General Market Comments

The last two weeks of summer, psychologically speaking, are the two weeks before labour day weekend. Families are still on holiday (whatever types of holidays are still available with the myriad of Covid-related disruption around us), children are not at school, and the weather is usually warm enough that one wants to stay outside before the big Canadian winter freeze commences.

In the markets, this also means institutional managers are in the same boat – major policy decisions on how to steer the computerized program trading will likely be made after labour day.

So I do not put much stock in market action that is occurring, other than to observe that the TSX and S&P 500 is at an all-time high:

The Nasdaq 100 is also the same way. Both US indexes are a functional proxy for Apple, Microsoft, Amazon, etc. The S&P 500’s top 10 is about 28% of the index, while the Nasdaq 100’s top 10 is just over 50% of the index.

The TSX’s top 10 are: SHOP, RY, TD, BAM.A, ENB, CNR, BNS, BMO, CN and CP. They are about 40% of the index.

You would think the markets reaching all-time highs would generate some news headlines. It has been exactly the opposite. What do we hear about today?

1. Disaster in Afghanistan
2. Disaster in Covid-19 (take your pick: vaccines not working, variants, travel curbs, ‘fourth wave’, etc.)
3. Disaster in supply chains
4. Disaster in climate (take your pick: hurricanes, wildfires, droughts, heat waves, etc.)
5. Disaster in the Liberal Party of Canada (OK, OK, this was a joke – I will write about the Canadian election later)

The one thing that has clearly NOT been a disaster are people that have their capital in return-bearing assets. Indeed, it has been a disaster if you were NOT in the markets. The TSX is up about 17% year-to-date, while the S&P is up 21%. If you’re lagging this number, you’re effectively ‘falling behind’.

This rise in the stock market continues to be fuelled by monetary policy, with the USA and Canadian central banks still vacuuming up treasury bonds like no tomorrow; and also fiscal policy, with both governments spending like crazy.

The cash will circulate in the economy until the point where it ends up locked in bank reserves, which currently earns a very low rate of interest and will continue to do so for the indefinite future. Individuals that have satisfied their material needs have no other choice but to put their capital into the asset markets, lest they lose purchasing power.

This is the market we have been seeing post-COVID-19, until at such point we do not.

We are well into seeing the price ramifications in this monetary/fiscal regime. The front-row-center for many is the elevated cost of residential housing in urban centers. Indeed, even second and third-tier cities/towns have had an influx of capital just simply because of the people escaping the urban centres. Because of the elevation of such asset pricing, correspondingly, the cost of everything else rises to bake in the extra capital required to use the land.

We also see the impact on the stock market.

The physical world is where things get interesting with regards to the impact of monetary/fiscal policy. Although most of what happens in finance is a transaction of electrons, the physical world is messy. Primary industries produce the raw materials necessary for the functioning of society, and this includes food, energy and minerals. Somebody needs to produce this. As the debasement of currency continues, it stands to reason that the elevated cost structure will result in these commodity prices elevating.

Almost everything (with the exception of gold and silver) has risen since the start of the Covid pandemic.

The result of the increase in commodity prices will be a price transmission on the physical side of the economy that we will have not seen since the 1970’s. This will likely continue until we see a market dislocation event. I do not know what or how this will take place, but when it occurs, it will be like a 9.0 Richter Scale earthquake right next to where you live. And just like earthquakes, it will be very difficult to predict.

Until then, and especially as the conventional media has completely tuned the masses away from the rising stock market, the major indexes are most likely to continue their existing trajectories.

Cervus Equipment buyout – takeover price undervalued

It has been an exciting 2021 with my third company getting receiving a takeover solicitation. Cervus Equipment (TSX: CERV) announced it was being acquired by Brandt Tractor for CAD$19.50/share in cash.

This is still a dirt cheap valuation.

Not surprisingly, they want to close the deal pretty quickly:

Cervus expects to hold the Special Meeting of shareholders to consider the Transaction in October 2021 and to mail the management information circular for the Special Meeting in September 2021. Subject to the conditions set forth above, the Transaction is expected to close in the fourth quarter of 2021.

A two-thirds vote is required, with the chair holding 18% of the stock, coupled with Brandt holding another 9%. Unless if there is some organized opposition to this deal, it looks like it is going to proceed.

The price that is being paid is cheap. CERV has 15.4 million shares outstanding and from the first half alone has generated about $1/share in earnings. Cash-wise, in the first half they have generated about $23 million (about $1.5/share) in free cash. Full-year, they’re probably going to pull in something around $2.50-$3.00/share. Balance sheet-wise, they are at around $40 million net cash, and approximately $13/share in tangible book value, or $16.85 if you include the intangibles and goodwill. Brandt is paying a slight premium over the balance sheet value, but given the earnings power of the company, they are getting a very good price. It is too good a price.

A fair deal would be around $23-24 in my estimation, but who am I to say?

There is some precedent for a small boost up in price – Rocky Mountain Equipment (formerly TSX: RME) was taken over in the middle of the Covid crisis last year for what could be considered a total steal of a price. The original all-cash $7.00 management takeover was boosted to an all-cash $7.41.

In a final slap in the face, the following:

Pursuant to the Arrangement Agreement, the Company has agreed not to declare or pay any common share dividends until the completion or termination of the Transaction.

That said, overall, if the deal goes through at the $19.50 price, I would have made around a 150% gain on this over a year. It was a small position (obviously should have been larger, but the liquidity was awful and there was other stuff on my radar at the time), but just like most good trades, you always wish you took more of it.

I’ll be voting against the deal if I still have my shares. The price of $19.29 presently is a 21 cent merger arbitrage on an October closing and at 6.5% annualized, I’ll hold and hope that there is a minor increase in the takeover price. Other than the Chairman, the greater than 5% owners holding this, at least according to TIKR, are Invesco Canada (7.3%), Burgundy Asset Management (7.2%), Fidelity (6.6%) and Van Berkom (5.8%). They will have to get together to extract another few dollars out of this thing before it delists.

Unlike Atlantic Power and its convoluted capital structure, I have no fears that this deal won’t be closing. At worst, it’ll be cashed out at $19.50/share in October and the capital will go to another happy home.

Ag Growth – Ag Shrink!

Ag Growth (TSX: AFN) used to be my largest portfolio component, but by virtue of depreciation and something else in the top 5 that has appreciated, is no longer. The company’s stock has taken a beating over the past 3 months:

The market was spooked by their Q1 (May 2021) announcement on their conference call regarding the pricing of steel (indeed, when looking at Stelco (TSX: STLC) you can see what they mean) – companies quote projects and their quotations typically remain open for 30 days, but this is like giving your customers a free one month call option on steel pricing, so they had to tighten this up. They said the high-cost backlog would cost them some margin in Q2 and Q3 but it would normalize in Q4 onwards.

In Q2, there was some margin degradation, and besides this, the quarter was reasonably decent. Sales up, gross profits up, margins slightly lower but this was to be expected. However, the killer payload was this line:

In 2021, two legal claims related to the bin collapse were initiated against the Company for a cumulative amount in excess of $190 million, one of which was received subsequent to the quarter ended June 30, 2021. The investigation into the cause of and responsibility for the collapse remains ongoing. The Company is in the process of assessing these claims and has a number of legal and contractual defenses to each claim. No further provisions have been recorded for these claims. The Company will fully and vigorously defend itself. In addition, the Company continues to believe that any financial impact will be partially offset by insurance coverage. AGI is working with insurance providers and external advisors to determine the extent of this cost offset. Insurance recoveries, if any, will be recorded when received.

I had a massive due diligence failure, especially considering one of these two events was within a car ride of where I am. Fibreco sued Ag Growth International and also the professional engineer that signed off on it, in BC Supreme Court on June 4, 2021. There was also a news article on the matter which I totally missed.

This is probably the biggest contributor to the stock getting tanked over the past quarter. $190 million is close to $10/share, but the larger impact is the balance sheet threat.

Ag Growth relies a lot on low cost debt capital to fund its operations. Given the nature of its business, their cash flows are relatively predictable and there is a seasonality with cash collections that require the usage of credit. Their debt structure is funded by unsecured debentures (AFN.DB.D, E, F, G and H) each of which is around $86 million in quantity. The unsecured debt is termed out, with D and E maturing in June and December 2022, while the rest of them are out in 2024 and 2026. They also have some tranches of first-in-line bank debt as follows:

Note that they all term out in 2025 and there is about $95 million of availability on the Canadian revolver and $29 million on the CDN swing line.

However, all-in-all, given there is a total of $900 million of debt between these two series ($430 million of unsecured, and $470 million of secured, roughly at an average weighted cost of around 3.9%), the company’s leverage position is quite extended. Tacking on another $190 million on top of that is a tall order. An increase in the cost of capital, needless to say, will be adverse for the equity holders (a 1% increase in capital cost is about 50 cents per share, pre-tax).

The risk has definitely increased due to the number of unanswered questions.

1. How much will insurance actually cover, especially in the event that AFN is found to be at-fault? What is the maximum coverage? (God forbid if the majority of it was self-insured).
2. When will these proceedings resolve themselves (typically it will be by settlement, but a trial would take a couple years to clear out undoubtedly)
3. (by far, the biggest factor of these three, in my opinion) Because AFN screwed up (whether it is their fault or not, doesn’t really matter at this point) building two grain towers, are there any other towers of like composition that are waiting to crumble down?
4. Will re-financing risk be a factor (specifically with AFN.DB.D, and E)?

Question number 3 could literally be a case of waiting for another time bomb to go off, in the form of another grain silo collapse. Another such event would tank the equity by 20% in a day. This is a sort of unknown-frequency, high severity event that elevates risk.

On the flip side, we have the following:

1. The market for AFN’s unsecured debt is still strong (trading just slightly above par at the moment across the entire term) although the whole point of doing this market analysis is to determine when the market is wrong! That said, if there is some debt distress, it isn’t being reflected in these prices;
2. The company, at least on a basis when grain towers aren’t imploding, should be able to generate around $45 million in cash this calendar year, and in a more normalized year, should be able to generate north of $100 million and de-leverage. This is…
3. … fueled by the fact that agricultural products have had their supply chains really disrupted and the demand for product should create demand for capital spending on agricultural equipment.
4. Lawsuits, especially in Canada, very frequently settle for below the “face value” on the claim.

My last comment is that there was some premium valuation in AFN on the basis of “Ag Tech”, but it appears that this bubble has popped with Farmer’s Edge (TSX: FDGE) cratering (it’s down 75% since its IPO and indeed closer to where it should be trading!). This part is healthy.

The current dividend, at 60 cents per share, or $11 million a year, is not particularly onerous to maintain, especially in the case of ‘normal’ business performance, which should be a lot higher than what they have been doing in the past.

If the overhang on the stock is purely on the basis of this lawsuit, the stock is at a price level where it is attractive. If there are more structural issues with the industry that AFN is in, then my original investment thesis was flawed. I do not believe this to be the case, but definitely the elevation of risk is reflected in the stock price. I’m not happy with this situation, nor am I happy about how it was presented in the past few quarters.

The last chapter on Gran Colombia Gold’s senior secured notes

Quoting the press release:

Gran Colombia Gold Corp. (TSX: GCM) announced today that it has successfully priced an oversubscribed offering of US$300 million in senior unsecured notes due 2026 at a coupon rate of 6.875% (the “2026 Notes”) pursuant to Rule 144A and Regulation S of the U.S. Securities Act of 1933, as amended, (the “Act”), with closing expected to occur on or about August 9, 2021.

The proceeds from the 2026 Notes will be used to: (i) to fund the development of our Guyana operations, (ii) to prepay the remaining Gold-Linked Notes, and (iii) for general corporate purposes. The 2026 Notes have been assigned a rating of B+ by Fitch Ratings and a rating of B+ by S&P Global Ratings.

That’s a lot of money they raised, and in unsecured form! It’s quite the turnaround from years ago when they had to struggle to raise capital through the gold-linked notes (TSX: GCM.NT.U).

It looks like the remaining US$18 million of notes will finally get called out at 104.13. GCM has to provide 30 days of notice of redemption and this will likely happen once the deal closes.

(Update, August 9, 2021: This redemption notice occurred, slated for September 9, 2021).

Robinhood IPO

The true top in the dot-com bubble had to have been the public offering of Palm in the year 2000. Does anybody remember that?

Likewise, Robinhood’s IPO portends to be the equivalent for retail investors gamblers. These sorts of things can only be determined in retrospect, so such statements are not predictive.

That said, Robinhood’s metrics are actually pretty good!

As of March 31, 2021, they have $81 billion in assets under custody and 17.7 million active users. After the IPO they will have 842 million shares outstanding, for a market cap of about $30 billion.

What do we compare this with? Interactive Brokers is a logical counterpart – both companies have functional controlling shareholders, so public investors are simply there for the ride.

IBKR’s public offering is about 22% of the “real” company, but I’ll put a lot of technical stuff aside and state their total market cap is $26 billion on 417 million shares.

This is very similar to Robinhood.

IBKR also provides very good data to the public. More so than Robinhood. For example, Robinhood does not disclose how many trades it executes, while IBKR does.

At Q1-2021, IBKR executed 306 million trades. They have 1.3 million customer accounts and total customer equity of $331 billion. Almost ten times less customers, but four times more customer equity.

In terms of the balance sheet, IBKR has a book value of $9.4 billion, and HOOD post-IPO is around $7.3 billion.

HOOD, however, is growing like a weed. Their Q2 estimate is 21.3 million active users and $102 billion in assets under custody.

The big difference is that HOOD isn’t making that much money (most of their revenues are being sucked up by operating costs), while IBKR is making a ton of money.

But given the amount of capital people are willing to dump into the Robinhood brokerage, coupled with encouraging them to gamble and/or pitch them financial products, makes me think that their valuation isn’t ridiculously stupid. It’s in the ballpark of where it should be.

Despite loving the IBKR platform (it truly is the best, once you use it, you can’t go back), I would not be an IBKR investor at this valuation, nor am I interested in HOOD stock.

My primary concern for HOOD investors is not the valuation. It is that their technology has some sort of problem where they end up like Knight Capital and simply blow themselves up. It’s a much more relevant possibility for them (simply because they are so new) compared to very seasoned brokers like IBKR that have been at it for decades.