The most profitable industry on the planet

At this time, the most profitable industry has to be mortgage insurance in Canadian real estate markets.

Genworth MI (TSX: MIC) reported Q4 earnings.

The loss ratio reported was 10%. The expense ratio was 21%.

This means out of every dollar recognized in revenues leads to 69 cents of pre-tax profit.

Needless to say, this is a gigantic amount of economic extraction from an industry that is somewhat protected (by virtue of the federal government taking the mountain’s share of profits through CMHC).

It is funny how the public hasn’t connected the dots on how this makes borrowing with large-ratio mortgages extremely expensive – a 10% down mortgage can incur a 3.1% mortgage insurance fee. While 3.1% may not intuitively seem expensive, it is a huge fee considering that the bulk of the risk of default in a mortgage occurs in the first 5 years (where in a typical 25 year amortization, about 15% of the loan is amortized) while the rest of the time period is generally “home free” for the loan provider. This effectively results in a 60bps accretion to a loan’s profitability (compare that to a bank that makes less spread than that on the mortgage loan itself!).

Brookfield is in the very late stages of taking MIC into its fold at CAD$43.50/share. At the rate they reported net income in 2020, that works out to about 8.5 times earnings.

Normally industries with such large profit margins attract competition. The barrier to entry is access to the Government of Canada guarantee (CMHC gives a 100% guarantee, backed by the Crown, while MIC is 90% guaranteed by the Crown, with the residual guaranteed by their shareholders), and access to the mortgage networks (which can give approvals based off of customer profiles). Not an easy industry to crack for a new entrant, and the only real basis of competition would be price.

Enbridge Line 5 and pipeline politics

It is going to be very interesting to see what happens with Enbridge and Line 5.

The reason why the Federal Government cares about keeping Line 5 operational is because it processes about half of the crude oil that is refined for southern Ontario and Quebec. You can take a car to Sarnia and see the refineries.

A shutdown of Line 5 would, needless to say, be very disruptive for the region. There isn’t a good way to get additional capacity into the area – the other routes are fully utilized.

The federal government only cares about what is good for, roughly, the traditional boundaries of Upper and Lower Canada. Any policies that are tailored for areas away from this geography is strictly coincidental.

Thus, the Keystone XL cancellation was of little concern to Ottawa. The usual lip service of condemnation by politicians, when it is so obvious they don’t mean it.

I am still somewhat mystified today that the federal government bought out the Transmountain pipeline project – most people do not know that there is an existing (profitable) pipeline in place. Its existence does not matter an iota to Ottawa.

Line 5, however, is different. It fuels Ottawa’s core geography.

It was not longer than a decade ago when this strategic and political vulnerability was identified and hence the Energy East project was conceived. After the Liberals got into office in October 2015, they proceeded to kill the project with a never-ending wall of regulation.

We fast forward today and see where such lack of strategic thinking is par for the course in Canada.

It is not my job to moralize about the inadequacies of government thinking, but rather to pick out winners and losers.

I am still puzzled why so many people are in love with Enbridge as being a staple in their yield portfolios. There is far more risk than they imagined.

The sentiment will change when there is a real connection between very poor decisions and actual hardship experienced by people. The lag between the two, however, could take many, many years and attribution of blame may be misdirected.

Likewise, few lament over how much richer we could have all been, collectively as a society, had we had our act together to begin with.

Politicians, however, are not rewarded for making optimal or efficient decisions. In fact, they have a gigantic incentive to not solve problems, lest their purpose of existence be threatened.

Dorel’s going private takeover bid increased

Dorel (TSX: DII.B) was in the process of going private. Their previous bid had been CAD$14.50, but today they announced this will rise to CAD$16.00.

This post is not to discuss the valuation of the offers, but to highlight a trend of increased bids:

Rocky Mountain Equipment: CAD$7.00 -> CAD$7.41
Great Canadian Gaming: CAD$39.00 -> CAD$45.00
Dorel: CAD$14.50 -> CAD$16.00

Dorel’s bid was already somewhat anticipated by the market, where at around Christmas they started to trade over the CAD$14.50 threshold:

One can have hope for Atlantic Power, but I’m not holding my breath!

How much to pay for yield?

Some near-guarantees of interest income, how much will people pay for it? This is typically represented in a “yield to maturity” calculation but here is another way of looking at things which may be a little more intuitive – it involves capitalizing the cash stream to be received to the present, with a zero discount rate. It is a fun exercise:

* Bombardier 8.75% December 1, 2021 unsecured debt, not callable: Trading at bid/ask 104.35 / 105.65. Bombardier has completed their disposition of their transportation division with Alstrom, and has indicated they are exploring how to manage their debt. This one is the nearest term maturity and is a lock to mature. As there is 10 months left to maturity, the remaining coupon is worth 7.3% of par, so at the midpoint, an investor would be paying 105% to receive 107.3% over 10 months.

* Yellow Pages (TSX: YPG.DB) 8%, stated maturity November 30, 2022 but callable at par, May 31, 2021. Trading at bid/ask 101.2 / 102.4. Management has stated for the past few quarters they will be redeeming this debt as soon as they can. With 4 months of interest remaining, that is 2.7%. There is a tiny, tiny amount of optionality in the potential conversion (they can be converted into stock at $19.04/share but that is 55% above the current trading price and not too probable, although one quarterly report showing revenue stabilization would alter that conclusion).

We also have some “zero-coupon” equivalents in the form of merger arbitrage.

* Atlantic Power (TSX: ATP) will be bought out for at least US$3.03 in the second quarter. Right now, trading at US$2.96, that is +2.4% over an estimated 3-5 months (more attractive than the bonds presented above, in addition to the gain being on capital and not income account!). The risk of merger arbitrage, of course, is that the deal will fall through.

The baseline for cash is the high interest savings ETF (TSX: PSA) which gives out a yield of about 50 basis points at present. There’s almost no point in investing in this ETF at present, but they have a whopping 2.4 billion in AUM, skimming off 15bps of MER, so good for them.

The above are examples that will yield superior returns than the risk-free option. Indeed, there are plenty of options to skim a few hundred basis points of yield for very little risk, but it involves work and paying attention. It does come at the cost, however, of liquidity.

A quick goodbye to January – some random thoughts

The month came and went, and despite all of the theater of Gamestop and the rest of the overall market, there weren’t any portfolio actions of note (some minor tweaking here and there, but it was some minor trimming and minor purchasing of existing positions, less than 1% of the portfolio).

In general, since the November “Biden jump”, many targets of opportunity out there have jumped up in price and presented themselves of being far less compelling than in 2020.

As a consequence of the two takeover offers that occurred in January (FLIR Systems (Nasdaq: FLIR) and Atlantic Power (TSX: ATP)), coupled with an imminent call of Gran Colombia Gold Notes (TSX: GCM.NT.U) and Bombardier’s inevitable debt repurchase offer, my effective cash position is in the teens at present. I’m still being paid to wait with these positions (merger arbitrage and collecting bond coupons is great, but oh-so-less exciting than watching Gamestop get volatility halted 8 times a day) so I’m in no rush to clear them out due to the lack of compelling alternatives.

There was one TSX stock that I performed an intensive research deep dive on, at a valuation that was compelling enough to put in an order to take a small starter position if the market allows for it. Price-wise, it did crash about 50% peak-to-trough during the Covid crunch (March 2020) but its recovery has been tepid, in a manner that I believe is relatively unwarranted. It is most definitely not a household name. It is also unlikely to triple overnight, but it should continue to retain value. Consider this a low risk, medium-reward type opportunity – a base hit single type investment.

Other than this, I’m happy to accumulate cash.

With vaccinations on the way, we will start to focus on the real economy again, the economy that has not been artificially inflated by fiscal spending in the name of COVID-19 mitigation. This is going to present itself as a very ugly picture.

For instance, when we look at the November 2020 snapshot of Canada’s Fiscal Monitor, we see the following:

Note the GST collections: In April to November 2019 (8 months), the government collected $27.2 billion. In April to November 2020, the government collected $18.8 billion, a 31% decrease.

GST collections form the purest indication of end-consumer activity of GST-able products – i.e. non-food, non-export, non-residential rent consumption. This part of the real economy has exhibited a gigantic depression in activity. It is inescapable that this will take a very long time to recover to pre-COVID levels.

For historical context, during the same time periods, here were the GST collections for 2016 to 2020, April to November:
2020: $18.8 billion
2019: $27.2 billion
2018: $27.8 billion
2017: $25.8 billion
2016: $23.5 billion

What’s interesting is that the real economy was already going south before COVID-19 occurred.

Finally, in the belief that lightning can strike twice, the retail crowd that took Gamestop up to the roof is trying the same with the silver commodity. I couldn’t have picked a worse commodity to try to engage in market manipulation with. It all makes me wonder if this is part of some massively elaborate joke. That said, you might wish to be rounding up the cutlery in your grandmother’s kitchen – if silver heads up to $420 an ounce (funding secured), I’ll definitely be selling it.