The best stock pick for the past 10 years

It is always interesting to pour over historical data and ask yourself how you could have figured this out had you not had the benefit of hindsight. Everybody calls this “the next Microsoft”, but these days, they are not turning out to be revolutionary software companies.

The largest gainer in the past 10 years turned out to be Green Mountain Coffee Roasters. Back in the beginning of the year 2000, they were $0.88/share, split adjusted. Today they are $69 a share. So $1,000 invested in this company back in the beginning of year 2000 would have resulted in a cool $78,400 today.

What does Green Mountain Coffee do? While their business at the beginning of the century used to deal with selling coffee, they made an acquisition of Keurig in 2006 which turned out to be a major value-added acquisition on their part. The rights to the Keurig coffee machine, and selling the K-Cup packs has been incredibly profitable. It is a razor and blades business model, where the coffee machines take K-Cup packs. Each K-Cup is good for a serving, and typically costs about 50-100 cents to purchase for each serving.

The trick is getting as many of the machines in the public, and then collect royalties on K-Cup sales. They appear to have done that.

My only experience with the K-Cup was in the Air Canada Lounge in LAX airport. They had a K-Cup machine and it made coffee, but I wouldn’t have sold my soul for it. The fact that the machine also creates a lot of disposable junk turns me off somewhat. But somehow GMCR has managed to get enough of its razors into the marketplace, and has enough consumer adoption that they are making huge money off the blades.

In terms of the stock price, I think it is safe to say that we won’t be seeing another 78 times appreciation over the next 10 years, but it will be interesting to see whether GMCR can grow its business to the level that the stock price suggests.

How could have one seen this 10 years ago? Nearly impossible. Even 3 years ago when they took over Keurig, instinctively I would have thought “Who in their right mind would pay 60 cents a pop for their own home coffee machine when you can just as easily grind your own beans?” I’m guessing that cost wasn’t the factor, rather convenience of having to not deal with the messy parts of good coffee making. If I thought that the coffee it produced was vastly superior to the traditional methods, then perhaps I thought the company would have a chance. But I guess convenience trumps cost in this case.

Bank of Canada getting nervous about debt levels

The Governor of the Bank of Canada in a recent speech is saying that while the economy appears to be recovering, that household debt levels are of a concern. Most consumer debt expense is through a mortgage.

In particular, the following paragraph is worthy of mention:

The simulation generates a scenario indicating that, by the middle of 2012, almost one in ten (9.6 per cent) Canadian households would have a debt-service ratio greater than 40 per cent, the threshold above which households are considered financially vulnerable (Table 2). Moreover, the percentage of debt owed by these vulnerable households would almost double. Both of these metrics are well above their recent peaks.

It is worthy to note that “Scenario 1” and “Scenario 2” of the Bank of Canada have short term interest rates at 1.5% at the end of 2010, and 3.1% at the end of 2011 (in Scenario 1) and 4.00% at the end of 2011 (in Scenario 2). These are hypothetical scenarios, but it does not appear that the Bank of Canada will be keeping rates at 0.25% past their June 2010 declaration.

A debt service ratio is generally considered to be debt interest expense divided by pre-tax income. Depending on what type of statistics one prefers to look at, household income in Canada averages roughly $86,000 for a married couple, or roughly $36,000 for an “unattached individual”. In the case of an individual, a debt coverage ratio of 40% is paying approximately $14,400 a year in interest payments, or about 1,200 a month.

Right this second, the best market rate you can get on a variable rate mortgage is prime minus 0.25%. Prime currently is 2.25%. So if you have your average unattached individual buy a condominium for $300,000, they will be paying about $6,000/year in interest payments. However, if the bank rate goes up 2.85% as it will in “Scenario 1”, suddenly that $6,000 interest payment will be going to $15,300 a year. On a $36,000 pre-tax income (or about $29,300 take-home given BC 2010 tax rates), this is a huge amount of debt service, just over half. If you use a $50,000 pre-tax income, your net take-home goes to $38,900 and interest represents 39% of after-tax income.

Harvest Energy Trust takeover by KNOC approved

The takeover of Harvest Energy Trust, for $10/unit and acquisition of debt by the Korean National Oil Company (KNOC), has been approved by Harvest Energy unitholders. The vote was 90.2% in favour. They required 66.7% for approval.

One particular note of amusement is the Harvest Energy Yahoo message board that was dominated by trolls were screaming about voting against the merger. If you believed that the message board was a representative sample of the unitholders, you would have received the impression that the takeover vote would have failed 90% against, instead of in favour! Message boards for most companies are worse than useless – the information that travels through them should be regarded with the same credibility of that of supermarket tabloids.

Retail investors generally do not matter in terms of corporate governance – it is the institutional investors, primarily mutual, pension and hedge fund owners that control most of the votes in publicly held corporations. The market had priced in Harvest units as if the takeover vote was a done deal, and indeed, the market was correct on this projection.

Once the takeover is finally cleared, with an expected date of December 22, 2009, Harvest will be delisted. My guess why they do this at the end of the year, opposed to the beginning of January is because so many people have accrued losses on Harvest Units that management decided it was worth crystallizing the capital losses for the 2009 tax filing, rather than deferring capital gains for 2010.

Within 30 days of the takeover, KNOC is obligated to make an offer to the debenture holders for the cash repurchase of debt at 101% of par value; I will be tendering my debt (or selling it on the open market above 101%, whatever the case may be) simply because of uncertainty of being able to be paid out. While I have glossed over KNOC’s financials, and believe them to be a very solvent and viable corporate entity, the information I have on them is not timely, they do not report to SEC or SEDAR, and I don’t want to have to deal with a Dubai-like situation where Harvest Energy defaults on its debentures, and KNOC will not guarantee the debt.

I am quite happy to tender the debt in 2010 as this way I can defer capital gains until I file my taxes in April 2011.

TFSA account transfers

If you are considering changing where your TFSA account is, it is probably easier to liquidate around this time of year (mid December) and withdrawal all the funds from your account and deposit the cash to a new account early in January of the next year. Assuming you have $5,100 in a TFSA account on December 15, 2009, if you withdraw it before the end of the year, your TFSA contribution room on January 1, 2010 will be $10,100 ($5,100 plus $5,000) and you can open up an account wherever you want and deposit it. In fact, you can open up an account and just fund it exactly at the beginning of the year.

If you withdraw the $5,100 on January 1, 2010, you will have to wait until January 1, 2011 in order to be able to bring the $5,100 of capital into the TFSA tax shield.

The true value of the TFSA won’t be felt until years later when everybody will have contribution rooms sufficiently high that you will be able to shield considerable amounts of savings – assuming interest rates ever rise to respectable levels again (e.g. 5%), in 10 years, you will be able to shield $50,000 at 5% interest, or about $2,500 of tax-free income a year. This essentially will create a risk-free situation for most ordinary people to shield interest income from the government.

The TFSA is truly a financial instrument of lower-income Canadians, while the RRSP is the preferred vehicle for higher-class Canadians. Unlike the USA Roth IRA, the Canadian TFSA is a heck of a lot more flexible – you do not have to wait until you are 59.5 years old to withdraw funds without tax penalty.

Dubai gets bailed out… sort of

Abi Dhabi decided to bail out Dubai, by providing a $10 billion equity injection. This was presumably after the insiders bought back a ton of Dubai debt (which was trading below 50 cents on the dollar and post-announcement is around 70 cents). About $4.1 billion of the equity injection is earmarked for repayment of maturing Islamic debt, while the other $5.9 billion is going toward paying contractors and other working capital needs.

My quick guess is that the Islamic debt gets paid off first to avoid any judicial inquiry on what happens to investors in such debt – i.e. whether they will get a stake in a reorganized company. The conventional debtholders (where there is an active secondary market) are going to be at the mercy of the Dubai courts; I doubt they will be getting any favourable treatment. Maintaining the perception of confidence in the Dubai debt system is crucial for Dubai if they are to retain any foreign institutional investors, and inevitably whatever settlement coming out of the Dubai debt default will be precedent-setting.

I decided to look up what Islamic Debt was, and the Wikipedia entry on Sukuk was rather enlightening – it seems that it has characteristics of zero-coupon debt. That said, I have no idea who would ever want to invest in such financial instruments – at least when investing in Canadian or US debt instruments, you would likely have a better chance in bankruptcy court than you will in Dubai (General Motors notwithstanding!).

(Update: Apparently this is not an equity injection, it is debt.)