Potash – Corporate takeover bid

Many years ago, the first time I heard the word Potash, I thought somebody was referring to a narcotic. I quickly educated myself (Wikipedia is a good primer) and nodded, and didn’t think about it otherwise. Potassium compounds aren’t exactly rare, nor are they terribly exciting – you can use potassium chloride instead of sodium chloride to replace your table salt, and more importantly, its usage as a fertilizer.

Canada apparently has the majority of potash reserves, and the major corporation is Potash Corp (TSE: POT). Never in my wildest imagination did I think back then that it would result in a triple over the past 5 years, but apparently agricultural fertilizer is in such demand that companies with potash reserves have been bidded through the roof.

Yesterday, Potash Corp received a hostile takeover bid for US$130/share, while the day before the takeover trading closed at US$112. After the takeover was announced, trading closed at US$143/share, which likely means that the takeover bid will fail at the present price.

Potash has about 297M shares outstanding (304M diluted), which implies that the price paid is around CAD$40 billion for the equity, plus CAD$4 billion in debt for a total price of around CAD$44 billion. The balance sheet has about $6.5 billion in equity, so there is a takeover premium of about $38 billion over book value. Presumably this is because of the embedded value of their resource reserves, but I skimmed their annual report and couldn’t find any clean quantitative data – it has to exist somewhere, but I couldn’t find it when wading through the many pages for a minute.

Apparently 2008 was a banner year for the company, where high prices allowed the company to mint about 11 dollars per share in earnings. 2009 was a more moderate year, with $3.25/share of earnings. The first two quarters of 2010 have an EPS of $3.02/share, so strictly from a backward looking P/E ratio, it looks expensive. Even if you assume every year is like 2008 from here on in, the CAD$44 billion valuation (roughly CAD$145/share) appears to be “average”.

Because of my investment laziness, combined with a lack of knowledge of the dynamics of the potash industry, I wouldn’t make a firm statement on the valuation of the merger. I don’t plan on touching this stock without doing a lot more research (which I am not going to do). Just strictly looking at the financial statements, it looks like the party willing to pay $44 billion for the company is over-paying, while the board of directors that are recommending the rejection of the takeover are likely playing for more money from their potential suitor.

Still, the general lesson here is that when you learn about some obscure compound or mineral, it might pay to look a little more carefully at it and see if it is plausible whether it will be an in-demand commodity in the future. Everybody knows about petroleum and potash, but what is next? Uranium already had its hype period in 2007, while “rare earths” and lithium are making the headlines currently – what’s next? Antimatter?

Investing in structured products

After alluding to disposing of a long corporate bond position, I received some comments as to what the exact ticker is of the issue in question. There were enough hints in the post to figure out the product, but I will be more explicit in this post.

Now that I have completely disposed of the position today, the ticker in question is (NYSE: HJR). This is one (of many, many) examples of an exchange-traded structured product. The specific structure is a trust that has a single asset – corporate senior bonds of Limited Brands (6.95% coupon, maturing March 1, 2033). The trust’s mission in life is to distribute income coming out of that bond. The trust itself has $25,340,000 worth of 6.95% corporate bonds and the distribution is at a 7.00% rate.

You can read the exact specification of the trust by reading its prospectus.

Effectively you are investing in a corporate bond that is exchange-traded. The payout times are identical to the bond, with the exception of the coupon (7.00% on the trust vs. 6.95% with the corporate bond) and that trades do not incur interest expense/revenue for a purchase/sale of securities. An investor purchasing one unit of HJR will receive a $0.875 payout every March 1 and September 1 until March 2033, where they will receive a $25.875 payout.

At the current transaction price of $24.40, an investor has a 7.2% current yield on investment, or about a 7.5% yield to maturity for a 22.6 year term.

There are slightly different risks involved with the structured product. The largest change is that the structured products have a “call provision” where the unitholder, if held in sufficient quantity, can redeem the trust in exchange for the underlying bond. This call provision ensures that there is an effective cap on the unit price, even if the underlying bond trades at a premium.

There are a couple hundred of these products trading on the exchanges – some are extremely illiquid, and in the example of HJR, it is lucky to have $50,000 par value traded daily. The spread is typically 40 cents.

As I have indicated before, I have recently liquidated my entire position in HJR as I do not feel the risk/reward ratio is right for my portfolio. Other investors that are looking for a stable 7.2% yield on a senior corporate security could consider HJR. It is still a far, far more inferior option at present than buying the actual corporate debt, which is priced at around 90 cents. Since HJR is trading around 97 cents on the dollar, I am very puzzled at the high price and hence sold my position. The bid is obviously from an irrational retail source.

There are other structured products carrying the exact same bond as collateral, and they are trading at more reasonable prices. If the products were marginable, there would be an obvious arbitrage opportunity.

Exchange-traded structured products are very research-intense. Although most of them have standardized provisions, there are some that have odd-ball provisions that require you to look at the prospectus of each and every security that you are considering. Once you have cleared the research hurdle, however, they are worth looking at. In late 2008 and early 2009, these products were being thrown out the windows of financial intuitions. At the depth of the financial crisis, HJR was trading for $8.40 (33.6 cents to par) and suffice to say, I thought this was one of the greatest opportunities the market was offering especially in consideration with the risk taken (the seniority of the bond ranks you ahead of common shareholders).

Although you would have done slightly better with an equity investment at the same time, you earned your capital gain with a significantly lower level of risk, in addition to having the luxury of having a well-defined exit point (at the lastest, the maturity date). You were also being paid a handsome sum of money to wait.

In the case of HJR, and in the case of a lot of other asset-backed securities that give out a yield, it is close to the time where it is worth liquidating the positions. As the 10-year bond yield is heading toward record lows, chasing yield will become more and more dangerous.

Spam filters

I notice that Larry MacDonald has had some issues with the Akismet spam filter, which has been over-zealous in filtering his comments on other people’s websites.

I notice that on this site, he had three comments which I had to fetch out of the spam filter.

Spam is really all about economics – you can produce enough of it for such a low cost that even with a microscopic payback rate, it still is profitable. It does cause a lot of pollution on the internet, but with some Bayesian filtering you can weed out most of it and have an acceptable false positive rate.

Spam is also about game theory – a cat-and-mouse type game. The new game is that spammers are trying to increase their “credibility scores” by making innocent-sounding comments and posts in the hopes that human operators will “approve” them and then they will be able to deliver their payloads more effectively elsewhere.

Akismet has been good at picking up comments like “Like your site, keep up the good work” and other such spam comments that were socially engineered to let site owners keep them on their site. Filtering techniques are quite effective at weeding out these types of comments, such as using the IP address of the comment origin, and the submitted name and/or email address included with the comment.

However, if filtering gets too hyper-aggressive such that it begins to block out legitimate comments (called false-positives), it undermines the entire system.

Imagine a cellular phone network taking 5% of your incoming phone calls and/or text messages and not relaying them to you. You would consider this unacceptable. In the comment world, the acceptable false positive rate is likely higher, but for emails, it has to be one in a thousand in order for the system to be effective.

If spammers are able to increase the false positive rate, it will also be a victory for them since it undermines confidence in the spam detection system.

Unfortunately for Larry, it is likely that Akismet has somehow flagged his online signature as spam. Not sure how that happened, but at least on this site, I have taken three of his comments out of the spam bucket.

Silly market tidbit of the day – GM

While General Motors is pondering going public again, one should keep in mind that their predecessor company (pre-bankruptcy) is now known as Motors Liquidation Corporation. They had their name changed to not confuse the general public into believing they owned shares in something that might be worth something.

The pre-bankruptcy shares of General Motors, amazingly enough, still trades at 50 cents a share. When all of the court settlements are completed, this will go to zero.

People should study why this is the case – why an asset that is fundamentally worth nothing is trading at something above zero. In addition, short-selling the stock is not as easy as one would think.

Another week of summer trading

I don’t think price movements should be taken too seriously this week or for the rest of the month. The price changes do create volatility that can be taken advantage of, however.

That said, I am beginning to have a few “hits” on my equity radar that are deserving of more research, so hopefully I will have enough time to look at them since I have been taking things relatively easy myself.

I continue to trim my long-term bond position in Limited Brands; I had the selling side of the trade at the 52-week high, but I didn’t have my entire position filled and now the position is trading about 1% less than that amount which is somewhat frustrating – I just wanted to clear out the whole thing at 96 cents. TRACE has the bonds at 92 cents on the dollar, while the exchange-traded version had them at 96 cents on the dollar, so I am unloading and taking my money. I remember the days that TRACE had them at least 5-10 cents higher in the bond market vs. the exchanges, so the market is relatively inefficient on these illiquid issues – a high volume day is considered to be $50,000 traded.

I also note my other long-term bond positions are creeping higher. If they get to the 8% yield stage I’ll consider a liquidation of them, and leak the position and fully dump them at around 7.5%. I also have to time whether I can unload them in 2011 for roughly the same value for tax reasons. TRACE has those exchange-traded issues and the bond values at roughly the same value at present so I am not losing a premium valuation by waiting.

I am also trimming my only equity position, which I had a very minor stake in. It was an obscure play that was slightly under-valued and had a market catalyst that never emerged. It has appreciated somewhat, so I am selling it. With my track record it will probably go up 2000% over the next 3 years after I dispose of it all.

All of this should make for a third quarter update that should hopefully show some more cash in the portfolio – assuming I don’t buy anything, it will get over 10%. Although cash yields a paltry 2% at present, it gives me the opportunity to strike at other opportunities when they arise and come to my attention. It is very difficult to do this when “fully invested” since going into margin to invest involves its own separate set of risks.

I am playing things ultra-conservatively, which doesn’t make for good writing, but at least I will be solvent.

I am also still looking for income-oriented securities, but I am finding this entire sector to be swamped with over-valued issues. It is painfully clear to me that the large amount of money sloshing around there is looking for yield.