2014 year-end report

Portfolio Performance

My very unaudited portfolio performance in the second half of 2014, the six months ended December 31, 2014 is approximately -8.4%. My year-to-date performance for the year ended December 31, 2014 is approximately -7.7%.

Portfolio Percentages

At December 31, 2014:

42% equities
1% equity options
22% corporate debt
35% cash

USD exposure: 52%

Portfolio is valued in CAD;
Equities are valued at closing price;
Equity options valued at closing bid;
Corporate debt valued at closing price;
USD Cash/Equity valued at closing exchange rate of 0.8603 CAD/USD.

Notification

I am still considering an e-mail subscription service for these updates. When I am in a position to do so, I may give an abbreviated summary of the report on the website, but send something more detailed through email.

Portfolio Commentary

Words cannot explain how self-destructive my own performance was with respect to my portfolio performance over the past half year. There were two decisions of colossal stupidity on my part that single-handedly evaporated quite a bit of performance in the year. In retrospect, one was a very good gamble (or at least when I did the forensic examination of the train wreck it left behind in my portfolio) that evaporated a bit of capital, but had this turned into the outcome I had been anticipating, it would have resulted in an extraordinarily outsized gain. The research I have accumulated on this particular play I am still employing and I have not revealed it quite yet.

The other capital-destroying decision was simply embarrassing and quite frankly, was an absolute failure of yours truly to just “go to the movies”, as Warren Buffett would say. Had I slipped into a coma on January 1, 2014 and woken up today, I would have turned in a slightly positive performance in 2014. It was a classic case of simply not thinking things through properly and I paid for it. C’est la vie.

Notwithstanding the two paragraphs above, the year would have nonetheless still turned out to be mediocre from a performance standpoint. An investor that decided to start the 2014 year in 30-year US treasury bonds would have seen a rough 25% gain for the year. An investor in the S&P 500 would have seen a return of about 12%, while the TSX was good for 8% despite the meltdown in the oil and gas sector. Although I have promised in the past that I could not keep up the 17%/year performance that I have accumulated from 2006-2013, I certainly did not want regression to the mean to consist of a negative performance year when the overall market condition was quite positive.

I have no direct exposure to oil and gas in the present portfolio. While I took a small position earlier in a few companies (as outlined in this article), I since took my lumps and got on with life since I was playing with forces far stronger than my brain could cope with. I was not smart enough at the time to figure that out and paid for it a bit. Thankfully the CRA will also be subsidizing these decisions somewhat, but it is really not a good sign when the CRA helps you out.

My performance was also assisted by the decline in the Canadian dollar.

My portfolio remains reasonably concentrated. I still have a fairly good chunk of Genworth MI (TSX: MIC), which continues to perform well. They will be facing headwinds as the market tries to price in increased default rates in Alberta and Sasketchewan, but this is only 17% and 3%, respectively, of their insurance in force. They did get really, really close to a liquidation price in November when they hit $41.98 a share, but I was too immersed in other activities at the time to start selling shares.

My largest equity stake is in a company that I still have not revealed, acquired back from 2013. It has appreciated about 20% from what my cost basis is, but this is still much lower than what I anticipate from it. Overall market conditions in 2014 resulted in the worst possible business environment for this company, but they are in a relatively unique position to capitalize on what I believe will be happening in 2015. I can’t be more specific about this without tipping away the name, so I apologize. If/when this gets to the 50% level, I might write the article about it.

On the debt side, there are some positions in companies that have relatively boring characteristics and this is just a matter of picking reasonable risk/reward situations that are not connected to oil and gas. I also hold a fair holding in Pinetree Capital debentures (TSX: PNP.DB), and as readers of this saga know, Pinetree is in the middle of trying to cure a debt covenant breach where they have to maintain a debt/asset ratio of less than 33%, but they are sitting at 38%. Their deadline to cure the breach is January 23, 2015 before the guillotine drops.

While investing in distressed debt is not an activity for the weak-cardiac individual, this particular case has enough wrinkles that one can’t help but hop on board and be a silent partner in what must be quite intense negotiations with stakeholders that have very different alignments. You can read my other rantings about Pinetree Capital by clicking here. Also note that the debt-to-asset covenant in the debt effectively makes the debentures secured debt, which is more than I can say for other capital management firms that have entrenched management and a market value of significantly less than the net asset values they are managing (e.g. Aberdeen International (TSX: AAB), but there are others).

If somebody is reading this that is actually in a position of influence, be sure to negotiate a mandatory debt buy-back provision (either through open market purchases or dutch auctions if the market value is under 95 cents) and ensure that in the event of maturity that debtholders aren’t going to end up with a slab of nearly useless equity since management would just love to let those debentures mature on May 31, 2016 for shares instead of cash.

I have retained a lot of cash in the portfolio because I am still waiting for circumstances to allow for deployment. There are a few companies on the research pipeline which I am considering pulling the trigger on, but I am in no rush. I want to ensure whatever mental programming that caused such flawed decision-making this year is eradicated.

Outlook for 2015

Given what happened in 2014, I should probably disconnect my internet connection and come back in December to review the portfolio. Nonetheless, I will try to offer some predictions and insight on how I believe things will turn out in 2015.

If I maintain my portfolio as-is, I have a reasonable expectation of achieving a return in the teens percentage (13-19%) and this is based on my estimated values of portfolio holdings and what I could liquidate them for if they exceed my fair value boundary. This also factors in including a 1/3rd cash balance at present, collecting zero interest.

The big macroeconomic question is not about the oil and gas markets, but rather what happens to short-term interest rates. Something that has received very little attention is that the yields on 1-year and 2-year US treasury bonds have increased considerably over the year. The 2-year, in particular, has gone from 0.4% at the beginning of 2014 to a high of 0.75% at Christmas. This is due to the term structure of interest rates, and the anticipation of a short-term rate increase by the US Federal Reserve. Right now the December futures say that the short-term rate will be 0.61%, so the question will be what will actually happen. The strength of the US dollar has already anticipated rate increases. The implication for Canada is that traditionally our central bank has lagged behind US policy rate changes, so if the US fed raises rates, this would clear room for Canada to do the same.

However, the long-term yield curve in Canada has a long-term bond rate of 2.33%, and with the existing 1% rate, I doubt the Bank of Canada will raise rates unless if there is a true chance of inflation exceeding their 2% target; what this means is that despite the drop in Canadian currency, I believe the decreased economic activity that will be forthcoming from the drop in commodity markets will mean on balance we are likely to see another year where the Canadian bank rate is held steady at 1%.

I generally believe the USA will increase interest rates, but they will creep them up so slowly and with a huge amount of information leakage as to not cause any collapse in the asset markets – this might be represented by a break from the 0.25% increment convention, and I would expect the rate at the end of 2015 to be around 0.5% as long as inflation remains subdued.

Currency-wise, there remains a global “race to the bottom”, and the net result is that the US dollar is continuing to be king. This will have an impact on my own cross-border shopping, but I have hedged successfully against this by simply holding nearly half of my portfolio denominated in US currency. Currencies of interest do include the Yen, Yuan and Euro, all of which has a vested interest in heading lower.

I do not remain a fan of Canadian real estate, but I do not anticipate a huge collapse in the offing either. I do not believe that dirt-cheap yields that are being received by large REITs are worth the risk/reward ratio. As an example, Riocan in August received 8-year money for 3.6% and these returns are not cognizant that a lot can happen between now and then that would cause them distress and an inability to renew their debt.

Don’t get me into proxy real estate plays like Cineplex, and debentures (TSX: CGX.DB.A) are at 2.9% for a 4-year maturity. There is some value in the optionality on the conversion feature, but still…

There does seem to be bargains available in the oil and gas sector, in particular, in the fixed income side of things, but one has to make sure that your ranking in the capital structure is not going to get blown away by the banks, whom are all likely in the midst of a mass renegotiation with companies that are about to breach their EBIDTA/debt service covenants.

There is a federal election looming in Canada which is also going to create considerable economic uncertainty for the country.

I also find that trading on macroeconomic beliefs is next to impossible, so I will try to concentrate on what has traditionally worked for me, mainly the review of very narrow situations and valuation of companies that are a bit misunderstood or obscure from most investment lenses. It remains a challenge to be able to invest in things that computers and robotic trading has not already permeated through – with the vast majority of funds being invested in passive vehicles, or quasi-passive vehicles (index funds that are primarily traded by robots and arbitraged by robots), there does appear to be opportunity in basically investing in things that computers cannot see. These are not easy to find in the least, but once identified, they will result in outsized gains and portfolio concentration will be rewarded.

Divestor Portfolio - 2014 Year-End - Historical Performance

YearPerformanceS&P 500TSX CompositeGeneral Comments
9.0 Years:+14.6%+5.7%+2.9%Compounded annual growth rate.
2006+3.0%+13.6%+14.5%Performance marked by several "wins" and several "losses" which nearly offset each other.
2007+11.7%+3.5%+7.2%One holding was acquired at a moderate premium; nothing otherwise remarkable about this year.
2008-9.2%-38.5%-35.0%Avoided market meltdown by holding significant cash; bought heavily discounted corporate debt at and around year-end.
2009+104.2%+23.5%+30.7%Most gains this year were in the corporate debt market. Anybody holding anything from February onward would have made money, but I mostly selected securities that were more heavily depreciated. I completely realized the once-in-a-generation opportunity that occurred here and was able to take advantage of it.
2010+28.0%+12.8%+14.4%Continued to realize gains and lighten up on corporate debt holdings which were mostly trading at par at year's end.
2011-13.4%+0.0%-11.1%Very poor performance, most of which stemmed from poor decisions around the August timeframe, and also completely missing on two targeted trades which completely fizzled. Wounds in this year were completely self-inflicted.
2012+2.0%+13.4%+4.0%Spent most of the year in cash, which explains the relative underperformance. Did not feel confident about significantly getting into equity or debt, but did dive into "value" equities at the end of the year.
2013+52.9%+31.8%+10.6%Despite making several unforced errors in the year, not to mention having a generally bearish outlook on the marketplace, insurance industry holdings appreciation and one very timely trade contributed for the bulk of performance. Half the year had more than 20% cash in the portfolio.
2014-7.7%+11.8%+7.7%Spent the most of this year about 1/3rd in cash; given my performance, probably a good decision. Performance was negatively affected by a series of unforced errors, and having absolutely nothing work out this year.