Diversification and risk

Textbooks in finance are written about the benefits of diversification and how to achieve your portfolio objectives. If you can find two assets that you estimate have the same expected return, in theory it makes sense to split your portfolio 50/50 among them to reduce the risk to achieve the expected value. Implicit behind this is that the returns achieved by these assets are not correlated. For instance, if your two assets are CNR and CP, if Canada goes bust, your diversification is not going to help. But if your two assets are CP and some boring and stable power generation utility out in India, chances are that the returns from the two assets are likely to be much less correlated. Computer algorithms can sort out all of these historical correlations and give you a pretty good idea of the mathematical risk, just from historical trading data.

Then we get into the business of asset allocation. Traditionally, equities and government bonds are inversely correlated to each other, and it has been a layer of portfolio protection when equities rise, you sell a little bit and buy (relative to before, lower priced) treasuries and vice versa.

However, it all goes haywire when traditional correlations do not manifest themselves.

One example is the usage of gold as a “world is going to hell” hedge and also a hedge against inflationary monetary policy decisions. In panicked market conditions, gold is just as susceptible as other asset classes for being liquidated.

Another example is the market for unsecured debt (e.g. TSX debentures or any other corporate bond that trades publicly in a reasonably liquid manner) – although many of these companies are sure-guarantees to pay out at maturity, the value of their debt trades down in market panic conditions.

Finally, another example is the usage of Bitcoin. Since there is limited historical data, there is a considerably higher element of human intuition that goes behind what the true risk profile of this asset is.

When traditional correlations break, it forces portfolio managers to either stay the course (assuming it will regress to some sort of ‘mean’), or to adjust the asset allocation to reflect the new reality with the correlations between various assets. In general, my gut feel is that markets are moving ‘faster’ than they were before, which will make institutional managers that much more challenged to adjust their models to reflect market reality.

Hertz is amazing

Take a look at the stock market’s favourite car rental company Hertz (HTZ):

This is what you call a short squeeze.

The catalyst was an announcement they received $1.65 billion in DIP financing.

Considering the unsecured debt is still trading a tad above 40 cents on the dollar, the bond market still doesn’t anticipate the equity receiving anything when the courts approve the Chapter 11 resolution.

This information (the equity fundamentally being worthless) was already priced into the markets. What rational participants don’t anticipate is a huge wave of paradoxically “rational irrational” behaviour consisting of gamblers, coupled with those trying to induce a short squeeze, which is what we are seeing.

A very fascinating display of market dynamics for the textbooks!

Gran Colombia Gold notes

A minor update on (TSX: GCM.NT.U), they will amortize another 8% of their notes effective October 31. (Press release)

They also received a credit rating increase from B to B+ on their senior secured notes. Considering that after the quarterly amortization that they will have US$35.5 million outstanding, coupled with a positive net cash balance, this isn’t surprising. However, Fitch is very correct in identifying that the life of the Segovia mine (which is substantially most of their cash flow) is quite limited and they will need to find additional reserves, and that ore grade levels are depleting. Even if the mine were to shut down tomorrow, the remaining cash balances will be sufficient to pay off the debt (albeit the equity holders will suffer greatly).

They’ll call off the notes on April 30th. In the meantime, holders continue to enjoy a disproportionately large coupon. The notes are trading in a tight bid-ask where it doesn’t make sense to either buy or sell them. I really wish somebody would bid them up into the one hundred plus teens. It hasn’t been the case – lately the bid/ask has been 108/109. So I’ll continue holding until maturity.

AcuityAds Holdings

I was looking at Atlantic Power (NYSE: AT, TSX: ATP) but accidentally typed in AT on the TSX, which is AcuityAds (TSX: AT). I saw the following chart:

They have nearly quadrupled their market value in about three months.

This got my interest (considering I’ve made the same error before in typing in the ticker, I generally saw a flat chart before). I didn’t see anything relevant in the financial statements – it was pretty sedated although they’ve been reasonably decent on cost controls from the first half of 2019 to 2020. I also tried to see why they spiked in July, but couldn’t find anything of relevance other than a remarkably increased amount of receivables collection in the first half, to the tune of about $6 million free cash flow.

Is this worth a market capitalization of $200 million? I don’t know much about exactly what they do (a bunch of fancy sounding names for using software to optimize advertising campaigns) but whoever invested in them during the Covid crisis will have made out very well.

Air Canada / Air Transat / Westjet

A tale of market timing…

Air Canada (TSX: AC) was going to buy out Air Transat (TSX: TRZ) for $18/share, but of course COVID-19 hit. They will instead do so for $5/share, and also with shares instead of cash (the details of this were not clear from the press release, but a typical provision is for people to elect to take cash up to a certain aggregate amount and after they will receive cash). The shares option has Air Canada equity valued at a level that is higher than Friday’s closing trading price.

Financially, Transat is not in terrible condition, with a whole bunch of cash and equivalents that are paid in the form of customer deposits (good luck getting those ticket refunds, customers!). They are still bleeding cash by virtue of their revenues going down to nearly nothing, but Air Canada is striking while the iron is hot (or rather, while the Covid craze is hot) and removing a future source of competition. The implied value in international ticket pricing they will gain will probably be a lot higher than the immediate costs of the costs they are paying.

We contrast this with Onex’s acquisition of Westjet, which closed in December 2019 for $31/share in cash (or $5 billion, debt included). Air Canada’s equity took a 3/4 haircut after Covid, and there wouldn’t be much reason to believe that Westjet would have fared any better had they still been public. Onex is a huge entity so their financial solvency is nowhere threatened, but still, they probably took an implied $3 billion haircut if they were to float Westjet to the public again.

This, and also an examination of Cineplex’s proposed takeover (at CAD$34/share), goes to show you that timing is everything.

I don’t buy airlines, nor do I particularly care for the sector as a whole. Almost everything associated with the retail side of commercial aviation is miserable. Other components of the industry have somewhat more promise.