Category: Finance

Finance and Economics related articles

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.

Verticalscope IPO

I’ve got it give it to the people that bought the Toronto Star back in May of 2020, they got a very low valuation which assumed the residual business was relatively worthless (the company had a lot of cash on the balance sheet and the pension debts weren’t too onerous). They really cashed in the middle of the COVID-19 crisis.

However, never in my mind did I anticipate that they’d be able to bring public their Verticalscope subsidiary (TSX: FORA) for triple the value that they bought Torstar for.

My, oh my, are the founding shareholders of Torstar probably feeling like they got ripped off.

Skimming the Verticalscope June 14, 2021 prospectus, we see a corporation that is flat on revenues (approx. $57-58 million/year in 2020 and 2019) and capitalized with about $100 million in debt on the balance sheet. The net debt will be gone with proceeds from the public offering. The entity does generate cash (about $14 million in operating cash flow in 2020) but overall it isn’t exactly what one would consider to be a huge money-winner, especially given what has been invested in it.

The business itself is a collection of online properties. It is a faint resemblance of what the Yellow Pages (TSX: Y) was probably trying to originally execute on their “digital strategy” before management (rightly) corrected that course from 2017 onwards. And just like Yellow’s original digital strategy, it’s likely they’ll use their enhanced liquidity position and/or their stock to acquire more online properties.

Indeed, one of the businesses that Verticalscope owns, Red Flag Deals, was sold to them by none other than the Yellow Pages.

Verticalscope extensively uses the phrase “adjusted EBITDA” to justify valuation and it indeed appears that investors are happy to overlook all the adjustments. At least with the IPO, there won’t be much in the way of interest expenses anymore.

It won’t be myself buying shares of this offering. I really wonder what the thought process of the institutional managers that do, or people that bidded it up another 10% on the after-market trading today!

When narrative and reality collide – ESG, politics and markets

One rewarding aspect of finance is that participants that correctly perceive reality are eventually rewarded with additional capital, provided you stay solvent longer than the market remains irrational.

As markets are an amalgamation of sentiment, there is an element to psychological timing with regards to asset prices. The prices that are currently seen represent the baked in assumptions of marginal buyers and sellers, each trading with their own motivations – some extremely short-term, some extremely long-term. Another vector is the advent of environmental, social and governance (ESG) driven investing. Formerly labelled as “socially responsible” or “ethical” investing, ESG has generalized this to refer to politically correct practices.

As the politicization of financial markets continue, it is obvious that a focus on ESG and politically sensitive institutional investors (e.g. public pension plans and the like) will take a factor in investment decision making. This has long-since been baked into certain asset prices. Political favourites, such as renewable energy initiatives, have resulted in such assets receiving premium valuations and hence low returns for current investors. Such assets are typically aided by government subsidies (in the form of attractive power purchase agreements, or in the case of Tesla, outright tax breaks and subsidies).

This sort of gaming goes on all the time in most industries, as participants jockey for position. Large entities try to assert control through rent-seeking techniques. Nothing is a better example than how various entities are reacting to COVID-19 – companies such as Amazon are cheering for continued lockdowns as they continue to eat away at conventional retail. The medical industry, both private and public, are cheering their nearly unassailable position as nobody can question the quantum of spending in relation to the overall benefit – “anything to save a life” is the current expectation. By the time it comes to pay the bills, the blame will be attributed to other factors.

On the flip side, we have the ‘enemies’ of ESG, which generally constitute a list of firms in politically incorrect industries. One of these industries that are deeply politically incorrect at present (especially in North America and Europe) is oil and gas exploration.

When looking at core valuation of the major Canadian oil and gas firms, there is a major valuation gap between what the ambient market is offering versus what cash is being generated by the companies in question.

For instance, Canadian Natural Resources (TSX: CNQ) gave out guidance on May 6, 2021 that assuming a US$60/barrel of West Texas Intermediate (right now it is US$63.50 on the spot contract), they will be able to generate around $5.7 to $6.2 billion in cash flow, and this is after their capital expenditure and dividend payout (which is another $5.4 billion). Backing out their $2.2 billion annualized dividend to zero, that’s around $8.2 billion in free cash flow (FCF).

Recall that CNQ’s enterprise value is currently around $67 billion, so a rough valuation would be an EV/FCF of 8 times. This means if things continue at current prices, CNQ could pay down all their debt and buy back all their shares outstanding (at current prices) in 8 years. This isn’t an isolated case. The other Canadian large players, Suncor, Cenovus, Tourmaline, are roughly the same (plus or minus one or two points). There are no other ‘substantially Canadian’ plays that have a market cap of above $5 billion at present (Imperial Oil is 70% owned by Exxon, and Ovintiv, the former EnCana, is now primarily a US producer).

You cannot find valuations like this anywhere else on the large-cap market. A typical utility such as Emera (TSX: EMA) trades at roughly 18 times EV/operating cash, never mind capital expenditures! Royal Bank (TSX: RY) trades at 15 times earnings. Perhaps the only outlier I can find in this respect is E-L Financial (TSX: ELF), which posted a 2020 net income of $129/share (on a current share price of $948).

Needless to say, Canadian Oil and Gas looks cheap, and one reason for this (other than the horrible regulatory climate) is the investment ineligibility due to ESG. The irony is that this creates opportunity for returns for those that want higher returns, such as international investors that do not take North American ESG into their investment consideration.

I can think of one analogy in the past which reminds me of today – the plight of tobacco companies in the late 90’s. Tobacco companies (most specifically, Philip Morris) were vilified in the 90’s for having the gall to produce a product that caused lung cancer and collectively denying it until they had lost all public support. The watershed moment was a US$200 billion settlement with the states in 1998, but in reality, this agreement secured incumbency rights for the existing players. The Philip Morris example (now known as Altria) has them earning $3.20/share in 1999, while the stock closed at $23/share for the year. They bought stock like mad during the dot-com boom and shareholders got very rich. Incidentally, Philip Morris was right up there with Microsoft in terms of generating shareholder value over decades (not really the case today anymore, although tobacco continues to remain very profitable).

I’m going to make a much looser analogy with Warren Buffett buying Apple stock in 2017 and 2018 (at his cost basis of $34/share to the tune of some 907 million shares he currently holds today) is giving him a current earnings yield of about 15%. There are of course key differences – with Apple, you have to assume they can continue selling iPhones, iPads, Macbooks and ‘iApps’ at their monstrously high margins indefinitely. With oil and gas you have to make an implicit assumption that the underlying commodity prices will stay steady. This is another argument for another post, but please humour me by granting this assumption.

Buffett, by virtue of his size and relative fame, is constrained by political considerations. The cited justification for selling off his shares in airline companies at the onset of the COVID-19 crisis was politically motivated – the chances of airlines getting public money bailout with (deep pocketed) Berkshire being a 10%+ shareholder was much less, so they had to sell (I am not sure if this is retrospective analysis that actually went on during the sale, or whether it was a simpler case of the original investment thesis being broken). This is not the only example.

In the most recent 13-HF, we had Berkshire disclose that it had sold half of its Chevron stake and all of its Suncor. Chevron is obviously going to be completely divested by next quarter. There is nothing in Berkshire’s public holdings that relate to oil and gas production going forward. This is very intentional, and I believe it is for political reasons.

Buffett is the son of a former US Congressman and should know a lot about the political dynamics that is going on with ESG currently. There were two shareholder resolutions that came up during Berkshire’s last annual meeting. One was from Calpers and the Quebec Pension Plan, two very credible institutional investors:

In order to promote the long-term success of Berkshire Hathaway Inc. (the “Company”) and so investors can understand and manage risk more effectively, shareowners request that the board of the Company publish an annual assessment addressing how the Company manages physical and transitional climate-related risks and opportunities, commencing prior to its 2022 annual shareholders’ meeting.

The other (from a generally unknown proponent) was:

Shareholders request that Berkshire Hathaway Inc.’s (“Berkshire Hathaway”) holding companies annually publish reports assessing their diversity and inclusion efforts, at reasonable expense and excluding proprietary information.

Normally such shareholder resolutions get voted down, heavily. The Board of Directors almost universally recommend a vote against such resolutions.

However, the actual results of the votes got somewhat close:

There were approx. 548,000 votes cast in the meeting (some votes are not cast due to them being held by brokers that do not vote). The directors control 272,900 of the votes (the vast majority of this is from Buffett himself). So the vote result was a foregone conclusion.

However, excluding the directors’ votes, both resolutions passed with a slim majority.

This has to be interpreted to be a warning shot across the bow to Berkshire and almost any other corporation out there with a large public presence. They are not immune from activist politics and the politics driven behind institutional shareholders.

You can imagine how Buffett might be frustrated in not being able to deploy capital into a field that is liquid enough to make an impact on Berkshire. However, with the world examining his holdings every quarter, he must take politics into his investment considerations.

ESG, just like most political interventions, cause market distortions between perception and reality that can last for years if not decades. Hundreds of billions of dollars of capital are being invested not with a return in mind, but rather with a heavier consideration to other factors, including those that are acceptable today (which may or may not be acceptable tomorrow). Pharmaceutical companies were completely vilified before COVID-19, and now they are being showered with immunity from Covid vaccinations and have a gigantic regulatory shield to work with (until they are no longer in favour again for making outlandish profits). Today’s enemies are those relating to climate change, but this may change in the future as demand for fossil fuel energy outstrips available supply.

I am not making a moral judgement on ESG and its intentions. I am claiming, however, that ESG-driven considerations are causing significant distortions in the returns of investments that would have not otherwise existed.

Ultimately for equity investors, cash flows will dictate returns. It might take some time for political fashions to turn, but just like Philip Morris investors in the late 90’s, they were very well rewarded. Eventually the paydown of debt and payments of dividends and buyback of shares trading at single digit multiples will result in higher equity pricing, no matter which trends are politically correct.