Preparing for a year 2000-type scenario

I am relatively convinced that although the economy appears to be muddling along with a low real growth rate, the markets are pricing in a growth trajectory that is optimistic. We are likely to see increased volatility in the future.

There are some good doomsday type stocks, but perhaps none would be better than Fairfax Financial (TSX: FFH), who have continually prepared for a gloomier future. They have hedged their entire equity portfolio against the S&P 500 and also have purchased CPI-linked derivatives that would profit in the event of a deflation. From Prem Watsa’s annual report, he believes that any credit event in China would cause commodities to collapse (they consume 40-50% of most commodities from iron ore to copper) and it would have an impact on the mining industry. He goes on to state that world iron ore capacity has increased by more than 100% in the last ten years, mainly due to increased Chinese demand.

The excesses in the Chinese real estate market are quite well known and have been reported extensively in the past, but just like what happened in the USA from 2004-2008, it might take some time before any credit events emerge. In addition, the Chinese government has proven to be very adept at managing the situation.

While I don’t profess to if or when such a credit event will happen, if it does occur, it would be very adverse for Canadian investors holding equity and debt in such entities. Fairfax is an interesting bet for a doomsday scenario, but at CAD$470/share they are considerably priced above book value (which is US$339 at the end of 2013 or about CAD$374 at current currency rates). Given the performance of Fairfax’s businesses, one would expect a modest premium over book, but 25% over book seems a bit heavy to swallow. The company also sold 1 million shares at CAD$431 (CAD$417 after expenses) in November, but this was also in relation to their purchase of Blackberry convertible debentures.

OSFI draft guideline on residential mortgage insurance

The OSFI has released draft guidelines (B-21) on residential mortgage insurance companies. There is a comment period up to May 23, 2014. Considering that CMHC and Genworth form substantially the entire market, I do not anticipate much comment.

Despite what the media is reporting (that it would involve a marginal tightening of the mortgage insurance market), upon reading the draft guidelines I do not see this conclusion, which is little change.

Specifically for investors, the only change that will be visible will be a slightly higher amount of disclosure than what is currently provided to the public. This includes (and the bold-print is what I believe will be new):

A breakdown of mortgage loans insured during the previous 12 months as well as the total stock of insured mortgage loans, with further separation by mortgage insurance type (i.e., transactional- vs. portfolio-insured loans), for the following categories:

* Volume: The number and outstanding balance of insured mortgage loans;
* Loan-to-Value: A breakdown according to LTV buckets of 5% increments (both estimated current and LTV at origination);
* Amortization: Amortization period ranges (e.g., 15 – 19.9 years, 20 – 24.9 years, ≥ 25 years, etc.) at origination and remaining amortization;
* Geography: Geographic breakdown by province and territory; and
* Delinquencies: Breakdown of the level of insured mortgage loan delinquencies.

FRMIs should also provide a discussion of the potential impact on insured residential mortgage loans in the event of an economic downturn.

Genworth MI is down less than a percent in today’s trading, which may or may not be caused by the above pronouncement by the OSFI. It continues to be my largest holding despite being trimmed at higher price levels.

Not much to say lately

The market has been going through some corrective headaches, likely on valuation concerns of the well-known high fliers out there (including the biotech sector, which has gone bananas). This all feels like the year 2000 over again.

I still haven’t had anything pop up on the investment radar lately. One opportunity which I did identify last year as a very likely candidate to provide two or three-bagger type gains over the next two to three years has exhibited price depreciation to the point where it is trading below tangible book value. What is even odder is that this company is pretty much top in its business niche and is unlikely to lose the competitive advantage in this niche. It is only trading down because of government regulatory fears. I might write a comprehensive research report on this company, but it is something I would not want to make freely available to the public.

Q1-2014 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2014, the three months ended March 31, 2014 is approximately +4%.

Portfolio Percentages

At March 31, 2014:

37% Equities
19% Equity Options
16% Corporate Debt
28% Cash

USD exposure as a total of the portfolio: 35%

Notification

I will likely suspend these quarterly updates. I do not believe they are adding much value. Does anybody reading this care?

Portfolio Commentary

This was a very muted quarter with a few transactions. The most pronounced was the adjustment of a position using long-dated options strictly due to the reason to employ cheap leverage and the relatively low implied volatility “price” that is being paid for this position. I initially made this investment in the previous quarter and the price went in my direction. The expiration of those options are coming up, so I needed to perform some transactions to sell the remaining time on the present series and extend it out for another half year. A baseball analogy is that I see a slow pitch being delivered that is going to hit the sweet spot of the strike zone, and I am swinging the bat for a home run. The risk-reward ratio is extremely attractive, although if the price I anticipate happening does not materialize in the timeframe I’ve purchased, then that will result in a loss.

I will point out that as of the time of this writing, the position is in the red due to some news concerning the overall industry that should, in my opinion, pass. Analogies include the concerns of government litigation of Phillip Morris and the tobacco industry, and anti-trust investigations of Microsoft when they dominated the operating system and office software market in the early 2000′s. In both cases, the companies in question were dominant players in their industry and quite profitable. The same case applies here.

I took the opportunity to purchase some corporate debentures that are in a distressed state. Time will tell whether this will work itself out or not. The risk-reward in this circumstance is quite attractive given the underlying company and management incentives to deal with the problem without causing a wipe-out in equity. It is not like Pinetree Capital where debenture holders are functionally secure in their investment, but the price paid is quite attractive.

I attempted a trade in a foreign-based security that exhibited perfect market timing in all respects other than the fact that I set the order to expire at 9:31am eastern time and the stock did not have its opening transaction on the NYSE until 9:31:02. This was incredibly frustrating as my trade would have hit the 52-week low. The security is also up 25% from where I had intended to take the position. My initial trade would have been for a 4% allocation in the portfolio, so this inept trading cost me 1% performance this quarter. I learned some lessons here.

I also performed some minor transactions in another security which traded lower after its quarterly result, and subsequently traded higher. I only received a minor fill of my desired position (about 2%) and thus I liquidated it for a quick 15% gain as I did not want this to consume mental bandwidth. It is still on my watchlist in case if it trades down again.

As reported earlier, I liquidated some Genworth MI during the quarter, around the $38 level. Subsequent to quarter-end, I have also liquidated some at the $39 level. Genworth MI still continues to be my largest position. It is a very well run company that is enjoying the confluence of very positive circumstances, mainly record low mortgage rates, a stable (albeit expensive) Canadian housing market, neutral to positive employment prospects and historical low mortgage defaults. It is also enjoying a change in regulatory regime where its primary competitor, CMHC, is slowing backing away from the industry and is also increasing prices in the marketplace.

As a result, my transactions are only for portfolio balance concerns as the fraction in my portfolio was getting ridiculously high. They also issued a 10-year debenture at a very low rate of interest (4.24%, or 1.74% above Government of Canada rates) without causing any blip in their equity. I expect them to be issuing a special dividend later this year to alleviate themselves of their excess capital once OSFI capital requirements are finalized.

The S&P 500 was up 1.3% for the quarter and the TSX was up 5.2%, so the quarterly performance is in-line with the major indicies, despite having a significant amount of zero-yielding cash.

Outlook

I have little inspiration for this quarter’s outlook. I remain in a wait and see position and am continuing to opportunistically look for areas to invest in, but I remain out of ideas at present. I do not have any confidence in any of the commodity markets, nor do I have much confidence in the broad equity indices at present. Sentiment feels like the universal consensus is that the party will continue until it ends, which means very little at present. When given uncertain convictions, the best thing to do is cash up and be patient until such a time that invest-able opportunities present themselves.

The outcome of the Quebec election will have a material impact on the political discourse of the upcoming 2015 federal election. Specifically if Quebec separation is off the table (i.e. the Parti Quebecois does not obtain a majority government, which polling likely suggests will occur), it should have a stabilizing effect on Canadian currency.

I remain fascinated by Russia’s geopolitical aggression to assert its old USSR sphere of influence. Putin has gambled correctly that the western world and NATO will not do anything other than give lip service at the Crimean annexation, but it is inevitable that there will be some other geopolitical rumblings in that part of the world once Russia has asserted itself again.

I equally remain fascinated how valuations in certain technology companies remain sky-high, but this is likely a function of low interest rates and a huge amount of liquidity available to investors. Bonds are horrible by comparison (who wants to earn 2.5% for 10 years?) and as long as this remains the case, then equity investors will continue to try to shoot for the 6%/year instead of taking such a low return on bonds. Pension funds also face the same pressure, which is why capital will continue to flow into equities until we start seeing a loss in confidence. This is why predicting “the top” or the next market correction is so difficult – it is not dependent on economic fundamentals.

This sort of low-rate behavior is also seen in real estate markets, where cap rates in commercial real estate is very low. Just picking a random press release from RioCan REIT, we have the following:

RioCan also completed the acquisition of the remaining 40% interest in Whiteshield Plaza, bringing RioCan’s interest in the property to 100%. Whiteshield Plaza is a 156,000 square foot grocery anchored shopping centre located in Toronto, Ontario. The additional 40% interest was acquired at a purchase price of $11 million, representing a capitalization rate of 5.5%. In connection with the acquisition, RioCan assumed outstanding mortgage financing of $8 million, bearing interest at Banker’s Acceptance plus 1.85%, maturing in September 2015.

A 5.5% cap rate? If I was a real estate portfolio manager, I’d be trying to sell everything I can and then put the proceeds split evenly into gold and Bitcoin!

But seriously, every professional manager out there is facing the same question: How the heck do you get a return in this environment? Do you buy overpriced assets and pray that they don’t crash down, or do you buy low-yielding bonds? They have no choice – they have to do either. An individual investor has discretion to hold high amounts of cash and as you can tell, that’s exactly what I’m doing until my investment radar starts to see more attractive things to invest in.

Divestor Portfolio - 2014-Q1 - Historical Performance

Year
Performance
S&P 500
TSX 60
General Comments
8.0 Years:+17.7%+5.0%+2.4%(Jan 2006- Dec 2013) 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.

Canadian social networking companies – Keek, Inc.

The whole investment world sees Twitter, Facebook, Linkedin, etc., and starts to wonder what the next hype is going to be as everybody gets financially envious at those who are bailing out en-masse with shares they have at a cost basis of pennies.

In Canada, the number of choices are quite limited. Most of the social media companies (at least in the English language) originate in the USA.

However, there is one Canadian firm, out of Toronto, that I know of which seems to have potential for hyped up valuations. That would be Keek, Inc. The company is attempting to be the Twitter of video. I have no idea whether this concept will take off or not, but I am reasonably sure it is something that teenagers with too much data on their mobile data plans would find creative ways to use.

In a rush to get public, they performed a reverse merger with Primary Petroleum Corporation (TSX: PIE, now TSX: KEK). This also temporarily solved another problem that they had, mainly a lack of cash.

Post reverse-merger, once all the dilution is taken into account, the entity will have about 400 million shares outstanding. This gives them a market capitalization for a company that has zero revenues and a burn rate of roughly $20 million a year given their financial statements for the six months ended August 2013.

The reverse merger will give them about a year’s worth of cash (from August 2013!) providing they can obtain some modest returns on the sale of the oil and gas assets that Primary Petroleum had. Between then and now, presumably they are going to count on their common share prices going to the roof in some sort of social media hype, where they can do a secondary offering for a bunch of cash.

Not that fundamentals matter with social networking companies, but it looks like they already their moment in the sun – the following two snapshots are from the management information circular:

Investors in Friendster probably know how this chart feels like.

I give Keek management full credit, however, for developing metrics that make utterly no sense in real life, like the following:

Wow!  The chart is going straight up!  I must invest!

Also, when digging into the documentation even further, I come up with gems such as the following paragraph:

In August 2013, Keek entered into an arm’s length lease agreement to lease approx. 17,947 sq. ft. at 1 Eglington Avenue, East (suite 300), Toronto, ON. The Lease Term was for 10 years and 3 months, commencing on July 1, 2013. Base rent for month 1 thru month 60 would be $15/sq. ft. with base rent for month 61 thru month 123 of $17/sq. ft. Keek was granted three months free rent for both base and additional rent for the first three months. Keek has recently decided that its office space requirements over the next five years are not expected to require 18,000 square feet and therefore has engaged a realtor to sublet the space while Keek look for alternative office space of approximately 5,000 square feet. There is no guarantee Keek will be able to sublet its existing space at values that approximate its current lease arrangements.

Oops!  Nothing like signing a long-term contract for a huge amount of space you suddenly discover you really didn’t need less than half a year later!

Sadly, I will not be investing in this story, but I could easily see others doing so and taking this up to a ridiculous level that is not rationally explainable by any business metrics relating to cash flow or revenues. However, if you had to spend a hundred dollars on the Lotto 6/49 with an average jackpot versus throwing it into Keek, you might actually get a better expected value on Keek, as long as you were allowed to liquidate your shares in the near-term future.

Tragically, I am indirectly invested through this via my Pinetree Capital debentures (TSX: PNP.DB), which I gave a rather cynical analysis on back in November 2013.  Pinetree owns about 52.8 million shares of Keek and if Keek goes to a hype valuation, I would hope Pinetree management would actually liquidate some shares so they can pay off their pesky debenture holders like myself.

Genworth MI – When do I cash out?

The largest component in my portfolio continues to be Genworth MI (TSX: MIC).

mic

The stock is trading at an all-time high today.

I acquired shares in July and August 2012 and have been patiently waiting. I took quite a large initial stake to begin with and I have done well by this decision, but the appreciation is getting to a point where the portfolio fraction is getting too concentrated. Unfortunately, I very much doubt mortgage insurance will be the next big hype in the financial marketplace unlike Twitter, Facebook and 3D printing! (Or if Marijuana is your thing, check out shares of Advanced Cannabis!)

A couple canary in the coal mine analogies include Equitable (TSX: EQB) and Home Capital (TSX: HCG) which interestingly enough, have not exhibited the deprecation that most mortgage REITs in the USA have. Just because this has not happened doesn’t mean it will not happen in the future – right now the economic climate in Canada is relatively stable, but this remains dependent on the commodity industries remaining solvent. I do note that the Canadian dollar has depreciated somewhat over the year, which would be supportive to Canadian real estate valuations. Also looking at the charts of EQB and HCG, it does not look like the canaries are in ill-health at all.

That said, my valuation metrics show that MIC is in the upper end of my fair value range and I have slowly start trimming my position in 2014. They’re almost at 20% above tangible book and I expect they will be booking about $3.60-3.80 EPS in 2014. I would estimate there is some upside left, but it isn’t a huge amount compared to what we have seen over the past 18 months, and it would be momentum-driven rather than any valuation-centric investors.

The recent CMHC announcement to increase mortgage premiums resulted in a nice one-time spike in the stock, but the market might not anticipate that this will have a dampening effect on demand for mortgage insurance itself. Time will tell. The other headwinds of concern is that loss ratios are at historical lows, and one wonders how much more potential unknown good news there is out there for the company.

Momentum and some potential for a catalyst-type event (especially with their huge cash hoard they have been sitting on) have kept me from hitting the sell button too quickly – historically my sales have had much worse timing than my entries. My exit will be slow and gradual and only if the common shares continue to appreciate – otherwise I am fairly satisfied at present to just clip dividend coupons and keep the capital in something other than cash, which has been increasingly difficult to deploy these days.

My only fear is simply one of greed – I can conceivably see momentum trading taking MIC far above what rational analysis would suggest is a fair value. Trimming the position, instead of eliminating it outright, is the rational way of addressing this – if they do shoot to the moon like they are a social media stock, I will have some participation.

Genworth MI up considerably after CMHC increases fees

CMHC has announced today a new fee schedule, to be effective May 1, 2014:

Loan-to-Value Ratio Standard Premium (Current) Standard Premium (Effective May 1st, 2014)
Up to and including 65% 0.50% 0.60%
Up to and including 75% 0.65% 0.75%
Up to and including 80% 1.00% 1.25%
Up to and including 85% 1.75% 1.80%
Up to and including 90% 2.00% 2.40%
Up to and including 95% 2.75% 3.15%
90.01% to 95% – Non-Traditional Down Payment 2.90% 3.35%

Assuming Genworth MI increases its fee schedule to compensate for this (which is likely), this will have the effect of increasing the company’s premiums written, which in turn will have a proportionate impact on the premium recognition as it is recognized over time. The effect on 2014 earnings will be minimal, but it will start to kick in 2015 and beyond.

At December 31, 2013, 73% of Genworth MI’s loan portfolio had a loan-to-value level of 80% or higher, so it stands to reason that they will be making a not trivial increase in this. However, one would observe that the 15% downpayment rate only will be experiencing a very minor increase in premium (1.75% to 1.80%) and chances are this “sweet spot” will lead to gains less than expected.

For the calendar year 2013, Genworth MI’s loss ratio was 25% and expense ratio was 20%. Mortgage delinquencies are quite low at present.

To those prospective homebuyers out there that want to avoid this mess: Just pay 20% down. If you have any decent credit profile, lenders will not require mortgage insurance.

Genworth MI is up about 5% as of the time of this writing.

CMHC announcement – February 28, 2014

CMHC is expected to make an announcement at 11:00am eastern time, on Friday, February 28, 2014.

The media (Globe and Mail) suspects it will be to announce that mortgage insurance premiums will be increasing.

This will have the effect giving people a disincentive to make low down payments (or use extended mortgage terms) and also conveniently allow CMHC to accrue even higher amounts of unearned premiums when they sell mortgage insurance policies.

Since the other two mortgage insurers in Canada (including Genworth MI (TSX: MIC)) mirror the CMHC rates, any increase in CMHC rates would have a proportionate impact on their top-line revenues going forward. CMHC is one of the Government of Canada’s best performing crown corporations, with a comprehensive income of $1.3 billion for the first 9 months in 2009.

The market anticipates a positive announcement, given that the pending news release was announced after the close of February 26, 2014 trading:

mic.to

Genworth MI continues to be a significant component of my portfolio so I am watching this like a hawk. I have no idea what the announcement is going to be.

My views on Genworth equity has been very well documented on this site since I took a position in them in July 2012.

Liquidating Bitcoins is not easy!

People should have seen this a mile away, but MtGox (the exchange that at one point facilitated the vast majority of Bitcoin transactions for real currency) finally packed it in and documents claimed that there was a gaping hole of about 744,408 Bitcoins due to some technical issues with the exchange software that accumulated over a couple years (not to mention a net of about US$33 million cash owed to customers!).

My hypothesis is more plausible: fraud. Anybody running an exchange operation like this would be looking at their account balances like a hawk, hourly, and have proper built-in mechanisms to ensure that there are no leaks in the system. Claiming a loss like this over a period of a couple years is simply incomprehensible.

One of the great things about how Bitcoin works is that the entire transaction ledger (the blockchain) is in public view, and some enterprising people will likely be able to reconcile what happened from publicly available data. 744,000 Bitcoins is about 6% of the entire amount in circulation.

Considering the underlying value of Bitcoin is zero, it is still amazing to see that one can still sell these things for US$500 a piece on other exchanges. This is assuming, of course, they won’t go under either.

I didn’t know how high the hype would go for Bitcoin. Guessing when the tops of markets occur is a tricky endeavour and is simply that, guesswork. My initial guess was “no higher than US$10,000 per bitcoin”, but I subsequently revised that to closer to US$900 than the $10,000 mark.

Now I’ll come with an even starker prediction: Bitcoins will never reach its all-time high (US$1,200) ever again. The hype is gone and the true weaknesses of Bitcoin have more or less been shown to make the entire system unusable except as a novelty.

Bitcoins to currency almost reminds me of what gift cards are to currency: like cash, except worse. If you truly want to invest in something that is relatively immune to the machinations of evil central bankers world-wide, this is the chart of the commodity that I think has profited the most from Bitcoin’s collapse:

gold

Right now a bitcoin is US$516 on Bitstamp (the now leading exchange for Bitcoin volume). You can get an ounce of gold for 2.6 bitcoins. An easy decision for those that still want to believe in hyper-inflationary theories.

Disclosure: No bitcoins, no gold!

More research, nothing found

Spent a bit of time today mining the equity haystack out there.

Nothing of note found at prices that would want to make me dive in. I did get the chance to educate myself on a couple obscure areas of the technology industry that would not make for very interesting cocktail conversation.

I have to keep telling myself that deploying cash for the sake of deploying cash is a good way to lose it.

And no, I’m not even interested in Bitcoins at US$160!