Featured on the Globe and Mail – reflections on dealing with short selling reports

I’d like to thank Larry MacDonald for mentioning me on his regular article on the Globe and Mail about short selling on the TSX.

A hedge-fund analyst once sold short a company in which Sacha Peter had invested. Then he published a critique on it.

Did Mr. Peter, author of the Divestor blog, rush to his keyboard to click on the sell button, or log into online forums to urge a squeeze on the short seller? Not at all.

Instead, he rolled up his sleeves and dived into the critique. After reading it, the shares remained in his portfolio and were later unloaded at a profit.

It may not always turn out as well as it did for Mr. Peter, but there is something to be said for monitoring the trades of short sellers to see if any are targeting a stock you hold. As Mr. Peter says, “I very much like reading the short-sale cases of anything I hold. It forces me to check my analysis.”

Larry was referencing my post back in April 2018, The case to short Genworth MI, where a very intelligent young analyst won an accolade for writing a fairly comprehensive short report on Genworth MI.

Keep in mind there is no “one size fits all” strategy concerning how one deals with new information that comes with people or institutions issuing short selling reports on your holdings. Everything depends on your ability to perceive fact from fiction, and perhaps more maddeningly, perceive the market’s sense of reality versus fiction that they bake into the stock price.

I’ll also talk about a time where I got things less correct.

Go read my August 2020 post on what happened when a short selling firm released a report on GFL Environmental. I had taken a small position on one of their hybrid securities (effectively yield-bearing preferred equity with equity price exposure above and below a certain GFL price range) and then a short sale report came out. I bailed very quickly. Retrospect has shown that wasn’t a good decision financially (right now GFLU is about 70% above what I sold it for including dividends), but one of the reasons for bailing was because I was not nearly as comfortable with my level of knowledge about the company than I was about Genworth MI. Another reason is that there were still very active market reverberations going on during COVID-19 so there were plenty of alternate investment candidates for my capital. I’d also like to give a hat tip to Jason Senensky of Chapter 12 Capital for his comment that has stuck in my mind ever since, which is his insightful analysis that my “return on brain damage is too low” – which indeed is an accurate reflection that my mental bandwidth on such cases is better spent elsewhere.

And while I’m on this topic, Jason also wrote a fantastic article on the near-demise of Home Capital Group, instigated by a high profile short seller. Hindsight is 20/20, but I feel like there was a missed opportunity on that one – I should have taken the cue after they announced they obtained their ultra-expensive secured line of credit facility (it marked the bottom of their share price).

The most profitable industry on the planet

At this time, the most profitable industry has to be mortgage insurance in Canadian real estate markets.

Genworth MI (TSX: MIC) reported Q4 earnings.

The loss ratio reported was 10%. The expense ratio was 21%.

This means out of every dollar recognized in revenues leads to 69 cents of pre-tax profit.

Needless to say, this is a gigantic amount of economic extraction from an industry that is somewhat protected (by virtue of the federal government taking the mountain’s share of profits through CMHC).

It is funny how the public hasn’t connected the dots on how this makes borrowing with large-ratio mortgages extremely expensive – a 10% down mortgage can incur a 3.1% mortgage insurance fee. While 3.1% may not intuitively seem expensive, it is a huge fee considering that the bulk of the risk of default in a mortgage occurs in the first 5 years (where in a typical 25 year amortization, about 15% of the loan is amortized) while the rest of the time period is generally “home free” for the loan provider. This effectively results in a 60bps accretion to a loan’s profitability (compare that to a bank that makes less spread than that on the mortgage loan itself!).

Brookfield is in the very late stages of taking MIC into its fold at CAD$43.50/share. At the rate they reported net income in 2020, that works out to about 8.5 times earnings.

Normally industries with such large profit margins attract competition. The barrier to entry is access to the Government of Canada guarantee (CMHC gives a 100% guarantee, backed by the Crown, while MIC is 90% guaranteed by the Crown, with the residual guaranteed by their shareholders), and access to the mortgage networks (which can give approvals based off of customer profiles). Not an easy industry to crack for a new entrant, and the only real basis of competition would be price.

Going from public to private

A few of these have hit the headlines recently in a relatively short time period:

Genworth MI (TSX: MIC) having their 43% minority interest held by the public acquired by the majority holder Brookfield; this can generally be attributed to a relatively inexpensive valuation if it passes.

Dorel (TSX: DII.A/DII.B) is going private, lead by the managing family. An investor in the COVID-19 bottom would have made an astounding 10x their investment, although at that time it should also be pointed out that their financial position was already quite leveraged (principle: the more dangerous they look, the cheaper they are).

Rocky Mountain Dealerships (TSX: RME) in a management-sponsored takeover of the company with a capital management firm. In general, I’d consider the $7/share offered in relation to the rest of the firm to be a fairly cheap acquisition.

Clearwater Seafoods (TSX: CLR), while not strictly going private, will effectively operate as such under Premium Brands (TSX: PBH) holding half the ownership while the Mi’kMaq First Nations will control the other half of the company. My assumption is the (relatively high) valuation paid has strategic value in light of the First Nations’ fishing rights – squeeze out the competition.

The last three are companies that are generally off the radar of most institutional investors. Makes you wonder if others are brewing – if your obscure company doesn’t get much love from the financial marketplace, why bother staying listed?

Genworth MI – now Sagen MI – going mostly private

This is nearing the end of the story for Genworth MI (TSX: MIC) – Brookfield is offering CAD$43.50 for the remaining 43% stake of the minority shareholders. In addition, they are ditching the Genworth name for Sagen (probably to remove any ambiguity with regards to their discontinued relationship with Genworth Financial). I don’t mind the name change, although I am confused whether it is pronounced with a soft or hard “g”.

Currently MIC shares are trading slightly higher than CAD$44, so there is some sort of anticipation of a minor sweetening to seal the deal (similar to what happened when Brookfield took over the minority stake of Teekay Offshore).

What is interesting is the following paragraph:

Following closing, Brookfield and the Company intend to continue to satisfy the public float requirement of the Insurance Companies Act (Canada) through the issuance of a new class of publicly-traded voting preferred shares of the Company, which preferred shares are intended to be issued prior to or concurrently with closing of the Transaction. A special resolution of shareholders to create this new class of voting preferred shares of the Company will be presented to Company shareholders for approval at the Special Meeting.

I do not know how this will work out in practice. I can’t think of any analogies of such publicly traded firms in Canada that have 100% of the common shares owned by one entity, but the voting rights remaining publicly traded – unless if the public listing is merely symbolic and does not actually trade in any volume. For instance, if the preferred shares have 0% of an economic stake and 100% of the voting rights of the company, what good is it if Brookfield owns 57% of these preferred shares?

In terms of valuation, in Q2-2020, the book value per share of MIC was $41.97, and on the income statement side, was supplemented by a combined ratio of 45%. Although there is a lag effect in terms of the loss ratio rising and an economic calamity (such as COVID-19), they are still minting plenty of cash. At the proposed CAD$43.50 price, shareholders are receiving a somewhat lower premium for their shares than what I would think is warranted, but this is typical to anybody that invests in an entity that Brookfield takes a bit out of – be prepared to get the short end of the stick, always.

I got rid of my shares of MIC in 2018 at a price slightly higher than the proposed takeover price, albeit I would have been a tiny bit richer had I held on – this was before the series of special dividends they declared in 2019.

This news also likely discontinues my coverage of the company – I have been writing about Genworth MI for over 8 years now. My first post about MIC was in June 2012, where I took a position at CAD$18/share. Fond memories.

Genworth MI Q4-2019: Adding the leverage

Genworth MI (TSX: MIC) reported their year end results last week.

Operationally they’re still minting a lot of money – loss ratio is 20% for the quarter, expense ratio is 20%, so they continue to earn 60 cents pre-tax for every dollar of insurance premium revenue they book. There doesn’t appear to be any storm clouds on the horizon.

An observation I will make is that with the new majority shareholder (Brookfield), they appear to now be deliberately targeting a higher return on equity policy. The company has been distributing a lot of cash in the form of special dividends:

During the fourth quarter of 2019, the Company paid a special dividend of $1.45 per common share, for an aggregate amount of approximately $125 million, on October 11, 2019 and a special dividend of $2.32 per common share, for an aggregate amount of approximately $200 million, on December 30, 2019. On January 15, 2020, the Board of Directors declared a special dividend of $2.32 per common share for an aggregate amount of approximately $200 million. This special dividend will be paid on February 11, 2020 to shareholders of record at the close of business on January 28, 2020.

In the span of a few months, the company has given off $6.09 in special dividends. Obviously I sold my shares too early! With these special dividends, however, the company is trading at about a 30% premium over book value, which is uncharted territory. Clearly given the cash generation capability of this business, it is likely to continue, but I have always wondered when there will be more competitive pressures in this market space – which if it occurs, will result in a dramatically reduced profitability landscape for the company. It won’t be triggered by the federal government – CMHC makes the lion’s share of the profit in this marketplace.

The company is obviously going to increase its leverage in the near future – on January 16, 2020 they took out a credit facility to allow them to borrow $200 million for a year, and another $500 million for 5 years. Part of this will be to rollover the $175 million in debt they have that will mature on June 15, 2020 but the remainder of it will probably head out the window in the form of special dividends so they can increase their return on equity from 11% to something higher.

Such strategies work until they start to face a large amount of mortgage claims whenever this near-mythical next recession occurs!