Davis and Henderson purchase – Corporate conversions from income trusts

Income trusts are starting to announce conversions to corporations and the effects on their unit/share prices are quite telling. For profitable companies, they will have to announce distribution/dividend cuts to compensate for the effect of the upcoming tax on trust distributions.

Davis and Henderson is a business services company, doing about $482M in revenues for 2009. They are primarily an acquirer and consolidator of smaller companies and they have been fairly good at streamlining synergies with these acquisitions. Their balance sheet is messy (negative $235M in tangible equity, little cash and about $200M in revolving term loans as debt) but they generate hefty cash flows. They also distribute, just like most profitable trusts, the vast majority of their free cash flow. However, they pass my ‘trust test’ which is that they generate more in net income than they distribute in cash.

They announced that they will be converting to a corporation and with it their distributions will be going from $1.84/unit to $1.20/share in 2011 because of the tax impact. This is a 35% reduction in distributions and they rationalized the 64 cent cut by saying that had they been a corporation in 2009, they would have had to pay $0.60 to $0.66 in taxes. Their communications person must be a good spin doctor since they didn’t mention that the projected tax would effectively have to be paid on a larger income amount than $1.84/share – after backing out the intangible amortizations, the company generates about $2.27/unit in cash and a 28% corporate tax take is appropriate. In addition, the corporate tax rate will be dramatically decreasing in Canada in 2010, 2011 and 2012. In 2011 it will be 16.5% federal, and roughly 11% provincial, while in 2012 it will be 15% federal and roughly 10% provincial in the major jurisdictions (BC, Alberta, Ontario).

The point is that the distribution cut is going to be more than covered by the company’s cash flows, and they can use the surplus to pay down debt and reduce leverage on their balance sheet.

I know how a lot of retail investors think, and whenever they see a dividend cut, they will panic and sell. So that, they did:

Trading instinct is a difficult thing to describe, but since I’ve been stalking Davis and Henderson for quite some time now, I knew this would be a good time to pounce. When examining their release and annual report, I estimated investors will take down the stock between 5-15% for the day, so I layered an order to buy shares continuously between 6-12% and got enough of a fill to get a 3% position in the company – I was prepared to take 6%, so this was better than nothing. The low for the day was 8.8% below the previous day’s trading price. As you can see, institutional investors and myself likely cashed in on the retail panic.

People that are not in the upper tax bracket can receive Canadian dividend income virtually tax-free. Starting in 2011, I will be getting about 7.6% “tax-free”, and this should be a sustainable yield on my investment given the financial state of the company and the relatively boring businesses they are involved in. The largest risk to this company (other than the slowdown in the business services they are involved in that will exhibit a natural decline, such as cheque-printing and processing) is rollover risk of their $200M term loans. They can equitize the debt with about 19% dilution to existing holders and the history of the company suggests that their relationship with the banks are stable and it is unlikely we will see an attack on their equity by hedge fund artists that want to bet on a recapitalization.

With Rogers Sugar being my other major equity holding, they are due to announce what they plan on doing with their corporate structure. As it is likely they will be contemplating the same thing, investors would be wise to look at trusts that are planning conversions and seeing if they can realize short term trading opportunities. I know that in 2011 the structure of my registered accounts will be looking different since I want to move dividend-bearing securities outside the RRSP because dividend income will be virtually tax-free.

Rogers Sugar, aftermath

Since Roger Sugar announced its fiscal Q1-2010 results in the middle of February 2’s trading day, the stock has been on a relative free-fall:

The current price of $4.40 is skimming the bottom of my fair value range for the units and it will be interesting to see if it slides below that.

Normal volume for the units are about 140,000 a day, so it is clear that there is some institution or fund that is trying to unload their units. They are not getting much liquidity in the market, which is why the price takes a dive. Opportunistic investors love to wait for moments like these to add to their positions, although it is difficult to game whether the institution or fund dumping units have half a million, or five million units to sell. If the entity dumping units is interested in selling more, they will be pressing the market further.

I would venture that a disproportionate amount of holders of Rogers Sugar are people that will be holding for a very long time, simply because the units do provide a good flow-through entity for investment capital – at a $4.40 unit price, there is a 10.5% yield and even better yet, the yield is sustainable with true earnings.

I also do not think the announcement of the fund considering a distribution cut because of the income trust taxation due 2011 is new news – all profitable income trusts will be doing the same. From my own investment perspective, it will mean shifting units out of my RSP and into my taxable accounts since eligible dividend income is taxed much more favorably than interest income that comes from the trust.

History of stock market crashes

October 28-29, 1929: Marked the beginning of the great depression – although the worst of it was only a couple years later, this was a very powerful signal that something wasn’t right in the US economy. This was characterized mainly by a lot of margin debt purchasing and rampant speculation on equities.

1973 to 1974: Marked the beginning of the rise of OPEC, and concerns about the world supply of crude oil in general. Also marked the beginning of the modern currency exchange systems we see today. This was in the middle of a recession and a period of high inflation (these two together are referred to as “stagflation”) and is the worst possible combination for equity markets.

October 19, 1987 (aka “Black Monday”): Probably the only “true” random market crash, potentially caused with inexperience with complexity through computer program trading, and also the Treasury Secretary mumbling about having to devalue US currency. Federal reserve chairman Alan Greenspan was also new on the job at this time. The US recovered despite having lost 22.7% of its market value for the day. Hong Kong got killed by 45.8%; in all cases buying this crash would have been fruitful. Easy to say when looking at past charts!

October 13, 1989: A small random market crash (6.1% loss on the S&P 500) for no particular reason at all.

October 27, 1997: The S&P lost 6.9% due to the Asian currency crisis and panic selling. This was at the time of the beginning of the run-up in technology issues. Although this was somewhat interrupted by the Long Term Capital Management fiasco in 1998, equities never looked back until February 2000, where they peaked.

September 11, 2001: The largest terrorist attack on US soil, and the biggest death count since the Pearl Harbour attack in December 1941. Equities dropped when markets re-opened a week later, mainly due to insurance and financial firms that had to perform some massive re-balancing after liquidating assets. This would prove to be a local bottom, but not a true bottom until in 2002 when markets finally reached their lows for the decade (up until the 2008 financial crisis).

October 2007 to March 2009: Fresh in everybody’s memory, the financial crisis caused wholesale liquidations in major financial firms, such as Bear Stearns, Lehman Brothers, Wachovia, Washington Mutual, etc. From peak to trough, the S&P 500 lost 56% of its value.

… and after this history lesson, will January 25, 2010 be on the books?

Obama wants to take out the stock market

Now that Barack Obama is done demolishing the US fiscal balance, he’s now going to work on demolishing the US stock market. Just a couple days after losing the Massachusetts senate election, the rumblings of the administration wanting to crack down on finance companies is hitting the pipeline, and we are seeing it in the form of rises in implied volatility. Here is a 5-day chart of the S&P 100 30-day implied volatility (otherwise called the VIX):

It will be very, very interesting to see how this gets played out. Volatility is good, as long as you can predict whether markets go volatile “up” or volatile “down”!

Trading against a computer

Most transactions on the stock market are done with computers and not with people behind the screens. A good example is when I did a minor order to do some tweaking of my portfolio, and got the following execution on something that only trades 1000 shares a day:

01/19/2010 14:28:28 Bought 100 of XXX @ $XX.XX
01/19/2010 14:27:23 Bought 100 of XXX @ $XX.XX
01/19/2010 14:26:16 Bought 100 of XXX @ $XX.XX
01/19/2010 14:25:10 Bought 100 of XXX @ $XX.XX

See the pattern? The computer probably had an algorithm that said “sell 100 shares, space each order at the bid 66 seconds apart until you’ve cleared your order”.

Algorithms that trade against each other fundamentally are playing rock-scissors-paper against each other in order to scalp profits against those who have the weakest or easiest to predict algorithms.

Enterra Energy Trust – Rising for no reason at all

Enterra Energy is a typical small-scale energy trust that has miscellaneous properties in Alberta and Oklahoma. They are not too remarkable other than the fact that they have been very diligent at reducing their balance sheet leverage over the past couple years – their unitholders received their last distribution in August 2007.

Today they announced that they will be converting to a corporation and changing their name. One would think this is typical considering that income trusts that do not give distributions to should change to corporations before the end of 2012 deadline. Income trusts that give out distributions in 2010 still have their tax shield for one more year – although the majority of them after 2010 should convert to corporations in either 2011 or 2012.

For whatever reason, the market decided that the announcement to convert to a corporation from a trust was worth a 25% mark-up in their unit price, as of the moment of this writing.

There is fundamentally no reason for this announcement to cause such a price spike. Either something else is going on, or the market is behaving very, very irrationally. Spikes like this make the market feel very bubbly.

Disclosure – I do own debentures in Enterra Energy Trust (the ones maturing in December 2011). They have been inching up closer to par over the past month and hopefully will continuing bubbling up above par, where I will proceed to dump them. If not, I keep collecting 8% coupons, which is a good reward to wait for a good price.

Don’t invest in corporate largesse

Putting a long story short, the board of directors of Cheasapeake Energy, in their infinite wisdom, decided that it was worth $12.1 million of its corporate assets to purchase antique maps from its CEO.

The only thing you can do when you see such a waste of corporate resources is selling your shares if you own them, and not buying them if you don’t.

I should take this opportunity to point out it was exactly the same company and its CEO that in November 2008 faced a margin call on his own stock, forcing him to liquidate 5.4% of the company in a very rapid transaction.

I said the following back in November 2008:

Some might think this would represent the best buying opportunity – cashing in on the misfortune of somebody’s financial errors. Unfortunately in the case of Chesapeake, the last company I would want to invest in would have a CEO that got caught by a massive forced liquidation like this one – first of all, his incentive to perform well has just disappeared (having no more equity stake in the company) and secondly, one would wonder whether he’d make a similar miscalculation with the company’s finances.

It appears that the CEO is just as reckless with the company’s finances as he is with his own – any prudent investor should blackball the entire Board of Directors of Chesapeake Energy – if any of them serve on a corporate board (or heaven forbid, management) of a company you are invested in, it would be a yellow flag.

This is why the iceberg theory of bad news is applicable – if there is a small piece of bad news, chances are there is a lot more to go with it. In the case of Chesapeake, this is the last energy company I would want my dollars invested in.

Ability to remain irrational longer than ability to remain solvent

John Hempton at Bronte Capital writes another high-quality piece about how having superior information doesn’t necessarily translate into stock market returns. It is just like people that shorted the stock market in 1999 because of insanely high valuations (or shorting Amazon in 2009 at $100/share!) – even though they might be correct, the market can remain irrational longer than your ability to remain solvent.

It is always frustrating in markets to be right, but to get the timing incorrect. This is why option markets are always so brutal to those don’t get the element of market timing to be correct. It is also an indication that even when betting against the majority, you will only be able to win if some of that majority decides to see the world your own way – this process can take years, just like it did for the former Dow Jones Industrial stock Eastman Kodak, or for the poor fellow (Alfred Wegener) that developed most of the geological theory on plate tectonics – he was completely correct, but ridiculed in his own scientific community and died before he was proven correct about 40 years after he proposed the theory.

You can also see other stocks that are on their death throes, such as nearly anything involved in newspaper or paper-based publishing. It also makes you wonder what industries today that aren’t visibly dead will be on their deathbed in the next 20 years – look around you and see what you use today, and wonder if it will be replaced with some substantial technology innovation that is just in its infancy today. Maybe this is why Amazon is trading so highly – maybe they will be exterminating conventional retail shopping?

I remember back in the late 90’s, back in the days when I started investing and didn’t know too much other than technology companies, that I did a lot of research on flat panel displays. Back then, 17″ CRT monitors were still about $500, but it was imminently clear to me that flat panel displays would be the way of the future – if anybody tried lifting up a 21″ CRT monitor you would end up breaking your back trying to move the thing. It lead me to two companies, Genesis Microchip, which did semiconductors in FPDs, and Photon Dynamics, which made diagnostic and factory equipment for the manufacturing of FPDs.

Both of these companies didn’t skyrocket like I anticipated them to and I never even invested in them, but it was worth noting that despite the fact that flat panel displays became the future of computer displays, I never was able to financially capitalize on it in the marketplace.

Present cost of portfolio insurance

I am noticing that the implied volatility of the S&P 100 is below 20% right now, which is the lowest it has been since when the financial crisis really picked up steam (September 2008). At the peak of the economic crisis this was around 80%.

The concept of portfolio insurance is simple – buying put options represents a form of insurance. You can play with these options and come up with some concepts that can be translated into English for less financially sophisticated people.

Let’s pretend you owned $100 of the S&P 500. If you wanted to insure your portfolio against any further downside for the rest of 2010 (i.e. you wanted to guarantee that you could sell your $100 of S&P 500 for $100 at the end of 2010), how much would it cost you? The answer is about $9.89 given closing option prices on December 24, 2009. This sort of insurance is good if you anticipate a possibility of the market declining, but you still want some “skin in the game” in the event the S&P 500 goes up between now and the end of the year.

We can repeat the same thought experiment, except asking ourselves if we wanted the right to sell your $100 of S&P500 for $90 by the end of 2010, a 10% loss. This insurance will cost you $6.14 to purchase.

The difference between these two values are $3.75.

What this practically means is you can bet the following ways (again, note I am indexing the value of the S&P 500 right now to 100 for the purposes of this post):

1. You can bet that the S&P 500 will not drop at the end of 2010. Reward for getting this right: $9.89 for $100 notional risk. Punishment for getting it wrong: $9.89 minus $1 for every $1 that the S&P goes below $100 at the end of 2010.

2. You can bet that the S&P 500 will not drop more than 10% at the end of 2010. Reward for getting this right: $6.14 for $100 notional risk. Punishment for getting it wrong: $1 for every $1 that the S&P goes below $90 at the end of 2010.

The “bets” to describe the results of predicting an S&P 500 level of 90 to 100 are a little more complicated to explain, but they can be done with portfolio insurance as well. Essentially you can feed any probability distribution into a model and have it crank out the optimal purchases/sales of options to correspond with your crystal ball forecasting.

Since I can’t forecast indexes, I’ll leave this to the gamblers. That’s what most option markets end up being. Right now, the option markets are saying that they expect volatility to be low, which keeps option prices low. This generally favours people that have strong beliefs that the markets will go rapidly in one direction or another.

Harvest Energy takeover finalized

Harvest Energy has finalized their takeover with KNOC, so their units will be delisted as follows, per the press release:

As a result of the acquisition the Harvest trust units will be delisted from both the Toronto Stock Exchange (“TSX”) and the New York Stock Exchange (“NYSE”). The NYSE has advised that the trust units will cease trading on that exchange on or about December 23, 2009 and the TSX has advised that the trust units will cease trading on or about December 29, 2009.

This is an interesting delisting schedule, mainly because if you own the Canadian version of the units, you have a tax election. If you are sitting on unrealized losses, you want to liquidate the shares immediately so that way you can claim the capital losses on your 2009 tax return. If you are sitting on capital gains, you can defer capital gains taxes to your 2010 tax year by selling the units on December 28, 2009.

(Update: I had failed to account for the fact that December 28, 2009 was a statutory holiday in Canada and the exchanges were closed this day, but the trust units were still traded on December 29, 2009, which means the election above was still available.)