Deploying some capital

After some considerable investigation, my US equity research has finally hit some pay dirt this week, and I have been attempting to get a position in two equities – one relating to the defense industry, the other relating to oil and gas. One of the companies is a well-established player in the industry, while the other one is relatively newer. I would not consider either to be “speculative” in that both firms generate cash, but I do have a good idea why the market believes they should be trading at relatively low levels, and why the market is incorrect.

One has a dividend yield close to 1%, and the other does not give out a dividend. Investors in either company will not be “yield chasing”, so I am happy to not be paying for other people’s yield-chasing demand!

It always seems to be the case that when I place my orders the market suddenly sees my interest in buying a 0.0001% stake in the firm, and then takes the bid up 5%. This is frustrating, but both companies should hopefully regress in price and I will ideally receive a relevant fraction in my portfolio. Both companies have liquid stocks, so somebody of my volume will not move the price.

I will eventually be deploying the rest of my US-denominated currency from bonds to equities, but the bulk of it will happen in early 2011 when I can get rid of the bonds.

I am still investigating a couple other candidates on the US side. I have already rejected many other names – investing in the USA is becoming economically more and more dangerous because of their domestic economic situation. Investors need to be careful of the impact of silly government decisions.

SNC-Lavalin trumps the CPP

In an interesting development, SNC-Lavalin (TSX: SNC) has announced that it will be exercising its right to first refusal in purchasing the CPPIB’s 10% stake in the 407 Highway.

SNC is now forming a new corporation, which will sell shares in a company (Transaxio) that has its ownership interest in the 407 Highway.

The only reason why SNC would do this is if they suspect that the CPP’s purchase was undervalued – so it will be interesting to see what the corporation will trade at when it goes public.

This will also be the first time people can directly take an ownership interest (although effectively a non-voting interest) in the 407 Highway.

Currency devaluations

The US dollar is clearly on a downslope:

With central banks having huge incentives to devalue their currency, it is going to be a classic case of a “race to the bottom”. It is not a surprise to see commodities and gold perform in such an environment.

Canada is in an odd position – with an economy strongly aligned toward commodity prices (energy and mining), it will create strength in the dollar. Exports become less competitive on pricing, which suggests that short term interest rates will not rise because of the cooling effect of a strong currency.

In a more retail oriented environment, this will also mean that imports will be cheaper, and the most Canadian tradition of them all – cross-border shopping – will be cheaper to partake.

Mass devaluation is not quite the same as inflation, but will likely have the same result. The only question is which assets to park your cash into.

Tax selling and income trusts

The concept of tax loss selling is not new – if you are sitting on unrealized losses in your portfolio, you liquidate those investments before year-end so that way you can crystallize the capital loss. The capital loss can be offset against capital gains of up to three years prior (e.g. a 2010 loss can be applied to 2007, 2008 or 2009 gains). If you think the investment still has merit, then it can be repurchased 31 days after the sale to avoid the “wash sale” rule (which would defer the loss and bake it into the cost basis of the new purchase).

As such, a common tactic is to look for securities that have not fared well during the year and purchase them close to year-end as there is likely to be more supply pressure.

It is also possible that this year there will be supply pressure on the income trusts that will be converting to corporations on January 1, 2011. As it is financially optimal for Canadians to be transferring these securities outside of registered accounts and into non-registered accounts, it will not be surprising to see some anomalous price action as the year comes to a close. Even though assets can be transferred between non-registered and registered accounts (by doing an equal-value asset swap in an RRSP, but not TFSA) there is likely to be extra volume seen on the exchanges.

CPP Investment board – 407 Highway

The CPP Investment Board announced it is buying a 10% stake in the operations of Highway 407 in Ontario – which is a toll freeway that is the outer loop of Metropolitan Ontario, a suburban route serving roughly Brampton to Markham.

The 10% stake is costing the CPP CAD$894 million. The CPP will also be acquiring another 30% stake by virtue of taking over Intoll, an Australian company, for roughly CAD$3.3 billion.

Is Highway 407 worth $9 billion total?

What is interesting is that the organization must report to SEDAR. Looking at their 2009 annual financial report, the 407 Highway has a debt of $4.8 billion, cash and equivalents (restricted or free) of $670 million, and equity of negative $1.08 billion. Not a stellar balance sheet, although the bonds themselves have a very long maturity profile and averaging about 5.7% interest.

On the income side, you have $560 million in revenues, and $116 million in operating expenses, leaving a yearly operating surplus of $444 million. Interest expense is another $275 million. Ignoring the other line items (depreciation, amortization and other capital expenses, plus taxes), you are left with an annual surplus of about $170 million.

Not that I like to criticize billion-dollar fund managers like the CPP Investment Board, but they obviously have something more strategic in mind if they are going to be spending this much money for a large minority equity stake at a price that appears to be 50 times present cash flows. There are a few mitigating factors, however.

The first is that Metropolitan Toronto is likely to grow, and with that is likely an increase in the suburb population – thus, traffic should increase. An increase in traffic also means the ability to increase tolls, which the organization does not need political authority to perform. The other deals with inflation-proofing: a toll highway is relatively insensitive to inflationary increases since you have little competition.

On the opposite side, if oil prices increase dramatically, or commuting takes a different shape, toll highways may not be a good business to be in.

Finally, there is political risk involved – if the CPP was able to take over a majority of the 407 operations (they are close with 40% currently), there will be a lot of pressure by the Ontario government to be able to lobby the federal government to recapture the rights to the highway. Although the CPP is an independent entity created by the federal government, one wonders how much political influence there would be.

In any event, the 407 Highway reverts back to the Ontario government after the 99 year lease expires. Although this lasts until 2098 (88 years from now) and I likely won’t be alive to see the end, there is a finite lifespan to this company.

The CPP is a very powerful player domestically with its $130 billion in assets – just over the scale of the Ontario Teacher’s Pension Board, which controls $96.4 billion in assets.

Is the CPP blowing this much money on a toll highway worth it? I think they overpaid, but they are probably just as desperate for yield as most investors are currently. This is possibly their best candidate to deploy $900M in cash, which is a telling statement on the entire marketplace.