Divestor Canadian Oil and Gas Index – Re-balancing Policy

The Divestor Canadian Oil and Gas Index (DCOGI) was created on February 5, 2021. You can view the index here.

Currently the DCOGI is up with a total return of 72%, with the nearest ETF comparators, XEG, ZEO and VCN, up 61%, 45% and 17%, respectively.

In the initial index construction, there was no contemplation of re-balancing or re-investment of dividends.

So far, the index has accrued 3.4% of its initial value in the form of cash and by year-end this will be around 3.5%. Likewise, XEG/ZEO/VCN will have accumulated substantial cash on their notional accounts.

Accordingly, I will be revising the reinvestment policy to a yearly deployment of accumulated cash.

On the first trading day of the year (January 4, 2022), the accumulated cash will be re-deployed in the 9 constituent components in the proportion of the original index construction.

As a reminder, this is:

20%: CVE, CNQ, SU
10%: TOU, WCP
5%: ARX, BIR, MEG, PEY

The opening price will be the price received on the dividend reinvestment. This also applies to XEG/ZEO/VCN, where cash dividends accumulated in the year will be applied to their own units to the maximum extent possible. This will happen on an annual basis going forward.

Also, at this time, while it has not occurred yet, if there is a merger/acquisition of one of the constituent components that involves an election, the election will be as equity-oriented as possible. If a DCOGI component is removed as a result, any future re-investment will be proportionate to the remaining components. If a merger results in a new component to the index, it will be included to the extent of the predecessor component as long as the entity is Canadian. I do not foresee a foreign entity acquiring any of the 9 DCOGI companies anytime soon, but if a successor entity is foreign, it will be sold at the opening of the first day of the completion of such merger.

The power of reinvestment and compounding returns

This post should not be news for anybody in finance, but it is worth refreshing fundamental principles of compounding and equity.

The most attractive feature of equities vs. debt is the effect of compounding. Stocks can rise infinitely while bonds have an effective price cap at the risk-free rate of interest.

To get on the equity gravy train and make outstanding returns, you need to have capital invested in a business with great prospects for reinvestment.

We will use an example of a debt-free company earning a perpetual $10 per year on a $100 investment, but the investment is of a style that does not scale upwards with further reinvestment. The long-term risk-free rate of interest is 2%. Our dream world also does not have income taxes or management expenses.

In this instance, the company can choose the following policies (or a blend thereof):
1) Give the money back to shareholders.
2) Bank its cash and receive 2% on that capital,
3) Speculate on other (preemptively higher-yielding) ventures.

If the policy option is (1) then in theory the valuation of this firm will be $500 (the risk-free rate of interest). The company will still generate $10/year for its shareholders whether the valuation is $100 or $500. An investor would be indifferent to sell the business for $500 and invest in the risk-free bond or just keep holding onto the business – you have magically created $400 of capital profit and you can clip dividends or bond coupons. With your $10/year you can do what you please, or put it in a risk-free 2% yourself.

This example is a constraint of reinvestment – after the re-valuation, your equity has effectively turned into a bond with no chance of compounding beyond the risk-free rate of interest.

If the policy option is (2) then you will see your returns in the appreciation of equity value. After the first year, your firm will generate $0.20 more in income and this will translate into $10 extra equity value, and this will compound at the rate of 2%.

Policy option (3) introduces the concept of risk – can management pull off the reinvestment? If there was an attractive investment at 5%, they would be able to generate $0.50 extra and this would translate into $50 of extra equity value for its holders, again, capitalized at the 2% risk-free rate.

So far we have made the assumption that the equity value follows lock-step with the risk-free rate of return. Of course in the real world, it never works that way and there are wildly divergent capitalization percentages used.

What is interesting is in this fictional example, the results you get if the initial equity investment does not trade at the risk-free return rate, but rather it trades at a higher rate, say 5%.

In this instance, the company would trade at an equity value of $200.

We will then consider a fourth policy option with the generated cash returns:
4) Buy back your own stock

This option requires a willing seller to the company (something that isn’t available to a 100% wholly owned firm!). Passing that assumption, an incremental deployment of $10 into the company’s own stock (a 5% reduction in shares) would result in continuing shareholders receiving 5.3% more returns in the future. Shareholders as an aggregate will still receive $10/share in returns, but the return per share will be 5.3% higher than before due to the reduced shares outstanding. This is a far better outcome than policy option (2).

The principle is the following: If a company is earning sustainable, long-lasting cash flows, it is to the benefit of shareholders that either the inherent business of the company has a capital outlay that offers higher returns on capital OR failing that, that the market value of the company’s equity is low to offer another conduit for reinvestment. Barring these two circumstances, returns should be given out as dividends.

This is unintuitive in that sometimes companies engage in really destructive practices with share buybacks. They are not universally good, especially if the future cash generation of the business is spotty. Likewise there are circumstances where buybacks work to massive benefit (a good historical example was Teledyne). However, in all of these cases, investors must possess a crystal ball and be able to forecast that the cash generation of the existing business (in addition to any other potential future capital expenditures) will be sufficiently positive over the required rate of return.

For example, Corvel (Nasdaq: CRVL) has a very extensive history of share buybacks:

The Company’s Board of Directors approved the commencement of a stock repurchase program in the fall of 1996. In May 2021, the Company’s Board of Directors approved a 1,000,000 share expansion to the Company’s existing stock repurchase program, increasing the total number of shares of the Company’s common stock approved for repurchase over the life of the program to 38,000,000 shares. Since the commencement of the stock repurchase program, the Company has spent $604 million on the repurchase of 36,937,900 shares of its common stock, equal to 68% of the outstanding common stock had there been no repurchases. The average price of these repurchases was $16.36 per share. These repurchases were funded primarily by the net earnings of the Company, along with proceeds from the exercise of common stock options. During the three and six months ended September 30, 2021, the Company repurchased 165,455 shares of its common stock for $25.6 million at an average price of $154.48 per share and 284,348 shares of its common stock for $39.8 million at an average price of $139.81, respectively. The Company had 17,763,576 shares of common stock outstanding as of September 30, 2021, net of the 36,937,900 shares in treasury. During the period subsequent to the quarter ended September 30, 2021, the Company repurchased 49,663 shares of its common stock for $8.7 million at an average price of $176.02 per share under the Company’s stock repurchase program.

We look at the financial history of the company over the past 15 years:

This is a textbook example that financial writers should be writing case studies about up there with Teledyne (NYSE: TDY) as this has generated immensely superior returns than if they had not engaged in such a buyback campaign. Share repurchases made over a decade ago are giving off gigantic benefits to present-day shareholders and will continue to do so each and every year as long as the business continues to make money.

The question today is whether this policy is still prudent. The business made $60 million in net income and there stands little reason to believe it will not continue, but should the company continue to buy back stock at what is functionally a present return of 2%? The business itself cannot be scaled that much higher (they primarily rely on internally developed research and development expenses and do not make acquisitions).

It only makes sense if management believes that net income will continue to grow from present levels. One has to make some business judgements at this point whether the company will continue to exhibit pricing power and maintain its competitive advantages (in this respect it looks very good).

Another example we are seeing in real-time is Berkshire (NYSE: BRK.a) using its considerable cash holdings to buy back its own stock. In the first 9 months of this year, they have repurchased just over 3% of the company. There’s more value right now in Berkshire buying its own massively cash-generating options than there would be on the external market – the last major purchase Berkshire made was a huge slab of Apple stock in 2017/2018 which was a wildly profitable trade.

In the Canadian oil and gas industry, right now we are seeing the major Canadian companies deal with the first world problem of excess cash generation. They are all in the process of de-leveraging their balance sheets and paying down (what is already low interest rate) debt, but they are also funneling massive amounts of money into share buybacks.

For example, Suncor (TSE: SU) and Canadian Natural (TSE: CNQ) are buying back stock from the open market at a rate of approximately 0.5% of their shares outstanding each month. Cenovus started their buyback program on November 9th and intends to retire 7% of shares outstanding over the next 12 months. The financial metrics of these companies are quite similar in that with oil at existing prices, an investment in their own stock yields a far greater return than what you can get through the uncertainty of opening up a major project (good luck getting through the environmental assessment!). My estimate at present is around 15% return on equity for these buybacks and needless to say, this will be great for shareholders.

It is why an investor should want low equity market values as long as these buybacks continue and the pricing power of the companies remain high. In the oil patch, this of course requires a commodity price that by all accounts should remain in a profitable range for companies that have had their cost structures streamlined and capital spending requirements that have been curtailed due to a hostile regulatory regime. The returns from these share buybacks are likely to be immense, barring a collapse in the oil price.

The MEG Energy Takeover Sweepstakes

Following up on my article “When will Cenovus or CNQ buy out MEG Energy?”

Things have evolved since Husky Energy tried to take out MEG Energy at $11/share back in October 2018:

At the time of the Husky offer, WTI oil was at US$75/barrel, MEG had 297 million shares outstanding (today they are at 307 million), and they had $3.2 billion net debt (today they are sitting at under $2.6 billion). Annual production in 2018 was 87.7 kboe/d, while in 2022 it will be around 95-96 kboe/d.

By all accounts MEG is in better shape today than it was 3 years ago. Will it be CVE or CNQ to first offer a stock swap for a 30-40% premium over the current price?

The big hidden asset not readily visible comes from the following two paragraphs on MEG’s financial statements:

With WTI at US$70/barrel, it will take a very, very long time to dig through these tax pools. Simply put, $5.1 billion in non-capital losses represents an additional $1.2 billion of taxes that can be bought off in an acquisition. With the way things are going, Cenovus will be able to eat through their tax shield mid-decade (they also inherited a tax shield from the Husky acquisition), and CNQ’s tax shield is virtually exhausted at this point (they did acquire some with their announced acquisition of Storm Resources on November 9th, but this will go quickly as Storm had about half a billion in operating loss and exploration credits).

Either way, this tax pool is a ‘hidden’ asset and will bridge the differential between the current market value and a takeover premium. Since valuations in the oil patch are still incredibly depressed (enterprise value to projected free cash flows are still in the upper single digits across the board), a stock swap makes the most sense.

Operationally this is the most likely course of action – without a major capital influx, MEG is constrained to around 100kboe/d of production and things will be pretty much static for them after this point. The only difference at this point is whether Western Canadian Select valuations rise (having Trans-Mountain knocked out for two weeks did not help matters any) and what the final negotiated value will be. The acquiring entity will be able to integrate MEG’s operations to theirs quite readily and shed a bunch of G&A after they pay out the golden parachutes.

Needless to say, I’ve had shares of this at earlier prices.

Formulating some thoughts about 2022

Light yellow line is the 10-year Government of Canada bond yield, orange line is the 2-year bond yield:

Over the past week, Omicron fears have triggered a huge demand for long-dated government debt, while central bank talks of tapering have pushed the front end of the yield up.

Indeed, when looking at the BAX futures, we have the following curve (for those that are unfamiliar, these are 3-month bankers’ acceptance futures, of which you derive the rate by going 100 minus the anticipated yield percentage, so a 98 would be equal to 2.00%):

BAX – Three-Month Canadian Bankers’ Acceptance Futures

Last update: December 5, 2021

Month Bid price Ask price Settl. price Net change Open int. Vol.
Open interest: 1,173,941
Volume: 145,981
December 2021 99.455 99.460 99.460 -0.005 136,604 34,223
January 2022 0 0 99.380 0 0 0
February 2022 0 0 99.220 0 0 0
March 2022 99.080 99.095 99.105 -0.015 242,041 25,545
June 2022 98.660 98.665 98.690 -0.030 185,438 16,971
September 2022 98.335 98.340 98.360 -0.025 167,920 15,778
December 2022 98.125 98.140 98.150 -0.015 144,759 17,816
March 2023 97.985 97.995 98.010 -0.020 107,855 13,145
June 2023 97.865 0 97.890 -0.020 62,554 10,228
September 2023 97.795 97.840 97.820 -0.025 69,061 6,586
December 2023 97.510 97.820 97.805 -0.020 38,357 4,960
March 2024 0 0 97.780 -0.005 12,729 386
June 2024 0 0 97.775 -0.010 4,613 181
September 2024 0 0 97.790 -0.005 2,010 162

The spot price is at 0.54%, while the December 2022 future is at 1.85%, which implies that in the next 12 months we will have a rate increase of about 125bps the way things are going.

The 2-year government bond is yielding 0.95% as of last Friday.  Using expectations theory, this is roughly in-line, but functionally speaking, the inversion of the yield curve is going to signal some ominous signs going forward.

Central banks are engaging in the tightening direction because of fairly obvious circumstances – there are leading indicator signs of inflation everywhere (labour market tightness AND the inability to find quality labour both count; the first is easily quantified, while the second one is not, and is a very relevant factor for many businesses), input costs rising or even being completely unavailable, energy costs spiking, etc.  With governments flooding the economy with deficit-financed stimulus, it is creating an environment where no realistic amount of money thrown at a problem can stimulate productive output.

My guess at present is that tapering and rate increases will go until the economy blows up once again – the evaporation of demand will be mammoth – when these supply chain issues are resolved, the drop-off in demand will commence very quickly.  It will likely happen far sooner than what happened in the 4th quarter of 2018 (the US Federal Reserve started shrinking its balance sheet of treasuries at the end of 2017 and the vomit started occurring around October 2018).  Indeed, you even saw hints of this economic dislocation occur in late 2019 – there was likely going to be an economic recession in 2020 even if Covid-19 did not occur.  Covid instead just masked the underlying conditions, and stimulative monetary policy coupled with shutdowns of global logistics and labour disruptions was the subsequent excuse when fundamentally things were already in awful shape to begin with.

This means that portfolio concentration (other than not being leveraged up the hilt) should be focused on non-discretionary elements of demand.

These are not serious suggestions, but Beer (TAP), Smokes (MO) and Popcorn (AMC…  just kidding!) will probably be the last industries standing among the carnage.  Even McDonalds (MCD) will not be spared as less and less will be able to afford the $10 “extra value” meals as central banks continue to drain the excess, but Dollarama (TSE: DOL) will thrive.

The conventional playbook would suggest that commodities would fare poorly with a precipitous decline in demand, but this is one of those strange interactions between the financial economy and real economy where hard assets will initially lose value in the face of interest rate increases (this has already happened), but the moment the central banks have stretched the rubber band too hard and it snaps, commodities likewise will be receiving a huge tailwind.

2022 is surely to be a worse year for most broad market investors and the public in general.  Returns are going to be very constrained and P/E expansion will be non-existent (other than by reduced earnings expectations!).  Watch out, and hold onto your wallets.  There will be few that will be spared.

High flying growth companies will badly damage new shareholders

The problem with having a huge amount of anticipated growth baked into your stock price is that the expectations become incredibly difficult to achieve.

High expectations result in high stock prices.

I’ll post the charts of two of these companies which are household names – Zoom (Nasdaq: ZM) and Docusign (Nasdaq: DOCU):

We will look at Zoom first.

At its peak of $450/share, Zoom was valued at around $134 billion. Keeping the math incredibly simple, in order to flat-line at a terminal P/E of 15 (this appears to be the median P/E ratio of the S&P 500 at the moment), Zoom needs to make $9 billion a year in net income, or about $30/share.

After Covid-mania, Zoom’s income trajectory did very well:

However, the last quarter made it pretty evident that their growth trajectory has flat-lined. Annualized, they are at $3.55/share, quite a distance away from the $30/share required!

Even at a market price of $180/share today, they are sitting at an anticipated expectation of $12/share at sometime in the future.

Despite the fact that Zoom offers a quality software product (any subscribers to “Late Night Finance” will have Zoom to thank for this), there are natural competitive limitations (such as the fact that Microsoft, Google and the others are going to slowly suck away any notion of margins out of their software product) which will prevent them from getting there.

The point here – even though the stock has gone down 60% from peak-to-trough, there’s still plenty to go, at least on my books. They are still expensive and bake in a lot of anticipated growth which they will be lucky to achieve – let alone eclipse.

The second example was Docusign. Their great feature was to enable digital signing of documents for real estate agents, lawyers, etc., and fared very well during Covid-19. It’s an excellent product and intuitive.

They peaked out at $315/share recently, or a US$62 billion valuation. Using the P/E 15 metric, the anticipated terminal earnings is about $21/share.

The issue here is two-fold.

One is that there is a natural ceiling to how much you can charge for this service. Competing software solutions (e.g. “Just sign this Adobe secure PDF and email it back”) and old fashioned solutions (come to my office to scribble some ink on a piece of paper) are natural barriers to significant price increases.

Two is that the existing company doesn’t make that much money:

Now that they are reporting some earnings, investors at this moment suddenly realized “Hey! It’s a long way to get to $21!” and are bailing out.

Now they are trading down to US$27 billion, but this is still very high.

There are all sorts of $10 billion+ market capitalization companies which have featured in this manner (e.g. Peleton, Zillow, Panantir, etc.) which the new investors (virtually anybody buying stock in 2021) are getting taken out and shot.

This is not to say the underlying companies are not any good – indeed, for example, Zoom offers a great product. There are many other instances of this, and I just look at other corporations that I give money to. Costco, for example – they trade at 2023 anticipated earnings of 40 times. Massively expensive, I would never buy their stock, but they have proven to be the most reliable retailer especially during these crazy Covid-19 times.

As the US Fed and the Bank of Canada try to pull back on what is obviously having huge negative economic consequences (QE has finally reached some sort of ceiling before really bad stuff happens), growth anticipation is going to get further scaled back.

As long as the monetary policy winds are turning into headwinds (instead of the huge tailwinds we have been receiving since March 2020), going forward, positive returns are going to be generated by the companies that can actually generate them, as opposed to those that give promises of them. The party times of speculative excess, while they will continue to exist in pockets here and there, are slowly coming to a close.

The super premium companies (e.g. Apple and Microsoft) will continue to give bond-like returns, simply because they are franchise companies that are entrenched and continue to remain dominant and no reason exists why they will not continue to be that way in the immediate future. Apple equity trades at a FY 2023 (09/2023) estimate of 3.8% earnings yield, and Microsoft is slightly richer at 3.2%. Just like how the capital value of long-term bonds trade wildly with changes of yield, if Apple and Microsoft investors suddenly decide that 4.8% and 4.2% are more appropriate risk premiums (an entirely plausible scenario for a whole variety of foreseeable reasons), your investment will be taking a 20% and 25% hit, respectively (rounding to the nearest 5% here).

That’s not a margin of error that I would want to take, but consider for a moment that there are hundreds of billions of dollars of passive capital that are tracking these very expensive equities. You are likely to receive better returns elsewhere.

Take a careful look at your portfolios – if you see anything trading at a very high anticipated price to cash flow expectation, you may wish to consider your overall risk and position accordingly. Companies warranting premium valuations not only need to justify it, but they need to be delivering on the growth trajectory baked into their valuations – just to retain the existing equity value.