Canadian Finance, Economics and Fiscal Analysis
Finance and Economics related articles
If you ever wanted to liquidate $2 million dollars of the CASH.to ETF in the last four seconds of trading, look what happens!
I could not imagine went on in the mind of somebody punching this order into the computer. Reading the tape, those sitting at around $49.75 on the limit would have received a reasonable fill and this is the financial equivalent of picking up the freest half a basis point on the planet.
In highly anticipated news, First Republic (NYSE: FRC) went bye-bye over the weekend.
As long as the yield curve remains inverted and quantitative easing continues, financial institutions are going to receive continued pressure and the “too big to fail” institutions will be the ones to vacuum up the money.
Think of it this way – behind each bank asset (a customer loan) is a bank liability (a customer deposit). If the asset to liability situation goes out of regulatory proportions (e.g. you took your customer loans and invested in them in high-duration government debt and suddenly your customer wants their deposits back and you can’t pay it), you get FDIC’ed. However, when the FDIC process occurs, it is not as if all of that capital goes away – it has to go somewhere. It doesn’t end up as paper banknotes inside the safe or underneath the couch, but rather it goes to another financial institution. The assets and liabilities go somewhere else within the financial net – they do not vanish!
In this case, it appears destined that the assets in this digital financial world (where assets get transferred with mouse clicks) will bubble up to the systemically important banks.
I’ve been trying to pick away at the entrails of the lesser banks within the USA, but I don’t have a clue how to project who will survive and who will not. So I’ve given up.
I will leave this post with one amusing note. Financial releases go through plenty of review cycles within management, but if they can’t spell the word “average” correctly, it is trouble:
There is a paradoxical rule in investing that when you anticipate the underlying price of whatever a company sells to rise, you want to be invested in a higher cost producer. The reason for this is embedded leverage. In a flat to declining price environment, you want to be invested in the low cost producer.
An example will suffice.
Say the market rate for widgets is $100. Company A (high cost producer) can make widgets for $90 a piece, leaving $10 of profit per widget. At a 10x multiple, the company would be worth $100 a widget. If the price of widgets goes up to $200, the company would be worth $1,100 a widget, 11x your money at the same multiple.
Company B (low cost producer) makes widgets for $50 a piece, leaving $50 of profit per widget. At the same multiple, it would be worth $500. If the price of widgets goes up to $200, Company B would be worth $1,500 or a mere 3x. Not bad, but nowhere close to the high cost producer.
The reverse is true – especially if the price of widgets goes below the costs of some producers. If the price of widgets goes to $70, Company A will suffer (they will have to dig into their balance sheet), while Company B will still make a living.
Markets can anticipate these leverage effects and compensate valuations accordingly – in particular price to earnings multiples decrease as prices increase. But over market cycles, costs matter.
I’m looking at earnings of coal companies, and the contrast between ARCH and BTU is quite striking.
In Q1-2023, ARCH produces its metallurgical coal at a cash cost of US$82.66 per short ton, while BTU is $151.13. In Q4-2022, HCC was $123.40, while AMR was $112.97. Teck reported US$103 per metric ton, which is about US$94 per short ton. (In the case of Teck, there is a bit of an accounting fudge factor as some of this cost is the amortization of “capitalized stripping”, which creates unevenness in cash flows, a technical matter well beyond the point of this discussion).
As met coal prices come back down to earth (they were as high as US$450 per short ton last year and are roughly US$260 or so presently), low cost producers should start to feel the pinch on their cash flows.
It leaves the question why one would want to invest in a company producing a commodity in a lowering cost environment, and that is where some market skill comes into place – there is an anticipation of cyclicality in these companies. You can also play expectations against each company by engaging in pair trading – long one, short another (and pray that your short doesn’t get bought out).
However, there is one raw number that really counts – cash dividends. If you’re going to get paid a reasonable return on equity, it still might be good enough.
In this respect, ARCH’s 50/50 plan (which is giving 50% of free cash flow directly off as special dividends and the remaining 50% for debt/capital/remediation/buybacks) has a certain elegance to it. As more shares get repurchased, the amount of the dividend that gets distributed will rise over time. It is like a very strange version of dollar cost averaging except the company is deciding to do it for you.
In 2022, ARCH gave out about $25/share in dividends. I do not anticipate this level of distribution will continue. For one, they will start paying significant cash income taxes which will reduce the dividend stream. However, there is a reasonable chance that the cash payouts will continue being in the double digit percentages, coupled with share appreciation through buybacks. Another paradox about having high amounts of cash flows is that you want to see the stock price lower, not higher – the reason is because reinvestment (in the stock) can compound at higher rates when done at lower prices.
It would not shock me in the least to see some more consolidation in the sector. We’re already seeing Teck trying to avoid one.
Also, for reference, read my December 2019 post on Arch. Even after Covid-19, this write-up is aging pretty well.
The USA is having another debacle concerning the debt ceiling.
With a split congress, ultimately you’re going to see a game of “chicken” play out and in the lead-up to this, will have financial consequences involving a lot of volatility.
This specifically involves the short end of the US yield curve:
Why is the short-term treasury bill trading at a good 100+ basis points under the Fed Funds Rate?
It is because everybody is cramming that tenor because the public has no idea when the treasury has to stop borrowing money – possibly in June, could go up to September if you believe the headlines.
So imagine if you’re holding onto one of these treasury bills maturing on June 15, 2023 and you are depending on the cash that comes for a major transaction on June 16, 2023.
Ordinarily you could depend on the treasury bill being just as good as cash, so you have optimized your cost of capital pretty good.
Unfortunately, now there is a chance that the US treasury is going to tell you, “Oops, we hit the debt ceiling and we can’t give you the cash. We’ll give it to you when Congress lifts the debt ceiling. Good luck!”. This is otherwise known as a default.
So today you have about 7 weeks of notice. What do you do? Sell the treasury bill today and get your cash before you’re stuck with a piece of paper that can’t be converted into US dollars (at least at the face value of the note – somebody will likely take it at a discount). You know that the USA is good for paying May-dated paper, so you bid for one of those treasury bills. This is why they are trading at yields significantly less than the 3 month tenor.
What will happen is you will see the demand for US currency rise as players across the entire planet face the same issue.
This will also cause spinoff effects on equities if it continues. I suspect volatility will rise in the short term going forward.
Whenever I get confused, I always try to simplify my thinking to basic principles. Sometimes a little too basic, but the foundation of knowledge has to start somewhere. It is always good to refresh one’s knowledge and make sure one doesn’t descend into senility.
So we will get really basic. As in the core of accounting and finance.
Finance and accounting is akin to physics and mathematics.
Let’s do accounting first.
Accounting is governed by two simple sets of equations. One is that assets are equal to liabilities plus equity. The other is that revenues minus expenses equals equity (retained earnings/deficits). The retained earnings line is the linkage between income statements and balance sheets over time.
If you can apply this rigorously, the rest of accounting is a relatively simple exercise of check-boxing and making sure you apply IFRS properly for the billions of different cases (then write your CFE exam and get your CPA designation!). Fundamentally, however, the two sets of equations is all you need. Everything else is layers of complexity on top of more complexity. The art of accounting is translating the literal (what is presented) into the economic substance (the reality) and this is the component of accounting which requires subjective judgement.
Finance is the practice of converting cash streams into capitalized sums and vice versa. The formulas governing this is the conversion of cash flows to a present value, and the present value into a sum of cash flows. Everything you see trading on the stock market comes down to these two tranformations. The subjective judgement in finance is determining these cash flows and the discount rate to apply over the relevant time period.
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I am looking at my long-term CAGR number and my financial objective during the rising interest rate environment was to just keep things steady as the increasing discount rate would inevitably lead to a drop in capitalized values.
For the most part, I have succeeded. Not being an index investor, I was able to avoid negative returns in 2022. For the most part I have considerably de-risked things in the second half of 2022 compared to the second half of 2020.
However, matching my long-term CAGR number in the 2023 environment is going to be next to impossible. High amounts of conventional returns are not going to happen. In order to make outsized returns, I would have to make non-typical directional bets. This means there is an element of gambling, something I do not partake lightly without having the odds seriously on my side. Having a cloudy crystal ball is the opposite environment where I want to be pounding the futures market like George Soros did with the GBP back in 1992.
If I managed client money at the moment, I would have to be justifying an “I am working hard by doing nothing” approach to asset management. I would probably be losing clients’ funds going to greener pastures to managers that put their money into NVidia or Facebook/Meta (both up 89% and 71%, respectively).
One huge cost of twiddling your fingers is the impact of inflation. While in prior years the 2% or so deduction you make to calculate a real return is an afterthought, in the current environment, just earning 5% is not going to keep one’s purchasing power. Finance has turned into one gigantic minority game where the slice of real proceeds continues to get whittled away by the corrosive force of monetary inflation, thanks to our deficit-loving governments.
I have not encountered anybody as paranoid as myself in the marketplace. It is psychologically unhealthy (not to mention making me really bitter and anti-social) but it has enabled me to survive in environments such as those in 2000, 2008 and 2020. Unfortunately, it also has the psychological effect of giving me a huge amount of financial PTSD, prevent me from taking opportunities that I otherwise should have taken had I been more rational.
It leads me to a conclusion that one of the biggest risks that I have of future underperformance is not interest rates, macroeconomics, or the decisions of increasingly authoritarian politicians, but rather the state of my mental health.
If I go bonkers, I’ll end up clicking the wrong buttons on Interactive Brokers, and let me tell you, there aren’t a lot of safeguards to clicking incorrect buttons. Indeed, I think platforms like Robinhood and Wealthsimple intentionally make it really easy for their clients to tap on financially inappropriate things (options, ahem) and lose money.
I’ve put a lot of internal mental safeguards and also some analytical safeguards on preventing this, but to maintain this readiness, I need to have my mental act together.
I wrote an article five years ago about Physical Fitness, Mental Fitness and Financial Performance and this applies more than ever today. Each year of age transforms into one year of further mental degradation.
About a week ago, I ran in Vancouver’s largest 10km race. Although historically the weather has been quite good during these races, this year it was a characteristic Vancouver day – about 8 degrees Celsius and pouring rain. However, this did not stop me:
This matched, exactly to the second, my run time in 2019, which was my lifetime best to date. Perhaps in 2024 with more training I can beat it.
Hopefully this physical measurement can be a proxy for mental measurement. It gives me some assurance.
However, it is not sufficient. The key risk to performance is the inability to adapt to changing circumstances, and avoiding mental traps that enable investing in false narratives. It is something that we all must be ever vigilant as the market does not care about your mental condition. The biggest risk for my portfolio is my mental health.