De-leveraging

Leverage is great – only when everything is appreciating. Indeed, if things appreciate, the leverage ratio goes down since the loan-to-equity ratio goes lower. A simple example is taking a $100 portfolio, borrowing $100, which gives you a 50% loan-to-equity ratio. If your portfolio appreciates 10%, the loan-to-equity goes down to 45%, and suddenly you’re feeling more comfortable again.

This basically explains the real estate market – you buy a house, take a mortgage for 80% of the house value (paying 20% down), and when the real estate market goes up 40% (like it has in the Vancouver area), suddenly your loan-to-value ratio goes down to 57% – let’s suck more money out of the house and get that back to 75%! This means borrowing another 25% of your original house value.

This all works, until the underlying asset value falls and you have to pay back your loans. In the instance of an initial 80% loan-to-value, a price drop of 10% means the loan-to-value goes up to 89%.

The same dynamics go for portfolio management – leverage is painful in the down direction because your loan-to-equity ratio becomes more concentrated.

Clearly, the best time to de-leverage is when you’ve made your anticipated gains.

I’ve started to take some money off the table. Specifically, Genworth (NYSE: GNW) and most US insurers have gotten hot because of the probability of the federal reserve increasing interest rates again.

After raising cash, the most difficult part of investing is to wait. The easiest way to lose money is to do something with cash just because it is earning zero yield in the brokerage account.

Genworth MI – Despite housing slowdown, still undervalued

mic

Genworth MI (TSX: MIC) has gone nowhere in the past three months, despite the corporation lowering losses from insurance claims and the housing market being relatively stable to date. The company trades at a 10% discount to book value, and also at a P/E of 9 (realizing that these two metrics are not the only ones that insurance companies should be valued by, but suffice to say, unless if the insurance written is completely bad, it is difficult to lose money when buying something under book and under a P/E of 10).

There are a few cautionary flags – the reduction of their portfolio insurance business (which allows third-party financing firms to securitize and sell their lower loan-to-value mortgages with portfolio insurance) and also the slowdown in housing sale volumes, combined with the attempts by the BC Government to quell foreign ownership with a 15% transfer tax for non-permanent residents or citizens.

In particular, the transfer tax has caused quite a quenching of the roaring housing fire that was occurring in the southwestern BC housing market. This in turn has spooked the various markets linked to residential real estate. However, it is my assessment that as it relates to mortgage insurance, the market has continually over-estimated the impact of the short-term gyrations in Canadian real estate.

What would cause issues is mortgage serviceability and this is a function of employment, not housing prices. Although there is correlation between housing prices and construction-related employment, if there is not mass unemployment it is difficult to see how somewhat lower housing prices would cause difficulties in the mortgage insurance space. Indeed, the $300 billion ceiling for private insurance in Canada seems to be more of a daunting barrier than the state of the actual insurance market.

It is worthy to note that during the depths of the 2008-2009 financial crisis that the loss ratio peaked out at 46% (June 30, 2009) and this still resulted in a profitable book for the firm. The subsequent combined ratio peaked at 62%, which means that for every dollar of revenue booked that the firm recorded a gross profit of 38 cents.

Also, the corporate has increased its quarterly dividend every year for the past 5 years – it is currently 42 cents and if prior patterns continue they will likely raise it to 45 cents per share. Although the yield is not important (cash generation is), there are various market participants out there that only care about yield and this would serve to boost the stock price.

Bombardier debt trading like it is investment grade again

What a difference a year makes for Bombardier’s (TSX: BBD.A, BBD.B) credit profile:

bbd

Their credit profile over the last year has improved considerably – they can now tap debt capital from the market at reasonable rates. Right now the closest comparable is the 8.5 year maturity for 8.5% yield.

The market is clearly believing that their solvency concerns are over. This would likely get cemented (and yields will compress even further) on successful deliveries of CS100/CS300 jets to their customers, of which two are already delivered and 356 are currently in the pipeline.

The more junior preferred share (TSX: BBD.PR.C) with a 6.25% coupon is trading at a current yield of 9% (eligible dividends), which should continue to go lower as confidence increases in the firm’s ability to be financially sustainable with the C-series. The rumours of the pending Learjet sale would also be an injection of capital if it did occur, but it does not appear that this is necessary, nor is the rumoured injection of capital by the Government of Canada (although this might occur to give future customers the impression that the government will not let the company fail).

The common equity remains pinned around CAD$2/share, and there is considerable overhang from the warrants issued from the two Quebec financings. I doubt that there will be cash dividends on the common shares until the turn of the next decade.

Selling volatility works, until it doesn’t

Since February, yields have compressed to the point where I am getting a bit suspicious that we are going to see some spreads widen again whenever we get some sort of credit event that will cause another round of financial distress. I am not forecasting when this will happen, but historically speaking, the lead-up to the presidential election always causes unwelcome volatility. Right now the assumption is that Hillary will win, but between now and the early November election date, things will change when the public actually starts to pay attention again to their two choices.

The markets, however, do not appear to indicate to price in much risk. Following is a chart of the VIX:

vix

The last time volatility got that low was back in the middle of 2014 (remember when oil was at US$100/barrel?).

Volatility is typically anti-correlated to positive price movement. Right now, investors that sell risk on the main index are not receiving much money for what is a piddling amount of yield – an at-the-money option sold a month out on the S&P 500 will only yield an investor about 1.1% on their at-risk amount, which is very, very, very low. Looking out nearly 5 months to mid-January, that same premium is 3.7%.

In the event of a market crash, an investment in put options not only profits due to the pricing differential between market and strike, but also due to the increase in volatility that occurs during turbulent markets. There’s probably never been a better time to invest in a potential market crash than right now, but the phrase that says markets can be calmer for longer than one can remain solvent applies.

Indeed, I am seeing many market prognosticators talk about skepticism of the existing market conditions, that the indexes (which are at all-time highs) are sputtering, that the economy recovery is long in the tooth, etc, etc. This does not bode well for crash conditions, which happen when there is stress and underlying causes to force entities to liquidate at all costs.

I can’t conceive what could cause crash conditions other than a major WMD event to the scale of a 9/11.

I still believe that a cautious approach is appropriate and that the market participants that will get the most out of the market will do so on the fixed income side. However, these opportunities I have noticed have basically vanished from the good risk/reward column to just ordinary. Ordinary valuations are good enough for me to hold onto things, but not nearly enough for me to invest in.

I was fortunate enough to fully participate in this market cycle, but in general at present, I am in a very slow liquidation mode as I do not see much worth investing in. There are a couple portfolio components (fixed income) that are trading at prices that are within 5% of me dumping it, but I am no rush for them to get there – I will keep collecting dividends, distributions and interest to pay down the very low interest margin debt. In general, I see about a maximum capital appreciation of about 15% in the remaining portfolio for still relatively low risk – even if the actual appreciation is zero, the weighted average coupon is 7.9% and I get paid to wait.

If we get some sort of spike that caused a general portfolio rise of 10%, I would have sold enough to have a healthy double-digit percentage cash balance. If this portfolio spike was 15% from present levels, the only things I’d be holding would be my bonds to maturity (unless if those too were trading ridiculously above par value). Then I would go on vacation and wait a long time.

Sometimes I am furiously active on trading, and sometimes there are very dull moments. The past few months have been very dull and I’ve been twiddling my thumbs. My investment strategies have been working and there will be a time to shift gears once my current strategy has run out of gas. Just not today.

An incorrect call made in the past – Whistler-Blackcomb

Everybody likes writing about their winners, but it is equally important to understand why failed predictions end up so.

Many, many, many years ago, I wrote about Whistler-Blackcomb’s (TSX: WB) IPO and about how I was quite leery about it.

With today’s acquisition offer by Vail Resorts, it should end this particular story – and was I ever wrong about the market valuation of the entity! WB went public in 2010 at $12/share, and they closed today at $36.63 a share, which would be about a 21% compounded annual gain for shareholders. I said when they got public “I might think about buying at $5.30/share”, but it never got close.

Why was I so incorrect with my projections? Putting a long story short, their resort operations ended up producing more profitable revenues than I originally anticipated, coupled with the fact that their capital expenditures remained below their ability to rake in cash flow – their net debt situation has been positive (i.e. net debt reduction) since they went public. With increasing profitability and decreasing financial leverage, I believe the partners of the Whistler-Blackcomb entity have done very well financially.

I never liked the fact that a good chunk of the publicly traded entity only represented a partial amount of the full operation – there was a huge amount of minority interest that would have siphoned a lot of economic upside. There were other residual risks (Whistler is quite developed as it is and there is significant political cost to further development in the area) that made me skeptical of the performance of the corporation. There was also the nagging feeling that the company was trying to cash out on the Vancouver 2010 Olympics.

The takeout price (a combination of roughly half cash, half stock in Vail Resorts) is higher than I would have ever expected such an offer to be. The acquisition is strategic in nature, so Vail Resorts should be able to achieve some sort of cost synergy with Whistler. That said, I’d be happy with the price received.

I have never owned nor shorted any shares of WB, and I am glad to have not!