Psychology of Portfolio Management – Doing half

There are some situations in the investment world that result in considerable confusion and risk.

In particular, I am still trying to process the action that has surrounded KCG Holdings (NYSE: KCG) last week. The position appreciated considerably, but there is obviously not going to be any resolution to the matter unless if I wake up one day and a definitive merger agreement has been signed. If the initial proposal and subsequent due diligence cycle does not come to fruition, then there will likely not be any press to that effect and the stock price will drop.

There is a very real reason to hold on (the suggested merger price was lower than my estimate of its fair value), and a very real reason to not hold on (there will be no formal merger agreement). Also, there is no information at all whether this merger would succeed or not, nor any indications on timing.

So the solution was obvious. Sell half.

David Merkel is one of my favourite finance authors and he concisely writes about it in an April 2009 blog post and a subsequent November 2016 post.

This is a perfect situation where doing half applies. The psychological advantage is that I don’t have to cry if there is a better price given to the company, nor do I have to cry if they trade lower (since I know where their fair value rests).

Researching Primary Market offerings

The market has run so dry, it has finally come to this – I’ve had to resort to looking at prospectuses of primary market offerings.

Questrade has a rather interesting link to offerings that they’re trying to peddle to the unsuspecting public. And being the sucker I am for these sorts of things, I glossed through a couple prospectuses.

Hampton Financial Corporation (TSXV: HFC) is trying to raise $20 million in preferred shares (plus warrants on their common shares that are nearly double the current market price). The preferred shares have a perpetual, uncallable (by either side) 8% yield. The head honcho owns a lifetime control stake in the company (and a decent economic interest) and a very sweet-looking employment contract. Try negotiating this on your employer (I’ve replaced the person’s real name with Mr. CEO as I don’t want to foul up his pristine search engine profile on his name):

“In consideration of Mr. CEO’s services, the Corporation has agreed to pay Mr. CEO an annual base salary of $200,000, which is to be increased by a minimum of 25% each year from the first anniversary of the commencement date of the employment and a one-time cash bonus of $200,000 payable at any time during the first year of the executive employment agreement, at the discretion of Mr. CEO. In addition, Mr. CEO is entitled to receive annual bonuses at the discretion of the board which may be paid in part by shares or equity-related instruments of the Corporation and a perquisite package of $24,000 per annum.”

There’s other stuff in the prospectus that is juicy, but suffice to say, I’m not too inclined to support this particular public offering, especially considering they don’t make money and they have about $3 million in stockholder’s equity. They also have some very interesting lawsuits that have judgements rendered which give a very good insight on the culture of the firm.

Who the heck would invest in this? If it actually sells, it’s certainly a sign that the market is willing to pay for anything with yield.

With most of these offerings, keep your hands on your wallet.

(Update, March 21, 2017: At the request of one of the issuers, I have amended this post.)

Pengrowth executes an asset sale

Pengrowth Energy (TSX: PGF) managed to execute an asset sale on its conventional production property north of Edmonton, the Swan Hills assets for CAD$180 million.

The debt profile at December 31, 2016 looked like this:

Right now the CAD/USD ratio is 0.75.

At the end of December 31, 2016 they also had CAD$287 million cash in the bank, plus another CAD$250 million for the 4% gross royalty sale on their Lindbergh asset.

They will be redeeming CAD$126.5 million in convertible debentures on March 31, 2017. They also have redeemed US$300 million of their 2017 debt maturity, and will redeem the rest after this transaction concludes at the end of May.

The company announced that after this sale, they have a pro-forma net debt of CAD$970 million.

My math suggests that after the 2017 redemption, they would have CAD$57 million cash left, assuming their operations consume zero cash (not a correct assumption!).

Payment of the debt will result in an interest expense decrease of $42 million per year.

They still need to have CAD$368 million on-hand on August 2018 in order to pay off their next debt maturity. It is possible they will run into covenant issues given that oil hasn’t moved around the US$50/barrel mark – their existing senior debt to adjusted EBITDA ratio would be the most material of it. They have about CAD$1.02 billion outstanding and their EBITDA needs to be above CAD$290 million in order to clear this hurdle.

Although the EBITDA value for covenant purposes was CAD$582 million, this is a skewed figure due to the employment of hedging. People not versed in accounting procedures for commodity hedging will have a tough time figuring out the mess, but I will just point out that management closed out their hedges in 2016 (which had been a VERY profitable transaction to them that otherwise would have guaranteed CCAA had they not had the foresight to doing so when times were much better).

KCG Holdings – Takeover bid from Virtu

The Q1-2017 report is going to be shockingly positive. Genworth MI (TSX: MIC) used to be my largest holding, but I have trimmed the position (mainly for diversification and deleveraging reasons). It still is a decent size of the portfolio, but not as prominent as it used to be.

My largest position after Genworth MI was KCG Holdings (NYSE: KCG).

Yesterday, near the close of trading, they confirmed that they received an unsolicited takeover proposal of US$18.50-20.00 per share from Virtu (Nasdaq: VIRT), another (very credible) high frequency trading firm. KCG did not file with the SEC.

Virtu filed 8-K with the SEC confirming they “made a preliminary, non-binding proposal to acquire KCG”.

Both entities have been quite silent otherwise. There is likely a lot of backroom jockeying going on.

KCG’s stock shot up from about $13.60 a share to $18/share today on over 6 million shares of volume. The company has about 66.4 million shares outstanding, and Jefferies (a wholly owned subsidiary of Leucadia (NYSE: LUK)) owns 15.41 million shares, and insiders own another 3 million shares, leaving a float of about 48 million shares that can be actively traded. 6.65 million shares traded today and suffice to say there is quite a large amount of speculation about what is going to happen.

My take on the matter is the following (in no particular order):

1. Tangible book value of KCG Holdings is $18.71/share as reported in their 10-K filing. A US$18.50 takeover price would allow Virtu to effectively take over KCG for free. This is the primary reason why I wouldn’t think this takeover would go anywhere as-is. My guess is that if Virtu was serious they would have to offer some equity as well, or some sort of premium to book value.

2. Virtu is a logical strategic acquirer to KCG – the synergies are quite obvious to both businesses. There might even be anti-trust issues with this acquisition.

3. Even though the acquisition at the low price range would be “free” for Virtu, it leaves the question of how they would immediately finance it.

4. The Jefferies control block is vital to the situation – if they can be persuaded to sell out, then management will likely have to follow. The question is whether they are motivated to sell out or not – obviously they will at the right price, but US$18.50 is too low.

5. The CEO was granted a huge amount of options at $22.50/share (priced well out-of-the-money at the time of the grant) and probably doesn’t have much of an incentive at this point to selling out the company for cheap.

6. Operationally, KCG is treading water in terms of cash flow, but this is because of unprecedented low market volatility conditions that is practically the worst environment for the firm (and also Virtu). In more normal conditions, one could easily estimate a value of US$25-30/share for the firm which is where I think management is targetting. They’ll probably sell out at 24ish if the bid got there.

7. Who leaked this unsolicited offer? Obviously KCG did – probably trying to drum up any counter-proposals out there as there are some other financial institutions that would be interested in acquiring the business. Perhaps management knows the end-game is nearing and this was a last ditch attempt to prevent a forced merger.

The decision forward is a high-stakes game for a lot of participants!

Disclosure: I own common shares of KCG, call options, and also their senior secured debt. Sometimes you really do hit the lottery in the marketplace.

A reason why I’m not a fan of index investing

Reading press releases like this one makes me quite happy to not being an index investor:

SMITHS FALLS, ON, March 10, 2017 /CNW/ – Canopy Growth Corporation (TSX: WEED) (“Canopy Growth” or “the Company”) today announced that by being added to the S&P/TSX Composite Index, it has achieved another major “first” in the cannabis industry. Management expects this to drive liquidity and increase the percentage of institutions holding Canopy Growth positions. In short, more investors than ever will be buying and holding WEED.

It is pretty obvious that future outsized gains to be made in the marketplace are going to be in companies that are not in the major indexes.

Seemingly the only variable that will dampen Canadian Real Estate

I’ve written a lot about this in the past, but Canadian real estate in urban centers is simply about too much capital chasing too little yield. Financially it makes sense to borrow at 2.83% like REITs such as Rio-Can (unsecured debt!!) and turn it around and invest it in a real estate yield product at 5.8% and pocket the difference in income.

This only becomes dangerous when credit markets start shutting down and you’re facing a cascade of debt maturities, or the collateral backing your loans (in this case, real estate) has a material mark-to-market drop (and then your debt leverage ratios will go out of whack and nobody will want to lend you money).

So I will bring your attention to interest rates. I’m fairly convinced at this point that until interest rates start rising (or we start seeing provincial governments enact serious foreign capital restrictions that can’t be easily bypassed like it is in British Columbia) we are not going to see any collapse in real estate pricing in Canada.

However, the US Federal Reserve is going to start to rise all boats fairly soon, and this will likely have knock-off effects in the rest of the world, including Canada.

I’m looking at Canadian interest rates at the Bank of Canada, and notice those longer term yields start to creep up again – 5-year government bond rates are at 1.23% and the trend on yields are seemingly upwards.

It remains to be seen whether this is white noise or whether this is the start of a trend, but it is something worth watching. If interest rates normalize to something resembling historical standards (e.g. 2% higher than present levels), Vancouver residential real estate that is currently renting for a 3% cap rate would be selling for a 5% cap rate – the result would be a 40% drop in price. This is not a prediction, it would be financial reality if a 2% rate increase occurred. Leverage has gotten to the point where such a change in interest rates would cause significant financial dislocation and this is likely why central banks are very afraid to make sudden changes to short term rates.

Difference Capital – Year-End 2016 Report

I wrote about Difference Capital (TSX: DCF) in an earlier post. They reported their 4th quarter results a couple days ago and their financial calculus does not change too much. They have CAD$29.6 million in debentures outstanding, maturing on July 31, 2018. Management and directors own slightly under half the equity, and thus they want to find a dilution-free way to get rid of the debt.

At the end of 2016 they have about CAD$14.4 million in the bank, plus $60.8 million (fair value estimate of management) in investments. One would think that in 2017 and the first half of 2018 some of these investments could be liquidated to cover the debentures. The situation is similar to the previous quarter, except for the fact that they’ve retired about 10% of their debt in the quarter, which is a positive sign.

Due to their investment portfolio not making any money (they have been quite terrible in this respect), they have a considerable tax shield: $186.3 million in realized capital losses, plus $41.9 million in non-capital losses which start to expire in 2026 and beyond. If you assume that they can realize both of these at half of the regular tax rates (I just quickly assumed 13% for the capital losses and 26% for the net operating losses), that’s $17.6 million.

Considering the market cap of the corporation is $26 million, there’s a lot of pessimism baked in. Mind you, there are a lot of corporations out there with less than stellar assets, a ton of tax losses, and tight control over the corporation (TSX: AAB, PNP quickly come to mind) so it is not like these entities are rare commodities. The question minority shareholders have to ask is whether the control group wants to bleed the company through salaries, bonuses and options or whether they are actually genuinely interested in profitably building the corporation (in all three cases, to date, has not been done).

Higher prices means more dangerous times

If the market perceives less risk, prices rise.

This is counter-intuitive, but an example should illustrate.

If risk-free rates are 1% and something is trading at a guaranteed yield at 2%, that something will trade at double the price of the risk-free product (all other variables being equal).

If that guarantee is less than 100%, then risk will cause the price of that instrument to decline.

Thus, it can be assumed that higher prices means that the market is pricing in less risk that a specific investment will fail to achieve their projected return on equity (or debt, whatever the case is).

The S&P 500 is up 6.4% year-to-date, despite all expectations. I’m willing to wager that most fund managers are underperforming this index and are starting to feel political pressure for their underperformance (“you’re in bonds???”). The way that psychology tells you to compensate for underperformance is to increase risk (i.e. equities) and join the party because it is the only way to “break even”.

The mentality shift that we are starting to see is startling – no longer is holding cash and being cautious is part of the game, rather, we are starting to see a more aggressive leaning towards risk-taking. Valuations? Who cares about valuation when you’re being left behind like a renter in the Toronto real estate market!

While I am not suggesting that you go out and purchase shares of Snap (Nasdaq: SNAP), be cautioned that I believe we are going to be entering a mania phase that will be punctuated with volatility that will be higher than what we have seen over the past year. Volatility means both up and down.

The federal reserve will try to dampen this process, but they will probably be too slow to react.

To outperform in the markets, despite what literature says about timing, market timing is everything. You want to be in cash when the markets are cratering, and you want to be fully invested when the markets are rising. While it sounds easy, it most certainly is not.

During periods of heightened volatility, an investor pays dearly for liquidity. Stocks and bonds that trade at reasonable valuations and seem like a “lock” suddenly are sold and taken out in the back and shot like cattle with mad cow disease. When the markets are like this, it is the time to be deploying cash instead of trying to shift things around in the portfolio to raise it.

The core reason for my outsized performance gains is not necessarily by doing well (yes, this helps), but rather being able to side-step market crashes when they occur. Sometimes my alarm clocks strikes and there is no need to wake up (I was ridiculously cash-heavy in 2014 and 2015), but better safe than sorry.

This is not a prediction for a market crash, but rather that I’m paying extra judicious caution when it comes to the portfolio. When you have Drudge and Trump bragging about the gains the stock market has seen since his election, coupled with friends asking you about investing, it makes me extra paranoid.

Pengrowth Energy – dodged a bullet

Pengrowth Energy’s debentures (TSX: PGF.DB.B) will be redeemed on March 31, 2017 and the company has also announced it will be redeeming USD$300 million in senior debt (announced February 21, 2017).

I own the convertible debentures and will miss their presence once they mature. I’m probably one of the few people that invested in the company and actually made money.

They also announced their year-end results on February 28, 2017. The operations of the company are fairly simple to understand – they are losing a relatively small amount of cash in the existing oil price environment, which they assume is at WTIC US$55/barrel and a 0.74 CAD/USD rate. Management has made some good decision-making on their oil hedges, but they have now closed them (for cold hard cash) and are completely at the whim of the oil commodity markets.

If you take their 2017 guidance to heart, you will end up with $195 million in “funds flow through operations”, a non-GAAP metric that is a proxy for operating cash flow excluding the impact of financing expenses and remediation. The GAAP statements are a mess to read because of derivative accounting (for oil price hedges), exchange rate adjustments, and require some mental massaging to be read properly.

All things considered, the corporation is not in terrible shape.

This is, however, except for the debt maturities coming up which need refinancing.

The company did have a $1 billion credit facility at the end of 2016. It was untapped, probably because the credit facility has a covenant similar to the senior debt. I believe the original intention of management was to use the credit facility to pay off the senior debt as it became due.

The corporation pre-announced in Q2-2016 that if oil prices continued their relatively low level, that they would be potentially in breach of their covenants. What was new in the Q4 announcement was that they alleviated their senior debt (before working capital) to book capitalization ratio covenant, at the expense of amending the debt agreement to redeem senior debt in the event of asset sales and also to reduce the ceiling of their credit facility to $750 million.

There are three other covenants remaining that an investor needs to pay attention to. The most material of them is the senior debt before working capital to adjusted EBITDA ratio, which ended at 3.1 in 2016, but needs to be below 3.5.

Pengrowth, to its credit, walked investors through their covenant calculations (page 10 of their MD&A). Doing some pro-forma (after debt repayment in the end of March) analysis, we have about $1,250 million in debt for covenant purposes, which means adjusted EBITDA needs to be above roughly $360 million for them to clear the mark. They did $581.6 million adjusted EBITDA in fiscal 2016, which gives them a relatively healthy margin of error – even though guidance is taking their production down about 10% for the year despite $120 million in projected capital expenditures.

So as long as oil prices don’t crash, they’ll probably use the credit facility to pay off the remaining US$100 million in debt due in July 26, 2017. The next major maturity is CAD$15 million + US$265 million on August 21, 2018, and if nothing changes between now and then, they will use the credit facility to pay that off. At that point, they will have about CAD$500 million utilized in their facility, plus the (presumably negative) amount of cash flow they burn through operations in the next couple years.

If oil does slip, there is a point where they will get into covenant trouble.

They did note in the MD&A:

After the above debt repayments, Pengrowth anticipates it will remain in compliance with its covenants through the end of 2018. In order to comply with certain financial covenants in its senior unsecured notes and term credit facilities through 2017 and 2018, Pengrowth has run a scenario, that accesses the capital markets before the end of 2017, and includes an improvement in realizations for oil and natural gas.

They will probably tap the asset market to give them a higher degree of comfort. This is what Penn West did when they gave up their Saskatchewan operations to stabilize their balance sheet.

In retrospect, I think the company erred in not using shares to repay the convertible debentures – they probably should have bit the bullet and increased their margin of safety by cheaply equitizing the convertible debt. Now, management is basically gambling that oil will be going up in the next couple of years and are basically playing a waiting game.