The rise of interest rates

Something that was a direct result of the US Presidential election was the entire yield curve lifting. The short end in the USA will likely change upwards 0.25% on December 14.

Canadian interest rates are inevitably linked to US interest rates due to the very close economic connection between both countries.

I generally do not profess to have a good radar when it comes to interest rates, but I do observe the trends and notice that the 5-year Canadian government bond yield (which determines most, if not all, rate-resets on Canadian preferred shares) has eclipsed 1.00% for the first time in over a year:

5yrrates

The last time it reached 1% was briefly in November 2015, and then before that it was briefly above 1% in May and June of 2015. Before that it was only consistently above 1% before January 2015.

The question is whether this is a short-term rise up as a knee-jerk reaction to Donald Trump’s election, or whether this will be something that will be sustained (and if so, rates will likely not settle at 1% and will head higher). I have no idea what will be happening.

D+H Corporation slashes dividend

I looked at D+H Corporation’s (TSX: DH) last disaster of a quarter and predicted the following:

My guess is that the dividend is going to get slashed in half.

So, today, they announced their 32 cent dividend is going down to 12 cents. The stock is up today because the company says they are going to do a share buyback with half the amount that they wouldn’t have paid out in dividends, but given their leverage situation, I’d be skeptical.

KCG Holdings – Significant share buyback

KCG Holdings (NYSE: KCG) I’ve identified as a fairly good risk-reward candidate last month.

Yesterday they announced they came to an agreement with one of their major shareholders (whom were part of the recapitalization/reverse takeover of the predecessor firm after their major trading glitch on August 1, 2012) and have swapped 8.9 million shares of BATS for 18.7 million shares of KCG stock and 8.1 million at-the-money (roughly) warrants.

After this transaction, KCG still has 2.3 million shares of BATS – they did liquidate about 2 million shares on the open market over the past month.

This transaction has a positive double-whammy for book value – not only are the BATS shares accounted for at less than market value (which means the transaction will cause an accounting gain), but the KCG shares are being bought back for well under book value. Even when accounting for the not insignificant tax bill that will result (about a hundred million!), the final book value of KCG would be around $18.79/share after the transactions.

KCG will have about 67.5 million shares outstanding and 5.1 million warrants outstanding (strike prices of $11.70, $13.16, and $14.63, with each about 1/3rds of the warrants). These are likely to be exercised and shares sold in time – each of these warrants expire in July 2017, 2018 and 2019, respectively.

The corporation is trading slightly more than 20% underneath tangible book value. They have historically made money, especially in volatile conditions. The word “volatile” is also used to describe the new President-Elect. Needless to say, this has potential.

The other note is that CEO Daniel Coleman owns 1,487,907 common shares, or about 2.2% of the company, which is not a trivial amount of capital. He also owns 161,132 warrants, and 1.7 million stock options at a strike price of $11.65/share (making the effective ownership about 4.8% assuming the exercise of warrants and options), plus stock appreciation awards at $22.50/share, due to expire in July 2018. There is some serious incentive for him to get the stock price higher.

Pengrowth Debentures – To be redeemed

A short couple months ago I wrote an article about a “very likely 12% annualized gain” in the form of buying (TSX: PGF.DB.B) at 97 cents.

So it looks like I gave up that return (at least with some idle cash holdings, I do have a position from far cheaper prices earlier this year) as management announced today they are seeking consent from debtholders to allow the company to redeem them as if they have matured on March 30, 2017 (i.e. you’d get about 3 months of accrued interest paid out to you immediately).

So it looks like debtholders will be paid off at $1.03116 per dollar of debt. The redemption will occur on December 30, 2016.

The choice of getting paid today vs. getting paid the same amount in three months is a no-brainer: take the money today and move on.

I have no idea where I will re-invest the proceeds. There was nothing nearly as “safe” as this specific debt issue. Any suggestions out there?

Canopy Growth Corporation

Canopy Growth (TSX: CGC), specializing in the production of marijuana, has gone parabolic.

cgc

Today, 12.9 million shares traded (about 10% of the company) around a level that valued the entire entity at around CAD$1.5 billion.

Fundamentally, looking at their last quarterly report, they have sold $15 million of marijuana in the last 6 months.

If you (exponentially) extrapolate their revenue growth curve, they will be selling over $1 billion in marijuana in five years.

Somehow, I don’t think this will happen.

I am predicting two things:

1. Management is going to do a massive secondary offering. They did two of them earlier in 2016 (raising an 8-digit sum of money), but they will scramble to raise an even bigger amount of money which would pay for a lot of marketing. I’m guessing they’re going to aim for over a hundred million. I’d do the same if I were in their shoes, in addition to personally selling shares at the earliest possible opportunity.
2. Eventually, within the next six months, a lot of people are going to lose money on this stock.

Right now, if you are short, I can imagine the pain. Maybe those short on the stock should get a prescription of medical marijuana to ease the pain.

No positions, no intention to take any, but looking at this stock with amusement.

Best ways to obtain gold exposure

The purpose of this article is to go over the various ways one increases exposure to the gold commodity. Clearly while investing in gold producers is another method, I will leave that for other smarter individuals.

The hypothetical investment is a CAD$10,000 or US$7,400 investment in gold. With institutional levels of capital, there are other facilities to expose oneself to gold. For the purposes of this article I am assuming a US$1,220/Oz price and a 0.74 USD/CAD exchange rate.

The largest gold ETF is (NYSE: GLD) and they are massively liquid. The MER is 0.40%. The next largest gold ETF is (NYSE: IAU) and they charge an MER of 0.25%. I would recommend IAU strictly on cost differentials – both have volumes that are well above retail levels. In terms of security, the custodian of GLD is HSBC, while the custodian of IAU is JP Morgan Chase. My very unprofessional ranking would put the two level in terms of security, hence IAU is the winner on costs. At today’s gold prices, you would be able to purchase 6.06 troy ounces and pay about CAD$25/year for the warm and snuggly feeling of it being safe. Purchase and disposal costs the price of a trading commission. GLD and IAU are denominated in US currency.

In Canadian currency, the best bet (and indeed, the only bet) is (TSX: MNT) which carries the unique feature of being backed by the Government of Canada and at an MER of 0.35% (thus a yearly maintenance of CAD$35/year). Its only apparent drawback is liquidity – bid-ask spreads typically are between 10 to 20 cents so this is not a product where you would want to place market orders. Each unit is currently equivalent to 0.0107125 troy ounces of gold. Purchase and disposal costs the price of a trading commission. MNT is legally an exchange-traded receipt (ETR) and they do trade above and below net asset value like ETFs.

Another option is purchasing the physical product. These suffer from three issues – divisibility of the product, transport, and storage. Looking at online vendors such as Kitco, you can purchase a 100 gram gold product for CAD$5,430. Pretending you can buy CAD$10,000 of product would result in 184 grams of gold or 5.92 troy ounces, which is a significant spread off market pricing. Getting it in one ounce gold coins results in a net gold mass of 5.86 troy ounces. Also, once you buy the product, you also have to pay to have it shipped (CAD$30) and insured (CAD$40 for a $10,000 purchase), which also adds to costs. Finally, it has to be stored somewhere securely – a bank safety deposit box is CAD$65/year at RBC, but these boxes are not covered by any insurance if there were circumstances that would cause them to be stolen or destroyed. Also, if the gold is to be subsequently liquidated, there will likely be additional frictional costs.

As a result, I do not believe that physical storage of gold is feasible on the retail level beyond trinket sums of capital.

The last option is using financial derivatives to emulate the price of gold. The best option is to use gold futures on CME. These are extremely cheap to trade and are liquid products, but suffer from the primary drawback of being in lots of 100 troy ounces. Margin requirements to hold a gold contract (US$122,000 notional value) overnight is US$5,400, so from a capital maintenance perspective, if your desire is to hold 100 troy ounces of gold, I would prefer utilizing futures. Clearly this is not a viable option if one’s intention is to invest CAD$10,000 in gold.

President Donald J. Trump – Immediate implications for Canada

I have been saying here since January 2016 and repeating ever since that Donald Trump will become the next president. Friends of mine will know the words out of my mouth back in August 2015, where I said “not only will Donald Trump win the Republican nomination, but he will become the next president of the United States” – and everybody else started laughing. “No, I’m serious! You laugh today, but just wait and watch”.

Making these sorts of predictions looks easy in retrospect, but there is a lot of genetic psychology that makes it quite difficult to be the one to stand out in a crowd with a very unconventional viewpoint (especially in a country where basically 90% of the people supported Hillary). Either you are regarded as crazy (as my friends clearly did), or shunned, or both. The funny thing is even when you are proven correct, those attitudes generally don’t change much. The only solace on marketable pieces of information such as this (or a lot of what goes on in the financial marketplace) is that correctly contrarian viewpoints tend to make a lot of money.

The markets have basically V’ed since the election (and indeed, I kept a real-time chart of the S&P 500 futures on my desktop as the election results came through, and it was very impressive how trading took it down and up on the returns of various polling stations in key states like Florida).

But there are some macroeconomic parameters that need to be factored into a Donald Trump presidency. While the US system is designed to make sure that you can’t enact too much change with a stroke of the pen (the US Constitution is an amazing structure demonstrating separation of powers), it is pretty clear that companies dependent on Canadian trade with the USA are going to have a more difficult time if there is any perception of protectionism in that particular industry.

Energy policy in the USA will be fairly obvious – there will be more friendly regulations concerning fossil fuel extraction.

In particular, in the political climate of Canada, Justin Trudeau already has staked a bit of his political credibility on his future relationship with Hillary Clinton, and that has now gone to dust. It will indeed be very interesting to see what happens when Trump wants to renegotiate NAFTA – the impression I will be getting is one if I was in a boxing ring with Mike Tyson.

The other quick conclusion I can reach is that it is more probable than not that interest rates will rise quicker than most people generally realize. My hypothesis for this is that the institutions behind the US Government are quite Democratic-party dominated at present and they will want to hamper anything that will come out of the President’s office. And the easiest way to do this is to starve the nation by raising interest rates. Watch the Federal Reserve this December raise rates.

So in general, we have the following parameters:
1. Sell long-term bonds or anything with medium to lengthy durations.
2. Long US dollars.
3. Get rid of anything Canadian that is US trade-sensitive.
4. Get rid of anything strongly dependent on Democratic-related domestic subsidies in the USA.

One of Obama’s legacies is saddling the nation with another US$10 trillion dollars in fiscal debt in his 8 year tenure. Even for a nation as rich as the USA, this is a lot of money (about US$30k per capita). This clearly cannot be sustained and unlike other forms of political actions, the direct connection to the standard of life and the increase in the nation’s debt is diffuse and won’t be felt until later – but I suspect the impact of the huge increase in debt will happen over the next few years.

Genworth MI reports Q3-2016

Genworth MI (TSX: MIC) reported their Q3-2016 report. This was a very “steady as she goes” type report fundamentally, with little hidden surprises. Some highlights:

* Stated book value per share is $39.01 (means the company is trading 29% below book value, which is a huge discount – I will also point out there is about $2.48/share of goodwill, intangibles and the deferred policy acquisition costs, so the most absolute conservative valuation of tangible book value is roughly $36.50/share diluted).

* Loss ratio goes to 25%, up from 20% in the previous quarter mainly due to oil-producing (Alberta, Sask) delinquencies and defaults. Delinquency rate is still at 0.10%.

* Investment portfolio is up another $200 million in invested assets (3.2% average yield).

* Transactional written insurance premiums down 15% from quarter of previous year; portfolio insurance up 7%, which was somewhat surprising given the rule changes after Q2-2016 (quarter-to-quarter comparisons here are not that useful due to seasonality).

* Minimum capital test under soon-to-be-replaced OSFI rules went up to 236% from 233% in previous quarter.

* Dividend raised from 42 to 44 cents (I was expecting a 3 cent raise, but this is probably to ensure they keep raising capital levels for the new rule changes – market may not like this although in strict financial theory they’d do best to scrap the dividend and repurchase shares at current prices).

* Credit score increases of client averaging 752 from 744, gross debt service level is 24% (would lead one to suspect that absent of catastrophe, clients would continue to pay mortgages above all else)

* They seemed to figure out how to stop losing money on buying Canadian preferred shares. They really should just outsource this to James Hymas, who I am sure will be able to provide superior risk/reward on these investments.

The big question is the looming impact of regulatory changes, an issue previously discussed on this site. Some snippets:

* On the issue of OSFI capital calculation changes, the “new” target is 150% (from 220%), and in the new framework, they are at 155-158%, the previous June 30, 2016 quarter had it at 153-156%.

* Impact of BC announcement of 15% property transfer tax on foreign buyers in Vancouver area:

As of August 2, 2016, foreign individuals and corporations will be subject to an additional 15% land transfer tax on the purchase of residential property in Metro Vancouver. The Company does not expect these changes to have a material impact on its business, as foreign borrowers are typically not eligible for high loan-to-value mortgage insurance.

* Impact of the mortgage changes and applicability of transactional and portfolio insurance on various mortgage properties:

After the Company’s review of the mortgage insurance eligibility rule changes announced October 3, 2016, it expects that the transactional market size and its transactional new insurance written in 2017 may decline by approximately 15% to 25% reflecting expected changes to borrower home buying patterns, including the purchase of lower priced properties and higher downpayments.

As the result of clarifications provided by the Department of Finance after the October 3, 2016 public announcement, the Company now expects that portfolio new insurance written in 2017 may decline by approximately 25% to 35% as compared to the normalized run rate after the July 1, 2016 regulatory changes for portfolio insurance. The new mortgage rules prohibit insuring low loan-to-value refinances and most investor mortgages originated by lenders on or after October 17, 2016.

Notes: I had anticipated transactional insurance would drop by 1/6th (so this is within the 15-25% estimate), and I thought portfolio insurance would get completely shot up (which is going to be the case).

Basic calculations would suggest that if transaction insurance gets dropped 20%, the annual run-rate is about CAD$521/year, plus whatever insurance premium increases that will happen in 2017 as a result of heightened capital requirements. I had originally given some conjecture that this number would be CAD$570 in the end – which is still a pretty good number even if the combined ratio goes up to 60% or so – you’re looking at a very, very, very profitable entity.

Portfolio insurance will taper down and contribute about $60 million/year in written premiums.

Going forward, Genworth MI should produce about $570-580 million/year in written premiums, without increases in mortgage insurance premiums.

Cash-wise, at a 50% combined ratio (30% loss and 20% expense) and a 26% tax rate, shareholders are looking at $210-215M/year or about $2.32/share in operating net income. A $6.2 billion investment portfolio at 3.2% blended yield gives $1.60/share, taxed at 26%. Combined, the entity would still pull in cash at $3.92/share – considering the $27.86 share price currently, this is trading at a P/E of 7, at a book value of 30% below par… needless to say, an attractive valuation.

I generally do not care about the top-line revenue number as this just represents an amortization formula of the unearned premium reserve. However, analysts and uninformed members of the public do tend to care about this since revenues translate into bottom-line results, and this number will continue to rise over the next year above the $162 million they booked this year. The only thing that will change this is a change in claim experience and time – for any given insurance policy, more of it gets booked in the earlier stages of the policy than the later ones. The increasing revenue number will result in higher amounts of higher reported net income, and higher EPS.

Questions for conference call:
– Impact of Genworth Financial’s acquisition on Genworth MI – what restrictions would there be on equity repurchases – and asking about the out-right sale of the MIC subsidiary (which, at current values, has to be put on the table);
– Ability/willingness for Genworth MI to repurchase shares at extremely discounted book value per share prices;
– Regulatory impact of private mortgage insurance $300 billion cap (currently at $275 billion for all private entities, MIC at $221 billion);
– What the MCT internal target will be with the new OSFI capital regime.

Final thoughts: Right now, repurchasing shares of Genworth MI is such a no-brainer shareholder-enhancing decision. I hope management can snap on it. The common shares are trading on the basis of Canadian real estate fear and not in any regard to the underlying financial reality which show an entity that is generating a massive amount of cash.

US Presidential Election: Current Guess

I apologize to my readers. Instead of writing anything relevant to the financial markets, I’m instead writing about Trump vs. Clinton. Please forgive me – this will pass after Tuesday.

The following is my November 3, 2016 guess. My prediction has nothing to do with endorsement of any candidate or policies they represent. In fact, a Kaine/Pence (choose one for president and vice president by flipping a coin) administration would probably be a lot more acceptable for most of the public.

Canadian readers of this site can remember what happened with the NDP and Jack Layton in the 2011 election in Quebec. While it isn’t huge like that election was, there is an element of it in this particular election.

2016-11-03-electoralmap

Polling:

If you are Hillary you do not want to see this:

2016-11-03-latimes

LA Times / USC has always had a pro-Republican skew to it from the very beginning of this election (although they were quite right in 2012), but that “hockey stick” boost at the end is something you don’t want to be seeing if you are a Democrat – people locking in their votes for Trump. Since this is a national poll, it can only be extrapolated so far since there are huge Democratic majorities in California and New York, but this isn’t what you want to be seeing if you are cheering for Clinton.

The aggregate polling also shows a Trump spike, but I have always claimed that poll samples (including the LA Times one above) is not representative of who Trump is going to actually get out to vote – voter turnout and the distribution of voters that show up is of paramount importance in elections in Canada and the USA.

2016-11-03-rcp

Polls do try to correct for this factor by including “likely voters”, but methodologies can only go so far. Since most political pundits use backward-looking lenses to project results, it is not surprising that they are all still predicting a Clinton victory.

The real-money markets (Pinnacle Sports is the best proxy for this) has Trump at +226, which is the highest probability odds I have seen him. Betfair (which is closed to Canadians), I also consider highly credible and they have him as 9/4, which is pretty much the same.