Markets are lulling people into a false sense of security

Been busy looking at various securities (trying to pick the entrails of the crash earlier this February), but still haven’t found anything too compelling. I will especially note on the fixed income side of things there appears to be a lot of traps hiding (similar to Toys R Us unsecured debt last year went from 90 cents on the dollar to 20 cents in about a week). Want another value trap? Here is another.

I’m going to warn readers that things may be quite boring for the next little while. Investing right now seems to be a matter of forcing money to work and that is a recipe for losing it. So I’m continuing to wait.

One last observation:

Do you think this is the market trying to lull people into a false sense of security? Convincing people that the mini-crash we had in early February 2018 was just some sort of aberration due to the overwhelming amount of money betting against volatility?

Instead, people should be paying attention to this chart:

The trajectory here, if the last six months is repeated in the next six months, should frighten people. Coupled with the reverse of quantitative easing eating away at the general liquidity of the marketplace (move the slider on the bottom of the chart to show 2017-01 and beyond), is a recipe for asset price compression. Almost everybody of my generation has only seen rock-bottom interest rates and loose monetary policy during their adult lives. Adjusting to a culture where interest rates are not zero may take some getting used to.

State of the overall markets – suggestions needed

The S&P 500 is now down 3.5% year-to-date, while just last week I was writing about how it was up 7.4%. This, my friends, is over a 10% drop in the market in just 9 trading days. Incredible.

There will be a bit more vomiting but things will stabilize once all of the volatility-linked financial instruments continue their algorithmic unwinding. There has been a surprising lack of candidates out there that appear to me to be obvious victims of margin liquidations (unless if you so happened to own XIV!).

Yield-based financial instruments (prefereds, corporate debt) appear to be doing just fine. REITs have shown weakness, but probably due to markets pricing in the increasing rate environment. The Canadian markets haven’t been disproportionately affected – probably because the Canadian markets were never up that big to begin with. I’ve only seen significant damage in fossil fuel companies, but for obvious reasons (the federal and provincial governments are trying everything possible to kill the sector).

One of my talents that sets me apart from most others is my ability to side-step market crashes. I’ve done it in my very early years of investing in 2000, I did so in 2007-2008, 2016, and this week. I’ve had a few false alarms (I am financially paranoid), so I am not claiming perfection. Normally when circumstances become so obvious to invest (like it was in the first quarter of 2016), I do so, and go on margin. Right now, I’m roughly at 30% cash.

I’ve been trying to figure out how to deploy cash. One would think that a 10% market crash in two weeks would unearth some opportunities. If I find things exceptionally cheap, I have no problems dipping 10, 15 or even 20% in margin depending on the valuation parameters. But it’s nowhere close to doing this.

Something I’ve found very frustrating is there’s still nothing on the radar that has really attracted my visceral instincts.

I’d appreciate some suggestions.

Genworth MI – Q4-2017: Capping off a very profitable year

Genworth MI (TSX: MIC) reported their 4th quarter results today. For those new here, I’ve been freely covering this company for ages. It is the stock in my portfolio I have held for the longest period of time (since 2012). It has sometimes been the highest concentration position in my portfolio, but it currently is not. Here are some notes:

1. The big headline-grabber should be the loss ratio. It is still exceptionally low (9%) – reflecting a relatively stable real estate climate. The average loss ratio for the fiscal year was 10%. This is at a record-low level.

Let me put some context to this. The loss ratio means that for every dollar of insurance the company recognizes revenues on (note this not the insurance they write in a given year although the two numbers are correlated), that the corporation books 10 cents on the dollar of expenses because they have to account for losses on insurance claims.

This means for every dollar the company recognizes, they retain 90 cents, before other expenses.

The expense ratio is 20%, which means it costs 20 cents on the dollar to administer the insurance (e.g. commissions paid to acquire the policies, the administration of claims, management, etc.).

So what is left over is 70 cents on the dollar.

From this pool of money, the two big expenses left to be paid is interest on debt and income taxes. $24 million was booked for interest expenses (about 3.5 cents) and $188 million (28 cents) was booked for the year in income taxes.

However, (this is where readers of Warren Buffet’s annual reports will know this on the back of their heads), Genworth MI has the benefit of float, which is the 6 billion in assets they have to invest before they pay out claims. As a function of premiums recognized (revenues), Genworth MI made 39 cents on the dollar with their investment portfolio.

So when you do the math, the company recognized $676 million in revenues, and recorded a bottom-line amount of $528 million, or 78 cents on the dollar of net profitability.

I want anybody to tell me any other company on this planet earning 78% net margins, after interest, depreciation/amortization, and taxes.

When people are paying their mortgages, this is a wildly profitable industry to be in.

This breaks when people start defaulting on mortgages, causing a collapse in real estate pricing due to forced liquidations, and then soon mortgage insurance providers will be hard-pressed to pay banks that will be knocking on the door. So far, this scenario has not happened. A rising real estate price environment means that even when people default on their mortgages, when they occur, such defaults are not severe from a mortgage insurance perspective – even when there is fraudulent underwriting (see: Home Capital Group).

The Canadian government is most unlikely to change this insurance scheme, because the 100% government-owned crown corporation, CMHC, is also raking it in – their volume is roughly double of what Genworth MI does. Why interrupt the gravy train when this crown corporation is delivering huge amounts of cash to the government in the form of mortgage insurance fees?

2. Premiums written on transactional insurance was up slightly from Q4-2016 – mainly due to the increase in mortgage insurance rates from last year, offset by decreased volume due to mortgage rule changes. Portfolio insurance is down significantly, but this was expected due to regulatory changes. My take on this is that it appears that the dollar amount of insurance written has stabilized. There is slightly less concentration in Ontario/BC than the rest of the country:

3. The interest rate swap they took to the tune of $3.5 billion notional value 3-5 years out continues to pay off – fair value of $131 million at Q4-2017 vs. $120 million in Q3-2017. This was a very, very smart move on interest rates.

4. In terms of balance sheet management, the only changes to the portfolio has been a slight shift away from corporate debt, in favour of collateralized loan obligations and an increase in corporate preferred shares (5-year rate resets). Fair value has increased to $6.45 billion from $6.34 billion.

5. It is still not entirely clear what the impact of the China Oceanwide merger with Genworth Financial (NYSE: GNW) will be – or even whether this merger can be consummated at all. Reading Genworth Financial’s 8-K, a huge stumbling block is “The delay in the review process is due to the difference in opinion of the fair market value for Genworth Life and Annuity Insurance Company (GLAIC)” which is a huge stumbling block (this subsidiary of Genworth Financial is saddled with liabilities concerning the long-term care insurance pricing disaster). One potential scenario has always involved Genworth Financial completely selling off their holdings of their Australian and Canadian mortgage insurance subsidiaries.

Genworth Financial is also looking at a secured bond transaction to finance their upcoming 2018 bond maturity – although they have the cash at the holding company level to pay it off, it will leave them constrained.

6. Minimum capital test level is at 168% with the target being 160-165%. Management has a history of either executing a share buyback or giving out a special dividend with the excess capital. Their history has typically been quite prudent and only buying when the stock is at a substantial discount to book value – which it is not presently. I would believe they will be holding tight and figuring out what to do with the excess capital later. Diluted book value is $43.13, while the common stock closed today at $41.49.

(February 7, 2018: Listening to the conference call, I believe management will let the MCT go substantially higher than 165% during 2018 – I no longer believe a share buyback or extraordinary dividend will be in the works in 2018).

The company remains in what I consider to be my fair value range at present.

Marijuana companies – smart moves

Marijuana companies have to know at this time their primary objective is the following: obtain real assets other than market goodwill, and do it quickly as possible.

To this effect, you have companies raising cash like mad. Canopy Growth (TSX: WEED) raised $175 million earlier this year. Aurora (TSX: ACB) is buying other marijuana companies like crazy with its inflated stock.

The recipients of these gushes of cash are the ones that will be making the better deals. Here’s an example: Today, an announcement that Aurora is buying nearly 25% of Liquor Stores NA (TSX: LIQ) with warrants to buy more of the company if the stock goes higher.

This works very well for Liquor store management, who will be getting a huge cash injection at an equity price well above market. It works for Aurora, who is trying to desperately diversify into other assets beyond their own stock price.

How did Aurora pay for it? A $200 million bought deal convertible debt financing, earlier in January! Some people have money to throw away I guess!

Volatility

I thought my previous posts about raising cash were correct, but I wasn’t expecting it to be that correct.

Picking through the entrails of this mini-crash, I actually don’t see much signs of margin liquidation – this was an old-fashioned concurrent stampede of trading that wanted to get out all at the same time, and they did it with the high-capitalization stocks.

I didn’t see much of an effect on the Canadian market. Normally there is a bit more correlation. I’d expect to see smaller, less liquid issues being sold off as people panic to sell anything to raise capital.

Something else odd was that normally when the market crashes like this, the 30-year treasury bond yield drops a lot, but like the past week, the equity and bond prices (not price-to-yield) are correlated.

This is one of the oddest high-volatility periods I’ve witnessed. It reminds me of the spring of the year 2000. Normally I should be deploying capital when the volatility index is high, but this is a one-day spike and it is nothing sustained. I would not be surprised at all to see a huge rally up followed by another gut-wrenching crash later.

I already have a list of stocks assembled for purchase if the price is right, but currently, the price is not right.

With the decline of the Canadian dollar, my portfolio (as measured in Canadian dollars) actually rose on Monday.

Finally, the S&P 500 at 2648 means that it is down for the year. I’m finally outperforming again.

General Comments – Canadian Debenture Market

I’ve finished my comprehensive sweep of the Canadian debenture market. Nothing much has changed except a bit of price weakness which can likely be attributed to the volatility seen this week. Very broadly, I’m not finding anything overly attractive in this marketplace.

On the TSX side, the exceptional items on the radar include the question of when Lanesborough (TSX: LRT.DB.G) will be formally going belly-up – you can buy their zero-yielding debt for under 10 cents on the dollar. Another luminary is Discovery Air (TSX: DA.DB.A), where you can gamble that the controlling entity (who controls most of the senior secured debt outstanding) will be generous enough to let the unsecured debentureholders get away with some cash.

There are quite a few of the smaller oil and gas issuers that are showing signs of financial stress. This is likely due to the fact that Alberta and Saskatchewan oil producers are facing a CAD$22/barrel selling price deficit with no signs of this going away. It turns out that it’s really difficult to sell crude oil when you can’t transport it anywhere! I’m guessing the majors (Suncor, etc.) are just licking their lips and are preparing for an acquisition spree once the less solvent juniors are forced into CCAA submission. I still maintain, for now, that fixed income investors in fossil fuel producers will be likely to make more money (or perhaps lose less of it) than the equity side.

It is also interesting to see how Kinder Morgan Canada Limited (TSX: KML) has not traded down much given the news from British Columbia’s government that will be implementing further regulations on the transport of diluted bitumen. The payload is in the last line of the backgrounder of the release:

In order to protect B.C.’s environmental and economic interests while the advisory panel is proceeding, the Province is proposing regulatory restrictions to be placed on the increase of diluted bitumen (“dilbit”) transportation.

KML does continue to operate the existing Trans Mountain pipeline (map), and since there is effectively a moratorium on long-distance fossil fuel pipeline building in the country, it does make existing pipeline infrastructure more valuable.

This hostility to fossil fuels is one reason (high taxation is another) why retail gasoline prices in Vancouver are the highest in Canada, short of remote northern areas. This will continue to go higher as the provincial government will be raising carbon taxes over (at least) the next four years.

As an interesting side note, retail gasoline in Vancouver, BC is currently at $1.43 per litre, while a little down the border in Washington State, it is US$2.68 per gallon, which works out to about 87 cents per litre.

General comments – market weakness

Another ranting post with little direction.

With marijuana-related equities and cryptocurrencies plummeting, the market for speculative investments appears to be topping. Probably the next short squeeze that occurs will be the best time to be shorting these instruments. Implied volatility on the options sadly are high, and the borrow rate on WEED, APH, ACB, etc., are astronomical.

I also note Aimia (TSX: AIM) has sold off one of their divisions today and most of the negative news is buried in a later paragraph concerning the tightening of their senior credit facility – this is basically part of the slow march to zero. The company is happy to cite the amount of cash on their balance sheet, but not so happy to cite the balance of their deferred revenues, which represents future commitments that will be offset by cost of goods sold – hence the cash reserve. Using an insurance analogy, they are running off their insurance book with little capacity to collect premiums written after Aeroplan expires in 2020.

There’s a lot of young people out there that have witnessed nothing but rising markets and low interest rates and the financial mindset is fixated on these two conditions. There is going to be a lot of financial roadkill along the way, similar to what happened in 2000-2002 where a lot of people got wiped out for believing the dot-com bubble.

Incidentially, 2002-2003 was the perfect time to invest in the inevitable winners of that technology boom (Amazon and Priceline being two great examples). There will have to be winners out of blockchain software, but it could just as equally come from a major player. Very difficult to say at this point in time as I still have not seen any functional system operating with blockchain that doesn’t have a parallel system that is better – unless if you believe that cryptocurrency’s best application is evading monetary authorities.

As I suggested in my previous post, the roller-coaster is just starting. No point in jumping in too early.

S&P 500 year to date

Caution investors – if your portfolio hasn’t risen +7.4% since the beginning of this year, you are underperforming! (Just for disclosure, I am underperforming the S&P 500 year to date!).

I’ve attached the above chart to show how parabolic things are going to get over the next little while.

I can just imagine clients telling their value managers about how much their friends are making on cryptocurrencies, marijuana, and also by people just dumping money in the top 10 large-cap companies, irrespective of any fundamental underpinnings of these corporations.

There are times in financial history where this has occurred before. I’m thinking 1999 or early 2000. It doesn’t end very well.

Raise cash. It is the most difficult trade to hold cash right now – precisely why it is correct.

Bombardier vs. Boeing

Just like most (but not all) of the financial community, I was not expecting the USA trade panel to vote 4-0 in favour of Bombardier.

The immediate implication here is that Boeing, by its actions, has pushed Bombardier into Airbus’ arms, and Airbus is obviously more capitalized and equipped to handle Boeing. By forcing the trade issue, they’ve allowed Airbus to take control of a superior product, which Airbus has a strategic interest in proliferating.

Suffice to say, Bombardier’s stock price is up today, but more relevant for myself, I will be holding onto their preferred shares.

Keg Royalties Income Fund – Impact of the Keg franchise buyout by Cara Group

The Keg chain of restaurants were acquired today by the owner of Harvey’s and Swiss Chalet (both of these names are much more prominent in Ontario than they are in British Columbia). In general, this does not bode well for food quality, but it does bode well for the continued corporatization of the brand name.

More specific to Canadian investors, the Keg Royalties Income Fund (TSX: KEG.UN) is one of those few royalty funds remaining. It’s sole purpose in life is to distribute cash obtained by its 4% revenue share in anything that the Keg sells. It was interesting to see its reaction to the news today:

The market believes the buyout is a revenue-negative event for the Keg.

Financially, KEG.UN is easy to analyze. The trick for an investor is determining the proper fraction to pay for the royalty income (currently investors are purchasing a KEG.UN unit in exchange for $1.13 of distributions, which at a $19/unit price means a 5.95% ratio), plus factoring in the future trajectory of the Keg franchise’s gross sales.

Personally the last time I ate at the Keg was 2009.