What a difference interest rates make

The market has long since baked in the upcoming drop in interest rates.

As a result, anything “yield-y” have been bidded up substantially.

I note the REIT sector, which at one point earlier this year was mostly negative year-to-date is now, with a couple exceptions, up solidly.

We have the go-private transaction (99% sure to succeed) for Melcor (TSX: MRD) repurchasing the minority interest in its REIT (TSX: MR.UN) – the fact that MR suspended dividends some time ago should have given a clue as to its financial condition, but apparently they have some assets on the balance sheet that’s worth paying a healthy 60% premium to market for.

The larger REITs, e.g. REI.un, AP.un, CAR.un, etc. are all up roughly 25% over the past three months.

This is purely due to the quantitative effects of interest rates dropping. I will question the economic fundamentals of such price moves.

We also look at other (restaurant royalty) income trusts, including KEG.un, AW.un, BPF.un, etc., and they are all up. I will also question the economic fundamentals of such price moves. Do lower interest rates cause more people to go to restaurants?

While high prices are great if you are already holding and intend on selling, returns on investment drop with higher prices.

It’s getting pretty tough out there. As cash yields less and less, investors will be compelled to march up the risk spectrum to make the same returns that investors are fighting for.

The good news, however, is that having a slate that is cleaner than it has been since 2008 gives some mental clarity. I am not going to force cash to work for the purposes of increasing yield. It does hurt in some manner, knowing that every day cash erodes in purchasing power.

Despite government-published CPI statistics showing that inflation has moderated, anybody with a functioning eyeball will know that cost escalation is still significant and ongoing, especially with goods and services that people actually require. Costco is an excellent barometer for this.

The deflation you see are for goods that nobody needs. Take a look at Craigslist ads for furniture and you can explore a market that is besieged by deflation. Do you want somebody’s discarded Roomba? That can be had for $50 or $60.

There is also another metric to determine how much purchasing power has declined and that is to measure the portfolio value not in dollars but rather ounces of gold – gold as measured in Canadian currency is up almost 25% year to date, which is more than my own year-to-date performance this year. Just in case if I wanted to pull off a “Scrooge McDuck” and cash everything into one ounce gold coins and go swimming in the vault, I’d have less today than I would have last year!

Interesting times always lie ahead. The environment today is a lot more difficult than it was in 2020-2022.

Income trustworthy investments

With the US Federal Reserve imminently seeking to drop interest rates, and the Bank of Canada dropping rates a quarter point a meeting, earnings on cash are starting to decline, and all of the below will head down proportionately to the central bank rate:

(All of this assuming you can buy it at NAV)
CAD-denominated:
IBKR = 3.575% net [interest, minus CAD$13k]
HSAV.to = 3.93% net [cash, capital gains]
CASH.to = 4.02% net [cash, interest]
ZST.to = 4.34% net [6 month maturity A-AAA bond income, mixed interest, capital gains]

USD-denominated:
IBKR = 4.83% net [interest, minus US$10k]
HSUVu.to = 5.02% net [cash, capital gains]

In the Canadian market, the futures are aligned for a 25bps drop on October 23, December 11 and January 29, which will bring cash down from 5%+ to just above 3%. That will be roughly a 40% drop in income on cash in about three and half months’ time.

Needless to say all of this central bank action will be getting participants to examine the “efficient frontier” in terms of adjusting their risk-reward profiles. Instead of getting a slick 5% on risk-free cash, we will now have to explore upwards to short-term bonds, and less credit-worthy financial instruments to achieve the same amount of returns.

Unfortunately the financial markets, by virtue of future contracts, already anticipates these interest rate changes and hence anything that can provide as a substitute has already been bidded up. For example, the GoC 5 year yield from July 1st to today has gone from 3.6% to 2.8% (people will pay a premium for five years of guaranteed yield vs. a higher short-term cash yield). The Canadian preferred share market has been bidded up across the spectrum – for example, we will choose a generic preferred share, PPL.PR.O, which is trading at a 6.9% current yield and a 6.4% yield at the current GoC 5yr rate reset (essentially the risk premium is you will get an extra 3% or so for taking some duration and credit risk).

Bond-like equities also exist. Rogers Sugar (TSX: RSI) has always been one of my favourite barometers of a very stable and government-protected market in domestic sugar and their equity yields 6.4% and they pay out nearly everything in the form of dividends.

Royalties are another stable category of income. For example, Keg Royalties (TSX: KEG.un) which is a very simple income trust that takes 4% of the top-line revenues of all Keg restaurants in Canada, gives out a 7.7% distribution yield at their current payout. If you had invested in early July, this would have been a 8.7% distribution yield.

If one were to achieve a 15% return, there is nothing invest-able mentioned in this post that you can do other than to leverage up – for instance, borrow at 5% to obtain a 6.4%, 6.9% or 7.7% return – either way it is a pretty thin margin.

Needless to say, returns on risk right now are awful. Returns above the numbers presented in this post will be coming from speculative capital appreciation which makes the current environment feel more like gambling at a casino than actually investing.

There are other targets of opportunity which I have not mentioned in this post which have a little more potential, but I am still patiently waiting for a little more market stress to occur and hopefully there might be a margin call wipeout or something, just like when the Nikkei cratered 13% in one day – an event that seems to be a distant memory now.

Investing in garbage – Dollar General

It has almost been a month since I have posted, but I have been quietly stalking targets of opportunity but still remain very defensively positioned. The economic landscape out there has deteriorated somewhat and central banks are trying to get ahead of the curve by cutting interest rates. Everybody has been pointing out that this is usually indicative of bad things happening and as a result, there has been a grab for yield, especially when you look at the Canadian preferred share market.

However, something quite interesting flashed on my radar – something that I would have never anticipated taking a position in a year ago, but have just done so.

I have (post-crash from their last quarterly report) taken a modest position in Dollar General (NYSE: DG), the largest dollar store chain in the USA. With the onset of inflation, “Dollar Store” is a misnomer now, but if you want a close comparison, just walk into a Canadian Dollarama and you will have the same feel (although I must say the American dollar stores tend to have better selection and value than the Canadian version!).

The chart is an absolute train wreck:

You have to go back to late 2017 since the stock traded this low.

I’ve done the core of my research on this just over a year ago when it started to fall from market grace from US$250 in November 2022 and I closely examined it at September 2023 but decided to take a pass. The last quarterly report had me dusting off the cobwebs from my notes and memories and re-reviewing the situation and I think it is more favourable today than it was back then.

To summarize the thesis of this investment, it is a simple regression to the mean thesis, coupled with some economic protection by virtue of the sector that the lower half of the economic cohort flock toward (in other words, economic misery should benefit this company as a consumer staple provider). As investors of Dollarama (TSX: DOL) know, the store features “Amazon protection” but also a degree of Walmart protection. Temu is probably the largest competitor in this respect. The market segment is stable and there is a consider amount of incumbency protection with amortization of fixed supply chain costs.

The stock has gotten nailed on not meeting expectations – primarily that net margins have fallen off a cliff. While gross margins have remained relatively steady, SG&A expenses have ballooned considerably and this has resulted in reduced profitability.

This suggests that there is a management problem. That said, most of the upper executive suite are only in their capacities from 2023 – notably the CEO was the CEO from June 2015 to November 2022 and only took the reigns again on October 2023. Corporations of this size and scale will take some more time to regress to proper metrics. The issues should have been acutely obvious, but being able to make adjustments financially will take time – historical contracts that get signed (e.g. crappy lease locations, supply agreements, etc.) will need to run off before being renegotiated on more favourable terms.

I also note that in the 2021, 2022 and 2023 fiscal years (note: ending January of the year), they blew nearly $8 billion in share buybacks – buying back stock at their all-time highs and at levels wayyyyyyyyyy higher than what they are trading at today.

Wage and cost inflation is also an issue, but this competitive matter will affect other industry participants and will get baked into selling prices.

Other than the large amount of lease liabilities outstanding (which is natural for a retail business), the company has about $7 billion in debt outstanding which, given their cash flows and presumed stability of their business, is not excessive:

One would have wondered how stronger the balance sheet would have been had they not engaged in value-destroying buybacks, but I digress!

I do note that the July 2028 and April 2030 tenor of debt trades at 4.9% and 5.0% yield to maturity, respectively – they should have no problem refinancing current maturities at acceptable coupons. There is also a $2 billion revolving facility that remains untapped.

I expect, after some fireworks, that the company in a few years should be able to post EPS well north of $10/share. Choose your P/E multiple to slap onto the stock price and it seems like a reasonable risk-reward.

Finally, I will make one last comparison. DG had about $40 billion in sales in the last 4 reported quarters. With a market cap of $18.5 billion, this gives it a P/S of less than a half. We look at Dollarama and they have CAD$6 billion in sales and a market cap of CAD$37 billion, for a P/S of over 6! You would think Dollarama is selling AI chips or something, but instead the only chips they are selling are Pringles and Lays! Buying some long-dated puts on DOL (and indeed, the implied volatility on them is rather cheap) is something I’ve been toying with – if they break it is going to be as hard as Dollar General and you’ll see at least a 50% correction in the stock price.

Market thoughts – volatility is finally starting to wake up!

The last two days have been quite stirring. In particular, on Friday’s trading, the volatility index spiked up to 29, which is the highest it has been since the Silicon Valley Bank debacle:

Notably, the yield curve also dived down, with the GoC 5-year going south of 3% for the first time in awhile:

There are a few lead theories that I’m thinking. In no particular order:

The “day of reckoning” of tightening interest rates is finally hitting the markets in some sort of liquidity crunch. Somebody big needed liquidity and decided to hit all the bids.

Was there somebody big that was caught short the Japanese Yen and spontaneously triggered a liquidation?

The commodity complex has also gotten hammered. For example, CNQ and CVE reported quite decent quarterly results, but their stocks have been taken down 10% since then (and WTI has dropped from US$77 to US$73 in short order).

Finally something that might be concerning is the liquidity of cash ETFs – in particular, I note that HSUV.u (the US dollar corporate class fund) in intraday trading actually was trading 0.3% below NAV in very illiquid trading (note: NAV is 111.01):

Somebody holding this fund was demanding US dollars in the middle of the trading day and simply was not getting it. This is the hallmark of liquidity issues during a market volatility event.

My gut says there is more to come, so don’t buy too early. However, I’m well positioned for something catastrophic occurring.