Q1-2012 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2012, the three months ended March 31, 2012 is approximately -3%.

Portfolio Percentages

At March 31, 2012:

14% Equities
86% Cash

USD exposure as a total of the portfolio: 22%

Portfolio Commentary

A severe underperformance of the main indices – The S&P 500 was up 12% for the quarter, the TSX was up 4%. The lack of performance dealt with baggage concerning Yellow Media and other lingering items which have hence since been disposed of. The only unfortunate aspect of this is that the cheque from the government to offset the capital gains made in previous years will only be coming in April of 2013. It was a high-risk, very high reward-type bet and when you place some money on these types of ventures, you should always be prepared to take losses and that I did.

With 86% in cash, there really isn’t a heck of a lot to talk about – the 14% I do have in equity is primary in two US companies. One can be considered to be a “value” play, a company that had about two-thirds of its market cap in case, but has a business that has stable revenues and should be able to produce earnings once they learn how to cut their marketing expenses. There are growth avenues for their product line, but it should be considered a mature industry. The company has a good name brand and the target market is not going to disappear.

The other company is a growth candidate that is in a technology-related field that I am very familiar with and have done plenty of homework a few years ago on it. Only now did the stock crash sufficiently on an announcement, which I considered to be ordinary for the business but the investors obviously did not, to a valuation where it was worth picking up shares. Unfortunately I did not receive my desired fill in this or the other candidate when they were trading at relative low prices, but I will be patient and we will see. This is not a get-rich-quick stock, but it is a company that has had a very solid track record since going public of increasing revenues and earnings in a lumpy fashion – and currently these lumps have a downward trajectory.

I was aiming for an initial 10% weighting in both companies but instead got less.

While I am not that happy to see the portfolio stagnate, especially in the context of a rising broader market (fueled by the likes of Apple), I take solace in the fact that I have a mostly “blank canvas” for the portfolio and that I have not made mistakes by forcing money to be invested.


I have been severely time constrained this quarter from researching as many investment candidates as I wanted to, but when I do have the time I continue to focus on companies that are not giving out dividends, or giving out very low dividends, both in the USA and Canada.

I remain quite cautious with respect to commodity-related companies, and I continue to be mystified with the price of natrual gas compared to oil – how long will it be before we start seeing gas to liquid energy conversion projects that will finally be able to address supply issues in the natural gas market? The easy and low-volatility play in the natural gas market continues to be Encana (TSX: ECA), but you wonder how long the supply glut is going to last? At $2.20/GJ the margins are simply not there to make huge amounts of money.

I notice industry stalwarts like Canadian Oil Sands (TSX: COS) continue to lag the market despite relatively high oil prices. They were recently able to get a 10-year bond financing out at 4.5% and 30-years for 6.0%. Plays like these all have the investor assume the underlying commodity will continue to be worth more than what the futures prices say.

The low interest rate environment continues to force people to invest in increasing marginal areas – I notice on my yield scans that almost everything with a yield is bidded up to the roof. Generally this is a great formula to generate income but generate even greater amounts of capital losses. The time to play for yield was in late 2008/early 2009 and while I am glad I cashed in on that opportunity, I realize it is not going to happen again for a long, long time.

Long-term interest rates have crept up somewhat – 10-year Canada government bonds have creeped up from the 2% floor to slightly higher. I am not sure whether this is the start of a trend toward higher long term rates or not, but something I am observing. Whenever long term rates do rise, it will create its own financial repercussions as the yielding securities I mentioned previously will inevitably look less attractive.

I remain economically cautious – zero interest rate environments create strange excesses that are quite difficult to predict how they resolve – the inflating asset prices we see today are a function of cheap financing. Regrettably this also includes most of what is available in the stock and bond markets as the thirst for yield continues. The path forward in terms of how this ends is not so clear.

Thumb twiddling

The biggest mistake any investor can do is just invest cash for the purpose of investing it in something instead of investing it in something proper.

Hence, I am still twiddling my thumbs.

Curiously I do notice Encana (TSX: ECA) is up about 6% despite the fact that natural gas futures are still depressed. Might be a sign of short covering?

I’ve also been doing some research on R.R. Donnelley & Sons Company (NYSE: RRD) – I have owned their corporate debt in the past so I have not had to do much additional work. They are facing the same issues that Yellow Media had, mainly a good chunk of their business (catalogs and cheque printing) is getting enveloped by the online world. Still, the company is hugely cash flow positive and doesn’t even have the debt albatross that Yellow Media has. If it wasn’t for the fact that they are a well-known case, I might dip my toes in.

There are a couple other smallish-cap companies ($100M-$250M range) that I am reluctant to mention here that seem to have very compelling valuations, plus almost no financial pundits are paying any attention to them.

The great thing about having a large cash position is that it feels like I am working with a blank canvass. Despite earning almost nothing in yield for cash, I also do not feel pressured to make any portfolio decisions. If I have to wait out an entire year without hitting any candidates, so be it.

Natural gas continues its trek down

A fairly mundane day in the market, but there is one item that has been flashing red on my screen for the past week, and that is the spot price for natural gas:

The March contract is trading at $2.50/mmBtu and this is very close to the lows that were reached during the 2008-2009 financial crisis. At present prices, it becomes very uneconomical to develop produce natural gas and it makes you wonder how long it will be before you start seeing insolvencies in natural gas companies. Those that have over-leveraged themselves will be facing the consequences soon.

I look at companies like Encana (TSX: ECA) – their operating and transport costs is approximately $1.60-$1.70/Mcf, which is still well below spot price. It explains the $12 billion market capitalization, but it makes you wonder when the bottom will be for it and also the spot price.

The geopolitical premium

Oil has been rising steadily over the past month:

This is, in large part, due to the geopolitical premium that has built up in the commodity on fears of supply disruption from a potential strike on Iran from Israel. Other commodities have been roughly flat, with the notable exception of Natural Gas crashing through the floor:

Until we start seeing more consolidation and shutdowns of natural gas drillers and producers, this supply-demand picture is not going to be changing anytime soon. Big fish such as Encana (TSX: ECA) look cheap, but until we start seeing liquidations of smaller players or spontaneous construction of significant amounts of natural gas burning facilities, I would not be touching natural gas commodities. Notably in the peak of the last economic crisis, natural gas went down to US$2.5/mmBtu and at that level it would bankrupt most leveraged small producers. Larger companies like Encana just need to wait with a pile of cash and mop up when the time is right.

As for the oil markets, it will remain volatile as traders are seemingly using it as a proxy for geopolitical event risk.

Encana – PetroChina deal fallout not that bad

I notice natural gas titan Encana (TSX: ECA) traded a bit lower after they announced that their previously announced joint venture with PetroChina for a shale gas field fell through.

I do not view this as being too adverse an event – Encana’s management has typically been quite long-range viewing and they are dealing with a very difficult situation in the natural gas market, with spot prices currently CAD$4.30ish and typical marginal costs of extraction higher than this. They have frequently stated that they believe the natural gas marketplace is artificially low and the best thing for resource companies with plenty of reserves on the ground is to wait for higher commodity prices before drilling. My guess is that PetroChina’s management had more of a short term focus.

Back in fiscal 2008, spot natural gas went well above $10 and Encana had a banner year on earnings, reporting over $8/share (note the 2008 number is not a direct comparison with the present company because the company split off Cenovus in 2009 which also benefited from $150 crude oil). If we ever see higher natural gas prices, Encana should be well positioned to capitalize. Currently with shale gas drilling there is a huge supply glut in the marketplace.

In 2010 the company earned $2/share on an average spot natural gas price of about $4.25 per mmBtu. Encana at present values appears to be a fairly good “grandmother” type stock that should retain its value even in adverse market conditions. Even in the depths of the 2009 economic crisis (which is generally what I use to gauge maximum downside) the stock did not trade lower than 20% below existing market values.

It is an interesting comparison to look at a company like Microsoft and ask oneself whether it is likely in the medium range future whether licenses for Windows and Office will be more or less valuable a commodity than natural gas.

Encana deal a signal of future natural gas prices

Encana’s deal with PetroChina, where it sold a 50% interest for $5.4 billion dollars in their Cutbank Ridge property is likely a signal that management believes natural gas prices will remain depressed relative to the run-up experienced in the middle of 2008. The management of PetroChina likely disagrees or is trying to rapidly deploy capital even if they have to pay an expensive price in doing so.

Although the exact terms of the deal are not known, an injection of $5.4 billion in cash leaves Encana in a fairly unleveraged financial position – their total debt at the end of December 2010, net of cash is about US$6.5 billion. Encana will also be spending most of its operating cash flows on capital projects in 2011.

Encana – cutting back capital expenditures

Encana (TSX: ECA) is a very large natural gas producer. In their recent quarter, they announced they will be cutting back capital expenditures and reduced expectations due to lower natural gas prices. Hydraulic fracturing is saturating the marketplace, leading to reduced prices. This is well known by the marketplace, and as such, Encana’s stock was only down by 3% today on the news.

The two charts will explain the story, one is of Encana’s stock price, and the other is the spot rate for natural gas, and one will see the correlation:

One can easily see the connection. Encana is a type of company that will not have its equity double in value in a short period of time, but it does represent a fairly good store of value in terms of the vast reserves it can control (especially reserves in politically stable climates such as Canada). It also represents a fairly good proxy for the price of natural gas.

One of the worst ways to play an increase in natural gas, however, is through the Natural Gas ETF (NYSE: UNG) which I have written about before. I will let the chart do the speaking here:

Natural gas prices getting slaughtered

The “discovery” of economical shale gas mining has done an extraordinary job of depressing natural gas prices since the price shock of 2008:

It is noted that the spread between crude oil and natural gas prices have reached an all-time divergence, but this is likely to be temporary – it will just be a matter of time before the laws of supply and demand force effective conversion between the two commodities. For example, it makes it more economical to use a higher natural gas input to achieve an output of crude given the price spread. Activities such as tar sands mining are very intense on natural gas (to generate steam) and as a result, the market should equalize over time.

One of the worst ways of playing natural gas is by purchasing a Natural Gas ETF (UNG), as it does not actually hold the physical commodity – traders will eat away at the fund when it has to rollover its futures contracts. Even purchasing calling options or the futures directly still exposes you individually to rollover risk. You could buy long-dated futures, but there is very little liquidity in the marketplace and you pay a significant premium, as the market is anticipating future price increases.

The only real way for people to play natural gas on a long-term basis are to purchase producers with considerable reserves. Which producers to pick is a matter of risk tolerance and market pricing. Typically if an investor wishes to be fancy, they would ideally pick a producer that has a marginal cost structure such that the cost to produce natural gas is that of the present market price; such a company will be losing significant amounts of money and will be trading at depressed valuations. Assuming this is the case and assuming the market has significantly marked down the equity in such a money-losing company, it is a very speculative way of playing for a natural gas price increase.

This principle also works with any other commodity on the planet – including crude oil and gold companies. Again, it depends on doing your homework with respect to valuations and knowing what value you are receiving when you put in the order for shares.

A more conservative strategy and one that relies on other market participants to have done their homework to receive a fair price is to purchase shares in EnCana or Canadian Natural Resources, which are the top two natural gas producers in Canada. After the split-up of EnCana and Cenovus, EnCana is a much more “pure play” on natural gas than Canadian Natural Resources. With either company you will not see your money double over the course of a year or two, but it will certainly be there at the end of the day and also provides a bit of comfort with respect to inflation-proofing a portfolio. Despite all of the media and political attention paid to carbon emissions, it is a given that natural gas and crude oil continue to be consumed in massive quantities for the foreseeable future. The only promise is that, over the long run, it will get more expensive.