Reversing course on a trade – Tailored Brands

A good part of investing is trying to constantly trying to figure out whether the information that got you into a trade is still applicable or whether it is flat-out incorrect. Unfortunately, the information that you glean from investing without insider information is diffuse and sometimes the decisions made are marginal ones – hence, it is never wise to bet too much of your portfolio on any investment thesis. More certainty of information over your perception of the information that others are pricing into the security allows for a more concentrated bet.

In the instance of Tailored Brands (NYSE: TLRD), it was a combination of diffuse information, hence a relatively modest position. There was a panic in September, coupled with management’s capital allocation decision to cut the dividend to zero, coupled with the actual numbers looking relatively cheap from a valuation perspective (they are a legitimate retail operation, albeit selling product that is facing an overall downtrend for various reasons). September quarterly guidance was very tepid which took the stock down:

* Men’s Wearhouse to be down 3% to 5%
* Jos. A. Bank to be down 2% to 4%
* K&G to be down 2% to 4%
* Moores to be down 4% to 6%.

I got in and out and flipped the stock like a pancake for mild profits. If you’re a large player, it takes a lot of time to scale in and out of stock positions and “pancake flipping” isn’t really an option – you’ll move the price of the stock too much on both ways.

What changed my thesis? One was that Gildan (TSX: GIL) is a precursor fashion company, and they pre-announced in October that things aren’t going too well. Obviously selling things such as t-shirts and underwear is not the equivalent of selling suits and fancy clothing (which involves more marketing and physical presence than raw material), but it was the continuation of the downtrend which is not a good sign. Does this guidance carry forward to other apparel retailers? Does TLRD’s already down-beat guidance already incorporate this, or will things be better than that or worse?

This is ultimately what makes it very difficult to judge as a market participant – what the market is currently betting on. Every piece of information is condensed down into one, and that is price – the assumptions driving the price among the market participants can only be inferred, and sometimes the causes for price changes are for completely hidden reasons (e.g. some hedge fund has to liquidate its entire holdings in a short time period at any price, and does so indiscriminately – these sorts of situations are great to get on the other side of the trades with).

The other reason why I closed out the trade was that I figured is that the psychological exhaustion associated with the suspension of the dividend, coupled with any anticipated benefits of a share buyback had played itself out. What I mean by this is that when a relatively well-known company suspends its dividend, there are many funds out there that invest in the company’s stock strictly on the basis that it has a dividend (any dividend or income-oriented ETF and so forth). These funds are forced to sell the stock within a predefined timeframe because they no longer fit the portfolio policy. Hence, when you see dividend suspensions, investors do not like it because it signals a negative psychology (Can’t pay a dividend anymore? Must mean you can’t make money to pay it, so I should sell!), but also for completely mechanical reasons (funds and ETFs selling due to policy).

Example: Vanguard at August 9, 2019 reported owning 6.8 million shares. Vanguard at October 10, 2019 reported owning 3.4 million shares. Vanguard, of course being the low-cost ETF provider of all sorts of funds running hundreds of billions of dollars of investor capital – pretty clear their income/dividend funds were getting rid of TLRD stock!

It could be the case that suspending the dividend to focus on stock buybacks is rationally the correct decision. Indeed, managements with value-creating characteristics would choose to engage in that, knowing that a dividend suspension would crater the stock price – it would just mean you can buy back more equity at depressed prices. The smartest managements time their annual option grants to coincide with this period, to get the lowest strike price!

Finally, TLRD’s cost of capital has increased considerably over the past month. This has been really noticeable over the past couple weeks where yields have risen on their July 2022 unsecured debt to about 10%, which is the point where the bond markets are getting quite nervous.

I’m guessing unsecured bondholders are not thrilled that some of the capital that is destined to pay them back is going into the hands of the stockholders. This is assuming management is repurchasing shares in lieu of the suspended dividend, but we will not get confirmation of that until the next quarterly report.

If there is a meltdown in TLRD, it will be very fast and spontaneous – similar to what happened to Toys R’ Us – bondholders will not have the opportunity to get out without taking a significant haircut. One big difference, however, is that TLRD still makes some money, so they have that going for them. That amount of money, as top line sales decrease, will be more and more difficult to realize without very diligent cost controls. It is one thing to manage a franchise that is on its way up, and another thing entirely to manage it on the decline – a whole different skillset is required to manage declines gracefully.

TLRD announces their next quarter on December 11, so we will see what happens. Such skittish trading is not the best way of making long-term gains but the cliche of cutting your losers quickly and let your winners run is also overriden by another cliche – when your original investment thesis is broken, get out. There’s always a market somewhere else.

Continental Gold merger – valuation – Gran Colombia equity

I’m not typically a gold mining investor. Gran Colombia Gold (TSX: GCM) was an exception but just by the method of how I got into the stock (via a debt to equity conversion). I’ve long since gotten out of it since it’s pretty clear management has other capital allocation priorities than optimizing returns for shareholders. I do still own their notes, which I expect to pay out high yield and low risk interest payments until they mature.

Today’s acquisition proposal of Continental Gold (TSX: CNL) by a Chinese company (Zijin) is interesting, mainly because of the very high valuation assigned – $1.4 billion of equity value (fully diluted).

Continental Gold is currently not producing, but is in the process of being able to produce gold sometime in 2020 with their Buriticá project in Antioquia, Colombia.

Building gold mines is not cheap. They’ve spent about $200 million on capital expenditures in the first 9 months of 2019. They had about $80 million left on the balance sheet at the end of September, so simple math would suggest that they needed to raise more money to finish their project.

They’ve got $300 million in loans outstanding, another $88 million in convertible debentures (which will now be converted into equity and sold), and they have sold a 2.1% gold stream and most of the silver output for another $100 million.

The Buriticá project is anticipated to produce 250,000 ounces of gold over 14 years at an all-in cash cost of US$600 per ounce, which is very cheap relative to most gold miners. If one believes these numbers and ignores all other costs, that works out to US$225 million/year in gross profits at an expected gold price of US$1,500/ounce.

Of course, things are never that easy. Projects remain at the 90% completed stage for a very long time, there are cost overruns, things never run as expected, etc., etc. I’m pretty sure after this acquisition closes that the new owners are going to get a “oh by the way…” reception before the predecessor management bolt out as quickly as possible with their new-found fortunes.

But I was thinking, if this company can receive a $1.7 billion enterprise value for a gold mine project that isn’t even operating, but is expecting 250,000 ounces of a gold in production next year, how come Gran Colombia Gold (another Colombian gold producer) with its 233,000 ounces of production is trading at about a $300 million EV? GCM’s all-in sustaining costs are much higher – around $950/ounce, but at least they’re pulling gold out of the ground. Their major mine still has a few years of life left in it, and the drill results they are getting should be able to sustain lower grade production for a few more.

Perhaps smarter minds out there can inform me why there is such a big difference in valuations. I’m still not interested in GCM equity, but relative to CNL’s takeover valuation, GCM stock looks very, very cheap.

Macroeconomics – one reason perhaps why the S&P 500 has been rising

Take a look at the S&P 500 over the past two months:

It is not entirely coincidental this aligns fairly well with the monetary loosening of the next phase of quantitative easing by the US Federal Reserve, which started in September:

Most of this excess capital tends to find its way pumping demand into the asset market. Right now, that demand gets centered around the large capitalization, large liquidity companies, but eventually that demand flows to parts of the economy that still offer morsels of yield.

Just Energy takes a dive

If you were holding preferred shares in Just Energy (TSX: JE.PR.U), you don’t want to be reading this announcement:

Just Energy Group Inc. (“Just Energy” or the “Company”) (TSX:JE) (NYSE:JE) announced today that it has amended its senior secured credit facility to increase the senior debt to EBITDA covenant ratio from 1.50:1 to 2.00:1 for the third quarter of Fiscal 2020. In addition, the Company has amended the covenants on its senior unsecured term loan facility to increase the senior debt to EBITDA covenant ratio from 1.65:1 to 2.15:1 for the third quarter of Fiscal 2020. Both changes are effective only for the third quarter of Fiscal 2020 and the covenants will revert to the prior levels following December 31, 2019.

In connection with the amendments, the agreements governing both facilities have been changed to restrict the declaration and payment of dividends on the Company’s 8.50% Series A Fixed-to-Floating Rate Cumulative Redeemable Perpetual Preferred Shares (“Series A Preferred Shares”) until the Company’s senior debt to EBITDA ratio is no more than 1.50:1 for two consecutive fiscal quarters. Accordingly, the Company is suspending, with immediate effect, the declaration and payment of dividends on the Series A Preferred Shares until the Company is permitted to declare and pay dividends under the agreements governing its facilities. However, dividends on the Series A Preferred Shares will continue to accrue in accordance with Series A Preferred Share terms during the period in which dividends are suspended.

Preferred shares proceeded to trade from $17 the day before to closing at $9.88, a 42% drop. The common stock, which paid out its last dividend in June 2019, traded down about 16%.

I did remark about Just Energy on September 1, 2019 that “Balance sheet is a train wreck, company is exploring a recapitalization, and the business model itself is highly broken. Good luck!”, but specifically, their big problem is this:

About $222 million is due for refinancing in the year 2020, with the lion’s share the first-in-line secured credit facility that has $203 outstanding.

It is pretty evident by the covenant amendment that the third quarter expectations (noting that Just Energy has their fiscal year-end on March) is not going to have a good quarter. They’ve bought themselves a little bit of time to negotiate with the senior secured creditors, but suffice to say, this one is trading low on all fronts (common, preferred and debentures) for a good reason – a recapitalization is probably in order.

In general, I’m not shocked that the market was valuing the yield on a financial product of a company that is in such precarious financial condition quite highly; the chase for yield blinds most individuals as the underlying framework as to what makes yields possible – cash flow and no imminent liquidity crises. These sorts of decisions that companies make are relatively foreseeable and why I do not have them in my portfolio.

The convertible debentures (TSX: JE.DB.C, JE.DB.D) came up on my radar today as a result. The company cannot suspend their semi-annual interest payment without it being an event of default, but right now the most likely outcome appears to be an equity conversion, and this is under the assumption they can come to some sort of arrangement to placate their senior secured creditor.

The most interesting part of this all is that the company also has a tranche of unsecured term loan facility (8.75% maturing on September 2023) which is partially guaranteed by a director: “On July 29, 2019, the Company drew US$7.0 million from the second tranche and US$7.0 million from the third tranche. These draws were secured by a personal guarantee from a director of the Company.” – this would certainly give this director an incentive to seeing the company not default on it!

Options Education Day – Vancouver

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.