Teekay Q1-2018: Still a leveraged mess

I won’t go into extensive detail over reading Teekay Corporation’s quarterly report (and daughter entities), but my summary is that the corporation and their daughters are still a leveraged mess.

The blood-letting at the Offshore (NYSE: TOO) subsidiary (no longer consolidated since Brookfield now formally is calling the shots) appears to be normalized, but management is on the verge of losing the Tankers subsidiary (NYSE: TNK). They just came to the realization that offering a dividend while trying to de-leverage the company is not so wise. The Tankers entity is bleeding cash with no recovery in sight. Shipping has been a miserable industry for half a decade now as overcapacity persists.

Teekay was trying to keep up the appearance of a minimal dividend since it was directly feeding into the cash flows of the parent (Teekay) entity, but the game is almost up – the only entity worth anything for Teekay is the LNG group (NYSE: TGP) which isn’t doing that badly – they are actually making money, but right now it is very slow in relation to the overall debt required to finance everything.

I wouldn’t be surprised if there was another debt crisis coming up for Teekay – why their January 2020 unsecured debt trades at around a 6.1% YTM is beyond me. I dumped out of their debt early this year (at 5 cents over par).

Teekay has value on its balance sheet as it does still own considerable equity interests in TOO, TGP and TNK, but operationally the only entity that will be feeding cash into it will be TGP, and immediate cash flows are going to be undoubtedly de-leveraging, especially as interest rates rise.

Holding Pattern

It’s been about three weeks since I’ve written. I’ve read and dissected a billion quarterly reports and now the cycle is mostly done. This time of year is always stressful on time – companies release their annual reports at the end of March and then another quarterly report either at the end of April or the first week or two in May, so there is a lot of reading that has to be done in a relatively short period of time. The most painful part is when I sometimes have to listen to conference calls when transcripts are not available.

Since then I have been on a liquidation spree. My favourite cash parking utility in the public markets (long-time readers here will have a deep suspicion as to what it may be) lately started to trade at a gigantic premium to intrinsic value that I just had to start liquidating – basically investors are pre-paying 7 months’ worth of future dividends on this fixed income instrument (i.e. it is trading at a lofty premium to par value) and I highly suspect it will be a ripe target to get called out by its issuing company (they are paying dividends a good deal higher than their cost of capital if they were to float a bond offering to replace it). So despite the fact that the yield on this was awfully attractive, it had to go for risk concerns.

Another position that was liquidated was a good chunk of my Gran Colombia Gold (TSX: GCM) debentures. I was fortunate enough to cash a good chunk of it out at a premium to par value and convert the rest into stock. I still haven’t decided what I will do with the stock. Financially, the company has made a remarkable turnaround since I invested in the debt early 2016 and basic math suggests that the common shares are undervalued – especially now that the company’s solvency is no longer in doubt because they’ve equitized a good chunk of their debt – US$150 million into what will be US$98 million in August (when TSX: GCM.DB.U auto-converts into stock). The company at that point will have around US$20 million cash in the bank which is no longer encumbered by the cash sweeps mandated by the previous debt holders. The new debt is auto-liquidating, so each year they will pay down about a sixth of the debt principal.

So on paper, in light of the relatively high EBITDAs it is generating, Gran Colombia looks cheap compared to its peer group. One possible explanation is the common stock has been a victim of convertible debt arbitrage and there simply hasn’t been sufficient demand for common shares – this theory will be tested in the upcoming months. The other risk of downside includes being effectively a single mine operation in Colombia, and also the feasibility of future capital expenditures to expand mine growth (I still have a 624 page NI 43-101 to plough through! I’ve prioritized other company quarterly reports before this technical mine report!). GCM is not exactly an unknown company either – other intelligent people have written about this company over the internet and there are various risks to consider which could explain the relatively low share price (especially resentment that equity holders got nearly wiped out in the late 2015 recapitalization).

Besides for this and a few other routine bond maturities (this was just small yield picking on short duration investment grade securities which weren’t worth the research I dumped into them), I’ve raised a lot of cash for future investment. The problem is I have no idea what to invest it in.

I have the highest weighting of cash in the portfolio than I have had in a long, long time. I ended 2015 at +42% cash and percentage cash today is even higher.

I have some marginal investment ideas on queue, but in a rising rate environment the risk one takes is a bit higher. It is nothing like early 2016 when things were being thrown out the window with double digit yields (I do miss those days). However, there are some glimmers of despair and panic out there – I’ve been looking quite closely at pipelines, which are currently the media focus of doom and gloom and all things wrong with society. Pipelines today is what tobacco was in the 90’s.

The case to short Genworth MI

I very much like reading the short sale cases of anything I hold. It forces you to check your own analysis and compare conclusions. I remember dissecting a post back in October 2016 that was posted on Seeking Alpha (David Desjardins said he bought January 2018 put options at a strike price of 18 – if held to maturity they would have expired out of the money).

The newest case I’ve read is from Tim Bergin, who wrote extensively about it on his website and even won the runner-up status in an investment idea contest (something to be fairly proud about considering the quality of presentations that go into these sorts of things – there is a large amount of raw financial brainpower that want to be noticed by hedge fund managers).

I agree with some of Tim Bergin’s analysis of Genworth MI (TSX: MIC), but there are some missing elements of the analysis. This post may appear to be a bit critical and if Tim – you’re reading this – please note I appreciate your work much more than what this post is letting on!

Items I agree with

* I generally agree that the maximum upside (as a short-seller this would be downside), in the short-term time horizon, is about 20-30%.

* I also agree that if the facts in his thesis materialize (specifically: 5-15% mortgage default rates, 20-40% housing price declines) that the price of Genworth MI will drop 60-100%. I believe that his projections are actually conservative if this occurs (i.e. the numbers he presented will be worse).

* B-20 will impact housing prices. What this will typically result in, however, is that would-be buyers would shop for lower valued properties that can fit the financing parameters.

* The correlated risks in the investment portfolio (e.g. debt/preferred share investments in financials that would presumably be linked to real estate credit markets).

* Using LTV and amortization is not a sound way of pricing an insurance product, but this is due to consumer simplicity and also just matching whatever CMHC charges – in any event, if the market was actually competitive, based on loss ratios, mortgage insurance premiums would be much lower.

Items I disagree with

* The analysis seems heavy on severity and not frequency. The trigger point for frequency is not debt ratios, but rather employment (something not discussed in the presentation).

* The most fatal flaw in the presentation: The “soft-landing” scenario (slide 26). Reading the slides, I don’t get the impression the author is differentiating between revenue recognition and premiums written. Cash intake (premiums written) in FY2017 was $663 million. Even if the company only recognized revenues on a 10-year basis (this modelling is also flawed), in a “soft landing” scenario, the revenue recognition would normalize to the rate that premiums were being written. There is no explanation for why premiums written would drop by 60%.

* The conversion to “actual loan-to-value (LTV)” (slide 19) is a very creative way to bloat the ratio and implies the liability book is larger than it may seem, but ultimately it doesn’t mean anything – the fact that it takes money to dispose of delinquent properties is known and banks also incur the same risks, or in any industry where there is collateral backing loans.

* The 10-year revenue recognition suggestion doesn’t make sense. Looking at FY2017 year end, the average transactional mortgage insurance LTV is 62% – each and every year after the mortgage loan is amortized even further, reducing risk. So even in the event that housing prices drop 25% universally, the LTV still is 83% – defaults that occur will not be severe, unless if the defaults are part of a (my terminology) “cascade selling” where selling of defaulted properties causes further price drops. What would the accounting basis be for delaying recognition of revenues that has an incredibly high probability of never incurring further cost? It’s pretty self-evident that the further the LTV drops (whether it is due to appreciation of property or amortization of debt) the less risky the insurance written is. Of course in a declining housing price environment, LTVs may go above 90% and then it becomes reliant on the mortgage holder to continue paying down the mortgage and amortizing debt instead of having the safety valve of just selling the property (which would explain how Home Capital Group and others got away with sloppy underwriting).

* In relation to US mortgages (strategic defaults), recourse in Canada is quite powerful.

* That MIC’s insurance portfolio is weaker because of the reduced (90%) government backstopping. Performance data between CMHC and MIC (loss ratios) would suggest otherwise. I agree I don’t know why this is the case, but it would suggest that MIC does have better screening techniques.

Items that should be in the analysis but isn’t mentioned

* That as long as CMHC profits from mortgage insurance that Genworth MI will as well and any “crash” scenario will also greatly affect the government (with even more political consequences than financial ones), thus the federal government has a high incentive to preventing a crash scenario from occurring.

* If mortgage insurance was such a crappy deal for MIC (and by extension CMHC), would they not have a justification to raise insurance rates even further, just like how they did when the OSFI raised mortgage insurance capital requirements?

* MIC’s data from the 2008-2009 economic crisis seemed to suggest that even in a sour economy that they can still make money.

* Genworth Financial’s 57% ownership in MIC is a big question mark considering the China Oceanwide merger process (that has been going on for over a year).

* What if MIC just said the following tomorrow: “We’ve stopped writing mortgage insurance. We will be letting our existing insurance book run to expiry and distribute the remaining free equity to shareholders.” – what is the terminal value of MIC in this case?

Closing Thoughts

I’ll be happy to let Tim Bergin borrow my shares of MIC if he wishes to short it. The market currently asks 2.4% for a borrow, plus 4.7% carrying costs for quarterly dividends.

Physical Fitness, Mental Fitness and Financial Performance

Yesterday, I finished the Vancouver Sun Run, a 10km road running event and the 3rd largest in North America. This year I finished in 54 minutes and 37 seconds, which despite my increasingly older age and having a body mass index higher than ideal, was my lifetime best. A decade ago, I took nearly a minute and a half longer. Other than trying to weave around the masses of people, I find thinking about abstract issues to be a good way to pass the time while in the process of running.

I will make a claim that mental discipline is necessary in order to sustain above-average performance in finance.

You might be able to do well in part of a financial cycle without mental discipline, but eventually all the monolithic dot-com investors in 2000, US real estate in 2007 and presumably now cryptocurrency and marijuana investors that thought (or still think) their investment vehicle was a one-way street to perpetual riches have had to face severe setbacks in their ambitions. In particular, when the market goes south determines whether your mental fortitude breaks and gets you to sell at the bottom, which many equity investors did in 2008 before seeing things rocket up again after February 2009.

Finance is a rare industry on the planet that exhibits inverse demand characteristics in that in many cases, a higher price induces more willing buyers for the product. Conversely, stocks that are trading low (and have downward trajectories) are frequently shunned and less people are interested.

In many cases, the price action is warranted. There is a feedback mechanism where people believe the market price is indicative of the relative fortunes of the underlying companies – basically believing that the crowd is smarter than they are.

One of the greatest tests of mental discipline is having something you buy in the marketplace go south in price. You invest a dollar today in something you think is worth double that. However, you wake up in a day seeing it is now valued at 90 cents. And the next week it goes to 80 cents. If your initial analysis was correct, the obvious and rational decision is to buy more. But there is always an inkling in the back of your head that you can be wrong and the market is clearly making you out to be a sucker. You never know except with the hindsight of retrospect – and then it is always too late.

Mental discipline is all about knowing what to do in these situations. There is no prescriptive formula because all situations are inherently different – it could be the case that your $2 analysis was completely junk. It could be the case that the CFO in the firm was actually cooking the books or the CEO was a complete fraud himself. Or it could be that what is now an 80 cent investment is still truly worth $2 and that future investments are going to be worth 150% of what you paid for instead of 100% at your original cost.

Mental discipline is what allows you to sort this out without making stupid decisions like averaging down to zero or holding excessive concentration. Mental discipline is also what allows you to exit at a loss and not feel the compulsion to “break even”. There are plenty of psychological traps of investing and mental discipline is what allows one to rationally navigate through it all.

Mental discipline is part of being mentally fit – i.e. having the psychological processes set in mind, and consistently reinforced to be able to function in the financial marketplace. Other aspects of being mentally fit include having the proper repertoire of knowledge, including knowing how to read financial statements, understanding businesses, math and statistics, economics, etc. All of this contributes towards mental fitness that makes one a better investor than those that do not have these key aspects of knowledge. Being able to distill all of this acquired information and knowledge and separate what is important from not important is also another critical skill of being mentally fit.

As an example, a conspiracy theory investor that claims that the Federal Reserve is turning the US Dollar into toilet paper and advocating gold will go to US$5,000/Oz in a year is not likely demonstrating a mastery of certain aspects of mental fitness. It should be pointed out, however, that people who are mentally unfit for investing will occasionally be right, but just for the wrong reasons – this is known to be “getting lucky”, or being right for the wrong reasons.

So who do you want managing your money? Presumably somebody that has a high degree of mental fitness.

The problem is that aside from looking at their track record, it is not easy to determine whether the person demonstrates capabilities of being mentally fit – they could have gotten lucky for many years. Reading letters to investors and examining other such soft information gives one insight on the thought processes of investors. Most people in finance read Buffett’s letters and know the type of person that they are placing their faith in. Likewise, anybody reading and listening to Thomas Peterffy, the CEO of Interactive Brokers, will know he is a genius. Prem Watsa of Fairfax is another. All of these people have very long-term track records and it is pretty clear what information they do transmit to the public is just the tip of the iceberg in relation to their overall mental capabilities. Until they get old enough where dementia and other mental afflictions impair their investment capability (particularly in the case of Buffett and Munger who are above the average life expectancy), it can be reasonably inferred that their above-average performance will continue.

But for the rest of the mere mortals in the investing industry, there usually isn’t enough real data to analyze to determine mental fitness beyond the track record. I will claim the track record alone is not a sufficient indicator of financial mental fitness.

I will also claim that mental fitness is greatly assisted by physical fitness, and physical fitness is greatly assisted by mental fitness (and indeed, both of them are correlated and cause each other to occur).

One aspect of physical fitness is that it can be objectively measured. While society looks for quick fixes for everything (fad diets, cosmetic surgery, instant on-demand entertainment, etc.), physical fitness is something that cannot be easily bought or accomplished without actually putting in the individual work and effort to do so. It is also easy to measure – you can swim 100 meters in a certain time, you can run a distance at a certain time, or you can keep your heart rate above a certain rate for a certain length of time, or you weigh so-and-so given your height and gender. All of these physical fitness parameters have result-oriented endpoints that make it easy to measure performance.

Getting to a physical fitness goal means that one has to engage in a process to get there, which requires plenty of mental discipline. Realistic physical fitness goals require a lengthy period of time to achieve – well beyond the “January 1st new year’s resolution to get fit” that a lot of people engage in without a proper plan and the proper mental discipline to execute on a long-term physical fitness program.

There is no way that I can run 10km in 55 minutes without consistently training and applying both mental and physical discipline to doing so throughout the course of a year. If I apply even more discipline and stop eating body-inflating carbohydrates and indulging in foods that I obviously know are not the best for me, I can shave off even more time in my next year’s measured performance. It is not an all-or-nothing proposition – it comes in small, incremental steps. Physical fitness also cannot be faked. Mental discipline is much more difficult to measure in such small increments.

Plenty of psychological literature suggests that exercising will improve mental health.

There is an amplifying positive feedback loop – in order to increase physical fitness, you need the mental fitness to give you the discipline to improve physical fitness. You can get that mental fitness by increasing your physical fitness.

So for anybody that is interested in improving their financial performance without wanting to read any of the academic theory behind financial statements, valuations and trading patterns (all of which would be very helpful), I would recommend they start by improving their physical fitness as a route to building on mental fitness.

Canadian housing stats vs. Mortgage Insurance

Genworth MI (TSX: MIC) has taken a hit over the past three weeks due to statistics that housing sales and average prices are declining nationally, according to a CREA report. Another sensationalist headline (“Canada’s average home price drops over 10% year-over-year in March”) is here.

Genworth MI stock rose in the month of March partially due to the company going on a buying spree on a stock buyback – it bought back 1.2 million shares. Other than that, there has been consistent selling pressure.

The report cites the impact of the B-20 regulation from OFSI, which increases the qualification criteria for people to obtain non-insured residential mortgages.

There are two factors here as it relates to Genworth MI that are being confused: 1) the pool of potential insurable mortgages, 2) what exactly the implication of average pricing statistics entails.

Aggregate Statistics

What market participants are failing to understand is that statistical averages fail to capture the economics of the mortgage insurance market, even in a declining average price environment and are probably taking down the stock due to incorrect reasoning (which usually leads to an environment where the stock will be undervalued).

The national housing price statistics are dominated by three regions: Toronto, Montreal and Vancouver. The “right-side tail” of the distribution of housing prices in the Toronto and Vancouver markets (especially in single-family residential) are dominant factors in statistical mean pricing. For instance, if your housing market consisted of a $3 million house, a $1 million townhouse and a $500,000 condominium, a 10% decrease in the house price would dominate over a proportionate decrease in the townhouse or condominium price, due to price weighting.

Vancouver is an extreme market, partially due to the huge influx of foreign capital buyers, which the government is actively trying to curtail. The 95th percentile of the real estate market is dominated with speculation from foreign (mainly people connected to Mainland China) buyers and asking prices have been decreasing in the hundreds of thousands of dollars for single family dwellings in the Metro Vancouver region. I have been paying less attention to the Greater Toronto Area, but apparently there is a similar mechanic going on there.

As a result, when speculation moves the 95th percentile market, it will result in massive price swings that have powerful effects on aggregate mean statistics. There is a “bubble-down” effect on the remainder of the real estate market, but this is more diffuse and domestic demand for lesser priced properties serves as a buffering effect for the absolute decline (not percentage decline) in those prices. It pays to longitudinally study properties that are in the 50th percentile (i.e. using median statistics) as a more intuitively accurate grasp of what is going on. These usually aren’t published.

Mortgage Insurance Eligibility

Keep in mind that properties over $1,000,000 are not eligible for mortgage insurance. Secondary residences in Vancouver, Calgary and Toronto are up to $750,000. (Good luck with this amount in Vancouver!).

Net Impact to Genworth MI

The only impact I would expect from what is happening in Vancouver and Toronto is that less mortgage insurance will be written – this is derived from the decrease in re-sales of real estate. The quality of the underlying insurance portfolio will also exhibit a higher loan-to-value ratio as prices normalize, but as mortgage insurance services the more “retail” element of real estate purchasers, I would expect them to continue paying their mortgages and amortize the existing debt amounts – 15% of the debt is amortized in 5 years with a typical 25 year amortization period and 3% interest rate. Employment is a much bigger driver – I would worry if unemployment rises.

Genworth MI will report the first quarterly report in late April or early May – I would continue to expect to see very good numbers posted with respect to loss and severity. Book value should also creep up another 60-70 cents per share, which would bring it close (but not quite) to $44. At the current price of $39, they are trading at a moderate discount.