Overall market thoughts – volatility – fossil fuels

This is another rambling post with no coherency. The quarterly reports from companies are flowing in and I am reading them – but there are few companies that are below my price range where I start to care about them in detail. As such, my research pipeline at this point is in the exploratory mode rather than doing detailed due diligence.

It is in the middle of summer and I am not expecting much in the way of volatility – it is truly a summer where major portfolio decision-makers have decided to take away from the trigger switches.

Accordingly I have been sitting and watching with respect to my own portfolio while I do my casual research. Probably my biggest error of omission was watching the solar market rise over the past six months – I’d written them off, along with almost everybody else, as languishing when the price of fossil fuel energy dropped. A lost opportunity there – there was one company in particular which I earmarked, financial metrics looked great, but didn’t even pull the trigger, primarily due to insider selling. If I executed correctly on it, I would have been looking at a double now. Oh well.

An equity chart that caught my attention was the high expectations of investors of Canaccord pulling a great quarter, which came nowhere to fruition:

This is very obviously the chart of expectations crushed after a quarterly report – a regression to the recent mean would suggest a $4.50-ish stock price. I also notice their domestic competitor, GMP, being crushed after their quarterly report.

I also notice most liquid fossil fuel companies are getting hit badly and are close to multi-year lows. In the USA, most of the companies receiving boosts are the ones that have had been relieved of their debt burdens through the Chapter 11 process (LNGG is a great example of this). I still don’t think equity holders of fossil fuel extraction companies are going to be too happy over the next 12 months.

I also took notice with Interactive Brokers, and Virtu’s commentaries with respect to Q2-2017 as being one of the lowest volatility environments possible – they are two types of businesses that generate revenues as a function of trading volumes. Volatility correlates negatively with an increase with the broad markets – I am looking for defensive-type companies that will do okay in an environment like present, but will really do well when volatility increases.

Interactive Brokers is a classic example of a great company (they are the best at what they do by a hundred miles over everybody else), but one who’s stock I am not interested in buying at current prices.

Mostly everything in the Canadian REIT sector seems to be over-valued. An interesting trend is that the downfall of retail is somewhat being projected by RioCAN’s chart – trading below book value, it might seem to be an interesting value, but are they able to keep up occupancy and lease rates to businesses that have to compete against Amazon? The residential darling of the market is Canadian Apartment Properties (CAR.UN) but they are most definitely not trading at a price that would suggest a future performance beyond a high single digit percentage point and this is under the assumption that their real estate portfolio asset value remains steady. Trading in the entire REIT sector seems to be entirely yield-focussed which is never a good basis to invest, but it is a good basis to evaluate other investors’ expectations on these entities.

Gold has also been up and down like a yo-yo and might be an interesting bet against dysfunctional monetary policy. Unfortunately my ability to analyze most gold mining firms is generally not that fine tuned.

The liquidity of my overall portfolio is very high (nearly a quarter of the portfolio is collecting dust at a short duration 1.5%), but right now I don’t see much investment opportunity that would suggest avenues for outperformance. I could shove the money into some sub-par debenture (e.g. TPH.DB.F which buys you a 7% coupon until March 31, 2018 maturity) but do I really want to lock my capital into something that is questionable? It is the literal metaphor of picking up pennies in front of a steamroller. My policy is that if I have to force my money to work, chances are the investment decision’s risk/reward is worse than if I just held it in cash and waited for some sort of crisis to hit. I generally define “crisis” as something that will take the VIX above 30%, but it has been awhile since we last saw it:

It is pretty ironic how the election of Donald Trump was foreseen by most pundits to be the end of the world and higher volatility times, but so far the opposite has turned out to fruition. Will it continue? Who knows.

I see a lot of people making the mistake of impatience, and also the mistake of assuming that the index ETFs that they are investing into (Canadian Couch Potato, etc.) will leave them safe through masked diversification – works great as long as there are net capital inflows, but what happens if there is a correlated bust among these products? Will retail continue their conviction when they see a 10% drop in prices, or will they grit their teeth and add to their positions?

I continue to wait. It might be a very boring rest of the year with very limited writing. If you think you’re in a similar predicament, I’d love to hear your comments below.

KCG Holdings merger arbitrage and should I invest in Virtu?

KCG Holdings (KCG) is due to be bought out by VIRT for $20/share cash. The meeting for KCG shareholders to approve is on July 19 (which at this point is practically a done deal). Over the past two days we had the following trading:

See that spike up to $20/share at the end of yesterday’s trading? I wasn’t expecting that! It is not financially rational to purchase shares at $20 unless if you believe there will be a higher bid for the company. At this point, however, a successor bid is simply not going to be happening.

A more reasonable $19.98/share means a 2 cent premium obtained over a week, which works out to about a 5.2% simple interest rate, assuming no trading costs.

I had some July call options so I figured it was a good time to dump the remainder of my shares into the market. There was a legal complication from one of the class action lawsuits that might require the company to obtain a 2/3rds shareholder vote of all non-insider owned shares and considering the general apathy of voters these days, that is not a threshold that I would want to bet my kidneys over.

Once the merger is completed then KCG’s senior secured bonds will be called away (at 103.7 cents on the dollar, while my purchases were a shade above 90 cents) and that will conclude one of the better investments I’ve made over the past 5 years. It took a lot longer to happen than I anticipated – had it occurred at select points over the past 5 years I had even higher amounts of leveraged option positions on this company (which sadly expired).

One thing I will miss about these bonds is that the 6.875% coupon I was earning was virtually guaranteed money to maturity. I will no longer see that.

The analysis for VIRT is a little more muddy – I expect some serious integration pain to occur after the merger is finished.  In the definitive proxy statement materials, however, I was very intrigued by the following table which illustrated the financial projections of a management restructuring:

So in the above, we had management projecting a 2019 estimated free cash flow of $132 million, which appeared to be sustaining for future years. This worked out to about $2 per KCG share, which VIRT is now purchasing for 10 times earnings.

Management projections are always on the optimistic end of things, so this is not likely to materialize as presented, but it still makes one wonder whether VIRT is worth investing in or not. I do not like their corporate structure (public shareholders have no control over the company and a vast minority of the economic stake of the firm) and I am inclined against it.

KCG cost of capital calculation

I will warn this is a very dry post.

The merger arbitrage spread with KCG has narrowed considerably.

When the $20 cash merger was announced the shares were trading at $19.75. There is little chance of the deal falling through or there being a superior offer.

Today KCG is trading at $19.88. The estimated close of the merger was reported to be “3rd quarter 2017”. The assumption is the mid-range, or August 15, 2017.

So there are 3.5 months until the deal closes.

12 cents appreciation is 0.6% over 3.5 months, which over the course of 3.5 months implies a 2.1% annualized rate, not compounding. This also excludes trading costs.

Because I had a small cash deficit in my USD account and a surplus in CAD, I’ve sold some shares at $19.88 to make up the shortfall. I placed it at the ask to minimize trading costs, which turned out to be 29 cents per 100 shares.

What’s interesting is my trade got hammered away, 100 shares at a time, approximately 2-4 seconds apart per trade. Interesting algorithms at play here.

I also believe Virtu (Nasdaq: VIRT) will have a more difficult time with the integration of KCG than they originally anticipate. The company cultures are significantly different and while the merger makes sense on paper, in practice it is going to be quite different. KCG was also dealing with a non-trivial data migration program on their own, from New Jersey to New York City and these sorts of technical details require highly skilled individuals to pull off without causing trading blow-ups. It might take them a year to get things stabilized after the merger is finished. KCG had huge growing pains of its own after it was reverse-takeovered by GetCo.

KCG Holdings: Bought out

KCG Holdings (NYSE: KCG) looks like it will finally be bought out by Virtu (Nasdaq: VIRT) for US$20/share, cash. They also announced their first quarter results, and according to my scorecard they did better than expected – while their bottom-line net income was slightly negative, they were significantly better on trading revenues than I was expecting. I was expecting a very lacklustre quarter due to incredibly low market volatility in the quarter. Interactive Brokers (Nasdaq: IBKR) is a regular conference call I read and they can attest to the impact of low market volatility on trading.

My investment history with KCG is quite fascinating. I did not disclose things here until October 2016, but I have been trading the stock at various times since 2013, which resulted in material performance gains, especially in 2013 (I took a fairly heavy call option position at the second half of the year). It has exhibited a narrow price range since its merger with GetCo after their August 2012 trading blow-up. The company has generally been off the radar of most investors as it received little analyst coverage and was treated like toxic trash.

Virtu has a plan to raise $1.65 billion in debt financing for the merger and also has sold $750 million in equity at $15.60/share, which should make the buyers happy considering they are now trading at $16.40/share – the market believes this will be quite valuable for Virtu. KCG’s existing 25% shareholder has consented to the agreement, which makes it very unlikely that the deal will not pass through KCG shareholder approval. Given the highly strategic nature of the acquisition, I also doubt there will be other competitors for KCG. Thus, this merger looks like a done deal.

Current trading is at US$19.75. The expected closing is in the third quarter of 2017. As the current spread between market and US$20.00 is around 127 basis points, this would imply a merger arbitrage spread of about 3.8% annualized, so I am in no rush to sell as I have nothing else to deploy my capital into.

The only other issue of concern is KCG’s senior secured debt, maturing on March 15, 2020. According to the fine print, the notes can presently be called off at 103.438 cents on the dollar and there is a required offer for 101 cents on the dollar due to the change of control (which would be redundant since the notes are trading over this in the marketplace). I would suspect Virtu would be eager to get these notes off the books as quickly as possible as they contain covenants that would otherwise restrict the KCG entity. I’ll hold onto these as long as possible but do not think they will survive much longer.

KCG Holdings – Takeover bid from Virtu

The Q1-2017 report is going to be shockingly positive. Genworth MI (TSX: MIC) used to be my largest holding, but I have trimmed the position (mainly for diversification and deleveraging reasons). It still is a decent size of the portfolio, but not as prominent as it used to be.

My largest position after Genworth MI was KCG Holdings (NYSE: KCG).

Yesterday, near the close of trading, they confirmed that they received an unsolicited takeover proposal of US$18.50-20.00 per share from Virtu (Nasdaq: VIRT), another (very credible) high frequency trading firm. KCG did not file with the SEC.

Virtu filed 8-K with the SEC confirming they “made a preliminary, non-binding proposal to acquire KCG”.

Both entities have been quite silent otherwise. There is likely a lot of backroom jockeying going on.

KCG’s stock shot up from about $13.60 a share to $18/share today on over 6 million shares of volume. The company has about 66.4 million shares outstanding, and Jefferies (a wholly owned subsidiary of Leucadia (NYSE: LUK)) owns 15.41 million shares, and insiders own another 3 million shares, leaving a float of about 48 million shares that can be actively traded. 6.65 million shares traded today and suffice to say there is quite a large amount of speculation about what is going to happen.

My take on the matter is the following (in no particular order):

1. Tangible book value of KCG Holdings is $18.71/share as reported in their 10-K filing. A US$18.50 takeover price would allow Virtu to effectively take over KCG for free. This is the primary reason why I wouldn’t think this takeover would go anywhere as-is. My guess is that if Virtu was serious they would have to offer some equity as well, or some sort of premium to book value.

2. Virtu is a logical strategic acquirer to KCG – the synergies are quite obvious to both businesses. There might even be anti-trust issues with this acquisition.

3. Even though the acquisition at the low price range would be “free” for Virtu, it leaves the question of how they would immediately finance it.

4. The Jefferies control block is vital to the situation – if they can be persuaded to sell out, then management will likely have to follow. The question is whether they are motivated to sell out or not – obviously they will at the right price, but US$18.50 is too low.

5. The CEO was granted a huge amount of options at $22.50/share (priced well out-of-the-money at the time of the grant) and probably doesn’t have much of an incentive at this point to selling out the company for cheap.

6. Operationally, KCG is treading water in terms of cash flow, but this is because of unprecedented low market volatility conditions that is practically the worst environment for the firm (and also Virtu). In more normal conditions, one could easily estimate a value of US$25-30/share for the firm which is where I think management is targetting. They’ll probably sell out at 24ish if the bid got there.

7. Who leaked this unsolicited offer? Obviously KCG did – probably trying to drum up any counter-proposals out there as there are some other financial institutions that would be interested in acquiring the business. Perhaps management knows the end-game is nearing and this was a last ditch attempt to prevent a forced merger.

The decision forward is a high-stakes game for a lot of participants!

Disclosure: I own common shares of KCG, call options, and also their senior secured debt. Sometimes you really do hit the lottery in the marketplace.