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.

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.