Canadian Housing Finance stocks, April 13

On April 13, three notable companies associated with Canadian housing pricing fell considerably: HCG, EQB and MIC.

There were a bunch of other companies that had issues, but it looks like that the trio above were fairly pronounced in the day’s list of losers:

April 13, 2017 TSX Percentage Losers

CompanySymbolVolumeClose% Change
Nthn Dynasty Minerals LtdNDM4,841,0272.17-10.3
Intl Road Dynamics IncIRD203,2032.81-10.2
China Gold Intl Res CorpCGG1,269,5942.43-9.3
Home Capital Group IncHCG972,60621.70-8.6
Aphria IncAPH6,005,7937.21-8.3
Equitable Group IncEQB287,51263.41-8.3
Fennec Phrmctcls IncFRX12,5375.50-8.0
Silvercorp Metals IncSVM1,516,9934.94-8.0
Alacer Gold CorpASR1,881,2092.52-7.7
Street Capital Group IncSCB28,4891.40-6.7
Taseko Mines LtdTKO794,6751.52-6.2
Trilogy Energy CorpTET182,4814.95-6.1
Genworth MI Canada IncMIC221,17434.63-6.0
Top 10 Split TrustTXT.UN9,8634.08-6.0
Guyana Goldfields IncGUY916,0127.41-5.4
Golden Star Resources LtdGSC548,2681.09-5.2
Continental Gold IncCNL852,8253.91-5.1
Arizona Mining IncAZ501,4501.96-4.9
Great Panther Silver LtdGPR387,1652.00-4.8
Argonaut Gold IncAR1,036,6442.43-4.7

I’ve been trying to find what caused this spontaneous meltdown in equity prices.

My 2nd best explanation is that Bank of Canada Governor Stephen Poloz is putting a torpedo to the Toronto housing market by making explicit statements about the 30% year-to-year rise in valuations and about how there is no explanation for it. Specifically, he stated “There’s no fundamental story that we could tell to justify that kind of inflation rate in housing prices, and so it’s that gap between what fundamentals could manage to explain and what’s actually happening which suggests that there is a growing role for speculation“, which is a mild way of saying that people are basically trading houses in Toronto like they did with Tulip Bulbs in the Netherlands in 1636.

He also politely stated that if you believe that housing prices are going up 20% year-to-year, it doesn’t matter whether he raises interest rates by a quarter or half point, and he could even raise them 5% and it wouldn’t make a difference (although it would be rather fun to see him try and see all the mathematical financial models predicated on stability go out the window in one massive flash crash).

However, my primary reason why I think the three stocks crashed is a simple announcement:

==========================

Media Advisory
From Department of Finance Canada

April 13, 2017
Minister of Finance Bill Morneau will hold a meeting with Ontario Finance Minister Charles Sousa and Toronto Mayor John Tory to discuss the housing market in the Greater Toronto Area.

A media availability will follow the meeting at approximately 3:30 p.m.

Date and Time
2:30 p.m. (local time)
Tuesday, April 18

Location
Artscape Wychwood Barns
601 Christie Street
Toronto, Ontario

==========================

Being somewhat experienced with the nature of government communications, there is no way you can get a federal and provincial Liberal with a Conservative mayor doing a joint announcement on something without it leaking to the marketplace.

The only question here is how deep they’re going to stick their silver-tipped oak stake into the heart of the Toronto real estate vampire.

Toys R Us – Not for me

Most people are familiar with the Toys R Us franchise of stores – they sell toys and baby stuff. The Wikipedia entry has a good summary.

Their equity is privately held, but they are still required to report publicly because of debt covenants.

Their financial summary is more grim. They are being slaughtered by Amazon and other online retailers, so their heavy physical presence is causing an erosion of sales and pricing power to the point where they are no longer making money during most of the year.

For instance, from the end of January to the end of October (9 months) in both 2016 and 2015, the company does not make money when factoring in amortization (those physical stores and logistics still need upkeep). The interest bite takes an even bigger chunk out of the corporation.

So the Black Friday and Christmas season is critical. It makes the whole year worthwhile in terms of profitability. Even then, in the past couple years it has not been enough to offset losses of the previous 9 months (In 2016 even when factoring in CapEx and interest, they were slightly short of generating cash).

For the most recent holiday season, same-store sales in the all-critical Black Friday and Christmas period were down 2.5% in the USA and more so internationally. This clearly is not a good trend, and one has to ask whether it will continue or whether it was a one-off thing.

I’m ignoring the fact that their balance sheet is a leveraged mess.

Looking at their latest 10-Q, we have an entity in a negative equity situation (negative 1.6 billion), $420 million cash on the asset side and $5.5 billion in long-term debt.

This is a huge mess. The vast majority the debt is secured. There are convolutions of financings behind the various corporate entities under the holding firm, but suffice to say, it is about as leveraged as things get without getting recapitalized. I believe a recapitalization is inevitable.

Somehow, in August of 2016, they managed to convince the 2017 and some of the unsecured 2018 debtholders to exchange their debt for senior secured notes maturing later in time.

It is the 2018 unsecured notes (7.375% coupon) that I was looking at. They mature on October 15, 2018 and there is US$208 million outstanding (about half decided to exchange their debt for 90 cents of par value of secured debt).

The following is a chart of their trading since the exchange offer was floated:

The debt, at the asking price, has a yield to maturity of 11.3%, and a term to maturity of 1.52 years.

This looked like a Pengrowth-ish type situation where you have unsecured debt that may trump the secured debt on the basis of maturity, rather than security. There is a credit facility that has around $630 million remaining that could pay the October 2018 maturity.

Sadly, the risk of a spontaneous credit meltdown is preventing me from purchasing the unsecured debt. One can also make a legitimate case that Toys R Us will burn through enough cash to prevent them from paying off the October 2018 unsecured debt (they have to accumulate inventory for the that Black Friday / Christmas season and this will be when they need the capital the most).

Hence, I will pass purchasing this debt. I’m going to guess it will trade lower over the next 18 months.

Home Capital Group – The cliche about smoke and fire applies

Home Capital Group (TSX: HCG) fired its CEO today.

The manner that it did suggests that there was a considerable disconnection between the information the Board of Directors was receiving and what management actually knew about the situation (or over-boasted about its damage-control abilities).

My guess is that the final straw was the dealings concerning the Ontario Securities Commission alluded to in the March 14th press release.

Home Capital Group is notorious in my mind for having a very high cost to borrow shares for shorting – it is the biggest proxy used by most people to bet against the fortunes of the Canadian real estate market – right now it would cost you about 22% to borrow to short. Those short sellers will probably be most happy to cover some of their holdings tomorrow (or depending on their risk horizon, add to their shorts!).

Psychology of Portfolio Management – Doing half

There are some situations in the investment world that result in considerable confusion and risk.

In particular, I am still trying to process the action that has surrounded KCG Holdings (NYSE: KCG) last week. The position appreciated considerably, but there is obviously not going to be any resolution to the matter unless if I wake up one day and a definitive merger agreement has been signed. If the initial proposal and subsequent due diligence cycle does not come to fruition, then there will likely not be any press to that effect and the stock price will drop.

There is a very real reason to hold on (the suggested merger price was lower than my estimate of its fair value), and a very real reason to not hold on (there will be no formal merger agreement). Also, there is no information at all whether this merger would succeed or not, nor any indications on timing.

So the solution was obvious. Sell half.

David Merkel is one of my favourite finance authors and he concisely writes about it in an April 2009 blog post and a subsequent November 2016 post.

This is a perfect situation where doing half applies. The psychological advantage is that I don’t have to cry if there is a better price given to the company, nor do I have to cry if they trade lower (since I know where their fair value rests).