2016 Year-End Report

Portfolio Performance

My very unaudited portfolio performance in the fourth quarter of 2016, the three months ended December 31, 2016 is approximately +3.1%. The year-to-date performance for the year ended December 31, 2016 is approximately +53.6%.

Portfolio Percentages

At December 31, 2016:

48% common equities
27% preferred share equities
44% corporate debt
1% options
-20% cash and cash equivalents

USD exposure: 42%

Portfolio is valued in CAD (CAD/USD 0.7420);
Equities are valued at closing price;
Values include accrued corporate bond interest;
Corporate debt valued at last trade price.

Portfolio commentary

What an interesting year, both in the portfolio and in the overall investment climate. The climate back in February 2016 was with much more peril than it is now. Prices are now reflecting the decreased amount of peril, hence they are higher. Much higher.

The TSX composite also had a good year – about 20% with dividends invested. This was undoubtedly on the back of the recovery in the energy sector – most issuers are all up over this year-to-year.

From the previous quarter, several positions appreciated, I bailed out in one position entirely, and also also added to another position. All of my common equity that I hold are in companies that are trading under tangible book value and generating cash.

My preferred share portfolio is mostly unchanged. They are half rate-reset and half of them have a fixed rate. I did do some slight additions of one issuer that was very temporarily trading about 10% lower than its ambient price for no good reason, but this addition was slightly less than 1% of the portfolio (which is too bad, since I wanted whoever was selling it to continue hitting the bid – I was willing to go another 4% or so). I am generally content with my holdings in these categories, and I will also note that my preferred share holdings of Birchcliff Energy (both TSX: BIR.PR.A and BIR.PR.C) have remained quite close to a point where I would want to liquidate and head for greener pastures. I am demanding a price, however, that prices in the circumstance that they will continue to pay out dividends for a very long time (and indeed, given how their common shares have performed this year, I should have just bought them to begin the year instead of the preferred shares). If my price gets hit, great, if not, I will keep collecting the cash flows since my cost of capital is cheap.

I have six issuers of corporate debt that I hold. One will mature early in 2017 (Pengrowth Energy, PGF.DB.B) which will add a not-inconsiderable amount of cash back to the portfolio. I was happy to see my analysis come to fruition back in March 2016 on this issuer. The underlying company will do well if oil continues to rise in price, but at the US$45-50 range they will not do so well as they have a series of debt maturities coming up and refinancing will not be trivial, although they seem to have taken good steps to mitigate the issue with a royalty sale.

The rest of the debt portfolio (minus Pengrowth) has an average weighted term of 3.2 years. One of the features of investing in debt directly instead of through an ETF is that over time, your interest rate exposure decreases. I am concerned that interest rate risk will continue to rise, hence a decreasing term to maturity of the portfolio will mitigate that risk. As long as solvency is not an issue (i.e. bondholders get paid), it should present no problem if rates do rise. In addition, some of the debt is callable and while this will decrease the interest payout over time, it would give me the opportunity to redeploy capital.

Teekay Corporation’s unsecured 8.5% debt maturing on January 15, 2020 has been behaving to thesis. Considering that the parent and daughter entities have been raising equity pursuant to a continuous equity offering, this can only be good for bondholders.

Currency-wise, the exchange rate differed a little bit – the CAD started the year at 72 cents, and closed the year at 74 cents, so this had a slightly negative impact on the portfolio performance.

Performance-wise, obviously this was a very good year for me. This seems to happen once every three years in generally market-positive years. I don’t have any specific insight why it happens when it does.

Finally, I will make a comment on the level of margin in the portfolio. It looks heavily leveraged at the moment (and historically this is quite high amounts of leverage for myself, who has been accustomed to holding significant amounts of cash in the past – up to half at times). Most of the margin is directly linked towards specific fixed income investments that have rather predictable cash outlay profiles. When considering the inexpensive (and tax deductible) financing provided, it makes a lot of financial sense to park idle capital into vehicles that can predictably give off stable streams of income and principal payments.

When looking strictly at the fixed (non-equity) component of the portfolio and offsetting it against the margin debt, the only conceivable scenario where there will be fast stress is if there is some sort of 6-sigma type event (such as a WMD (nuclear, chemical, biological) event in a major metropolitan center in the USA) that will fundamentally change variables. Despite the margin, there is quite a layer of safety embedded.

Reviewing the predictions of 2015

It is a time to look back at the predictions I made back in the 2015-year end report and see what I got right and what I didn’t.

1. Canadian Dollar, Canadian interest rates, Canadian Economy: Mixed bag. I was wrong on the trough on the Canadian dollar (I thought it would go to 65 cents), but I was right about the interest rates being fixed at 0.5%, and the general impact of natural resource extraction in Canada, although the late-year pipeline approvals from the federal government surprised me.

2. Crude Oil and natural gas: These were both a failed prediction. A lid was not kept on the price of crude, and natural gas, while performing better, was also considerably higher.

3. Canada Real Estate: Successful prediction, although BC enacting a foreign buyer transaction tax, coupled with the federal government’s change on mortgage financing is slowly putting a lid on credit conditions on this market.

4. Canada Federal Budget: Correct. The forecast deficit was higher than initial projections. Not a surprise considering the existing spend-everything government.

5. US Federal Reserve: Correct.

6. Next US President: Yes, I predicted Trump would win by a considerable margin. The definition of “considerable” can be debated, but a 304-227 margin, in presidential terms, is a very healthy victory. My prediction was 295-243.

Outlook

Similar to the Presidential election, 2016 was a unique year in that there were some very defined amounts of stress applied as a result of the oil and gas market reaching the trough of its leverage issues. Once this was done, there has been relatively little of opportunity in terms of reasonable risk/reward ratios. Most of my trades this year were done before April and the rest of it has served as a mild detriment to my own performance. Trading because one is bored and looking for thin value situations should only be limited to the smallest of percentages and thankfully I obeyed this rule.

I am projecting a rising price environment over the next couple months of the calendar year. My hunch is reliant on inflows of capital into the equity markets primarily as a result of past performance. While pension funds will have to execute on an equity-to-bond rebalancing, this will probably be offset by hordes of cash that will be dumped into robotic management (so called robo-investors).

Psychologically, it is one thing to invest in something and lose 20% of your capital. It hurts. It is even worse for an investor to have cash sitting in their bank account earning 1% (if that) and seeing the rest of the market rise 20%. Consider the vantage point of somebody prospectively wanting to buy real estate in the Vancouver area over the past decade (link to Teranet) – there was no decent time to not pull the trigger (until perhaps now).

I was fortunate enough to employ leverage at the best time possible, but it is time to harvest gains and bunker down a little.

Fiscal policy in Canada remains very deficit-driven. Politically-speaking, now that the Liberals have gotten their feet wet again in government, they will know that this year will be the year to enact the most publicly unpopular policies. They are also facing an issue of trying to raise money since they inherently have an inability to contain spending. An interesting document to scour is the report on tax expenditures (specifically this table), where you can be a finance minister and ask yourself what the best ways to net the government money would be. There already have been trial balloons floated on the taxation of health insurance plans for employers, and also an increase to the capital gains inclusion rate.

Predictions about how the Canadian government’s Budget 2017 tax proposals with my confidence factors:

1. (50%) Flow-through share deductions will be eliminated.
2. (75%) Employee stock option deduction will have a full, instead of half inclusion rate, OR the amount will be capped to some nominal amount (e.g. CAD$50k allowed or something).
3. (40%) Taxation of capital gains on principal residences is going to have some restrictions (time, or value) placed.
4. (75%) Partial inclusion of capital gains will rise. Using the year 2000 model, Canadians should consider crystallizing gains in early 2017 before the budget. The only question is whether this will apply to individuals or corporations, or whether there will be a limited dollar value applied to this condition.
5. (90%) I do NOT believe the non-tax exemption for private and public health plans will be scrapped. This would be a political nightmare for the government compared to the rather esoteric notions on the items.
6. (50%) The GST will rise (probably to 7%, but this prediction will be judged a success if it is simply raised at all).
7. (50%) Corporate income taxes, on large corporations, will rise.

Fiscally speaking, I see another CAD$25-40 billion deficit year coming ahead, with the low end only coming to fruition if they raise the GST. The budgetary projections will show a slow return to surplus, but in actuality I will be writing here in January 2018 and the same forecast will occur.

Switching to Canada’s largest trading partner: the election of Donald Trump everybody has been trying to figure out the impact, but until January 20 comes rolling around, it is all imagined at the moment. If he is able to execute on even half of his economic policies, it would suggest that the best analogy to be applied is what happened when Ronald Regan was elected – although the initial starting conditions between Jimmy Carter today are vastly different – unemployment in the USA is at record lows and the economy, despite everything the existing administration has tried, is not in bad condition.

The power of hope is something that is not easily captured in forward-looking economic statistics, but the messaging of the Trump administration (which has still yet to officially take power) is that domestic US concerns will “trump” all others, especially with respect to employment.

That said, I shudder to think about the application of the business acumen of Trump’s administration versus Canada’s government (think about the trade minister crying after the EU agreement broke off) and the simple fact that Canada is in a very poor negotiating position in relation to the USA.

It is clear that Canada will not be able to negotiate a favourable deal on softwood lumber, nor will it be able to with automobiles, energy, or anything else for that matter simply because our country’s primary export had been real estate, which will soon be evaporating. Also by pre-emptively stating that we are willing to renegotiate NAFTA after Trump got elected has to be one of the top damaging statements to make in 2016 (and there was a lot coming from the government in this category, thinking about the completely incompetent Minister of Democratic Reform). Once the counter-party knows that you’re willing to negotiate, you’re in deep trouble.

The net result of this is that the USA is going to obtain much higher benefits out of NAFTA than Canada in historical context. Once the USA also reduces their corporate tax rate, one of the only advantages that Canada has will evaporate and you can be pretty sure that capital that was previously slated for deployment here will be heading down south. This clearly will have a negative effect on the Canadian dollar.

The only predictable event that would save us is the re-emergence of high energy pricing, but this event would not be of the existing government’s actions – it would be by pure luck.

About 80% of Canada’s oil production comes from Alberta and the provincial government is as hostile to fossil fuels as it gets and will only be replaced in 2019 by a government very likely to be lead by Jason Kenney. So while this is still at least a couple years away, investors are not going to be putting anything but maintenance money into the Alberta oilpatch even if the federal government gets its act together.

Our economic malaise is amplified by the case that our second largest export (energy) is hampered by the inability to actually get the product to market – alternatives (such as crude by rail) costs a lot more than pipeline.

Outlook – broader markets

As it relates to the market, however, most of the price appreciation seems to be baked in. When scanning the equity markets and the preferred share markets and debt markets, most of everything appears to be trading at relatively lofty valuations. There is little out there that appears to be trading with distress, which typically means that one will only get market-sized gains as opposed to making extraordinary gains.

I face the confusing notion that even if I am able to appreciate my portfolio by 10% in 2017, that it results in a drop in overall performance! I manage my portfolio for absolute returns, so I do not take this into consideration. If I have to sit the year out mostly in cash because I don’t see good opportunities, I will. Ideally, however, short-duration bonds with likely payouts fit the bill for idle cash, but those have been difficult to find at acceptable risk-reward ratios.

Just like how Costco is a great corporation, their stock is another story. The US economy will likely be roaring in 2017, but will this result in stock market success? Has it already been priced in after the November election of Trump? It is difficult to say. I am not very good with macroscopic forecasts of stock markets, and can only concentrate on the microscopic – and I don’t see a lot of stocks out there trading at 52-week lows which leads me to think a lot has been priced in already, but think there is going to be plenty of cash inflows for “follow-alongs” that felt like they missed the party.

Scanning the Canadian corporate debenture market, just as an example, leads me to precisely zero leads. It is a great time for issuers to be issuing debt.

I’m afraid I don’t have much insight other than that when in this state, raising cash and being patient for opportunities is the order of the day. I intend on de-leveraging and doing just that. I might have to wait an extended period of time until stress is visible in the marketplace.

Currency-wise, while I usually don’t have any grand prognostications and as a result, I tend to keep a balance of CAD and USD in the portfolio, I’m generally of the belief that the US dollar is going to continue to strengthen. This will continue to keep a lid on commodities.

Outlook – Portfolio in 2017

If absolutely everything works in 2017, the gains should be in the low teens. It is more probable that it will be a mid-single digit percentage year for me. My research pipeline is relatively thin at the moment (not a good sign for gains). Keeping my past 11 year record of 17% right now is a pipe dream.

Predictions for 2017:

1. The 1st half of the year will contain the high water mark for the S&P 500, Nasdaq and TSX. (The TSX’s high water mark was on the last trading day of the year!).
2. The Bank of Canada will not raise the short-term interest rate (0.5%), UNLESS if the 10-year bond yield rises above 2.5% (right now it is 1.72%).
3. The Canadian dollar will depreciate below 70 cents USD at some point during the year.
4a. Kevin O’Leary becomes the next leader of the Conservative Party of Canada, first-ballot victory with around 60% of the vote.
4b. He will speak better Fran├žais better than the media expects (think about Facebook’s Zuckerberg speaking Mandarin).
5. The 2017 Budgetary proposals as written above (I’ll consider this prediction successful if at least 4/7 occur).
6. Spot WTIC pricing will spend the majority of its time around the USD$50-65 price band.
7. If China experiences something akin to Japan’s early 1990-type economic malaise, there will be significant ripple-down effects on Vancouver real-estate (let’s define this as a Teranet average of less than 220).
8. The US federal reserve will raise interest rates once to 1%, but will relax the interest re-investment policy on their balance sheet assets during the year and retain a tightening bias.
9. “Canada Recession” will register a Google Trends search index rating of higher than 10 sometime in 2017. This is basically a prediction that by year-end that it should be fairly evident that we are close or going into recession.
10. Minister of Democratic Reform Maryam Monsef will get shuffled out of her portfolio (in addition to others from theirs) during 2017. There will be some “face-saving” measure applied for the justification (e.g. she suffered an injury, or something to explain it other than her performance).
11. In the May 2017 BC election, the BC NDP win 20 seats or less (down from the 35 they currently hold). I note polling now has them neck-and-neck with the governing BC Liberals.
12. There will be at least one volatility spike (VIX index) that will take it above 30 as a result of some geopolitical (not economic) event.
13. (Added January 2, 2017) Canopy Growth Corp (TSX: CGC) trades below CAD$9.14/share (2016 year-end closing price) at 2017 year-end (background info).

Portfolio - Year-End 2016 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
11 Years (CAGR):+17.2%+5.5%+7.7%+2.8%+5.8%
2006+3.0%+13.6%+15.6%+14.5%+17.3%
2007+11.7%+3.5%+5.5%+7.2%+9.8%
2008-9.2%-38.5%-36.6%-35.0%-33.0%
2009+104.2%+23.5%+25.9%+30.7%+35.1%
2010+28.0%+12.8%+14.8%+14.5%+17.6%
2011-13.4%+0.0%+2.1%-11.1%-8.7%
2012+2.0%+13.4%+15.9%+4.0%+7.2%
2013+52.9%+29.6%+32.2%+9.6%+13.0%
2014-7.7%+11.4%+13.5%+7.4%+10.6%
2015+9.8%-0.7%+1.3%-11.1%-8.3%
2016+53.6%+9.5%+12.0%+17.5%+20.4%

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.

Bombardier credit market completely out of the woods now

Bombardier’s bonds have traded considerably higher since their latest 8.75% bond issue (maturing December 2021) which is now trading at a premium to par.

They have to be looking at this and thinking about securing further long-term funding. It also gives them a lot more negotiating power with the Canadian government, who wants to inject some more money into the corporation (whether they need it or not) for political reasons.

Floating rate preferred shares are yielding 8%, while the fixed rate is yielding 9% (quite the premium to pay for a floating rate). Given the difference between the bond market and the preferred share market, I still believe the preferred shares are trading slightly cheap to what they actually should be.

The equity is also receiving quite a bid as of late, despite the massive warrants overhang in their earlier year government fundings. If they receive another large order for C-Series aircraft (something slightly larger than Air Tanzania), it is quite likely the stock will rise even further.

Details of Genworth Financial merger

There are lots of juicy details of the merger proposal with Genworth Financial in their preliminary proxy filing. In particular there are some hints that Genworth MI in Canada will get sold off whether this merger is successful or not.

Despite all short-sellers and naysayers believing that the Canadian housing market is going to crap, Genworth MI continues to appreciate post-Trump and is still trading 10% below their book value. They’ll continue to be mystified when the stock will break through its all-time highs it reached back in November 2014:

Not coincidentally, that’s when I last sold shares. I will note the price has been adjusted multiple times due to their rather large dividend (currently $1.76/share), and whether the Genworth Financial merger is successful or not, it is quite probable that Genworth MI Canada will be sold for as much as can be sought for it, because doing so before the Canadian housing market collapses is the only smart thing to do.

In terms of valuation, one can make a good claim for over CAD$40/share.

The market is also not appreciating at all the notion that mortgage insurance rates will be headed higher in early 2017 due to capital changes. The last time mortgage insurance rates went higher, the stock went up about 10%.

They are also somewhat buoyed by the “good politics, bad policy” decision by the BC government to extend a 5-year interest-free loan, matching dollar-for-dollar on the first 5% of a downpayment (for an insured mortgage). It would be a poor decision for a prospective buyer in BC to not take advantage of this, but they would need to pay mortgage insurance to do so.

Genworth Financial / Long-Term Care Insurance

For those of you that are interested in why Genworth Financial (NYSE: GNW) is willing to be bought out at US$5.43/share when their book value is far, far higher should take notice of this following Wall Street Journal article about the woes of another long-term care insurance provider that went belly-up.

Putting a long story short, there is an accounting mismatch – the liabilities on the book are less than what the actual liabilities will be.

There has been a lot of incorrect analysis (especially on Seeking Alpha) on the actual value of the holding company. In general when one sees sloppy analysis that is regarded as consensus, there is a necessary, but not sufficient condition for an investment decision in the contrary.

The rise of interest rates

Something that was a direct result of the US Presidential election was the entire yield curve lifting. The short end in the USA will likely change upwards 0.25% on December 14.

Canadian interest rates are inevitably linked to US interest rates due to the very close economic connection between both countries.

I generally do not profess to have a good radar when it comes to interest rates, but I do observe the trends and notice that the 5-year Canadian government bond yield (which determines most, if not all, rate-resets on Canadian preferred shares) has eclipsed 1.00% for the first time in over a year:

5yrrates

The last time it reached 1% was briefly in November 2015, and then before that it was briefly above 1% in May and June of 2015. Before that it was only consistently above 1% before January 2015.

The question is whether this is a short-term rise up as a knee-jerk reaction to Donald Trump’s election, or whether this will be something that will be sustained (and if so, rates will likely not settle at 1% and will head higher). I have no idea what will be happening.

D+H Corporation slashes dividend

I looked at D+H Corporation’s (TSX: DH) last disaster of a quarter and predicted the following:

My guess is that the dividend is going to get slashed in half.

So, today, they announced their 32 cent dividend is going down to 12 cents. The stock is up today because the company says they are going to do a share buyback with half the amount that they wouldn’t have paid out in dividends, but given their leverage situation, I’d be skeptical.

KCG Holdings – Significant share buyback

KCG Holdings (NYSE: KCG) I’ve identified as a fairly good risk-reward candidate last month.

Yesterday they announced they came to an agreement with one of their major shareholders (whom were part of the recapitalization/reverse takeover of the predecessor firm after their major trading glitch on August 1, 2012) and have swapped 8.9 million shares of BATS for 18.7 million shares of KCG stock and 8.1 million at-the-money (roughly) warrants.

After this transaction, KCG still has 2.3 million shares of BATS – they did liquidate about 2 million shares on the open market over the past month.

This transaction has a positive double-whammy for book value – not only are the BATS shares accounted for at less than market value (which means the transaction will cause an accounting gain), but the KCG shares are being bought back for well under book value. Even when accounting for the not insignificant tax bill that will result (about a hundred million!), the final book value of KCG would be around $18.79/share after the transactions.

KCG will have about 67.5 million shares outstanding and 5.1 million warrants outstanding (strike prices of $11.70, $13.16, and $14.63, with each about 1/3rds of the warrants). These are likely to be exercised and shares sold in time – each of these warrants expire in July 2017, 2018 and 2019, respectively.

The corporation is trading slightly more than 20% underneath tangible book value. They have historically made money, especially in volatile conditions. The word “volatile” is also used to describe the new President-Elect. Needless to say, this has potential.

The other note is that CEO Daniel Coleman owns 1,487,907 common shares, or about 2.2% of the company, which is not a trivial amount of capital. He also owns 161,132 warrants, and 1.7 million stock options at a strike price of $11.65/share (making the effective ownership about 4.8% assuming the exercise of warrants and options), plus stock appreciation awards at $22.50/share, due to expire in July 2018. There is some serious incentive for him to get the stock price higher.

Pengrowth Debentures – To be redeemed

(Update, December 21, 2016: The proposal was shelved because PGF’s senior debt holders did not want cash to go to junior creditors.)

A short couple months ago I wrote an article about a “very likely 12% annualized gain” in the form of buying (TSX: PGF.DB.B) at 97 cents.

So it looks like I gave up that return (at least with some idle cash holdings, I do have a position from far cheaper prices earlier this year) as management announced today they are seeking consent from debtholders to allow the company to redeem them as if they have matured on March 30, 2017 (i.e. you’d get about 3 months of accrued interest paid out to you immediately).

So it looks like debtholders will be paid off at $1.03116 per dollar of debt. The redemption will occur on December 30, 2016.

The choice of getting paid today vs. getting paid the same amount in three months is a no-brainer: take the money today and move on.

I have no idea where I will re-invest the proceeds. There was nothing nearly as “safe” as this specific debt issue. Any suggestions out there?

Canopy Growth Corporation

Canopy Growth (TSX: CGC), specializing in the production of marijuana, has gone parabolic.

cgc

Today, 12.9 million shares traded (about 10% of the company) around a level that valued the entire entity at around CAD$1.5 billion.

Fundamentally, looking at their last quarterly report, they have sold $15 million of marijuana in the last 6 months.

If you (exponentially) extrapolate their revenue growth curve, they will be selling over $1 billion in marijuana in five years.

Somehow, I don’t think this will happen.

I am predicting two things:

1. Management is going to do a massive secondary offering. They did two of them earlier in 2016 (raising an 8-digit sum of money), but they will scramble to raise an even bigger amount of money which would pay for a lot of marketing. I’m guessing they’re going to aim for over a hundred million. I’d do the same if I were in their shoes, in addition to personally selling shares at the earliest possible opportunity.
2. Eventually, within the next six months, a lot of people are going to lose money on this stock.

Right now, if you are short, I can imagine the pain. Maybe those short on the stock should get a prescription of medical marijuana to ease the pain.

No positions, no intention to take any, but looking at this stock with amusement.