Featured on the Globe and Mail – reflections on dealing with short selling reports

I’d like to thank Larry MacDonald for mentioning me on his regular article on the Globe and Mail about short selling on the TSX.

A hedge-fund analyst once sold short a company in which Sacha Peter had invested. Then he published a critique on it.

Did Mr. Peter, author of the Divestor blog, rush to his keyboard to click on the sell button, or log into online forums to urge a squeeze on the short seller? Not at all.

Instead, he rolled up his sleeves and dived into the critique. After reading it, the shares remained in his portfolio and were later unloaded at a profit.

It may not always turn out as well as it did for Mr. Peter, but there is something to be said for monitoring the trades of short sellers to see if any are targeting a stock you hold. As Mr. Peter says, “I very much like reading the short-sale cases of anything I hold. It forces me to check my analysis.”

Larry was referencing my post back in April 2018, The case to short Genworth MI, where a very intelligent young analyst won an accolade for writing a fairly comprehensive short report on Genworth MI.

Keep in mind there is no “one size fits all” strategy concerning how one deals with new information that comes with people or institutions issuing short selling reports on your holdings. Everything depends on your ability to perceive fact from fiction, and perhaps more maddeningly, perceive the market’s sense of reality versus fiction that they bake into the stock price.

I’ll also talk about a time where I got things less correct.

Go read my August 2020 post on what happened when a short selling firm released a report on GFL Environmental. I had taken a small position on one of their hybrid securities (effectively yield-bearing preferred equity with equity price exposure above and below a certain GFL price range) and then a short sale report came out. I bailed very quickly. Retrospect has shown that wasn’t a good decision financially (right now GFLU is about 70% above what I sold it for including dividends), but one of the reasons for bailing was because I was not nearly as comfortable with my level of knowledge about the company than I was about Genworth MI. Another reason is that there were still very active market reverberations going on during COVID-19 so there were plenty of alternate investment candidates for my capital. I’d also like to give a hat tip to Jason Senensky of Chapter 12 Capital for his comment that has stuck in my mind ever since, which is his insightful analysis that my “return on brain damage is too low” – which indeed is an accurate reflection that my mental bandwidth on such cases is better spent elsewhere.

And while I’m on this topic, Jason also wrote a fantastic article on the near-demise of Home Capital Group, instigated by a high profile short seller. Hindsight is 20/20, but I feel like there was a missed opportunity on that one – I should have taken the cue after they announced they obtained their ultra-expensive secured line of credit facility (it marked the bottom of their share price).

Corporate earnings for the quarter – Oil and Gas

The next couple weeks will be busy processing quarterly earnings reports.

Oil and gas, however, will be the most interesting. There will be a bonanza of cash flows.

MEG Energy (TSX: MEG) was the first off the bat.

I’ll spare the details and focus on the following line in their PR:

Based on the current commodity price environment, MEG anticipates generating approximately $275 million of free cash flow in the second half of 2021, which will be directed to further debt repayment.

Just below that they talk about one of the worst hedges I can think of, which was to hedge for oil prices in Q2-2020 in a US$39-46 WTIC band. They have about 1/3rd of their production hedged at this level (29k BOE/d) which has lost them a gigantic amount of money. Fortunately it is done after the year is over, but it will be another $125 million of damage (lost potential) at current prices. The hedges cost them nearly half a billion dollars in lost opportunity in the first half of the year.

Adjusting for their hedge disaster, the “true” projected free cash for the second half is closer to $400 million.

Considering the enterprise value of the company is around $5 billion, that’s trading slightly above 6x EV/FCF. This isn’t a case of some US shale driller with a 35% annual decline rate – MEG’s asset is much longer lasting.

MEG currently does not give out a dividend. They are pouring free cash into reducing their debt – they announced they are paying back US$100 million of their existing US$496 million 6.5% senior secured second lien notes (matures 2025). At the rate cash is being generated, they will be able to retire debt this sometime in 2022, and after they will be able to work on the US$1.2 billion 7.125% senior unsecured notes. This tranche matures in 2027.

If oil stays at current pricing, the debt gets removed pretty quickly (in addition to saving money on interest expenses).

Eventually there is a point where it becomes logical to buy back stock, assuming they stay at 6x EV/FCF. It’s a matter of whether management wants the sure 6.5 to 7.125% return, or whether they want to buy back stock at a 16% return on equity.

I speculated that somebody else might be happy to do that for them.

Brilliant marketing for yield-challenged investors

The chase for investment returns in our zero interest rate environment incentivizes the creation of all sorts of financial products to give one the perception of yield.

Indeed, I can promise you today a 10% yield. Just give me $100 and I will give you a 10-year yield of 10% a year, starting with a 10% distribution 365 days from now. Boom, guaranteed yield!

But hold on, it isn’t enough that I hold onto your capital for a decade, I want to charge some management expenses.

So how about you give me $100 today, and I’ll give you a target 8.5% yield. That might change if I can’t actually generate the returns, or if I can’t find more people to give me money to pay you.

A good example of yield-promotion financial instruments are split-share corporations, which appear to no longer be in vogue. There has to be new financial products that promote high yields!

Cue in the marketing geniuses at Hamilton, who have spammed the media with their “Target yield of 8.50% with monthly distributions” fund!

I couldn’t resist looking at the detail of the financial wizardry to make it happen.

This is a fund-of-funds:

And the strategy: “The fund seeks to replicate a 1.25 times multiple of the Solactive Multi-Sector Covered Call ETFs Index (SOLMSCCT), comprised of equal weightings of 7 Canadian-listed sector covered call ETFs.”

In other words, there is some person that puts in a buy order for 7 ETFs, and does it with 20% margin (i.e. buy $125 of funds with $100 of equity).

The geniuses at Hamilton don’t even have to program any software to manage the covered calls or the index balancing – they leave it to the constituent funds to doing so. The fine-print prospectus references a semi-annual rebalancing to equal-weight the funds, and to keep the leverage between 123% to 127%.

The 8.5% indicated yield is not in the prospectus, but it is clearly the marketing pitch. 8.5% divided by 1.25 is 6.8%, which is the basis for this yield claim.

For this, they charge 65 basis points.

A pretty good business for them.

I find this phenomena of covered call ETFs and the promotion of covered calls to be highly over-rated. Most retail people perceive covered calls to be free money (“even if I do get called out, it is at a price that I would have wanted to sell anyway”), but there is a significant exchange of future upside capital appreciation for a “yield” today. This yield is not free, especially during times of low volatility. Implied volatility of options tend to drop when the underlying price appreciates, and vice-versa. The best time to get the highest option yields (when implied volatility is the highest) is typically during a market crash, which is precisely the time you do not want to be selling the capital upside of equities.

Conversely, at that exact moment tends to be the ideal time to sell put options, but few people in the heat of a market crash want to do so, and indeed, selling puts during a market crash is not the most financially productive activity since the amount of upside you capture is limited to the put premium. There is no free lunch in this game although slick marketing makes it appear to be the case.

The TSX 60 currently yields around 2.7%. At 125% leverage, it would yield around 3.4% ignoring the interest cost. If you got rid of Shopify (about 10% of the index now!) that yield rises to about 3.7%. Is it a stretch to think the capital component of the TSX will rise 5% in the future? Maybe. But the sale of 2-month at-the-money covered calls on the TSX right now is 1.4% and that more or less locks in a (unleveraged) 4% return with only capital downside. The 2-month covered call option yield if you wish to retain about 2% capital upside is about 40 basis points. When you include a friction of 65bps MER, I don’t see how the math works at all.

Virgin Galactic – Cool but economically challenged

I wrote back in 2019 about the original SPAC that took Virgin Galactic (NYSE: SPCE) public and my thoughts haven’t changed much from today.

Indeed, they had their hype – astute traders gamblers have seen their capital go from $10 up to $35, down to $15, up to $60, down to $15, up to now $50, in what is oddly like the trajectory the Virgin Galactic spaceship flies itself.

Today the main headline is Richard Branson flying out in one of those spaceships, in what was a massive marketing exercise – I bet Branson was jealous of all of the hype that Elon Musk was stealing over the past few years.

Much to their credit, the rocketship flight made it – they got their 70 seconds of propellant out and made it to the height of about 280,000 feet (or about 85 kilometers above the ground).

The marketing exercise is caused by the perverse anticipation of disaster, similar to how some people watch automobile racing to see car crashes.

This is all great and everything, and SPCE is likely going to trade up Monday morning, but I deeply suspect it will be a great time to short the stock. I will not be – I only mentally trade these sorts of situations with a million eyeballs and daytraders that will inevitably be crowding around the stock.

The issue is that the while the venture tries to do cool things, from an engineering perspective sending a craft out 85 kilometers over the surface is much, much more trivial than it is to send it to a practical altitude (low earth orbit) with the energy required to keep it there – Virgin Galactic’s ship just requires it to go up, and it glides to the bottom. A rocket ship going into low earth orbit requires it to go up (for example, the international space station is about 420 km above the surface), but also horizontally (about 28,000km/h) to keep it in perpetual free-fall. This requires a lot more energy to perform, and a lot more engineering with the design frame and engines which need to scale up disproportionately in order to haul these loads into orbit (mainly to handle the amount of fuel required to get there). This isn’t a matter of “extending the frame” to fit further usages – that design is hard-wired.

Amazon’s Jeff Bezos’ Blue Origin has a different system, the New Shepard rocket ship (which unlike Virgin Galactic, starts on the ground instead of on an airplane), which is designed to send people in a capsule up to around 105km – with a 110 second rocket burn. They will launch in just over a week. The same analysis applies to them as well. Scaling up to a point where you can do SpaceX-type activities requires a lot more engineering than slapping on a few extra engines and increasing the size of the fuel tank.

As such, the Virgin Galactic ship, as currently designed, has little use other than a tourism vessel. This was the intent of the design, the company was not meant to be other than an amusement factory. Cool but useless – and it’s a business model that almost guarantees there will be no repeat customers, similar to the skywalk at the Grand Canyon.