Category: Finance

I will promise not to hijack my own website with too much in the way of US politics, but it does influence the markets in general as the current president will manipulate stock markets in a manner that best suits his political fortunes. Also the perception of Trump’s re-electability will have an impact on capital flows.

Back in my year-end report, I wrote:

USA Politics

In my previous year’s report, I made an educated guess that President Donald Trump would make all the gestures of running again for president but not actually run. Looking at the lead-up to what is a presidential election year, I am going to back out that prediction, mainly because of the competition that Trump is facing.

Odds markets have the following:

Biden: 2:1
Sanders: 3:1
Warren: 5:1
Buttigieg: 8:1
Bloomberg: 16:1
Hillary: 27:1
Yang: 34:1

In my scorecard, I would rank Sanders #1 probability to win the thing. My guess is that Bernie Sanders (“authentic”) is going to give the Democratic Party establishment a run for their money, much more so than when he did in 2016. The evidence is in the fundraising figures. The fact that he has gone through the entire primary process before is a huge assist in terms of his campaign structure and this cannot be underestimated.

Likely to place second is Pete Buttigieg (“young”, “first (credible) LBGT presidential candidate”). He checks the correct Democratic Party boxes.

Third will be Elizabeth Warren (“establishment”). I would view Warren as having a better chance than the other establishment candidate, former VP Joe Biden. For the life of me, I can’t understand why Biden has been ranked so highly other than incumbency.

Bloomberg has the huge disadvantage of trying to replicate what Trump did to the Republican party, but it won’t work. And in the very rare chance he actually did win, I do not think he would contrast well to Trump in the general election, and everybody knows it.

I am fairly certain on my Sanders / Buttigieg projection, and absolutely certain that Biden is toast (he will likely give up after South Carolina, which is his strongest state, and held on the leap year day February 29, 2020), but the question is where the establishment vote is going to end up – originally I thought it was going to be Elizabeth Warren, but now it is looking like a contest between her, Amy Klobuchar or Michael Bloomberg. Interesting times indeed. Warren’s performance in the technology-error riddled Iowa caucus is good enough to give her credibility in New Hampshire (and geographically it is a closer state for her), but in future primaries, it will be interesting to watch that Democratic establishment vote.

Something to always keep in mind is that whenever you see a transaction, it represents a price that a buyer and seller agree to. When the price is lower than the previous trade, media and people alike state that “the stock has been sold off”, when more precisely it means that “the price that people are willing to sell it at is lower than those willing to purchase”. The number of shares outstanding after a trade is the same with the exception of a primary offering (a company offering shares directly to the public, which can also come in the form of option exercises or restricted share vesting) or a share buyback.

When can an investor get the lowest price? There are a couple circumstances that come to mind, both which are somewhat intertwined. One is that the sentiment for the underlying company is at a low – sometimes the reasons for this is legitimate (e.g. the business model went bust, such as what we are seeing in the marijuana sector at present), but sometimes the lowering of sentiment is transient – for instance when a poor two or three quarterly earnings results comes but the underlying business is still solid (yet stock traders cannot see the underlying strength). This happens all the time in investing, and one advantage of investors with smaller portfolios is that they can jump in and out of these circumstances.

The second circumstance where an investor will be able to capitalize on a low price is if there is forced selling, but these opportunities are transient. There are several situations where selling can be forced and I will outline them.

a) Index selling. For instance, if a stock is delisted from a major stock index, there will be a point in time where mechanical index funds will be forced to liquidate such stock, causing an increase in supply usually resulting in a lower price. Another variant of this is that the underlying ETF containing the stock is contracting its assets under management and the stock is required to be sold. This is one of the residual fears of passive investing – if ETFs are invested in financial products that are inherently illiquid, it will cause more price volatility. A nimble trader can take advantage of such downswings, although be forewarned there are many algorithmic traders looking exactly for these types of price dislocations – once you see it, it’s likely too late to act on it.

b) Fund policy required liquidations. For instance, if a bond fund is required to hold investment grade bonds, but a rating agency downgrades an issuer’s corporate debt into junk, the bond fund in question will be forced to liquidate the bonds, usually after some grace period to avoid a stampede to the exit. Another example are dividend funds that have a mandate that requires their funds to be invested in dividend-bearing securities – if a company decides to change its capital allocation strategy and cut dividends to zero, I usually wait a little bit before investing because there is usually a period of time where funds try to dump supply of such companies into the market. Another interesting variant we are starting to see is ESG-related divestitures, such as the divestment of fossil fuel companies in funds, or thermal coal divestment.

c) Margin liquidations. During significant market downturns, leverage forces leveraged funds to liquidate, which causes price decreases, which in turn requires them to liquidate more, etc. An extreme example of this were volatility ETF fund liquidations that occurred in February 2018 (thinking about the XIV ETF).

d) Required financing raises. This is where a company is floated on the market because the underlying entity requires capital. Two examples of this are Genworth MI (TSX: MIC) which was performed to raise money for Genworth Financial post-economic crisis, and AltaGas Canada (TSX: ACI) which I already wrote about being one of my worst misses that I did not take a stake in.

Ultimately if you want to capitalize on anything on the above, the supply pressure created by forced selling has to be in sufficient quantity and in a short enough timeframe to occur at a velocity that will create a low price. We saw a lot of this in the 2008-2009 timeframe, and more closer to present, in early 2016 and late 2018. When these forced liquidations occur, being on the opposite side of the trade at the right time can result in significantly excessive returns. As always, timing is important, and doing your research in advance and having a ballpark notion of valuation greatly assists in reducing the fear factor when you see a very ugly stock chart.

In particular, if a company has fundamental strength but is being subject to forced selling (which in itself could be caused by excessively negative sentiment), it can create highly profitable circumstances. Watch out for these situations.

I do not write about options that much, nor do I use them that often. This post I wrote last year illustrates my thoughts and they have not evolved much since then. Options are expensive to trade, both from a commission and spread perspective, and they are much less liquid than their equity counterparts.

On a whim, I decided to attend the Montreal Exchange’s Options Education Day in Vancouver last Saturday. Once in a blue moon, I try to attend something in-person to just get a feel for the environment and see if I can learn any tidbits of information. Since this conference was sponsored by the exchange itself, I figure that it wouldn’t be too scammy in terms of having people promote perpetual money-making machines. This assumption was somewhat true – there was some reflection on risk, but not too much. The cost to get in was $55 plus HST, so that probably filtered out the completely degenerate. It was at the Fairmont Vancouver and included a (average) buffet lunch, and all the coffee you could drink. I had no problems with the venue – it was spacious and the service was excellent.

After the end of the presentations, which went for the better part of the morning and afternoon, I did not learn too much that I didn’t know already. In no particular order here are some tidbits:

* CIBC (one of the sponsors of the event) is still struggling to come up with an investment brokerage platform that can compete against Interactive Brokers. Their interface looked oddly early 2000’s in look and feel as they were navigating through it in a presentation.
* I was left with the impression that selling covered calls and puts was effectively free money. It is mostly certainly not. In particular, one presentation was mostly dedicated towards the notion of selling puts instead of purchasing stocks through limit orders and “generating a 1/2 to 1 percent discount per month on your order”. What they conveniently omitted was the fact that if the stock goes under the strike price, in a limit order you will get your fill right there and then, while on a short put option trade you pretty much have to wait until expiry in order to figure out whether you’re going to be owning the stock or not, and this time difference is materially crucial.
* I was left with the impression that taking a long call option (at varying strike prices) in a low volatility option with two months to expiry can lead to similar upside and lower downside compared to just flat-out buying the stock. The analysis of this particular presenter was reasonably good, but what was missing was that a low volatility option would not be expected to have the underlying stock go plus or minus 10% in the first place in a couple months.
* One particular example focused on a short-term option in Manulife. I forgot the exact strikes but it effectively involved paying 20 cents extra for exposure on a $20 stock, but they conveniently forgot to mention that Manulife paid out a 25 cent dividend between the hypothetical purchase price and expiry of said option, which changed the “no-brainer” proposition and made it effectively more expensive.
* There was no discussion at any time of the actual mechanics of trading options, including costs of trading, and dealing with the awful bid-ask spreads on most of the issues trading on the Montreal Exchange (which desperately needs competition).
* There were about 65 people there, about 55 of them were men, definitely skewed toward those that have more grey hair than I do.
* There does seem to be an obsession about “yield” and “income”, which I think is true for the overall market.
* At no time did the notion of fundamental analysis of the underlying securities ever factor into any discussion, nor, more relevant for options trading, any relevant discussion as to what determined the implied volatility or factors that could change volatility. Almost all the discussion on trading was of a technical analysis nature.

In general, I could easily see without more foundational knowledge, how less educated investors could be convinced that options trading could be beneficial for them, and probably over-engage with it. Options trading seems to solve a problem in people’s portfolios that they do not have – guess whether the stock is going up or down is difficult enough, let alone trying to figure out the probability distribution of future prices over time!

I’d be much more curious about how the market makers fare and get insight from their perspective. I know Interactive Brokers’ market making division (Timber Hill) got out of the options market making business a few years ago, citing that they were not able to make money because they got killed by people that had more information than they did on underlying companies.

Here’s an interesting press release from a marijuana producer company Alefia (TSX: ALEF, ALEF.DB) – the relevant snippet I’ve quoted below:

2019 OUTDOOR HARVEST HIGHLIGHTS

10,300 kg of dried flower harvested
1,000 kg per acre yield in Zone 1, which was planted in June 2019
$0.08 cash cost per gram to harvest (unaudited)
$0.10 all-in cash cost per gram to harvest, including facility capital costs (five-year amortization) (unaudited)
Cannabinoid content (THC and CBD per gram) of harvested flower was strong, at levels near to the cannabinoid content in identical strains harvested indoor
Quality assurance testing to date is successful, including for microbial content, pesticides and contaminants

“Our inaugural 2019 outdoor harvest was successful due to the commitment and capabilities of our team. I’d like to thank our on-site growers who navigated the challenging environment of starting the cultivation season late into the year and ultimately delivered an excellent harvest that we are measuring in tons,” said SVP of Production Lucas Escott.

The key line here is the $0.10 per gram “all-in” cost per gram to harvest, which bakes into some “half-baked” amortization scheme (pun most definitely intended).

Simple math follows.

1 kilogram (kg) is 1,000 grams.

So this batch of 10,300 kg of dried flower marijuana cost $1.03 million using their numbers.

How much is 10,300 kg?

Apparently 5.2 million Canadians have consumed cannabis over the past three months.

Consumption statistics are not that easy to find, but apparently in 2017 (when Marijuana was still technically illegal in Canada) the annual consumption was about 20 grams per user (with the distribution of consumption highly skewed towards the high frequency user in a typical Pareto distribution – I’d argue that these people are more likely to have their own sources, but let’s ignore this for now). This works out to 104,000 kg per year of consumption (if legal).

The latest statistics (link 1 – October 2018 to June 2019, link 2 – July and August 2019) show the annualized consumption at around 155,000kg (medical and non-medical usage – the pretense of medical usage has gone completely away after legalization).

So let’s say it is 155,000kg and rising. What I find particularly amusing is that if distributed evenly among 37 million Canadians, that’s 4.2 grams for every man, woman and child – apparently this is good for about 10 joints per individual.

Of course, not every Canadian is going to smoke marijuana. Statistics suggest that about 1 in 6 Canadians use it. The addressable population for Cannabis is about 6 million people in Canada – or about 26 grams per person. Assuming this 1 in 6 number is constant (I don’t see how non-smokers can convert into smokers too easily), that works out to about 26 grams per smoker – how much higher is this going to go?

Later in Alefia’s press release, we have the following:

Based on the 2019 results, the Company estimates that it can produce 1,200 kg per acre for a total of 102,000 kg of dried flower in 2020 at its expanded 3.7 million sq. ft. (86 acre) outdoor site, at full capacity. The modest increase in the expected yield per acre for 2020 is due a number of factors which should improve the overall outdoor grow operation, including commencing cultivation several weeks earlier relative to 2019.

So we have one company that is making a claim they can produce 2/3rds Canada’s annual consumption of (legal) marijuana, and implying they can do it for a relatively low cost (10 cents per gram, all-in).

If this is true, then there are a few implications, especially considering that growing marijuana doesn’t appear to involve much in the way of patent-able or proprietary technology (it is a weed, after all!).

One is that there is going to be a massive over-supply of marijuana, and there will be a huge “race to the bottom” effect as price leaders attempt to leap-frog each other to dump their supply into the market place. This is already happening.

Two is that because the marginal cost of production is effectively nothing, that the value chain in producing is going to capture precisely zero profit beyond a cost of capital – and indeed, that will only happen when other inefficient producers get squeezed out of the market due to oversupply – is the company that is able to produce at 6 cents per gram all-in going to have a competitive advantage when all others can do it at 8 cents? Sure it will, but how much value will they be able to extract from that advantage? Not a lot.

Three is that governments are going to make a huge amount of profit on volumes (one of the winners of the value chain, and also having a huge financial incentive to encouraging as much volume as possible to be transacted in the legal market). (CRA Cannabis Excise Duty Information) At the federal layer, the government stands to make a minimum of $1/gram sold, or 10% of the product cost.

Four is that the low price of producing cannabis is going to create its own markets for ultra-low priced product, but this has to happen before it hits the excise tax layer – hence, the production of oils and other cannabis knock-off products that try to find some way to use what is otherwise worthless biological inventory.

Where is the profit going to be in the product? Obviously it is going to be in branding and marketing like most commodity products – tobacco has its Marlboro, and if/when Cannabis has their equivalent, that brand will probably end up making money. These brands take decades to build, sort of like Coca Cola and Pepsi. Until then, good luck – everybody in the marijuana production industry is going to lose.