Interactive Brokers / Options / Probabilities

Interactive Brokers (Nasdaq: IBKR) is the best brokerage out there that is available to the retail level. They give me a degree of comfort that simply doesn’t exist in any other brokerage firm that I have dealt with. One of the reasons for their superiority is their founder, Thomas Peterffy, continues to push the innovation curve in such a manner that makes the firm cutting-edge.

The company is publicly traded and has been on an unsual uptrend over the past few months:

ibkr

The only reason why I have never put money in them is because the publicly traded entity is essentially a minority slice (12.4%) of the “true” asset and this creates all sorts of perversions of incentives that are not necessarily in shareholders’ best interests. It is a classic case of the underlying business being fantastic but the stock not necessarily being a good investment.

Anyhow, they have a tool that is relatively easy to utilize that highlights potential option strategies given the differences between the market’s implicit probability distribution and your own personal expectation of outcomes. Although I do not trade options very often (indeed, it is very rare that I do so simply because trading options is quite costly in terms of spread), this tool and this explanation is quite intuitive. If you do not understand how options are priced, this is a pretty good tutorial that avoids math.

Clearly understanding the math helps and I would highly recommend people learn some option pricing theory before considering trading them. Putting it mildly, options are a fantastic way of losing money if you don’t know exactly what you are doing. Options also appeal to gambler-types that love seeing huge rewards in total disproportion to the amount risked.

Petrobakken / Lightstream

It has been some time since I’ve written about Petrobakken (prior slew of articles here), now renamed Lightstream Resources (TSX: LTS).

Pretty much the trajectory to its share price was what I was more or less expecting, simply because investors would come to the realization that capital expenditures are indeed expenses that are incurred today, as opposed to over some mythical amortization curve:

lts.to

A few weeks ago the company announced its targeted production rates, but finally started introducing language concerning the leveling off of its production. The language used in the release was quite creative:

As our resource play assets mature and our base decline rates gradually reduce, we continue to work towards levelling out our production profile and increasing our annual average production levels on a year over year basis. As we enter the fourth quarter, we are on target to exceed the lower end of our forecasted 8% to 12% annual average production growth (46,000 to 48,000 boepd) and we continue to target exit production in excess of 47,000 boepd. By addressing facility challenges and executing the remaining components of our 2013 capital program, we believe these achievements will be met within our capital budget of $700 to $725 million.

We are currently finalizing our operational and financial plans for next year and remain committed to improving our sustainability ratio (cash outflows compared to cash inflows), lowering our debt to cash flow ratio and improving our liquidity through the many options available to us, which include, but are not limited to, modulating capital expenditures, selling assets, terming-out debt, altering our dividend program or issuing equity. Over the long-term, we continue to target a sustainability ratio of 100% and a debt to cash flow ratio of 2.0 or less. We plan to announce further details with respect to these options when we release our 2014 guidance later in the fourth quarter of 2013.

I love the use of the word “modulating” instead of what it really is – a reduction. Once the production curve is levelled, the financial game is finally over – there is a very clear indication how much money is required to maintain stable production. And investors figured out some time ago that it is quite expensive to do so for what they are purchasing.

So when we look at the debt side of the balance sheet, both the banks and the bondholders are wondering how they’re getting their $2.1 billion back. The bondholders have to wait until 2020, but the banks will extract their pound of flesh in 2016 unless if the company gets serious in reducing its cash burn profile.

There is only one way this is going to occur – a reduction in dividends. They tried doing this stealthily by introducing a stock component to the dividend, but this will only further increase the erosion of the value of equity holders in the company. The lion’s share of cash will be going to debtholders in the future. That said, there is some value in the equity, but just not what it is currently trading for.

Genworth MI Q3-2013 report

Genworth MI (TSX: MIC) reported their third quarter earnings report yesterday evening. The highlights are not too dissimilar from their second quarter report (which I wrote about in an prior post) with the prevailing trends continuing:

– Year to year, gross/net premiums written continue to track lower this year than the previous, by about 12%, solely due to government regulatory changes. For the 9 months, premiums written were $382 million vs. recognized revenues of $430 million, so premium recognition at this rate should drop proportionately going forward.
– Loss ratios, and subsequently losses on claims, are the lowest they have been for a very, very long time. The loss ratio is 22% and this is incredibly low.
– The share buyback, as I reported earlier in the preview, brings down the shares outstanding to about 95.1 million. I very much doubt they will continue buying back shares at existing prices.

Also, while not directly relevant, they increased the dividend from 32 cents to 35 cents – historically they have increased the dividend by 3 cents each year. Cash-wise, the company has paid back $199 million to investors in the first nine months of the year and generated about $250 million through operations.

Portfolio-wise, they continue maintaining a bond portfolio – $5.06 billion, yielding roughly 3.7% at 3.8 years duration, and $219 million in dividend-yielding equity.

Business-wise, they’re clearly in a sweet spot where relatively few are defaulting on their mortgages and they continue to make a lot of money on insurance premiums. They also have a valuable vested interest in keeping the duopoly situation – the Government of Canada is the other player in the market via CMHC and they will obviously not want to pop the balloon which keeps them solvent as well. The question is whether this will continue and at least in the short term, it will. Market momentum might take this company higher than what its valuation on paper seems to be, which currently looks like what it is trading for presently. If we start seeing significant premiums over book value then I might consider paring back some of the position, but I am not in a rush to do so right now – even though due to appreciation this is starting to be quite a concentrated position.

Fairfax Chart and Blackberry

Normally when a corporation is buying out another entity (especially at a premium), the market’s instinctive reaction is to jettison the shares of the purchaser.

Fairfax’s slow attempt to take Blackberry out has a rather odd effect: Fairfax’s common share price has skyrocketed (at least relative to its historical trading patterns, which has been relatively boring):

ffh

There is a deep insider’s game being played with Blackberry and some of this information leaks into Fairfax’s stock price. Maybe I’m reading too much into this (realizing that Fairfax’s 10% stake in Blackberry is only about 5% of Fairfax’s market cap).

My hunch:

1. The terms of the deal were materially struck on October 25th and will likely be announced on November 4th in absence of any other deals;
2. Facebook getting into the scene is priced in as a negative (i.e. potential to pay more, hence worse for Fairfax).
3. The market believes Fairfax is getting a good deal.

Zuckerberg at Facebook is not an idiot and realizes that his $120 billion market cap is not going to last forever and the company needs to branch out. Similar to what Steve Case did with AOL and Time Warner, there is an interesting business case of just sheer diversification of doing an all-stock deal for Blackberry at some double-digit per share price – Facebook stock is now expensive currency and why not do a late 1990’s internet stock type move and purchase something tangible?

Its a low probability outcome, but right now capital is cheap and the market is giving the titans lots of currency to play with.

Why Carl Icahn is a smart fellow

Most people think that good investors are able to buy undervalued companies. People forget that good investors also know when to sell. Take a look at Netflix (NFLX):

nflx

Carl Icahn apparently went in at $58/share, and sold half his stake in the $300s.

The headline quote in the media articles:

… as a hardened veteran of seven bear markets I have learned that when you are lucky and/or smart enough to have made a total return of 457 percent in only 14 months it is time to take some of the chips off the table.

I’d say this is a pretty good rule of thumb for anybody to follow if they are so fortunate.

Just as a matter of arithmetic, if you invested $100 in something that went up 457% and then sold half of it, you still have $278.50 worth of something left over, not an insubstantial amount in relation to the original investment. Another way of looking at this is you would have to sell 18% of your investment to play with “house money”, so to speak (although this is a huge misconception in retail finance as there is never such a thing as house money – it is your own!)