When is it time to cash in the chips?

It’s been a good run up in the market in the past month. Just last month I thought I was headed for the first negative quarter since Covid hit. Now it’s a race for the finish in the last two weeks of September.

There’s been a component in my portfolio (you can guess which one it is, I’ve written about it before) that almost has GME-like properties at the moment, albeit the business model is slightly more viable and I think the hype cycle is around the 3rd inning of this particular baseball game.

One always needs to ask themselves when enough is enough.

The trading mechanics of stocks nearing a mania high is punctuated by intense volatility both on the upside and downside.

Gamestop is a perfect illustration of this.

You had a few trading days (look at late January) where it ranged from $200 to $450 in what could be classified as insanity.

Even a week before that, when it spiked from $40 to $100, that was considered insanity.

Nobody wants to be the person selling GME at $40 on its way up to $400, but you had to wait four trading days (not to mention a weekend) to make this happen. Retrospect makes for 20/20 vision, but doing this in the heat of the moment is a hugely difficult endeavour.

What’s funnier is if you set your limit order at $300, psychologically you would have still felt ripped off since you had the potential for another 50% gain ($450)… “If only I set the limit sell price at $400 instead of $300 that day”.

That said, share dispositions do not have to be a binary decision – you can choose to trim tiny amounts as prices rise. This is my personal approach to things, although logically it doesn’t make sense.

Overall, however, we are seeing a commodity-driven boom. There is a lot of forward expectation and you can see this with the single digit P/Es projected in most of these companies.

ARCH, for instance, is trading at 6 times projected 2021 earnings. Coking coal is going crazy and Arch is down 4% today. What gives?

My Divestor Oil and Gas index has Q2 guidance below current spot prices and even with that guidance, companies are trading at EV/(free cash flow) levels of the high single digits (and if you ignore debt leverage, the price to cash flow ratio is even lower). Natural gas is spiking – you’re seeing Henry Hub gas prices this winter heading north of US$5/mmBtu, and AECO is north of CAD$4 and it’s still September.

It’s a really difficult decision to be selling equities that are trading at single digit multiples of cash flows when prevailing investing options for near-safe money is so terrible. You can’t even go to the debenture or preferred share markets, which are more or less a wasteland in my humblest of opinions.

Still, I sold a small holding of Western Forest (TSX: WEF) earlier this year, when they were on track to earn about a quarter of their market capitalization in 2021.

Embedded in each of these companies is an implied bet on the future of specific commodities (met coal, gas, oil or otherwise). There is also an embedded skepticism that current prices will remain in each of the share prices. It could entirely be the case that the market is assigning a gigantic discount to future cash flows for whatever reason. If this is the case then buying and waiting for the returns to flow in is logical. Inevitably, it will happen – the most conservative approach companies make is paying down their debt, and then after that, they will have the choice of raising dividends or buying back stock.

This is unless if the real economy crashes and takes the commodity market with it. Then, those single-digit P/Es will rise very quickly.

As for the title of this post, I do not know. As much as it makes mathematical sense, margin investing always makes me nervous. The proper time to do it is when you are feeling absolutely sick in the stomach to buy and right now it just makes too much damn sense to borrow at 1.5% and buy these single digit P/E stocks. This is why I’m not doing it and am slowly raising cash instead, because the decision to increase zero-yield cash in my portfolio hurts the most. It won’t be an extreme move – just enough to make me a little more comfortable.

Teck / Metallurgical Coal

The rumour mill has Teck (TSX: TECK.B) looking at selling or spinning off their metallurgical coal unit for $8 billion.

In the 3 months ended June 30, Teck’s metallurgical coal unit did $1.1 billion in revenues and generated $191 million in profit.

However, since June 30, metallurgical coal prices have exploded. Teck is going to be making a lot more money from this unit in the near term future. Hard coking coal, shipped to China, is nearing US$500/ton. Domestic is approaching US$300/ton.

Realized sales in Q2 was US$144/ton with 6.2 million tons sold. Costs were $64/ton plus $42/ton for transport (moving 6.2 million tons of anything, let alone across the Pacific Ocean is going to be expensive).

While the coal volume will drop slightly in Q3 (due to BC wildfires and such), the realized price is going to increase dramatically, especially with Teck having two points of egress (they are no longer hamstrung by having Westshore Terminals (TSX: WTE) being their only exit point for coal).

If Teck manages to get $8 billion out of this unit, they will be able to eliminate their debt and become that much closer to being a pure copper play.

I also thought they were going to get rid of their energy division, but clearly management is waiting for higher prices before pulling the trigger on that (likely in the form of a sale back to Suncor of its division).

This would be an interesting turnaround for Teck – their coal division was primarily acquired through the Fording River acquisition in July of 2008, and they paid US$14 billion for them, with the lion’s share (US$12.5 billion) in cash.

We all know what happened in late 2008 – the economic crisis really hit the fan. The acquisition was possibly the worst-time acquisition in Teck’s corporate history and it nearly bankrupted them.

So now we fast-forward 13 years later, and Teck is looking at getting rid of their coal division.

My question is – who would buy this? There’s no logical strategic buyer for the entity. Financially, perhaps some hedge funds want to make a gamble that coal pricing will be excessively high for a longer duration of time than the markets anticipate. One financial combination that would make some sort of faint sense is one of the British Columbia crown corporation pension plans (think about the regulatory protection that would afford the company), but one could imagine the political outrage of taking over a coal company in the era of climate change consciousness.

A spinout would be more likely, but I would see the Teck umbrella affording the coal entity much more regulatory protection than being a standalone entity.

As such, I do not believe they will take any real action on the coal entity. I could be wrong.

If they were able to dispose of the coal unit on acceptable terms, the financial engineering motive is pretty simple – by being seen as a more pure copper play, the company would receive a higher valuation. I know how my cautious investing colleague John Cole is feeling about Teck, but this commodity cycle is not at the point of peaking yet. Unlike lumber (where starting up and shutting down is a way of life and can be done with relatively quick frequency), other commodities have much longer cycles and activating coal/copper supplies is a matter of years and not months.

The other observation is that Teck is exporting 6 million tons a quarter, Arch (NYSE: ARCH) is going to do about 2.5 million tons of met coal a quarter now that Leer South is opened. While Arch has a geographical disadvantage (more difficult to ship the material to China from West Virginia), ton-for-ton would give them a US$2.6 billion valuation, which is about 60% higher than their current stock price, accounting for the moronic convertible debt financing they did a year back.

Hunting for ideas in this market

I’ve been noticing that certain sectors get hyped at certain periods of time. There are various influences out there (intelligent ones that, in general, are typically directionally correct and hence they gain a credible following over time) which form narratives and the digital financial wave decides to latch on until such a point they get washed away.

Today it appears that a bunch of hype is building up with uranium producers, the claimed narrative is that with Sprott opening up a physical Uranium ETF (TSX: U.UN) that this will suck up world supplies to a point where prices will rise and make all uranium miners spike. If storing vaults of gold and silver wasn’t enough to spike their respective commodity prices, surely storing yellowcake will be different!

The uranium market has been a cesspool for over a decade, which was not helped by Fukushima. In general, worldwide supplies of Uranium ore has been healthy to the point where Canada’s Cameco (TSX: CCO) decided it was easier to just buy than mine.

The claimed investment thesis is that an entity is essentially trying to corner the market on Uranium, so therefore you should buy the crap out of it before Sprott does. We also get a bunch of narrative about how China and India are building nuclear power plants, etc., etc. It’s a great narrative. The story is very easy to understand.

Uranium production itself is also a relatively small space in the publicly traded sphere (especially in North America) and there isn’t a lot to pick and choose from, hence it is a great target to hype up – a relatively small amount of capital will result in outsized price changes.

When I read these narratives from external sources (especially confirmed in multiple locations, which makes me suspect that there is a degree of inter-connectedness in these pronouncements) I get skeptical that I am behind the curve rather than leading it. I literally do not buy into these things.

I am sure there will be a decent price ramp (it is already occurring) but once the capital inflow dries up, it’ll be really interesting to see the conviction of these people that are looking for triple-digit gains in months when the geopolitical situation for this particular commodity will play out over years (specifically when fossil fuels get really expensive… come back later this decade for the resolution of this story).

My investment ideas have to be generated from non-narrative sources, and especially from sources that are not trying to sell subscription newsletters.

Unfortunately, this means that I tend to not pay much attention to various stories of hype – including the boom in marijuana companies in the second half of the last decade, the cryptocurrency boom, etc. I’m content with letting others gamble in that casino.

So when you are trying to be sold a story, ask yourself which stories are not being pitched to you, and look in that direction. It is much more difficult, cognitively, to look at a piece of information and then figure out what is not there, instead of fixating on the piece of information itself.

Stock screeners are great for generating a reasonable amount of random and obscure selections that can be subsequently mined for suitability. If one has views on specific sectors, selections can also be concentrated on that.

At present, however, my usual cautious approach to the markets has been getting even more cautious as of late. A chart of the S&P 500 or the TSX is not properly reflective of the level of fragility that likely exists out there.

Bank of Canada stopping quantitative easing?

Since the beginning of July, the Bank of Canada’s balance sheet hasn’t really gone anywhere. This is despite stating in the July 14th interest rate announcement that they would be continuing QE at a $2 billion/week rate.

Before COVID-19 began, the Bank of Canada historically has held about $75 billion in government bonds and $25 billion in (short term) treasury bills.

Today, the balance sheet consists of about $6 billion in treasury bills and $414 billion in government bonds.

The size of the Bank of Canada balance sheet is the same on August 11th as it was on September 1st. I would expect the balance sheet to increase slowly with QE but this hasn’t been happening.

For every asset there is either liability or equity, and in this case, the liability is the amount due to Members of Payments Canada (the big banks) – they collectively are owed about $276 billion as of the last September 1st snapshot.

We will see what happens on September the 8th when the next rate announcement is made. Given the ongoing federal election, there will be a lot of eyes on this report from non-traditional viewers.

On the US side, things still show no sign of stopping – it’s QE forever there.

This monetary froth, one way or another, ends up inflating the value of yield-bearing assets. The most obvious targets are government bonds themselves, but as money permeates up the risk spectrum, anything with a yield gets bidded up, making future returns on capital much lower, to the benefit of incumbent asset holders.

Short note – Coal

Market pricing for metallurgical coal is going nuts in China – right now it is north of US$400/ton cfr (and given how gong-showed marine transportation logistics are these days, freight is not a trivial expense). However, the point is that even with freight these are very, very, very high prices. This has impact on prices that Teck will receive on their met coal production (a good chunk of their met coal production goes over the Pacific). In addition, my briefing note and financial forecast I wrote on Arch Resources in June (cash generation of $15-20/share) is looking increasingly conservative.

In the current commodity price environment, both Teck and Arch will be cash machines. While both companies aren’t going to make US$400/ton on all of their sales (the North American market is much less pricier), the overall impact on pricing across the geographical spectrum is clearly up from where it was 18 months ago.

Teck will also have the supplement of its 70% owned QB2 project when it is completed in 2022. QB2, at US$4.00/pound of copper, will generate about US$1.7 billion EBITDA on a 100% basis and after baking in 40% taxes, Teck should be able to generate an incremental US$700 million/year in cash out of this project. Every 50 cents of copper above this will be about US$125 million more. On a consolidated company basis, it is foreseeable they will be able to pull in about $3 billion a year in cash. Once the capex on QB2 is finished (which is the primary cash drain for Teck at the moment), they will be able to begin a simultaneous debt paydown and dividend increase at the same time – my guess is they will ramp up their existing $0.05/quarter dividend to around $0.25/quarter once QB2 is finished and dump the rest into debt repayment. My guess is they’ll want to get below at least $5 billion net debt.

Arch’s net debt probably peaked out at Q2-2021 and at this point forward, it will be generating significant sums of cash. When examining coking coal statistics, the Leer South mine (pretty much finished) will be positioned to grabbing the lion’s share of this market. It takes years to get a coal project out of the ground and mal-investment has finally taken its course. In 2022 they will likely be able to pay off their net debt and then re-institute a dividend or share buyback (offsetting their near-disastrous capital allocation decisions of previous years post-Chapter 11).

The virtual investment prohibition (fueled by ESG and other environmentalism) has created an environment of impossible-to-get capital for coal projects – a perfect formula for elevated prices for those that have incumbency rights. Both Teck and Arch fit the bill for metallurgical coal in North America.

The question is when the party will end. As long as worldwide demand for steel remains red-hot, not anytime soon.