A nice time to be holding cash

This is a rambling post.

Downward volatility is the best friend of an investor that has plenty of cash.

You will also see these punctuated by magnificent rallies upwards which will get everybody that wanted to get in thinking they should have gotten in, until the floor drops from them again which explains today.

By virtue of having well over half cash and watching the carnage, I’m still not finding anything in fire-sale range except for items in the oil and gas industry which are having their own issues for rather obvious reasons. Examples: Penn West (TSX: PWT) and Pengrowth (TSX: PGF) simultaneously made announcements scrapping and cutting the dividends, respectively, and announcing capital expenditure reductions and their equity both tanked over 10% today. Crescent Point (TSX: CPG) had a fairly good “V” bounce on their chart, but until oil companies as an aggregate start going into bankruptcy and disappearing, it is still going to be a brutal sector to extract investor value from.

I just imagine if I was one of the big 5 banks in Canada and having a half billion line of credit that is fully drawn out in one of these companies. Although you’re secured, you don’t envy the train wreck you have to inherit if your creditors pull the plug.

The REIT sector appears to be relatively stable. Looking at charts of the top 10 majors by market capitalization, you don’t see a recession in those charts. If there was a true downturn you’d expect to see depreciation in the major income trusts. I don’t see it, at least not yet.

Even when I exhaustively explore all the Canadian debentures that are publicly traded, I do not see anything that is compelling. The last debt investment which was glaringly undervalued was Pinetree Capital (TSX: PNP.DB) – but this was in February. They recently executed on another debt redemption which puts them on course to (barely) fulfilling their debt covenants provided they can squeeze more blood from their rock of a portfolio. I wouldn’t invest any further in them since most of what they have left is junk assets (Level 3 assets which will be very difficult to liquidate). One of those investments is a senior secured $3 million investment (12% coupon!) in notes of Keek (TSXV: KEK) which somehow managed to raise equity financing very recently.

The preferred share market has interesting elements to them as well. Although I’m looking for capital appreciation and not yield, it is odd how there are some issuers that are trading at compellingly low valuations – even when factoring in significant dividend cuts due to rate resets (linked to 5-year Government of Canada treasury bonds yielding 0.77%!). I wonder if Canada’s bond market will go negative yield like some countries in Europe have – if so, it means those rate reset preferred shares will have even further to decline!

Inattention to the site caused errors

A very rare administrative post.

For some reason, the links on the specific articles were breaking. I’ve now fixed them. I have no idea why this happened and do not care to investigate further in case if something else breaks. It had to do something with the permalink structure of the site.

This affected commenting and thank you to Safety once again for sending me an email informing me of the problem on this site.

Plunge in the markets

It is very obvious that there was a forced liquidation at the beginning of today’s market session and also parts of the morning. There are some securities out there that were clearly force-sold at the bid. Unfortunately when I am scouring the entrails of this market vomiting, I still don’t see anything terribly compelling that is at insanely clearance prices. There are discounts, but nothing on wholesale liquidation at present. While my expectations might be too high, I remember when Sprint corporate debt was trading at 30 cents on the dollar during the 2008-2009 economic crisis. I don’t expect these types of discounts on large cap corporations, but something close would be nice.

That said, I believe this episode of market panic will end shortly and we’ll probably get some form of a “dead cat bounce”. I find it interesting that despite the fact that Japan went through exactly the same thing that China is going through presently that North American equity markets continued to rocket upwards.

China’s Shanghai index also, despite everything happening recently, is still up year-to-date.

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Days like today are a good reminder why one holds cash – even if you were invested in “safe” securities, liquidating safe securities in market panic situations is not easy – you will still receive adverse pricing due to the bid-ask spread.

Genworth MI Q2-2015 review

This is part of my continued coverage of Genworth MI (TSX: MIC). There wasn’t anything too remarkable about Q2-2015’s report other than that delinquencies in Alberta have not been materially increasing. Combined ratio is at 37% for the quarter, which is in-line, and the company wrote $205 million in premiums, which is significantly higher than the $160 million from the previous year’s quarter. As the premiums recognized is significantly less than this number ($144 million) as policies amortize, the revenues to be recognized will be increasing over time.

The conference call transcript would suggest that management is quite aware of the economic fallout with regards to oil prices and Alberta’s economy and also the mortgage fraud issues that Home Capital Group (TSX: HCG) disclosed.

Portfolio management moved out of common shares and into preferred shares – from the beginning of the year they moved about $190 million of capital into preferred shares in the financial and energy sectors. Considering all the carnage going on in that sector (please read James Hymas for his most brilliant descriptions of the Canadian preferred share market) this is probably a reasonable decision on valuation.

The company repurchased 1.54 million shares at $34.38/share during the quarter. Considering this is below their book value, share buybacks are an accretive transaction. The company’s ability to conduct share buybacks relies upon them being “modestly” above a 220% minimum capital test ratio (which was at 231% at the end of Q2).

With MIC.TO shares trading at $29 as of last Friday, any further share repurchases at this price range (in my humblest of opinions) would be a highly beneficial transaction for remaining shareholders and the company should be exercising another share buyback this quarter – basically at current prices every dollar they spend on a buyback is minting about 25 cents of value from thin air.

The market price is clearly trading on fears of some sort of downturn in the Canadian real estate market. With the carnage going on in China there may be some foreign liquidation of domestic land, but how much collateral damage this may cause in the broader market remains to be seen. Employment rates are the primary determinant of the ability for people to be servicing their mortgages and right now this is appearing to hold steady at 6.8%. Although the horizon appears to be stormy, there seems to be a reasonable economic buffer between the fundamental valuation of Genworth MI and the risks ahead concerning the mortgage insurance market. Cash generation is still immensely huge and combined ratios are incredibly low.

I have always likened Genworth MI to be a glorified bond fund with a housing-linked component that will boost returns providing the Canadian economy doesn’t implode (i.e. default rates will rise) beyond the 2008-2009 economic crisis levels. The current trading price is on the lower depths of my fair value range and I am eyeing it closely.

Search for yield – Dundee Corp

Dundee (TSX: DC.A) is an investment corporation. They are family-controlled (by the Goodman family) who control approximately 87% of the voting interest and 18% of the economic interest of the firm through a typical dual class share structure.

By virtue of owning Dundee Financial and other majority and minority-held investments, their consolidated financial statements are a mess to read. When pulling apart the components, they are diversified among real estate, energy, financial, mining and agriculture, in that order.

At the end of the day their stated book value is about $1.45 billion dollars, trading at a market capitalization of about $540 million. There are good reasons to believe the book value will be impaired simply due to their slowness in writing down some investments that clearly will not perform, but even assuming a 50% write-down (which seems appropriate) this brings the entity down to a liquidation value that is still well above its market capitalization.

On the liability side, the holding company has $92 million in term facility debt and subsidiaries make up approximately $100 million more in non-recourse debt. The leverage is not huge. The term facility is good for $250 million total and expires in November 2016 which is salient to the discussion below.

I generally have an aversion to controlled corporate structures as a minority holder unless if there are significant reasons why one would believe there is an alignment of interests. There also needs to be some reasonable assurances there isn’t a cesspool of conflict of interests in the other subsidiaries / operating companies that would cause shareholders to believe they are being taken to the cleaners with. I don’t get this element of confidence with Dundee, so I would steer away from the common shares. This is also found in companies with similar capital holding companies, including firms that have been on and off my radar (let’s be specific: Pinetree Capital is one of them – trading at around 50% of reported net asset value!).

On a more humorous note, Dundee’s logo also looks like the Blackberry logo, which is kind of disturbing considering how Blackberry has fared:

At least their logo is pointing upwards instead of flat.

I am writing not about the common shares, but rather the preferred share securities of Dundee. They have a series of preferred shares (Series 4) which has a par value of $17.84/share. The reason for the unusual par value was because Dundee split off DREAM Unlimited (TSX: DRM) which partitioned the original preferred share series issue (into DC.PR.C and DRM.PR.A). The shares have a coupon of 5%, paid out quarterly.

The preferred share series has an interesting feature: they are redeemable by the holder for $17.84/share after June 30, 2016. They are also retractable by the company indefinitely (at $17.84/share cash) and convertible into common shares at 95% of TSX market pricing or $2/share, whichever is more until June 30, 2016. The aggregate value of the preferred shares at par is $107 million.

This creates a rather interesting situation where an investor can purchase shares today (trading at roughly 97 cents on the dollar) and force a redemption in about 10.5 months’ time, skimming a 5.15% preferred yield and a 3% capital gain. One clear risk is whether the common shares will be trading above $2/share by June 30, 2016, which would seem to be a likely bet even if the underlying asset value of Dundee’s oil and gas companies are seriously impaired. It also does not help that most of their operating entities and equity-accounted entities are losing money, but the question is how much money will they actually end up losing between now and June 30?

There is also sufficient management interest in ensuring that their (not trivial) 18% economic stake in the firm is not diluted with a share conversion, coupled the with the fact that their operating credit line appears sufficient to pick up the bill (in addition to the $87 million cash they already have on hand in the holding corporation).

The preferred shares are extremely illiquid and trade in a narrow range that is presumably due to the redemption/retraction feature.

It is an interesting gamble that seems like it is reaching out for yield, but with an element of security given the pre-existing credit facility and 80% distance between the existing common share price and the $2 floor for preferred conversion.

In relation to the tax-preferred status of an eligible dividend coupled with a (presumed) capital gain at the end, one is looking at a functional tax-preferred 8% with a reasonable amount of asset security (although the security is implied by redeem-ability, definitely not direct security!), contrasted with a fully-taxable 1-year GIC at 1.2% (without liquidity) or 0.85% with liquidity. The spread seems to be a reasonable compensation for risk.

I would like to thank a comment poster by the name of Safety, who on May 25, 2015 posted about this in one of my prior rantings. I was indeed quite surprised at the quality of this person’s comments and hope he can chime in here again.

Anyhow, I finally picked up a few shares.