Q2-2017 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the second quarter of 2017, the three months ended June 30, 2017 is approximately +0.6%. The year-to-date performance for the 6 months ended June 30, 2017 is +19.3%.

My 11 year, 6 month compounded annual growth rate performance is +18.2% per year.

Portfolio Percentages

At June 30, 2017 (change from Q1-2017):

20% common equities (-4%)
28% preferred share equities (+8%)
31% corporate debt (-7%)
4% net equity options (+1%)
18% cash and cash equivalents (+3%)

Percentages may not add to 100% due to rounding.

USD exposure: 52% (+2%)

Portfolio is valued in CAD (CAD/USD 0.7714);
Other values derived per account statements.

Portfolio commentary

All things considered, the nearly flat performance was a good indicator of a relatively boring quarter – there was very little theatrics to discuss. Major portfolio decisions include liquidating my KCG Holdings equity stake, and retaining the equity options until the last possible nanosecond before expiration. I will promptly liquidate the position if the market is acceptably close to the USD$20.00 cash buyout number (or I will just wait for the transaction to proceed). This will result in an effective liquidation of another 4% of the portfolio. I also have another 4% position in their senior secured bonds which will be called out after the transaction completes, which should be around July 21st (after the quarter-end). The net result of these transactions are that the portfolio is effectively 25% cash and I have no idea where to deploy it beyond VGSH (USD) and VSB.TO (CAD) – at least with those I get paid around 125 basis points to wait.

Sadly my entries into the VGSH/VSB.TO short-term fixed income vehicles has been incredibly lacklustre – with continued threats of rising interest rates, even these short duration vehicles are taking a minor hit of capital value – an inexpensive lesson that yield is rarely risk-free.

I took a single digit percent position in a company trading well under tangible book value and earning positive income and cash flows during the quarter. I estimate when the market wakes up to this position (there has been little if any analyst coverage, nor has there been any public exposure to it at all) it will trade up to double its present value. I won’t write about this one until it appreciates or my original investment thesis is incorrect. There is a credible reason why there is still price pressure even at the depressed levels. The company has spent most of its public life trading around 25% higher than what it is trading at right now.

This was my first new common share position in over a year. I’ve been close to pulling the trigger on some other ones but they didn’t quite reach the correct price point.

I also took a non-trivial stake in DRM.PR.A preferred shares. I’ve been in and out of this over the past couple years, but this time I suspect it will be a staple position for quite some time. It only requires 33% margin so it is not too much of an anchor to keep, especially since the spread between the margin rate and the dividend rate is huge. This is effectively a “cash parking” vehicle until they get called away by the parent company (I was expecting this to happen quite some time ago). When it happens I will have the problem of more capital going from a near-guaranteed 7% tax-preferred income to 1%. It is my hope that management continues to ignore this issue (other than paying quarterly dividends). I wouldn’t buy it at the current premium.

That’s about it for the quarter.

In terms of price movements, there were three items which caused negative portfolio movements. Genworth MI took collateral damage with regards to the collapse of Home Capital Group, but has swiftly recovered from reaching a low of about $30.50/share. At that level, Genworth MI was in the low end of my price range, but it wasn’t low enough that I would re-purchase shares. Conversely, it is too cheap to sell at present prices. So I will be waiting and continuing to collect 44 cent quarterly dividends until the market decides that the equity is worth more.

Teekay Corporation unsecured debt also significantly declined to reflect the calamity that is hitting their offshore division, but I do not believe the underlying value of this debt is compromised by virtue of the value of their natural gas division. This was the primary detractor from my portfolio performance this quarter. At a YTM of 13%, investors have a decent risk/reward situation at current prices.

The third detractor to performance was the Canadian dollar – as it appreciates, although I appreciate the purchasing power, it does detract negatively on my US dollar components. Since my portfolio is nearly 50/50 CAD/USD, each percent the Canadian dollar rises means a half percent drop in my portfolio value.

Finally, Gran Colombia Gold announced they will be redeeming 5.7% of their 2020 senior secured debt outstanding at par. I will be pocketing the cash and looking forward to future payments – this series of debt is first in line, secured by a gold mine and an investor can be patient to collect on the debt. Although I do not have a place to deploy the cash, I look forward to receiving the payment and reducing my concentration in this particular debt issuer (I purchased most of the senior secured debt at around 55-60 cents on the dollar). The two relevant risks here are the political stability in Colombia (which is not bad at present) and the price of gold continuing to meander at its present level – or go higher. 75% of the free cash flows from the company have to go towards redeeming the senior secured debt due in 2020, so over time I will expect to get paid back.

The portfolio underperformed the S&P 500 slightly, while outperforming the TSX. I do not invest for relative returns, but psychologically it always feels better to know that somebody is losing more money than I am. The portfolio in the last quarter has also underperformed my 11.5 year CAGR (Compounded Annual Growth Rate), but this is to be expected given my very risk-adverse positioning at present. I will warn readers that my +18.2% CAGR is likely to decline in the upcoming quarters as making a percent or two each quarter is below the +18.2%/year benchmark.

Outlook

Crude oil markets are trending significantly lower than what most participants thought would be happening. This is having a significant impact on most Canadian oil and gas companies, whom have been continuing to address leverage matters. While prices imply there is pressure, it is not yet at a crisis point that it was back in February 2016, but if the prevailing trend continues, it definitely appears that there will be some more fractures in the Canadian oil and gas space due to excessive leverage levels. There may be opportunities in the debt market at this point (witness the calamity hitting Teekay right now).

In the USA broad market, the S&P 500 is dominated by the top 10 companies (Amazon, Facebook, Google, Netflix, etc.) and when extracting out those liquidity high-flyers, we have a market that is treading water and some targets of opportunity are starting to emerge that have value-like characteristics. However, the US federal reserve is slowly tightening the screws in terms of loose monetary policy and this most certainly will have a continued dampening effect on equity valuation as the cost of capital continues to rise. They are doing this slowly as to not trigger a market crash, but most participants should be alerted that the 30-year treasury bond, currently at a yield of about 2.8%, is not rising despite the rising-rate environment. This is something to be very cautious about.

The Bank of Canada also spooked the markets in the second week of June when they were making public noise about increasing the interest rates. Although I do not predict they will take much action, if any, until the corresponding long bond rates rise, this may have the effect of putting a bottom on the slow and steady decline of the Canadian dollar. Clearly the commodity markets are not helping Canadian currency, and if there is some sort of return in commodities, then the Canadian dollar would actually be better positioned for a rise.

In general, I continue to remain bearish. Although this stance has not been in correspondence with the major indicies (which have risen considerably), my portfolio continues to generate a positive return while remaining extremely risk-adverse at present time. I am of the general belief that index investing continues to dislocate pricing in the market from true value and this trend is not likely to abate until such a point that it is identified that pouring capital in a non-price discriminatory vehicle is not a prudent way to invest money – instead, it is diversifying through obscurity and not achieving true risk reduction.

I am finding it very difficult to invest cash in this environment. It is painful to wait, but waiting I will do.

The average maturity term on my debt portfolio is just a shade over 30 months. This will continue to lower as my issuers go down to maturity. I am not interested in long-duration bonds at all at the moment.

I project over the rest of this year, if things go to a reasonable level of fruition, that I will see another 2-3% of appreciation, while taking little risk. This is also assuming that I do not see further candidates for investing the non-trivial amount of cash in the portfolio. Nothing imminent is on the horizon. My research pipeline has been bone-dry.

To put a polite summary to my investment prospects, I feel stuck. Little in the pipeline and little of inspiration. Waiting is not popular, but it will allow me to preserve capital for the time where it will be more appreciated.

(Update, July 17, 2017: After doing my internal audit, the quarterly performance was revised from +0.7% to +0.6% for the quarter. The year-to-date was revised from +18.7% to +19.3% due to a rather embarrassing formula error on the tracking spreadsheet. The changes are reflected in the numbers above. The 11.5 year CAGR remains unchanged.)

Portfolio - Q2-2017 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
11.5 Years (CAGR):+18.2%+5.9%+8.2%+2.6%+5.6%
2006+3.0%+13.6%+15.6%+14.5%+17.3%
2007+11.7%+3.5%+5.5%+7.2%+9.8%
2008-9.2%-38.5%-36.6%-35.0%-33.0%
2009+104.2%+23.5%+25.9%+30.7%+35.1%
2010+28.0%+12.8%+14.8%+14.5%+17.6%
2011-13.4%+0.0%+2.1%-11.1%-8.7%
2012+2.0%+13.4%+15.9%+4.0%+7.2%
2013+52.9%+29.6%+32.2%+9.6%+13.0%
2014-7.7%+11.4%+13.5%+7.4%+10.6%
2015+9.8%-0.7%+1.3%-11.1%-8.3%
2016+53.6%+9.5%+12.0%+17.5%+20.4%
Q1-2017+18.6%+5.5%+6.1%+1.7%+2.2%
Q2-2017+0.6%+2.6%+3.1%-2.4%-1.6%

DREAM Unlimited and Birchcliff Preferred Shares – cash-like with higher yield

I’ve written in the past about DREAM Unlimited 7% preferred shares (TSX: DRM.PR.A) and the situation still applies today. They, along with Birchcliff 7% preferred shares (TSX: BIR.PR.C) are the only holder-retractable preferred shares trading on the entire Canadian stock market.

They are both trading slightly over par value.

In the case of Birchcliff, the preferred shares only become retractable on June 30, 2020. As such, the implied yield to retraction is around 6.14% (assuming CAD$25.50/share and not factoring in the accrued dividend). You would receive eligible dividends over the next three years and a capital loss upon retraction. The underlying corporation, while somewhat leveraged, is quite well positioned if you assume the North American natural gas market is not going to evaporate. There is also some upside catalyst to the business fundamentals (not to the preferred shares!) if North America finally gets a liquefied natural gas plant on the Pacific Coast, but this is not likely to happen since price spreads have narrowed significantly over the past couple years.

Liquidity on Birchcliff preferred shares is not the greatest – but if you float an ask at the ambient price level you will likely get hit a few hundred shares at a time.

In the case of DREAM, the premium is not extreme when factoring in the amount of accrued dividend (at the closing price of $7.29/share, implies a 6.88% yield with a risk of an immediate capital loss if the company decides to redeem at $7.16/share). It has been quite some time since they have traded at a discount to par, and this is likely due to scarcity of shares – shares outstanding have decreased from 4.87 million at the end of 2015 to 4.01 million at the end of 2016, and this trend is likely to continue. Holders are probably waiting for the inevitable call by the company to redeem the preferred shares. But until this happens, holders receive an eligible dividend of 7% on their preferred shares.

Likewise with Birchcliff, liquidity with DREAM preferred shares is not good. However, there is usually daily activity on the shares and the spreads are typically within pennies. In a financial panic, however, that liquidity might fade and in a quick trading situation you might get a price a percent or two below par value.

There is conversion risk – the company can choose to redeem the preferred shares in DREAM equity, to a minimum of $2/share or 95% of the market price (which is the standard 20 business day VWAP, 4 days before the conversion provision, as defined in section 4.09 on page 68 of this horrible document). With the common shares trading at $6.60 and the business fundamental not being terrible, the risk seems to be quite low that preferred shareholders will leave this situation with anything less than par value.

I have some idle cash parked in both instruments. I consider them a tax-advantaged cash-like instrument and do like the fact that they are margin-able at IB (Birchcliff at 50% and DREAM at 33%!). This is much better than putting the money in a Home Capital Group GIC (earn 2% fully-taxable interest income AND have the privilege of losing principal when they go insolvent)!

Does anybody out there know of any similar situations that relate to US-denominated preferred share securities that are “cash-like” in nature?

Dream Unlimited Preferred Shares

With the calamity hitting the preferred shareholders of Dundee Corp (of which I narrowly escaped), I have long noticed that their spinoff corporation, DREAM Unlimited (TSX: DRM) has a similar situation going on with their own preferred shares.

You will have to dig through SEDAR and look for a May 31, 2013 document that is 8783kb in size and go to page 60 of 141 in the PDF document for a legal definition of what these preferred shares are. They made it so convenient as the documents are not even made searchable with the usual control-F function on Adobe Acrobat.

They trade as DRM.PR.A and they are retractable by the corporation at $7.16/share, and redeemable by the shareholder at $7.16/share, in both cases with accrued dividends (7% coupon on a $7.16 par value). Redemption and retraction are given with at least 30 calendar days of notice.

Unlike Dundee Corp, there is no ability for DREAM Unlimited to sneak a shareholder-hostile proposal to scrap the redemption feature without a significant sweetener – if they did so, you can “vote” by exercising your redemption rights and get your money 30 days later instead of voting your shares against such a hypothetical proposal.

The only risk is the underlying corporation, DREAM Unlimited, elects to pay the redemption with common shares. The provision is 95% of the typical 20 day volume weighted average price scheme that is common to a lot of other offerings out there, or $2/share if this is the higher price. DREAM Unlimited common shares are trading at $7/share and with a market capitalization of $526 million, so a dilution of $36.7 million is not going to hammer the common shares below $2 if they tried an equity redemption – you’d likely be able to get out above par value in such an instance. The underlying business is not prone to “gap risk” (i.e. this isn’t some biotechnology company that will drop 70% one day due to a failed clinical trial), but it is in real estate development – this means that any of their properties that are not in Alberta or Saskatchewan, should be relatively stable (at least until you can get your redemption money in 30 days time).

In typical Dundee fashion, however, while the corporation is reporting considerable GAAP profits, their cash flow statements leave much to be desired. They do have ample liquidity in the meantime, having negotiated a $175 million million first-line facility with the banks expiring June 2018 and also $200 million of spare capacity on their operating line of credit which expires on June 2017. There is easily enough room to pay for a redemption of preferred shares – indeed, the fact that the preferred shares occupy a $36.7 million hole on their balance sheet probably forces them to be more conscious about this liability. I wonder why they haven’t even just bitten the bullet and redeemed this expensive capital.

In other words, the market value of this preferred share issue is going to be anchored around the $7.16/share mark as investors are able to skim off a 7% eligible dividend until such time the corporation bites the bullet and finally redeems the shares. If it goes too below $7.16, it is an easy arbitrage to buy below $7.16 and instantly redeem if you believe there is any sense of credit risk. It is as close to a risk-free 7% as it gets.

I note that the preferred shares were trading as low as $7.00 today and this was likely fueled by some investor out there getting his RBC Margin account spontaneously liquidated – it wasn’t a trivial amount either, around 40k shares worth. About 30,000 of them traded at $7.00 and somebody redeeming them back to the corporation at $7.16 made the easiest CAD$5000 on the planet. Ordinarily DRM.PR.A is not an actively traded stock and with all of the stress occurring in the marketplace, what may be “risk-free” isn’t as liquid as cold hard cash!

Anyway, I bought some shares at $7.00 today.