Inactivity is my friend

The only transactions being performed so far this year has been the accumulation of relatively illiquid warrants (over the past two months I have single-handedly been about 30% of the volume in this market) that give you the right to purchase the underlying shares at a strike price significantly in-the-money and the current market value of such securities is still trading under the tangible book value of the corporation (i.e. I expect further and significant price appreciation). In other words, the warrants are a leveraged free-ride compared to the common shares and the history of its management has been appreciation through buybacks rather than dividends.

My leverage fraction is somewhat higher than I am normally used to, but despite the scare tactics that the market will be employing over the next little while to shake soft money out of equities, the trend is indeed up. Too much cash out there is chasing an inadequate amount of yield, and fund managers will need to continue taking more risk in order to reach their required levels and this means equity investment.

With US 10-year bond yields at 1.85% (Canada is 1.94%), pension managers will not be getting these returns out of AAA-rated securities. They must take more and more risk to get their yield.

The most damaging thing I can do at this point is exit. There will be a time to exit, but it is too early. Sentiment is still very damaged by the US fiscal situation and people still think bonds are a safe investment, which they are not.

Ally acquired by RBC

Ally Canada (which was formerly General Motor’s financing division before the parent company went into bankruptcy proceedings) was a competitor in the Canadian high interest savings market. They had a fairly decent product a couple years ago where they offered 2% on a fully liquid savings account. They reduced that to 1.8% last year when they presumably received enough capital from their customers, but it still was in the top tier out of their competitors.

However, Ally was acquired by RBC late last year and now RBC announced they are closing down most of Ally’s accountholders and are encouraging you to open up an account with RBC.

I received in the mail a “special offer” from RBC to open an account with them for a 1-year GIC at 1.8% or redeemable GIC at 1.5%. I laughed as I dumped it into the paper shredder.

Somebody has been kind enough to maintain a site that has a compilation of various high interest savings banks that can be accessible by most Canadians. I’m generally not interested in going through the paperwork hurdles for the privilege to accumulate a less-than-inflation rate of interest. Unfortunately the new economic reality in this extended low-interest rate environment is forcing people to find cash alternatives in the marketplace to find low-risk yield. There are not a lot of opportunities left in this space anymore.

I even notice my standby US-dollar short-term ETF, the 1-3 year iShares bond fund (NYSE: SHY) is giving out a paltry 40 basis points of yield. At least in Canada the floor is 1% – the Canadian ETF equivalent is (TSX: XSB) and they give out 1.48% albeit at some interest rate risk – their average term of maturity is 2.80 years.

The decline of the Canadian dollar

I have been watching the chart of the Canadian dollar. Over the past three years it has exhibited a surprising amount of non-volatility, trending roughly between 96 to 103 cents on the US dollar in the last year:

cad

This is compared to a currency such as the Yen which has had some obvious devaluation going on over the past half year:

jpy

This leads to the obvious question of whether the Canadian dollar is still in a range or whether there is something going on that will trend into a further decrease in the dollar. Typically the dollar has been linked to the fortunes of the commodity market, and the general commodity market hasn’t really gone anywhere over the past year, so one would think this is part of a trading range as opposed to some breakout on the downside.

I continue to hold a majority of my holdings in US-denominated securities and despite the fact that the US federal reserve is doing its best to turn its currency into toilet paper, I would expect the US currency to be better toilet paper than other world currencies out there. I am guessing the phrase “in the world of the blind, the person with one eye sees all” is the most appropriate here.

Actual good performance

Performance-wise, at present my portfolio is sitting in a position where I’d be happy to book this percentage return in a year. Part of me wants to just sell the whole thing and wait again, but a lot of what I have purchased is still well below my fair value range.

So I continue to wait. I have been nibbling on one low-liquidity position but other than that, it has been just a matter of waiting and hoping the party isn’t finished yet.

Genworth MI Canada Q4-2012

Genworth MI Canada (TSX: MIC) reported their 4th quarter and annual results today. Because they never bothered to post the full financials on their investors website, sadly I had to dredge it out of the parent company SEC filing.

The chart has suggested there is an improvement of sentiment and there was also a scurry of investors in the past few days lightening up their risk in the company in the leadup to the quarterly announcement:

mic

The results have to be translated to exclude the positive impact of the December 20th announcement concerning how they were accounting for the government guarantee fund (which caused a non-trivial reversal in expenses). After doing all the adjustments, the magic number is 90 cents per share earned in the quarter.

The CMHC hitting its insured portfolio ceiling is also visibly helping the business on the private side, despite changes to amortization and down payment rules.

Delinquency rates continue to remain exceptionally low at 0.14% for the quarter (0.2% in the previous year’s quarter).

I haven’t been able to see the consolidated balance sheet as of yet, but book value is $30.62/share, while intangibles and goodwill is approximately 20 cents a share.

With a market value of $23.68/share, they are still deeply betting that the Canadian housing market is going into the gutter. While this might be true price-wise, what is important is the ability for people to pay off their mortgages, and this means employment. Nothing has changed in Canada at present with respect to this and although I believe housing prices will exhibit long-term depreciation (especially when interest rates decide to rise again), this will not adversely affect the mortgage insurance business unless if such price drops are precipitous.

The effective loan-to-value of the insurance portfolio is a good metric of how buffered the company is in the event of a mortgage default. Most of the embedded risk are on new purchases and as payments continue amortization of mortgages continue to result in risk reduction for the company. At the end of the year, the loan-to-value (essentially an inverse measurement of equity) on such insurance is as follows:

2006 and prior – 40%
2007 – 68%
2008 – 73%
2009 – 75%
2010 – 82%
2011 – 88%
2012 – 92%

It should be pointed out that on a typical 5-year fixed rate mortgage at current rates, if there was a 5/10% downpayment made, that the homeowner at the end of the 5-year period will have 18.7/23.0% equity in the property. This is the buffer room that insurance companies have with respect to price deprecation and also are compensated with the 2.75% premium paid on such mortgages.

Needless to say my original thesis is still in effect – Genworth MI is an inexpensive cash machine, even at current prices. Not as good as when it was in the teens when I bought my shares, but still is a very good value. All things being equal, at existing market values, investors should be realizing about a 14% annual return and this does not include any accretion that comes out of a realization of the negative differential between book value and market value. Compared to putting money in bonds, this is a pretty good return given the risk taken (which is low, but certainly not zero – this is what you are being compensated 11% over bonds with!).

The company also gives out a 32 cent/quarter dividend, but this is utterly irrelevant to the investment thesis, which is that there is incredibly deep value in the company. I am quite frankly surprised that the company already hasn’t been hived off to Sunlife (TSX: SLF) or Manulife (TSX: MFC), both of which desperately need diversification from the tragic errors they made with variable life annuities a few years back.

There’s excellent potential for this company to get back to book value and it is just a matter of being patient and not watching the Canadian real estate market implode. As long as that market does not implode, the shareholders should profit immensely.