Speech worth reading

Take a moment to read Bank of Canada chief Mark Carney’s speech, Living with Low for Long. It gives some interesting perspective in terms of the macroeconomic and monetary policy side of the economy.

Export-related economies are “unsustainable” – this is a kick at China for sure:

This is an increasingly uneasy emergence. Growth strategies reliant on exports and excess national savings are unsustainable in the long term. In the near term, for many emerging economies, the limits to non-inflationary growth are approaching and the challenges of shadowing U.S. monetary policy are increasing.

US householders are still suffering:

Unfortunately, the best contemporary analogue to the Japanese zombie firms is probably the U.S. household sector. Problems with the foreclosure process, government programs and forbearance by lenders are all delaying the adjustments. Absent more aggressive restructuring, the impact of negative equity on one-quarter of U.S. homeowners will weigh on consumption for the foreseeable future.

Sensitivity of householders to rising unemployment is significant:

The Bank has conducted a partial stress-testing simulation to estimate the impact on household balance sheets of a hypothetical labour market shock. The results suggest that the rise in financial stress from a 3-percentage-point increase in the unemployment rate would double the proportion of loans that are in arrears three months or more. Owing to the declining affordability of housing and the increasingly stretched financial positions of households, the probability of a negative shock to property prices has risen as well.

Apparently if more people adhered to the following quotation, we might not have the 2008 financial crisis:

Similarly, financial institutions are responsible for ensuring that their clients can service their debts.

Makes you really wonder about who’s buying sovereign debt in countries clearly unable to pay it back.

And finally, when rates rise, they may rise very quickly, leading to:

More broadly, market participants should resist complacency and constantly reassess risks. Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce: the greater the complacency, the more brutal the reckoning.

An interesting speech. Nothing concrete, but you can infer what the Bank of Canada is guessing their tea leaves indicate.

Sleeping through 1999 and not learning the lessons of the past

It appears that China-related IPOs that list on the US exchanges are the latest fad, with Youku.com being the latest example. Shares (Nasdaq: YOKU) went up 161% upon their offering, and reached as high as $50/share from an initial price of $12.80.

Doesn’t anybody remember what happened in 1998 and 1999? Amazing how history is repeating itself. The only difference is that these companies are foreign, and even less accountable to shareholders than if they were domestically held!

Already you have a chorus of people that say the company is overvalued and ripe for shorting, but most prudent investors know that timing when “the top” will be is exceedingly difficult – a phrase to always remember is that the market’s ability to remain irrational can be longer than your ability to remain solvent. It will just be a matter of time, but predicting when this Chinese asset bubble will finally deflate will be a matter of debate – until after it occurs.

Although I am sure there will be some Chinese equities out there that will be stable and provide a decent return on investment, it should be noted that management is even more entrenched in these companies than in the US/Canada, where at least you can pick out some corporations that have shareholders’ interests at heart. It is impossible to pick out the very suspicious cases (e.g. earlier coverage of Universal Travel Group, NYSE: UTA) versus the legitimate companies. Investing in Chinese equities feels more like pure gambling, hoping for the herd to ram the share prices higher, rather than investing or even “speculation”.

Anybody from North America playing these types of equities has to realize that they are playing against players that are loaded with insider information, and Chinese language/culture knowledge. As a result, people would have to be insane to invest in these types of companies. It’s like going to war with a pellet gun when your opponents are armed with sniper rifles – and you don’t even know what your opponents were armed with when you entered into battle.

I am sure there will be a few people here and there that will be bragging about the small fortunes they made by investing in Chinese equity, but this is the financial equivalent of reading the list winners from the last lottery.

Lululemon goes ga-ga

Lululemon (Nasdaq: LULU) is up another 18% today, as of the time of this writing, after reporting a much better than expected quarter (36 cents EPS on 25 cents analyst consensus).

This tells you what I know about fashion – I wrote about their previous blow-out quarter, warning that:

They will need to continue achieving rapid growth in order to grow into the existing valuation. If not, you will see a significant haircut in the stock price

… and …

Lululemon is a classic case of a well-run company that you do not want to own stock in.

This was back at $40/share (or a 2.8 billion market capitalization). Today, I see $66/share or a $4.6 billion dollar company!

Where did I go wrong? Don’t underestimate social trends when it comes to fashion – most importantly, I should have taken the subtle hints when I see family relatives wearing Lulu material. From my neanderthal male perspective, I remember walking into a Lulu store outlet with my wife, and while she went looking for some overpriced pants, I was looking around the store, asking myself how the heck they deserve a $2.8 billion dollar valuation when it is so clear that they will be prone to predatory competition.

Financial lesson of the day: Never underestimate the value of brand.

I have never had a position in LULU stock, and plan to keep it that way. I will disclose I did consider buying shares at $5 in the middle of the 2009 economic crisis, but decided on going with long term corporate debt of another fashion star, Victoria’s Secret (Limited Brands) instead, so I’m not kicking myself too hard about the matter.

Even though I don’t understand the fashion world, from an investment perspective I have always found it to be utterly fascinating because of the intense amount of “social research” required in order to properly value these companies.

Holloway Lodging REIT vs. George Armoyan

I note with interest that Holloway Lodging REIT (TSX: HLR.UN) has finally received a notice from Royal Host REIT (TSX: RYL.UN) that they want to kick out the three independent trustees and replace them with people of their choosing. Royal Host REIT owns about 7.4 million shares of Holloway, which is about 18.9% of the equity.

Royal Host REIT is chaired by George Armoyan, an east coast Canadian that has various financial interests and is similar to a small-scale Carl Icahn. Armoyan, in addition to being the chairman of Royal Host REIT, former chair of Clarke (TSX: CKI), runs his private corporation Geosam Investments. He has a very interesting history of taking minority stakes of companies, enough to control the board, and then convert the operations into more profitable ones. While his record is not 100% by any means, he does generally have a track record of success mixed in with a few failures.

Holloway Lodging REIT can be classified as a broken income trust – having gone public in the middle of 2006 during the boom in income trust issuance (just before the federal government shut the door on trusts), their equity has more or less gone on a straight downward trajectory and now trades at about 28 cents a unit. At 39.1 million units outstanding, the trust has a market capitalization of $10.9 million. The company’s current operations involving owning and operating 22 hotels, which consist of 2,386 rooms. About 60% of the hotel rooms are in Alberta. You can also dig into their financials and see that management has been wheeling and dealing with related entities (Pacrim Hospitality) and has lost money on various failed joint ventures (Windham, Winport).

Not helping their business is that capacity has been growing in their target markets (which generally consist of Super 8-type motels in back-country areas like Grand Prairie, High Level, Fort Nelson, etc.) which has lead to price competition and a drop in booking amounts. The company’s operations on the eastern side of the country, however, have not been that bad. When you look at the bottom line statement, the company is barely operating cash flow positive – about $2.3 million for the first 9 months. The last 3 months of the year will likely be a net loss. When capital projects and other miscellaneous items are factored in, it is pretty clear that this company is not financially on strong ground.

On the balance sheet side is where things are interesting, and I am using September 30, 2010 figures. The cost basis of the various capital investments the corporation has made is $367 million (mainly buildings for $297 million), offset by $44 million in accumulated amortization. Thus, the book value of $323 million in assets is something to be considered, even if the market value of these assets are to be impaired further than what the stated carrying value is.

On the liability side, it is much more ugly – the company is $1 million into its $5 million line of credit, and has $154 million in first-line mortgages (with a blended rate of 6.81%). $1.3 million of this is due by year-end, $7.4 million of this is current (i.e. due by September 30, 2011) and $30.5 million is due by the end of 2011.

Finally, the company has two convertible debenture offerings outstanding. The first is a $20.2 million offering, 8% coupon, that matures on August 1, 2011. The second is a $52 million offering, 6.5% coupon, that matures on June 30, 2012.

Suffice to say, the company has no way of paying off the prinicpal of the convertible debentures without performing a wholesale asset liquidation. While they may be able to refinance the mortgage, using the building and property as security, they will have a very difficult time refinancing the debentures without raising cash.

The 2011 debenture trades at bid/ask 92/93 and the 2012 debenture trades at 51/55. Yield to maturity is an irrelevant calculation in this case – what matters is capitalization. Using midpoints for both of them, the debentures have a combined market value of $46 million.

The math for a potential investor, is simple. If you assume you can actually liquidate the assets at the stated carrying value, and use the proceeds to pay off the mortgage and convertible debentures, you are left with approximately $117 million (i.e. this is the amount of unitholders’ equity). This is considerably above the current $10.9 million market capitalization.

The market realizes that things are not this simple. For example, if you assume that the carrying value of the property assets are actually 30% lower than what is stated on the balance sheet, suddenly your $117 million has shrunk into $20 million take-home. Still, this is not a bad haul if you just paid $11 million for the company.

When you factor in the price of the debentures, and price the equity at zero, the market is implicitly assuming that the property and land is equal to about 65% of its carrying value. The question for an investor is whether this should be lower (in this case, sell the debentures) or higher (in this case, buy the debentures). This assumes that the operations of the company are cash-neutral.

Obviously George Armoyan is taking enough of an interest in Holloway’s assets that he is spending time and energy on this little project. His own REIT, Royal Host, is not exactly a financial superstar in its own right, but there are obvious administrative synergies to be obtained if it were to merge together with Holloway. The only downside is that there would have to be a mandatory offer to redeem the debentures at par – something that skittish debenture holders would likely waive if the debt were to be backed with a stronger partner than the existing management at Holloway, which has been proven to be a dismal failure.

It is likely management is going to spend time and energy, and more importantly, money to try to fight this battle. Hence, the debentures dropped from a quote of 60/61 to 51/55 when the news came out – normally a battle for the board would usually stimulate prices because somebody is actually interested in taking an economic interest in the company, more so than existing management.

The reason why I am taking an interest in what is otherwise a fairly obscure sector of the business world is because I have a position in Holloway Lodging’s June 2012 debentures. I bought them in the first half of 2009 during the economic crisis, and it was one of the worst binary decisions I made – although if I liquidated today I am still nominally up on the investment, my other option that I was contemplating at that time was InnVest series B debentures, which is now a “lock” for a maturity at par.

Watch the long term rates, and a portfolio update

Long-term rates are creeping up slowly – it is difficult to tell whether the increases in 30-year bond yields over the past couple months will be part of a longer-term trend, but I believe this will be the case as people become leery of lending money to the government for the long haul.

I will have more to write about this in my year-end report.

Finally, I have been slowly deploying some cash, specifically in the oil and gas sector. I had identified an opportunity back in September, and set some orders slightly below market but they were not filled. It was frustrating to see that company trade above, and indeed it is about 25-30% above where I had originally wanted to purchase it. C’est la vie.

More recently, there were a couple low-volatility equity opportunities in the oil and gas sector that I believe are trading at the low band of their fair value range. One in particular seemed fairly attractive and appeared to have their “yield premium” excised from them. As readers here know, I have been seeing many companies that have their equity overpriced because of the market paying a significant premium for yield, and it is important when shopping for stocks that you do not pay this premium.

Conversely, it seems that there may be a discount for companies paying zero dividends or low dividends (other than well known issuers such as Apple and Amazon!), so I have been paying attention to the zero-or-low yield equity market. I am just as happy to take money in the form of capital gains rather than dividends.

On the fixed income side, I have not seen anything attractive. The fixed income market has been drier than a summer afternoon in the Las Vegas desert. I could string together a short-duration low-risk portfolio of debentures that will yield a pre-tax yield of approximately 6%, but there would be zero opportunity for capital appreciation. The only other speculative opportunity I saw earlier was in First Uranium notes, but even this has been priced to a market-efficient level given its high risk nature.

It is not the most pleasant of times if you are forced to deploy cash at present. Patience, and the ability to keep your cash for a better time, is the name of the game.