Q2-2014 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the second quarter of 2014, the three months ended June 30, 2014 is approximately -3%. My year-to-date performance for the six months ended June 30, 2014 is +1%.

Portfolio Percentages

At June 30, 2014:

69% Equities
3% Equity Options
17% Corporate Debt
11% Cash

USD exposure as a total of the portfolio: 49%

Notification

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Portfolio Commentary

With the S&P 500 up 5%, this quarter’s performance clearly underperformed. The same performance as the equity indices could have been achieved holding long-term government bonds. Holdings in US currency also accounted for some of the negative performance.

The primary reason for the negative result is due to the concentration of the portfolio in a specific yet-to-be-mentioned on this site company’s equity. There is regulatory risk in this particular title which has the valuation clearly depressed relative to where it should be, but it is just a matter of waiting for the risk to be removed. Due to the depressed valuation, the company is engaging in a share buyback and this will inevitably increase value for shareholders whenever the regulatory risk resolves itself. It is a matter of time. It almost reminds me of what happened when tobacco giant Philip Morris was being persecuted from all fronts earlier last decade and they were doing massive share buybacks when they were trading at price to earnings of 6 to 8 (in addition to giving out 5%+ dividend yields). It ended very, very well for those shareholders.

The major changes to the portfolio this quarter includes the exercise of equity options that were purchased in the previous year (and in the previous year they were purchased out-of-the-money and were a significant contributor to 2013’s relatively good performance). I did purchase some additional out-of-the-money equity options in a lottery ticket-type play, but so far this trade has not panned out. As purchasing out-of-the-money options at low prices typically implies, these may indeed go to zero. They may also go to the roof. We will see, but in any respect, the risk-reward ratio is better than when you have the Lotto MAX at $50 million.

During the quarter, I sold just over half of my holdings of Genworth MI (TSX: MIC) at an average price just north of CAD$39 a share, a couple bucks higher than current market prices. There is nothing wrong with the company fundamentally – they are very profitable, the market environment is nearly perfect for them, and the scale-back of their regulatory competitor (CMHC) will benefit them greatly. That said, the market is giving them the appropriate premium, so any appreciation in equity will be due to the earnings they generate (not a trivial amount – will be around the $3.80 range, or about a 10% earnings yield at present). I am also factoring in a medium probability of them declaring a special dividend (about $1.50 to $2.00 per share) before the end of the year as they have an excessive amount of capital on their balance sheet and this is cutting into their return on equity statistics. At present prices, I am comfortable with my exposure to this company.

I have also increased my exposure to US currency, mainly to maintain my general policy of keeping a balance of the two currencies in the portfolio (whether it is in raw cash or equities/debt denominated in such currency). I do not have a strict 50/50 policy, but I start to rebalance if things go beyond 30/70. I generally have no strong feelings on currency other than that given my geography, I will be using Canadian and US dollars for the rest of my life and there is little reason to consider the Euro, Yen, Bitcoins, etc. If Gold goes below CAD$1,000 an ounce I might buy one or two just so I can hold it in my hand and stare at it before burying the bars in my backyard.

The quarter was characterized more with what did not happen rather than what did happen. The portfolio is quite boring at present other than the one concentrated bet that I have alluded to above. I may decide to reveal the trade at a future date.

Outlook

My crystal ball continues to be quite clouded. There is a lot of conflicting information out there, probably because using means and medians on aggregate economic data does not tell the completely picture of the very bifurcated world we are entering. Absent of the relatively large concentrated pick (where I believe there is the potential of a relatively good risk/reward of about 5:1), I have literally nothing on the immediate radar that is worth picking up (or at least worth picking up in the anticipation of significant gains – there are a few incremental type picks out there which are better than average on the risk/reward spectrum).

Macroeconomically, the US Federal Reserve is signalling to the world that their special market operations are going to cease by year’s end and after that they will probably go to some sort of rate normalization regime, but in a way that will attempt not to crash the stock market. Until then, borrowing money is cheap and as long as short money is cheap, you will have lots of players trying to leverage their money into lower and lower quality financial products until the whole system goes boom again. My gut feeling is that we’re about half way there.

Much has been mentioned about liquid ETFs holding illiquid products and this is the financial equivalent of lighting cigarettes near gasoline station pumps. Even though you save a few pennies a litre on your gasoline at these safety-deficient stations, eventually your car will catch on fire and generate losses. Keeping your cash (and car!) away from these future fires should prove worthwhile. Investing in the best parts of the smothered remains will produce outsized gains. I do not see things occurring like they did in 2009-2011 when you had glorious opportunities to seize gains, but a miniature version of this should be on the horizon. Perhaps not this year, but maybe the next. I would just be on the lookout for anything the usual pundits would consider to be highly toxic.

Right now, most pundits think the stock market and bond markets are highly toxic.

I am reasonably sure the catalyst to start some sort of panic will be something relating to interest rates, and this usually will stem from inflation reporting. It is ironic how the first step to instigating the deflationary bust that Prem Watsa (of Fairfax fame) will be through an inflationary fear period, but it is plausible to see how that can occur. Once the excess inflation fear has been removed with the appropriate increases in rates (short or long term, whatever the case is), you will start seeing the carry trades out there completely unwind, and with that, the unwinding of the incredible amount of financial leverage there is out there – borrowing at 3% to make a 5% return on some crummy asset-backed security product.

Put yourself in the shoes of a typical mortgage bank. How much money is there to be made on 5-year fixed term products at 3% rates? Your spread over risk-free rates is nearly nothing after you deduct costs for marketing, bureaucratic infrastructure, etc, etc. This doesn’t end well when there is some sort of shock that reduces confidence in asset prices and people’s ability to pay.

I remain quite focussed in this part of the market cycle that more and more financial garbage will be pumped out into the system for eager investors that are going to pay anything for yield. This is reminding me of the mid 2000’s when income trusts were going public with very questionable ability to actually pay the distributions promised. Yield games can be played with securities, but when confidence is lost (either through real interest rate increases, or some other crisis of confidence), the underlying asset values can no longer support the yield and that is when you will see a huge domino effect.

This is the reason why I remain very reluctant to invest in yield-bearing products unless if the underlying entity has a clear ability to sustainability generate such funds. Even though there is a pile of cash earning next to nothing, it is quite dangerous to throw it into some low-risk debenture with a 4% yield to maturity (example #1, example #2, example #3, etc.). The liquidity will not be there when it is needed, and when there is a mini-credit crisis, it will very likely cost more than the yield that is currently being given away.

Given the long-term track record of the portfolio (see below, over the past 8.5 years it has achieved 16.7% compounded annual growth), it is quite difficult to produce gains at this level. Mathematically, if I managed to produce an absolute return of 12% for the year (which ordinarily is quite good assuming I don’t take a ridiculous amount of risk to achieve this), I would still be bringing down my long-term return. Psychologically, it is tough to see myself tread water for the first half of the year (producing something that barely would outperform a GIC), but this is part of the investment game – in order to perform better in the long run, I have to accept that I effectively will have to step away from the market and during these times, I will underperform my own long-term averages.

One of the costs of heavy portfolio concentration is that this will occur. With any luck, the second half of the year will be better. I’m guessing it will be.

Divestor Portfolio - 2014-Q2 - Historical Performance

YearPerformanceS&P 500TSX CompositeGeneral Comments
8.5 Years:+16.7%+5.5%+3.5%(Jan 2006- Jun 2014) 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 (Q1)+4.2%+1.3%+5.2%Little transaction volume this quarter. Still over 1/4 in cash, trimmed a large position.
2014 (Q2)-3.4%+4.7%+5.7%Little action this quarter; continuing to hold onto a significantly concentrated position.

Q1-2014 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2014, the three months ended March 31, 2014 is approximately +4%.

Portfolio Percentages

At March 31, 2014:

37% Equities
19% Equity Options
16% Corporate Debt
28% Cash

USD exposure as a total of the portfolio: 35%

Notification

I will likely suspend these quarterly updates. I do not believe they are adding much value. Does anybody reading this care?

Portfolio Commentary

This was a very muted quarter with a few transactions. The most pronounced was the adjustment of a position using long-dated options strictly due to the reason to employ cheap leverage and the relatively low implied volatility “price” that is being paid for this position. I initially made this investment in the previous quarter and the price went in my direction. The expiration of those options are coming up, so I needed to perform some transactions to sell the remaining time on the present series and extend it out for another half year. A baseball analogy is that I see a slow pitch being delivered that is going to hit the sweet spot of the strike zone, and I am swinging the bat for a home run. The risk-reward ratio is extremely attractive, although if the price I anticipate happening does not materialize in the timeframe I’ve purchased, then that will result in a loss.

I will point out that as of the time of this writing, the position is in the red due to some news concerning the overall industry that should, in my opinion, pass. Analogies include the concerns of government litigation of Phillip Morris and the tobacco industry, and anti-trust investigations of Microsoft when they dominated the operating system and office software market in the early 2000’s. In both cases, the companies in question were dominant players in their industry and quite profitable. The same case applies here.

I took the opportunity to purchase some corporate debentures that are in a distressed state. Time will tell whether this will work itself out or not. The risk-reward in this circumstance is quite attractive given the underlying company and management incentives to deal with the problem without causing a wipe-out in equity. It is not like Pinetree Capital where debenture holders are functionally secure in their investment, but the price paid is quite attractive.

I attempted a trade in a foreign-based security that exhibited perfect market timing in all respects other than the fact that I set the order to expire at 9:31am eastern time and the stock did not have its opening transaction on the NYSE until 9:31:02. This was incredibly frustrating as my trade would have hit the 52-week low. The security is also up 25% from where I had intended to take the position. My initial trade would have been for a 4% allocation in the portfolio, so this inept trading cost me 1% performance this quarter. I learned some lessons here.

I also performed some minor transactions in another security which traded lower after its quarterly result, and subsequently traded higher. I only received a minor fill of my desired position (about 2%) and thus I liquidated it for a quick 15% gain as I did not want this to consume mental bandwidth. It is still on my watchlist in case if it trades down again.

As reported earlier, I liquidated some Genworth MI during the quarter, around the $38 level. Subsequent to quarter-end, I have also liquidated some at the $39 level. Genworth MI still continues to be my largest position. It is a very well run company that is enjoying the confluence of very positive circumstances, mainly record low mortgage rates, a stable (albeit expensive) Canadian housing market, neutral to positive employment prospects and historical low mortgage defaults. It is also enjoying a change in regulatory regime where its primary competitor, CMHC, is slowing backing away from the industry and is also increasing prices in the marketplace.

As a result, my transactions are only for portfolio balance concerns as the fraction in my portfolio was getting ridiculously high. They also issued a 10-year debenture at a very low rate of interest (4.24%, or 1.74% above Government of Canada rates) without causing any blip in their equity. I expect them to be issuing a special dividend later this year to alleviate themselves of their excess capital once OSFI capital requirements are finalized.

The S&P 500 was up 1.3% for the quarter and the TSX was up 5.2%, so the quarterly performance is in-line with the major indicies, despite having a significant amount of zero-yielding cash.

Outlook

I have little inspiration for this quarter’s outlook. I remain in a wait and see position and am continuing to opportunistically look for areas to invest in, but I remain out of ideas at present. I do not have any confidence in any of the commodity markets, nor do I have much confidence in the broad equity indices at present. Sentiment feels like the universal consensus is that the party will continue until it ends, which means very little at present. When given uncertain convictions, the best thing to do is cash up and be patient until such a time that invest-able opportunities present themselves.

The outcome of the Quebec election will have a material impact on the political discourse of the upcoming 2015 federal election. Specifically if Quebec separation is off the table (i.e. the Parti Quebecois does not obtain a majority government, which polling likely suggests will occur), it should have a stabilizing effect on Canadian currency.

I remain fascinated by Russia’s geopolitical aggression to assert its old USSR sphere of influence. Putin has gambled correctly that the western world and NATO will not do anything other than give lip service at the Crimean annexation, but it is inevitable that there will be some other geopolitical rumblings in that part of the world once Russia has asserted itself again.

I equally remain fascinated how valuations in certain technology companies remain sky-high, but this is likely a function of low interest rates and a huge amount of liquidity available to investors. Bonds are horrible by comparison (who wants to earn 2.5% for 10 years?) and as long as this remains the case, then equity investors will continue to try to shoot for the 6%/year instead of taking such a low return on bonds. Pension funds also face the same pressure, which is why capital will continue to flow into equities until we start seeing a loss in confidence. This is why predicting “the top” or the next market correction is so difficult – it is not dependent on economic fundamentals.

This sort of low-rate behavior is also seen in real estate markets, where cap rates in commercial real estate is very low. Just picking a random press release from RioCan REIT, we have the following:

RioCan also completed the acquisition of the remaining 40% interest in Whiteshield Plaza, bringing RioCan’s interest in the property to 100%. Whiteshield Plaza is a 156,000 square foot grocery anchored shopping centre located in Toronto, Ontario. The additional 40% interest was acquired at a purchase price of $11 million, representing a capitalization rate of 5.5%. In connection with the acquisition, RioCan assumed outstanding mortgage financing of $8 million, bearing interest at Banker’s Acceptance plus 1.85%, maturing in September 2015.

A 5.5% cap rate? If I was a real estate portfolio manager, I’d be trying to sell everything I can and then put the proceeds split evenly into gold and Bitcoin!

But seriously, every professional manager out there is facing the same question: How the heck do you get a return in this environment? Do you buy overpriced assets and pray that they don’t crash down, or do you buy low-yielding bonds? They have no choice – they have to do either. An individual investor has discretion to hold high amounts of cash and as you can tell, that’s exactly what I’m doing until my investment radar starts to see more attractive things to invest in.

Divestor Portfolio - 2014-Q1 - Historical Performance

YearPerformanceS&P 500TSX CompositeGeneral Comments
8.0 Years:+17.7%+5.0%+2.4%(Jan 2006- Dec 2013) 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 (Q1)+4.2%+1.3%+5.2%Little transaction volume this quarter. Still over 1/4 in cash, trimmed a large position.

Q4-2013 Year-End Divestor Portfolio Performance Report

Portfolio Performance

My very unaudited portfolio performance in the fourth quarter of 2013 is approximately +26%. For the year ended December 31, 2013, the performance is approximately +52.9%.

Divestor Portfolio - 2013 Year-End - Historical Performance

YearPerformanceS&P 500TSX CompositeGeneral Comments
8.0 Years:+17.7%+5.0%+2.4%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.

As you can see from above, my eight-year performance (compounded annual growth rate) is +17.7%. I will warn that I do not regard this figure as sustainable for future performance.

Portfolio Percentages

At December 31, 2013:

40% Equities
19% Equity Options
10% Corporate Debt
31% Cash

USD exposure as a total of the portfolio: 38%

Please note that equities are accounted for with the closing price on December 31, 2013. The equity options are accounted for roughly at the bid-ask spread; while corporate debt is accounted for at the posted bid at year end.

Portfolio Commentary

I had to double-check my performance numbers to make sure they are correct. Indeed, the year is actually at +53%, which is quite frankly a big shock to me. I was expecting a decent year from the dirt-cheap insurance firms I was holding at the beginning of the year, but I divested most of them in the third quarter of the year. The performance is even more of a shock when considering the high quantities of cash I have been holding in the portfolio since the disposition of most of these.

Had I been perfectly clairvoyant and held onto the things I had and also properly dumped some other losers which caused a performance drag, there would have been another +15% or so of performance for the year figure, but of course, hindsight is 20/20. Otherwise, I would have bought those out of the money call options on Tesla (Nasdaq: TSLA) at the beginning of the year!

Other completely clairvoyant market participants would have also done very well to simply buy out-of-the-money call options on the S&P 500 and would have made a fortune in the process. Just as a simple example, if you are expecting another 30% market performance in the S&P 500 in 2014, you can make above 21 times your money by buying those call options with a strike price of 2100.

There was a slight improvement in performance due to the exchange rate, and the USD fraction of the portfolio was reduced from the previous quarter not because of any revelations of the relative values of the currencies (my own opinions of where the Canadian dollar is going is utterly useless – I do not have strong currency trading insight that can be market-worthy) but rather to just balance cash balances (I had been incurring interest expenses on Canadian cash while my US balance was sitting in the account earning nothing). My instincts tell me to target a 50/50 mix, but to not go out of my way to making it happen.

In relation to the indicies, an S&P 500 index investor netted about +32%, while the TSX appreciated +11%; investors should take note of the chronic underperformance of the TSX – an artifact of having such a strong resource component. I think this will continue. Bucking this trend are the financials – Just picking two random names, Royal Bank (TSX: RY) is up 20%, and Manulife (TSX: MFC) is up 57%, before dividends.

This quarter was punctuated by a couple losers, and one extremely large winning trade (yet to be realized). I still am not going to disclose the name, but suffice to say, a single digit percentage out-of-the-money option purchase transformed into the significant percentage you see above. It was like going to the casino and transforming $1 into $5 overnight. When dealing with such gains the natural instinct is to take your profits (see Icahn on Netflix), but the underlying equity is still trading some 25% below where I think it should be, and it should actually get there eventually. The options expire in April, so I will have to make a decision what to do with the position closer to expiry.

The implied volatility on this issue was, in my opinion, extremely low and likely priced with computer algorithms that had garbage inputs. The market has somewhat picked up on this and normalized it to something slightly more reasonable, but I still think the options are undervalued on the basis of volatility. Whenever you see low volatility, you want to purchase longer dated options to pick up more of the mis-valuation. This is why I chose options rather than the equity. I very rarely buy options as most of the time, implied volatility is quite high on anything I am generally interested in.

One disadvantage of having such a concentrated position morph into such a huge portfolio fraction is that now the day-to-day dollar value volatility is quite gut-wrenching. It is financially suicidal to take such a large option position if I did not have any today. But this trade is playing remarkably close to the mental script I had in mind when making the trade in the first place so I am not divesting this highly leveraged position until the underlying equity reaches my price target.

Reassuring me is that this company’s underlying business fundamentals will perform better if the stock market started to exhibit higher volatility. Not many companies can make this claim. Maybe that is a sufficient hint for somebody to figure out where I invested it in.

One of the better trades I did not make was the decision to do nothing with Genworth MI (TSX: MIC). This continues to be my largest position (due to its appreciation) and I do not see storm clouds on the horizon for this equity even though it is in my fair value range. The company gives out a 4% current yield that it can easily afford. There is also still one more catalyst in the woodwork that I believe will give this equity a further boost than it has already received. I will not comment on this catalyst other than it will be obvious to those after it has been announced, but not so obvious right now. It would likely cause another 10% spike upwards. Considering that the fears of the Canadian housing market imploding at this time is significantly less (and indeed, you can see this reflected in the stock price), there is still justification to play for some more upside. Perhaps this is greed, but I am relatively confident that my research with this issue is superior than how the market has valued this equity.

Looking at my previous transactions in 2013, I would have been better served by not trimming the insurance equities that I considered to be trading dirt cheap at the beginning of 2013, but I had good reasons to raise cash beyond the individual valuations of those equities.

I wrote the following in my year-end report of 2012:

Essentially those dollars on the ground are willing to be picked up at 60 cents at relatively low risk. If the market goes where my valuations project my holdings to go, I should do better than the +28% in 2010 if I just stay away from the trading console all year.

Indeed, I believe 2013 will be a type of year where I will accomplish more for the portfolio by simply staying away from the trading button.

I should have listened to myself – I bought 60 cent dollars and sold them for 90 cents, but right now they’re sitting at the market for about $1.05. Oh well.

As a result of winning positions increasing their size in the portfolio, the portfolio has significant concentrations. I am feeling uncomfortable with this and will likely trim some concentration in 2014. How much gets trimmed depends on the market.

Outlook and 2014 Predictions

Broadly speaking, there were three big losers in 2013:
(a) Anything relating to the production of gold and silver and other precious metals – if you’re into the majors, ABX, GG, K, etc. are down about 50%, while the juniors are mostly down even further;
(b) US Mortgage REIT investors – e.g. NLY, HTS, etc. They are down about 30% or so on tapering an interest rate fears. A lesser-so category was Canadian REIT investors, but the level of losses here were relatively sedated compared to the US Mortgage REIT sector.
(c) Asset class investors that did not hold 100% US equity indices underperformed badly. Let’s pretend your mix was 60% North American Equity and 40% broad-spectrum debt, you’re still way below what the S&P 500 is as a whole.

I do not consider the market environment to be terribly helpful to gold and silver investors as I believe the commodity price will continue to decline through the year as the fear trade “tapers” off. Likewise, I do not believe the environment for mortgage REITs or Canadian REITs are going to be materially better. Normally there is opportunity in pessimism, but I am not comfortable as usually you want to see bankruptcies and consolidation and just more doom and gloom. Even though your average gold investor is no longer bragging, there still continues to be this hope for inflationary times to finally vindicate their convictions. In other words, watch out for more downside.

The amount of NYSE Margin Debt, while correlated to the general performance of the markets, does give a bit of insight on how much froth is in the asset markets – the amount of margin debt is at an all-time high. This is not too surprising considering that the federal reserve is keeping interest rates at the 0.00 to 0.25% target rate – hedge funds are taking their “free money” and deploying it into the stock markets. This is not a secret. With leverage comes increased brittleness in the marketplace. A snap 10% correction in two or three trading days can easily occur and this will force some margin selling to amplify the market momentum. Think of October 1989.

The amount of froth I see in social media (TWTR, FB, LNKD, YELP, etc.) continues to be mind-numbing. I have no explanation for this, nor any real inclination to call a top. The same goes for Bitcoin. The insiders will make a lot of money on this, and my question is who will be holding the bag when these assets (not necessarily all of them, but some) go into a terminal decline. As Blackberry shareholders can sympathize with, technology and consumer sentiment is fickle.

Sentiment-wise, there is this looming impression that the economic recovery is more or less complete – unemployment is dropping, financial firms have stabilized, the USA is approaching and is actually going to achieve energy independence, etc. What can go wrong? The problem is two-fold: these positive sentiments are baked in current prices, and the macroeconomic variables have been promoted to stimulate asset valuations as much as possible with the easy monetary policy everywhere. Eventually there will be a form of mean reversion on monetary policy and when this occurs, asset values will have to correct. “Eventually” can be longer than most expect – indeed, most did not expect things to go as far as they did.

My instincts, however, tell me that the first half of 2014 will be a stock market ‘party zone’, punctuated with luring those that have stayed out of the equity market (being burned by the 2008-2009 experience) and getting them back in. When this occurs and sentiment reaches a peak, watch out.

Prediction #1: We will see some sort of market correction in the second half of 2014 that results in the S&P 500 go down 15% within a one month time period. The S&P 500 never went down more than 10% in 2013. On this note, volatility is extraordinary cheap: VIX has not gravitated beyond 20% too often in 2013, when my own personal barometer of market fear has been when VIX is above 30%. The last real bout of market panic was during the Euro-Greece crisis in the second half of 2011 (incidentally a year where I made really terrible decisions).

It has been over two years where we have not seen any real market panic.

There are the stereotypical “black swan” events that may perturb the financial landscape, but by definition such events are unpredictable and don’t appear on your radar until they’ve already hit. Even moving from the “unknown unknown” to “known unknown” category is difficult with these sorts of things.

My own personal biggest surprise of 2013 was the performance of Air Canada (TSX: AC.B), where an equity investor at the beginning of the year would have realized over a triple on their investment. Getting social media performance out of an airline stock is something you don’t see very often. Historically one would not be sitting on a good risk/reward at present valuations for the stock.

As illustrated by the amount of cash in the portfolio, I have been finding it difficult to identify investment candidates of sufficiently good risk/reward. This is likely to continue in 2014 as I have been doing significant amounts of screening to no avail. Since almost every sector out there has been “hot”, this has not been a very good environment to find bargains. Indeed, even 30-year treasury bonds, while trading at year lows, are still relatively over-valued compared to the ambient 4.5% levels they exhibited in the first half of 2011. There are some companies on my watchlist pipeline where I have done sufficient due diligence which are trading at the lower part of a fair value range, but I want these to go lower to make them no-brainer trades.

As such, I am generally starved and I am consistently looking at my previous discards to see if anything has fundamentally changed that warrant a second bout of research. In most cases, no. My portfolio remains very highly concentrated.

As a result of my risk-averse stance that I will be taking in 2014, I do not anticipate anything more than single digit gains for the year. My thumbs will be receiving a lot of exercise from twiddling them in-between reading the SEC and SEDAR filings, looking for those microscopic golden needles in haystacks that seem bigger than ever.

Prediction #2: Volatility will increase, especially in the second half of the year. Considering that volatility is at all-time lows, this is not a difficult prediction. Putting a long story short, hedge funds have been making a fortune shorting volatility and this is likely to blow up soon in conjunction with the increased leverage in the marketplace.

Non-Prediction #3: Emerging market blow-ups will give investors some decent opportunity if they care to look outside of the developed nation markets. Specifically, what is going on in Thailand, India, Brazil and Turkey I am finding to be interesting. I also detect some hints that Russia of all places is exhibiting anomalous behaviour compared to their post-USSR past and that their administration might be figuring out that attracting foreign capital might be a way to project global influence, similar to China’s roadmap. That said, this is a non-prediction since I don’t really have any specific angles here, and with the exception of India, the language barrier gives any western investor a hand behind their back when doing due diligence. Cultural barriers (or specifically the lack of intuition of the country’s institutions) also present another investment barrier. That said, one of the promises to myself in 2014 is to pay a bit more attention internationally.

That’s all I really have to say at this time. My own strategic investment roadmap is a little more fuzzy this year than the previous year. Clearly I am not expecting 53% returns in 2014. My aim is simply to ensure it is above zero.

Q3-2013 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the third quarter of 2013, the three months ended September 30, 2013 is approximately +1%. Year to date, the performance is +21%.

Portfolio Percentages

At September 30, 2013:

55% Equities
1% Equity Options
18% Corporate Debt
26% Cash

USD exposure as a total of the portfolio: 47%

Portfolio Commentary

I spent the quarter clearing out some existing equity positions. Compared to current market values, I believe I timed the exits fairly well (nothing feels better than selling shares only to see them decline in value after you emptied the last of your position). Most of this was from boring insurance firms, but I also got rid of the warrants I had in an obscure corporation that primarily dealt with real estate interests. Although all of these firms are certainly in the “value” category, I believe I have already experienced the majority of appreciation compared to their vastly undervalued prices when I acquired shares last year. If there is some fear that starts building up in the industry again, I will be more than happy to go long again, but there is a perception of stability and low risk within these companies at present.

One of my equity positions (that I have roughly a 10-15% stake in) experienced a severe decline this quarter when they had a disappointing quarterly report in addition to other concerns going on. I thought the market had discounted these concerns sufficiently, but apparently it did not. There was a significant appreciation leading up to their quarterly report, undoubtedly fueled by speculation that it would be unusually positive, and I should have hammered that opportunity and cleared out the position as it was already close to my exit point. I failed to do so, and this ultimately caused a significant amount of performance drag this quarter. I am generally unhappy with my performance with this particular equity. I can sense management is also in the same boat (insiders do own a relatively large non-majority fraction of the company), but they are relying on external market factors to provide a particular uptick which will finally cause some explosive growth to their revenue base. This was the primary drag on my performance this quarter and is also why I have underperformed the market indicies.

Not helping is that every other investor in the planet will be choosing this equity as a candidate for a tax liquidation.

The S&P 500 was up 4.7% and the TSX was up 5.4%, so I underperformed this quarter. Year-to-date, I am slightly above the main indicies, despite being encumbered with a significant and zero-earning cash balance.

In this quarter, I took positions in two corporate debt issuers. This was my first entry into the corporate debt market since I exited positions in 2011 – generally yields have been quite low, even on the most marginal of firms. I still see securities trading at 6% yields to maturity for medium terms (e.g. 5 years) when higher spreads are warranted.

Both debt issues I have purchased have significant considerations with respect to managements’ interests in the company in question. One of the issues was a special situation – unfortunately my accumulation was cut short by a Seeking Alpha (pro) article posted exactly about this situation and the opportunity it presented to investors. I was unaware of this article until a few days after the ultimate bottom for this debt issue was reached, and I was on the purchase of the 52-week low trade for this particular issuer. I had open orders at a price below the 52-week low that I wanted to get filled in as well, but they weren’t reached.

At my average purchase price, this will result in a roughly 30% compounded annual return over the next (roughly) 3 years that this debt issue has. The only bad news is that I was only able to obtain half the position I had desired in it. This opportunity was the biggest “near guaranteed win” I found in the market this year, which required reading a bunch of boring public documentation. I’m generally not happy that I did not manage to get my full allocation on this winning trade.

Readers here may recall that I did offer to sell this information, but I subsequently informed people that expressed interest that I was no longer going to sell it. One reason was because somebody else exposed this information.

Since I am less concerned now about people knowing the name of this relatively illiquid security, when they went to their debtholders to ask for a relaxation of terms, they had to raise the coupon and give the people that voted yes to the arrangement a cash sweetener, which worked out to a one-time bonus of an extra 6% on face value. Obviously I voted yes for the arrangement since this meant that the poor equity holders (including management) were left to pay this one.

The other debt issue is more speculative in nature, but deals with a company that has significant management interests to avoid any sort of default and transfer of ownership. The firm itself is not insignificant and is a very well established player in its field. The company also has a fairly good ability to streamline its cost structure in such a manner to make its banks happy (as they have a credit facility that is first in line, but the term facility expires into 2016), but there is also a debenture maturity coming up late in 2014 which they have to navigate around. There will likely be some sort of equity sweetener and debt extension that will make debtholders whole. Again, this is not for the faint of heart, as yields to maturity are well into the double digits.

I still also maintain a heavily weighted position in Genworth MI (TSX: MIC) which is still undervalued and is trading on fears of a Canadian real estate collapse, coupled with a cooling credit market. They are still slated to appreciate further, at least to my calculations. They are, in a very boring manner, generating substantial amounts of cash. I am not complacent about Canadian real estate, but currently I do not see any catalyst type events that will be resulting in mass loan defaults (at least not yet!).

Outlook

The big macroeconomic news is the US federal reserve’s inability to change course without imploding the world economy, mainly the lack of any “tapering” of their massive monetary stimulus experiment they are conducting. Merely the mention of the end of easy money is enough to turn emerging markets into tailspins and it is quite clear that the markets are headed for some sort of rupture as asset prices continue to balloon.

There seems to be a hint that the oil market is receiving some revival in their price range – this probably is a function of geopolitical risk, and also that former countries that were producing oil (Libya, for example) are now having difficulties getting supply. Most people completely underestimate the engineering prowess and large capital investments that are involved in pulling crude oil out of the ground. I don’t have a good feel for the future of oil prices, but I do know that the world’s growth in oil consumption is coming from China, and commodities in general have been a function of how much countries like China can consume them.

I continue examining natural gas pricing in North America and am starting to suspect prices are going to go higher in the future. I am slowly (and this is much slower than I wish) looking at companies that are mostly into the natural gas space, but have been disproportionately hammered in the current price environment. I believe there are more innovative ways of taking advantage of natural gas than just purchasing shares of Encana (TSX: ECA). Companies, especially low cost producers such as Peyto (TSX: PEY) have already experienced significant price appreciation, and I am just not very accustomed at buying things when they have appreciated in the marketplace.

I have noticed that most of the Canadian REIT sector (e.g. Riocan (TSX: RCI.UN), and many, many others) are trading relatively lower than their highs they were generally at earlier in this spring. Their downturn started when the tapering talk began at the US federal reserve. I still do not believe current valuations are at all compelling and still do note that they have a huge capability to raise debt capital at extremely cheap rates of interest. It is a sector, however, I keep watching with a few brain cells.

The portfolio also maintains a healthy portion of zero-yielding cash and I am well prepared for some sort of market downturn. That said, I also believe patience is the word of the day. Although the S&P 500 is at record heights, this is more of a function of very loose monetary policy (translating into very low borrowing rates for good credits) than anything else. Valuations on certain corporations (e.g. Apple) look cheap, but I inherently do not trust them.

I do not expect portfolio performance in the fourth quarter to be disproportionately better or worse than market averages. I am generally dissatisfied with what I have seen out there in the marketplaces, but I have not been looking hard enough due to other constraints. I am also more likely than not to continue increasing my cash allocation and wait for rainier days (and indeed, in southwestern British Columbia, it is quite rainy at the moment!).

Divestor Portfolio - 2013-Q3 - Historical Performance

YearPerformanceS&P 500TSX CompositeGeneral Comments
7.75 Years:+14.9%+3.9%+1.6%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 (Q1)+14.6%+10.0%+2.5%Most of the portfolio was in low price-to-book/low price-to-earnings holdings in the insurance industry.
2013 (Q2)+5.0%+2.4%-4.9%Spent most of the quarter selling insurance holdings that exhibited substantial appreciation. Ended quarter 22% in cash.
2013 (Q3)+0.9%+4.7%+5.4%Continued liquidation of insurance holdings, purchased some debentures, and one equity position had a significant downturn causing a drag on performance (unforced error). Ended quarter 26% in cash.

Q2-2013 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the second quarter of 2013, the three months ended June 30, 2013 is approximately +5%. Year to date, the performance is +20%.

Portfolio Percentages

At June 30, 2013 (this does not total 100% due to rounding):

71% Equities
8% Warrants
22% Cash

USD exposure as a total of the portfolio: 70%

Portfolio Commentary

I got a good chunk of my portfolio out the window and into cash before the markets peaked in mid-May. Some of the timing (such as Rosetta Stone (NYSE: RST) in the last quarter) was less than ideal, but the general decision has been correct. With the recent divestments, I have gone from a -9% cash position to 22% cash at quarter end, so this is a substantial shift in strategy. Volatile times always seem to call for volatile strategies – compare this to the post-February 2009 strategy, which was “just hold on for dear life and don’t sell!” which was good for a couple years before a shift was required.

Comparing to indicies, in the quarter, the S&P 500 was up 2% and the TSX was down 5%. My portfolio is quite different in that the number of issues is significantly less, and in the case of the TSX, I do not have any existing investments in the resource sector, which the TSX is heavily weighted in. In addition, foreign exchange has been favourable to the portfolio by about 3%, so the reported figure is somewhat higher than its “true” performance if measured in terms of the currencies of the underlying investments. If the Canadian dollar maintained its strength in the year, it would have reduced the reported performance to nearly what the S&P 500 performed.

Remaining in the equity portfolio are still remnants of boring insurance-type companies which continue to remain slightly over half the portfolio. These companies are trading close to tangible book value and should be retaining value better than most other firms in the event of market calamity. That said, they have crept toward the higher values of my price range and some of them stepped high to a point where I removed some of the position. The liquidation will continue as prices continue to rise.

I still believe Genworth MI Canada (TSX: MIC) remains undervalued for a multitude of reasons – and management is correctly capitalizing on their relative undervaluation by executing on a stock buyback, which is effectively purchasing $1.20 of value per $1 paid for the stock. They are overcapitalized and they are currently being depressed by very bearish predictions on the Canadian real estate market – predictions which are not likely to materialize unless if there is a huge interest rate shock (beyond what we have seen in the past couple months) and significant rates of unemployment. We are unlikely to see either.

By virtue of not selling those shares in any quantity since the past quarter, it is currently my largest holding. I continue to pick up a 5% yield on current prices (and higher yield at cost, which is an irrelevant statistic), but I still believe there is a significant chance of a further capital-returning event such as a dutch auction or a one-time special dividend that will likely enhance the return of this investment. Its tangible book is about 20% higher than current market value and the only two reasons why it is trading at such a deeply discounted level is the public fear of the Canadian real estate market and also the 57% Genworth majority ownership.

In the meantime, their stock buyback will mean that their dividend payout ratio will continue to decline.

I don’t have much more to add that I didn’t already include in the previous Q1-2013 performance report.

Outlook

Whenever you’re up 20% in a year, the normal instinct is to sell everything, pay the capital gains taxes, and call it a good year. Unfortunately things are never quite as simple – why settle for 20% when you can go for 40%? I very much doubt the portfolio will ever see that amount considering the selling focus that is going on at present.

The question to ask at this point is – are rising long-term interest rates an illusion, or are they likely to continue? Right now, the short part of the interest curve is still near-zero but the futures are projecting rate increases in late 2014. Canadian rates are currently projected to increase in the middle of 2014. Is this real, or will interest rates continue to compress with another round of quantitative easing? These sorts of fundamental questions determine how one optimizes their portfolio in the fixed income realm, but it also has macroeconomic implications for those other firms out there that depend on a low rate structure for borrowing purposes.

Translating the Greek in the preceding paragraph, it is going to be exceedingly difficult to determine who the winners and losers are going to be in the so-called “great unwind” of the most accommodation of monetary policy we have ever seen.

In rising yield environments, short-term duration is the only method of preserving capital. A great example of those that thought they had a sure thing were preferred share investors in relatively stable financial companies – they saw peak-to-trough market losses in excess of 10% this quarter, which is the equivalent of a couple years’ worth of dividend payments. Will this panic accelerate or is it a small hiccup before the rush to fixed income yields continues business-as-usual?

That said, I am of the belief that longer term rates will compress back to historical low levels. It is fairly counter-intuitive that higher government debt levels will result in lower interest rates, but that is the symptom of the fiscal largesse rather than the cause of it. Until any meaningful form of deleveraging on the public front can occur, yields will find it more and more difficult to continue their ascent. Keep in mind that expectations are currently that there will be a full economic recovery globally, but there are significant risks to that forecast that if any emerged, would result in a rush back to fixed income.

Looking across the spectrum and looking for equities that have been hammered recently, a common sector is gold mining stocks. Looking at stalwarts like Barrick (TSX: ABX) and Kinross (TSX: K), they are down about 2/3rds from their highs in 2011. Is there value in the gold mining sector? Probably not for a couple reasons – dropping commodity prices and increasing costs on the ground. Most people looking at commodity extraction companies focus on the commodity price, but an equally important part of the equation is the cost to actually get the material out of the ground.

Likewise in the oil and gas space, looking at Suncor (TSX: SU) and Canadian Oil Sands (TSX: COS) as decent proxies for the fortunes of the Alberta oil sands, their stock charts show them spinning their wheels into a muddy piece of ground and headed nowhere. At least for those investors, they are doing better than the gold mining sector.

Investors should also remember when commodities get hyped up that it may take a long, long time before stocks reach valuations where they get frothy again. A prime example was when uranium companies were getting bidded to the roof in the 2005-2007 era and subsequently collapsed – you can see the Canadian top dog, Cameco (TSX: CCO) going nowhere. And remember the fury over Potash Corporation (TSX: POT) and the proposed takeover from Australia? That was the golden opportunity to sell those shares and cash out on the hype over there.

Commodities are always cyclical and investors should always be aware of what point in the financial cycle and capacity cycle they are in before getting their feet wet. Need I say anything more about how I think Westjet (TSX: WJA) and Air Canada (TSX: AC.B) investors are going to do in the future once they’ve built up their capacity again?

I don’t have to write about rare earths (TSX: RES) as a lot of people lost about 90% of their money since 2011 on this sector.

What will be the next hyped up commodity sector?

It could entirely be the case that there is going to be no safe sector other than cash. As dispassionate as cash may sound, if there is going to be any deflationary environment, the real rate of return on holding cash is indeed positive. In Canada, there are still options for putting cash at work in a risk-free manner that will get you about 1.5% nominal interest. Most importantly, the risk of loss is nothing.

I’m still waiting for some washout event that will cause considerable amount of public fear. I know this has somewhat occurred in the junk fixed income market and also US municipal debt and gold, but I need to be buying when there is blood on the street. There is bleeding, but not enough blood at present. Thus, I continue to cash up and wait for opportunity.

Q1-2013 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2013, the three months ended March 31, 2013 is approximately +15%.

Portfolio Percentages

At March 31, 2013:

101% Equities
8% Warrants
-9% Cash

USD exposure as a total of the portfolio: 66%

Portfolio Commentary

I had good performance during the quarter, and I am painfully aware that +15% on a quarterly basis is obviously an unsustainable amount of performance. While I can’t promise anything, it will likely not be repeated next quarter. The performance is also tempered with the fact that the S&P 500 was also up 10.0% for the quarter and there was a moderate degree of leverage applied to the portfolio so the performance number is not as good as it seems at first glance. The TSX Composite was up 2.5% during the same period, but since I am not invested in any resource commodities and the TSX is heavily weighted in commodities and financials, I am not using the TSX as a comparative benchmark at present. Foreign exchange was also mildly beneficial to the portfolio.

Other than the sale of Rosetta Stone (which I discussed earlier – and looking like it was divested too early at present!) and the acquisition of some warrants that have a strike price that is significantly in the money, the portfolio has had very little change. For the most part, it continues to be invested in companies that are trading under tangible book value, although one of these companies has appreciated above tangible book value from the previous quarter.

Most of the common shares in the portfolio are of very boring insurance firms. I am patiently waiting for them to trade at a modest premium over book value, plus paying attention to other valuation metrics (i.e. earnings and reserving). They should get there whether the overall markets do well or poorly. Of particular interest is Genworth MI (TSX: MIC), which continues to have skittish investors bailing out of it with fears of the Canadian real estate market getting too hot for comfort. Even if Genworth MI decided to close up shop and run down their mortgage insurance portfolio, they would still appreciate from current prices and converge to book. Clearly they are not going to do that, but they will be reducing underwriting volumes as transaction volume decreases. MIC also has a huge cash buffer and it remains to be seen what they will want to do with this excess capital.

The warrants are simply a proxy for a common share holding by virtue of the in-the-money strike price and long expiry. This is effectively acting as embedded leverage without having to expend the capital to do so. The entity in question does give out a mild common share dividend, but management’s historical approach with excess capital has been such to buy back shares, which is beneficial for the warrants (compared to increasing the regular dividend). The underlying company’s common shares are trading under tangible book value.

There is one significant and speculative position in a company that I believe will have a very good chance of exploding on the upside when it gets traction and I am simply being patient with it. For speculative types of companies (especially with financial metrics that do not fit in with a typical value investing perspective), there are a few factors that need to line up into place. The company needs to be targeting a market that clearly has future potential for profitable revenue growth, the story needs to be simple enough when it gains traction for others to easily “buy into” it, management needs to be competent and have a good sense of direction and care about shareholder value, and finally, management ownership needs to be significant. Typically when you get these factors (and some others) you will have a better chance than just throwing darts at a newspaper.

Outlook

The outlook that I issued a couple quarters ago materially stands. There is some deep psychology games going on in the marketplace with respect to the relationship between equities and bonds. When looking at the past figures with respect to fund inflows, there seems to be a warming up toward the equity side again, and when this gets too bubbly then we still start to see some more volatility in the markets again.

Looking at the chart of the S&P 500 and historical patterns would suggest we are due for some corrective action and whenever this occurs, one would want to have cash to take advantage of such opportunity. The trick, as always, is in the timing.

Although I have a slight margin position as present, the equities I have invested in have a significant margin of safety embedded in them which is why I am not too concerned about a correction, if one indeed occurs.

One of the boring insurance firms in the portfolio is less than 5% appreciation away before I’ll consider to start selling it. The next closest insurance firm that is on the selling block is when it appreciates by about 15%. Whenever I buy or sell stocks, it is usually through layered transactions. I am not in a rush to hit the sell button, although when I do look at all of their three-year charts, they are sitting nearly at highs. Sounds simple, but one should sell when prices are high and buy when prices are low – and right now, prices do not appear to be low.

Also, for some strange reason, I have been somewhat fascinated at looking at the price of gold chart. I note that the Gold ETF (NYSE: GLD) has had some material drawdowns in gold lately – from December 10, 2012 when they had 1353.35 tonnes of gold in the trust to the 1221.16 tonnes – a 9.8% drop in holdings. The underlying commodity spot price has only gone down 6% since that time.

The other development is that the spot natural gas price appears to be showing signs of life. Perhaps the cyclical supply-demand aspect of this commodity is moderating? A cursory scan of the usual natural gas stocks appears to show signs of life.

Real estate is another angle that people pursue to try to increase yield in their portfolio. The biggest Canadian REIT, RioCan (TSX: RCI.UN), reported year-end equity of $6.88 billion, and its current market capitalization is $8.25 billion. At the end of 2012, there are 31 separately traded REITS on the TSX (less if you exclude the REITs that have common management) and 13 of them have a market capitalization of over $1 billion. It does not take an eternity to look at them and come to the quick conclusion that people are paying dearly for yield.

The most painful thing to hold these days appears to be zero-yield cash, which makes me suspect that in the days where Euro-nations are restricted in taking out 300 Euro per day from their bank accounts, perhaps accumulating cash right now is not that bad a move. In any respect, I would expect the portfolio leverage to decrease and a cash balance to once again build up over the next few quarters, especially if we continue to see the appreciation that we have seen this quarter. Maybe if I got another 15% quarter, I could then sell everything and call it a year and wait for the market to crash. There is a huge amount of “borrowed time” feeling with the current market. Sell now and wait for a 20% drop? Or get greedy and see how much longer the momentum upwards will last?

Either way, if prices rise, I will be continuing to sell parts of the portfolio and start to cash up.

Q4-2012 Year-End Divestor Portfolio Performance Report

Portfolio Performance

My very unaudited portfolio performance in the fourth quarter of 2012 is approximately -5%. For the year ended December 31, 2012, the performance is approximately +2%.

My historical performance is as follows:
2006: +3.0%
2007: +11.7%
2008: -9.2%
2009: +104.2%
2010: +28.0%
2011: -13.4%
2012: +2.0%

My seven-year performance, compounded annual growth rate, is +13.4%.

Portfolio Percentages

At December 31, 2012:

118% Equities
-18% Cash

USD exposure as a total of the portfolio: 65%

Portfolio Commentary
The past quarter of performance, suffice to say, has been disappointing. The leveraging did occur after the quarter’s worth of losses were reported, however.

The bulk of the 5% loss in the quarter revolved around one particular small-cap company that made a cash acquisition of approximately 20% of its market cap that I considered was a moderate negative in terms of the company’s future prospects. The market also did not like this acquisition and my execution in terms of exiting the company was lacklustre and both of these factors contributed to most of the loss this quarter. C’est la vie. The only silver lining in this is that the CRA will be partially subsidizing this loss when capital gains are filed. I have been burned once before with this particular company (back in 2006!) and just when things seemed to be hitting a stride and was priced right, something materially bad occurred that caused me to change my outlook significantly enough to warrant dumping the stock.

Probably the other story in the portfolio is the relatively large leveraging in terms of the margin debt. Out of the 118% equity position, 81% of this is invested in a small basket of insurance companies that are trading under tangible book value and should produce cash flows that represent (on average) 1/8th of the market capitalization. There are individually researched stories for each of these companies (two of which are published on this site, mainly Assurant (NYSE: AIZ) and Genworth MI Canada (TSX: MIC)), but generally the extra tangible book value on the balance sheet side deals with the low interest rate environment for high-grade debt.

The majority of the portfolio for the beginning half of the year was primarily in cash as I was in a preservation mode and did not feel comfortable in putting idle money in the S&P 500 index (or any other index). The timing of the entries on the insurance companies I believe will be opportune and the market will eventually realize that the world is not going to end on the insurance front because of continually low interest rates – instead, premiums will just have to increase.

The other equity components in the portfolio are invested in a particular value play which I have written about before, and a smaller technology company that I have done some extensive research on and I believe 2013 will be a significant break-out year for the firm. Not that I am greedy or impatient, but there is fairly good potential for a triple of the market capitalization. The management team that has been assembled by the CEO (that owns more than 10% of the common shares in the company) has fairly good credentials and history and it should be a winner – expectations were too high a few years ago, but right now they are low.

Outlook and 2013 Predictions

Now that two years of significant under-performance of the market is behind me, I am something optimistic that 2013 will be a market-beating year. Valuations in certain parts of the US equity side are exceedingly low and the portfolio, despite the fact that the leverage appears to be excessive, is relatively less risky than what the raw numbers would otherwise indicate. Essentially those dollars on the ground are willing to be picked up at 60 cents at relatively low risk. If the market goes where my valuations project my holdings to go, I should do better than the +28% in 2010 if I just stay away from the trading console all year.

Indeed, I believe 2013 will be a type of year where I will accomplish more for the portfolio by simply staying away from the trading button.

I believe interest rates will continue to remain low and as long as this is the case, I do not think there will be any fundamental ruptures going on. Even if something does occur on that front, the equity in the portfolio should not be that adversely affected compared to other sectors. The “news” to focus on will not be the usual bantering about the dysfunction on the US fiscal side, but it will rather be geopolitical. China will have effectively brought in a new government, Russia is starting to flex its muscles again, and there will be lurking instability coming out of South America (especially Argentina) that will throw some wrenches into the global gears.

Domestically, the anticipated downturn in Canadian real estate is already occurring, and as long as this continues to be anticipated and the downturn in valuation continues to be gradual and slow, the market reaction to this should be mute. Looking at mortgage lenders (TSX: ETC, HCG), you would actually think that there is a boom in (solvent) housing lending going on. I am indirectly benefiting from this by being long Genworth’s Canadian mortgage insurance arm, which is still the recipient of record low delinquency rates. As long as the Canadian economy continues to trudge along without any dramatic rises in unemployment, the real estate market should continue to meander along, similar to how between 1992 to 2002, real estate in Vancouver did practically nothing.

It should also be pointed out that Canadian REITs were the top performing sector in the country, returning 17% to investors in 2012. This is be a sign that the sector is being tapped out. Indeed, when players like Loblaws (TSX: L) are scrambling to spin out their REIT assets, I would be very wary before putting anything into REITs. I would be putting my money on the sellers and not the buyers.

I don’t have much opinion on the natural resource sector at this time other than that high prices has spawned capital expenditures to the tune that supply and demand appear to be relatively levelled. The only exception will be the natural gas market, where one wonders how long it will be before the depressed prices of shale gas will take out producers to the point that prices will eventually rise again. I don’t know if 2013 will see significant increases in natural gas prices, or whether the market will even depress further. I know this “up or down” forecast is hardly taking a stand, which would explain I have zero exposure to the natural resource sector as of present.

I do like the concept, at least from a retail level, of performing a “lifestyle hedge”. This consists of purchasing enough equity in energy companies to hedge off one’s consumption of natural gas and oil when you see opportunistic prices. Hedging off one’s future natural gas consumption at present prices seems to be a relatively low risk, low reward type play – just have to pick a natural gas company with an inherently low cost structure and sufficient amounts of untapped reserves.

Finally, I will comment on the chase for yield. Yield is what people are aiming for since it is nearly impossible to make a decent return on AAA-rated securities. Investment capital continues to swim around REITs, high-yield equities, and less than stellar-rated debt securities. It is just a matter of time before there is a serious amount of overreach in these securities and although I have been talking about this “chase for yield” for quite some time now, I believe it will eventually catch up to investors. The best opportunities are probably very thinly traded securities or private ones.

I know this outlook is not saying a heck of a lot – which is why my portfolio, despite the leverage, is actually quite conservatively aligned in a low volatility basket of stocks. I continue to be wary of the strangeness that the low interest rate environment brings, but continue to pick away at niche areas that exhibit undervaluation. 2013 should be a better year in terms of my portfolio return – hopefully around the levels I earned in 2010 if my valuations are correct and the market comes to my level.

Q3-2012 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the third quarter of 2012 was +7%. For the nine months ended September 30, 2012 the performance is approximately +7%.

Portfolio Percentages

At September 30, 2012:

73% Equities
27% Cash

USD exposure as a total of the portfolio: 41%

Portfolio Commentary

The relatively low performance year-to-date is because the first half of this year was spent mostly in cash (75% in the beginning, 86% on March 31, 62% on June 30). At the end of September, there has been more of an investment in equities – the bulk of the purchases were made in July. Also, there was a shift from Canadian-denominated assets to US-denominated assets, which is a mild bet that the Canadian currency is somewhat “toppy”.

Performance should take into consideration the high cash holdings (which yields next to nothing). Although the decision to hold cash in retrospect was incorrect, I was not comfortable with the environment and forcing cash into work is usually a good way of losing money. I am sure the rest of the world wished they bought Apple at $400/share at the beginning of 2012 as well (it is up some 65% since then), but large-cap companies has never been my focus. An index investor in the S&P 500 would be up about 30% for the 1-year period or about 15% for the year-to-date period, so parking idle cash in the index would have obviously been better (in retrospect!).

When looking at a chart of the S&P 500, it is up 7% for the quarter (goosed up on back of Apple stock in addition to others), so the performance in this portfolio is relatively well. I am not using the S&P 500 as a benchmark simply because my portfolio components are not that compatible with the index (despite actually investing in a component of the S&P 500 – very rare for me). I have written in the past on a few components of the portfolio – Rosetta Stone (NYSE: RST), Genworth MI Canada (TSX: MIC), and also Assurant (NYSE: AIZ). I have other holdings which are thankfully above my cost basis and I may write about them in the future when they have cleared my upper threshold of fair value.

Notably, companies like MIC and AIZ are in the insurance industry and are deep value plays – both are trading well below tangible book value and have clear reasons why the market is betting against them (reasons that I disagree with). Once the market (hopefully) comes to the realization it is wrong, then I will be able to realize significant value out of both of these investments.

Outlook

My outlook as issued in my Q2-2012 report stands mostly intact.

I am still moderately bullish on equities, although the markets have been exceptionally frothy over the past quarter. There might be a mini-correction that will take the major indicies down 5-10%, but it will be temporary and I expect the macroeconomic environment that is awash in liquidity to take asset prices up even higher. So much money is being pumped into the US market place through the purchase of debt instruments by the federal reserve that it will have to flow into asset prices.

If there is a type of investment where I believe people in the long-run will be losing money, it is anything packaged with high yield and fixed principal. Bonds (especially junk debt) (NYSE: JNK) continue to go even higher and I find this to be somewhat alarming. I don’t think junk debt is a losing bet today, but it is something I would be aware of once the inevitable happens – defaults. Reading about the financial history of the 80’s and junk debt – I see the same thing happening here. The way that this blows up is with a few defaults after enough people have bought into the various high-yield products that will be structured to take advantage of those just looking at the yield. Investors might get their 6-7% coupon payments, but when they take a 30% haircut in principal value, they will wonder what they were doing this for in the first place.

Canada recently had one of these incidents last decade, but with much less fanfare: the development and creation of income trusts, a fair deal of them posting high yields but no sustainable income to keep it up, until the government put an end to that charade. The reason why they were put to an end had little to do with the creation of income trusts with unsustainable yields, however!

There will be a time to liquidate, but I do not see it occurring by year’s end – generally, when looking at fund flow statistics, retail people are still shunning equities, especially those not giving out high yield, and this will continue to mean that the bulk of opportunities will be in the non-income bearing equity market. When straight equities suddenly become politically correct again, especially in the retail market, will be a decent precursor for hitting the exit button and seeing which cards fall where before getting back in again.

I do have a residual concern: low implied volatility. It would add somewhat to the bullish thesis that this number were somewhat higher.

The big macroeconomic variable that is going to come up which will cause some choppy seas will be the US fiscal situation and their so-called “fiscal cliff”. Timing this will not be easy – and indeed, with the 10-year bond still trading at 1.6-1.7% as this is being written, means that right now institutions still are having no fears in giving their money away to the US government. 30-year yields are at 3% as well – if somebody gave you a million dollars at 3% for 30 years, would you snap on it?

In terms of the details within the portfolio, I do not anticipate purchasing or disposing of any securities in the next quarter. They are performing as expected with plenty of room for appreciation. As much as I like to see everything go up 50% after I have taken my full position, good investment decisions require time and patience for the market to come to your own conclusions about the valuation. I will continue to be on the lookout for further deployment of cash, but my stance in general at this moment is wait-and-see. There are some more targets of opportunity on the watchlist, but they are at prices that I consider to be too high.

Ideally, I try to time my entry points after the announcement a bad quarter caused by some transient event that has nothing to do with the underlying business potential, the equity gets taken down some ridiculously large percentage as a result and that is usually a good time to invest. The market’s psychological trauma of actually having lumpy returns will fade away and the price will then restore to a level that represents less risk (and hence higher price).

Good companies should report lumpy returns – it tells you the accounting is honest and not geared to analyst estimates.

Database corruption

The site was down for quite a few hours apparently because of some database corruption. Using some wizardry that I haven’t had to use in quite some time (e.g. command prompt restoration of the database backup file) I restored the database and lost the two weekend posts which I recovered out of Google Reader.

Hopefully this wasn’t a result of a directed hack attack or anything.

Q2-2012 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the second quarter of 2012 was +4%. For the six months ended June 30, 2012 is approximately 0% (flat).

Portfolio Percentages

At June 30, 2012:

38% Equities
62% Cash

USD exposure as a total of the portfolio: 26%

Portfolio Commentary

Given that throughout most of this quarter my portfolio was well over 80% cash, I was not expecting a high degree of performance. That said, Rosetta Stone (NYSE: RST) was a relatively well-timed entry (I wrote about it here) and did drive a substantial portion of performance for this quarter.

I am nearly dead-even for the year-to-date, which is a desired outcome of my relatively risk-adverse posturing I have taken generally since the 3rd quarter of 2011. Although I am not benchmarking my portfolio to the major indices, the S&P 500 is up 8.3% to date, while the TSX Composite is down 3%. This in itself is a hint that resource-based investments have not been performing well – of which I have none.

Later in this quarter, I started to accumulate shares in other companies. One is a low-risk, medium-reward scenario that has a depressed valuation because of a majority opinion that the industry the company is participating in will result in losses. The trading in this equity has likely baked in emotional sentiment in addition to extrapolating wrong parallels with the logical historical analogy. I am still trying to accumulate shares in this company and am hoping for some sort of spike down in the share price which would finish off my position. The margin of safety on this stock is massive and although it will not triple, my fair value calculations suggest that the low part of the price range is about 30% higher than where it is trading today. With a little bit of momentum, I am targeting a 50% gainer for this particular purchase. Despite my focus on non-dividend yielding equities, this company does have a dividend yield that represents roughly a 1/3rd payout ratio.

Company #2 and #3 are both in the technology field. They trade on a US stock exchange. The branding of one is probably recognizable by a decent number of people, while the other company nobody would recognize. Basically both companies have relatively unique positions in the marketplace and have significant moats. They are also in industries which will be very likely to expand and will have increasing demand. Unfortunately I can’t be more specific. Given the nature of these technology companies, I would rank the risk as medium, but the reward potential to be very good.

Outlook

I am slightly more bullish on equities. Not just any equities, but rather equities in companies that do not give out yield. Almost anything with a yield has been disproportionately bidded up, which has lead my research elsewhere. As evidenced above, there were a few “hits” that managed to light up and I have subsequently been trying to deploy capital.

I note that the government bond rates have reached all-time lows during this quarter. In particular, as of today the 10-year Canada government bond is down to 1.68%. You can short a 10-year bond and re-invest the proceeds in some boring preferred share of a boring institution (e.g. Power Corporation) and make a 3% spread. The problem with this logic is that everybody else has likely done so and is continuing to push that spread lower and lower. The danger is not in the yield, but rather in the capital – your 10-year bond’s duration goes lower as it approaches maturity, but your perpetual preferred share’s duration will always be larger than the bond. So if interest rates decide to rise again, your price drop in the 10-year bond will be lower than the preferred share and you will start to lose capital and face an eventual margin call if your equity slips to the negative point. The other factor is credit risk in the company that issued the preferred share (although this is what you try to mitigate by choosing a boring company in the first place).

While people play this “race to the bottom”, or rather the “race to see who is leveraged the most before interest rates finally go the other direction”, money cannot be reasonably pumped into this yield arms race. Instead, it must go toward stocks that aren’t involved in the arms race.

For the same reason, I observe the debenture and corporate debt markets are pretty much a write off in terms of risk-to-reward. There are a lot of non-investment grade bonds out there that people are dumping capital into. Eventually we’ll see defaults, but not yet. A good marker on this would be the asset base of ETFs such as (NYSE: JNK).

I remain skeptical of commodity prices and thus commodity equities in general. The only industry that has really caught my interest from a valuation perspective is the utter cheapness of natural gas relative to its oil cousin, but considering there is little incentive for producers to stop capital projects that are already in progress, these projects will finish and continue dumping supply into the marketplace. Although you see power producers picking up some slack, it won’t be enough to put a significant spike on price. At least not yet. When I start seeing some bankruptcies and fire-sales of assets (perhaps Chesapeake is this example) then I’d start to get interested.

There are macroeconomic risks. In particular, the situation in Europe is hardly inspiring, but the spillover to North America will probably be somewhat more muted than the 2008-2009 US financial crisis was to Europeans. The other eerie piece of historical information is that when the Nikkei started to crater after 1989, that index basically bobbed up and down but remained in a relatively tight range for the next decade. I am not saying that the US indices will be the same, but that the only way to make money in a market where the major indices are locked is to look at much smaller companies.

It is always a point of guidance for fundamental type investing to consider more broader measures of demand, such as looking at demographics and where demand will be shifting.