Monthly Archives: May 2011

Here we go again – Market volatility

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The main US indicies are down under the reports that more European countries are facing debt downgrades – Italy today is the prevalent one.

However, since I think it is safe to say the whole world knew that other European countries other than Greece are going to face similar meltdowns in their finances, investors should be aware that there are other possibilities – such as a slowdown in demand.

Such a slowdown in demand will not be in favour of commodity markets, but will be in favour of anything defensive – consumer staples, utilities and bonds. The insurance sector should also look good, but these companies are difficult to research.

It is also very difficult to make money in these sorts of marketplaces (at least long-only) since indexers will be selling their equity and thus it becomes a game of timing when the supply stops – this could be months down the road. It is a good time to prime that research list and take advantage if we are going to be seeing a significant drop in equity prices.

Soft Drinks and Pseudovariety

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Philip H. Howard, a professor at a university in the state of Michigan, wrote a paper dealing with the structure of the soft drink industry. He determined that when you link the variety of brands back to their parent companies, three companies controlled 89% of the scene given a retail sample in Lansing, Michigan (the state capital, metropolitan area population of approximately half a million people).

When reading the paper, strictly from an economics standpoint, leads me to ask two questions:

1. If you are invested in the industry (e.g. in Coke or Pepsi), how likely is it that the industry will continue to be entrenched as-is for the indefinite future? Warren Buffett made a large bet that it will be. How can a company such as Coca Cola destroy its own brand?

2. If you are a potential competitor to the industry, how do you break into the field and still make money? The industry is quite self-protective and will purchase or destroy competitors, as appropriate – they have plenty of tools to doing so, such as purchasing optimal shelf space at grocery chains, etc. Witness Jones Soda (Nasdaq: JSDA) for an example when you get on the radar of the majors.

Note that there are similar industries in nature – in particular, tobacco and liquor distribution come to mind. Tobacco is an industry that is almost impossible for a newcomer to break into the field because of government protection. Liquor is somewhat less restrictive, but the only real breakthroughs have been with beer and wine as opposed to hard liquor.

Reviewing track record of IPOs and other matters

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Now that I have been thinking about some IPOs that I have covered in the past, we have the following:

Whistler Blackcomb (TSX: WB) – I stated in an earlier article that this is one to avoid and I might think about it at $5.30/share and so far nothing has changed this assessment.

Athabasca Oil Sands (TSX: ATH) I did not have a firm valuation opinion other than that the shares seemed to be overpriced at the offering price ($18/share) and stated the following (previous post):

Once this company does go public it would not surprise me that they would get a valuation bump, and other similar companies that already are trading should receive bumps as a result. I have seen this already occur, probably in anticipation of the IPO.

If you had to invest into Athabasca Oil Sands and not anywhere else, I would find it extremely likely there will be a better opportunity to pick up shares post-IPO between now and 2014.

While the valuation pop from the IPO did not materialize (unlike for LinkedIn investors!) the rest of the analysis was essentially correct – investors had the opportunity to pick up shares well below the IPO price (it bottomed out at nearly $10/share in the second half of 2010), although I don’t know whether the company represents a good value at that price or not. I didn’t particularly care because Athabasca Oil Sands has some other baggage that made it un-investable (in my not-so-humble opinion).

While I am reviewing my track record on this site, one of my other predictions dealt with BP, Transocean and Noble Drilling, that:

Over the course of the next 2 years, $10,000 invested in BP (NYSE: BP) at the closing price of June 16, 2010 will under-perform $10,000 evenly invested in Transocean (NYSE: RIG) and Noble (NYSE: NE). Assume dividends are not reinvested and remains as zero-yield cash.

At present, BP would have returned US$14,392.46 to investors, while RIG and NE would have returned US$14,198.52. If I had the ability to close this bet for a mild loss, I would – the political risk for the three companies in question have completely gravitated toward the “status quo” once again after the Gulf of Mexico drilling accident. Drilling capacity is likely to rise, depressing the value of the contractors and favouring BP in this particular bet.

LinkedIn valuation

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LinkedIn (Nasdaq: LNKD) went public on Thursday and many people became very rich, especially as it traded over twice as much as its initial offering price of $45/share. You can be sure those insiders are just dying for the holding period to expire before they start dumping their shares into the marketplace.

Looking at their financials reveals a company that has about 95 million shares outstanding after this offering, plus another 16 million options that are deeply in the money gives a diluted share count of about 111 million shares. Multiply that by Friday’s closing price of $93/share gives a company with a capitalization of $10 billion. This puts it on line with technology companies such as Sandisk (SNDK) and Checkpoint Software (CHKP).

The company has increased revenues dramatically from its inception ($120M in 2009 to $243M in 2010) but the company has also increased expenses to obtain those revenues – as such it is marginally profitable. It can be expected to make money in the future, but how far can it scale up before they hit the law of large numbers and their revenue growth starts to taper?

It is interesting to note that the original site on the internet for jobs, TMP Worldwide, now known as Monster (NYSE: MWW) has a capitalization of $1.85 billion, expected 2011 revenues of $1.1 billion and expected 2011 profitability of $52 million.

Obviously the media will portray this IPO as the rise of social networking sites (just as how the Netscape IPO started the rise of the internet boom), but as history as shown, whether these companies will be able to justify their lofty valuations or not remains to be seen. I don’t have any other comment than that I will be looking elsewhere to deploy my capital – the insiders in LinkedIn (even the ones getting in as late as April 2011 got their options at an exercise price of $22.59/share!) will be the ones making the money, not the public.

Parking Canadian Cash

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Retail Canadian investors these days don’t have much option for their cash, assuming they want it available at a moment’s notice – one optimal route is putting it in Ally and getting your 2% on a perfectly liquid balance. There are also other competing services that are CDIC insured that give similar returns.

Anything more and you have to work your way up the risk and term spectrum. In terms of term, you can get GICs that give larger rates, but it is at the cost of yield in case if you want your cash to be liquid (e.g. a 5-year term deposit has a break penalty becomes progressively more expensive as you approach maturity).

When you increase risk, the corporate debt market is the next logical step up – there are some short term maturities out there of companies that are virtually guaranteed to pay off their debt giving out yields that are about 300 basis points better than what you can get with Ally. The cost is the “virtual” part in terms of the guarantee of repayment and also liquidity risk dealing with the term – you generally want to wait until maturity or you will have to pay the bid-ask spread.

Investors generally get trapped aiming for yield, but I am finding it difficult to not tweak the portfolio to shift idle cash balances into something earning a bit more, with nearly equivalent safety. I do not think this will burn me and is a suitable way of earning a little more on cash until I can decide what to invest it in. When I think of how many pizzas this can purchase at the end of the day, it becomes a little more meaningful.

CN Rail vs. CP Rail

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This chart or post is not a value judgement on the respective companies, but it looks like that somebody playing the two-stock Canadian railroad industry should be shorting CN and longing CP:

CP Rail’s market cap at present is about CAD$10.1 billion, while CN Rail is at CAD$33.6 billion. In terms of profitability metrics, for the year ended 2010, CP had $651 million income, while CN had $2.1 billion income. Strictly in terms of backward looking P/E, they both scale equivalently which could justify the upper end of the price differential seen by both companies historically.

Weakness in commodities

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I have been doing some further analysis on micro-cap Canadian stocks, but I notice on the side that the weakness in commodity markets must be getting a lot of asset players concerned – leveraging on the way up made people look like geniuses, but did too many people join the bandwagon on the long trade?

Commodity markets have always been prone to huge booms and busts, and this one is not going to be too different – whether the “bust” will be the existing 15% correction we have seen, or whether it will be something more deep remains to be seen. The more people that had or have conviction that the present correction is simply an aberration on a longer trend, the more likely it is that the markets will continue to take these people into loss positions. The market might not be tasting blood quite yet, but a whiff of it is in the air.

My portfolio positioning continues to be extremely defensive and with little linkage with the performance of oil and gold. This exposure might increase if the market is tasting blood, but this is not going to happen until I start seeing different psychology than what is out there today with commodities.

The lowest risk commodity appears to be natural gas, simply by the virtue of not having had a run-up like the others.

Petrobakken – Watch for a dividend cut

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I wrote earlier about how Petrobakken (TSX: PBN) was a value trap. After PBN reported their first quarter results, my assessment has not changed that much.

Serious investors will just look at their financials, but you can also look at their press release.

The most salient point (and note that this analysis is not exhaustive by any stretch of the imagination – I will leave it to the reader to punch holes in this summary assessment) is that the company has maintained their production at around 41,500 barrels of oil equivalent per day. However, in order to maintain this production they needed to spend about $300 million in the quarter in capital expenditures. Operationally, the company did roughly $140 million in cash, so when you subtract another $45 million out in dividends, you are left with a negative $200 million cash flow quarter.

The company is expecting to spend another $600 million in capital expenditures this year. Doing some paper napkin calculations, if you assume for the rest of the year the company will be able to maintain a rough $150M/quarter operating cash flow, a $45M/quarter dividend rate, and $200M/quarter capital expenditure rate, you are still net negative $315M cash. Their bank facility has about $240M room left. The difference in cash is a $75M gap.

If they get lucky, they can bridge this gap with increases in revenues from increased crude and gas prices or an increase in production (via drilling new wells), but their margin of error is tight. The only other realistic option that management has (since I do not foresee them doing another debt financing) is cutting their dividend.

Anybody investing in PBN for yield is going to receive a nasty shock if this occurs. Petrobakken shares do have value, but I believe they are still trading above their fair value.

Skype – Another kick at the can

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The news is making the rounds that Microsoft is paying a large amount of money for Skype, approximately $8.5 billion in cash.

It is virtually guaranteed the acquisition will lose money. EBay tried their hand with Skype back in late 2005 and they only had to pay $2.6 billion for the privilege before they threw up their hands in late 2007 when they dumped the company for a loss.

Now Skype has found a bigger sucker to sell itself to, which in this case is Microsoft.

All of these value investors that have their money in Microsoft have to be wondering what Steve Ballmer is thinking, and how much more money Microsoft will run themselves through before realizing that it has gotten to the size where it is unable to compete effectively outside of its Windows/Office monopoly.

Why consistent high returns are impossible without leverage

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On the right-hand side of my bookmarks, I posted a 5-year performance of about 22% compounded annually. This is a high number, and as the years tack on, this will likely become lower. 2011 is going to likely be a low single digit percentage year.

The mean value theorem in mathematics can explain why such a level of return is not likely to continue. Let’s pretend that every company I put my money in will have a 15% earnings yield (either retained or given out in dividends; it does not matter). In the long run, my portfolio will be able to increase 15% a year. However, in order to achieve a 22% return, I must invest in something that has a greater than 22% return.

If I cannot find those investment candidates, then in order to achieve 22% on a 15% investment base, I need to borrow money at a rate less than 15% and put it into that 15% investment.

The risk of this is that my capital might “blow up” and I will be forced to liquidate my assets at precisely the wrong moment. Another way of thinking about this is that I want to be investing at precisely the moment that everybody else is forced to liquidate, rather than an arbitrary point in time such as now.

Unfortunately at present I am having grave difficulty identifying candidates that will give these types of returns. I also do not feel comfortable with employing leverage, so I will continue to twiddle my thumbs and wait for a better opportunity. I also do not think ploughing into commodities is any sort of “fix” to this problem – there are much better lower-variation equities out there that will give you a more stable return on investment and also be able to provide inflation-adjusted returns over the long run. Even though it is abundantly clear that commodities such as inexpensive-to-mine oil is rapidly depleting, it is still no reason why the price of such commodities at some point will not go to marginal cost of extraction, or even lower (e.g. natural gas). Commodity markets are cyclical and investors should never assume that the trend will be continuously straight-line up. There will be brutal price corrections in the interim – they are just very difficult to predict.