Performance Addicition

21 June, 2010 | Sacha Peter | No Comment

Article on the Financial Times – “How to best avoid performance addiction” which you might have to type into Google and click through there in order to get the full article. It describes how performance is the only barometer that most (retail) investors allocate capital, so when fund managers get money, they usually are already in quite “hot” sectors due to the prior years’ outperformance. A quotation is the following:

Most asset managers exhibit “enabling behaviours” that reinforce investors’ performance addiction by selling investment products on the basis of past – particularly short-term – performance. Although we all repeat the mantra that “past performance does not guarantee future success”, we still pay too much attention to performance.

…

Imagine a world in which every adviser and asset manager had to discuss three categories of investments with their clients: out-of-favour strategies worthy of consideration; high-performing strategies that continue to have legs; and “hot” performers that have had their run, from which investors should scale back their investments. It certainly would lead to rather different discussions than what typically occurs today.

Unfortunately I disagree with the conclusion. In the investment world, risk-adjusted future performance is everything. Risk-adjusted past performance is the only measurement tool. Note I mentioned the phrase “risk-adjusted” – a fund could have achieved a 1-billion-percent increase of capital by winning a $5 bet on the Lotto MAX (into $50 million) which would be very good fund performance, but the risk taken to get that performance was ridiculously stupid.

Most retail investors know nothing about performing this risk calculation when glossing through various promotional literature of mutual funds.

From an individual perspective, you should absolutely crave inefficient capital allocation (e.g. what we are likely seeing in the Vancouver Real Estate market). It causes less capital to chase other assets (which presumably will exhibit relative undervaluation) which you can snap up for cheaper prices. From a macroeconomic perspective, however, it is very unhealthy for economies to have significant inefficiencies, so when the focus of the speculative boom busts, you usually have to content with economic fallout (e.g. late 19th century/early 20th century railroad companies, mid 20th century automakers, the internet stock bubble, 2008 US real estate market etc.).

Posted in Economics | No Comments »

CRA Prescribed Rates – Update

20 June, 2010 | Sacha Peter | 3 Comments

Earlier I wrote about CRA Prescribed Rates and how they are used.

Given that it is nearing the end of June, the CRA has not published updated prescribed rates for the third quarter yet. They traditionally publish the next quarter’s rates at the beginning of the month before the next quarter (i.e. for a second quarter announcement, they would announce the prescribed rates at the beginning of March).

I would suspect they are doing this because they are planning on increasing the prescribed rate for interest on loans to 2% from 1% currently. They would want to give as little notice as possible of this, to avoid a scurry of people making quick 1% loans to avoid interest attribution.

So for those of you that take advantage of this process, I would highly advise you to get your paperwork prepared for a quick transaction at the end of June in the event that my suspicions are correct.

Posted in Canada, Taxation | 3 Comments »

First Uranium reports FY2010 annual report

20 June, 2010 | Sacha Peter | No Comment

First Uranium, which is a completely mis-named company in light of the fact that most of its revenues are derived from gold sales, reported its fiscal year-end report on a Friday evening. Note their calendar quarter ends on March, so FY2010 is April 1, 2009 to March 31, 2010.

While the company has been, kindly put, a basket case over the past year, the report does give glimpses that recovery is on the way. It has two primary operations – Mine Waste Solutions, which reprocesses previous tailings for gold (and uranium in 2012 and beyond), and this part of the business is quite profitable – about $22.8 million in profit from this operation and likely to increase in the future. However, the other project, the Ezulwini Mine, has suffered through massive setbacks and managerial incompetence and has lost about $63 million for the year.

First Uranium spent most of the first calendar quarter of the year getting rid of its management and restructuring its board of directors with people that seem to have extensive credentials in the mining business.

Most of the solvency concerns were alleviated with the March 2013 secured debenture issue, which will be listed on the TSX sometime in August.

First Uranium at this point becomes an interesting case on whether they can turn around the Ezulwini mine operation or not. From the MD&A:

The Ezulwini Mine has yet to build up sufficient production to generate positive operating cash flow. The production build-up to date has progressed much slower than originally anticipated due to a number of factors including:
- The estimation of gold available compared to the gold accounted for was significantly below expectations, a relationship better known as the mine call factor. The planned mine call factor for the year was 87% whereas the mine achieved a factor of lower than 70% during the first nine months of the year.
- The face length creation proceeded as planned but the start-up and conversion from development to stoping was slower than anticipated. Significant improvements are expected in FY 2011.
- The face length utilization was relatively low during the year due to the newly appointed mining teams as well as inadequate face equipping. Special attention is being paid to the training of crews and equipping of panels, thus mining readiness is expected to improve in the forthcoming year.
- During the fiscal year, some seismic activity occurred in the shaft pillar which caused delays but more importantly required special attention to resolve it in a safe manner. The extra precautions and diligence paid to rock engineering issues resulted in slower than anticipated performance in FY 2010. The majority of the engineering issues are now resolved, thus improved mining performance is expected.

The new management appears to know what’s going on, and they are performing a detailed bottom-up production plan which is apparently going to be ready by the end of June 2010.

On the equity side, FIU closed Friday at $1.25/share, and has 180.8 million shares outstanding. Factoring in the senior secured debentures converting at $1.30/share, this brings shares outstanding to 315.3 million shares.

I am not sure how much cash flow they can get out of Ezulwini even if they turn around the operation. The interest “bite” is not too severe – the unsecured debentures have $155M at 4.25%, while the seniors are approximately CAD$150 at 7%. It is likely if the common shares are trading higher than $1.30 by the time June 2012 comes rolling around that it will simply be a debt-for-equity swap which will make the unsecured debenture holders whole.

The unsecured debentures have turned very illiquid and have recently traded around 66-70 cents on the dollar. Assuming a purchase of 70 cents at the ask, you are looking at a 6.1% current yield and 19.5% annualized capital gain assuming a maturity payout at par. I do own these debentures, and think they represent a fairly priced risk. I still cannot recommend the common, although it could double or triple in value if the Ezulwini project does indeed turn around from the financially disastrous fiscal 2010.

If they managed to pull off a steady-state operation of about 250,000 ounces a year (note: far above 30,000 in the last year, geologist report has 5.2 million ounces over 18 years), at current gold prices that would suggest First Uranium would clear operational profits of roughly $80-100 million. Flow this and the Mine Waste Solutions project into the bottom line and you get a justification for a much higher stock price than present, even with all the potential future dilution – my paper napkin valuation model suggests around a $4-5 share price with a conservative valuation multiple. There are a lot of “ifs” and given the track history of the company, it’s no wonder that First Uranium equity is currently in the toilet – it indeed represents a large risk.

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Posted in Canada | No Comments »

Canadian Finance Links

19 June, 2010 | Sacha Peter | No Comment

I have been very slowly adding in links to my sidebar in the “Canadian Finance” category. The criteria are as follows:

1. The site author posts with his real identity;
2. The site’s focus is of a Canadian investor’s perspective and has decent content;
3. Site is focused more on fundamentals rather than technical analysis;
4. The site is not too “spammy”.

There are amazingly few sites out there that fit these criteria.

Posted in Links | No Comments »

What will the US do with Transocean?

18 June, 2010 | Sacha Peter | No Comment

Now that BP has effectively settled with the US Government to the tune of $20 billion and taking out their shareholders’ dividends for the next year, it leaves the question of how Transocean, the owner of the drill, will fare.

I’m guessing that the cessation of risk with BP’s settlement with the US government will not last too long when the government decides to go after Transocean for something. I don’t believe this is correctly priced in the market yet.

One of the smartest decisions Transocean made was relocating its corporate headquarters to Switzerland for tax reasons. Most of the assets of Transocean are international, and thus they can be shielded from US taxation. The ability of the US government to extort money out of Transocean is potentially more limited considering that the only active offshore drilling area in US waters is around the Gulf of Mexico.

I have a mental buy order where I will purchase shares of RIG, but it would require a price trend down in order for the market to reach it.

Fundamentally, the supply of crude oil is limited by the amount of drills available to do offshore drilling, and there are only a few companies on this planet that have the capability of providing such services. Until the field becomes saturated, lease rates should be substantially profitable for the players that are doing it and consequently the shareholders. Higher oil prices will also stimulate more demand for offshore drilling (as well as on-shore development) and are obviously more beneficial to those companies that have unmined oil reserves.

Posted in Equity | No Comments »

BP cuts dividend

16 June, 2010 | Sacha Peter | 1 Comment

BP has now cut its dividend:

As a consequence of this agreement, the BP Board has reviewed its dividend policy. Notwithstanding BP’s strong financial and asset position, the current circumstances require the Board to be prudent and it has therefore decided to cancel the previously declared first quarter dividend scheduled for payment on 21st June, and that no interim dividends will be declared in respect of the second and third quarters of 2010.

The Board remains strongly committed to the payment of future dividends and delivering long term value to shareholders. The Board will consider resumption of dividend payments in 2011 at the time of issuance of the fourth quarter 2010 results, by which time it expects to have a clearer picture of the longer term impact of the Deepwater Horizon incident.

The Board believes that it is right and prudent to take a conservative financial position given the current uncertainty over the extent and timing of costs and liabilities relating to the spill. BP’s businesses continue to perform well, with cash flows from operations expected to exceed $30bn in 2010 at current prices and margins before taking into consideration costs related to the Deepwater Horizon spill. BP’s gearing level remains at the bottom of its targeted band of 20-30 per cent. In addition, the Company has over $10bn of committed banking facilities. To further increase the Company’s available cash resources, the Board intends to implement a significant reduction in organic capital spending and to increase planned divestments to approximately $10bn over the next twelve months.

This decision has a double benefit to BP – first, it will provide them some mild political cover for not dishing out money to shareholders. In theory, this is a value-neutral decision since the company is effectively investing that capital into its liabilities (either related or not to the Gulf of Mexico oil spill). However, value funds and income funds will likely jettison BP shares for mechanical reasons.

The second benefit is that each quarterly dividend costs BP about $2.63 billion dollars – this money will shore up their balance sheet. Since they have some maturing debt that needs to be paid off, BP needs to conserve cash to avoid a short raid on their stocks and bonds – already their short-term maturities are trading around 7-8% yields to maturity when they should really be trading around 2-3% (i.e. nearly a “sure thing”).

For people that insist on getting into BP, the next couple weeks should be a good time. The exact timing in terms of price is an unknown variable, but I would estimate layering in 25-30 dollars a share (e.g. if it goes down to 28, you will get a 40% allocation).

There is also an off-chance that the US government will introduce some other hidden risk into the equation that would end up tanking the stock price. You would think, however, that most of the risk has already been introduced into the stock price.

Option fans should also consider that the implied volatility for BP is well into the 90′s (very high when compared to its price history).

Posted in Equity | 1 Comment »

Prediction: BP vs. Drillers

16 June, 2010 | Sacha Peter | 1 Comment

I have now been asked by many different people about the valuation of BP.

My response to them is the same as before: “I would not bother thinking about this [buying shares] until BP has cut their dividend.”

However, I will offer up a prediction:

Over the course of the next 2 years, $10,000 invested in BP (NYSE: BP) at the closing price of June 16, 2010 will under-perform $10,000 evenly invested in Transocean (NYSE: RIG) and Noble (NYSE: NE). Assume dividends are not reinvested and remains as zero-yield cash.

The analysis of BP has converted from a financial/resource calculation to purely a political risk calculation. The current US administration is very adverse towards their non-donor constituents and while BP has donated scalds of money to the Democratic party in 2008, it is very likely they will still be made into a scapegoat for the Gulf of Mexico oil spill.

I am very interested in the drillers, and I am waiting for one more “shoe” to drop before likely placing some bids. Implied volatility on Transocean would suggest that selling near-the-money put options is a viable strategy for entry, but I am waiting for a price drop before executing on that. This also goes outside of my “don’t invest in companies outside an English-speaking jurisdiction” rule, but there are times to make exceptions and it seems to be close to one.

I also notice that Canadian oil sands companies are getting quite a bid – I am guessing capital is flowing into the politically safe Alberta oil sands. Suncor and Cenovus are the big players here, although there are a couple interesting bitumen plays that have a smaller capitalization worth looking into.

All of these oil investments assumes an implicit risk that the price of oil will at least be stable or preferably increase.

Posted in Equity | 1 Comment »

Enhancements to CPP do not come free – comparing to USA Social Security

16 June, 2010 | Sacha Peter | No Comment

Earlier this week, the Minister of Finance stated that a substantial majority of premiers were amendable to a modest expansion of the Canadian Pension Plan.

Being active on the political end myself, most of the unionists that were at a public meeting on retirement income proclaimed their support to expand the Canadian Pension Plan. This positioning was undoubtedly due to their concerns that defined pension plans from sponsoring companies were only as good as the solvency of the company, while the Canada Pension Plan is effectively guaranteed by the Canadian government. Their arguments, generally summarized, is that the CPP benefit of (currently) $11,210/year is insufficient to live on.

An important point for people to remember is that the Canada Pension Plan, when instituted in the mid 1960′s, was never intended to be an income that people can live on. However, now there seems to be some sort of expectation that governments can fund people’s entire income requirements when they get older. Such expectations cannot be fulfilled without costs.

Already those costs have been reflected into the system. In the mid 90′s, there was a fundamental shift on CPP rates, increasing from 1.8% to 4.95% for both employees and employers. This allowed surpluses to develop and the management of a funded CPP that could compound asset growth and be able to better provide for the aging population.

Putting the CPP into raw numerical terms, if you earned a salary of $47,200 in 2010, you would contribute $2,163/year and your employer would contribute the same. CPP numbers are indexed to the consumer price index, so your contributions would go up over time (as well as your expected benefit when you start collecting CPP). If you work for roughly 35 years at this salary (you can exclude up to 15% of your lowest income-earning years for the purpose of the CPP calculation) you will receive a $11,210/year payment from the CPP until you die. Your spouse will also receive 60% of your CPP payment as a survivor benefit if you die earlier than he/she does.

Financially, this is a fairly raw deal. Pretending, starting at the age of 30, at that you would have put your 2x$2,163 contributions into an investment earning 5% a year. By the time you turn 65, you would have stored up about $414,600 on a pre-tax basis. While 5% interest on this amount alone would be about twice the maximum benefit ($11,210/year), even assuming you earned no return on the capital, you would still have about 37 years before exhausting your asset reserve. The advantages over the CPP are quite obvious.

Another way of looking at this is that you would need to repeat the same procedure at 3.62% return over 35 years in order to be able to create a $11,210 income for perpetuity. The easiest brain-dead way of doing this is investing in government of Canada 30-year bonds, currently yielding around 3.8%.

Anybody having the discipline of investing in very safe return securities should be able to replicate something better than CPP with the capital they would otherwise have contributed to CPP.

So with the proposed “modest expansion” of the CPP, I am guessing the government will propose a 25% increase in maximum CPP benefits, which would likely come with a 25% price tag increase in CPP premiums.

Maybe for people that are not financially sophisticated at all this would be a good option. However, for anybody with the aforementioned discipline, it is a bad deal. I would not consider this “robbery” or “taxation”, however – one of the benefits of having a relatively low payoff at the CPP retirement age is that the fund is solvent, which is more than can be said for USA Social Security, which is a complete financial write-off.

In the USA, for example, a person earning $47,300 a year and retiring at age 65 (note this comes with a penalty provision since their normal benefits begin at age 67) will earn roughly 50% more a year than somebody in Canada. Their premiums are 6.2% of the salary, about 25% higher, paid by the employee and employer, up to a maximum of $106,800. USA Social Security is funded by a trust fund, which the benefit provisions are purely paid for by current workers and does not have a build-up of assets. As a result, social security is very likely to either reduce benefits (by extending the age requirement, or clawing back high-income earners), raise premiums, or a combination of both. Canada is unlikely to do this.

Posted in Canada | No Comments »

Loyalty program points are subject to inflation

11 June, 2010 | Sacha Peter | No Comment

I note with amusement that Shopper’s Drug Mart is devaluing their “loyalty program” points by about 9-18%, effective July 1, 2010. I am sure there will be some sort of uproar about it.

Before, you needed the following points to redeem the following dollars:
7,000 – $10 (700 points/$)
15,000 – $25 (600 points/$)
30,000 – $55 (545 points/$)
40,000 – $75 (533 points/$)
75,000 – $150 (500 points/$)

Effective July 1, 2010 it will be:
8,000 – $10 (800 points/$) – 12.5% devaluation
22,000 – $30 (733 points/$) – 18.1% devaluation
38,000 – $60 (633 points/$) – 13.9% devaluation
50,000 – $85 (588 points/$) – 9.4% devaluation
95,000 – $170 (559 points/$) – 10.6% devaluation

Whenever dealing with any sort of currency, including “points” (of which the vendors have no legal requirement to redeem for any acceptable value whatsoever) you always have to be aware of its purchasing power and the chance that such purchasing power will decrease in the future.

I personally find it a pain to participate in any of these programs (who wants to keep extra cards in their wallet?), but there is a significant segment of the population that are actually influenced into making uneconomical decisions by offers of air miles or “save-on-more”. This is presumably why these marketing programs exist – to enhance lock-in of consumer dollars. For those that participate in it, it is best to cash out their holdings as early as they can since you will never see an increase in the purchasing power of your points – essentially, there is a negative interest rate on points earned through loyalty programs.

In the event of holding cash, Canadian dollars have inflated away over the past 96 years at the rate of 3.13% according to the Bank of Canada. If you wish to retain any sort of purchasing power, you are forced to invest your cash somewhere – at the very minimum, a short term high-yield savings account will help stem the decay of the purchasing power of cash.

There is no “investment” option with respect to loyalty programs, which is why points and perks for putting up with the hassle of these marketing programs should be cashed out immediately. If you do a lot of dollar volume business with a particular retailer offering such a program, it probably makes economic sense to sign up. However, it makes no sense whatsoever to not liquidate the proceeds when you can for something that you find useful.

Posted in Finance | No Comments »

When will the Lulu bubble burst?

10 June, 2010 | Sacha Peter | No Comment

People in and around the Vancouver area are probably quite aware of Lululemon, a marketing firm that sells retail apparel. Most people would consider them to be a retail apparel firm, but I would dispute this classification.

I have been watching this company since it went public, not because I ever intend to buy shares in the firm (or their clothing), but rather because it is a Vancouver-based business that has been insanely profitable and has done an incredible job permeating amongst my own age demographic.

Although I have very little intuition about fashion, I have studied the industry extensively and currently have some money where my mouth is in the form of a stake in corporate debt of Limited Brands (one major holding they own is the branding to Victoria’s Secret).

This morning, Lululemon reported their first fiscal quarter results. While I am less concerned about them beating or missing analyst estimates (they exceeded them) my focus is on their gross margins – 54% for this year’s quarterly result. This is a high gross margin for an ordinary clothing manufacturer, so they are adding much value on the marketing side and thus having their customers pay more for products that otherwise would cost the same to make.

Gildan Activewear, for example, has a gross profit of around 28% in their last quarter.

If you look at other firms to benchmark Lulu with (of which I will use Limited Brands, Abercrombie & Fitch and Nike) – Limited’s after-Christmas quarter reported gross margin of 36% (which includes “buying and occupancy” costs), while Abercrombie’s gross margin was 63% (strictly on “cost of goods sold”, not including store and distribution expenses), and Nike’s is 47% (albeit for the Christmas quarter, but their yearly results are comparable to this). If you were able to drill into the numbers and make them on an equivalent basis (which is not very easy to do when mining the details of the company’s detailed quarterly reports that they externally report), the profitability of Lululemon is not that much higher than equivalent (i.e. “high-end”) and established US corporations.

So looking at a relative valuation basis, you now have the following (not factoring in Lulu’s recent quarter):

LULU – Market cap $2.8 billion, TTM revenues $453M, net income $58M; (cash: $160M, debt: $0)
LTD – Market cap $8.0 billion, TTM revenues $8.84B, net income $558M; (cash: $1.7B, debt: $2.8B)
ANF – Market cap $3.1 billion, TTM revenues $3.01B, net income $90M; (cash: $633M, debt: $71M)
NKE – Market cap $34.8 billion, TTM revenues $18.65B, net income $1.73B; (cash: $4.0B, debt: $0.6B)

This very brief comparison gives me the belief that Lululemon is being valued as a marketing company (like Nike) rather than an “high-end retail” apparel company (like Limited and Abercrombie). It is also much, much differently valued than a “commodity clothing” firm like Gildan (which does not have a direct retail presence).

The most cursory glance at the financials would lead one to believe that if you were to believe that LULU was a “buy” at the moment, they would have to grow, considerably, into their valuation even to make it comparable to Nike’s valuation level. Assuming a “steady state” valuation of 20 times earnings and/or 2 times sales, you would have to extrapolate Lulu growing their top line at 30% a year for roughly 5 years with the share value being roughly the same as it is now.

Even though in the last quarterly result they grew their top line 70% over the previous year, it is very difficult to swallow a company’s shares thinking that they have an implicit requirement to grow their sales from $450M/year into $1.4 billion just to cut even. Will they do it? Who knows. But the level of baked growth makes the stock look very risky for the reward offered – if they have one misstep, they will see a 2008-style haircut. It won’t be nearly as bad as the 90% cut from the 2007 highs, but it will be considerable.

Posted in Canada, Equity | No Comments »

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