Finance – Page 5

The Lehman Brothers moment

Silvergate (NYSE: SI) and Silicon Valley Bank (Nasdaq: SIVB) have both suffered immense market value losses this week.

In the case of SIVB, the story is fairly simple – they had a huge duration mismatch between their (asset) held-to-maturity portfolio and (liability) short-term deposits.

Held-to-maturity assets are held on the balance sheet at cost value, while fair (market) value is indicated.

SIVB had a differential of $15.2 billion between the stated book value and the fair market value of such securities, while the total equity of the firm was $16.3 billion.

Assuming they liquidated everything at once, the entity as a whole would be worthless.

One other problem they had was that their source of capital (zero-interest bearing deposits) was getting pulled out very rapidly and the only thing they could replace them with was high-interest deposits.

It eventually crashed this week – going from $275 per share to what will effectively be a zero. The unsecured debt is trading around 40 cents on the dollar, but it remains to be seen whether there will be any recovery there.

This was a classic bank run, coupled with financial mismanagement by the bank – when the asset duration and liability duration are mismatched, and when your depositors decide they want their money now, if you can’t raise the short-term funds to pay the depositors, you’re forced to sell those held-to-maturity securities and that is when your capital adequacy ratios goes into the toilet – and the FDIC steps in.

The media will make this out to be a crypto/digital-currency related issue, but that was only part of the story (how the bank got all of these short-term non-interest bearing deposits in the first place). The stronger part of the story is mismanagement of the duration risk.

There will be some collateral damage here, but unlike Lehman (which was a much larger entity) I suspect this will be somewhat more contained, although will cause volatility ripples in the next couple weeks in the financial sector as financial institutions shore up their solvency/liquidity books. It is a warning shot across the bow of every institution out there – liquidity is golden.

A few small observations

A mixed post.

Where I was mistaken

I made a claim earlier that I thought employment around January or February of this year would be shown to decline, presumably due to a slowdown in demand and companies cutting costs. Unless if you were one of the victims of a big tech company’s layoff, wow, was I ever wrong with this! Gross employment trends continue to exhibit strength, consistent with anecdotal reports of employers finding it difficult to source labour.

So where was I wrong here? Is there a demographic issue? Are companies out there finding additional vectors of demand to necessitate employment? Or am I just premature with my prognostication? I’m not sure.

There are some hints on the Fiscal Monitor – income tax collections and GST collections are up over comparative periods last year, and especially corporate income taxes. The government is likely to report an improved fiscal balance as well. This leads me to the second issue, which is…

The progression of QT

Members of Payments Canada (a.k.a. financial institutions parking reserves at the Bank of Canada and earning the short-term rate) continues to hover at the $190 billion level. The recent slab of government debt maturing off of the Bank of Canada’s balance sheet got directly subtracted from the Government of Canada’s bank account at the Bank of Canada, but the GoC is still sitting with $65 billion cash as of February 15, 2023.

What does this mean? The presumed pressure on liquidity is not happening – yet. Banks can still lend out capital, but you have to have an awfully good proposition since they’re not going to give it to you for cheap interest rates. Why should they lend it out to you at 6% when they can keep it perfectly safe at the Bank of Canada and skim their 4.5%?

While there’s liquidity, it’s definitely a lot more expensive. When you combine what I wrote about employment above, coupled with real estate finding its two legs again (helps that there is zero supply in the market), makes me think that the Bank of Canada was incredibly premature to call a pause on rates – March 8th they’ll be guaranteed to stand pat, but perhaps we might continue to see rate increases if CPI doesn’t drop quickly enough in the next couple months. Also, the US-Canada currency differential is also going to widen as the US Fed will be raising rates for longer.

A public market investor at this point is facing a crisis of sorts. Asset prices (unless if you owned garbage technology companies) haven’t deflated that much, so what is trading out there is really not the greatest competition for the risk-free rate. You have cash.to giving off a net 4.89%, and when you look at some average 20 P/E company, one has to ask yourself why you should be bothering to take the comparative risk. Just look at the debenture spreadsheet and the spreads over risk-free rates is minimal.

Commodities

In the middle of 2020, the trade was a no-brainer. Ever since then, it has become less and lesser so, to the point today where it is no longer about throwing capital into random companies and winning no matter what – discretion has been critical from about June of last year. The meltdown in the natural gas market is one example of where an investor could have turned into roadkill, especially with leverage. In general, you can lose less money by investing in low cost structure companies, ideally with as low debt as possible. The problem is if you have a whole bunch of industry participants in a good balance sheet situation – the race for the bottom becomes brutal since they can mostly survive low commodity price environments until some finally do get eliminated due to high cost structures and/or high debt service ratios.

Teck

They explicitly had to disclose they’re looking into strategic options for their met coal unit, which would be a cash machine of a spinoff if they went down that route. Seaborne met coal has rebounded as of late and it would be really interesting to see the price to cash flow ratio assigned to a pure met coal unit. A comparable would be Arch Resources, and they are trading at 4x 2023 earnings. Teck does have considerable competitive advantages, however – better access to the Pacific and a lower cost structure, in addition to being able to pump out more coal. Stripping out the coal business would leave the copper and zinc business in core Teck, and the residual copper business might get a 20x valuation (looking at Freeport McMoran as the comparable here). When you do the math on both sides of the business (especially as Teck’s QB2 project is ramping up this year and will produce gushing cash flows at US$4 copper), the combined entity would be worth well more than $30 billion today. So with a little bit of financial engineering, Teck can generate market value from nothing.

Let’s look at the first 9 months of the year (which is abnormally high for met coal, but just to play along).

I have (for met coal) their gross profit minus capital expenditures, minus taxes, at around $4.5 billion annualized. Give that a 4x multiple and you have $18 billion. On copper, with QB2 at full swing, it should be (very) roughly $1.5 billion total for their consolidated copper operations and at 20x you get $30 billion. Add that together and it’s well over the existing market cap.

What you also do to complete the financial wizardry is that you load the coal operation with debt, say around $10 billion. Give it to the parent company as a dividend, or perhaps give it to shareholders as a dividend in addition to the spun-off equity and the projected return on equity will skyrocket (until the met coal commodity price goes into the tank, just like what happened two seconds after Teck closed on the Fording Coal acquisition before the economic crisis).

Despite the above calculation, I’ve been taking a few chips off the table. My overall position has continued to be of increasing caution, one reason being that I don’t have a very firm footing on what is going on.

Toxic financings

When interest rates are no longer zero and there is actually an appreciably large cost of capital, corporations with negative cash flows and heavy debtloads are finding terms like these three examples.

First example

Goodfood (TSX: FOOD), a previous Covid-darling (to-your-door delivery would clearly replace regular grocery shopping when a trip to Superstore would kill you with viral pathogens!) has been losing money since day one, and now they have exhausted their cash balances to the following point where they have to issue this debt:

MONTREAL, Feb. 06, 2023 (GLOBE NEWSWIRE) — Goodfood Market Corp. (“Goodfood” or the “Company”) (TSX: FOOD) is pleased to announce that it has closed an offering (the “Offering”) of $12,675,000 aggregate principal amount of 12.5% convertible unsecured subordinated debentures of the Company (the “Debentures”) due February 6, 2028 …

The Debentures will be convertible at the holder’s option into Goodfood common shares (the “Common Shares”) at a conversion price of $0.75 per Common Share. The Debentures will bear interest at a rate of 12.5% per annum. The interest portion for the period commencing on the issuance date and ending in February 2025 will be capitalized semi-annually and convertible at a price equal to the volume weighted average trading price of the Common Shares on the TSX for the five (5) consecutive trading days ending on the date on which such interest portion becomes due, plus a premium of 50%. As of February 6 2025 and until the Maturity Date, the interest portion will be payable semi-annually in cash. As of February 6 2026, Goodfood may repurchase the non-converted portion of a Debenture at an amount of the principal and accrued interest plus an amount providing the holder with an internal rate of return (IRR) equal to 18% for the period during which such Debenture will have been outstanding. The holders may require a repurchase on the same terms upon a change of control of the Company.

This second paragraph is a terrible clause for common equity holders in that there will be a share issuance in February 2025 that will be quite expensive. In addition, the entire issue, if converted at 75 cents per share, would constitute about 18% of the shares outstanding, not counting any dilution before-hand with the interest capitalization.

While Goodfood has stemmed some of the cash bleed, it’s cash position on December 3, 2022 sits at $28.5 million and it has a $9.5 million credit facility due November 2023, ~~$47 million~~ $35 million in convertible debt (TSX: FOOD.DB, FOOD.DB.A) due 2025 and 2027, and now this debt above. There are also the customary IFRS 16 lease obligations. The cash burn got down to $6 million in the first fiscal quarter (3 months ended December 3, 2022).

I am always very wary when companies have to obtain debt financing at double-digit returns. In rare instances, when a company’s back is pressed against the wall, the equity will be trading like such utter trash that it is a reasonable risk-reward ratio better than a casino to take a small position, but such situations are extremely risky in nature. Usually for the company to bail themselves out of the situation, equity holders have to take some sort of bath (either through Chapter 11/CCAA or a highly dilutive transaction) which makes an investment in a more senior part of the capital structure more lucrative.

Second example

Greenbrook TMS (TSX: GTMS), a company that operates trans-cranial magnetic stimulation clinics across the USA, has a corporate strategy of “We will lose money on every acquisition, but we will make it up on volume”. Suffice to say, such strategies will require capital.

On July 14, 2022 they made an agreement with an asset manager for a US$75 million credit facility and the material term was:

The Credit Facility provides Greenbrook with a US$55 million term loan, which was funded on closing. In addition, the Credit Facility permits Greenbrook to incur up to an additional US$20 million in a single draw at any time on or prior to December 31, 2024 for purposes of funding future M&A activity. All amounts borrowed under the Credit Facility will bear interest at a rate equal to the three-month LIBOR rate plus 9.0%, subject to a minimum three-month LIBOR floor of 1.5%. The Credit Facility matures over 63 months and provides for four years of interest-only payments.

Three-month LIBOR plus 9% these days is around 13.8%.

On February 7, 2023 they announced:

The Company announces that it has entered into an amendment to its previously-announced credit facility with Madryn (the “Credit Facility”), whereby Madryn and its affiliated entities have extended an additional tranche of debt financing to the Company in an aggregate principal amount of US$2.0 million, which was fully-funded at closing (the “New Loan”). The terms and conditions of the New Loan are consistent with the terms and conditions of the Company’s existing aggregate US$55.0 million loan under the Credit Facility (the “Existing Loan”) in all material respects.

The New Loan also provides Madryn with the option to convert up to approximately US$182,000 of the outstanding principal amount of the New Loan into common shares of the Company at a conversion price per share equal to US$1.90 (the “Conversion Price”), subject to customary anti-dilution adjustments and approval of the Toronto Stock Exchange (“TSX”). This conversion feature corresponds to the conversion provisions for its Existing Loan, which provide Madryn with the option to convert the outstanding principal amount of the Existing Loan into common shares of the Company at the Conversion Price.

Sweet deal.

Third example

Bed Bath and Beyond (Nasdaq: BBBY) fights away Chapter 11 with a really toxic financing:

UNION, N.J. , Feb. 7, 2023 /PRNewswire/ — Bed Bath & Beyond Inc. (the “Company”) (Nasdaq: BBBY) today announced the pricing of an underwritten public offering (the “Offering”) of (i) shares of the Company’s Series A convertible preferred stock (the “Series A Convertible Preferred Stock”), (ii) warrants to purchase shares of Series A Convertible Preferred Stock and (iii) warrants to purchase the Company’s common stock. The Company expects to receive gross proceeds of approximately $225 million in the Offering together with an additional approximately $800 million of gross proceeds through the issuance of securities requiring the holder thereof to exercise warrants to purchase shares of Series A Preferred Stock in future installments assuming certain condition are met. The Company cannot give any assurances that it will receive all of the installment proceeds of the Offering.

At the initial closing, the Company will issue (i) 23,685 shares of Series A Convertible Preferred Stock, (ii) warrants to purchase 84,216 shares of Series A Convertible Preferred Stock and (iii) warrants to purchase 95,387,533 shares of the Company’s common stock.

While I haven’t read the terms and conditions of the S-3 filing that references the preferred securities and warrants as above (off the top of my head it is not clear what the strike price of both sets of warrants are), I can guarantee there’s huge dilution. What’s even more impressive is that the Reddit WallStreetBets and pretty much the whole financial universe is treating BBBY as the Gamestop of 2021:

This is simply insane trading. Multiple opportunities to make and lose money on a very liquid market (and option implied volatility is sky-high, especially on yesterday’s 100% spike up to ~$7/share). This casino-like trading is one reason why I think central banks are quite intent still to keep sucking liquidity out of the marketplace (QT), until this sort of thing ends.

Take-home message

Tightening financial conditions are triggering marginal companies (ones that have negative cash flows and debts) to engage in toxic financings. At what tier will the debt contagion persist? If you own shares in companies that are going to face financing crunches in the upcoming year or two, you may wish to brace yourself.

Yield chasing is back in vogue

(rest assured, I have never been paid to post anything on this site, and this will pleasantly continue)

ETF marketing is clever as always. Did you want a 13% yield? Introducing the Hamilton Canadian Financials Yield Maximizer ETF!

They politely inform you that they are “Canada’s Highest Yielding Financials ETF”, featuring a “13%+ target yield”.

Not just 13%, 13%+.

Who can resist?

They also inform you, in bold font, that “HMAX does not use leverage.”

Is this a dream come true?

Digging into the much dryer prospectus, we get the following:

HMAX will seek to achieve its investment objective by investing in the top ten Canadian financial services stocks by market capitalization (each, a “Financial Services Company”, and collectively, the “Financial Services Companies”).
…
To mitigate downside risk and generate income, the Portfolio Adviser, in conjunction with the Sub-Advisor, actively manages a covered call strategy that will generally write at or slightly out of the money call options, at its discretion, on up to 100% of the value of HMAX’s portfolio. Notwithstanding the foregoing, HMAX may write covered call options on a lesser percentage of the portfolio, from time to time, at the discretion of the Portfolio Adviser. The Manager has retained Horizons to act as sub-advisor to HMAX solely in respect of the writing of such covered-call options on its portfolio securities. HMAX’s strategy seeks to generate attractive option premiums to provide increased cashflow available for distribution and reinvestment, downside protection, and lower overall volatility of returns.

Here lies in the secret sauce. They invest in highly capitalized Canadian financials, and then try to make up the differential with selling call options. You can actually replicate this fund at home if you wanted to.

Here’s the problem. Essentially the fund is taking the worst of both worlds of split share funds and covered call ETFs.

The call options simply aren’t going to make that much money, especially if the fund starts to scale up in size.

The top holdings of the fund is the Royal Bank, at 23%. The “big five” Canadian banks consist of 71.4% of the fund. If your throw in National, it’s over 3/4 of the fund. Let’s concentrate on Royal.

Royal Bank has a 3.9% dividend. So you need to make up 9.1% over the course of a year to get your quota.

The front-month for Royal Bank options is trading at a Black-Scholes implied volatility of 11%:

So your strategy is to buy stock and sell the next nearest strike at the money, which in the case of RY would be a 1% premium over 23 days (16% annualized!). If you take the next month, you get a 2% premium over 51 days (14% annualized!).

The math goes like this – you repeat this every month and you suddenly earn 3.9% in dividends and an additional 12% yield, you can “easily” get to your 13% quota. Free money!

Forget about capital upside with this strategy – it is a guaranteed “ratchet” that can only click down in price.

Let’s tear this apart a bit.

The above chart is the 30-day historical volatility of RY and the implied volatility. The IV index in this chart is normalized to fixed tenors (30, 60, 90, 120, 150, 180 days) using a linear interpolation by the squared root of time, and does not represent the “spot month”‘s implied volatility, which is why the IV index is higher than the front month at the moment.

The point I am trying to make here is that covered calls are being sold cheaper than the likely actual forward volatility of the stock.

Most, if not all, of these covered call strategy funds are, at their core, leaking value through selling call options below intrinsic value because the covered calls are being sold blind to their value. The same style of arguments have been levied against index funds in general in regards to the price insensitivity to the equities in their respect indices. I am sure the initial covered call fund realized a reasonable semblance value, but when you have hundreds of millions or billions of dollars of assets under management employing a strategy into a less than robust Canadian options market that is not going to fundamentally support the liquidity, the response is that the option market makers are going to price the options cheaply.

This is not limited to Hamilton Funds, there is plenty of this going on in the overall marketplace. Volatility can be ‘harvested’ by selling theta on a variety of securities out there. It appears like “free money”, until the market rips up.

Essentially is the other side of the market will be able to “rent” the stocks for relatively cheap rates.

What I project happening is that this fund will discover that making its 13% quota through covered calls will become progressively more difficult to achieve and inevitably distributions will come from return of capital to make up the difference. While the fund will be able to distribute its mandated $0.185 monthly distribution, it will come at the cost of its capital value. It will take a few years for this effect to be apparent.

The easiest way to measure this effect over time is to make a comparable index basket with just strictly the equity (with dividends reinvested) and no derivative trading on the portfolio, and compare the performance between this index and HMAX.

Notwithstanding the 0.65% MER, I predict that the index of straight equity ownership would outperform. This is the inevitable result of employing price insensitive derivative strategies.

However, I have to commend Hamilton for their marketing. I am sure there will be another fund along the way that will promise 15% returns, and 20% returns, and 25% returns until it all busts. This is kind of reminding me of the chase for yield that occurred in the mid 2000’s when you had a huge proliferation of Canadian income trusts going public, which many of them were simply return of capital vehicles.

Mixed signals – thoughts 1/24ths into the year

This is going to be a fairly rambling post, be warned.

After the first week of the year, I extrapolated that by the end of the month that I would be bankrupt. I was then carefully preparing my own bankruptcy filing and then things went 180 degrees from there onto the upside, so I’ve had to shelf my consumer proposal until the next market downturn.

As some of my readers may know, I have been in a state of confusion and have found the cross-currents to be very difficult to swim in. The good news is that despite being jerked around in the currents, the lifejacket I am wearing is very buoyant and to quote our Prime Minister, “the portfolio will take care of itself”.

That said, I am always on the lookout to add value where possible, but the hurdle rate for cash (nearly 5%) is the highest it has been since before the 2008 economic crisis. This brings a different variety of challenge, namely that the speculative winds are blowing in rather odd directions.

Natural Gas

Partly due to a very fortunate warm winter in Europe, the commodity price of natural gas has been completely hammered down:

Because of this, LNG delivery prices to Asia (I’ll use the summer 2023 chart, but you can choose whatever delivery date you want) has gone from something huge (up to $76/mmBtu!!) to $19 today:

People that have leveraged long on natural gas have gotten killed. Interestingly enough, the impact on equity prices has not been as terrible as the charts would indicate, but this is because company capitalization rates have increased. The simplest entity that characterizes your typical Canadian (exclusively Alberta) natural gas producer is Birchcliff Energy (TSX: BIR) and they give fairly detailed (and perhaps more importantly, honest) guidance and effectively at this point it is a direct proxy for spot gas with some linkage to Dawn, Henry Hub and AECO. When natural gas was making its highs, the company was trading at around 4x free cash flow to EV. Today, the company will be making less than half of what it would be three months ago, but the EV/FCF ratio has increased from 4 to 9, so the stock has only taken a mild hit (about 20% below the October peak). Even day-to-day trading has exhibited less correlation to spot prices, which I am finding interesting. Are markets slowly pricing in other variables than cash flow (e.g. reserve capacity)?

Bed, Bath and Beyond

I must say, this has been as fun as Gamestop in the glory era to watch trade:

Shares are not available for short sale, and what kicked off the recent price spike was rumours that the company was shopping around for bankruptcy consultants. Needless to say, the company is in awful financial position. They filed for a late 10-Q on January 5th, and had the following paragraph:

While the Company continues to pursue actions and steps to improve its cash position and mitigate any potential liquidity shortfall, based on recurring losses and negative cash flow from operations for the nine months ended November 26, 2022 as well as current cash and liquidity projections, the Company has concluded that there is substantial doubt about the Company’s ability to continue as a going concern.

This is a “brace for impact” statement.

Let’s get a little more specific – at the end of November, they had $153 million cash in the bank and $1.9 billion in debt (not including lease liabilities, something that would be considered critical for a retail operation!). Add onto that $400 million of cash bleed in the three months ended in November, and suffice to say, this is like a 747 jetliner that is a thousand feet above the ground and heading down at a 60 degree angle. It is not pretty. The publicly traded long-term debt is trading at around 5 cents on the dollar.

However, the equity is going wild.

What is the conclusion that you can make from this?

My obvious take-away: Interest rates still have to rise. There is still plenty of speculative capital sloshing around in the marketplace and until this speculative fervor gets suppressed, money is still loose.

Office REITs and REITs in general

Despite rising interest rates, the REIT sector, and most of all, office REITs appear to be doing very well.

Allied Properties (TSX: AP.UN) was the poster child for depreciation in 2022, but is up 17% YTD as I write this.

Dream Office REIT (TSX: D.UN) is up 13%.

Even residential is doing reasonably well – the bellweather in this space, (TSX: CAR.UN) is up 12%.

Given that many of these REITs have fixed debt exposure that has to be renewed over time at interest rates considerably higher than what the maturing debt is, this price action is surprising, especially when you model out the reduction in available free cash to unit-holders at the higher rate of interest.

I don’t know what to make of this. Is real estate a flight to safety despite rising rates?

Gold and Bitcoin

Both have been very strong early this year. Bitcoin, in particular, ripped upwards in January:

Gold has been on a steady incline since last November as well:

While Bitcoin and Gold do not pay interest, against an inflationary backdrop they have some semblance of a “real” return. Just like REITs, is there a safety element in play? Or is this a play on the general state of monetary policy? Cash is trash, even if it pays 5% interest?

Picking up shares of illiquid stock

My due diligence screens finally picked up a target candidate. Unfortunately, my timing on my “greenlight to buy” occurred just as the stock was jetting up (which I notice is a general trend for the overall markets in January):

It’s obvious that somebody else has some great ideas as well at the same time as me, but I also am wondering whether my own brokerage firm is trying to front-run my own slow trading? Should I just wait for a big ask in the future (not too common) and just hit it?