely lose control of the company; it would be in the debentureholders’ best interests to see a timely liquidation of a company that presumably still has a positive net asset value of 46 cents per share, as reported on December 15, 2014 – it would be a good educated guess that they could derive $54.8 million in remaining par value with the $148 million in reported assets on the books.

And finally, yes, I will disclose that I own some debentures in this train wreck. This one is not for the faint of heart, nor for those that will have issues with liquidity in the future (there will be none if they go through the creditor protection route, rather there will be a payout by the trustee at some distant point in the future).

2014 year-end report

Portfolio Performance

My very unaudited portfolio performance in the second half of 2014, the six months ended December 31, 2014 is approximately -8.4%. My year-to-date performance for the year ended December 31, 2014 is approximately -7.7%.

Portfolio Percentages

At December 31, 2014:

42% equities
1% equity options
22% corporate debt
35% cash

USD exposure: 52%

Portfolio is valued in CAD;
Equities are valued at closing price;
Equity options valued at closing bid;
Corporate debt valued at closing price;
USD Cash/Equity valued at closing exchange rate of 0.8603 CAD/USD.

Notification

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

Portfolio Commentary

Words cannot explain how self-destructive my own performance was with respect to my portfolio performance over the past half year. There were two decisions of colossal stupidity on my part that single-handedly evaporated quite a bit of performance in the year. In retrospect, one was a very good gamble (or at least when I did the forensic examination of the train wreck it left behind in my portfolio) that evaporated a bit of capital, but had this turned into the outcome I had been anticipating, it would have resulted in an extraordinarily outsized gain. The research I have accumulated on this particular play I am still employing and I have not revealed it quite yet.

The other capital-destroying decision was simply embarrassing and quite frankly, was an absolute failure of yours truly to just “go to the movies”, as Warren Buffett would say. Had I slipped into a coma on January 1, 2014 and woken up today, I would have turned in a slightly positive performance in 2014. It was a classic case of simply not thinking things through properly and I paid for it. C’est la vie.

Notwithstanding the two paragraphs above, the year would have nonetheless still turned out to be mediocre from a performance standpoint. An investor that decided to start the 2014 year in 30-year US treasury bonds would have seen a rough 25% gain for the year. An investor in the S&P 500 would have seen a return of about 12%, while the TSX was good for 8% despite the meltdown in the oil and gas sector. Although I have promised in the past that I could not keep up the 17%/year performance that I have accumulated from 2006-2013, I certainly did not want regression to the mean to consist of a negative performance year when the overall market condition was quite positive.

I have no direct exposure to oil and gas in the present portfolio. While I took a small position earlier in a few companies (as outlined in this article), I since took my lumps and got on with life since I was playing with forces far stronger than my brain could cope with. I was not smart enough at the time to figure that out and paid for it a bit. Thankfully the CRA will also be subsidizing these decisions somewhat, but it is really not a good sign when the CRA helps you out.

My performance was also assisted by the decline in the Canadian dollar.

My portfolio remains reasonably concentrated. I still have a fairly good chunk of Genworth MI (TSX: MIC), which continues to perform well. They will be facing headwinds as the market tries to price in increased default rates in Alberta and Sasketchewan, but this is only 17% and 3%, respectively, of their insurance in force. They did get really, really close to a liquidation price in November when they hit $41.98 a share, but I was too immersed in other activities at the time to start selling shares.

My largest equity stake is in a company that I still have not revealed, acquired back from 2013. It has appreciated about 20% from what my cost basis is, but this is still much lower than what I anticipate from it. Overall market conditions in 2014 resulted in the worst possible business environment for this company, but they are in a relatively unique position to capitalize on what I believe will be happening in 2015. I can’t be more specific about this without tipping away the name, so I apologize. If/when this gets to the 50% level, I might write the article about it.

On the debt side, there are some positions in companies that have relatively boring characteristics and this is just a matter of picking reasonable risk/reward situations that are not connected to oil and gas. I also hold a fair holding in Pinetree Capital debentures (TSX: PNP.DB), and as readers of this saga know, Pinetree is in the middle of trying to cure a debt covenant breach where they have to maintain a debt/asset ratio of less than 33%, but they are sitting at 38%. Their deadline to cure the breach is January 23, 2015 before the guillotine drops.

While investing in distressed debt is not an activity for the weak-cardiac individual, this particular case has enough wrinkles that one can’t help but hop on board and be a silent partner in what must be quite intense negotiations with stakeholders that have very different alignments. You can read my other rantings about Pinetree Capital by clicking here. Also note that the debt-to-asset covenant in the debt effectively makes the debentures secured debt, which is more than I can say for other capital management firms that have entrenched management and a market value of significantly less than the net asset values they are managing (e.g. Aberdeen International (TSX: AAB), but there are others).

If somebody is reading this that is actually in a position of influence, be sure to negotiate a mandatory debt buy-back provision (either through open market purchases or dutch auctions if the market value is under 95 cents) and ensure that in the event of maturity that debtholders aren’t going to end up with a slab of nearly useless equity since management would just love to let those debentures mature on May 31, 2016 for shares instead of cash.

I have retained a lot of cash in the portfolio because I am still waiting for circumstances to allow for deployment. There are a few companies on the research pipeline which I am considering pulling the trigger on, but I am in no rush. I want to ensure whatever mental programming that caused such flawed decision-making this year is eradicated.

Outlook for 2015

Given what happened in 2014, I should probably disconnect my internet connection and come back in December to review the portfolio. Nonetheless, I will try to offer some predictions and insight on how I believe things will turn out in 2015.

If I maintain my portfolio as-is, I have a reasonable expectation of achieving a return in the teens percentage (13-19%) and this is based on my estimated values of portfolio holdings and what I could liquidate them for if they exceed my fair value boundary. This also factors in including a 1/3rd cash balance at present, collecting zero interest.

The big macroeconomic question is not about the oil and gas markets, but rather what happens to short-term interest rates. Something that has received very little attention is that the yields on 1-year and 2-year US treasury bonds have increased considerably over the year. The 2-year, in particular, has gone from 0.4% at the beginning of 2014 to a high of 0.75% at Christmas. This is due to the term structure of interest rates, and the anticipation of a short-term rate increase by the US Federal Reserve. Right now the December futures say that the short-term rate will be 0.61%, so the question will be what will actually happen. The strength of the US dollar has already anticipated rate increases. The implication for Canada is that traditionally our central bank has lagged behind US policy rate changes, so if the US fed raises rates, this would clear room for Canada to do the same.

However, the long-term yield curve in Canada has a long-term bond rate of 2.33%, and with the existing 1% rate, I doubt the Bank of Canada will raise rates unless if there is a true chance of inflation exceeding their 2% target; what this means is that despite the drop in Canadian currency, I believe the decreased economic activity that will be forthcoming from the drop in commodity markets will mean on balance we are likely to see another year where the Canadian bank rate is held steady at 1%.

I generally believe the USA will increase interest rates, but they will creep them up so slowly and with a huge amount of information leakage as to not cause any collapse in the asset markets – this might be represented by a break from the 0.25% increment convention, and I would expect the rate at the end of 2015 to be around 0.5% as long as inflation remains subdued.

Currency-wise, there remains a global “race to the bottom”, and the net result is that the US dollar is continuing to be king. This will have an impact on my own cross-border shopping, but I have hedged successfully against this by simply holding nearly half of my portfolio denominated in US currency. Currencies of interest do include the Yen, Yuan and Euro, all of which has a vested interest in heading lower.

I do not remain a fan of Canadian real estate, but I do not anticipate a huge collapse in the offing either. I do not believe that dirt-cheap yields that are being received by large REITs are worth the risk/reward ratio. As an example, Riocan in August received 8-year money for 3.6% and these returns are not cognizant that a lot can happen between now and then that would cause them distress and an inability to renew their debt.

Don’t get me into proxy real estate plays like Cineplex, and debentures (TSX: CGX.DB.A) are at 2.9% for a 4-year maturity. There is some value in the optionality on the conversion feature, but still…

There does seem to be bargains available in the oil and gas sector, in particular, in the fixed income side of things, but one has to make sure that your ranking in the capital structure is not going to get blown away by the banks, whom are all likely in the midst of a mass renegotiation with companies that are about to breach their EBIDTA/debt service covenants.

There is a federal election looming in Canada which is also going to create considerable economic uncertainty for the country.

I also find that trading on macroeconomic beliefs is next to impossible, so I will try to concentrate on what has traditionally worked for me, mainly the review of very narrow situations and valuation of companies that are a bit misunderstood or obscure from most investment lenses. It remains a challenge to be able to invest in things that computers and robotic trading has not already permeated through – with the vast majority of funds being invested in passive vehicles, or quasi-passive vehicles (index funds that are primarily traded by robots and arbitraged by robots), there does appear to be opportunity in basically investing in things that computers cannot see. These are not easy to find in the least, but once identified, they will result in outsized gains and portfolio concentration will be rewarded.

Divestor Portfolio - 2014 Year-End - Historical Performance

YearPerformanceS&P 500TSX 60General Comments
9.0 Years:+14.6%+5.7%+2.9%Compounded annual growth rate.
2006+3.0%+13.6%+14.5%Performance marked by several "wins" and several "losses" which nearly offset each other.
2007+11.7%+3.5%+7.2%One holding was acquired at a moderate premium; nothing otherwise remarkable about this year.
2008-9.2%-38.5%-35.0%Avoided market meltdown by holding significant cash; bought heavily discounted corporate debt at and around year-end.
2009+104.2%+23.5%+30.7%Most gains this year were in the corporate debt market. Anybody holding anything from February onward would have made money, but I mostly selected securities that were more heavily depreciated. I completely realized the once-in-a-generation opportunity that occurred here and was able to take advantage of it.
2010+28.0%+12.8%+14.4%Continued to realize gains and lighten up on corporate debt holdings which were mostly trading at par at year's end.
2011-13.4%+0.0%-11.1%Very poor performance, most of which stemmed from poor decisions around the August timeframe, and also completely missing on two targeted trades which completely fizzled. Wounds in this year were completely self-inflicted.
2012+2.0%+13.4%+4.0%Spent most of the year in cash, which explains the relative underperformance. Did not feel confident about significantly getting into equity or debt, but did dive into "value" equities at the end of the year.
2013+52.9%+31.8%+10.6%Despite making several unforced errors in the year, not to mention having a generally bearish outlook on the marketplace, insurance industry holdings appreciation and one very timely trade contributed for the bulk of performance. Half the year had more than 20% cash in the portfolio.
2014-7.7%+11.8%+7.7%Spent the most of this year about 1/3rd in cash; given my performance, probably a good decision. Performance was negatively affected by a series of unforced errors, and having absolutely nothing work out this year.