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.

Pengrowth Energy – dodged a bullet

Pengrowth Energy’s debentures (TSX: PGF.DB.B) will be redeemed on March 31, 2017 and the company has also announced it will be redeeming USD$300 million in senior debt (announced February 21, 2017).

I own the convertible debentures and will miss their presence once they mature. I’m probably one of the few people that invested in the company and actually made money.

They also announced their year-end results on February 28, 2017. The operations of the company are fairly simple to understand – they are losing a relatively small amount of cash in the existing oil price environment, which they assume is at WTIC US$55/barrel and a 0.74 CAD/USD rate. Management has made some good decision-making on their oil hedges, but they have now closed them (for cold hard cash) and are completely at the whim of the oil commodity markets.

If you take their 2017 guidance to heart, you will end up with $195 million in “funds flow through operations”, a non-GAAP metric that is a proxy for operating cash flow excluding the impact of financing expenses and remediation. The GAAP statements are a mess to read because of derivative accounting (for oil price hedges), exchange rate adjustments, and require some mental massaging to be read properly.

All things considered, the corporation is not in terrible shape.

This is, however, except for the debt maturities coming up which need refinancing.

The company did have a $1 billion credit facility at the end of 2016. It was untapped, probably because the credit facility has a covenant similar to the senior debt. I believe the original intention of management was to use the credit facility to pay off the senior debt as it became due.

The corporation pre-announced in Q2-2016 that if oil prices continued their relatively low level, that they would be potentially in breach of their covenants. What was new in the Q4 announcement was that they alleviated their senior debt (before working capital) to book capitalization ratio covenant, at the expense of amending the debt agreement to redeem senior debt in the event of asset sales and also to reduce the ceiling of their credit facility to $750 million.

There are three other covenants remaining that an investor needs to pay attention to. The most material of them is the senior debt before working capital to adjusted EBITDA ratio, which ended at 3.1 in 2016, but needs to be below 3.5.

Pengrowth, to its credit, walked investors through their covenant calculations (page 10 of their MD&A). Doing some pro-forma (after debt repayment in the end of March) analysis, we have about $1,250 million in debt for covenant purposes, which means adjusted EBITDA needs to be above roughly $360 million for them to clear the mark. They did $581.6 million adjusted EBITDA in fiscal 2016, which gives them a relatively healthy margin of error – even though guidance is taking their production down about 10% for the year despite $120 million in projected capital expenditures.

So as long as oil prices don’t crash, they’ll probably use the credit facility to pay off the remaining US$100 million in debt due in July 26, 2017. The next major maturity is CAD$15 million + US$265 million on August 21, 2018, and if nothing changes between now and then, they will use the credit facility to pay that off. At that point, they will have about CAD$500 million utilized in their facility, plus the (presumably negative) amount of cash flow they burn through operations in the next couple years.

If oil does slip, there is a point where they will get into covenant trouble.

They did note in the MD&A:

After the above debt repayments, Pengrowth anticipates it will remain in compliance with its covenants through the end of 2018. In order to comply with certain financial covenants in its senior unsecured notes and term credit facilities through 2017 and 2018, Pengrowth has run a scenario, that accesses the capital markets before the end of 2017, and includes an improvement in realizations for oil and natural gas.

They will probably tap the asset market to give them a higher degree of comfort. This is what Penn West did when they gave up their Saskatchewan operations to stabilize their balance sheet.

In retrospect, I think the company erred in not using shares to repay the convertible debentures – they probably should have bit the bullet and increased their margin of safety by cheaply equitizing the convertible debt. Now, management is basically gambling that oil will be going up in the next couple of years and are basically playing a waiting game.

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.

Who’s short on Genworth MI?

Genworth MI has 57.2% of its shares outstanding held by Genworth Financial (NYSE: GNW). This leaves approximately 39.3 million shares outstanding in the public float. Q4-2016 in the following annotated chart refers to the quarterly earnings report at the end of February 7, 2017:

On January 31, 2017 there was a reported short position of 2,844,353 shares and on February 15, 2017 that position increased to 3,188,297. This is a 343,944 share increase in short interest since their earnings report (which means that somebody is taking on a position to profit from their presumed downfall).

Borrow rates on MIC are relatively modest, at around 2.75%.

That said, when the price increases and short interest rises it will raise volatility – is the entity with deeper pockets the one that is accumulating shares and driving up the price, or are they the ones that are selling shares and applying downward pressure on the price? It is impossible to say without the benefit of retrospect, but if either party exhausts its funds or changes the pace that they are accumulating or distributing, it will result in higher price volatility. Imagine if those 3.2 million shares that are shorted decide that it is time to cover their position. Could there be a short squeeze? Share volume has been higher than normal lately which suggests that there is interest in both sides of this price battle to see who breaks first. Right now, clearly the winning side is the one accumulating shares and slowly raising the bid – I noticed the same price trend post-Presidential election, where the algorithm was simply “accumulate shares at whatever rate that it is sold to you and raise the bid by a nickel each trading hour until you hit some sell pressure”.

Technical analysis these days is simply about guessing the competing algorithms at work and who has the most money behind them – almost no institutions use non-algorithmic trading anymore as such manual trading leaks information like a sieve which increases frictional costs (you’ll get front-runned).

Teekay Offshore’s common units are not going anywhere

Reviewing Teekay Offshore’s financial results (NYSE: TOO), it strikes me as rather obvious that they have missed their initial early 2016 targets when they proposed a partial equitization (issuing common units, preferred units, and some refinancing) of their debt problems. They also borrowed $200 million from the Teekay parent entity (NYSE: TK).

In Q1-2016, they delivered a presentation with this chart:

In subsequent quarters, the company has generally not referred to progressing tracking to this projection, mainly because their debt to cash flow through vessel operations ratio has not met these targets. While the underlying entity is still making money, revenues are eroding through the expiration and renegotiation of various contracts, couple with some operational hiccups (Brazil) that is not helping matters any.

Putting a lot of the analysis away from this article, while in 2017 the future capital expenditure profile is going to be reduced (which would greatly assist with the distributable cash flows), the company doesn’t have a lot of leftover room for matters such as debt repayment and working on improving their leverage ratios in relation to cash generation ability. This leaves them with the option of continuing to dilute or depend on the parent entity for bridge financing. Indeed, one reason why I believe management thinks the company is still open for dilution is due to them employing a continuous equity offering program – they sold nearly 1.9 million units in the quarter at an average of US$5.17/unit. If they don’t think the company is worth US$5.17/unit, why should one pay more than that?

I don’t believe that they are a CCAA-equivalent risk in the current credit market (this is a key condition: “current” credit market), and I also believe that their preferred units will continue to pay distributions for the indefinite future, I don’t believe their common units will be outperforming absent a significant and sustained run-up in the oil commodity price. Note that there is a US$275 million issue of unsecured debt outstanding, maturing on July 30, 2019, which will present an interesting refinancing challenge. Right now those bonds are trading at around a 10% yield to maturity.

I have no positions in TOO (equity or debt), but do hold a position in the Teekay Parent’s debt (thesis here).

Pengrowth Energy Debentures – cash or CCAA

A quick research note. Pengrowth Energy debentures (TSX: PGF.DB.B), something I have written in depth about in the past as being one of the easiest risk/reward ratios in the entire Canadian debt market, has reached the “point of no return” with regards to its redemption. They are to be redeemed on March 31, 2017 for cash (and an extra half year of accrued interest at 6.25% annually). For the company to exercise its option to redeem them for shares (of 95% of TSX VWAP), they needed to give 40 to 60 days of notice from the redemption date.

(Update, February 21, 2017: Pengrowth announced they will be redeeming the debentures on maturity at March 31st. Also on their senior debt covenants, it looks like somebody is trying to steal the company… they might be forced into making an equity offering.)

My math says that the next market opening, February 20, 2017, will be 39 days before March 31st.

Barring some sort of mis-interpretation of the legalese, this means that the company must redeem this debt (CAD$126.6 million) for cash. The alternative is CCAA, which I do not deem is likely considering Seymour Schulich would likely have something to say about that particular option (he controls 109 million shares or 19.9% of the company at present). There is no longer any time to negotiate an extension with debenture holders.

This debenture issue was acquired as a result of the NAL acquisition back in 2012. It was originally CAD$150 million but they company repurchased some at a considerable discount to market earlier this year.

Pengrowth is in the middle of a silent negotiation with their senior creditors as they are in covenant troubles. Their senior creditors will no doubt be unhappy with the fact that some company cash is going towards a junior creditor.

Sadly I have no good candidates for re-investment at this time. Suggestions appreciated.

Genworth MI reports Q4-2016

Genworth MI (TSX: MIC) reported their fourth quarter a couple weeks ago. This post is a little late in the game (and irritatingly, a conference call transcript has not been made available and I have had to suffer the indignity of actually listening to the conference call). By virtue of the Canadian housing market not imploding over the quarter, the company likely exceeded market expectations, which registered a 10% price spike since their announcement.

Here are some of my takeaways:

* Loss ratio is exceptionally low, at 18% for the quarter. Management projects 25-35% for 2017 as they identified that Fort McMurray and Quebec were abnormally low in Q4-2016 and that a more normalized loss ratio is to be expected in BC and Ontario (which have been quite dormant in terms of mortgage defaults).

* Book value is up a little bit to $39.28, which is $2.46 more than the previous year. The market value continues to converge to book.

* Premiums written, Q4-2015 to Q4-2016, was down about 20%. Portfolio insurance is down as expected per the rule changes, and transactional insurance is down due to the changes in the mortgage rules. The new capital requirements and new premium changes will kick in at the end of March which will offset reduced volume with price increases.

* Investment portfolio continues to be managed in line with previous quarters, in addition to the losses incurred by the preferred share portfolio seemingly normalizing (and if rates continue to rise, discounted rate-reset shares should fare quite well in that environment).

* Regulatory ceiling for private mortgage insurance was raised from $300 billion to $350 billion, which makes this a non-factor for the next while (a low risk that did not materialize).

* New capital requirements result in a “recalibration” of the minimum capital test ratio. The company is internally targeting 160-165%, and each percentage point is about $25 million in capital. Once they head over 165% then the surplus will likely be distributed via buybacks or dividends – it does not look like anything special is going to happen on this front in 2017 as they will be using retained earnings in order to buffer the capital levels. The new OFSI regulations have grandfathering components with respect to the capital requirements which should mathematically ease in the new capital requirements (especially with the evaluation and testing of the mortgage books acquired 2016 and earlier), but the MCT ratio is not likely to materially climb higher to the point where one can start thinking of extra dividends or buybacks.

* Insiders have exercised options and dumped stock after the earnings release, which is a negative signal.

I will warn readers that I have also lightened my own position in Genworth MI in the days ahead (i.e. after they announced) of the earnings announcement, my first sale since the second half of 2015. The last quarter was undoubtedly a good one for the company. I still have a large position in the stock, but I was reducing my position strictly for reasons that it had gotten too concentrated and I want to reduce my overall portfolio leverage. There is still a lot of runway for Genworth MI to run up to the low 40’s as they have everything going correct for them fundamentally and are generating a lot of cash in a semi-protected business environment. The whole country has been so bearish on Canadian housing that they forget to realize there are considerable pockets of profitability and Genworth MI is one of the spaces where there is money that continues to be made – I am guessing that the short sellers have gotten killed on this one.

Most surprising chart of the month

January has generally been proceeding to plan (i.e. nothing really exciting going on in my neck of the financial woods!). But the real surprise to me to date is the following chart:

The strength of the Canadian currency has been quite impressive in light of what is going on (coupled with a general lack of rise in the fossil fuel commodity market rate). I am generally agnostic about the strength of the Canadian currency (i.e. I rarely have strong feelings about its primary direction), but lately I have been getting pessimistic about it strictly due to various macroeconomic factors (including the fiscal situation, Canadian/US monetary policy, geopolitical, commodity situation, etc.).

Macroeconomics for me is a complete crapshoot so I don’t place too much of a stake on my own predictions in terms of currency. I generally keep a balance between 30-70% USD exposure (the exact amount depends on appreciation/depreciation of CAD/USD components in the portfolio as well).

Market is predicting Genworth Financial’s merger with China Oceanwide will fail

The market is projecting that Genworth’s (NYSE: GNW) US$5.43/share cash merger with China Oceanwide will fail:

The issue revolves around the insurance unit that contains their long-term care insurance liabilities – the theory would be that the Genworth is unlikely to obtain state approvals without taking the full burden of the LTC division.

The salient part of a piece of nearly unreadable verbiage from the finalized merger proxy form is the following:

In addition, it is a condition to the obligations of Asia Pacific and Merger Sub to consummate the merger that certain affiliates of Genworth shall have received regulatory approval (or non-disapproval, in certain instances) from the Delaware Department of Insurance and the Virginia Bureau of Insurance to effect the U.S. Life Restructuring, including the unstacking and the following intercompany reinsurance and recapture transactions between GLAIC and GLIC: (i) a reinsurance transaction pursuant to which GLIC will reinsure certain long-term care insurance business from GLAIC (which we refer to as the “Long Term Care Reinsurance Transaction”); (ii) separate reinsurance transactions pursuant to which GLAIC will reinsure from GLIC (A) certain universal life insurance business and term life insurance business, (B) certain company-owned life insurance business and (C) certain single-premium deferred annuity business, single-premium immediate annuity business, structured settlement annuity business and fixed annuity business (which we refer to as the “Life Restructuring Reinsurance Transactions”); and (iii) a transaction pursuant to which GLIC will recapture from GLAIC certain single-premium deferred annuity business that is currently reinsured by GLAIC from GLIC (which we refer to as the “Recapture Transaction”). GLIC and GLAIC have received approvals for the Long Term Care Reinsurance Transaction from the Delaware Department of Insurance and the Virginia Bureau of Insurance and completed the transaction effective November 1, 2016. Genworth made regulatory filings with respect to the unstacking with the Delaware Department of Insurance on December 21, 2016 and the Virginia Bureau of Insurance on January 3, 2017. Genworth made regulatory filings with respect to the Life Restructuring Reinsurance Transactions and the Recapture Transaction with the Delaware Department of Insurance and the Virginia Bureau of Insurance on December 16, 2016. In addition, the merger agreement provides that Genworth, in consultation with China Oceanwide and applicable insurance regulators, may explore the feasibility of the transfer of GLAIC’s 34.5% ownership interest in GLICNY to GLIC and, if approval from such regulators is received, to pursue such transfer.

If, for whatever reason, you believe these applications will succeed, then there is a very easy method to turn $3.30/share into $5.43/share in less than six months. Won’t tell you what I think, but I’ve been digging.

What’s happening in Canadian energy?

I’m looking at the charts of several high-quality energy companies in Canada and their trajectory is down.

Looking at the raw commodity prices first:

Spot Natural Gas is down about 15% from December highs (recall that natural gas pricing is seasonal, for comparison the July futures are down less than 10% from the December highs):

West Texas Intermediate spot prices have not done anything over the past month and a half:

So why are the following down?

Peyto and Birchcliff (both very well managed natural gas producers) – Peyto appears to be down disproportionately in relation to natural gas prices:

However, despite that crude has gone nowhere, why are the oil producers starting to drop?

Crescent Point Energy:

Pengrowth (they have liquidity issues with an upcoming debt covenant that they may or may not blow in mid-2017) and Cenovus (another SAGD firm):

There are numerous other examples, but the only one unhurt to date appears to be Encana.

Makes me wonder what is going on. Something geopolitical coming with pipeline access to the USA?