November 2013 – Divestor

When will Bitcoins peak?

Bitcoins are once again making headlines, for exceeding US$1,000 per Bitcoin on various exchanges.

I wrote about them back in 2011 when they were trading at around US$20 a piece. The analysis is really still the same.

The debate here should not be whether Bitcoins are useful as a currency or not, but the lesson here is strictly one in economics – people see value in very strange things, and when people do see value, there will be markets created. In this case, the product is a currency that is only valuable because of its rarity and difficulty of generation, and is not too different than trading artwork or collectibles which have similar appeal.

More people are seeing something valuable in something very odd and this is apparently spreading world-wide to anybody with a computer.

As for answering the question as to what Bitcoin’s peak is, I do not know for sure. This reminds me of when I asked myself when the dot-com bubble is going to burst, or how far the US stock market was going to plunge in late 2008/early 2009.

There are a few headwinds I see for Bitcoin, and they generally deal with hitting the law of large numbers.

The first deals with liquidity.

There are 12 million Bitcoins outstanding, but the reported liquidity is quite thin. Right now if you wanted to liquidate 5,000 Bitcoins and raise a cool $5 million, according to the liquidity chart you would move things about 13% if you wanted to hit the bid with everything you have. Obviously you would want to fragment the order and leak it out over a period of time over multiple exchanges, but I would suspect that there are some component of technical traders that are simply out there to scalp dollars and not actually give a hoot about the currency.

The reported market cap of Bitcoin is about $11 to 12 billion and when looking at a typical equity trading with the equivalent capitalization, Bitcoin’s liquidity is nowhere close. How many dollars can you actually extract out of the market if you had 100,000 Bitcoins and wanted to liquidate in a timely manner?

Another issue deals with the ability to control the blockchain (the accounting equivalent of the general ledger, with the notable exception that the blockchain contains ALL information of transactions since the history of Bitcoin). Without getting into a lot of technical details, there are collusion opportunities to corrupt the blockchain if you control a majority of Bitcoin miners. Bitcoin mining has become a very specialized art and to effectively compete in mining, you need to own arrays of specialized devices for the purposes of mining Bitcoins. Since the difficulty of Bitcoin mining increases as a function of both time and the amount of computational power on the Bitcoin network, there has been a technological arms race, with the following result:

Please observe the y-axis is logarithmic – mining Bitcoins has been over a hundred times more difficult than it was at the start of the year. This is like your typical 10MBps residential high-speed internet connection scaling down to twice the speed of a dial-up modem.

The technology to do the proper calculations are application-specific integrated circuits (ASICs) that have their sole purpose in life to mine Bitcoins, but as these are permeating the Bitcoin marketplace, there are limited opportunities for exponential improvement to Bitcoin hash rates through technological innovation – most performance improvement from this point is going to be linear as more machines get added to the cluster networks that are solely dedicated to Bitcoin mining.

I note with amusement the announcement that somebody is producing a 20nm process ASIC rig that can do some insanely high hash rate, but this will be the end of the line: 20nm semiconductor processing is the peak of the current technology limit – even Intel is still working on perfecting the 14nm process. Even then, the company has already announced the product (which apparently will be shipped in Q2-2014) will be at the threshold of the limits that a typical household power supply can handle.

So when you get into industrial-level operations to run arrays of computer hardware solely for the purpose of mining Bitcoins, some group is going to consolidate a majority of miners and be able to corrupt the network. With billions of dollars of market capitalization, it is getting to the point where that group is probably thinking about implementing some scheme to control the blockchain.

The blockchain concept also creates a scaling issue as eventually it becomes impractical for it to be maintained by distributed “retail” computers – “institutional” resources are increasingly employed to maintain the blockchain as they will be the only ones to have sufficient computational muscle to be relevant.

When will this blow up? I’m not sure, but I’m reasonably sure we’re within an order of magnitude (i.e. not higher than US$10,000/Bitcoin) just because of the law of large numbers – liquidity (the quantity of dollars Bitcoin is able to extract from others) and blockchain dynamics.

The current phase in Bitcoin is still adding people with money into the system, which is required for the scheme to continue, but those that have caught onto the scheme earlier will presumably be continuing to diversify their Bitcoin holdings into harder currency.

When reading Reddit’s Bitcoin chatter, I see a lot of financial illiteracy out there, which doesn’t bode well for those that have high hopes for Bitcoin.

I do not own any Bitcoins, nor will I, but I am watching this with curiosity. It is indeed is fascinating to watch non-financial people get involved in what is inherently a financial specialty product with a touch of well-designed technology sprinkled in. Whoever conceived of this did their homework and never would have guessed the technology arms race that has developed as a result.

Pinetree Capital – Possibly the worst closed-end fund, ever

This article is about Pinetree Capital (TSX: PNP), which came across my radar a few months ago when doing some casual screens of the market. I’ve analyzed this one many, many years ago and dismissed the idea for obvious reasons. Nothing much has changed since then other than that management has blown about half a billion dollars – this is an accomplishment that very few non-fraud artists can claim. The firm itself is quite easy to analyze.

The company functionally operates as a closed-end fund that invests in extremely risky microcap ventures in the mining sector. They were lucky enough to catch the uranium boom half a decade ago, but judging by their subsequent performance it was likely due to luck more than anything else. Their existing investment portfolio is full of unrealized losses in failed ventures:

With a whopping 378 investments, this company is a functional proxy for the TSX Venture exchange index. And as investors might know, the Venture exchange has taken a serious beating over the past year, especially as most gold ventures have cratered (the TSX Venture is down 24% year to date, while you can see Pinetree capital’s portfolio is down about 45% in a year where there is a raging bull market in practically everything else than what Pinetree is invested in).

It is kind of amazing to see the $494 million unrealized loss row on the financial statements as this type of prowess in investment picking should be carefully harvested in a hedge fund designed to mirror 180 degrees exactly whatever the Pinetree investment committee chooses to engage in. Investors would have made a fortune.

On the balance sheet side, the asset portfolio is primarily capitalized with $388 million equity from generous investors and the usage of convertible debentures (TSX: PNP.DB) of which $61 million is currently outstanding. Strictly in terms of assets and liabilities, the debentures are the only major liabilities on the book and they are currently the only debt on the books (aside from some broker margin loans that arise from time to time):

There are a couple comments I will make on asset quality (or lack thereof):

1) Fortunately, most of them ($124 million) are level 1 assets, which means that there is some external methodology (market quotations) that can be attributable to how management values them. The level 2 and 3 assets I would mentally write off. Even the level 1 assets will likely have questionable amounts of liquidity (given that the history of the corporation is to purchase minority stakes in various junk firms) and should be mentally discounted for this reason.

2) The company is likely to exclude the $23 million in deferred tax assets when they release their year-end audited report as it will be a very, very long time before they’ll be able to use it all. In fact, one of the likely liquidation scenarios for the entire firm is to sell the whole thing to somebody that knows what they are doing, and will recapitalize the firm and utilize all the capital losses the company will be booking – indeed, if you journal the half billion in losses, the company does have about $65-70 million in a reasonable capital tax shield to a potential acquirer.

This tax asset does have hidden value, but you have to get by the fact that management has a heavy severance penalty.

So when doing some mental adjustments on these assets (eliminating the deferred tax asset, eliminate level 2 and level 3 assets, and taking a 20% haircut off the level 1 assets) you have about $100 million, offset by about $61 million in convertible debentures. The residual $39 million is reasonably close to the current market cap of the company ($42 million at present).

Management is entrenched in the company and they make a pretty profit from simply being there. I will let this chart speak for itself:

Suffice to say, pulling a cool million a year out of this train wreck is rivaling what Robert Mugabe has done to ~~Zaire~~ Zimbabwe over the past few decades.

So what is the thesis on this train wreck? The answer is in the debentures. They are trading at around 2/3rds of par value for obvious reasons – they mature in May 2016 and investors are wondering whether the level 1 assets are going to have any hope of recovery or not. That said, there was a covenant in the debentures that required the company’s liability to asset ratio to not be greater than 33%, which they breached earlier this year (mainly due to losses on their investment portfolio). They had to arrange a special meeting to obtain a partial cure (where the liability to asset ratio would be 50%) for 9 months, and endeavour to buy back some debentures and raise a little more equity capital on a best efforts basis. They were able to obtain this by giving out a 6% sweetener and increasing the coupon from 8% to 10%, effective at the end of this month.

If the company didn’t broker this deal, debenture holders could have foreclosed on the entire firm and then there would be a firesale to make the debtholders whole. Indeed, the salaries of top management could be used to pay for bankruptcy trustees.

In addition, the following terms and conditions were agreed upon:

It is clear that there is some large holder out there of the debenture that is dictating terms to the company. Notwithstanding the external pressures being applied by the major debenture holder, management still has firm control of the company and it is clear that nobody rational would ever want to own the common shares of the business.

Management has a clear incentive to seeing that this train wreck continues as long as possible – it is a million dollar per year vehicle to extract capital out of unwitting investors and this incentive should make it possible for them to get rid of the pesky debenture holders by just selling enough assets and getting rid of them.

Of course, the scenario of destruction is that management will continue to bleed away their asset base. At the rate they have been going, they will hit zero at 2014. I think the value of the gravy train is more of a powerful force for management than trying to screw over debtholders, however.

The debentures can be redeemed at maturity for shares of common stock at 95% of the market value at a pre-defined time before maturity. This is the ultimate nuclear button for management, but it would virtually ensure they would lose control of the firm at this point.

There is the additional catalyst of the 9 month deadline for the company to once again be compliant with the 33% liability-to-asset ceiling. This is June 12, 2014. By then, the company should have bought back $20 million in debentures and raised $5 million in equity.

The risk/reward dynamic here is obvious – if the Venture index does not plummet any further, debtholders should come out whole and also receive some very healthy-sized coupon payments along the way as compensation for holding onto the train wreck. The risk is the aforementioned market risk with the index-like exposure the company has to the penny stock market.

Anyhow, I took a position in this early July before some other insightful writer identified this opportunity and it became public on Seeking Alpha. It received a temporary boost-up in value then, but it has recently sunk to values that made me want to write about this in case if somebody wanted to hold their nose and purchase some of this stinker – the debentures, not the equity.

The results after many hours of research – not much

Doing investment research these days (when the S&P 500 has reached all-time highs) feels like mining Bitcoins – a very high-energy consuming process with a very high probability you will get zero return on investment.

I was afforded the luxury of having some dedicated time off and did about six hours of research, most of which was on the US equity side. Initially, I did some preliminary screening of the Canadian side for potential value stocks, but mostly turned up ones relating to gold mining, which I very rarely dabble in just because I do not have strong thoughts about the metal other than it looks pretty when holding it. I decided to focus on the US equity market instead and broadened my screen to avoid stocks that were explicitly trading at their relative lows.

The net result of this was I did some fairly heavy research on two companies of which were closer to their 52-week highs than their lows (which is always a turn-off, but it is nearly impossible to find anything that is trading at their lows these days which were worthy of further research). One of these companies was a retailer, the other was a company selling customized consumer products which appeared to be on the cusp of becoming a universally known name. I will focus on the first one.

Retailers, especially those that cater toward women’s fashions (e.g. Coach (NYSE: COH), please note this was not the retailer, but I am consistently fascinated how they can produce the financial results they do) are very difficult to analyze from an equity perspective. I can read the financial statements and tell you how much money they are making and how they are making it, but predicting how much mind-share they will have in the consumer market (and in Coach’s case, the mind share they have with women, which I am not one of) is a very critical and intangible asset to measure.

I will keep these companies on my watchlist and just be patient. The cash value in the portfolio continues to be quite high and it is earning a whopping zero percent yield, but the easy way to lose money is to throw it at something for the sake of having it invested.

The end of November is as good a time as any to look for candidates that are ripe for tax loss selling, but they are consisting of companies that are related to precious metals, biotechs with particular clinical trial blow-ups and obscure semiconductor companies with genuine issues that caused them to plummet in the first place. I haven’t been able to find too much.

Are you up 26.1% for the year? General market commentary follows…

If not, you are lagging behind the S&P 500 and are UNDERPERFORMING. So those sitting in a paltry 20% year-to-date return may think they are sitting pretty, but hedge fund managers out there know they are lagging and their customers are demanding heads to roll. Looking at my year-to-date performance, I’m barely ahead, but this is because I’m Canadian and can cheat a little via the amazing accounting practice of mark-to-market for currency translation, (i.e. my returns are always denominated in Canadian dollars, and the Canadian dollar has gone lower this year hence I get a little boost up in performance for having the audacity of holding US-denominated stocks and cash during the year). In my defence, however, is the fact that I’ve had a relatively large quantity of zero-yielding cash in the portfolio for financial Armageddon’s sake.

In the last phase of a bull market (which we are indeed going to be entering, if not there already), all of the naysayers (such as myself and “professional market analysts”) warning of a market crash and chronic over-valuation will suddenly start shutting up and believing there is some sort of new economic paradigm that has caused the markets to go wildly up. I’m pretty close to reaching that point myself, which probably suggests that the end is near. I had these visions of the world entering into a 2009-like economic crisis again when the Greek Debt thing hit in August 2011, which was probably one of the worst calls I made over the past decade, and it indeed cost me.

Of course, the whole world knows the asset inflation is primarily due to the federal reserve pumping trillions of dollars of liquidity into the system, only to end up as bank reserves for JP Morgan and Bank of America, but who cares at this point? Politicians know the general public does not know the true implications of free liquidity, and here in Canada, the government knows that if the central bank raises interest rates, they will end up crashing the entire economy because our debt-to-income ratios are sky high.

There’s clearly no vulnerability or risk here.

For memory’s sake, here is a chart of the Nasdaq from the beginning of 1999 to the end of 2000:

I remember these days as being wildly irrational. I got my start in the public markets a year or two before this and even when I was beginning my journey to compounding assets on my balance sheet, I realized that things were frothy and I had better stick my capital in anywhere but dot-com technology, and that I did. Even when I ventured into technology it was relatively “value-based” – the first company I owned that got bought out was Sterling Commerce, and they were trading at a relatively modest P/E of around 20 at the time. I didn’t keep proper records during the 2000-2002 timeframe, but I do distinctly recall that the overall hit to my portfolio was quite modest compared to the market averages, similar to my performance in 2008.

Let’s pretend we’re sitting at the year 2000 and the Nasdaq is sitting around 4000 (where it is presently). The world discovered the computer systems did not melt down and bidded up the markets another 20% before finally collapsing down to earth again.

A repeat of that scenario would mean the S&P 500 would go to 2160.

So just before somebody thinks “things can’t go higher”, in bubble-type situations, they usually do, a lot longer and a lot farther then most people rationally expect, especially with the winds of the federal reserve still clearly behind the market’s back.

Interactive Brokers / Options / Probabilities

Interactive Brokers (Nasdaq: IBKR) is the best brokerage out there that is available to the retail level. They give me a degree of comfort that simply doesn’t exist in any other brokerage firm that I have dealt with. One of the reasons for their superiority is their founder, Thomas Peterffy, continues to push the innovation curve in such a manner that makes the firm cutting-edge.

The company is publicly traded and has been on an unsual uptrend over the past few months:

The only reason why I have never put money in them is because the publicly traded entity is essentially a minority slice (12.4%) of the “true” asset and this creates all sorts of perversions of incentives that are not necessarily in shareholders’ best interests. It is a classic case of the underlying business being fantastic but the stock not necessarily being a good investment.

Anyhow, they have a tool that is relatively easy to utilize that highlights potential option strategies given the differences between the market’s implicit probability distribution and your own personal expectation of outcomes. Although I do not trade options very often (indeed, it is very rare that I do so simply because trading options is quite costly in terms of spread), this tool and this explanation is quite intuitive. If you do not understand how options are priced, this is a pretty good tutorial that avoids math.

Clearly understanding the math helps and I would highly recommend people learn some option pricing theory before considering trading them. Putting it mildly, options are a fantastic way of losing money if you don’t know exactly what you are doing. Options also appeal to gambler-types that love seeing huge rewards in total disproportion to the amount risked.