First stock purchase in some time

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For the first time in about half a year, I’ve purchased a straight stock (not preferred or ex-income trust) for my portfolio. Current position is 1% but I am targeting a 5-7% position, so I am currently in accumulation mode. I’d be a little miffed if it moved up to my fair value tomorrow, which is about double-to-triple the current stock price.

Some metrics include roughly a $50M enterprise value (i.e. market cap minus cash plus debt), revenues of a quarter billion, negative profitability in the past 12 months and a brand name moat that some, but not most should recognize. In terms of expenses, over 60% goes to sales and marketing expenses. No dividends.

The “over 60% goes to sales and marketing expenses” should give the reader a hint that I am not talking about a company that is related to commodities!

The general thesis is that while revenues have appeared to be flattening, this company is generally regarded as the best of breed in its product category, and they should be able to reduce expenses to restore profitability.

If the world economy goes into a 2008-style meltdown, there is some downside protection in the stock, mainly embedded in the huge cash position it has relative to its market cap.

Using my not-patented risk-reward measure, I would say this is a low risk, medium reward type situation.

Rogers Sugar

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The last little bit of my longest-term holding, Rogers Sugar (TSX: RSI) I have unloaded today. The company is very well run, but substantially all of its free cash flow is sent out the window in dividends – at a yield of roughly 6-6.1%, historically this is expensive and by virtue of being in the sugar refining industry, isn’t exactly in a position to dramatically expand revenues and earnings.

Investors are paying bond-like premiums for equity-like returns. At the rate that yield-chasing is going, investors might even bid up the company to 5.5% or even 5%, but I won’t have any part of it. The golden moment was when in early 2009 it was trading at $3/unit and I did load up during this time since the stable 15% pre-tax returns made much more sense in terms of valuation. The only problem was that most other equities at that time were also exhibiting high risk-reward potential!

Apple and the winner-take-all market

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Every media outlet is reporting the blowout quarter that Apple had – the financials are just something to be salivated at. With $46.3 billion in sales, $25.6 billion in cost of sales, you are left with $20.7 billion of gross profit. Subtract $3.4 billion in operating expenses and you are left with $17.3 billion in operating income.

This was in a single quarter. A lot of people must have wanted their iPhones and iPads for Christmas.

Subtracting taxes and other matters still left shareholders with $13 billion net at the end of the day.

When you add up the cash and marketable securities, they still have $98 billion to splash around.

Normally in technology, companies face incredible price pressure as competition is very fierce. Apple behaves as if it has a monopoly on its market, and in the minds of many consumers, they might as well.

There is erosion potential with the iPhones (specifically with Google’s encroachment with Android), and the iPads are starting to face some functional competition. However, this will not dissuade people from the name brand, as Apple has turned into somewhat of a status icon – this in itself will make it more difficult for competition to break.

The question for Apple – can they keep it up?

The question more relevant for investors would be – what technology upstart ten years from now will be doing the same thing?

Thumb twiddling

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The biggest mistake any investor can do is just invest cash for the purpose of investing it in something instead of investing it in something proper.

Hence, I am still twiddling my thumbs.

Curiously I do notice Encana (TSX: ECA) is up about 6% despite the fact that natural gas futures are still depressed. Might be a sign of short covering?

I’ve also been doing some research on R.R. Donnelley & Sons Company (NYSE: RRD) – I have owned their corporate debt in the past so I have not had to do much additional work. They are facing the same issues that Yellow Media had, mainly a good chunk of their business (catalogs and cheque printing) is getting enveloped by the online world. Still, the company is hugely cash flow positive and doesn’t even have the debt albatross that Yellow Media has. If it wasn’t for the fact that they are a well-known case, I might dip my toes in.

There are a couple other smallish-cap companies ($100M-$250M range) that I am reluctant to mention here that seem to have very compelling valuations, plus almost no financial pundits are paying any attention to them.

The great thing about having a large cash position is that it feels like I am working with a blank canvass. Despite earning almost nothing in yield for cash, I also do not feel pressured to make any portfolio decisions. If I have to wait out an entire year without hitting any candidates, so be it.

Natural gas continues its trek down

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A fairly mundane day in the market, but there is one item that has been flashing red on my screen for the past week, and that is the spot price for natural gas:

The March contract is trading at $2.50/mmBtu and this is very close to the lows that were reached during the 2008-2009 financial crisis. At present prices, it becomes very uneconomical to develop produce natural gas and it makes you wonder how long it will be before you start seeing insolvencies in natural gas companies. Those that have over-leveraged themselves will be facing the consequences soon.

I look at companies like Encana (TSX: ECA) – their operating and transport costs is approximately $1.60-$1.70/Mcf, which is still well below spot price. It explains the $12 billion market capitalization, but it makes you wonder when the bottom will be for it and also the spot price.

Mortgage rates in Canada

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It is making the airwaves that the Bank of Montreal is offering a 5-year fixed rate mortgage at a 2.99% APR rate. There are slightly less favourable conditions attached to such a mortgage (lower prepayments throughout the mortgage), but otherwise this is the lowest 5-year fixed rate ever offered.

With the risk-free 5-year government bond rate at 1.3%, the bank is still making money from the loan. I’m guessing the only people qualifying for such a mortgage would be those that have very good credit ratings and those purchasing homes with reasonable leverage (e.g. 25% down payment or above).

Interestingly enough, since most financial institutions have raised rates on their variable rate mortgages – (last year there were offerings that went as low as prime minus 0.9%, or 2.1% with existing interest rates, while today you will be lucky to receive prime minus 0.25%), it makes the fixed rate offer a significantly superior option. Although I do not believe short term rates are going anywhere in 2012, it is difficult to fathom that short term rates will still remain at the levels they are through the duration of a five year term.

This is yet another function of the low interest rate environment where people are encouraged to financially leverage on cheap credit. At 3%, why not spend the extra $100,000 on those granite counters? That’s only $250/month extra…

The argument that low interest rates increase asset prices is a simple mathematical argument, but the real estate market in the USA, where interest rates are equivalently low for long-duration mortgages, is proving that rates alone are not a sufficient explanation for asset values.

Unloading illiquid shares

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Just a side note in the portfolio, I unloaded the last 100 shares of a company that was relatively illiquid (market cap under $20 million). The algorithmic order I set was placed in early October and the execution finished today.

The whole trade (in and out) ended up losing the portfolio less than 2%, but obviously the story after the investment was made changed which triggered my exit order. Getting in and out of illiquid stocks is a real pain, and unless if the potential risk-reward ratio is disproportionate, such transactions should be valued explicitly with a discount acknowledging the lack of liquidity.

Throughout my history my dabbling in illiquid stocks has been less than spectacular – my sweet spot of investing has tended to be small cap stocks ($100M-$1B capitalization) instead of microcaps.

Lululemon again

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Lululemon (Nasdaq: LULU) is up to US$61/share, nearly at its all-time high upon announcing that it made more money in the fourth quarter than analysts expected.

I have written about LULU before and am continually amazed at their ability to “surprise” in such a fashion. The most valuable asset such companies have is their branding, and LULU has been able to strike the sweet spot in women’s fashions for quite some time – although there is competition encroaching, they have still been able to keep surprisingly ahead.

At a market cap of 8.8 billion, it makes you wonder how much higher they can go – looking at what that capital can purchase, instinctively I would not want to put a single penny of that into Lulu given existing valuations. That said, I thought the same thing when it was trading at $4 billion. Tells you know much I know about fashion trends.

A reminder on yield chasing

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One other conviction that I have compared to the host of “I don’t know”s I gave in my 2011 year end report is that everybody is chasing yield. In a low interest rate environment, capital is shifting towards securities that can spin off safe income – just imagine if you are a pension fund manager and need a targeted return – formerly you could bank on 30-year treasury bonds giving you a ~6% yield in the first five years of the century, but the zero interest rate policy has pushed down yields to currently 3%. If your mandate is to make 8%, formerly if you had a 50/50 bond/equity allocation you would need to make 6% on the bonds and 10% on the equity. With bond yields presently at 3%, the same allocation forces you to make 13% on equity – a much more difficult task for a fund manager. Suddenly placing bets on that speculative pharmaceutical research firm seems to make financial sense.

How do you make up the yield difference on the fixed income side? By investing in treasury bond-like securities and this means climbing up the risk spectrum – provincial/state debt, municipal debt, corporate debentures, and even preferred shares.

Everybody is chasing yield and prices today reflect this. Just be warned that the markets might face a Europe-type situation where the underlying entity no longer can pay out such cash flows – even when European banks are getting interest-free loans, they are still choosing to put their capital into safer 10-year German bonds at 1.9% compared to Italian debt (7.15% currently). Measuring the ability of corporations and sovereign states to actually pay the income is always a vital calculation. As the cliche goes, it is about return of investment, not return on investment.

This could be an explanation why certain large cap stocks are trading at very low P/E ratios – albeit, it makes no difference (taxation differential between dividends and capital gains notwithstanding) whether a corporation makes a 10% after-tax return and retains it, or gives it out in a dividend. Somebody would look at both companies and likely favour the one actually giving out the dividend. The true answer is whether the company can deploy its retained capital as profitably.

The opportunities presenting themselves currently seem to be very narrow and opportunistic and off the radar. It’s not like buying shares of Starbucks under $10/share back during the economic crisis.

Petrobakken trying to find the cash

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On December 13, 2011, Petrobakken (TSX: PBN) released more information with respect to their 2012 plans and numbers.

The two salient snippets are as follows:

We are also pleased to announce our initial capital plan for 2012, which allow us to build on our 2011 operational success. We anticipate capital development expenditures of approximately $700 million, primarily focused on horizontal drilling and completions, predominantly in the Bakken and Cardium light oil plays. We expect that this drilling-focused activity will generate a 2012 exit production rate of between 50,000 and 54,000 boepd. Our estimated year-over-year average production growth will exceed 15%, on an absolute and per-share basis. We expect this initial 2012 program to be executed entirely from funds from operations, with surplus cash flow available to fund dividends and debt repayment.

For 2012 we estimate that our corporate base decline rate will be in the range of 30-35%. In 2010, our base production declined approximately 40%, while the 2011 base decline rate is now forecast at approximately 35%. We have been encouraged by the results of our recently completed wells, and we are also beginning to see the benefit of the continued maturation of our producing assets with a significant proportion of our production now coming from older, shallower decline, horizontal wells.

…

As part of our ongoing balance sheet management, and to reward continuing support from existing shareholders, we are pleased to announce the implementation of a DRIP. The DRIP provides eligible holders of common shares resident in Canada the opportunity to reinvest their monthly cash dividends in PetroBakken shares at a 5% discount to the then current market prices. Petrobank (59% shareholder of the Company) has indicated an intention to participate in the DRIP with respect to 50% of their PetroBakken shares, which will amount to $53 million in additional liquidity to the Company on an annual basis. Subject to the receipt of approval of the Toronto Stock Exchange, the DRIP will be implemented for the January 2012 dividend, which is payable in mid-February 2012. Additional information regarding the DRIP can be found below.

The company is planning on spending $700M in capex in 2012, which is a decrease from projected 2011 capex numbers of $900M. The capital budget for 2012 will be slightly below their operating cash flow for the year, assuming current oil prices remain steady (a 12-month extrapolation of 2011 figures for the first nine months is $650M, noting that WTIC prices were lower then than they are now).

It still leaves one wondering when the company is actually going to generate significant amounts of cash in excess of capital expenditures – when you add the $180M of dividends projected in 2012 (minus the ~$53M that Petrobank will re-invest for Petrobakken equity), it does not leave much for them to pay off their February 2013 debenture, which holders have a one-day put option to redeem (and given the small coupon and the credit profile of the company, they most certainly will unless if there is a sweetener given to them in the interim).

The DRIP decision in itself is rather interesting – it effectively starves half the cash flow that Petrobank will receive from Petrobakken in exchange for further equity. Since Petrobank owns 59% of Petrobakken, it will result in Petrobank foregoing $53M/year in dividends in exchange for further equity. Assuming a $13/share price for Petrobakken, this will mean Petrobakken will issue 4.3M shares to Petrobank over 2012 – a cost of capital of 7.8% for Petrobakken, assuming the dividend is not cut. This is expensive capital for the company.

The company has hedged a significant amount of oil (20,000 boepd, about 40% of its expected production) with existing high prices which I think is a smart decision. Still, they are extremely leveraged and their only salvation is continued high oil prices. If there is any significant contraction in the price of oil, they will be in clear financial difficulty, especially when it comes to negotiating with the $750M debenture that is effectively due in February of 2013.