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.

What if Alberta shut down the Trans-Mountain Pipeline?

There are media rumblings that Alberta will be shutting off the flow of oil to British Columbia on the Trans-Mountain Pipeline (TSX: KML) with the enactment of Bill 12. Right now the Bill is sitting on the notice paper of the Alberta legislature so we do not know precisely what the content of the Bill says.

Enactment of Bill 12 (or at least one that would cut off the pipeline) would not happen for a variety of reasons – one is that Kinder Morgan is contractually bound to deliver oil, and an act of the legislature stopping this would mean that Kinder Morgan could make a civil claim for damages. At the very least the Government of Alberta would be civilly liable for such an action. It would also likely be deemed to be against the Canadian Charter.

But let’s run a thought experiment and pretend that for whatever reason it actually happened. The media report states that one of the consequences would be that the price of gasoline would rise above $2/litre.

I would claim that gas prices would go much higher than this – my paper napkin estimate would be a free market price closer to $5 per litre after a month of pipeline shutdown. It is at this price range that there would be a material amount of price elasticity in terms of decreasing gasoline consumption. In addition, it is quite likely that YVR airport would have to significantly curtail a material amount of flight activity as there would be an insufficient supply of aviation fuel. I would view it as probable that a prolonged period that Trans-Mountain was inactive would cause a severe logistical constraint on the cost of transportation and the subsequent cost structure would result in significantly increased costs for transportation services (e.g. bus and cargo logistics).

The rationale for this: The Vancouver, BC area used to have 4 oil refineries but three of them have shut down in the mid 90’s. The sole remaining refinery is the Chevron Burnaby refinery (now owned by Parkland Fuel (TSX: PKI) but will refer to them as Chevron for the remainder of this post), which processes about 55,000 barrels of oil a day. A barrel of crude oil (roughly 159 litres) can be refined into ordinary unleaded gasoline, diesel, kerosene (aviation fuel), paraffins, etc. Very roughly for dilbit (and this depends on what comes in), you can get around 40% to gasoline, 30% goes to diesel/jet fuel, 10% liquid gas, 10% fuel oils, and 10% other.

The Chevon refinery receives most of its crude oil (feedstock) via three routes: tanker (barge), rail, pipeline. By curtailing the pipeline, there would have to be increased traffic on other transportation modes. Chevon has a 3 day supply of feedstock.

Metro Vancouver (Greater Vancouver Regional District – extending from Bowen Island, Lion’s Bay and West Vancouver eastwards to Maple Ridge and Langley) pays 17 cents per litre of gas taxes to Translink on regular gasoline and clear diesel. Translink is on track to earn about $380 million this year from gasoline taxes, which works out to roughly 38,000 barrels of gasoline a day for the region. This does not include gasoline sold in Abbotsford and Chilliwack, which is fed from Metro Vancouver and would contribute another 10% of gasoline consumption (assuming a proportionate consumption to population).

This also does not assume that any “border leakage” of taxation occurs. It is second nature to a lot of people that live close to the border to go down to Blaine, WA or Bellingham, WA to save on gasoline – prices are CAD$0.35-$0.50/litre cheaper. We will assume that this does not occur in a material manner (one estimate is 1-2% of consumption).

Putting aside this assumption, this means roughly 42,000 barrels/day of Chevon capacity is used for gasoline consumption, which would infer that the refining capacity at Chevon is just about at its maximum limit. There is another Chevron terminal which deals strictly with refined product (65% motor fuel and 35% diesel) that imports another 8 million barrels/year of product (22,000 barrels/day). It is not entirely clear to me how much of this is “external” and how much of this is from the Chevron refinery.

We have not included the consumption effects of the YVR airport. The airport consumes approximately 5 million litres of jet fuel each day, which is another 31,000 barrels per day. Its primary source for this fuel is from a Kinder Morgan Pipeline (despite all the attention that Trans-Mountain gets, this Kinder Morgan pipeline extends underneath most of the residential area of Vancouver within incident) – but due to insufficient capacity on this pipeline, YVR has to import approximately 20% of its refined jet fuel product from Cherry Point, WA.

The residual jet fuel from Cherry Point to YVR is carried by tanker truck, approximately 30 each day. This is the most expensive and inefficient form of transportation (in relation to pipeline, tankers and rail).

In Washington State, there are two major crude refining facilities which receive their crude oil feedstock via tankers from Alaska (another irony of Canada’s “tanker-free” Pacific policy) – the closest refineries are at Cherry Point and Ferndale. Cherry Point has a refining capacity of 225,000 barrels/day and the Ferndale refinery is about 100,000 barrels/day.

If the BC Chevon refinery was starved from its crude oil feedstock from pipeline, there would be an immediate shortfall of refined fuel product at current levels of consumption. Needless to say, it would not matter at this point how many tanker trucks you tried to bring over the border or how much you tried to feed the Chevron terminal, it would not come close to the amount of domestic consumption – there would not be enough tanker trucks available, and Cherry Point would not be able to economically supply that amount of refined product on short notice as has other customer commitments in-state.

There is a pipeline that connects Cherry Point to Sumas, but the logistics of converting this into a refined product pipeline is not clear to me. Either way, this would not be easy to pull in on short demand.

At this point there would likely be severe rationing of fuel stocks and I would suspect that in a short period of time (within about a week of being starved from crude from Trans-Mountain) pricing would go much, much higher than the $2/litre estimated by the media report. In addition, YVR airport operations would likely be impacted. Needless to say, the economic disruption would be massive and at this point it should be completely self-evident how important the pipeline and the domestic refinery is for the Metro Vancouver economy.

OPINION: The Metro Vancouver public consciousness of the importance of the crude oil pipeline would likely be extremely amplified by a shutdown of the Trans-Mountain Pipeline. It is probably one reason why the NDP government in Alberta is considering this action, even though they would know it would come with huge future consequences in the form of an adverse court verdict – one that they are happy to deal with after their next election.

Indexing Illusions

Article: This $100 Billion Fund Manager Says Canadian Stocks Are About to Bounce.

The argument is that because the TSX has underperformed the S&P 500, there will be a regression to the mean that will have the TSX align to the S&P 500 (or vice versa).

This article implies that over-weighting the TSX and under-weighting the S&P 500 would outperform an even-weighting of both indicies.

I’m not predicting the future of each index, but the relevant variable to consider is that the top two sectors of the TSX currently are roughly 35% financials (think the big banks, insurance, etc.) and 20% energy, while the top two sectors of the S&P 500 are roughly 24% IT (think about the FAANGs – Facebook, Amazon, Apple, Netflix, Google, etc.) and 15% financials.

Very roughly speaking, if you think financials and energy will do better, invest in the TSX. If you believe in the FAANGs and want a flatter distribution of sectors, invest in the S&P 500. (Intuitively, it would appear to me that if you bought the S&P 500 and shorted the high P/E components such as Facebook, Amazon, Netflix, Google, and others such as Tesla, you’d probably have a comparable value index – I’m sure some quants out there have already done this simple work years ago).

An index always consists of components that can be individually analyzed. Conventional financial literature suggests that an index somehow is better than investing in components, but the only inherent benefit of this is the risk-reduction power of diversification rather than any basis in valuation.