Market volatility

Look at the last couple weeks of trading on the S&P 500:


This is a panic down-panic up type chart – especially over the past few days, it resembles a short squeeze more than anything else.

The overall trend in the S&P 500 over the past couple years has been nearly a straight-line up chart:


Is this going to continue?

Normally in the prior market dips you get this “slowly climb the wall of worry” effect, but this time it appears to be different.

Implied volatility continues to be strongly anti-correlated to market price, but is now settling back into the teens again. Will there be another violent outburst?


And finally, 10-year bond yields are still trading below what they were when this whole market calamity started:


I’d be careful. My guess is that we’re going to see some stormy seas over the next couple months. Whatever started this is not likely finished yet.

Genworth MI Q3-2014 preview

Genworth MI (TSX: MIC) is going to report their 3rd quarter earnings on November 6, 2014. I do not expect anything too different than the previous quarter other than the seasonal factor of higher insurance underwriting as the Canadian housing market is more active in the summer.

Specifically, loss ratios are likely to be at significant lows. Q2-2014 reported 12%, which can only be classified as insanely low – Q3-2014 will be low, but probably not as low as that.

Earnings-wise, given their revenue recognition model, they will likely report revenues around the $141 million range and if their typical rate of realization on investment gains continue, should report around a $1.00 EPS level of operating income. Treasury bond yields were down quarter-to-quarter which should result in unrealized gains.

In terms of solvency, the company’s internal target is 220% of minimum capital required (which they state is sufficient for them to survive a severe recession). They reported 230% in Q2-2014, and this will be higher in Q3-2014. It is quite probable they will increase their dividend rate from 35 cents a quarter to a higher number (their track record has consistently lifted dividends in the Q3 of each year), but there is also a possibility of them declaring a special dividend to eliminate the excess capital.

I do not anticipate a share repurchase – management has been relatively diligent at only buying shares at or below book value.

Other than the usual cries of a pending Canadian real estate market crash, the only pending storm clouds for the company appear to be the fact that they might attract public scrutiny for simply being too profitable. While CMHC takes the lion’s share of the mortgage insurance market (and indeed this is a very lucrative industry for the crown corporation), Genworth MI takes the other slice of the market and earns duopoly-type returns for doing so. The party continues until it doesn’t.

A few bargains – Oil and Gas

I’ve been examining the wreckage of the market carnage over the past few days (these types of high volatility situations tend to create opportunities) and in general I have not been too impressed with what I have seen. Either that, or what I have been examining has been unfruitful material.

The big exception: the oil and gas sector.

The reason why they have cratered is because of this chart:


Then I start scouring the list of TSX oil and gas sector companies that are over a market capitalization of a billion dollars. The TSX maintains a comprehensive list of listed companies which I find to be of surprising value when I look for quick lists of companies. I generally don’t tread below a billion in capitalization for resource firms since companies of that capitalization are dominated by insider information where a good drilling result will make the difference between life and death and the last person to get this information will be the outside public.

Larger capitalization companies also receive the benefit of financial economies of scale as they will be able to raise capital in meaningful amounts at lower costs – just imagine if you were a bank lending to a $10 million microcap exploration company versus lending to Suncor – a world of difference.

I also exclude anything international (e.g. CNOOC) as my comfort level with companies with international operations (outside Canada/USA) is quite low. There are some Canadian companies with international operations (e.g. Husky) but I have not excluded them from the list.

This leaves the following:

O/S Shares
Price Aug 31
Price Oct 17
Suncor Energy Inc.SU65,392,529,9631,465,214,653$44.63$37.43-16.1%
Canadian Natural Resources LimitedCNQ51,752,147,4691,092,047,847$47.39$38.64-18.5%
Imperial Oil LimitedIMO49,042,078,776847,599,011$57.86$51.56-10.9%
Husky Energy Inc.HSE32,835,380,634995,641,711$32.98$27.89-15.4%
Cenovus Energy IncCVE26,251,047,328756,950,615$34.68$26.44-23.8%
Crescent Point Energy Corp.CPG19,054,037,160423,423,048$45.00$37.80-16.0%
Encana CorporationECA18,575,904,053740,961,470$25.07$20.99-16.3%
Talisman Energy Inc.TLM11,519,723,5791,044,205,268$11.03$7.41-32.8%
Canadian Oil Sands LimitedCOS11,349,573,179484,610,298$23.42$17.97-23.3%
Tourmaline Oil Corp.TOU11,093,225,024201,438,624$55.07$46.15-16.2%
ARC Resources Ltd.ARX9,961,515,096316,942,892$31.43$28.70-8.7%
MEG Energy CorpMEG8,663,315,635223,684,886$38.73$29.03-25.0%
Baytex Energy Corp.BTE8,074,310,078166,069,726$48.62$36.10-25.8%
Vermilion Energy Inc.VET7,547,863,325106,713,747$70.73$64.36-9.0%
Paramount Resources Ltd.POU6,310,684,139104,654,795$60.30$51.77-14.1%
Peyto Exploration & Development Corp.PEY5,921,706,832153,690,808$38.53$34.20-11.2%
PrairieSky Royalty Ltd.PSK5,135,000,000130,000,000$39.50$34.00-13.9%
Enerplus CorporationERF5,108,169,000205,229,771$24.89$17.15-31.1%
Whitecap Resources Inc.WCP4,521,895,736245,621,713$18.41$14.98-18.6%
Penn West Petroleum Ltd.PWT4,182,765,734495,001,862$8.45$5.51-34.8%
Pengrowth Energy CorporationPGF3,938,186,665531,408,321$7.41$4.90-33.9%
Athabasca Oil CorporationATH3,181,210,140401,667,947$7.92$4.46-43.7%
Trilogy Energy CorpTET3,034,453,657105,071,110$28.88$20.80-28.0%
Bonavista Energy CorporationBNP2,991,583,651201,861,245$14.82$11.61-21.7%
Africa Oil Corp.AOI2,120,742,964312,333,279$6.79$4.14-39.0%
Bonterra Energy CorpBNE2,112,574,63332,086,492$65.84$53.82-18.3%
Gran Tierra Energy Inc.GTE2,003,447,146274,821,282$7.29$5.37-26.3%
Raging River Exploration Inc.RRX1,980,564,289180,051,299$11.00$8.14-26.0%
Birchcliff Energy Ltd.BIR1,969,417,138150,796,625$13.06$9.16-29.9%
Freehold Royalties Ltd.FRU1,925,524,14674,058,621$26.00$21.48-17.4%
Northern Blizzard Resources Inc.NBZ1,914,042,495101,810,771$18.80$15.85-15.7%
Surge Energy Inc.SGY1,889,478,484217,681,853$8.68$6.54-24.7%
Parex Resources IncPXT1,877,462,466126,287,061$14.87$10.73-27.8%
Kelt Exploration Ltd.KEL1,731,091,845126,727,075$13.66$10.55-22.8%
Bankers Petroleum Ltd.BNK1,721,811,689260,880,559$6.60$4.67-29.2%
Bellatrix Exploration LtdBXE1,611,292,542191,364,910$8.42$5.59-33.6%
NuVista Energy Ltd.NVA1,583,757,118135,944,817$11.65$10.05-13.7%
Legacy Oil + Gas IncLEG1,563,886,292199,730,050$7.83$5.06-35.4%
TORC Oil & Gas Ltd.TOG1,362,827,02893,344,317$14.60$11.29-22.7%
Painted Pony Petroleum Ltd.PPY1,362,274,68393,627,126$14.55$11.38-21.8%
Crew Energy Inc.CR1,359,860,601121,960,592$11.15$7.90-29.1%
Oryx Petroleum Corporation LimitedOXC1,296,506,662119,825,015$10.82$9.47-12.5%
Lightstream Resources Ltd.LTS1,257,107,698200,176,385$6.28$4.08-35.0%
Advantage Oil & Gas Ltd.AAV1,228,830,837170,651,966$7.20$5.10-29.2%
Long Run Exploration Ltd.LRE1,097,545,166194,204,965$5.65$3.58-36.7%
Spartan Energy Corp.SPE1,096,574,094262,338,300$4.18$3.22-23.0%
RMP Energy Inc.RMP1,068,310,163122,092,590$8.75$6.30-28.0%

A cursory look reveals that the quoted market price of all of these corporations are significantly less than what they were from August 31st, however, some got hammered more than others.

Whenever one invests in a resource company, there is always the implicit assumption that you believe the commodity price underlying the resource will rise. There is absolutely zero point in investing otherwise unless if there is a very special situation to warrant it (e.g. the firm in question has a huge hedged position on the resource that will allow it to economically outlast its soon-to-be bankrupt peer group).

Ideally you want to invest in a company with a cost structure that is at the marginal point of profitability and that has the market pricing the company assuming it will make little money in the future, and then have the commodity price increase. The embedded leverage in these high cost producers is significant – and I will keep on repeating this – under the assumption that the underlying commodity price increases.

Looking at the “least and most killed” list, we have two companies that I consider to be the cream of the crop in the Canadian oil and gas industry, ARC Resources (TSX: ARX) and Peyto Exploration (TSX: PEY) that are scratched – about 9 and 11% losses, not too bad considering the drop in commodity prices. These two companies have quite good managements and they are very focused on financial return on investment. I actually consider it too bad they did not get a 25 or 30% haircut as they are reasonably good “grandmother and grandfather” type equities that should be able to weather the full storm of a commodity cycle.

On the “ripped to shreds” list, we have Athabasca Oil Corp (TSX: ATH) that I will not touch because they simply have the incorrect economic structure (this can be saved for another post although you can read me correctly passing up on their IPO on this post).

Working the way down the losers list, a few names caught my attention. Lightstream Resources (TSX: LTS), formerly Petrobakken (TSX: PBN) is an entity that I will not be investing in, but I amusingly note that it is finally reaching what I would consider to be a fair value. There was a very dedicated individual out there that was deriding my analysis on its over-valuation which the market finally appeared to have corrected. (Feel free to read these articles here).

However, a couple old titans from the income trust era, Penn West (TSX: PWT) and Pengrowth (TSX: PGF) caught my attention. Penn West notably went through an accounting scandal when they changed top management and the subsequent audit resolved some issues pertaining to the capitalization of what should have been operating expenses. This involved the inflation of the net income line. Having the commodity oil market fall from underneath them did not help either. PWT made the unfortunate mistake of going to natural gas development at precisely the wrong time, but they hold a bunch of other more conventional oil assets which firmly put them in the ordinary category.

Notably they are trading at about a third of their stated book value. One would have to ask themselves if they were to start up that company from scratch how much would be paid to do so. Even when dumping goodwill and accumulated exploration assets (money already spent to do exploration work), there’s still about $4.9 billion in equity on the balance sheet while the market cap is around $2.7 billion today. Just from a fundamental value perspective, while previous investors got hosed, it may be a better entry point than not. The stock is likely to face tax loss selling pressure between now and the rest of the year so there’s not likely any rush to get in on a retail level.

Pengrowth is also going through an ambitious capital plan with the development of a heavy oil resource (their “Lindbergh” project) that apparently has good economics, along the lines of a Cenovus project. There is obvious execution risk with this project as many oil and gas companies have touted the promise of heavy oil while being able to produce nothing. The couple differences I see here is that Pengrowth has been in the game long enough (they’ve been public since 1989) that they should by now know what they’re doing, and also they’ve successfully executed on a pilot project that has dredged up a not trivial amount of oil from the ground already. Time will tell.

Dumping goodwill and exploration assets from PGF’s balance sheet leaves $2.4 billion in book value, while market value is about $2.6 billion presently. On its face it does not appear to be as good a value as PWT, but it appears relatively cheap from a valuation perspective.

Notably, Penn West’s equity is trading with incredibly high implied volatility – about 85% on the January series for an at-the-money option. Pengrowth’s volatility is muted (around 35%). Liquidity in their option markets is garbage, plus trading options on Canadian exchanges is a very expensive process in terms of trading costs.

Both firms give out dividends and are roughly at 10% yield at present market value. Yields might be compromised in the future if oil prices continue to decline. At least investors here clearly are not paying any premium for yield since I think most of them have been scared away from the common stock when they stare at their capital losses – a few months ago they were paying for a 5% yield and while they received that, they got a 50% capital loss in exchange.

The last time oil was at around US$80/barrel was in June 2012. Both companies’ equities were trading at significantly higher levels than they are now, plus they have the advantage of the Canadian dollar being about 10 cents lower than what it was a couple years ago.

Do I have any clue where oil is going in the future? No. However, if you believe things have stabilized, certain oil and gas producer stocks seem to have been sold off disproportionately and would probably make a decent entry point.

Pinetree Capital Re-visited: Another debt opportunity

Please read my prior article, Pinetree Capital: Possibly the worst closed end fund ever, for a good backgrounder on what I am writing about here.

How would you like it if you bought an equity interest in 70 cents per share for the market price of 20 cents?

Normally most people would snap up on the opportunity. Every dollar you invested is backed by over 3 dollars of real net financial assets! What could be the catch?

The catch, of course, is that the assets you are purchasing are illiquid, of dubious value beyond a thin market quotation, and is managed by somebody that has an impressive track record of losing money.

Otherwise the market would not be giving such a steep discount to the whole consolidated operation.

What is interesting is that the capital fund continues to be hampered by debentures that have a 33% ceiling on the debt-to-asset ratio. Last year the fund breached this and had to pay handsomely for the privilege of obtaining more time.

Management has a huge incentive to not let the debtholders take over – surely the big players in the debenture space would liquidate the fund piece by piece and would not be hamstrung by pesky management or their insanely huge salaries.

The debentures, by virtue of the debt-to-asset covenant, are functionally secured, first-in-line debt, next in line to the margin loans the fund has been taking to fund its incredibly speculative investment portfolio.

They also mature in 1 year and 7 months time.

Now that the whole world stock market has tanked over the past month, speculative issues get hammered the most. Pinetree has been suffering, and its equity has thus gone down to the huge discount over stated asset value that you see today.

There is probably some value in the equity, but it will take time to realize the value due to liquidity issues.

However, the real value is in the debentures mainly because they have the noose over management at the moment, who have shown every indication they will dilute and use every trick in the book to maintain control of their lucrative salaries.

Who wants to invest in this train wreck? I don’t know, but if you have a very thick stomach wall for scraping the bottom of the investment barrel, consider purchasing some Pinetree Capital Debentures (TSX: PNP.DB) if you feel brave. There is a reasonable chance that you will be made whole.

Disclosure: I own the debentures.

Market rallies in downward trending markets

It is fairly well known that the largest one-day market rallies occur in the middle of bear market trends. I don’t have the table immediately in front of me, but suffice to say today reminds me of one of those days:


So instead of getting this trickle increase of climbing the “wall of worry”, the rallies are now consisting of manic one-day rallies.

It is thus also not surprising that volatility is trending upwards.

Whatever is happening in the markets is not likely over yet. My guess is that this has to do something with the continuation of the withdrawal of liquidity from the US federal reserve, coupled with trade issues in China and a lacklustre economy in Europe and Japan, with the appreciation of the US dollar vis-a-vis other major world currencies. That was a mouthful?

The only question is that the financial markets make it very difficult to tell which variables are causes of others, and whether the chicken or the egg came first.

Bitcoin valuation review

Here is a chart of milli-Bitcoins to US dollars over the past month:


Anybody having bitcoins over the past month has seen a 1/3rd drop in their US-denominated equity. (As a side note, investors in precious metal gold would have seen a 5% drop in the same time period).

However, the gist of this post is that Bitcoins has long since moved away from the “novelty” factor where people would speculate on them just on the basis of being collectibles (think of Beanie Babies in the late 90’s) and now the market is pricing in true economic worth of Bitcoins – in this case, it is far, far less than what it has been trading for.

Companies and entities that are collecting bitcoins for payment (!) inevitably have to liquidate them or they will continue to face currency risk in transactions.

In addition, it is perfectly obvious at this point that using bitcoins as a currency medium for illicit (silk road, etc.) transactions is just inviting the relevant authorities to digitally track the transactions and make the appropriate associations with the wallets to the identities of the people holding such wallets – the illicit marketeers might as well be writing paper cheques to each other. These illegal trades likely constituted a high amount of the initial bitcoin traffic but this has now ceased.

The only transactions I would see at this point that are economically viable for the medium are currency transactions to avert low denominations of capital controls in countries that are constrained by such measures (think of examples like Argentina, Venezuela and most African dictatorships). I do not see this being particularly viable considering the liquidity of bitcoin markets is nowhere close to institutional levels. In addition, such transactions are indeed illegal in their host countries!

There are structural issues with bitcoin that will continue to hamper its viability, of which I have addressed in earlier posts on this site.

One is that as the blockchain gets bigger and computational difficulty rises, it will become more incumbent upon large digital processors to maintain the transactions. I have already written about the well-known 51% risk where somebody with sufficient computational power over the rest of the network can subvert transactions and simply ruin it for the other 49%. In addition, computational difficulty of Bitcoin continues to increase to levels where it makes no sense except for industrial data-center levels of computational power to operate Bitcoin networks. Ironically, this is not what was envisioned by the pioneers of Bitcoin, which preferred a much more decentralized mechanism to arbitrate the transactions. Instead, concentration will be leading to an obvious state of the union where the 51% owner to the network will be, in effect, the central bank.

Large scale data centers such as have pledged to keep under 40%, but why kill your golden goose so prematurely by scaring away dumb money from coming into the marketplace?

There are also more and more other digital currency schemes (Litecoin, Dogecoin, etc.) which continue to trade, but are simply there just to be an alternative to bitcoin – most of the mindshare out there is on bitcoin compared to the alternative currencies. However, with all of these new digital currencies, there are always incumbent advantages – the group establishing the coins will have all the advantages of mining them first, and then with the hopeful attempt to build a marketplace for it so they can just dump it for real currency. Bitcoin has some inherent advantage than other digital currencies simply because the implementation of this was relatively “innocent” compared to most crypto-currencies being created today that are simply there to steal money from other gullible people.

There is the casino-type element of currency trading. I continue to read the Reddit thread and continue to see people with less financial knowledge give out wisdom on Bitcoin. I would be very curious to know the total amount of bitcoin float out there that is simply being held for speculative (i.e. nothing other than for the reason they believe others will believe it is going up) purposes. Now we are reading threads like this or like this, both of which remind me of Canadians that said “I have shares in Nortel purchased at $80, what do I do?”.

Finally, there is the risk that the cryptographic features of Bitcoin that make it very difficult to access other people’s wallets, may be cracked. While this is unlikely, if such a discovery were to be made, it would clearly cause a collapse in the entire Bitcoin system. The only analogy I could make to this in the central banking fiat currency system is having other people being given access to your own bank account at any time without any reversibility (although you can go and find their wallet and spend it right back if you know the algorithm to doing so!). The system would simply collapse.

I can’t see any reason why any Canadian would want to purchase Bitcoins at this time other than for the novelty factor. If you’re planning on buying currency to prepare for the end of the world (whether it be war, hyperinflation or alien abductions), I would not buy something that depended upon a reliable electrical connection, let alone internet connectivity!

Alibaba IPO – thoughts

If you ever had any thoughts of investing in Alibaba (NYSE: BABA), I will just summarize it in this following chart:


The most relevant footnotes are as follows:

(1) Includes approximately 70 subsidiaries and consolidated entities incorporated in China and approximately 120 subsidiaries incorporated in other jurisdictions that are not illustrated in this chart. In addition, the entities pictured in this chart hold, directly and indirectly, an aggregate of approximately 40 additional subsidiaries and consolidated entities incorporated in China and approximately 40 additional subsidiaries incorporated outside of China not pictured in the chart.
(7) Each of these variable interest entities is 80%-owned by Jack Ma and 20%-owned by Simon Xie, other than Zhejiang Taobao Network Co., Ltd., which is 90%-owned by Jack Ma and 10%-owned by Simon Xie.

Good luck figuring out what is beyond the first layer of the corporation and what these variable interest entities are all about. I am reasonably sure insiders will do quite well as long as they are continued to be sanctioned by the state.

Make no mistake – Alibaba is an incredible commercial operation on the level of Ebay and lesser to Amazon, but the people that are going to get rich out of this operation are not going to be the people investing in Alibaba Group Holdings Limited (Cayman Islands) common shares.

Signs of a crash coming up

I don’t like using this sort of language (mainly predicting a crash), but the following are some tea leaves that I am reading in the teacup:

* The market has completely baked in the fact that the money spigots from the Federal Reserve is coming to a close. Yields are rising (take a look at the Bank of Canada).

* Speculative issues (specifically on housing, and small-cap venture type firms) are getting dumped away. Just look at the TSX Venture, or anything resource-based on the TSX (including most commodity issues).

* Likewise, leveraged financial products (e.g. most REITs, financials) are trading down. For example, Genworth MI (TSX: MIC) has traded down over the past month from its highs of about $40/share (where I was fortunate enough to get rid of a bunch of it). I will be able to attribute this due to the implied real estate market risk in Canada, combined with an anticipated increase in interest rates. Compared to the financing firms (HCG, EQB), I would view mortgage insurance as being relatively better in terms of continuing to provide earnings and cash flows. Tangible book value is $34.11 from the previous quarter so the company is still not a huge bargain at present prices.

* The strength in the US currency is now starting to weigh in on commodity prices and this is not good for Canada’s economy in general.

* Liquidity appears to be entirely centered around large cap issues.

So here are some general ideas with the assumption that you’re going to bank on a market crash (or less dramatically, a correction):

* Volatility futures – I bring to your attention the following 3-year chart of the VIX, which is correlated deeply to the implied volatility you get on short-dated S&P 500 index futures:


Be warned that it is not unusual for this index to be well below 20 for extended periods of time (e.g. a long-dated chart is here).

* Buying puts on the Russell 2000 (IWM). If there is a flight to liquidity, almost by definition less liquid small-cap issues are going to receive the brunt of increased demand to offload them into the marketplace, resulting in lower prices.

You do pay for this, however – a January 2015 at-the-money put on the Russell 2000 is at about 18% implied volatility, while the S&P 500 is at 12%. The S&P 400 midcap (considerably less liquid) is around 14.5%.

* Buying long-dated treasury futures.

* Or even more conservatively, just holding onto plain old cash and brace for impact.

In general, it appears that we’re headed to some sort of decompression of the utilization of leverage, which will have ripple effects.

Fine-tuning the operations of a restaurant

One of the more interesting SEC filings I’ve gone through lately is that of Starboard Value, who is attempting to replace the board of directors of Darden Restaurants (NYSE: DRI).

I will warn you this is a 130 megabyte download, but a very educational one that makes me appreciate the complexity of operating a restaurant business (something I would never want to do).

One example is the following slide. Apparently they don’t put salt in the water they use to boil pasta because it will invalidate the warranty they have on their cooking pots. This is amazing to hear simply because anybody that has half a brain in the kitchen knows to salt the water that you cook pasta with. Not only does it marginally increase the temperature of the boiling water, but it imparts better flavour on the pasta itself.


I’ve been to an Olive Garden once in my life and never felt the need to ever return.

Blackberry making a comeback?

I’ve written before about Blackberry (TSX: BB), but with a relatively large difference: I’ve been using a Q10 (the one with the keyboard) for a few months.

My mobile phone usage patters are relatively spartan, but I needed something with a keyboard on it. There was amazingly few options to choose from, so I picked up a Blackberry since it was the only thing available in Canada. I also do not feel compelled to be locked into a cell phone plan (which are all considerably more expensive than what I have presently, so would be functionally deferring the payment of the hardware device in the form of monthly cell plan payments), so I picked an unlocked phone for CAD$299 directly from Blackberry’s site. Surprisingly, the phone came a couple days after clicking on the purchase through FedEx. I also had concerns regarding second-hand phones (mainly that they were stolen and their IMEI would be blocked) and thus didn’t feel compelled to go down that route.

My previous phone could only be described as a very basic messaging phone that ran a proprietary Samsung operating system (not Android). It did the job until its touchscreen decided to slowly crap out. I have had little experience with the iPhone other than borrowing a friend’s on occasion. With Android (which is currently the world’s most popular mobile operating system), I do use it with a tablet, but only have used it with a phone on very rare occasion.

My quick no-BS review of the Blackberry Q10 is as follows: Once you get used to the user interface, it is a surprisingly good phone. It does a very good job of email and text management, especially how it consolidates multiple email accounts. Battery life is very lengthy, to the point that one generally doesn’t think about it. The browser is fine (although not a replica of what you would see on the tablet), but the relatively large drawback is the smaller screen (which is the tradeoff of having a keyboard). When turning off data, the Wi-fi function works seamlessly well with the rest of the phone. It is an incredibly functional device and a very large step up from what I previously had.

I generally do not use many other external applications. This is probably why I don’t mind the phone, while others seem to have a need to access the millions of pieces of junk software out there that are available to download (Candy Crush, etc, etc.) on Android. Curiously, the one Android application that I found is a “killer app” (which is an offline mapping application) works perfectly on Blackberry. It was shockingly seamless to get onto the phone and operate.

I will now discuss the investment analysis of Blackberry. Despite the fact that they are going to launch another (larger) phone with a keyboard, it will not materially matter for the company. The mobile phone market has well progressed beyond the stage where hardware no longer matters, and everything is about software.

The analogy is very similar to when personal computers (PCs) were hitting the mass market, and the bulk of the profit margins were not made with the hardware makers (Hewlett Packard, Compaq, Gateway and Dell), but rather the software makers (Microsoft functionally winning the winner-take-all market of operating system and office suite, while the rest were left with the scraps).

The mobile phone market has considerable differences to the PC analogy.

One is that it doesn’t matter what software the phone is running, they will all connect to the cellular network. All the major operating systems have basic functionality (email processing, text messaging, phone calls, contact list management, web browsing) that all perform roughly equivalent to each other. Other than consumer taste (or in the case of Apple, an element of positional good), there is little difference between the choices in terms of functionality. The big difference between the three is the ancillary services that they are able to offer. iPhone offers the Apple ecosystem. Android offers the Google ecosystem. Blackberry offers no real ecosystem, but allows access to the Android market.

Unlike Microsoft Windows during the days when operating systems mattered (if you didn’t run it, you couldn’t access anything that made your computer productive unless if you were into Unix), mobile operating systems matter a lot less and thus their relative market power is reduced. The application market (and choice) is a somewhat relevant consideration on the mobile end, but much less so than 20 years ago when Microsoft Office was the killer product. Today, there would be a “killer product” if only one offering had a functional web browser and had a huge patent moat to prevent others from getting it, but clearly that is not the case.

Apple and Google are going to have to figure out how to prevent mobile carriers from extracting most of the economic value out of the market, but this is another topic for another day.

The point of this post is that Blackberry could come out with the best hardware phone on the planet, and it will not make much difference on their profit margin because mobile phone hardware has more or less become commoditized like PCs were about 15 years ago. Instead, the money is to be made on the software end and the sale of ancillary services.

In Blackberry’s case, this comes in the form of providing business-level integration with corporate information systems. I am not sure how they are going to make this as profitable as it once was, but there is likely a market to be made considering that Android and iPhone were not designed with corporate concerns in mind (e.g. security is often-cited, although it remains to be seen how Blackberry can restore its reputation after giving its keys away to the government of India a few years ago). Another platform which they clearly have an advantage with is the issuance and tracking management of corporate-owned mobile devices.

The QNX operating system unit does have potential with embedded systems (e.g. automobiles and other devices), but this is mostly under the radar.

Finally, BBM is often cited as having value, and in an era where Snapchat and Whatsapp can fetch billion-dollar valuations, there would surely be some market value ascribed to an instant messaging network (although if you ask me, there is far less than what the market valuations would suggest).

So in terms of raw valuation, while Blackberry is going to launch a major new product this month, I very much doubt that it will lead to bottom line improvement. This would come elsewhere in the company’s pipeline. I suspect the new CEO, John Chen, realizes this, but also knows that public perception is an integral part of restoring Blackberry’s credibility, and this includes having good hardware to support the software that will be generating the actual profits.

So at CAD$11.80 or a $6.2 billion market cap, is this a buy or a sell? Too tough to say at present. I was thinking about it earlier this year at CAD$8 (which my gut-feeling suggests is a low, but not ridiculously low valuation for the technology pieces), but did not pull the trigger.