Category: Finance

Finance and Economics related articles

When is it time to cash in the chips?

It’s been a good run up in the market in the past month. Just last month I thought I was headed for the first negative quarter since Covid hit. Now it’s a race for the finish in the last two weeks of September.

There’s been a component in my portfolio (you can guess which one it is, I’ve written about it before) that almost has GME-like properties at the moment, albeit the business model is slightly more viable and I think the hype cycle is around the 3rd inning of this particular baseball game.

One always needs to ask themselves when enough is enough.

The trading mechanics of stocks nearing a mania high is punctuated by intense volatility both on the upside and downside.

Gamestop is a perfect illustration of this.

You had a few trading days (look at late January) where it ranged from $200 to $450 in what could be classified as insanity.

Even a week before that, when it spiked from $40 to $100, that was considered insanity.

Nobody wants to be the person selling GME at $40 on its way up to $400, but you had to wait four trading days (not to mention a weekend) to make this happen. Retrospect makes for 20/20 vision, but doing this in the heat of the moment is a hugely difficult endeavour.

What’s funnier is if you set your limit order at $300, psychologically you would have still felt ripped off since you had the potential for another 50% gain ($450)… “If only I set the limit sell price at $400 instead of $300 that day”.

That said, share dispositions do not have to be a binary decision – you can choose to trim tiny amounts as prices rise. This is my personal approach to things, although logically it doesn’t make sense.

Overall, however, we are seeing a commodity-driven boom. There is a lot of forward expectation and you can see this with the single digit P/Es projected in most of these companies.

ARCH, for instance, is trading at 6 times projected 2021 earnings. Coking coal is going crazy and Arch is down 4% today. What gives?

My Divestor Oil and Gas index has Q2 guidance below current spot prices and even with that guidance, companies are trading at EV/(free cash flow) levels of the high single digits (and if you ignore debt leverage, the price to cash flow ratio is even lower). Natural gas is spiking – you’re seeing Henry Hub gas prices this winter heading north of US$5/mmBtu, and AECO is north of CAD$4 and it’s still September.

It’s a really difficult decision to be selling equities that are trading at single digit multiples of cash flows when prevailing investing options for near-safe money is so terrible. You can’t even go to the debenture or preferred share markets, which are more or less a wasteland in my humblest of opinions.

Still, I sold a small holding of Western Forest (TSX: WEF) earlier this year, when they were on track to earn about a quarter of their market capitalization in 2021.

Embedded in each of these companies is an implied bet on the future of specific commodities (met coal, gas, oil or otherwise). There is also an embedded skepticism that current prices will remain in each of the share prices. It could entirely be the case that the market is assigning a gigantic discount to future cash flows for whatever reason. If this is the case then buying and waiting for the returns to flow in is logical. Inevitably, it will happen – the most conservative approach companies make is paying down their debt, and then after that, they will have the choice of raising dividends or buying back stock.

This is unless if the real economy crashes and takes the commodity market with it. Then, those single-digit P/Es will rise very quickly.

As for the title of this post, I do not know. As much as it makes mathematical sense, margin investing always makes me nervous. The proper time to do it is when you are feeling absolutely sick in the stomach to buy and right now it just makes too much damn sense to borrow at 1.5% and buy these single digit P/E stocks. This is why I’m not doing it and am slowly raising cash instead, because the decision to increase zero-yield cash in my portfolio hurts the most. It won’t be an extreme move – just enough to make me a little more comfortable.

Hunting for ideas in this market

I’ve been noticing that certain sectors get hyped at certain periods of time. There are various influences out there (intelligent ones that, in general, are typically directionally correct and hence they gain a credible following over time) which form narratives and the digital financial wave decides to latch on until such a point they get washed away.

Today it appears that a bunch of hype is building up with uranium producers, the claimed narrative is that with Sprott opening up a physical Uranium ETF (TSX: U.UN) that this will suck up world supplies to a point where prices will rise and make all uranium miners spike. If storing vaults of gold and silver wasn’t enough to spike their respective commodity prices, surely storing yellowcake will be different!

The uranium market has been a cesspool for over a decade, which was not helped by Fukushima. In general, worldwide supplies of Uranium ore has been healthy to the point where Canada’s Cameco (TSX: CCO) decided it was easier to just buy than mine.

The claimed investment thesis is that an entity is essentially trying to corner the market on Uranium, so therefore you should buy the crap out of it before Sprott does. We also get a bunch of narrative about how China and India are building nuclear power plants, etc., etc. It’s a great narrative. The story is very easy to understand.

Uranium production itself is also a relatively small space in the publicly traded sphere (especially in North America) and there isn’t a lot to pick and choose from, hence it is a great target to hype up – a relatively small amount of capital will result in outsized price changes.

When I read these narratives from external sources (especially confirmed in multiple locations, which makes me suspect that there is a degree of inter-connectedness in these pronouncements) I get skeptical that I am behind the curve rather than leading it. I literally do not buy into these things.

I am sure there will be a decent price ramp (it is already occurring) but once the capital inflow dries up, it’ll be really interesting to see the conviction of these people that are looking for triple-digit gains in months when the geopolitical situation for this particular commodity will play out over years (specifically when fossil fuels get really expensive… come back later this decade for the resolution of this story).

My investment ideas have to be generated from non-narrative sources, and especially from sources that are not trying to sell subscription newsletters.

Unfortunately, this means that I tend to not pay much attention to various stories of hype – including the boom in marijuana companies in the second half of the last decade, the cryptocurrency boom, etc. I’m content with letting others gamble in that casino.

So when you are trying to be sold a story, ask yourself which stories are not being pitched to you, and look in that direction. It is much more difficult, cognitively, to look at a piece of information and then figure out what is not there, instead of fixating on the piece of information itself.

Stock screeners are great for generating a reasonable amount of random and obscure selections that can be subsequently mined for suitability. If one has views on specific sectors, selections can also be concentrated on that.

At present, however, my usual cautious approach to the markets has been getting even more cautious as of late. A chart of the S&P 500 or the TSX is not properly reflective of the level of fragility that likely exists out there.

Featured on the Globe and Mail – reflections on dealing with short selling reports

I’d like to thank Larry MacDonald for mentioning me on his regular article on the Globe and Mail about short selling on the TSX.

A hedge-fund analyst once sold short a company in which Sacha Peter had invested. Then he published a critique on it.

Did Mr. Peter, author of the Divestor blog, rush to his keyboard to click on the sell button, or log into online forums to urge a squeeze on the short seller? Not at all.

Instead, he rolled up his sleeves and dived into the critique. After reading it, the shares remained in his portfolio and were later unloaded at a profit.

It may not always turn out as well as it did for Mr. Peter, but there is something to be said for monitoring the trades of short sellers to see if any are targeting a stock you hold. As Mr. Peter says, “I very much like reading the short-sale cases of anything I hold. It forces me to check my analysis.”

Larry was referencing my post back in April 2018, The case to short Genworth MI, where a very intelligent young analyst won an accolade for writing a fairly comprehensive short report on Genworth MI.

Keep in mind there is no “one size fits all” strategy concerning how one deals with new information that comes with people or institutions issuing short selling reports on your holdings. Everything depends on your ability to perceive fact from fiction, and perhaps more maddeningly, perceive the market’s sense of reality versus fiction that they bake into the stock price.

I’ll also talk about a time where I got things less correct.

Go read my August 2020 post on what happened when a short selling firm released a report on GFL Environmental. I had taken a small position on one of their hybrid securities (effectively yield-bearing preferred equity with equity price exposure above and below a certain GFL price range) and then a short sale report came out. I bailed very quickly. Retrospect has shown that wasn’t a good decision financially (right now GFLU is about 70% above what I sold it for including dividends), but one of the reasons for bailing was because I was not nearly as comfortable with my level of knowledge about the company than I was about Genworth MI. Another reason is that there were still very active market reverberations going on during COVID-19 so there were plenty of alternate investment candidates for my capital. I’d also like to give a hat tip to Jason Senensky of Chapter 12 Capital for his comment that has stuck in my mind ever since, which is his insightful analysis that my “return on brain damage is too low” – which indeed is an accurate reflection that my mental bandwidth on such cases is better spent elsewhere.

And while I’m on this topic, Jason also wrote a fantastic article on the near-demise of Home Capital Group, instigated by a high profile short seller. Hindsight is 20/20, but I feel like there was a missed opportunity on that one – I should have taken the cue after they announced they obtained their ultra-expensive secured line of credit facility (it marked the bottom of their share price).

Brilliant marketing for yield-challenged investors

The chase for investment returns in our zero interest rate environment incentivizes the creation of all sorts of financial products to give one the perception of yield.

Indeed, I can promise you today a 10% yield. Just give me $100 and I will give you a 10-year yield of 10% a year, starting with a 10% distribution 365 days from now. Boom, guaranteed yield!

But hold on, it isn’t enough that I hold onto your capital for a decade, I want to charge some management expenses.

So how about you give me $100 today, and I’ll give you a target 8.5% yield. That might change if I can’t actually generate the returns, or if I can’t find more people to give me money to pay you.

A good example of yield-promotion financial instruments are split-share corporations, which appear to no longer be in vogue. There has to be new financial products that promote high yields!

Cue in the marketing geniuses at Hamilton, who have spammed the media with their “Target yield of 8.50% with monthly distributions” fund!

I couldn’t resist looking at the detail of the financial wizardry to make it happen.

This is a fund-of-funds:

And the strategy: “The fund seeks to replicate a 1.25 times multiple of the Solactive Multi-Sector Covered Call ETFs Index (SOLMSCCT), comprised of equal weightings of 7 Canadian-listed sector covered call ETFs.”

In other words, there is some person that puts in a buy order for 7 ETFs, and does it with 20% margin (i.e. buy $125 of funds with $100 of equity).

The geniuses at Hamilton don’t even have to program any software to manage the covered calls or the index balancing – they leave it to the constituent funds to doing so. The fine-print prospectus references a semi-annual rebalancing to equal-weight the funds, and to keep the leverage between 123% to 127%.

The 8.5% indicated yield is not in the prospectus, but it is clearly the marketing pitch. 8.5% divided by 1.25 is 6.8%, which is the basis for this yield claim.

For this, they charge 65 basis points.

A pretty good business for them.

I find this phenomena of covered call ETFs and the promotion of covered calls to be highly over-rated. Most retail people perceive covered calls to be free money (“even if I do get called out, it is at a price that I would have wanted to sell anyway”), but there is a significant exchange of future upside capital appreciation for a “yield” today. This yield is not free, especially during times of low volatility. Implied volatility of options tend to drop when the underlying price appreciates, and vice-versa. The best time to get the highest option yields (when implied volatility is the highest) is typically during a market crash, which is precisely the time you do not want to be selling the capital upside of equities.

Conversely, at that exact moment tends to be the ideal time to sell put options, but few people in the heat of a market crash want to do so, and indeed, selling puts during a market crash is not the most financially productive activity since the amount of upside you capture is limited to the put premium. There is no free lunch in this game although slick marketing makes it appear to be the case.

The TSX 60 currently yields around 2.7%. At 125% leverage, it would yield around 3.4% ignoring the interest cost. If you got rid of Shopify (about 10% of the index now!) that yield rises to about 3.7%. Is it a stretch to think the capital component of the TSX will rise 5% in the future? Maybe. But the sale of 2-month at-the-money covered calls on the TSX right now is 1.4% and that more or less locks in a (unleveraged) 4% return with only capital downside. The 2-month covered call option yield if you wish to retain about 2% capital upside is about 40 basis points. When you include a friction of 65bps MER, I don’t see how the math works at all.