A few small observations

A mixed post.

Where I was mistaken

I made a claim earlier that I thought employment around January or February of this year would be shown to decline, presumably due to a slowdown in demand and companies cutting costs. Unless if you were one of the victims of a big tech company’s layoff, wow, was I ever wrong with this! Gross employment trends continue to exhibit strength, consistent with anecdotal reports of employers finding it difficult to source labour.

So where was I wrong here? Is there a demographic issue? Are companies out there finding additional vectors of demand to necessitate employment? Or am I just premature with my prognostication? I’m not sure.

There are some hints on the Fiscal Monitor – income tax collections and GST collections are up over comparative periods last year, and especially corporate income taxes. The government is likely to report an improved fiscal balance as well. This leads me to the second issue, which is…

The progression of QT

Members of Payments Canada (a.k.a. financial institutions parking reserves at the Bank of Canada and earning the short-term rate) continues to hover at the $190 billion level. The recent slab of government debt maturing off of the Bank of Canada’s balance sheet got directly subtracted from the Government of Canada’s bank account at the Bank of Canada, but the GoC is still sitting with $65 billion cash as of February 15, 2023.

What does this mean? The presumed pressure on liquidity is not happening – yet. Banks can still lend out capital, but you have to have an awfully good proposition since they’re not going to give it to you for cheap interest rates. Why should they lend it out to you at 6% when they can keep it perfectly safe at the Bank of Canada and skim their 4.5%?

While there’s liquidity, it’s definitely a lot more expensive. When you combine what I wrote about employment above, coupled with real estate finding its two legs again (helps that there is zero supply in the market), makes me think that the Bank of Canada was incredibly premature to call a pause on rates – March 8th they’ll be guaranteed to stand pat, but perhaps we might continue to see rate increases if CPI doesn’t drop quickly enough in the next couple months. Also, the US-Canada currency differential is also going to widen as the US Fed will be raising rates for longer.

A public market investor at this point is facing a crisis of sorts. Asset prices (unless if you owned garbage technology companies) haven’t deflated that much, so what is trading out there is really not the greatest competition for the risk-free rate. You have cash.to giving off a net 4.89%, and when you look at some average 20 P/E company, one has to ask yourself why you should be bothering to take the comparative risk. Just look at the debenture spreadsheet and the spreads over risk-free rates is minimal.

Commodities

In the middle of 2020, the trade was a no-brainer. Ever since then, it has become less and lesser so, to the point today where it is no longer about throwing capital into random companies and winning no matter what – discretion has been critical from about June of last year. The meltdown in the natural gas market is one example of where an investor could have turned into roadkill, especially with leverage. In general, you can lose less money by investing in low cost structure companies, ideally with as low debt as possible. The problem is if you have a whole bunch of industry participants in a good balance sheet situation – the race for the bottom becomes brutal since they can mostly survive low commodity price environments until some finally do get eliminated due to high cost structures and/or high debt service ratios.

Teck

They explicitly had to disclose they’re looking into strategic options for their met coal unit, which would be a cash machine of a spinoff if they went down that route. Seaborne met coal has rebounded as of late and it would be really interesting to see the price to cash flow ratio assigned to a pure met coal unit. A comparable would be Arch Resources, and they are trading at 4x 2023 earnings. Teck does have considerable competitive advantages, however – better access to the Pacific and a lower cost structure, in addition to being able to pump out more coal. Stripping out the coal business would leave the copper and zinc business in core Teck, and the residual copper business might get a 20x valuation (looking at Freeport McMoran as the comparable here). When you do the math on both sides of the business (especially as Teck’s QB2 project is ramping up this year and will produce gushing cash flows at US$4 copper), the combined entity would be worth well more than $30 billion today. So with a little bit of financial engineering, Teck can generate market value from nothing.

Let’s look at the first 9 months of the year (which is abnormally high for met coal, but just to play along).

I have (for met coal) their gross profit minus capital expenditures, minus taxes, at around $4.5 billion annualized. Give that a 4x multiple and you have $18 billion. On copper, with QB2 at full swing, it should be (very) roughly $1.5 billion total for their consolidated copper operations and at 20x you get $30 billion. Add that together and it’s well over the existing market cap.

What you also do to complete the financial wizardry is that you load the coal operation with debt, say around $10 billion. Give it to the parent company as a dividend, or perhaps give it to shareholders as a dividend in addition to the spun-off equity and the projected return on equity will skyrocket (until the met coal commodity price goes into the tank, just like what happened two seconds after Teck closed on the Fording Coal acquisition before the economic crisis).

Despite the above calculation, I’ve been taking a few chips off the table. My overall position has continued to be of increasing caution, one reason being that I don’t have a very firm footing on what is going on.

Toxic financings

When interest rates are no longer zero and there is actually an appreciably large cost of capital, corporations with negative cash flows and heavy debtloads are finding terms like these three examples.

First example

Goodfood (TSX: FOOD), a previous Covid-darling (to-your-door delivery would clearly replace regular grocery shopping when a trip to Superstore would kill you with viral pathogens!) has been losing money since day one, and now they have exhausted their cash balances to the following point where they have to issue this debt:

MONTREAL, Feb. 06, 2023 (GLOBE NEWSWIRE) — Goodfood Market Corp. (“Goodfood” or the “Company”) (TSX: FOOD) is pleased to announce that it has closed an offering (the “Offering”) of $12,675,000 aggregate principal amount of 12.5% convertible unsecured subordinated debentures of the Company (the “Debentures”) due February 6, 2028 …

The Debentures will be convertible at the holder’s option into Goodfood common shares (the “Common Shares”) at a conversion price of $0.75 per Common Share. The Debentures will bear interest at a rate of 12.5% per annum. The interest portion for the period commencing on the issuance date and ending in February 2025 will be capitalized semi-annually and convertible at a price equal to the volume weighted average trading price of the Common Shares on the TSX for the five (5) consecutive trading days ending on the date on which such interest portion becomes due, plus a premium of 50%. As of February 6 2025 and until the Maturity Date, the interest portion will be payable semi-annually in cash. As of February 6 2026, Goodfood may repurchase the non-converted portion of a Debenture at an amount of the principal and accrued interest plus an amount providing the holder with an internal rate of return (IRR) equal to 18% for the period during which such Debenture will have been outstanding. The holders may require a repurchase on the same terms upon a change of control of the Company.

This second paragraph is a terrible clause for common equity holders in that there will be a share issuance in February 2025 that will be quite expensive. In addition, the entire issue, if converted at 75 cents per share, would constitute about 18% of the shares outstanding, not counting any dilution before-hand with the interest capitalization.

While Goodfood has stemmed some of the cash bleed, it’s cash position on December 3, 2022 sits at $28.5 million and it has a $9.5 million credit facility due November 2023, $47 million $35 million in convertible debt (TSX: FOOD.DB, FOOD.DB.A) due 2025 and 2027, and now this debt above. There are also the customary IFRS 16 lease obligations. The cash burn got down to $6 million in the first fiscal quarter (3 months ended December 3, 2022).

I am always very wary when companies have to obtain debt financing at double-digit returns. In rare instances, when a company’s back is pressed against the wall, the equity will be trading like such utter trash that it is a reasonable risk-reward ratio better than a casino to take a small position, but such situations are extremely risky in nature. Usually for the company to bail themselves out of the situation, equity holders have to take some sort of bath (either through Chapter 11/CCAA or a highly dilutive transaction) which makes an investment in a more senior part of the capital structure more lucrative.

Second example

Greenbrook TMS (TSX: GTMS), a company that operates trans-cranial magnetic stimulation clinics across the USA, has a corporate strategy of “We will lose money on every acquisition, but we will make it up on volume”. Suffice to say, such strategies will require capital.

On July 14, 2022 they made an agreement with an asset manager for a US$75 million credit facility and the material term was:

The Credit Facility provides Greenbrook with a US$55 million term loan, which was funded on closing. In addition, the Credit Facility permits Greenbrook to incur up to an additional US$20 million in a single draw at any time on or prior to December 31, 2024 for purposes of funding future M&A activity. All amounts borrowed under the Credit Facility will bear interest at a rate equal to the three-month LIBOR rate plus 9.0%, subject to a minimum three-month LIBOR floor of 1.5%. The Credit Facility matures over 63 months and provides for four years of interest-only payments.

Three-month LIBOR plus 9% these days is around 13.8%.

On February 7, 2023 they announced:

The Company announces that it has entered into an amendment to its previously-announced credit facility with Madryn (the “Credit Facility”), whereby Madryn and its affiliated entities have extended an additional tranche of debt financing to the Company in an aggregate principal amount of US$2.0 million, which was fully-funded at closing (the “New Loan”). The terms and conditions of the New Loan are consistent with the terms and conditions of the Company’s existing aggregate US$55.0 million loan under the Credit Facility (the “Existing Loan”) in all material respects.

The New Loan also provides Madryn with the option to convert up to approximately US$182,000 of the outstanding principal amount of the New Loan into common shares of the Company at a conversion price per share equal to US$1.90 (the “Conversion Price”), subject to customary anti-dilution adjustments and approval of the Toronto Stock Exchange (“TSX”). This conversion feature corresponds to the conversion provisions for its Existing Loan, which provide Madryn with the option to convert the outstanding principal amount of the Existing Loan into common shares of the Company at the Conversion Price.

Sweet deal.

Third example

Bed Bath and Beyond (Nasdaq: BBBY) fights away Chapter 11 with a really toxic financing:

UNION, N.J. , Feb. 7, 2023 /PRNewswire/ — Bed Bath & Beyond Inc. (the “Company”) (Nasdaq: BBBY) today announced the pricing of an underwritten public offering (the “Offering”) of (i) shares of the Company’s Series A convertible preferred stock (the “Series A Convertible Preferred Stock”), (ii) warrants to purchase shares of Series A Convertible Preferred Stock and (iii) warrants to purchase the Company’s common stock. The Company expects to receive gross proceeds of approximately $225 million in the Offering together with an additional approximately $800 million of gross proceeds through the issuance of securities requiring the holder thereof to exercise warrants to purchase shares of Series A Preferred Stock in future installments assuming certain condition are met. The Company cannot give any assurances that it will receive all of the installment proceeds of the Offering.

At the initial closing, the Company will issue (i) 23,685 shares of Series A Convertible Preferred Stock, (ii) warrants to purchase 84,216 shares of Series A Convertible Preferred Stock and (iii) warrants to purchase 95,387,533 shares of the Company’s common stock.

While I haven’t read the terms and conditions of the S-3 filing that references the preferred securities and warrants as above (off the top of my head it is not clear what the strike price of both sets of warrants are), I can guarantee there’s huge dilution. What’s even more impressive is that the Reddit WallStreetBets and pretty much the whole financial universe is treating BBBY as the Gamestop of 2021:

This is simply insane trading. Multiple opportunities to make and lose money on a very liquid market (and option implied volatility is sky-high, especially on yesterday’s 100% spike up to ~$7/share). This casino-like trading is one reason why I think central banks are quite intent still to keep sucking liquidity out of the marketplace (QT), until this sort of thing ends.

Take-home message

Tightening financial conditions are triggering marginal companies (ones that have negative cash flows and debts) to engage in toxic financings. At what tier will the debt contagion persist? If you own shares in companies that are going to face financing crunches in the upcoming year or two, you may wish to brace yourself.

Refinery explosions

Oil refineries are incredibly complex pieces of machinery.

I’ve read the technical report at the now-Cenovus, formerly Husky Superior refinery that occurred in 2018 (this was before Cenovus took over Husky).

If you ever want to get a sense of appreciation at the technological marvel of oil refining, you should read this report.

This refinery is currently being rebuilt and should become operational again sometime this year.

Cenovus has had bad luck with their refineries. About a month after they signed a deal to acquire the remaining 50% of their Toledo refinery (the other 50% is owned by BP and the refinery is operated by BP), the refinery blew up on September 20, 2022 which resulted in the death of two workers. Thankfully for Cenovus, it was before the deal actually closed, and one would presume that the acquisition contact would require the refinery to be in a non-blown up state before the deal closes.

The preliminary report, released on October 31, 2022, indicates that a release of flammable materials from a specific drum was the origin of the fire.

These investigations take a lot of time and I do not think the repair job will be a speedy process either. It is too bad for Cenovus, as refinery spreads are sky-high at the moment and considering the lack of capacity expansion on downstream operations, will likely be this way for some time.

Bank of Canada – beware of future guidance

Almost two months ago (December 7, 2022) we had the key paragraph:

Looking ahead, Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target.

Now, the forward guidance has been shaded to:

If economic developments evolve broadly in line with the MPR [monetary policy report] outlook, Governing Council expects to hold the policy rate at its current level while it assesses the impact of the cumulative interest rate increases.

This is being interpreted as a “If things are in expectations, interest rates will hold steady.”

That said, this quarter point raise is relatively a consensus decision and one that I was expecting myself.

However, the yield curve says otherwise:

The bond market, and also the short-term interest rate futures market, are projecting a rate drop – March 2024 futures have a 3-month bankers’ acceptance rate of 3.65% (right now that 3 month rate is 4.86%).

When reading the MPR, we have the following projection of inflation:

Pay attention to the dual y-axis on the chart, specifically where the 2% inflation target lies in relation to various inflation components.

The other item is the huge amount of the yellow component “Other factors”, which is a huge fudge factor that is given little bearing in forward inflation forecasting.

My reading of the tea leaves is that the future is not going to be nearly as easy as presented. My crystal ball is starting to clear up somewhat.

I’m expecting, due to the mathematical quirk of how headline inflation is calculated (year-over-year) that comparisons between March and July will be very favourable. The reason is due to this chart:

Due to the Russia-Ukraine conflict and all of the spillover effects thereof, the baseline energy inputs (which drive a good chunk of industry) will be dissipating.

The change in natural gas pricing is even more drastic. (It is too depressing to post here).

Inflation will obviously be seen as tapering. The markets will declare victory, and there will be a massive push of capital into the equity markets since clearly central banks are done – why get 4-5% on long-term investment grade corporate debt when clearly there’s more opportunity with equities? All of that cash that is on the sidelines will plough in, Gamestop and AMC will have another hurrah, and everybody will have this sense of comfort that Covid is behind us, the damage done in 2021-2022 is over and we can look forward to living happily ever after?

Between now and around the month of May, I would say “risk on”. Recession? What recession? Rising interest rates? No more! Inflation? Dropping!

Where things are going to get really dicey is the time period after September, where it will become really clear what’s going to happen in terms of the conflict and the global trade situation, especially with India and China. The import of materials from China historically was deflationary but things are changing with on-shoring.

We look at the various components of Canadian CPI (Table 1 on this link – scroll to the bottom):

Food (16%) – whether from a store (transportation, F/X, labour) or especially a restaurant (labour, municipal land taxes, and retail REITs passing on higher interest costs to customers), this will increase and I do not see supply conditions improving to mitigate this
Shelter (30%) – especially rents in urban centers (7%), mortgage costs (3%), or raw construction (6%), there is not enough supply, and when you keep cramming in half a million people into the country each year, with no real expansion of supply, the net result here is obvious
Household operations, furnishings and equipment (15%) – This should actually be roughly level.
Clothing and footwear (4.5%) – Steady
Transportation (16%) – A function of energy prices. The car market should stabilize somewhat, you are already seeing used car indexes in the USA begin to flatten, and one-time windfalls on used vehicles are no longer to be had
Health and personal care (5%) – This is a service sector and rates will continue to rise with labour costs
Recreation, education and reading (10%) – Post-covid, there is much continued demand for this and limited supply (e.g. take a look at international flight pricing, and hotel pricing) – this is heading up. There is a huge labour cost component here.
Alcoholic beverages, tobacco products and recreational cannabis (5%) – Up, namely due to taxes and raw input costs.

In general, I see the supply side continuing to have a great impact on pricing – not enough supply is being thrown into the economy.

Think of it this way – when you have central banks saying “We are trying to kill demand by raising interest rates until people feel pain”, are you, as a business owner, going to be putting in long term capital investments into anything consumer-related? No way, unless if you have some sort of secured demand (e.g. government funding – look at how much money the Government of Canada is blowing on EV subsidies at the moment).

Right now, the crystal ball says that inflation will appear to flatten for the first half of the year, but the assumption of the downward trajectory is going to be mistaken.

I suspect the short-term interest rate will remain steady for longer than people expect. Right now the Bankers’ Acceptance futures for September 2023 give a 4.69% expectation – roughly half-pricing in that the Bank of Canada will start to drop rates on their September 6th interest rate announcement.

In the meantime, the true deflationary headwind is still ever present – in the form of quantitative tightening.

These balancing factors (suppressed demand due to high interest rates, limitation of supply from both material and labour and decreased productivity, and monetary compression due to QT) will continue to cause confusion. The strategy of the Bank of Canada is that these factors will balance out. I don’t think they have much choice.

However, later this year, if for whatever reason you see inflation refusing to taper below the 4% point, this really puts the central bank into a quandry. Just beware of future guidance.

Yield chasing is back in vogue

(rest assured, I have never been paid to post anything on this site, and this will pleasantly continue)

ETF marketing is clever as always. Did you want a 13% yield? Introducing the Hamilton Canadian Financials Yield Maximizer ETF!

They politely inform you that they are “Canada’s Highest Yielding Financials ETF”, featuring a “13%+ target yield”.

Not just 13%, 13%+.

Who can resist?

They also inform you, in bold font, that “HMAX does not use leverage.”

Is this a dream come true?

Digging into the much dryer prospectus, we get the following:

HMAX will seek to achieve its investment objective by investing in the top ten Canadian financial services stocks by market capitalization (each, a “Financial Services Company”, and collectively, the “Financial Services Companies”).
…
To mitigate downside risk and generate income, the Portfolio Adviser, in conjunction with the Sub-Advisor, actively manages a covered call strategy that will generally write at or slightly out of the money call options, at its discretion, on up to 100% of the value of HMAX’s portfolio. Notwithstanding the foregoing, HMAX may write covered call options on a lesser percentage of the portfolio, from time to time, at the discretion of the Portfolio Adviser. The Manager has retained Horizons to act as sub-advisor to HMAX solely in respect of the writing of such covered-call options on its portfolio securities. HMAX’s strategy seeks to generate attractive option premiums to provide increased cashflow available for distribution and reinvestment, downside protection, and lower overall volatility of returns.

Here lies in the secret sauce. They invest in highly capitalized Canadian financials, and then try to make up the differential with selling call options. You can actually replicate this fund at home if you wanted to.

Here’s the problem. Essentially the fund is taking the worst of both worlds of split share funds and covered call ETFs.

The call options simply aren’t going to make that much money, especially if the fund starts to scale up in size.

The top holdings of the fund is the Royal Bank, at 23%. The “big five” Canadian banks consist of 71.4% of the fund. If your throw in National, it’s over 3/4 of the fund. Let’s concentrate on Royal.

Royal Bank has a 3.9% dividend. So you need to make up 9.1% over the course of a year to get your quota.

The front-month for Royal Bank options is trading at a Black-Scholes implied volatility of 11%:

So your strategy is to buy stock and sell the next nearest strike at the money, which in the case of RY would be a 1% premium over 23 days (16% annualized!). If you take the next month, you get a 2% premium over 51 days (14% annualized!).

The math goes like this – you repeat this every month and you suddenly earn 3.9% in dividends and an additional 12% yield, you can “easily” get to your 13% quota. Free money!

Forget about capital upside with this strategy – it is a guaranteed “ratchet” that can only click down in price.

Let’s tear this apart a bit.

The above chart is the 30-day historical volatility of RY and the implied volatility. The IV index in this chart is normalized to fixed tenors (30, 60, 90, 120, 150, 180 days) using a linear interpolation by the squared root of time, and does not represent the “spot month”‘s implied volatility, which is why the IV index is higher than the front month at the moment.

The point I am trying to make here is that covered calls are being sold cheaper than the likely actual forward volatility of the stock.

Most, if not all, of these covered call strategy funds are, at their core, leaking value through selling call options below intrinsic value because the covered calls are being sold blind to their value. The same style of arguments have been levied against index funds in general in regards to the price insensitivity to the equities in their respect indices. I am sure the initial covered call fund realized a reasonable semblance value, but when you have hundreds of millions or billions of dollars of assets under management employing a strategy into a less than robust Canadian options market that is not going to fundamentally support the liquidity, the response is that the option market makers are going to price the options cheaply.

This is not limited to Hamilton Funds, there is plenty of this going on in the overall marketplace. Volatility can be ‘harvested’ by selling theta on a variety of securities out there. It appears like “free money”, until the market rips up.

Essentially is the other side of the market will be able to “rent” the stocks for relatively cheap rates.

What I project happening is that this fund will discover that making its 13% quota through covered calls will become progressively more difficult to achieve and inevitably distributions will come from return of capital to make up the difference. While the fund will be able to distribute its mandated $0.185 monthly distribution, it will come at the cost of its capital value. It will take a few years for this effect to be apparent.

The easiest way to measure this effect over time is to make a comparable index basket with just strictly the equity (with dividends reinvested) and no derivative trading on the portfolio, and compare the performance between this index and HMAX.

Notwithstanding the 0.65% MER, I predict that the index of straight equity ownership would outperform. This is the inevitable result of employing price insensitive derivative strategies.

However, I have to commend Hamilton for their marketing. I am sure there will be another fund along the way that will promise 15% returns, and 20% returns, and 25% returns until it all busts. This is kind of reminding me of the chase for yield that occurred in the mid 2000’s when you had a huge proliferation of Canadian income trusts going public, which many of them were simply return of capital vehicles.