What ever happened to Menu Foods?

Menu Foods was a company that ran into a huge amount of trouble for distributing pet food that contained Melamine, which caused kidney problems in pets, sometimes leading to death. The first precautionary recall was in March 2007 and then it took another month for them to isolate what exactly was causing the problem. It was through a supplier, ChemNutra Inc., who used wheat gluten that was imported from Xuzhou Anying Biologic Technology Development Co. in Wangdien, China. The whole history of the case is documented on the company’s website here.

These series of events took the company’s units from seven dollars a share to about one dollar less than a year after the news broke. Financially, the company is not on solid ground – although it was somewhat profitable before this incident (making about $24 million in distributable cash in calendar 2006), its balance sheet was quite leveraged, with a net debt of about $100 million.

Fast forward a few years, it still has the debt – some $105 million. The only difference is that $75 million matures in October 2010. The company breached its covenants in 2007 (primarily due to the aforementioned recall) and as a result had to cut its distributions to zero and pay its creditors a rate of LIBOR plus 5.8%.

Lately, however, the company seems to have recovered from its near-death experience: they have settled the lawsuit, and they are now generating cash again – about $11.1 million in free cash in the first 9 months of 2009. Their units, in response, have gone up from about 80 cents at the beginning of the year to $2.50 currently; at 29.3 million units outstanding, that is approximately a market value of $73 million.

The primary hurdle for Menu Foods at this point seems to be the renegotiation of their $75 million debt. If they can achieve this, then unitholders will be sitting pretty and perhaps distributions could continue after they have continued to deleverage their balance sheet. It is interesting to note that a company that was originally on its deathbed is now positioned to survive, in no part due to investors’ risk preferences being expanded in the zero interest rate environment.

A quick look at the top 10 Nasdaq stocks

The following is a very superficial look at the top 10 capitalized companies trading on the Nasdaq (not the NYSE), their market capitalization, and the P/E based on the next fiscal year’s analyst consensus estimates. Also added in are some very quick notes on the respective companies. In order for the index to rise, the top 10 usually must rise as well. I typically do not invest in large capitalization companies because you implicitly are giving up an advantage as a small investor that most large investors do not – the ability to be nimble and build substantial positions in small companies.

Amazon – $58B – P/E 53, pricing in INSANELY high growth, both top line and margins
Amgen – $57B – P/E 11, patent expiration on Epogen coming soon
Apple – $170B – P/E 20, lock on the digital music market, perhaps not the hardware side though, probably under-valued amazingly enough.
Cisco – $139B – P/E 15, essentially a ‘commodity’ network hardware company now
Comcast – $49B – P/E 14, boring cable company
Google – $186B – P/E 22, profiting on any mouse clicks on the internet, decimated traditional media, probably has reached upper end of scale.
Intel – $112B – P/E 14, commodity CPU maker
Microsoft – $264B – P/E 14, commodity OS maker, eroding margins from open source software
Oracle – $113B – P/E 13, commodity DB maker, same thing as Microsoft (they really should merge)
Qualcomm – $75B – P/E 17, basically half the cell calls on the planet (CDMA) make a profit for this company

Canadian Interest Rate Projections

The following are the projected 3-month interest rates, determined by the 3-month Bankers’ Acceptance Futures… note that these are quoted in 100 minus the percentage rate expected, so 97 would be equal to 3%. My gut instinct would suggest that the March and June contracts are slightly undervalued, but well within a margin of error. Essentially this is a bet on whether the Bank of Canada will stick by its conditional June 2010 deadline before it will consider raising interest rates:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 09 DE 99.560 99.565 99.565 0.000 5301
+ 10 JA 0.000 0.000 99.545 0.000 0
+ 10 FE 0.000 0.000 99.525 0.000 0
+ 10 MR 99.510 99.520 99.510 0.010 3909
+ 10 JN 99.330 99.340 99.330 0.000 13737
+ 10 SE 98.910 98.920 98.910 0.000 5674
+ 10 DE 98.450 98.490 98.470 0.050 2102
+ 11 MR 98.120 98.130 98.130 0.040 945
+ 11 JN 97.720 97.820 97.810 0.030 429
+ 11 SE 97.410 97.500 97.500 -0.010 150
+ 11 DE 97.090 97.190 97.260 -0.040 75
+ 12 MR 96.870 96.950 96.960 0.010 7
+ 12 JN 96.670 96.770 96.790 -0.020 46
+ 12 SE 96.550 96.650 96.690 -0.050 32

What makes Vancouver Real estate so expensive?

What makes Vancouver real estate so special? It is very difficult to isolate to a single variable, but geography, immigration, culture, historical performance, and interest rates are all contributing to a very high degree of real estate price inflation, much higher than conventional rational analysis would suggest. I will address these elements separately.

A rational framework for real estate pricing: A rational price would be a discounted cash flow model of rental revenues, subtracting carrying costs (property taxes, insurance, maintenance, cost of capital) and adding in an amount for the ‘ownership premium’. Just browsing through MLS, I came up with the following example:

Richmond-House

Working out the math, we have $15,600/year in rent collection, subtracting roughly $2,500 in property taxes, $800 insurance, $1,200 in maintenance, factoring in zero for cost of capital, assuming a 4% “return on investment”, and adding in a very generous 50% “ownership premium” leaves us with a “rational” valuation of $416,250. Asking price: $838,000, so our model was off by about half. The rational real estate valuation model is clearly broken and should be thrown out – it fails to adequately model what we see presently in Vancouver.

Just like the stock market, real estate in Vancouver is governed (at least for now) by a different model other than discounted cash flows. Let’s look at the variables I outlined in the first paragraph.

Geography: The Greater Vancouver area is surrounded by mountains to the north, water to the west, the United States to the south; all three directions cannot be expanded upon. The only direction available for further land development is east, which is constrained primarily to Surrey and western Langley due to the commute times to where the job centres are located. In addition, another constraint to the land supply is the Agricultural Land Reserve (ALR), which protects a substantial amount of land south of the Fraser River. I will attach a map below showing the extend of the ALR’s boundaries:

GVRD-with-ALR

We see that most of the potential new residential development within an hour’s drive of Vancouver and Burnaby can only be located in Surrey, west Langley Township and west Maple Ridge. Otherwise residential development has to concentrate on density, which has definitely been the case in Richmond, Vancouver, Burnaby and New Westminster. We also see, strictly as a function of geography, that northwest Surrey has a good chance long-term of being the economic centre of the Lower Mainland area.

Finally, there is an interesting study to be made to comparing the prices of real estate in Blaine, WA, versus that of neighbouring White Rock, BC or South Surrey; $250,000 purchases you a pretty nice home in Blaine, while that amount gets you into a 35-year old 2-bedroom apartment in White Rock. It is clear that geographical constraint is one major variable in explaining large real estate prices in the Lower Mainland area, and is the primary supply-side consideration.

Immigration: There are two categories of immigration of concern – net intraprovincial migration (mainly people moving from Ontario to British Columbia), and international migration (people moving from overseas to BC, from mainly Asia). The vast majority of people coming into BC are moving into the Greater Vancouver area, and is neatly summarized by reports from BC Statistics. The BC Stats Q2-2009 Population Report is worth reading. Of note is that the net migrants from the rest of Canada tend to be older people, presumably escaping to BC for the better winter climate. These people will likely be more asset-rich than average migrants (they can afford to move into a more expensive area), thus adding more demand to the local condominium or townhouse markets.

The formula is pretty simple – increasing population means an increased need for housing supply. Due to the subsequent demand from more people via migration, the net result is an increased price for housing.

Culture: It is drilled into the fabric of society that owning is better than renting especially with housing. The ‘ownership premium’ is an economically relevant variable – it essentially says that if the costs of renting or ownership are equivalent, a rational individual would choose to own. This, in itself, would explain a higher amount of demand and thus higher prices, especially when compared to relative costs of renting.

In addition, a significant minority of international migrants that have come into the Vancouver area over the past 20 years are Chinese, and in Chinese culture, the importance of owning your own strip of real estate is even more powerful than it is in western culture. As a result of increased net international migration and this cultural mindset, demand for ownership is increased, increasing prices.

Contrasting this is the European mindset, where property prices are generally so high that the thought of owning them (unless if you are part of society’s elite) is a foreign concept.

Fortunately in North America, everybody can be elite enough to own their own piece of real estate – and jump on the opportunity, whatever the cost may be. The urgency to do this (typically seen with the lines such as “you will be priced out forever if you don’t get into the market now”) seems to be awfully attractive to those that don’t know how to generate returns elsewhere.

Historical Performance: The Vancouver real estate market has endured quite well over the past 10 years (a non-logarithmic chart is here), and as mentioned previously, survived two stock market crashes with great resiliency. Since the mentality of Joe Public is to extrapolate the financial trajectory of asset classes out to infinity, it would give the impression that real estate is a stable investment, and will continue producing gains at historical rates (which if you randomly ask people on the street, should be anywhere between 5 to 20 percent annualized over the next 10 years). The confidence in future capital gains increases demand for real estate for two reasons – one is because it makes sense to borrow money for less and buy into an asset class that will return more, and secondly because of the sense that real estate will not depreciate.

Putting a different spin on this, if everybody “knew” that real estate prices would go down 2 percent a year, a significant amount of demand we see presently would evaporate, and we would see increased supply as people would try to unload their depreciating properties.

A significant number of people got burned in the stock market crashes in 2000-2002 and lately in 2008, with both crashes seeing the stock market indexes down from their local peaks about 45% and 55%, respectively. The same people, investing in mutual funds, will have seen similar performance, whether they have invested in active funds (taking a 2.0-2.5% reduction each year in management expenses) or passive index funds (typically taking 0.2% to 0.6% for most exchange-traded funds). Either way, people would have taken a huge haircut in 2008, similar to how most Canadians fared when they invested in Nortel shares at $100 a pop back in the tech boom.

So Joe Public, based on past performance, is unlikely to invest in stocks, simply because they are seen as a money-losing financial instrument. Risk-free money also earns nearly nothing in the present low-rate environment. Historically (over the past 10 years), the only three sectors that Joe Public has been able to obtain a significant return on investment has been one of the following:

1. Gold, or related precious metal commodities that are typically seen as a store of value when confidence in paper currency erodes; five years ago, gold was roughly US$430 and is now US$1160.
2. Long-dated government bonds. As short term rates continue to drop, long-term risk-free debt with higher coupons trade at premiums; depending on when you timed this, you would have realized roughly a 7% compounded return.
3. For the Vancouver area only (although there may be other regions of Canada that this analysis will apply to), real estate. Note that most of the US real estate market has been decimated with the sub-prime mortgage crash (caused by excessive foreclosures).

I would argue that capital allocation is a major part of real estate demand locally in Vancouver, simply by the virtue that the real estate market has not crashed.

These four variables alone contribute to a significant amount of demand in the market, which likely explains the performance of the market for the past five years. However, there is another factor that has increased demand even further, and that is interest rates.

Interest Rates: With short-term interest rates at an all-time low (the Bank of Canada’s overnight target rate is 0.25%, which is as low as it can practically get, and Prime is 2.25%), this has the effect of skewing people’s dollars from savings accounts (which earns roughly 1% in a short-term savings account) into more riskier assets. For “Joe Public”, where does most of this risk capital go toward? Real estate. In addition to other variables which tend to favour real estate, I would content that low rates cause an already expensive market to be fuelled by further incremental demand.

The simple example is that a variable rate mortgage these days will result in a 2.05% interest rate, as long as rates continue to remain dirt cheap. The result is an interest payment of about $1,400 a month on a $800,000 mortgage loan, which is comparable to rental rates (seeing the Richmond house example above).

Conclusions: If we were to use some marginal analysis, it would suggest that whenever interest rates rise, it will have a disproportionally negative effect on real estate demand, as mortgages would become quite expensive. The second analysis point is that one would have to look at net immigration into BC to see whether demand will increase or not. Finally, likely the real reason why real estate in Vancouver continues to remain high is because… prices have remained high. It is the perception of stability and high prices that keep demand high in Vancouver.

Will the real estate market see pricing decreases in the future? I don’t know. The market is quite reflexive in terms of its price as a determinant of future pricing. Any commodity market (and this does include real estate) faces periodic 40% downturns (Vancouver’s last 40% downturn was in 1981-1982), but timing this event, if it indeed does happen, requires luck – pundits have been calling for the downfall of Vancouver’s real estate valuations for the last five years. The strongest argument for a downturn is valuation, but just like in stock markets, valuation is rarely a just cause for short selling a stock – there needs to be psychological circumstances that changes the nature of the investing climate in order for prices to permanently decline. My guess is that such a psychological change would be perpetuated by… lower prices.

A shot across the bow – US Dollar

The US reported that unemployment dropped to 10% in November; the market reaction to this has been swift and adverse to those betting against the US dollar – as of this writing, the Euro is down 1.7% and Gold is down 4.0%.

If it takes just one report to get the market jittery on their ultra-bearish stance against the US currency (and by definition this means pro-Gold), I wonder what will happen when any other “good for USA” news comes through the pipeline – there must be a huge amount of traders out there that are going to get caught in the wrong position and start scrambling for the exits.

This is probably just a shot across the bow for these people – I wonder what will happen when there is a direct hit.

Taiga Building Products notes

I was doing some research on Taiga Building Products subordinated notes (TBL.NT, coupon 14%, due September 2020). The amount outstanding is $129 million face value. They are trading around 49 cents on the dollar so this is obviously in the distressed debt category – the yield to maturity calculation is an irrelevant figure (32%). The debt traded as low as 17 cents (if it did so today, the yield to maturity would be 103%). Yield to maturity is a misleading figure because it assumes coupons can be reinvested at a rate that is at the YTM. This will obviously not be the case.

In early 2008 the notes were trading very close to par value. Around October 2008 they went below 90 cents and never came back.

The first thing that struck out at me is that any company willing to shell out debt at 14% is a high credit risk. They issued the notes in September 2005.

The equity is around 41 cents, at 32.4 million shares outstanding this is a market capitalization of $13.3 million. This would rule out any debt-for-equity swaps, at least outside the context of bankruptcy proceedings.

The other salient detail is that they deferred interest payments up until September 1, 2010. This is also conveniently the date where their revolving credit facility ($53 million) becomes due. This essentially means that the credit facility gets paid off first (as it is secured by various assets of the company) and then the noteholders will get the second stab at the company.

Looking at their financials, Taiga is a profitable company, but they are not generating net income nearly as quickly as they need to in order to pay off the debt by September 2010. They generated about $11 million in free cash flow for the first 6 months of their fiscal year, but this will likely moderate for the rest of the fiscal year. Their balance sheet is in rough shape, with equity at negative 82 million and a significant chunk of debt due in less than a year. If I was a creditor to Taiga I would be somewhat concerned as the September 2010 debt payment date comes closer.

The value of the notes strongly depends on whether they can refinance their credit facility. Presumably the company would be in better financial shape if they paid off their 14% notes and refinanced the amount for a lower rate of interest.

That said, the market right now is not going to let the company do that.

It is essentially a gamble to decide whether Taiga will be able to refinance. My bet is that they will not be able to without giving some sort of concession on the interest rate, plus an equity stake in the company. It will be very expensive for shareholders and the company in general. It is clear that Taiga can be a sustainably profitable company, but it has simply taken on too much debt – my unprofessional estimation would be that it needs to go down to about half of existing levels.

As such, I wouldn’t touch the notes at current values.

How to take advantage of social networking for investing advantage

Read the Reddit (a link aggregation/dissemination site that is mainly dominated by teenager/sub-30 year old people) comments on “I have about $12,000 to invest, what should I do? I’m 26 and never invested before!“.

There are some decent responses (for example, people asking for more information on the person’s balance sheet), while there are a lot of comments that sound quite sophisticated but are quite incorrect.

While responses like these are not typical of the pricing you typically see in the marketplace, if you were locked in a room with teenager/sub-30 year old people and were forced to trade with them, you could use this information in a way that would give you a disproportionate advantage.

That said, in most cases people that have never invested before, if they do invest in risk-bearing instruments, will lose money. Even indexers, adjusting for management expenses, will not be able to outperform the rest of the market because so much money is tracking the S&P 500, Nasdaq 100 and the TSX 60 in Canada.

Outperforming the market requires you to know what you are doing, and to know it better than the people you are playing against in the marketplace. Most of the time the market gets it close, and knowing when the market is errant is crucial.

Dubai World default a lesson on foreign investing

I do not have any exposure to equities or debt outside of Canada and the USA, but I have been watching with fascination the fallout with respect to the default of Dubai World. Although most of Dubai’s investor base is European, it should have a small ripple effect around the world in absolute terms, but in psychological terms should reinforce that unmitigated speculation in real estate properties in might have adverse consequences in the future.

The parallel analogies between China (which one could argue has sufficient economic growth to warrant such capital investment) and Vancouver (which continues to mystify almost anybody that tries to perform a rational valuation on most properties) is obvious. However, even Vancouver does not have the excesses that Dubai did, mainly valuing waterfront properties so highly that they are to be reclaimed from the sea (or here). Looking at these projects makes me wonder what the monthly “strata fee” would be for one of these strips of land – just the costs to make sure that your island is not reclaimed by the Persian Gulf must be huge.

Financially, what is more complicated for investors is the lack of any idea of how subordinated their debt is, and what guarantees, if any, are embedded in the debt financing that was used to build such structures. The closest governmental analogy is that Dubai is a municipal government, while Dubai is one of seven divisions of the senior government, the United Arab Emirates (UAE). That said, the UAE (and the government of Dubai) made it quite clear that they will not be guaranteeing any debt of Dubai World, which means investors are hooped and can only claim whatever embedded asset value there is in the properties. This is even assuming the corporation follows whatever legal rules that are available to foreign investors in the UAE or Dubai.

It is these legislative nightmares that keep me clear away from foreign investments. In order to have a true grasp of the risk that one takes while investing, one needs to know the legal framework of the jurisdiction in question. Good luck trying to figure out Dubai World.

That said, China has gotten to the point where one might wish to more intensively study how their corporate legal structures work – from what I can tell, signed contracts and written documents are guidelines, opposed to binding, which makes analyzing social frameworks a much more relevant avenue than here in North America.

Half-year fiscal report card for Canada

The September update of the Fiscal Monitor is out. This is the half-year mark for fiscal reporting in Canada. We have as follows, for the first half-year comparing 2008-2009 vs. 2009-2010:

1. Personal income tax collection down 7.5%. This is slightly offset by income tax reductions (by virtue of raising the thresholds for the lower two tax brackets).

2. Corporate income tax collection down 39.5%. This is slightly offset by corporate tax reductions, but this shows that corporate profitability has fallen off a cliff between years.

3. GST collection down 17.9%. This is a good indicator of consumer spending.

4. EI Benefits paid up 50.1%. Probably the best proxy measure for unemployment – these people in the future, assuming they do not get jobs, will be paying less in personal income taxes as well.

5. Budgetary balance of a $28.6 billion deficit for the half-year. Extrapolating this out for a full year will result in a $57 billion dollar deficit for the year, slightly higher than the government’s projection of $55 billion.

Oddly enough, public debt charges (i.e. interest on debt) is down from $16.5 billion to $15.1 billion which is because of the very low interest rates offered by the Bank of Canada on public debt. As the term structure of interest rates is severely low at this point in time, it makes one wonder what will occur if or when interest rates start to rise again. Right now the Bank of Canada will happily take your money at 1.12% for 2 years. It will also take your money for 3.22% for 10 years. At this moment, the Bank of Canada should be trying to sell as much long-dated debt as they can, as they are receiving exceptionally low rates.

John Jansen a true financial journalist

Across the Curve was written by John Jansen, and it was something that I thoroughly enjoyed reading. He was quantitative, and factual and to the point. It was very good writing.

Probably a recent highlight for the author was when he got invited to a meeting with a few other bloggers to a meeting with some senior US Treasury officials, and ended up on television for an interview shortly after on Canadian business television.

Anyhow, he got a job with TD Securities and will presumably not be allowed to write about his views on the market, which is tragic, but I wish him the best of luck in his job.