Divestor

There are a few ways that stocks come across my desk. One is running some screens for issuers that fit my desired parameters (small to mid cap, low volume, among other characteristics). Sometimes I just randomly encounter companies that come up on various sector lists. Sometimes I just type in random ticker symbols and examine (seriously – try it). Another way is to go through 13F-HR filings of various fund managers I respect and try to examine some of their holdings.

Most popular fund managers realize that people like myself have parasitic tenancies in investment. Warren Buffett is a great example of this (think about Berkshire’s investment in Amazon).

One of the huge advantages of being a relatively small investor is that you can get in and out of positions without having to go through the pain of combating high frequency trading and the other chicanery of building or disposing of a position. As a result, smart managers do try to obfuscate this information to a degree, so 13F-HR filings are not the risk-free treasure trove of information one would initially suspect.

An example today is Scion (of Michael Burry fame) and their 13F-HR filing:

There are 14 positions to deal with, a most manageable number. Note that 13F-HR filings do not have to disclose short positions, nor do they have to disclose securities that are not included in a gigantic listing of 13F-HR disclosable securities, which mainly consist of USA-tradable securities (and foreign securities that trade on US exchanges).

So managers also have the option of trading securities that are not on this list to cover their tracks.

1. Alphabet – Why would I invest in Google? Pass.

2. Altaba – Same, too big. Pass.

3. Cleveland Cliffs – More interesting. Iron Ore producer. Canadian analogy is TSX:LIF which I kick myself today for not investing in early 2016 when it was on my radar and I gave it a thorough look. My knowledge of the iron ore industry is less than adequate, but the financials of Cliffs was less than inspiring in relation to its market value. They may have some competitive advantage by virtue of being the only regional game in town, coupled with Trump’s tariffs, which could bode well for it. But otherwise, don’t know enough to make a decision. Pass.

4. Corepoint Lodging – Hotel REITs are cyclical entities. When room rates rise, everybody and their grandmother seeks to build new hotels and they can be bought at $2-3 million a pop, in markets with relatively low barriers to entry. They are at a high point right now. The next recession will be wiping out a lot of equity value. Corepoint’s financials don’t show an entity making a ton of money on operations and are instead banking on land. Pass.

5. Disney – too big. Pass.

6. Facebook – I don’t even use Facebook. I’m a Luddite. Pass.

7. Five Point Holdings – Land developer, small scale, San Fran, LA and Orange county. Any business doing business in California has tolerance for a massive amount of self-abuse, which gives some incumbency protection. Not a terribly broken business, dual class structure. Relatively new entity, started trading 2017. Income statement showing very lumpy revenue streams. Huge non-controlling interest. Probably not worth further research, but can’t totally dismiss.

8. Gamestop – too many eyeballs on it. Pass.

9. Greensky – Another dual-share structure with a large non-controlling interest, dealing with payment processing and real-time lending solutions. Probably another pass.

10. JD – Do I have any expertise on Japanese online retailing? Nope. Pass.

11. PetIQ – This one is interesting. A lot of money has been lost on the retail side of animal care, but this company deals with the branding and distribution of foods and veterinary care products. Financials are not a complete disaster, but they are in an expansion phase and need capital to do this. The income statement is very low margin and the industry is competitive to the point where they’d need to be the lowest cost producer on the virtue of localized economies of scale – this has been tried before in many instances. Worth further research, but skeptical. Also they announced a major acquisition a couple weeks ago, which usually means huge integration pains for at least a year to come.

12. Sportsman Warehouse Holdings – What’s amazing is how this company can still continue to make money. Lots of money to be made on the equity side if you predict they can keep their gross profits at the levels they are at and keep a cap on their SG&A expenses. Will Amazon/Walmart kill them? Not my cup of tea to analyze, but the stock is trading low enough that there is a compelling case to be made if you have an inclination that they are not doomed to Circuit City-type retail oblivion.

13. Tailored Brands – Otherwise known as the old Men’s Warehouse. Unlike most other clothing companies, Amazon doesn’t really compete very well in the suits category. They had a gigantic amount of debt to work with, but they are still chipping away at it. Valuation is actually not that bad, all things considered! I did look at them many, many, many years ago, so I do have some familiarity with the company.

14. Western Digital – Too big, but a respected hard drive manufacturer. Pass.

So after this screen, I found a few prospects to do further due diligence on.

I am pretty convinced that the purpose of a lot of IFRS edicts is to make financial statements unreadable. The introduction of IFRS 16 adds two lines to most companies’ balance sheets and while mildly annoying (mentally one has to make a provision for lease-heavy companies that the amortization of the lease asset/liability is akin to a lease payment and make sure not to perform apples-to-oranges comparisons when looking at EBITDAs), the biggest pain has to be IFRS’ tenancies to use mark-to-market fair value adjustments whenever such data is available.

As an example, I am going through Gran Colombia Gold’s (TSX: GCM) last quarterly statement and the income statement is getting to the point where it is almost unreadable.

For example, under “Other income (expense)”, the entire $4.591 million under “Loss on Financial Instruments” consists of fair value adjustments. For an untrained eye these would seem quite relevant in that one would perceive the company is ‘paying’ more in financial expenses than is actually the case. From an analytical perspective, these fair value adjustments are irrelevant.

I’ll break down this even further, which is covered by the rules of IFRS 9.

$2.569 million of the $4.591 million consists of a mark-to-market adjustment on the fair value of warrants the company has outstanding.

When the company issued the warrants in conjunction with a notes offering, they issued 12.151 million warrants which were publicly listed on the TSX (TSX: GCM.WT.B). The warrants are convertible at CAD$2.21/share.

Let’s step back and remember the following law of accounting:

Assets = Liabilities + Equity

In a sane world, these warrants should reflect equity (the warrants in no circumstances can ever reflect a drain on the assets of the company). However, in our brave new IFRS world, they are a liability because they represent value that has not been set at a fixed price by the company. GCM reports in US currency, so therefore the warrant liability in Canadian dollars is a floating obligation and thus needs to be re-valued every quarter!

Once the door was open to expensing stock options, the logical progression is that any issuance of like instruments (such as warrants) need the same treatment.

Since the warrants are publicly traded, the fair value of the liability can be recorded using the market price. This needs to be updated quarterly.

The warrants at the end of December 31, 2018 were worth $13.8 million. On March 31, 2019 they were worth $16.4 million. Therefore, the company “lost” $2.6 million and this has to be reported on the income statement as a financial expense.

This expense, in no manner, reflects an actual cash expense. Nor does this expense affect the valuation of the company in any respect. This “expense” does not impact the taxes the company has to pay.

What it does, however, is really skew any ratios that may need to be calculated. For example, if you have an excessively high non-cash expense due to a fair value adjustment, it would serve to understate your net income, or make your apparent tax rate higher than it actually is.

Perhaps this is why most people do not read financial statements anymore – they’re becoming more and more difficult to read.

However, opportunity exists in complexity – if computer programs that are designed to screen for fundamentals do not factor in irrelevant expenses such as these fair value adjustments, companies that appear to be losing money on the income statement could be undervalued by the market as standard stock screens will report them as less profitable than they actually are. I’ll leave it at that.

Here are a few more general thoughts on the markets:

1. As long as American oil producers are able to pump progressively higher amounts of crude oil, Canadian producers will always be at a relative disadvantage to the USA unless if they develop a proper export facility that goes outside the USA. This is a very well known fact, and one of the reasons why even if the federal government changes this October, it will still be quite some time before Canadian oil producers reach the glory days like they did a decade ago. The completion of the expansion of Enbridge Line 3 (late 2020) will alleviate this somewhat but ultimately, Canada will receive full price for its crude oil if they can export elsewhere. Good luck!

2. The dynamics for natural gas are a little different. While domestic production exceeds domestic consumption, there is the promise of BC’s LNG project near Kitimat, which is expected to be active in 2025. What will be interesting is if any court challenges will stall the project out like the Trans-Mountain pipeline. In general, natural gas producers (and there are a handful of them to look at) look more promising from a valuation perspective than do crude oil counterparts. They have both been hammered as AECO pricing has been terrible – again, there is just no way to get rid of the product when the USA’s own production has been expanding like no tomorrow.

3. The acronym TINA – There is no alternative – is what explains a lot of what I see in equity pricing. If you are a pension fund manager, and your expected rate of return is 7%, you can invest in some BBB-rated bonds and get a 4% return. You need to pile onto the equity in order to make up the the other 3% for the remaining part of the portfolio. When equity prices fall, in order to generate the extra needed return, you rebalance and purchase more equity. With central banks very loose with money supply, there remains ample firepower to throw into equities – and it doesn’t matter what equities, as long as they are as liquid as possible.

I have no idea when this blows up, but I suspect when it does, it will be very, very quick – similar in scope to December 2018, or the crash of the inverse volatility ETFs which happened in February 2018.

There will be pockets of safety here and there, but everybody remembers what happened in 2008 – mostly everything got sold down, no matter how attractive the assets were.