Marijuana stocks – if there was any question of over-valuation

(December 18, 2017: Article featured on the Globe & Mail: TSX short sales: What bearish investors are betting against)

This post applies to the recent December 5, 2017 press release by the British Columbia government regarding how they plan on implementing marijuana regulations in the province.

Saving you from reading the actual release, they plan on having a sole wholesaler (the BC Liquor Distribution branch) and a private/public retail distribution mechanism.

This is very similar to how liquor in other major provinces are distributed – the government gets to keep the lion’s share of the profit on the wholesale side.

In British Columbia, liquor retailers can purchase product from the government monopoly wholesaler at a 16% profit margin for licensed retail stores. These stores will have to then sell enough volume in order to pay for the usual business expenses (leasing a physical location, maintaining inventory, staffing, etc.).

Using the liquor analogy, profits from the retail end of things will be minimal. The best example is Liquor Stores NA (TSX: LIQ) which, despite booking 25% gross margins on their product, when things are good, earn a 3% operating profit margin (not before financing costs, but this is after depreciation expenses).

People following this company will shout out that they are undergoing a significant restructuring, but the central theme still sticks – it is a very low margin industry when your only supplier is government-controlled and has every incentive to maximizing its own profit and not yours.

This is a miserable business climate to be in.

Another, much smaller, example is Rocky Mountain Liquor (TSX: RUM). They operate retail entirely out of Alberta. Cherry-picking their best results in the last year, they are earning a 2% operating profit margin (and this is BEFORE financing and depreciation expenses).

Is marijuana going to be any different than liquor?

I would float the claim that retail marijuana profitability will be even worse than liquor because people can easily grow their own product sufficient for their own consumption. Federal legislation actively encourages people to grow their own marijuana plants at home (4 plants that you can now grow larger than the original 100cm proposed in the initial draft of Bill C-45).

This leaves the question of wholesale – there will need to be suppliers of this. I will also make the claim this will be a race to the bottom, with the exception that the “grow it at home” market will erode profits to the point that wholesale will nowhere near justify the 3.6 billion market capitalization seen from Canopy Growth (TSX: WEED) today – even assuming they captured the entire Canadian marijuana market.

The hype is marijuana producers will be able to achieve tobacco company margins – Rothmans was the last publicly traded Canadian tobacco company and they achieved roughly 50% operating margins (before financing and depreciation). It won’t be happening this way again – this margin will be siphoned by the government from the very beginning.

Canadian interest rate futures

There are three Bank of Canada announcements concerning interest rates for the rest of the year: September 6, October 25 and December 6.

Right now 3-month Banker’s Acceptance rates are 1.2%.

The BAX futures are signalling that there is a better than 50/50 chance that rates will increase 0.25% in the September 6 cycle, and that there is a slight chance of two 0.25% rate increases by the end of the year:

Month Bid price Ask price Settl. price Net change Open int. Vol.
Open interest: 942,178 Volume: 86,058
August 2017 0 0 98.765 0 0 0
September 2017 98.655 98.660 98.645 0.010 137,868 7,160
October 2017 0 0 98.615 0 0 0
December 2017 98.500 98.505 98.490 0.010 224,303 15,544
March 2018 98.395 98.400 98.375 0.020 163,606 19,552
June 2018 98.330 98.335 98.305 0.025 112,558 15,558
September 2018 98.270 98.280 98.250 0.030 120,395 10,055
December 2018 98.210 98.220 98.200 0.020 102,302 9,439
March 2019 98.160 98.170 98.140 0.020 45,030 5,208
June 2019 98.090 98.100 98.080 0.020 17,655 1,763
September 2019 98.010 98.030 98.010 0.010 10,774 827
December 2019 97.940 97.960 97.940 0.010 5,193 646
March 2020 97.860 97.870 97.870 0 2,199 198
June 2020 97.780 97.800 97.800 -0.010 295 108

Guessing the impact of these short-term interest rate changes I will leave as an exercise to the reader for now. The one salient fact, however, is that when short-term financing rates increase, the incentive to leveraging decreases and so marginal investments will be less viable. Parking cash in a rising-rate environment is best done with cash rather than using any debt instruments with duration (I wish I had stuck to this – my cash parked in VSB.TO has decidedly unperformed zero-yield cash!).

Worst-performing portfolio components

The biggest hits my portfolio has taken this year has been with the appreciation of the Canadian dollar and the cash-parking vehicle of VSB.TO. Sadly (not including monthly distributions, which is about 5 cents a month) they’re down about 40 cents over the past couple months, due to the short-term rate curve rising considerably.

I take solace knowing that the increased Canadian dollar gives me larger purchasing power parity and the increase in interest rates in theory should make credit-sensitive assets cheaper to purchase.

Bank of Canada raising rates to 0.75% – makes no sense

Most of Canada has heard that the Bank of Canada raised the short-term target interest rate from 0.5% to 0.75%, which was the first increase in about 5 years. The rate increase itself serves to increase a very small rate into another very small rate and is insignificant other than the fact that this sounds like it is a warning shot.

Indeed, when reading the Monetary Policy Report, I’ve come to the conclusion that there was really no justification for raising interest rates in accordance to the Bank’s mandate of maintaining inflation at a 1-3% band – their own research suggested that the economy was headed in that direction with the current monetary policy. The decision to raise interest rates appears to be completely arbitrary, or guided by other considerations that are not captured in the standard reports.

It is this scenario that makes me believe that barring any economically cataclysmic events, the Bank should probably raise again (to 1%), but for reasons that has nothing to do with maintaining a 2% CPI rate.

All in all, this policy decision by the Bank of Canada is mysterious.

2017 British Columbia Election Prediction

This article is entirely political, so for those of my readers who care about finance and not politics, please disregard everything below.

Prediction is an activity that is subject to a lot of error. Most pundits issue predictions and there is usually little social consequence for getting them wrong, so they make as many as possible and then stick to the ones they got right as a sign of their prognostication abilities. So I’ll thump my chest and say that I saw Trump getting elected despite the fact that he was a 3-1 odds against of winning (if you were to put money on it).

So far my political predictions in my year-end 2016 report have been quite poor – I predicted incorrectly most of the federal budget actions and I completely failed to predict Kevin O’Leary’s surrender in the Conservative leadership contest (I initially predicted he would take it in the first ballot, but this was under the presumption that his French wasn’t as bad as the media made it sound to be – but it indeed was!).

It is quite clear to me right now that my original prediction (at the end of 2016) of the BC NDP winning 20 seats or less in the upcoming election is going to be incorrect. Just how incorrect is going to depend on the volatility of who shows up to vote tomorrow.

Overall notes

The NDP’s campaign has performed better than my expectations. It hasn’t been perfect, but my original expectations were them campaigning on matters relating to social justice which would have appealed to some narrow niches within their party but not appealed to any wide swash of the electorate in order for them to win. Instead, I saw this:

These sorts of “bread and butter” issues are ones that can relate to people that otherwise would not be voting or worse yet, voting against you.

In particular, what got my attention was the initial battle on the issue of the toll bridges. The BC Liberals promised to cap tolls to $500/year as a measure of ‘affordability’, while the NDP a few hours later promised to eliminate them entirely.

While this in itself might not sound like anything special, it was a sign that (whether accidentally or purposefully) the NDP knew what they were doing politically – they knee-capped the BC Liberals on this topic and got them to shut up about transportation entirely across the region, which normally should have been a strength of the BC Liberals. This was the first data point that suggested to me that the NDP were running a good campaign.

As the federal Liberals demonstrated, a good portion of the voting public do not prioritize the status of the fiscal balance until it begins to hit them directly in their pocketbooks. The BC Liberals are smart enough to know that fiscal conservatism is not a strong political selling point when times are good and they wisely chose to focus on other matters.

Unfortunately for the NDP, they failed to keep a laser-like focus on the affordability section of their platform after approximately the two week mark in the four week campaign – they got distracted and somehow they seemed to lose focus while they attempted to also battle the left side of their flank (the Green party). They did not, however, commit any huge errors this campaign like they did in 2013 (the infamous reversal of policy position on the Kinder Morgan pipeline by Adrian Dix being the key example).

The BC Liberals, for the most part, ran a very predictable and I might say cautious and boring campaign. Being in government for 16 years to date, it is difficult for them to make any sort of “change” argument. That said, they have significant messaging strengths in the BC interior geography (natural resource development and jobs) and they still appeal generally to the older electorate (property-owners and those generally with money).

Their messaging beyond the track record, however, is a bit muddy. For instance, on their website, we have the following mish-mash of platform points:

I realize that only opposition researchers and media will be scouring political parties’ webpages for information, but this gives a general sense of what the BC Liberals are trying to focus on (short of the odd obsession over ride-sharing, which is probably the only bone thrown to millennial voters).

The Greens’ strategic objectives were obvious from the very beginning of the campaign and their goal is to expand out in Vancouver Island to elect 4 MLAs (this will qualify them for official party status and entitle them to various privileges that they otherwise don’t have in their current situation). Their other objective is to be the balance of power in a minority government situation, but that part is out of their control – it depends on the BC Liberals and NDP very narrowly balancing each other’s seat count.

The Greens’ primary marketing point is that they’re not the other two parties. It’ll be enough to get them another seat, but not much more. A lot of their candidates across the province are paper candidates – for instance, they have somebody running in a Richmond riding that actually lives in Castlegar. Without having credible candidates on the ground, their vote share will bleed to the NDP.

Projecting voter turnout is the key task in this election prediction. Who is motivated to vote, who will they vote for, and for what reasons?


In 2013, polling agencies had the NDP up approximately 45-37 and the actual result of the election was the BC Liberals winning 44-40. This was a huge “miss” in terms of polling agencies failing to predict the outcome of the election. It is also instructive that final election numbers has a huge amount of inherent volatility that make the “margin of error” a theoretical and not a practical figure.

In 2017, the big difference is that the polling agencies are showing a tight contest provincially – both major parties are around the 40% mark, with the Greens sitting around 15-20%.

The message is not whether these polls are correct, but the message that unlike 2013, the race in 2017 is significantly closer, which tends to increase voter turnout.

In reality, I’d venture (this being a gut instinct feel) that the +/- factor in polls is around 5%, and would suspect the BC Liberals and NDP are indeed gravitating towards 40% each.

BC Interior (24 seats)

I believe the BC Liberals have a significant edge in their messaging and policies concerning the BC Interior. The population is also more aged, has higher homeownership levels and is the bread-and-butter of the BC Liberal party support from the Social Credit days. The old influences of union workers are fading away which works against the NDP, especially as NDP platforms have become more focused on urban issues. Thus, I only see the NDP winning swing ridings such as Skeena and Columbia River-Revelstoke. Ridings such as Cariboo North, Kamloops-North Thompson, Boundary-Similkameen, Fraser-Nicola (Harry Lali’s nomination victory was a disaster here for the NDP) will go BC Liberal. The biggest question mark I have is Columbia River-Revelstoke – if the NDP lose this riding they will have zero chance of forming government.

You can also see evidence of the relative importance of the interior ridings in some BC Liberal campaign spin:

This is probably a rare piece of political advertising that appears to be truthful.

There are 24 ridings (out of 87) in the interior, and 18 will go BC Liberal and 6 will go NDP.

Vancouver Island (15 seats)

On Vancouver Island, the main contest is between the Green Party and the NDP in certain southern Vancouver Island ridings. The Greens will win Oak Bay-Gordon Head, and Saanich North. Cowichan Valley has been the other riding that has generally been considered a swing riding between the NDP and Greens, and I believe this will go NDP, along with the rest of the island short of Parksville-Qualicum (which will be the sold riding remaining BC Liberal on the island). Courtenay-Comox stands a good chance of swinging back to the NDP and I will note this is contrary to most public predictions.

There are 15 ridings in Vancouver Island, and 12 will go NDP, 2 Green and 1 BC Liberal.

City of Vancouver (11 seats)

In the City of Vancouver, the prevailing issue is affordability and while this means homeowners vs. renters, the geography of past elections only allow a swing in a single electoral district – Vancouver-Fraserview, which should probably go NDP. The rest will remain the same. There is an outside chance of Vancouver-Langara going NDP, but the components of the electorate will not be enough to swing the seat to the NDP.

There are 11 ridings in the City of Vancouver, and the NDP will win 8 and the BC Liberals will win 3.

Fraser Valley (9 seats)

The geography here includes Pitt Meadows, Maple Ridge, Mission, Kent, and Langley to Hope. I do not think there will be any surprises south of the Fraser River. North of the Fraser, the two selections I have that run contrary to consensus is that the NDP will win both Maple Ridge-Pitt Meadows and Maple Ridge-Mission, although I do not give these predictions with huge conviction.

There are 9 ridings in the Fraser Valley, and the BC Liberals will win 7 and the NDP will win 2.

Metro Vancouver minus Vancouver (28 seats)

The specific question is who wins Burnaby North, Coquitlam-Burke Mountain, Port Moody-Coquitlam, North Vancouver-Lonsdale, Delta North, Surrey-Fleetwood and Surrey-Guilford.

The geography of these areas suggest that the electorate of these sub-urban ridings will have the influence to decide who gets to be in government. There are competing variables in play – transportation was a big one (most of these ridings are heavily influenced by the Port Mann Bridge toll and motorists that want to vote for shorter commutes, whether by car or TransLink), affordability (renters vs. owners), and perceptions of economic competency (jobs, jobs, and jobs). It is difficult to juggle these influences on the overall electorate. Political parties have likely done their statistical research to attract their target demographics on these topics.

In the 2015 federal election, we saw firm evidence that voter turnout from people between the age 18-34 turned out when previously they would not before. Judging from my experiences in that election, predominantly these voters went (federal) Liberal as there was a desire for change.

Survey data (e.g. Reddit, polling and so forth) would suggest that the average younger individual will be voting NDP or Green. And in the event that they are in a riding where the Green party is not a realistic contender, they will probably vote NDP if they do indeed vote.

Question: Will this same millennial voting wave take over provincially? This is the key to the election and one where I have no insight on until looking at things retrospectively. I do not have a good intuitive grasp whether Christy Clark or John Horgan have actually been able to galvanize the average millennial voter.

Polling with regional splits indicates the NDP has a significant advantage in the Metro Vancouver area, but I take these sub-regional splits with a grain of salt for various reasons. All it indicates to me is that the race is competitive.

Factoring in everything, I am going to venture that the NDP will take 15 of the 28 sub-urban seats, while the BC Liberals will take the other 13.


NDP – 43 (41%)
BC Liberals – 42 (42%)
Green – 2 (15%)
Others – 0 (2%)

This is a low conviction prediction. I’m probably wrong. The numbers don’t really add up for me (which is the first sign that my election modelling is not right). The BC Liberals have a higher popular vote because their interior and Fraser Valley victories are going to be what might be a bunch of narrow victories in the Lower Mainland for the NDP. Also despite this prediction, I view the odds of a minority government to be very slim.

We’ll see tomorrow what happens.

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.

Most surprising chart of the month

January has generally been proceeding to plan (i.e. nothing really exciting going on in my neck of the financial woods!). But the real surprise to me to date is the following chart:

The strength of the Canadian currency has been quite impressive in light of what is going on (coupled with a general lack of rise in the fossil fuel commodity market rate). I am generally agnostic about the strength of the Canadian currency (i.e. I rarely have strong feelings about its primary direction), but lately I have been getting pessimistic about it strictly due to various macroeconomic factors (including the fiscal situation, Canadian/US monetary policy, geopolitical, commodity situation, etc.).

Macroeconomics for me is a complete crapshoot so I don’t place too much of a stake on my own predictions in terms of currency. I generally keep a balance between 30-70% USD exposure (the exact amount depends on appreciation/depreciation of CAD/USD components in the portfolio as well).

What’s happening in Canadian energy?

I’m looking at the charts of several high-quality energy companies in Canada and their trajectory is down.

Looking at the raw commodity prices first:

Spot Natural Gas is down about 15% from December highs (recall that natural gas pricing is seasonal, for comparison the July futures are down less than 10% from the December highs):

West Texas Intermediate spot prices have not done anything over the past month and a half:

So why are the following down?

Peyto and Birchcliff (both very well managed natural gas producers) – Peyto appears to be down disproportionately in relation to natural gas prices:

However, despite that crude has gone nowhere, why are the oil producers starting to drop?

Crescent Point Energy:

Pengrowth (they have liquidity issues with an upcoming debt covenant that they may or may not blow in mid-2017) and Cenovus (another SAGD firm):

There are numerous other examples, but the only one unhurt to date appears to be Encana.

Makes me wonder what is going on. Something geopolitical coming with pipeline access to the USA?

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.

Canadian Preferred Share price appreciation nearly done

Preferred share spreads (in relation to government) have compressed significantly since last February and it appears that the macro side of the preferred share market has mostly normalized and accounted for the incredible drop of dividends on the 5-year rate reset shares due to the 5-year government bond rate plummeting (0.62% at present with short-term interest rate futures not projecting rate increases until at least 2018).

We are still seeing significant dividend decreases as rates continue to be reset.

I have looked at the universe of Canadian preferred shares (Scotiabank produces a relatively good automated screen) and further appreciation in capital is likely to be achieved through credit improvement (e.g. speculation that Bombardier will actually be able to generate cash indefinitely) concerns rather than overall compression in yields.

As such, one should most certainly not extrapolate the previous three months of performance into the future. Future returns are likely to primarily consist of yields as opposed to capital appreciation.

While investment in preferred shares, in most cases, is better than holding zero-yielding cash (in addition to dividends being tax-preferred), one can also speculate whether there will be some sort of credit crisis in the intermediate future that would cause yield spreads to widen again. If your financial crystal ball is able to give you such dates, you can continue picking up your quarterly dividends in front of the steamroller, but inevitably there will always be times where it is better to cash out and then re-invest when everything is trading at a (1%, 2%, 3%, etc.) higher yield.

I am also finding the same slim pickings in the Canadian debenture marketplace.

Valuations have turned into such that while I’m not rapidly hitting the sell button, I’m not adding anything either and will continue to collect cash yields until such a time one can re-deploy capital at a proper risk/reward ratio. If I do see continued compression on yields I will be much more prone to start raising significant fractions of cash again. Things are very different in 2016 compared to 2015 in this respect – in 2015 I averaged about 40% cash, while in 2016 I have deployed most of it.