Timing of the market downturn

Likely due to the Greece situation in Europe and anticipation of financial disruption, the markets are raising cash like no tomorrow by liquidating everything that can be liquified.

Naturally, this has gotten me somewhat interested in the markets again from a broad perspective.

Something fascinating is that anything relating to crude has been hammered for the past month. For example, Canadian Oil Sands (TSX: COS) has a relatively boring business that has been disproportionately traded down in relation to crude prices. An example is that a year ago you could have bought a share of COS for about 0.29 barrels of spot crude and today that ratio is 0.22.

This is generally the same effect that is seen with investors in gold – the underlying commodity is the volatile component while the stocks that produce the commodity are underperforming (Barrick, Kinross, etc.).

I don’t have much comment on COS other than that while it does seem like it is trading relatively cheap, my gut feel suggests that it can get even cheaper – especially if the unthinkable occurs. The unthinkable event in everybody’s mindset today is that the price of crude oil will make a significant fall. It’s similar to how nobody anticipated how low natural gas prices could go (and indeed, even lower than the economic crisis point), and how Canadian 10-year bond yields could not get lower than a very low 3% (they are now at 1.93%).

The other comment is that a good investor makes money by deploying it at the relative trough of a period of panic and crisis, and holding on for dear life until things feel rosy again, and then selling and going away until they see the panic and crisis again.

The problem is that it is very difficult to identify moments of panic and crisis, and even when you know you are in the middle of it, you still don’t know whether it can get worse than what you are seeing. It is expensive to be early to the party. One particular barometer that I use as a guideline (and many others do as well, so the information content of this proxy is somewhat diluted) is the VIX:

This would suggest we’ve got some way to go before deploying capital would be wise. I also still don’t see hints of any panic simply by looking at corporate bond yields – nothing is breaking in that department yet.

But assembling that watchlist would be a good idea. And this time, my instinct would be to go for non-commodity, non-yielding securities. And certainly not Facebook equity.

Converting crap to cash

I think everybody has a lot of spare junk that they wish they could click a button and just sell. It is also cumbersome to list items on Craigslist since there is a lot of filtration required. Likewise, Ebay is no longer a good place to get rid of unnecessary garbage since competitive forces have rendered markets full of supplies of garbage that nobody needs.

Scale this problem up by a factor of a thousand and you have companies with warehouses full of garbage they don’t need. So insert in a company like Liquidity Services (NYSE: LQDT) and take a look at what they’ve done since the economic crisis:

Suffice to say, the horse is completely out of the barn now and the company will be facing the law of large numbers soon (i.e. growth percentages are going to slow down), but I just found this interesting. Companies finding profitable ways of getting rid of junk assets (either through re-selling them or otherwise trashing or recycling them) should continue to do well.

JP Morgan and large financial companies

One reason why I don’t own companies like JP Morgan (NYSE: JPM) is because you truly don’t have a clue what’s going on inside these companies. Even top management (such as Jamie Dimon) has to find out through a relatively roundabout way that some of his employees have blown away $2 billion in equity making trades they presumably thought were hedging some other risk but turned out not to be.

Can anybody with a straight face look at their 10-K and make heads or tails of it?

In essence, when you invest in these types of companies you are really taking a leap of faith that the assets they claim to have are real and collectible, and that the liabilities aren’t misstated in such a way that causes them to pay out more than what you see on the books. You are also taking a leap of faith that their loan portfolio takes in more income than they pay out to depositors.

On paper, you are paying $37/share for a company that analysts (before this 50 cent per share trading loss) believe will make $4.97/share this year and $5.60/share next year. Let’s pretend this is true. Sound cheap? Sounds like it, but ultimately do you really know what you are purchasing?

You are buying an implicit guarantee that JPM will crank up its dividend yield over a period of time and hopefully rack up some capital appreciation since its earnings are significantly higher than its dividend payout. The question is – will the company blow up? JP Morgan blowing up doesn’t seem all that likely right now, but just ask people that invested in Bear Stearns, Merrill Lynch, Wachovia, or Washington Mutual five years ago, where an implosion equally seemed unlikely. Who knows? I don’t, and that’s why I’m staying away from these true leap of faiths like JP Morgan equity.

This type of thinking applies to most large cap financial companies, including the large Canadian Banks (specifically, TD, RY, CM, BMO, BNS and to a lesser degree NA and CWB).

That said, you can also invest in these large capital financial firms as a variety of a Pascal Wager where if companies like JPM collapse (or one of the big five Canadian banks) that there is going to be so much collateral damage that subsequently earning a return on investment is not going to make much difference since you’ll be hiding in your underground bunker while civilization collapses around you.

Chesapeake Energy – Fishy

The saga with Chesapeake Energy (NYSE: CHK) continues – today they released their 10-Q filing where the new pronouncement was that their asset divestiture program was taking a bit longer than expected. The market subsequently took them down 14%, which took them down into lows not seen since the 2008 financial crisis (and the CEO’s infamous margin call which I wrote about earlier).

The company subsequently announced later that day they inked an agreement with Goldman Sachs for a $3 billion credit facility that is on par with the senior bondholders – at an initial rate of LIBOR plus 7%, which is currently 8.5%; this rate will go on for the calendar year and presumably will dramatically increase thereafter.

When glossing over the 10-Q, the imminent need for liquidity appears to be the voracious cash-guzzling appetite of its capital expenditures – $3.7 billion in the quarter alone, offset by about $274 million in cash flows through operations. Ouch.

Also, looking at the balance sheet makes me wonder why they have more in payables than receivables, usually not a good sign.

Goldman Sachs is giving them liquidity at a high cost and presumably they’ve been smart enough to look at their books and loan them money at an appropriate level of capitalization. This does not, however, bode well for the equity holders. My intuitive would suggest there is a lot more garbage going on within the company that shareholders aren’t going to be exactly receptive to. This might look like a deep value play given the purported value of its assets, but if you’re taking money short term money from Goldman Sachs at 8.5%, the other side of the negotiating table is going to see this and realize you might be more desperate than it seems to get rid of your assets.

The company also gives out a 9 cent quarterly dividend, which amounts to $240 million a year, which will now be financed by this Goldman Sachs bridge loan.

No positions in CHK, although I’ve done a little digging and don’t really like what I see.

Rosetta Stone

My first equity purchase in 2012 was Rosetta Stone (NYSE: RST) at a basis of approximately $8.50. I had started accumulating shares at the $7.50 to $7 range and was hoping to obtain more of a position, but unfortunately the stock slipped away and the last pieces I acquired was at the $9-$10 level. My original wish was that their stock would decline down to $6.50-ish where I would have obtained a full position, but instead I got about half of my desired position, at a higher than desired basis – c’est la vie!

The company was compelling for a few reasons:

1. They had a well known, existing franchise in a sector (language learning) that clearly would benefit from globalization and not be whittled away by other companies’ offerings (which exist and are relevant competition);
2. Their balance sheet was very clean, having (assuming the $7.50 price point) about $100 million in the bank and a market cap of about $160 million; this means an investor was paying for very little to own the underlying franchise;
3. And speaking of the franchise, it is a $250M/year business selling software. Similar to selling pharmaceuticals, software tends to be a very capital-intense up-front business, and the main operating expenses tend to be sales and marketing. So for the princely sum of about $60 million, you could buy into a business at a P/R of about a quarter, fairly cheap if you assume that the software asset is actually worth anything (and indeed, it is, you just can’t see it on the balance sheet since R&D expenses are mostly expensed away and not capitalized).
4. Google Translator and other such “free” services (such as speaking into your iPhone) doesn’t really intersect too much with the language learning software market. If anything, these free services are a compliment.

There were some negatives, including:

1. The previous history of the company being an LBO target and then going public again; there were significant shareholders in the corporation that are actively divesting their interest. Correspondingly, management doesn’t have too much of an ownership stake in the firm – the new CEO has about a 1.5% stake in the company, while the former CEO has about 5%;
2. The profitability of the company has been low, but this is primarily due to marketing expenses;
3. Penetration into international markets has been less successful than originally desired by management;
4. Pressures dealing with US markets (specifically those somewhat exposed to government funding such as education);
5. Management changes – the CEO at the top recently stepped down and they have internally promoted their CFO to CEO and recently hired a new CFO.

I’ll leave out the hard-core quantitative metrics. I’ll condense it by saying the company appeared cheap at their single-digit valuation. Since I’m no longer interested in accumulating shares, I’m holding it in my portfolio since my price target has not been reached yet even with the past week’s action where a relatively rosy quarterly report took them up 30% and I am revealing this holding to the world.

All I have to do now is find 6 or 7 of them and start using the cash balances and who knows, 2012 might turn out to be profitable compared to the (relative) disaster I had in 2011.