Next TFSA investment – First Uranium

Following the success of getting out of Harvest Energy debentures, I had a lot of cash in my TFSA, especially after the January 2010 contribution of $5,000. There was only one debenture candidate left on my radar that appeared to have a good risk/reward characteristic. Although it wasn’t great, it was good enough and I executed a trade on it.

Continuing with my less than diversified strategy, I have placed the sum of the TFSA into the debentures of First Uranium (FIU.DB). The debentures give a 4.25% coupon, maturing in June 2012. They are convertible into equity at $16.42/share, but this is unlikely to be a factor in the valuation. The total issue was for CAD$150M. They went as low as 41 cents in the debenture crash of early 2009.

The price I received was 74.5 cents on January 11, which is a 5.7% current yield and an implied annualized capital gain of 13.0%. Assuming a 1.2% (short term interest rate) reinvestment of coupon, this is a realized return of about 16.8%, which is (barely) above my investment threshold. The previous Harvest Energy investment was above 30% at the time and price I made it, but the spring of 2009 was a very special investment climate where buying anything would give you massive returns. Today, things are much different and you really have to pull out a high powered microscope since anything with a high return has a lot of baggage you have to sift through. First Uranium is no exception.

First Uranium is a Toronto corporation, but with operations primarily in a South African mine with uranium and gold reserves. The name is misleading in that the bulk (~85%) of the company’s revenues are expected to be from gold sales. The foreign nature of their operations introduces a risk, but South African mining operations have been able to operate sustainably in other circumstances. Although I have my geopolitical concerns about South Africa in the medium term (10 years out), I have discounted such concerns in the 2.4 year timeframe of this present investment. It is also likely that coming closer to maturity that the investment may be liquidated sooner than later, or when the yield shrinks to my sell target (around 95 cents presently).

Most of the operations have been financed by equity – the last financing was done in June 1, 2009 at CAD$7/share. Today the common shares are at $2.66/share with 167M shares outstanding – a market capitalization of about $444M. Some portion of the gold reserves have been hedged off at below-market rates for up-front financing. In addition, the mining operations are still at the end of the initial capital injection phase before they can start producing sustainable positive cash flow, which is expected in the March 2010 to March 2011 fiscal year.

In terms of management and ownership risk, this is an interesting story. Simmer and Jack, another (larger than junior) South African mining company, owns 37% of the company as of September 2009. There has been a recent management and board struggle dealing with the Simmer and Jack management, who have moved over to First Uranium after they were kicked out of the Simmer and Jack board. The kicked-out CEO and Chairman, Gordon Miller, owns 1.66% of Simmer and Jack and roughly 0.1% of First Uranium. Although this struggle has an indirect impact on the value of the debentures (mainly that I am concerned about being paid off rather than owning the company), it is worthy to note that some deal must have been cut with the existing Simmer and Jack board such that he be allowed to run First Uranium since the 37% minority ownership of Simmer and Jack would likely be able to prevent him from doing so if they did so voluntarily.

There is a complex relationship here with respect to the debentures – Simmer and Jack is highly incentivized to make sure the debenture holders don’t take over the company so they can realize value of their equity stake. Gordon Miller likely wants to make a ton of money out of the deal and try to get some sort of revenge against Simmer and Jack and try to wrestle control away from the company. Either way, the debentures will have to be paid and it seems likely at this point it will be done by a simple equity swap – the current market capitalization is sufficient to pay off the debentures with about 25% dilution to existing shareholders.

On the balance sheet, First Uranium has US$60M in cash at the end of September and they have poured in about US$563M into their mining operations. Their only significant liabilities are a $22M loan from Simmer and Jack, and the CAD$150 of debentures. The income side is ugly when one looks back, but the corporation should start to generate cash through mining operations in the upcoming year and slow down capital expenditures – and perhaps even pay some common share dividends sometime in the second half of 2011 if things really go well and the refinancing of the debentures are in the bag.

The risks otherwise are typical of a mining firm – commodity pricing (gold and uranium) and realization of “proven” reserves into actual output. There is also some currency risk – they report in US dollars and their equity and debentures are denominated in Canadian dollars. Reading the technical report on the main mine and getting a feel for the operation is also essential (and rather dry) reading.

Although this investment is not the most ideal, I do believe that the company will be able to pay off the debentures, whether by refinancing, equitizing the debt or generating cash flow before the June 2012 maturity. There is enough of a margin of error to feel comfortable, but not “home free”, which is why the market value is trading significantly below at present. Assuming their story turns out, the equity side is also a compelling story, but it contains a high degree of risk that I am not willing to take – especially concerning the future of gold prices. That said, I expect these debentures will be made whole and will be a positive decision in terms of my risk-reward profile and being able to avoid income tax and capital gains tax by virtue of it being in the TFSA.

I also prefer short duration plays simply because when interest rates rise again, cash might be a more attractive option.

(Subsequent note: Operational risks include adverse news releases after hitting the “publish” button, although I do not think this one is too severe to my underlying investment thesis.)

Canadian Interest Rate Projections

This is updated from December 7, 2009. The end of December rate (these rates are 90 day bank rates) has moved from 1.53% to 1.45%, while the end of December 2011 has gone from 2.86% to 2.77%. The market is signaling that rate increases will be less than anticipated from last month.

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 FE 0.000 0.000 99.530 0.000 0
+ 10 MR 99.540 99.545 99.535 0.005 3742
+ 10 AL 0.000 0.000 0.000 0.000 0
+ 10 JN 99.380 99.390 99.370 0.020 19921
+ 10 SE 98.970 98.980 98.960 0.020 13407
+ 10 DE 98.540 98.550 98.520 0.030 6731
+ 11 MR 98.130 98.140 98.130 0.000 3180
+ 11 JN 97.800 97.820 97.810 0.000 918
+ 11 SE 97.500 97.520 97.500 0.010 35
+ 11 DE 97.210 97.250 97.210 0.040 15
+ 12 MR 96.960 97.010 96.960 0.040 16
+ 12 JN 96.730 96.770 96.720 0.030 16
+ 12 SE 96.520 96.570 96.490 0.050 14

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.

Taiga Building Products resumes interest payments

Taiga Building Products has resumed paying interest on their notes. I have written about the notes earlier and pointed out the risks associated with the notes. At that time the notes were trading between 45 and 50 cents on the dollar.

After the closing of trading on January 13, 2010, Taiga announced the following:

BURNABY, BC, Jan. 13 /CNW/ – Taiga Building Products Ltd. (“Taiga” or the “Company”) is pleased to announce that due to strengthening cash flows, it will be resuming interest payments on its 14% subordinated notes, including monthly interest on deferred interest, as per Section 2.04 of the Note Indenture dated as of September 1, 2005. Interest deferred from March 1, 2009 through November 30, 2009, including interest on deferred interest, will be paid by September 1, 2010 as per Section 2.04 of the Note Indenture. The Board of Directors may choose to pay interest prior to September 1, 2010 subject to cash flow considerations.

The first reinstated interest payment date will be January 15, 2010, with respect to interest, and interest on deferred interest, accruing for the month of December 2009.

… and on the following day, announced:

BURNABY, BC, Jan. 14 /CNW/ – Taiga Building Products Ltd. (TSX: TBL & TBL.NT) announces that it will be paying the monthly interest payment of $11.6667 per $1,000 principal value subordinated Notes. Taiga will also be paying the interest on deferred interest, accruing for the month of December 2009, in the amount of $1.1233 per $1,000 principal value subordinated Notes. The payments will be made to shareholders and noteholders of record at the close of business on December 31, 2009 and will be payable on January 15, 2010.

The question for the noteholders will continue to be how the company will pay the deferred interest in light of the fact that their credit facility, as of September 30, 2009 was around $53 million and without any cash on the asset side of their balance sheet. The equity in the company is negative $82 million at this date. At the September 2010 date is the expiration of the bank credit facility, which would be senior to the notes and secured by most of the company’s remaining assets.

The market, however, didn’t seem to care. Taiga equity went up 15 cents to 60 cents a share (so its market capitalization is roughly $19.5 million) and for noteholders, the market value went from 60 cents to a high of 92 cents, closing at 91 cents.

It appears that the market is applying a very rich valuation to the notes in response to this news. If I held notes, I would be dumping them if the market rate was 91 cents.

I suspect within a year there will be some sort of recapitalization of the company’s debt balance, and the issue for the noteholders will be one of recovery, rather than yield.

Just an item of disclosure; I have never had a position (equity or debt) in Taiga Building Products. They are interesting to track, considering that they are a (relatively) local company to where I live and wish their business the best of luck in slaughtering their debt issues with a minimum of pain for everybody involved.

Bank of Canada on Canada’s real estate bubble

The Bank of Canada is very correct in saying they won’t raise rates because of the obvious real estate bubble.

The interest rate is a very crude tool which affects many more facets of the economy than just the real estate market.

Right now you can cool down the real estate market by changing the minimum leverage ratios required to purchase – the subsequent decrease in available credit will accomplish this.

Right now the law permits you to take out a mortgage with a 35-year amortization and a 5% down payment. The primary concern is the down payment fraction, and not the amortization rate (although a longer amortization will allow for a larger purchase due to a decreased payment to principal). Essentially you can buy a house on 19:1 “margin”. The most leverage you are legally allowed to use with equities is 30% down.

A simple mathematical example will demonstrate why a 5% down payment requirement is ridiculously low.

With a 5% down payment, you can buy a $400,000 house with a $20,000 down payment, so you would be borrowing $380,000. In the event you couldn’t actually afford the down payment, banks have developed convenient “cash back” mortgages that give you cash up front, but in exchange for a higher rate of interest throughout the mortgage. An example is TD’s “5% cash back mortgage“, where instead of paying a posted 4.24% 5-year regular mortgage rate, you can pay 5.49% for the cash-back option.

Let’s say you purchase this place, and then your house appreciates 5% – so you have $40,000 equity in a $420,000 home. In theory, you can then get a second mortgage on the home for $20,000, cough up another $1,000 from your VISA or Mastercard (since 5% of $420,000 is $21,000) and then buy another $400,000 home with a $380,000 mortgage. If your two homes appreciate another 5%, then you can afford two more $400,000 homes, etc.

One can see how a single person can leverage a lot of money with a 5% down payment requirement. It becomes ridiculously easy in a rising real estate market. Of course, when the real estate market goes down, your ability to borrow money stops, and you then have to face the music when it comes to paying the mortgages (or just calling it a day and default).

With a 10% down payment, it becomes a little more difficult to perform this operation – your fictional $400,000 home requires a $40,000 down payment. Your home will have to appreciate just over 10% in order to be theoretically eligible for a second mortgage that would give a a sufficient down payment to buy another equal-priced place.

The legal minimum down payment before a mortgage should be granted is set to a number higher than what it is currently. Ideally it should be linked to the Canadian government 5-year bond – a lower interest rate should require a higher minimum down payment, while a higher interest rate should require a lower minimum down payment. A more simplistic solution (and much easier to market) is just to increase it to a particular rate. The Canadian government has hinted it may increase.

While in theory people should be left alone to select their preferred debt leverage ratio, it was shown in the USA that the actions of a lot of fiscally irresponsible people (and their banks) caused genuine impact to those that could actually manage their affairs properly – savers in the current environment are basically being punished by the actions of the squanders. As such, it is an easy decision to raise the minimum down payment percentage required to obtain a mortgage.

As a matter of personal finance, people that don’t have at least 20% squirreled up for a down payment should likely not be purchasing a place. This is the minimum amount required to avoid paying any CMHC home mortgage insurance premiums, which is an absolutely unnecessary expense since you are not receiving any benefit out of the insurance (other than the ability to get cheap credit in the first place) – the bank is getting the benefit, while the public is securing it with federal taxpayers’ money.

Debt investing advice

The reason why debt is valued more highly than equity, thus giving off a smaller yield, is because of its higher ranking in the seniority chain. If the company fails to pay interest and principal according to the terms of the debt agreement, then the debtors will usually be able to take some equity stake in the firm after a bankruptcy proceeding.

The tip of the day is not to invest in an entity where it is mandatory for the existing equity owners to maintain control of an organization in order for it to operate. The leverage the debtholders have in such a situation is precisely none – if they force the organization into bankruptcy, they will be left with nothing, while if they do not, they will still be left with nothing except a promise to be paid.

A debtholder needs more than a promise to be paid – they need the ability to force the company into bankruptcy or liquidation if a default occurs.

ING Direct trying to trap capital in TFSA accounts

I noticed at the start of the year that ING Direct was offering a 3% 90-day GIC for RRSP accounts (no transfers required) and also 3% for a TFSA account, but with the rate subject to change at any time.

Anybody with an RRSP in ING Direct would do well to lock in the 90-day rate as soon as they can; even though they stated they will offer it until March 1st, they could revoke it. The difference between a 3% rate and a 1.25% rate (which is more representative of the current market rate for a 1-year GIC) is $43.15 on a $10,000 investment. It is not huge money, but it is more money nonetheless.

The 3% TFSA offer is quite a lure, but it is designed to trap as much money before they reset the rate back to a lower rate. The trick with the TFSA is that once customers have deposited their money into the TFSA, it is a lot of unnecessary paperwork to get their money out of the TFSA account once the rate resets to something lower. If customers decide to withdrawal the TFSA once the rate goes lower, then they lose the contribution room into their TFSA until January 1, 2011.

For those people that want to keep their money in a risk-free instrument (e.g. a GIC), use the ING Direct TFSA at your own peril. As a matter of financial planning, the TFSA should not be used as a risk-free account anyhow, but some people will want to use it to park idle cash.

ING Direct used to be the undisupted best place to save money, but over the past few years they have become just “normal”. They are still excellent with respect to having a no-fee operation and this works to their benefit – if money is easy to get out of them, then I feel much safer keeping money with them. For matters such as RRSP and TFSA transfers, however, there is a real bureaucratic cost associated with these and it is not worth it to capture an extra 0.5% elsewhere for the dollar amounts in question that people typically deal with.

If ING Direct wanted to raise a lot of longer duration capital, they’d do fairly well if they offered a 5% 5-year GIC.

Chasing yield is easy until the party ends

I have successfully liquidated my debentures in Harvest Energy (series D and E) for 101.5 and 102.0, respectively. Since they are trading above the 101 that will have to be offered after the takeover, it is unlikely that investors will tender the debt. I am happy to be rid of the bonds so my capital can find some more productive areas. My opportunity cost of this transaction is giving up about a 6% yield, but there are equivalent risk instruments that the money can be parked in the interim.

I have another issue (Bellatrix Exploration, formerly True Energy Trust) that has seen its equity rise about 400% over the past four months and its bonds have correspondingly traded near par. It is very close to my liquidation point and there will be a high probability it will be sold very soon.

As such, my portfolio is starting to look cash rich. While cash is good, it is also earning a return that is less than flattering (mainly zero) and while I can shift the funds into a short term savings account for 1.2% (or 2% if I shopped around) I am always looking for a better place to put my money – something that will give a yield.

In my tax sheltered accounts, I am looking for investments that will generate income. Outside the tax sheltered accounts, I am looking for investments that can generate capital gains (taxed at half the rate) or eligible dividends (taxed significantly less depending on what income bracket you are in).

Most of the income trusts have been bidded up to yields that are not representative of the risks embedded within the company – for example, a trust that is always on my watchlist (but I never get around to purchasing) is A&W – currently yielding about 8.01%. This is not adequate compensation for a company that is distributing more cash than its distributable cash allotment. It is possible that A&W could trade higher (and yield lower) but this is essentially the equivalent of gambling and could just as easily go to 8.5% ($14.82/unit) as it could to 7.5% ($16.80/unit). I do not want to get into coin flipping competitions with the market.

Since my hurdle rate is above 8%, I am forced to lower my standards if I am to seek a home for my cash. This means either accepting higher risk, or accepting a lower rate of return.

Right now if I accepted a lower rate of return, I estimate I could generate about 10% a year with debentures, but this is still a relatively low rate of return in consideration of the risk taken.

As such, I must broaden my search to more obscure securities and companies. This will also require some research and time. It will also require appropriate market conditions when people are less confident.

Fortunately, time is on my side – while the cash is sitting there, earning nearly nothing, it will at least be there when I need it. The temptation to quickly deploy cash is one of the most destructive psychological behaviours one has while investing.