A little bit of QT – and general economic thoughts

The whole financial sector of the country knows that the Bank of Canada dropped interest rates by a quarter point a few days ago (from 5.00 to 4.75%). Those holding floating rate debt will see a little bit of alleviation of expenses, and those holding CASH.TO and the like are seeing their risk-free rate drop – nudging the capital further right along the risk spectrum.

However, the overall picture of the inverted yield curve has not changed –

It is still deeply inverted, with a 125bps spread between short and long term yields.

The transmission rate of dropping interest rates (or raising them) and the impact on the real economy is a very slow process – the literature cites around 12-18 months before the full impact of rate hikes and drops come into play. Entities look at their cost of capital and decide to invest or not in projects (e.g. residential strata condominiums or chemical factories) that have a five year development cycles and when the decision is made, the economic impact occurs well into the future. It is not like you can order one of these on Amazon and get it shipped in a day!

You can infer this by looking at employment statistics. Why is construction labour down about 34,700 jobs year-to-year? Major capital projects are running off the ledger (e.g. TMX is finished, Coastal Gaslink is nearly done, etc.) and the decisions to do residential construction occurring in cities were made in 2021 when rates were at rock-bottom and these projects are just completing now. The only sort of capital projects are are hitting the “buy” button are government works – except these are all running into massive cost overruns (e.g. using some BC examples, the Site C dam, the Metro Vancouver sewer plant, any hospital project, the Broadway Skytrain project, etc, etc.). Only government projects are allowed to have any amount of money thrown at them for completion – and this of course attracts contractors like a moth next to the flame. When your competition is able to spend infinite amounts of money, what makes you as a private developer, able to compete for those services? No chance at all – hence cost inflation. With your cost of capital is still relatively high, there’s no avenue for profit.

Finally, I will observe that the progression of quantitative tightening, albeit very slow, is still progressing – the following chart is the “Members of Payments Canada” line item on the liabilities ledger of the Bank of Canada:

The last slab of QT took the “Members of Payments Canada” line item (which is a measure of reserves the financial institutions have with the Bank of Canada) below $100 billion for the first time since the Covid-19 pandemic. As the current $248 billion stack of government bonds, mortgage bonds and provincial bonds get bled off of the Bank of Canada balance sheet, there will be a corresponding drop in bank reserves held at the Bank of Canada. This is not a fast process – $15 billion is scheduled to mature in the remainder of 2024, while $32 billion is slated for maturity in all of 2025. While QT is still ongoing, it is at a glacial pace – hence, “a little bit of QT”.

My reading of the tea leaves makes me suspect that the Canadian currency is going to get pushed down further in relation to the US dollar. Canadian exporters should benefit from the upcoming shift. I also do not view this as beneficial for the domestic economy. There is not a lot of safety out there and cash continues to earn a very good risk-free rate while patiently waiting for the capital values of various entities out there to implode in some sort of panic (the last one being 4 years ago with Covid, although I am not anticipating anything with that magnitude happening again in my lifetime).

The only question that remains is whether we will see a bounceback in inflation. Given the million+ increase in demand for housing in urban areas without a corresponding increase in supply, I do suspect that the most heavily weighted component of the CPI will continue to exhibit an increase. A lower Canadian dollar will also result in costlier imports. Finally, labour inputs are also increasing – wage growth provisions in contracts are rising and here in BC, minimum wage is now $17.40/hour – and correspondingly, your “extra value meal” at a fast food joint is now at least $10, and that’s with a coupon! The wage-cost spiral is a very difficult one to break without a deep recession.

It is difficult to passively wait, but I don’t see the risk/reward for moving up the risk spectrum that good right now. Even the oil and gas sector in Canada with current commodity prices are trading at valuations that are “blah” rather than being a great value.

Any sectors out there getting your attention?

Dollarama – Valuation

Dollarama (TSX: DOL), the dollar store that is all over the place in Canada, came up on my investment radar during a screen. I last looked it many years ago, and obviously I would have done very well had I just bought it, but even back then I recall thinking the stock was over-valued. Shows you how little I know!

The following is a snapshot from their last fiscal annual result ending January 2024:

Some quick thoughts:

* Dollarama is one of the few retail segments that can effectively compete against Amazon, hence its ability to retain its margins is relatively good;
* They seem to out-compete other dollar store chains as well;
* Somehow they manage to successfully compete against the Loblaws (TSX: L) and Soebys (TSX: EMP.A) discount chains (No frills, Freshco, etc.);
* How many stores can they possibly run in Canada? 1,551 is the current number, what is the saturation point;
* Net operating margins (before taxes and interest expenses) of 25.5% – pretty damn good! Up from 23.6% in the previous year!
* Expansion out to South American in a 50.1% owned subsidiary of the company gives them more runway, but the dynamics of that market remain to be seen.
* Company is goosing up its stock price with buybacks – 7.12 million shares at $92/share

… the valuation currently is a share price of $118.32 over a $3.56/share, relatively “clean” net income, balance sheet not too levered (2x net income) with expansion expecting to increase the bottom line. DOL is trading at 33x trailing earnings, but ultimately the question here is – when do we get to the point where the entire world is flooded with these types of shops and margins come down or expansion simply stops? Dollar General (NYSE: DG) is the big fish in the USA (sales are about 10x that of Dollarama) and their operating margins are 6.3% and well down from 8.8% in the previous year! DG had quite a fall from grace, with their stock falling about 60% from their peak before they started to recover. While the market in Canada is a different (we tend to have less competition), it would not shock me if their stock had a similar change in fortune. The price being paid for shares is very high and assumes a significant amount of growth well into the future. Don’t get me started on the valuation of Costco, a retailer that I love with a stock I would never touch!

Slate Office REIT – The next episode of boardroom drama

Continuing on from my April 19, 2024 post about the board room and proxy drama occurring at Slate Office REIT, we have the following developments:

April 20, 2024 – an incumbent trustee decides to not run again, and in replacement Armoyan’s nominee is put forward (Scott Dorsey).

Following receipt of the Notice, Lori-Ann Beausoleil advised the Board that she is declining to stand for re-election to the Board and tendered her resignation as a trustee of the REIT effective May 2, 2024 and, thus, will not be standing for re-election at the Meeting. Following unsuccessful attempts by the REIT to come to a cooperative outcome with Mr. Armoyan, and in light of the resignation of one of the Board’s nominees for election at the Meeting, on the recommendation of the Governance Committee, the Board resolved to nominate Scott Dorsey in place of Ms. Beausoleil and to add Mr. Dorsey to the REIT’s slate of management nominees to be considered for election as trustees at the Meeting. Mr. Dorsey is also one of the individuals put forward by Armco.

April 24, 2024 – another incumbent trustee, Jean-Charles Angers, decides to not run again (obviously knowing that the writing is on the wall and he would not win a seat).

May 2, 2024 – Slate reports their quarterly result, a rather tepid quarter. FFO and AFFO is roughly $4 million. Loan-to-value still hovering around 68% and interest expenses creeping higher. They are basically continuing their slow fire-sale of properties to try to deleverage.

May 3, 2024 – AGM day! Voting results:

Brian Luborsky and Scott Dorsey and Sam Altman were endorsed by Armoyan.

And finally, after the vote…

May 8, 2024 –

Slate Office REIT (TSX: SOT.UN) (the “REIT”), an owner and operator of high-quality workplace real estate, announced today that Scott Dorsey has informed the REIT that, for personal reasons, he is unable to serve as a trustee on the REIT’s board of trustees.

What??? Who strong-armed him into leaving Slate with a five-trustee board?

Practically speaking, it appears the George Armoyan takeover of Slate Office REIT is nearly complete. The question at this point is what he can salvage from the entrails of this debt-laden entity before it will have to go through some inevitable recapitalization.

Berkshire / Apple

I rarely write about Uncle Warren, but when he makes moves, he picks them really well. Burlington Northern at $100/share was a stroke of very well-timed genius, and even more for him, I am still amazed by his Apple trade he made between 2017-2018, which was a slow and steady accumulation of a huge stake. Don’t get me wrong, he’s had his fair share of disasters (Airlines pre-Covid, for example), but for the most part his investment successes have massively overshadowed his failures.

Warren Buffett’s final cost base on his Apple shares as reported on December 31, 2018 was $35.30/share (he paid $36.044 billion for 1.021 billion shares, split-adjusted). He sold a hundred million shares by the end of 2020, ending with 907,559,761 shares of Apple at an average of $34.26/share. Prior to today’s announced divestment of 13% of his stake, those shares at $180/share amounted to $163 billion. The unrealized gain that he was sitting was $130 billion. So his 13% liquidation nets him about $21 billion and he can offset the capital losses on his Paramount trade which fizzled.

He still has a stack of $142 billion in Apple stock which, needless to say, is still a lot of capital tied up in a single company. There are competing interests that Buffett is facing – one is that the concentration risk of Apple in the overall Berkshire portfolio is massive. Two is that he does not want to give up on the tax deferral value of the unrealized gain (which is likely why his choice to recapture the losses from Paramount was to diversify out of Apple first before anything else). Three is that Berkshire is facing a lack of reinvestment choices – apparently their cash stack is now up to $188 billion and just the interest alone on this, if invested in 5% short-term government bonds, would be around $9.4 billion dollars annually.

Apple reported a diluted EPS of $3.71/share for the past six months (October 1, 2023 to March 30, 2024). This puts Apple at around a P/E of 25 and I bet you Buffett is looking at the announced additional $110 billion share purchase authorization (making it a total of about $140 billion at the end of March 30, 2024) and will be dumping into it further over time.

While the Apple franchise will continue to make a lot of money, the stock is another matter – I personally think it is about 40% over-valued. The company seems to be very happy to buy back their overpriced shares – they bought back 130 million shares in the past three months at $180 a piece, and this is likely to continue for future quarters – this demand pressure on the stock will keep its value artificially inflated until economic and technological headwinds take it down further.

Slate Office REIT – attention to details

It looks like things are getting heated in the board backroom of Slate Office REIT (TSX: SOT.un). 17 days before the scheduled Annual General Meeting, George Armoyan decided to let loose a proxy solicitation to install two additional directors out of six. If he won, including himself, that would constitute a board of six directors – George himself, two controlled by him, two directors (the co-founders, who are brothers) and an independent.

To take action this late in the game suggests that there was some sort of board decision that pissed him off.

Armoyan controls 17.7% of the units, or 15.1 million units of Slate, which gives him huge sway considering that only 36 million units voted on the resolution to increase the gross book value to debt ratio of 65% earlier this year. When adding the 1,123,880 units that one of the director nominees owns, it’s a near majority. 32 million units voted in the 2023 annual general meeting. It’s quite likely that Armoyan will find at least a million or so disgruntled Slate Office holders to vote in his direction to put him over the top.

Part of the previous vote was a consent to decrease the board size from 8 to 6 trustees, which means there are less people for him to take out. If he is successful, he will effectively have at least a veto on every decision from the board, which is close enough to having control of the entire operation.

I do note, however, when reading the proxy solicitation statement, that it must have been hastily constructed. Witness the following from their proxy solicitation:

On the bottom, “PROTECT YOUR IVESTMENT IN SLATE OFFICE REIT”. Not the greatest look for the professionalism of Morrow Sodali, the firm being engaged to solicit the proxies.

Perhaps they all just need to hold on until after June 25 before going into CCAA – at least when everybody disposes their units for zero, they get 2/3rds and not 1/2 inclusion on the capital loss. To be clear, this was a joke and not a prediction although the last financial statement released by the trust is not looking that good!