Congratulations to Tim Horton’s equity investors

Tim Hortons shareholders (TSX: THI) have made a killing – the stock is up about 50% from its average level over the past year. It closed at $88/share, up from about the $60 level it has been at.

I’ve written about the company last year about how they were leveraging (issuing cheap debt to buy equity) and how they appeared to be roughly at the top of their price range which seemed to make an equity repurchase imprudent. I have to commend Tim Horton’s management for engineering what can only be described as a very high liquidation value for their shareholders.

Suffice to say, if I was holding any THI at this moment I would not wait too long before hitting the “sell” button.

On paper, the synergy makes sense – Burger King commands the USA, while Tim Horton’s takes Canada.

However, history would suggest that the synergies are likely not to be realized in the form promised by this merger. THI already has tried the “Burgers and Doughnuts” concept with their failed integration with Wendy’s (NYSE: WEN) so I am actually quite skeptical of their combined ability to find operating synergies on the basis of scale. There is likely some sort of implied belief that Tim Horton’s can try to make some sort of breakthrough in the USA, but they have tried that before, and for whatever cultural reasons, it is not happening.

Maybe if Burger King went into the coffee, doughnut and breakfast market they could be assisted by offering THI products, but Burger King is paying a very pretty premium for Tim Hortons.

When to buy shares in a company

You’ve been tracking a company for a year and generally know its ins and outs (fundamentals and the way its stock trades).

They report quarterly earnings. It is a bit worse than you thought it would be, but this is due to the industry conditions being as bad as it can possibly get.

The stock initially trades down, but starts trading back up to its pre-earnings market value.

A fairly good sign that bad news has been baked into the company and likely the risk/reward is in your favour.

Market volatility coming up

The charts suggest that volatility is going to ramp up. Investors should ensure that their portfolio components can take advantage of volatility rather than participate in the negative price trend.

My own portfolio feels appropriately sheltered against this, but we will see if it takes any collateral damage. In particular, one company that I own (the one with the highest concentration currently in my portfolio) takes direct advantage of profiting from volatility so we will see if this proves to be an adequate hedge.

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.