Genworth MI Q3-2014 results

My previous projection on Genworth MI’s (TSX: MIC) Q3-2014 was mostly in-line.

Specifically, I projected a dividend increase (which was done – from 35 cents to 39 cents), and a likely chance for a special dividend (which will be 43 cents this quarter). Operating EPS was slightly less than I expected (95 cents diluted vs. “around $1” expected) and this was primarily due to the larger loss ratio.

A few notables:

1. They wrote $217 million in premiums this quarter, which indicated a very high volume market for mortgage insurable Canadian real estate. Year-to-year, about $20 million of the $56 million increase was due to the premium increase announced by CMHC earlier in the year. The rest of it is sheer volume, mostly in the high loan-to-value business (i.e. highly leveraged loans).

2. Loss ratio was 21%, slightly higher than I was expecting but still quite low by historical standards. The MD&A projects “35-40% over an economic cycle” and for those of you that are mathematically astute, this implies that there will likely be times where the loss ratio will be at the 60-70% range (and the common stock would be quite battered at this rate was it would show the entity as barely making any money and shelling out huge amounts for mortgage claims).

3. Delinquency rates are still quite low although they went ever so slightly up from quarter to quarter, interestingly enough in the low loan to value category. I believe this is just white noise.

4. OSFI regulations regarding minimum capital for mortgage insurers has more or less been finalized and using 2015 standards, has the company at a 223% position in terms of minimum capital required – the company’s internal target to survive a prolonged recession is 220%. This excess capital is presumably given off in a special dividend.

All-in-all, the company is continuing to mint cash and shareholders should be extremely happy. The downside to this is that I can’t really see how things can get any better for the company. Maybe if CMHC pulled out of the mortgage insurance market, but there is no way the federal government will allow this cash cow to stop generating money for the federal coffers.

At current valuations (CAD$40/share) I cannot recommend a purchase. It is on the upper end, but not quite exceeding, my fair value range for the company. This has been a big winner for me over the past couple years and it will be sad to see it leaving the portfolio, but superior gains are only to be made when there is blood on the street. A couple years ago, the blood was projected to be in Canadian real estate. Right now it is elsewhere.

For those with nerves of steel – buy oil

Most investors are likely aware that the price of oil has plummeted. This has taken a lot of equities down with it.

This is a very rough statement (some areas are cheaper to mine than others), but it is getting to the point (roughly US$75-ish) where a lot of tight oil (shale) is unprofitable to mine. This is where most of the oil boom from North America has originated. Heavy oil (oil sands) highly depends on where it is mined.

There are geopolitical games being played by OPEC and Saudi Arabia and the rest of the world. Commodities can trade under the marginal cost of extraction for awhile, but not indefinitely – especially in the case of crude oil, there will be demand.

The question is who shuts off the supply first? It will be the most insolvent high-cost producers, and then increasingly the more solvent unprofitable producers until the market supply decreases. Only then will we see oil prices turn around.

I do not believe a downturn in the oil commodity price will be sustainable for a long period of time in light of global demand still being high.

Decreasing capital budgets for 2015 will translate into decreased supply. However, this is not a speedy process. Most tight oil producers require a continual stream of capital to keep production levels stable and so I would guess some time in 2015 you are going to see a very sharp rebound in oil prices once enough supply has been shut off.

There is a cliche that markets go up slowly but crash quickly. With commodities, they go down slowly and rise quickly.

From my 50,000 foot perspective, there seems to be opportunity. I’m going to guess that low prices will persist until the end of this year. I do not see low prices continuing throughout 2015 unless if there is some sort of major global slowdown beyond what we already see in Europe and China (in the latter case, if you can call a decrease from 7% GDP growth to 5% GDP growth a “slowdown” when your GDP is already 9 trillion dollars, then it is a very odd definition of a slowdown!).

Picture yourself as some economic analyst in the People’s Republic of China with a mandate of securing global energy supplies. Right now you’d be licking your lips and looking at the various publicly traded entities out there. Your only fear is having governments refusing takeover offers out of national security concerns.

Broad energy ETFs (which also include refiners) that encompass this category are XLF, and VDE, but the exporation and producer index (XOP) has been significantly more impacted. XOP has an MER of 0.35%. The Canadian equivalent (and this ETF would provide eligible dividends as it would be from Canadian and not American sources) is XEG.TO and this ETF contains the usual list of Canadian energy producers (Suncor, CNQ, etc.) for an MER of 0.6%.

If you’re brave and have nerves of steel, buy oil. I can’t tell whether right now or the next three months or so will provide the lowest price point, but from a historical perspective, it is closer to the bottom than it was a month ago!

Reviewing underperforming Canadian oil and gas producers

One observation: It is abundantly clear that oil and gas producers in North America are going to be trimming their 2015 capital budgets. This will disproportionately affect the service companies, but most of this has already been baked into equity prices.

I have no idea where oil prices will be going in the short term. There is plenty of incentive for those that have already sunk a boatload of costs into their wells to keep them flowing. In the short term you might see some price shocks, but in the medium and long term, I cannot see oil losing too much demand relative to supply levels. While getting into my vehicle and experiencing heavy traffic is hardly a statistical sample that you can extrapolate across the world, intuitively I do not think electrification of transportation is going to be an imminent threat on crude oil (or natural gas) as being the transport fuel of choice. Nor do I see the requirements for plastics or any derivative products of crude being replaced anytime soon.

The point of the preceding paragraph is that crude oil is not going to disappear off the map anytime soon (unlike its predecessor, which was whale oil).

With my very generalized valuation theory on oil and gas producers that “oil prices are a reasonable proxy for company performance plus financial leverage effects”, I note that WTIC (West Texas Intermediate Crude) reached the US$80/barrel level back in June of 2012:

wtic

A very simple theory is that oil and gas producers that are trading below what they were trading in June of 2012 should be given a second look to see what caused their relative dis-valuation from present oil levels. A surprisingly large number of Canadian oil and gas companies are trading well above their June 2012 levels despite the oil price difference.

One reason is simply due to good (or lucky timing!) hedging strategies.

Another is due to the mix of oil (and the different types of oil), transport issues, and the percentage of natural gas and natural gas liquids in the revenue mix of a company – in general, while you aren’t suffering pure hell at US$2.50/GJ back in June 2012, your typical gas driller hasn’t been wildly profitable compared to the good ol’ days back in 2008 when you were at US$10.

There’s also the simple reason of having excessive financial leverage and not being able to finance the corporation at revenues obtained at current prices.

There’s plenty of reasons why an oil and gas company would be trading lower today than in even worse price environments seen in June 2012.

So given everything trading on the TSX, I’ve done some homework as a starting point and gone through the companies with the following criteria:
– Share price over CAD$2
– Market cap over $1 billion
– Not a foreign entity (although they can have foreign operations).
– Trading lower today than they generally were in June 2012.

We have, in descending order of market cap:

CVE.TO
TLM.TO (not that they’ve been having difficulties lately!)
BTE.TO
PWT.TO
PGF.TO
TET.TO
BNP.TO
LTS.TO (I was a prolific writer that commented on its ridiculously high valuation when it was known as Petrobakken).

I note that Canadian Oil Sands (COS.TO) is trading barely above what it was in June 2012. This is probably the most purest equity play on WTIC possible beyond putting money in USO (not advisable).

Any thoughts? Comments appreciated.

Market volatility

Look at the last couple weeks of trading on the S&P 500:

spx

This is a panic down-panic up type chart – especially over the past few days, it resembles a short squeeze more than anything else.

The overall trend in the S&P 500 over the past couple years has been nearly a straight-line up chart:

spx-2

Is this going to continue?

Normally in the prior market dips you get this “slowly climb the wall of worry” effect, but this time it appears to be different.

Implied volatility continues to be strongly anti-correlated to market price, but is now settling back into the teens again. Will there be another violent outburst?

vix

And finally, 10-year bond yields are still trading below what they were when this whole market calamity started:

tnx

I’d be careful. My guess is that we’re going to see some stormy seas over the next couple months. Whatever started this is not likely finished yet.

Genworth MI Q3-2014 preview

Genworth MI (TSX: MIC) is going to report their 3rd quarter earnings on November 6, 2014. I do not expect anything too different than the previous quarter other than the seasonal factor of higher insurance underwriting as the Canadian housing market is more active in the summer.

Specifically, loss ratios are likely to be at significant lows. Q2-2014 reported 12%, which can only be classified as insanely low – Q3-2014 will be low, but probably not as low as that.

Earnings-wise, given their revenue recognition model, they will likely report revenues around the $141 million range and if their typical rate of realization on investment gains continue, should report around a $1.00 EPS level of operating income. Treasury bond yields were down quarter-to-quarter which should result in unrealized gains.

In terms of solvency, the company’s internal target is 220% of minimum capital required (which they state is sufficient for them to survive a severe recession). They reported 230% in Q2-2014, and this will be higher in Q3-2014. It is quite probable they will increase their dividend rate from 35 cents a quarter to a higher number (their track record has consistently lifted dividends in the Q3 of each year), but there is also a possibility of them declaring a special dividend to eliminate the excess capital.

I do not anticipate a share repurchase – management has been relatively diligent at only buying shares at or below book value.

Other than the usual cries of a pending Canadian real estate market crash, the only pending storm clouds for the company appear to be the fact that they might attract public scrutiny for simply being too profitable. While CMHC takes the lion’s share of the mortgage insurance market (and indeed this is a very lucrative industry for the crown corporation), Genworth MI takes the other slice of the market and earns duopoly-type returns for doing so. The party continues until it doesn’t.