Capitalized vs. Operating expenses

The easiest way of inflating current year earnings to the detriment of future years is to capitalize cash outlays when they should be expended when they are incurred.

The new financial management at Penn West (TSX: PWT) are looking at the degree as to which this has permeated into the balance sheet of the corporation.

The numbers are not extreme, but a change of 20 cents per share on the income statement is significant. There will likely be some sort of re-statement issued at the end of this process that will take a non-cash hit on equity.

Just strictly from a balance sheet perspective this looks like a deep value play, especially if your prognostication on crude believes that prices will rise. Companies like this are not my thing, but this recent accounting crisis has put the value of the firm clearly in low territory.

This is also another indication of how corporate auditors are not as comprehensive as one would believe. In an ideal world, they would be held accountable in addition to the (no longer working with the company) staff that transacted the questionable journal entries.

Genworth MI Q2-2014 report

Genworth MI (TSX: MIC) reported 2nd quarter earnings yesterday. The results were smashingly positive for the company and show that the state of credit stability in the Canadian mortgage market is very high.

My calculated tangible book value for share, diluted, is $34.11 compared to the current market price today of approximately $39.70 per share (a 16% premium over book value). Booked income was $1.02 per share, noting the mild accounting change regarding how deferred policy acquisition costs are processed. This also would have been even higher if one backs out the extingushment of debt expense that occurred during their bond refinancing (offset by backing away the one-time capital gains from their portfolio).

In general, the trend for the company has been very positive with declining loss ratios and delinquencies in their mortgage insurance portfolio. This quarter has proven to be an exception in that the ratio has gone even further lower than the prevailing trend:

Loss Ratio
Q1-2013: 31%
Q2-2013: 25%
Q3-2013: 22%
Q4-2013: 22%
Q1-2014: 20%
Q2-2014: 12%

Suffice to say, this is incredibly low – indeed, a record low since the company went public. The existing stability in the Canadian mortgage insurance market is leading to the top dogs (mainly CMHC and Genworth MI) to book a lot of revenues as people continue to amortize their mortgages (and thus reduce the risk even further of mortgage defaults occurring).

On the top line, premiums written was also better than last year’s Q2 (160 million vs. 137 million), but not quite as good as 2012 (which had 176 million). This amount bodes fairly well for revenue stabilization (which is lagged behind the actual premiums written as most of this gets amortized in the subsequent 5+ years of the life of the mortgage).

In terms of their portfolio, it continues to be relatively unexciting, consisting of the usual staples of bonds and a small smattering of equity – yield is 3.6%, duration 3.7 years.

The other significant piece of news is the establishment of a new amount of internal minimum capital required to operate the business:

The Insurance Subsidiary is regulated by OSFI. Under the MCT, an insurer calculates a ratio of capital available to capital required in a prescribed manner. Mortgage insurers are required to maintain a minimum ratio of core capital (capital available as defined for MCT purposes, but excluding subordinated debt) to required capital of 100%.

Under PRMHIA and the Insurance Companies Act (Canada) (“ICA”), the minimum MCT ratio for the Insurance Subsidiary is 175%. In
conjunction with this requirement, the Insurance Subsidiary has set its internal MCT target capital ratio to 185%. The Company manages its capital base to maintain a balance between capital strength, efficiency and flexibility. As at June 30, 2014, the Insurance Subsidiary’s MCT ratio was approximately 230%, or 45 percentage points higher than the Company’s internal target of 185%. The Company regularly reviews its capital levels, and after reviewing stress testing results and after consulting with OSFI, the Company established an operating MCT holding target of 220% pending the development by OSFI of a new regulatory test for mortgage insurers which is targeted for implementation in 2017. While our internal capital target of 185% MCT is calibrated to cover the various risks that the business would face in a severe recession, the holding target of 220% MCT is designed to provide a capital buffer to allow management time to take the necessary actions should capital levels be pressured by deteriorating macroeconomic conditions. Under this framework, capital in excess of the operating holding target may be redeployed.

Currently the company’s MCT is at 230%, while the new minimum will be 220%.

The implication of this is fairly obvious – there will be a reduced amount of capital available to give out a special dividend and/or share buybacks. There is an excess of about $150 million over the 220% minimum required. The company declared a 35 cent dividend this quarter (which translates into roughly a $33 million distribution) and will likely increase the dividend to 38 cents in the next quarter with the potential of a special dividend of a dollar to bleed the excess capital away. Since the company is booking income of about $1 a quarter, this should not be a problem for them.

Since the Canadian mortgage insurance unit is so profitable at the moment, it will not be surprising if there was attempted encroachment in the market by competition, and I wonder if we are going to see price competition that deviates away from the CMHC payment schedule. If this happens, shares in Genworth would start to decrease.

Right now the market is pricing in perfection in the Canadian mortgage insurance scheme. This continues to worry me that the fundamental picture for Genworth MI cannot get much better than it is at present, especially with their 12% loss ratio.

I continue to remain long in Genworth MI as I generally see it being a reasonably good store of capital at the moment. I did sell some when it was trading in the upper 30′s and lower 40′s earlier this year, but this was to reduce concentration in what is otherwise a company that is firing on all cylinders.

Q2-2014 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the second quarter of 2014, the three months ended June 30, 2014 is approximately -3%. My year-to-date performance for the six months ended June 30, 2014 is +1%.

Portfolio Percentages

At June 30, 2014:

69% Equities
3% Equity Options
17% Corporate Debt
11% Cash

USD exposure as a total of the portfolio: 49%

Notification

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Portfolio Commentary

With the S&P 500 up 5%, this quarter’s performance clearly underperformed. The same performance as the equity indices could have been achieved holding long-term government bonds. Holdings in US currency also accounted for some of the negative performance.

The primary reason for the negative result is due to the concentration of the portfolio in a specific yet-to-be-mentioned on this site company’s equity. There is regulatory risk in this particular title which has the valuation clearly depressed relative to where it should be, but it is just a matter of waiting for the risk to be removed. Due to the depressed valuation, the company is engaging in a share buyback and this will inevitably increase value for shareholders whenever the regulatory risk resolves itself. It is a matter of time. It almost reminds me of what happened when tobacco giant Philip Morris was being persecuted from all fronts earlier last decade and they were doing massive share buybacks when they were trading at price to earnings of 6 to 8 (in addition to giving out 5%+ dividend yields). It ended very, very well for those shareholders.

The major changes to the portfolio this quarter includes the exercise of equity options that were purchased in the previous year (and in the previous year they were purchased out-of-the-money and were a significant contributor to 2013′s relatively good performance). I did purchase some additional out-of-the-money equity options in a lottery ticket-type play, but so far this trade has not panned out. As purchasing out-of-the-money options at low prices typically implies, these may indeed go to zero. They may also go to the roof. We will see, but in any respect, the risk-reward ratio is better than when you have the Lotto MAX at $50 million.

During the quarter, I sold just over half of my holdings of Genworth MI (TSX: MIC) at an average price just north of CAD$39 a share, a couple bucks higher than current market prices. There is nothing wrong with the company fundamentally – they are very profitable, the market environment is nearly perfect for them, and the scale-back of their regulatory competitor (CMHC) will benefit them greatly. That said, the market is giving them the appropriate premium, so any appreciation in equity will be due to the earnings they generate (not a trivial amount – will be around the $3.80 range, or about a 10% earnings yield at present). I am also factoring in a medium probability of them declaring a special dividend (about $1.50 to $2.00 per share) before the end of the year as they have an excessive amount of capital on their balance sheet and this is cutting into their return on equity statistics. At present prices, I am comfortable with my exposure to this company.

I have also increased my exposure to US currency, mainly to maintain my general policy of keeping a balance of the two currencies in the portfolio (whether it is in raw cash or equities/debt denominated in such currency). I do not have a strict 50/50 policy, but I start to rebalance if things go beyond 30/70. I generally have no strong feelings on currency other than that given my geography, I will be using Canadian and US dollars for the rest of my life and there is little reason to consider the Euro, Yen, Bitcoins, etc. If Gold goes below CAD$1,000 an ounce I might buy one or two just so I can hold it in my hand and stare at it before burying the bars in my backyard.

The quarter was characterized more with what did not happen rather than what did happen. The portfolio is quite boring at present other than the one concentrated bet that I have alluded to above. I may decide to reveal the trade at a future date.

Outlook

My crystal ball continues to be quite clouded. There is a lot of conflicting information out there, probably because using means and medians on aggregate economic data does not tell the completely picture of the very bifurcated world we are entering. Absent of the relatively large concentrated pick (where I believe there is the potential of a relatively good risk/reward of about 5:1), I have literally nothing on the immediate radar that is worth picking up (or at least worth picking up in the anticipation of significant gains – there are a few incremental type picks out there which are better than average on the risk/reward spectrum).

Macroeconomically, the US Federal Reserve is signalling to the world that their special market operations are going to cease by year’s end and after that they will probably go to some sort of rate normalization regime, but in a way that will attempt not to crash the stock market. Until then, borrowing money is cheap and as long as short money is cheap, you will have lots of players trying to leverage their money into lower and lower quality financial products until the whole system goes boom again. My gut feeling is that we’re about half way there.

Much has been mentioned about liquid ETFs holding illiquid products and this is the financial equivalent of lighting cigarettes near gasoline station pumps. Even though you save a few pennies a litre on your gasoline at these safety-deficient stations, eventually your car will catch on fire and generate losses. Keeping your cash (and car!) away from these future fires should prove worthwhile. Investing in the best parts of the smothered remains will produce outsized gains. I do not see things occurring like they did in 2009-2011 when you had glorious opportunities to seize gains, but a miniature version of this should be on the horizon. Perhaps not this year, but maybe the next. I would just be on the lookout for anything the usual pundits would consider to be highly toxic.

Right now, most pundits think the stock market and bond markets are highly toxic.

I am reasonably sure the catalyst to start some sort of panic will be something relating to interest rates, and this usually will stem from inflation reporting. It is ironic how the first step to instigating the deflationary bust that Prem Watsa (of Fairfax fame) will be through an inflationary fear period, but it is plausible to see how that can occur. Once the excess inflation fear has been removed with the appropriate increases in rates (short or long term, whatever the case is), you will start seeing the carry trades out there completely unwind, and with that, the unwinding of the incredible amount of financial leverage there is out there – borrowing at 3% to make a 5% return on some crummy asset-backed security product.

Put yourself in the shoes of a typical mortgage bank. How much money is there to be made on 5-year fixed term products at 3% rates? Your spread over risk-free rates is nearly nothing after you deduct costs for marketing, bureaucratic infrastructure, etc, etc. This doesn’t end well when there is some sort of shock that reduces confidence in asset prices and people’s ability to pay.

I remain quite focussed in this part of the market cycle that more and more financial garbage will be pumped out into the system for eager investors that are going to pay anything for yield. This is reminding me of the mid 2000′s when income trusts were going public with very questionable ability to actually pay the distributions promised. Yield games can be played with securities, but when confidence is lost (either through real interest rate increases, or some other crisis of confidence), the underlying asset values can no longer support the yield and that is when you will see a huge domino effect.

This is the reason why I remain very reluctant to invest in yield-bearing products unless if the underlying entity has a clear ability to sustainability generate such funds. Even though there is a pile of cash earning next to nothing, it is quite dangerous to throw it into some low-risk debenture with a 4% yield to maturity (example #1, example #2, example #3, etc.). The liquidity will not be there when it is needed, and when there is a mini-credit crisis, it will very likely cost more than the yield that is currently being given away.

Given the long-term track record of the portfolio (see below, over the past 8.5 years it has achieved 16.7% compounded annual growth), it is quite difficult to produce gains at this level. Mathematically, if I managed to produce an absolute return of 12% for the year (which ordinarily is quite good assuming I don’t take a ridiculous amount of risk to achieve this), I would still be bringing down my long-term return. Psychologically, it is tough to see myself tread water for the first half of the year (producing something that barely would outperform a GIC), but this is part of the investment game – in order to perform better in the long run, I have to accept that I effectively will have to step away from the market and during these times, I will underperform my own long-term averages.

One of the costs of heavy portfolio concentration is that this will occur. With any luck, the second half of the year will be better. I’m guessing it will be.

Divestor Portfolio - 2014-Q2 - Historical Performance

Year
Performance
S&P 500
TSX 60
General Comments
8.5 Years:+16.7%+5.5%+3.5%(Jan 2006- Jun 2014) 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 (Q1)+4.2%+1.3%+5.2%Little transaction volume this quarter. Still over 1/4 in cash, trimmed a large position.
2014 (Q2)-3.4%+4.7%+5.7%Little action this quarter; continuing to hold onto a significantly concentrated position.

Quiet times

Sometimes doing nothing is the best policy and the last two weeks have been exactly that. There’s been a small amount of portfolio adjustments, but nothing too serious. If I have something more exciting to report, I would have. There isn’t anything. Credit spreads are tiny and investors are generally not being very adequately compensated for risk.

In a “would have, should have” world, Lululemon (Nasdaq: LULU) would have been a short in my portfolio a year ago, but that opportunity has now passed. Coach (NYSE: COH) is also on that short list. Both of these are subjected to confirmation bias by females that I know are into these sorts of things. Both of them are trading at valuations which can (now) be considered reasonable (LULU still being a tad expensive, but not as ridiculous as they were before), but both brand names are clearly on the downtrend. In fashion, trends are everything. Apparently Kate Spade (Nasdaq: KATE) is the next up-and-comer and while traditional valuation metrics say this one is very expensive, perhaps talk to some teenagers that have disposable income and your opinion may change.

No positions, just curious. It makes outlet shopping somewhat more tolerable when looking at these various brands from a purely financial perspective.

Year-to-date

Here are some indicies and their year-to-date performances:

Equities
S&P 500: +4.1%
TSX Composite: +7.2%
Nasdaq Composite: +1.6%

However… the winner so far is bonds!

iShares 20+ Yr Treasury Bond ETF (NYSE: TLT): +12.0%

Who would have ever thought?

In the brains of an institutional pension manager

Just put yourself in the shoes of this person – your pension plan has an expected rate of return on plan assets of 7.1% and your actuarial balance is 90% of funded levels for your plan because of weak market performance.

I picked 7.1% because this is an example of a large-scale pension plan (the British Columbia government, for example – others may vary).

How do you allocate to get a 7.1% return?

Perhaps investing in high quality fixed income – even if you’re the world’s best bond trader and get a 200bps spread over Canadian government bonds on A and AA paper (which you are functionally restricted to in your pension plan), you are still well below the 7.1% threshold.

In fact, simple math would state that if you are 50% allocated in high-quality fixed income (let’s just use Genworth MI’s latest A/AA bond offering as an example – 10 years and 4.24% yield), you still need an allocation of equity that would net you 9.96% to “break even” on your 7.1% expected rate of return.

So obviously the deeper the portfolio dives into high-quality fixed income, the higher the return it needs from other components, which would likely come from equity and further up the risk spectrum.

Further up the risk spectrum are BBB bonds, which is the lowest rated bonds that most pensions are allowed to invest in. The yield premium you get on these versus A/AA investments is presently not much better (a lot of low quality debt is trading as if it is a guarantee), but you incur the risk of defaults down the line (in addition to illiquidity when you’re trying to unload them).

Finally, any bond trader will point out to a yield graph and show you that long-duration bonds are trading at high levels (low yields). Probably the reason why most high-quality fixed income continues to trade at low yields is that whenever yields do pop up, they are snapped up by institutional managers that want to fill in that income component of their asset allocation models.

The point is that while historically you could have run a pension plan in the 1980′s to about the year 2005-ish primarily investing in long-dated high quality fixed income securities, today that is clearly not possible.

The other component is typically equities, but an institutional manager will look at the graph of the S&P 500 (trading at all-time highs never seen before in the index) and ask themselves whether they can squeeze more than their 7.1% threshold out of the index when it is trading so high. Nope! Can’t invest here! Additionally, lower sub-indicies such as the S&P 400, and the smallcap S&P 600 are less liquid. Just as an example, the S&P Midcap 400 index has a market capitalization of about $1,600 billion at present. For smaller players this is liquid, but for larger players (e.g. if you have a $200 billion pension plan), it would move the market.

So you move up the risk spectrum, get into junkier debt issues and “alternative investments”, the latter of which is a codeword for illiquid and speculative. They also are cursed by the fact that there is no active market trading on things such as toll roads and other public-private partnerships, and that these investment decisions have to be made very, very carefully made in terms of valuation and expected business results. Still, institutions that need to do higher-yielding investments in size have to venture into these speculative ventures.

So all-in-all, the low-yield environment we are currently in is a function of yield demand – institutions around the world are starving for yield and they are willing to take more capital risk to achieve it.

The smaller individual investor, however, should figure out where the demand is not located and there should be a higher probability of value being located at such points.

Interest rates and Macroeconomic ramblings

This is a rambling post, so be cautioned that there is little rhyme or reason to the thought pattern here.

I look at the following chart of the 30-year treasury bond:

tyx

The risk-free return is very low at present. Relative to other sovereign entities (e.g. Euro-zone, Japan, Canada, etc.), however, the US 30-year bond actually still looks cheap and this can explain why it is the best performing asset class in 2014 to date.

As an exercise to the reader, please reconcile what we are seeing in front of us:

- S&P 500 is at all-time highs (approximately 1,900 as I write this)
- The economy appears to be plodding along at a low real rate of return
- Inflation is rising but not at ridiculous proportions (yet)
- US currency appears to be making a comeback
- Short-term rates are still basement low (fed funds target is 0-0.25%, but the effective daily rate has been closer to around 0.09%)
- Long-term treasury rates are relative low (see above chart)
- US government is still projecting $500 billion deficits although this is quite better than previous years; other liabilities (e.g. social security) and various other entitlements (e.g. pensions) generally remain huge liabilities and difficult to get a good rate of return
- Almost every retail Joe that is not involved in stock (lottery) picking is dumping their money in a variety of index funds that invest in the same things in the same proportions (Typical Canadian allocation: 40% TSX 60, 30% S&P 500, 30% some fixed-income ETF)

The demographic story is that the bulk of the population pyramid is entering in the stage of life where they are transitioning their capital into income-bearing instruments, which accounts for the very high cost of yield at present.

It remains very difficult to say whether we are entering in the Fairfax world of upcoming deflation despite everything (which would guarantee low interest rates for some time to come), or whether we’re entering some sort of inflationary world (because of all of the available credit, which would presumably translate into spending and consumption).

Although my style of investing does not depend on macroeconomic outcomes, it is always nice to know where you have the winds at your back. In terms of the big world-picture view, it is difficult to tell where these winds are blowing at present.

The only real convictions I have at this point is a general aversion to commodity-related products and a realization that those that are paying for yield are likely paying a premium beyond what the risk/reward ratio would suggest.

In other words, you are more likely than not to find the “hidden gems” amongst the list of zero-dividend yielders (or very low) on the equity side. Due to the “rising tide lifts all boats” phenomenon that we are encountering at present, until we see defaults of junk debt issues that go out for insanely low coupons and high durations, finding these gems is not easy. Most of them have been bidded up.

This leaves potential investment candidates in very un-ideal categories: the nearly illiquid and special situations (e.g. spinoffs, emerging from Chapter 11/CCAA, SEC/SEDAR “fine-tooth comb required because GAAP financials simply don’t explain the story” companies, closed-end ETFs, etc.). Not a lot of pickings here.

Canadian credit cards without foreign currency exchange fees

Something that always is a pet peeve is currency exchange fees.

As I type this, Interactive Brokers can give you currency spreads that are enormously small:

ib-usd

If you want to buy USD$100,000 it would cost you CAD$108,760. If you wanted to sell USD$100,000 you would receive CAD$108,755. The spread is next to nothing.

We compare this to a typical credit union that posts the following rates:

ccs-usd

Although I am reasonably sure the bank would give you a “discount” rate if you dealt with higher currency volumes, at their posted rates that USD$100,000 would cost you CAD$111,550 or about $2,790 difference from Interactive Brokers.

It is a simple procedure to get the cash out from the bank once you beam it from IB. Due to the miracles of margin accounts, you don’t even have to explicitly convert the currency – you just withdraw the amount and deal with the debit balance later (if you do not already have the US cash on hand).

When dealing with small amounts (e.g. less than $100) it is generally immaterial to pay the $3 or so compared to going through the optimal route, but when dealing with larger quantities of money, exchange fees add up considerably.

Most credit cards will do an exchange at the legitimate market rate, but tack on a 2.5% or 2.9% currency exchange fee. There is only one company that I know of in Canada that does not charge such a fee, and that is at Chase Canada. Unfortunately their cards in question are lacking in any other features that would make this useful for anything other than foreign credit card purchases. However, if you know you are going to spend a significant amount of money outside of Canada using your credit card, then these cards in themselves would constitute an implicit “reward” of the 2.5% or 2.9% currency conversion fee that you would otherwise be charged.

Cheap capital being dumped into the housing market

There’s more media sensation over the Investor’s Group offering a 3-year prime-minus 1.01% variable rate mortgage (which gives a snazzy 1.99% headline).

The rest of their rates are fairly mediocre, so this is clearly pure marketing instead of them trying to invade the mortgage market. The three-year government bond yield is 1.17% and they will pocket the (albeit) smaller spread. After three years, they’ll try to convert those mortgages into a high-cost fixed rate mortgage or some other product.

But it leads to the question of – let’s say you had access to capital for three years at 2% (assuming those short term rates don’t rise!). The number of safe investment harbours to earn a larger spread is definitely diminished.

So where do typical retail people put low-cost capital? The answer seems to be pretty clear – housing. For that matter, institutions are pouring it into almost everything other than cash – anything with a yield, including equities and bonds, have been bidded up substantially. Financial assets are quite expensive.

Another source of cheap credit is Interactive Brokers, assuming you can post the appropriate equity security to back the margin loan. Canadian dollars right now are 2.5% for up to $100,000, 2.0% for up to a million, and 1.5% after that.

The one thing about accumulating debt is that you’ve got to pay it back. Leveraging when the stock market is at all-time highs and yield spreads between AAA debt and junk bonds are at a minimum is not the world’s best formula to get rich.

As you might tell by the tone of this post, the pickings are slim out there. Almost anything worth speculating on (i.e. with cheap prices) has considerable baggage.