How to deal with the black swan market event

Although the trigger of this recent trend down in the markets feels like it stemmed from the Japanese earthquake, it appeared to start with the civil unrest in Egypt.

The Nikkei today is staging a comeback – up about 6% after yesterday’s panic volatility that took the index a further 20% down before bouncing back. International traders presumably are mining their selections of Japanese equities. I will provide a list of directly (from the NYSE and NASDAQ, although Interactive Brokers clients have direct access to Japanese equity markets):

Company Name Symbol Sector
ADVANTEST CORP ATE Electronic Technology
CANON INC CAJ Electronic Technology
HITACHI LTD HIT Producer Manufacturing
HONDA MOTOR CO LTD HMC Consumer Durables
INTERNET INITIATIVE JAPAN INC IIJI Technology Services
KONAMI CORP KNM Consumer Durables
KUBOTA CORP KUB Producer Manufacturing
KYOCERA CORP KYO Electronic Technology
MAKITA CORP MKTAY Consumer Durables
MITSUBISHI UFJ FINANCIAL GROUP INC MTU Finance
MITSUI & CO LTD MITSY Distribution Services
MIZUHO FINANCIAL GROUP INC MFG Finance
NIDEC CORP NJ Producer Manufacturing
NIPPON TELEGRAPH & TELEPHONE CORP NTT Communications
NOMURA HOLDINGS INC NMR Finance
NTT DOCOMO INC DCM Communications
ORIX CORP IX Finance
PANASONIC CORP PC Electronic Technology
SONY CORP SNE Consumer Durables
SUMITOMO MITSUI FINANCIAL GROUP INC SMFG Finance
TOYOTA MOTOR CORP TM Consumer Durables
WACOAL HOLDINGS CORP WACLY Consumer Non-Durables

Very quickly mining the selections above (which generally represent global large-capitalized Japanese companies), Kyocera appears to have decent value, with similar valuations to the old-school technology index.

However, investors should be cautioned that they are not nearly out of the woods yet – the civil disruptions in Northern Africa and the Japanese earthquake could be the trigger to a prolonged downslide in the markets. It is very difficult to determine whether now, a moment of relative uncertainty, is a good time to jump in, or whether the markets will reward the patient.

I’m choosing to be patient. My portfolio has been extremely defensive and I continue to wait with a large amount of cash and cash-like instruments that are uncorrelated to the woes of the equity marketplace.

Some might argue that the damage has all been priced in – my guess is that there will be damage to the market beyond the immediate economic impacts of geopolitical uncertainty and natural disasters that we have seen over the past month.

Quick review of some large cap technology stocks

I am continuing to look at the US large cap sector, just for personal review rather than serious consideration. I am continued to be surprised by relatively good valuations, around the 10% yield levels. Most of these are in the first-generation “old-school” technology sector. Very well-known companies include the following, with some very anecdotal remarks on my behalf:

Microsoft (MSFT) – Trading at 9.3x FY2012 projected earnings, with $30B net cash on balance sheet, Windows/Office empire continued to be chipped away at with competition;
Intel (INTC) – Trading at 9.5x FY2012 projected earnings, $20B net cash on balance sheet, likely to be around for a long time, competition in mobile processors, but nothing in really ‘large scale’ CPUs except AMD;
Dell (DELL) – Trading at 8.6x FY2012 projected earnings, $8B net cash, well-known customer support/service issues, but otherwise entrenched in computer/IT market;
Hewlett-Packard (HPQ) – Trading at 7.3x FY2012 projected earnings, $10B net debt, along with Dell, entrenched in computer/IT market;
Lexmark (LMK) – Trading at 7.7x FY2012 projected earnings, $600M net cash, major supplier in printer/imaging market;
Xerox (XRX) – Trading at 8.3x FY2012 projected earnings, $8B net debt, in a similar domain as Lexmark;
Seagate (STX) – Trading at 7.2x FY2012 projected earnings, $0 net cash/debt, hard drive/storage manufacturer;
Western Digital (WDC) – Trading at 9.3x FY2012 projected earnings, $3B net cash, in a similar domain as Seagate;
Micron Technology (MU) – Trading at 8.4x FY2012 projected earnings, $600M net cash, memory manufacturer;

One would think that diversifying a position into these nine companies and calling it the “Old-school technology fund” would probably be considered a relatively safe alternative over the next 10 years, compared to the 3.4% you would achieve with a 10-year US treasury bond.

My gut instinct would suggest that these companies would still be around in 10 years, especially Intel, which has the biggest competitive advantage out of the nine listed above.

I am also assuming that smarter eyeballs than my own have looked at these companies, which is why I suspect there isn’t much extraordinary value here other than receiving a nominal 10% return on equity, which is pretty good for zero research.

Holloway Lodging REIT – Default on radar screen

The last time I wrote about Holloway Lodging REIT (TSX: HLR.UN) was back in December when there was a corporate governance spat between a significant shareholder and management. That conflict resolved differently than what I had expected, with the significant shareholder being given a minority slate of trustees.

I have been continuing to dump my debentures in Holloway (the 2012 issue, TSX: HLR.DB.A) at around the 65 cent range and got rid of my last piece today at 62, leaving $1,000 in par value of debt just so I can see how this train wreck ends.

Holloway released their 2010 annual results yesterday, and reading it contains two not-so-subtle inclusions on their financial statements and management discussion that warrants further analysis:

The REIT is also subject to financial covenants on its mortgages and loans payable, which are measured on an annual basis and include customary terms and conditions for borrowings of this nature. These include the Debt Service ratio presented above. The REIT is in compliance with, or has obtained waivers for all of its financial covenants except one. One lender has not provided a waiver however, as a result of discussions with this lender, management believes the loans will not be called prior to maturity. The two mortgages with this lender, on hotels in Fort McMurray and Drayton Valley, are included in current liabilities and mature in October 2011 and January 2012.

Notably, the company has $153M of mortgages outstanding which are secured by the property and buildings within those mortgages. If the company does not abide by their debt covenants, in theory, the lender can call the debt unless if the company can cure the breach. If this occurs it would likely result in the company being pushed into creditor protection as their line of credit is not large enough to cover the difference.

The REIT has $25.4 million of mortgages maturing in 2011. The REIT expects to refinance its maturing mortgages at similar or better terms with existing or other lenders.

The REIT also has $20.2 million in convertible debentures that mature on August 1, 2011. The REIT has a signed term sheet to finance the repayment of the debentures. The Board and management continue to explore other alternatives to raise funds to repay the debenture holders which may include other debt financing, the sale of certain properties or some combination, thereof.

HLR has $45 million in debt in 2011 that they must be able to roll over in order to avoid creditor protection. The mortgage debt they should be able to renew at acceptable rates (they did so in 2010 for about 6.6% for a 5-year term). The August 1, 2011 debenture is an interesting issue ($20M) in that it is trading near par (TSX: HLR.DB, 93.5/97 bid/ask presently, albeit very illiquid) which suggests the company can refinance that, but the June 30, 2012 debenture (a $45M issue) is down to 62/63. This suggests the market is betting on the company being able to rollover the 2011 debt but not the 2012 debt. Both debentures are equal in seniority to each other.

It would be a logical and low-risk paired trade to short the 2011 debenture and long the 2012 debenture, but I could not short the 2011 debenture.

The business is not generating a sufficient amount of cash and this is in large part due to the interest bite that comes out of operating income. In 2010, the business pulled in about $19.3M in operating income, but the interest expense was $15.8M. This does not leave much room for other incidental expenses, such as general and administration, and future capital expenditures. Capital expenditures in 2010 I am presuming were of a maintenance-type nature, totaling $3.6 million.

There is nothing to suggest that they will be able to improve their revenue per room or capacity utilization rates over the next couple years.

There is probably residual value left in the operations, but I don’t want to be around to find out what low-ball offer management will be offering to the convertible debenture holders when maturity comes around. I’ve exited the 2012 debentures, short of $1k par value. My basis was about 44 cents on the dollar, so this is a nice gain for nearly 2 years of holding, but as I pointed out earlier, one of my largest mistakes during the 2008/2009 economic crisis was putting money in the debentures of this company compared to Innvest (TSX: INN.DB.B) at the same time period.

Questrade – Cash withdrawing is timely

Out of all the issues (1, 2) that Questrade has, cash management is not one of them. I have made several cash withdrawals through the course of late 2010 and 2011 as I have exited my debenture positions and they have been deposited via EFT to my bank account in a timely fashion.

I have been scouring the internet and have been reading nothing but trouble stories from people as they have done significant back-office migration since early February. It generally does not inspire confidence, which is why I entrust most of my idle cash balances to Ally (up to the CDIC limit!) and Interactive Brokers.

As long as you keep your transactions simple with Questrade, you should have no problem with them. If there is anything out of the ordinary or anything that could possibly warrant human interaction, then your mileage will vary – greatly.

Petrobakken – Value trap

(Update, June 23, 2011: Readers may be interested in further coverage of Petrobakken by clicking here.)

Petrobakken (TSX: PBN) has been on the top of my radar screens for oil and gas companies for quite some time. The reason is fairly simple – it appears to be a high-yielding security that has a large amount of reserves and land rights. During my extensive investigations of this company during the autumn of 2010 (when the common equity was at around $23/share) I rejected PBN as an investment candidate.

The past three years of trading have had investors seen their better days in earlier times:

The drop in late 2008/early 2009 can be attributed to the economic crisis and the decrease in oil prices, but the price drop lately can be solely attributed to financial management. In 2009 and 2010 the company engaged in a series of significant purchases with companies with large holdings in the Bakken oil fields (southeastern Saskatchewan). It also has significant holdings in the Cardium (roughly northwest of Calgary and south of Edmonton). These acquisitions were very costly and ended up hurting shareholders.

The company is paying off about $180M/year in dividends to its shareholders when it is spending far above its operational cash flow to drill for more wells in order to keep its production levels steady.

The large dividend yield probably serves as a psychological crutch for investors, in addition to providing its parent company, Petrobank (TSX: PBG), with a cash stream. Petrobank owns roughly 60% of Petrobakken. This appears to be a classic example of knowing the risks of investing in companies that are majority-held or controlled – a retail investor’s interest may not be in alignment with the parent company, and when this is the case, you may receive an adverse outcome.

The big operational issue in the Cardium and Bakken fields is that your production falls off steeply after the initial drilling (as opposed to your typical Steam-assisted gravity drainage project that a company like Cenovus does):

Although the capital expenditure can be justified, the economics are not as pleasant as what most people may anticipate by looking at the “trend” of oil production based on first year results. Most of the growth in revenues has to be looked at with the knowledge that the first year of wells will be extraordinarily high, while the second and subsequent years will have slower, but steadier production.

In 2010, PBN took in about $562M in operational cash flow, but they also spent $36M repurchasing their common shares (questionable given their balance sheet), $812M in capital expenditures, $483M in corporate acquisitions (mainly for land rights discussed previously). When you net everything together, the company had to borrow $750M in cheap financing (6-year notes, 3.125% coupon) and also maintain a line of credit with a bank ($825M outstanding of $1.2B available) in order to finance all of this spending and payouts.

Although the company is producing a lot of operational cash flow (in particular, they like quoting the statistic funds flow from operations, which was $3.51/share in 2010), in order to maintain this cash flow they need to continue spending significant sums of money on capital expenditures.

The valuation then becomes a matter of determining the decay rate of the various wells drilled on the Bakken/Cardium fields and the prevailing price of oil – and there are smarter people than myself that can model the decay rate better.

Most retail investors, however, would just look at the dividend yield at the current $19.60/share and say “Wow, look, 4.9%!” and buy in, not realizing that the company has probably hit the point where it can’t borrow money as cheaply as it has in the past. If you look at the GAAP net income, 26 cents per share does not look that impressive compared to the share price. One does have to model for a significant amount of depreciation (which is a non-cash expense that represents money already paid for drilling) in order to receive a more relevant free cash-flow figure.

This is not to say that Petrobakken is not a legitimate oil company – just that to my knowledge, its equity valuation does not represent an under-valuation at present, even factoring in the existing price of oil.