My very unaudited portfolio performance in the second quarter of 2016, the three months ended June 30, 2016 is approximately +18.3%. The year-to-date performance for the six months ended June 30, 2016 is +33%.
At June 30, 2016:
44% common equities
26% preferred share equities
52% corporate debt
Percentages do not add to 100% due to rounding.
USD exposure: 38%
Portfolio is valued in CAD;
Equities are valued at closing price;
Values include accrued corporate bond interest, but not that from Canadian exchange-traded debentures;
Corporate debt valued at last trade price.
Portfolio commentary and outlook
Back in February 11, 2016, I wrote the following:
I do have a general rule and that is whenever [financial market panic] hits the headlines of mainstream publications, it is likely closer to the 9th inning of the ballgame rather than the beginning.
The environment right now is once again reminding me of something like mid-2008 when everything is all panicky. Bargains that have good potential for double-digit appreciation are hitting the radar in huge frequency.
Just like what I did in 2008-2009, I listened to my own advice and started deploying some cash, for dramatic effect.
This quarter can only be described as insanely positive. It was a quarter where nearly everything worked. In relation to risk, the portfolio achieved returns that were far greater than anything ever done before since the 2008-2009 financial crisis (recall that 2009 was a year where I made +104% on my portfolio, an achievement that is not likely to be surpassed in my lifetime, but in my rational estimate there was more risk taken to achieve that return).
When everything is working, there are a couple attitudes:
1) Why change direction? Why not stick with a proven strategy?
2) Keep cautious, as something that works in the markets during one time period may not work in another time frame.
I am always of the #2 mentality, but apply discretion to “let winners run”. And indeed, I am letting my portfolio run.
The actual risk exposure of the portfolio is significantly less than what the asset allocation fractions above would suggest. The corporate equity portfolio consists entirely of companies that are trading under tangible book value and all of those entities are producing positive cash flows (with the exception of Genworth Financial (NYSE: GNW), where their LTC portfolio is going to be a huge negative cash drain, but financial challenge is to calculate how much of their asset base will go out the window to pay for future claims). GNW is a small equity holding.
I would not expect to liquidate any of these equity securities until they have appreciated further than present, but even then, I only like to sell when they are above my fair value band rather than at fair value.
The preferred share securities and corporate debt securities are higher up on the capital structure and for each and every of these investments I am expecting to be paid dividends or interest. In the case of the debt, my credit risk is mitigated with either security or functional first-in-line subordination status (i.e. little in the way of further senior or secured liabilities). There are a couple long-shot, distressed debt securities in the portfolio, but these have been kept to less than 1% position limits.
A notable debt highlight is Pinetree Capital (TSX: PNP) had their senior secured debentures mature on May 31, 2016 for cash, which ended a huge saga of the previous management’s inability to manage the balance sheet. I had actually liquidated most of these holdings at 101 cents before the rights offering was announced since my calculations showed that a cash maturity was going to be very tight (and indeed, if the rights offering did not come through that they likely would have had to go into CCAA to give them time to pay off debtholders with a mostly illiquid private asset portfolio). I wish Peter Tolnai, the new CEO and indirect 31% owner, the best of success in trying to unlock the value within the corporation’s huge pool of un-utilized capital losses. You can read the whole saga from November 2013 to May 2016 at this link. I expect things to be a lot more calm with Pinetree Capital in the future, except for them probably changing their company’s name to finally turn the page. I will disclose a very small equity holding by virtue of the January debenture redemption, which gave debtholders some shares.
For my fixed-income securities (bonds and preferreds), my yield at cost was in the low double-digits for something I consider to be between very low to low risk investments, despite the fact that such securities were trading at what I considered to be distressed price levels. The current yield of this basket of securities has decreased since purchase because of price appreciation (and will continue to drop because of rate-resets occurring over the next 12 months), but there is still room to run.
The beauty of debt securities is that I can fall into a coma and when I wake up, I very likely will have interest and principal deposited into my brokerage account. I do not have to take any action unless if I have a good reason to sell (which would likely be the securities trading above par value at a point where the call risk becomes meaningful). The preferred share securities are a different story – they have to be somewhat more actively monitored for both credit risk purposes and also if they are at a point where they have appreciated enough that their current yields are inferior to a superior alternative, measured from a risk-reward ratio. Due to the considerably low 5-year government bond rate, the rate-reset mechanisms of most preferred shares have taken their value well below the range where there is call risk so it is very likely that if I woke up from such a hypothetical coma, these shares will still be in the portfolio spinning away cash.
I do not have a good feel for the intermediate interest rate environment other than that there is continued downward pressure from the capital that is awash out there as a result of central bank liquidity. Let’s pretend you were given a trillion dollars with the provisio that you’ll have to pay it back in a decade – the easiest no-brainer is to dump it into US treasury securities and skim a few bucks of interest income. Enough players doing this will depress yields and then eventually pensions and institutions become so risk-adverse to the equity side that they invest in negative-yield securities like they are doing in Europe. Something is terribly amiss in the finance world, but it is tough to tell how this will play out.
It is ironic, however, with negative yields that a real cheap way for governments to pay down their sovereign debts is by issuing more negative yield debt. Forget about inflation for now!
The following few paragraphs are some of my opinions on economics. Please realize that I did not take more economics classes than Economics 100 when I was in university.
With all of these bits of paper (dollars and Euros) floating around, eventually it needs to be spent on something in order to realize their value – currency is about trading a unit of economic storage (dollars, gold coins, sea shells, bitcoins or whatever) into something tangible (planes, trains, automobiles, or the servitude of lawyers, accountants, engineers and management consultants). Optionally, if you don’t want to spend it on something today, you can put it into future claims (stocks, bonds) where you can then buy the tangible goods. This explains the rise in asset values, but not why we haven’t seen general inflation increases in tangible products.
Presently, the world is finding it quite difficult to spend money on the products, but is finding it much easier to spend on the entertainment components – explaining why service prices and the cost of specialized labour is going up much more than product prices – a product can be mass-produced a billion times over with reasonable economies of scale, but services that cannot be automated are ultimately supply-constrained by those that can practice it – and the price of this is skyrocketing above the ambient inflation rate.
So when published reports of GDP come out, it is important to distinguish between “stuff” and “non-stuff” components.
My general theory is that it will take some sort of world war, or massive natural disaster to spur “stuff-related” (i.e. physical production) related inflation. The big exception is the price of energy – while being eroded away by significant technological advances in solar power, I still do not see fossil fuels being displaced until well into the middle to end of the 21st century. The basic story is that people can only consume so much garbage and we are exceptionally efficient at mass-producing garbage, well beyond our ability to consume it. Just take a look inside a Walmart or Costco.
That ends my economic sermon for the quarter.
This quarter was also very bi-polar in terms of trading – most of the transactions were performed in April, while May was dormant and June had a couple transactions – one was a significant addition of an existing portfolio component, while the other was a new position in a corporate bond that should be an “easy” 10% yield to maturity.
Another bond purchase that happened earlier was my purchase of Teekay Corporation unsecured debt (maturing January 2020), which was purchased at a significant discount to par (link to article here). At my cost level, this will most likely provide the portfolio with a near 20% yield to maturity with a lot of bad news that would have to occur in order for a payout to not happen.
There were some other transactions that took place, but I do not feel like disclosing them at present.
Cash and Margin
The portfolio right now is utilizing a large amount of margin for the first time in many years. The cost of capital is extremely cheap, and is collateralized by certain fixed-income investments that give off increased cash flows than the floating rate interest expense.
On paper, it makes logical sense – invest at something with a 10% yield, and if this is financed with a 2%, 1.5% or 1% margin loan, you can skim the yield, earning 8%, 8.5% or 9% pre-tax yields, respectively. With most equities you can get at least 2:1 leverage (i.e. put up $10k to purchase $20k of stock) and bonds that have any sort of credit rating can be purchased with leverage.
It is finance 101 speaking: To convert a 5% yield into a 5%+X return on equity, you just need to use leverage that costs less than your yield. The bigger the differential between your yield and your cost of leverage, the less leverage you need to employ. Indeed, an investment that offers a “guaranteed” 5% yield that is financed with a 4.9% fixed rate loan can magically turn into a 10% return on equity with a hundred times of financial leverage – as long as you can find an institution willing to give you this leverage at the desired rates.
These sorts of products are structured and securitized and sold on the open market. You can even invent entire corporations that have a sole purpose of doing this in life. See (TSX: EQB) for an example. There are ETFs out there that will also employ such strategies with junk debt.
In practice, there are a few relevant issues, including doing this at an individual level:
1) The price of whatever you are investing in may fluctuate and you may be forced into a spontaneous liquidation scenario if you are too aggressively leveraged (and those sales will be at the most adverse prices). These fluctuations may happen for company-specific or general macroeconomic concerns and be well beyond your control to mitigate. The macroeconomic stuff you can’t really have control over but the company-specific concerns can be mitigated through diversification;
2) Interest rates might rise, killing the entire market. This can be mitigated somewhat with shorter duration investments, but you will have adverse impact on fixed-income streams as a result of a rise in rates;
3) Margin requirements might change, increasing the “stress point” where you get into a liquidation danger zone;
4) Leverage causes psychological stress and also by definition, does not allow you to take advantage of better price opportunities in the future (i.e. you can only take advantage of market opportunities by going further into leverage).
The most important consideration is:
5) Every single institution on this planet is trying to do the same thing and you are competing against them for exactly the same perceived low-risk, high-yield return on investment.
I am painfully aware that general funds flows are going into the corporate debt market, and this generally means that bond trading is going to get crowded. It is also very difficult to buy at the bid and sell at the ask for corporate bonds, although liquidity spreads on issues (such as Bombardier) are remarkably narrow (about a penny on average). Still, one cannot flip bonds around like one can with much more liquid equities.
In order to achieve outsized returns, one must always compete in marketplaces with less eyeballs and less capability for algorithimic investors to do their magic – and I do find that there have been some opportunities in the bond space as of late.
I will not go overboard doing this, however. The investment climate is not stressed enough and I generally prefer to make my investments in times of stress, such as what prevailed earlier this year and during Brexit.
Most of the retail market (at least locally here in the Greater Vancouver region) is getting into this game in the form of residential real estate – banks will give you money at 2.5%, you go buy a house with 20% down, and voila – you’ve leveraged yourself 4:1 on an asset. As long as your piece of real estate appreciates higher than 2.5% a year net of (not insignificant) carrying costs, you’re golden.
The leverage game usually (but not always) ends badly – the 2006-2008 blowup in the US residential real estate market was a great example. But a more modern example is with oil and gas producers that simply tried to squeeze too much juice out of their balance sheets – LINN Energy, Ultra Petroleum, Magnum Hunter, Sandridge Energy, etc. On the Canadian end we have a bunch of others, including some that are in the palliative care unit (best example is the company formerly known as PetroBakken, Lightstream Resources (TSX: LTS)). A lot of these oil companies are profitable, but they just ended up leveraging too deeply and financing brought them down.
Canadian Dollar vs. US Dollar thoughts
My USD allocation has crept up somewhat, but this due to appreciation of US-denominated holdings relative to the Canadian holdings. There were some minor purchases of US currency in the quarter which also added to the percentage. My policy with currency is to not pay too much attention to it other than keeping it at a band roughly between 30-70% CAD/USD. Appreciating Canadian dollars from the beginning of the year dragged portfolio performance somewhat, but this quarter the Canadian dollar was about the same. I have no big prognostications on the fate of the Canadian dollar and consider a 50/50 equilibrium to be perfectly satisfactory. I may change my opinion if the currency swings beyond 70 or 90 cents.
Anticipated future returns
In terms of future returns, I do not anticipate that my portfolio will achieve anywhere close to the returns that were achieved in the first half of this year – a stunning 33% year to date, most it achieved from March onwards. Still, if the prices of the assets in the portfolio march up to what I consider to be a fair value, there is a double-digit percentage that can still be realized and hence I am not particularly inclined to rapidly hit the sell button. Indeed, even if asset prices went nowhere over the quarter, the current yield alone would represent a passive gain of about 8% annualized with low risk, a lot better than sticking it in a zero-risk, 1% GIC.
Portfolio - 2016-Q2 - Historical PerformancePerformance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
|Year||Divestor Portfolio||S&P 500 (Price Return)||S&P 500 |
|TSX Comp. (Price Return)||TSX Comp.
|10.5 Years (CAGR):||+16.47%||+5.07%||+7.26%||+2.13%||+5.09%|