Still watching and waiting

The markets are continuing to get interesting. I’ve been slightly nibbling on some picks on the watchlist lately, but still am holding most of the portfolio (80%) in cash at the moment. The so-called “risk-off” trade is winning big-time: 10-year US treasury bond yields have cratered to a amazingly low 1.46%, 30-year bonds closed at 2.54%. These are really, really, really low yields. It is the bond market betting on seriously bad economic times ahead.

Commodities (except for gold) continue to plummet. Another notable is that spot crude (WTIC) at $83.23. This is still not near the lows seen in 2011. The S&P 500 and Nasdaq still are trading above the levels at the beginning of 2012.

I still don’t believe that we have seen “the bottom” of this recent market malaise yet. There is not yet enough volatility. There’s a bit more action on the downside yet to occur, but it would pay to hold onto that cash stack and be able to hit the “buy” button on some issues that have had panic liquidations.

It is when I start seeing price responses consistent with panic liquidations that I start to salivate. While I have seen some hints of this on the equity side of the market, I haven’t noticed this on the bond side yet.

Hold fast! Things will continue to get more interesting.

Nokia vs. RIMM

While Apple’s iPhone continues its consumer mania and Android being almost akin to what Microsoft Windows was when it was dominant in the 1990’s, one has to wonder whether there is a market for the low end of mobile phone users.

For example, this includes myself, where I am perfectly happy not having a data package which is slowly making me a rare individual in my age bracket.

So I took a brief look at Nokia (NYSE: NOK) which attempted to compete in the high end market but obviously lost. However, there should still be a space for them in the market – just not at the insanely huge margins that companies like Apple get on every iPhone. It is not like the winner-take-all market of operating systems back in the 90’s – although the application market does drive some component of sales, ultimately if the device has a web browser and is compatible with the local telecom company’s wireless infrastructure it will sell. The question is at what price.

Strictly looking at the numbers, paying a $4 billion enterprise value for a company still making $44 billion in sales seems like a relatively decent margin of error cushion. An additional factor is that the analysts still project Nokia to be losing money this year and barely making anything in the next year. Ideally you’d want to see both of those projections to be even less rosy.

This is why I wouldn’t invest in RIMM at the moment – expectations have not been hammered down enough, although they are getting to the point where your margin of error is somewhat compelling relative to sales and what you are paying.

Disclosure: No positions in either company.

Niska Gas Storage Partners

I did a quick review of Niska Gas Storage Partners (NYSE: NKA) since I was curious about companies that store natural gas. NKA was trading relatively low and had an abnormally high yield ($1.40/unit or 12.2% at the end of today’s trading price).

Given its governance structure (majority-controlled by another shareholder), this is purely a cash flow play – and it appears that the distributions are well above what the company is generating in cash. It doesn’t even appear to be an asset play either – once you subtract the goodwill and intangibles, book value is considerably lower than existing market prices.

Notably, the bonds that mature on March 15, 2018 have a coupon of 8.875% and some trades went off at a yield to maturity as high as 10.6%, which is probably the safer play if you were to buy into this one for cash flow reasons.

Days like today…

It are days like today that make me appreciate the beauty of holding 86% cash.

While some interesting targets of opportunities have traded down in the recent two weeks, I still believe that we have further to go. Sufficient amounts of volatility and fear just still aren’t there yet, which makes me think that we will continue to see more price depreciation.

I was able to spend a couple hours yesterday doing some genuine random research. This random research consisted of typing in random characters on the keyboard for ticker symbols and then doing cursory scans of the subsequent company. It usually takes a couple minutes to decide whether detailed research is required or whether I move onto the next symbol. The one company I did some extensive due diligence on unfortunately I had to reject at current valuations, but will keep it on the watchlist in case if there is subsequent depreciation. It was a Canadian firm based in Quebec that had roughly a $100 million market capitalization.

Normally I do some pre-screening with certain criteria (market cap, volume, etc.) but I just felt like doing random research. Sometimes I do pick up needles in the haystack doing this method. The expected return is proportional to the amount of quality time put into the process, but just like a lottery you never know when you will get a payoff.

REITs and leverage

It was announced today that Dundee REIT (TSX: D.UN) and H&R Reit (TSX: HR.UN) will be purchasing 2/3rds and 1/3rd, respectively, the Scotiabank headquqarters in Toronto, for a price of $1.266 billion. This was a classic sale-and-leaseback transaction by Scotiabank.

The salient press release is here. Specifically, this line caught my attention:

Highlights:

Going-in capitalization rate of 5.2% – The $1.266 billion purchase price reflects a 5.2% going-in cap rate.

$650.0 million of 7-year first mortgage bonds, provisional A (high) rating, to be issued – To provide partial funding of the purchase price, $650.0 million of first mortgage bonds (100% interest) will be issued with a 7-year term at an effective interest rate that will not exceed 3.45%. Dundee REIT and H&R REIT have entered into an underwriting agreement with Scotia Capital Inc. and TD Securities Inc.

…

The current weighted average in-place office rent is approximately $31.45 per square foot, more than 10% below estimated current market rates of $34.49 per square foot.

The company is also issuing $300M in equity at $35.90/unit. Their annualized yield at that price is 6.12%.

A cap rate of 5.2% basically means you invest $100 to get $5.20/year back. The income figure is usually net operating income, which excludes the depreciation and interest expense associated with owning the property. The figure also implies that it is calculated with the present occupancy rate (99.5%).

So Dundee is receiving a fairly slim return. Let’s just assume that they exclusively purchase this building with debt financing and ignore the more expensive equity. Also, let’s generously assume they can flick a switch and charge the “market rate” for their leaseholders (which is unlikely since Scotiabank is their majority tenant in the building and presumably negotiated a bulk discount associated with the sale of the building!). Their cost of debt is 3.45%, and they anticipate receiving 5.7%, so a spread of 2.25%.

When you do factor in the other attributes (e.g. the true cap rate of the building, depreciation, real estate pricing risk, state of the Toronto economy, occupancy, cost of equity) there is not a heck of a lot when it comes to a margin of error. One predominant question is what happens when interest rates rise to the point where you are paying 200 basis points more on everything? A lot of the higher levered REITs are going to get killed on two fronts – financing expenses and balance sheet write-downs when others are trying to liquidate exactly the same assets. Your compensation as an equity investor is amazingly small.

My conclusion here is that the Bank of Nova Scotia (TSX: BNS) made one hell of a deal.