KCG cost of capital calculation

I will warn this is a very dry post.

The merger arbitrage spread with KCG has narrowed considerably.

When the $20 cash merger was announced the shares were trading at $19.75. There is little chance of the deal falling through or there being a superior offer.

Today KCG is trading at $19.88. The estimated close of the merger was reported to be “3rd quarter 2017”. The assumption is the mid-range, or August 15, 2017.

So there are 3.5 months until the deal closes.

12 cents appreciation is 0.6% over 3.5 months, which over the course of 3.5 months implies a 2.1% annualized rate, not compounding. This also excludes trading costs.

Because I had a small cash deficit in my USD account and a surplus in CAD, I’ve sold some shares at $19.88 to make up the shortfall. I placed it at the ask to minimize trading costs, which turned out to be 29 cents per 100 shares.

What’s interesting is my trade got hammered away, 100 shares at a time, approximately 2-4 seconds apart per trade. Interesting algorithms at play here.

I also believe Virtu (Nasdaq: VIRT) will have a more difficult time with the integration of KCG than they originally anticipate. The company cultures are significantly different and while the merger makes sense on paper, in practice it is going to be quite different. KCG was also dealing with a non-trivial data migration program on their own, from New Jersey to New York City and these sorts of technical details require highly skilled individuals to pull off without causing trading blow-ups. It might take them a year to get things stabilized after the merger is finished. KCG had huge growing pains of its own after it was reverse-takeovered by GetCo.

Canadian preferred shares education

James Hymas has published a considerable volume of information concerning fixed-reset preferred shares. It makes for very heavy reading (i.e. this is not something you can casually read at a Starbucks), but if you are in the right frame of mind, there is a ton of educational content that you would never see in your typical MBA program.

He also has an equivalent document for a class of preferred shares that stand a better chance of being redeemed early due to regulatory capital requirements rules which I will not repeat here.

While I’m on the topic of James Hymas, he is very concise with his analysis on the Canadian real estate market, mainly that it is caused by “low interest rates”, “an explosion of CMHC guarantees”, and “unsatisfactory stock market returns”. Capital has to go somewhere and if you can’t get a 4% return from the stock market, you can at least go for a cap rate for the same in the real estate market. I will observe that 5-year bond yields have slipped to the 1.00% level again and 5-year fixed rate mortgage are available for 2.39% on insured mortgages. Why bother to put up any equity when money is virtually being given to you at the rate of inflation?

Psychology of Portfolio Management – Doing half

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

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

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

So the solution was obvious. Sell half.

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

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

Researching Primary Market offerings

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

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

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

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

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

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

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

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

Higher prices means more dangerous times

If the market perceives less risk, prices rise.

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

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

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

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

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

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

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

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

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

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

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

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

How not to sell covered call options

Most retail investors use covered call options as a cash generation device. The algorithm generally goes like this: “I’m going to sell a call option at a strike price that I would have sold the shares at anyway – if the stock does not get up to the strike price, I would have held onto the shares, and if the stock goes above the strike I will be cashed out anyhow, so why not make a few pennies selling the call option?”

Unfortunately, such thinking is more damaging than not as investors are usually selling such options at an implied volatility that is lower than what the option should be priced at. Most of this is evident in illiquid option markets (such as the options that trade on most of Canadian issuers on the Montreal Exchange).

The reason selling low-priced covered calls is hurtful is because of the “lottery” aspect of stocks (statistically speaking, this is referred to as the “fat tails” of a price distribution curve) – stocks sometimes do not move in continuous prices, although these jumps do not occur frequently. For example, when selling a call option, you are giving up most of the takeover premium that you would potentially receive. Another example is jumps during quarterly earnings reports. The other significant disadvantage of using covered calls is giving up liquidity – in most retail cases, selling a covered call obligates one to hold the capital in the common shares until expiration, or unwinding the position (which requires paying a spread on less liquid options).

So when somebody is willing to sell you 8 weeks of time on a call option at a strike price that is about 5% away from the money for about 0.8% of the market value of the common shares, they’re probably letting things go for cheaper than they realize. This option is still likely to expire worthless, but the potential upside is far, far better than the price paid simply because it can rocket higher than the 0.8% of premium paid. So I spent a few bucks (far, far less than 1% of the portfolio) on hitting somebody’s low asking price.

Covered calls do have their usage in portfolios, but they typically are constrained to high volatility situations when the action to sell calls seems to be a difficult decision.

AMA (Ask me anything)…

The irreverent (but not irrelevant!) Nelson has linked to me in the past, so I will link to his post on something non-finance related and repeat the theme here.

I’m compiling the year-end (as today was the last trading day in the markets for 2016) and doing some year-end reflections, in addition to some projections of what we will be seeing in 2017.

In the meantime, I invite readers here to “ask me anything” via the comments below, and I will endeavor to answer in a timely fashion.

Happy New Year.

US Presidential Election: Current Guess

I apologize to my readers. Instead of writing anything relevant to the financial markets, I’m instead writing about Trump vs. Clinton. Please forgive me – this will pass after Tuesday.

The following is my November 3, 2016 guess. My prediction has nothing to do with endorsement of any candidate or policies they represent. In fact, a Kaine/Pence (choose one for president and vice president by flipping a coin) administration would probably be a lot more acceptable for most of the public.

Canadian readers of this site can remember what happened with the NDP and Jack Layton in the 2011 election in Quebec. While it isn’t huge like that election was, there is an element of it in this particular election.



If you are Hillary you do not want to see this:


LA Times / USC has always had a pro-Republican skew to it from the very beginning of this election (although they were quite right in 2012), but that “hockey stick” boost at the end is something you don’t want to be seeing if you are a Democrat – people locking in their votes for Trump. Since this is a national poll, it can only be extrapolated so far since there are huge Democratic majorities in California and New York, but this isn’t what you want to be seeing if you are cheering for Clinton.

The aggregate polling also shows a Trump spike, but I have always claimed that poll samples (including the LA Times one above) is not representative of who Trump is going to actually get out to vote – voter turnout and the distribution of voters that show up is of paramount importance in elections in Canada and the USA.


Polls do try to correct for this factor by including “likely voters”, but methodologies can only go so far. Since most political pundits use backward-looking lenses to project results, it is not surprising that they are all still predicting a Clinton victory.

The real-money markets (Pinnacle Sports is the best proxy for this) has Trump at +226, which is the highest probability odds I have seen him. Betfair (which is closed to Canadians), I also consider highly credible and they have him as 9/4, which is pretty much the same.

Markets will be asleep for the next week and a half

Mark November 8, 2016 on your calendars – the date of the US Presidential Election.

Until then, no major market participant is going to be doing anything, short of the knee-jerk reactions from quarterly earnings reports.

You’re also starting to see a build-up of volatility which bettors are using to hedge:


And yes, Donald Trump becomes the next president. This isn’t an endorsement of him, but rather what I have been saying for the past year and a bit. This is an election where the standard calculus does not work, and people are continuing to make the mistake of using those lenses in a very different environment (similar to the error that the Conservative Party of Canada in the lead-up to the 2015 election).

Pinnacle Sports had Trump at +580 (roughly 1-in-7) to win a week ago and now he is at +280 (roughly 1-in-4), so the betting markets have been very volatile.

Also I have noticed most Canadians use Canadian lenses to look at what is going on in this very American election. Most of the time the political culture is similar, but this is a very special situation.