An actual purchase

Today one of my watchlist items fell well below what I considered to be a fair value range and I decided to nibble on a few shares. My first purchase of the year has the following metrics, without giving away what it is I’m investing in:

– Trading within 5% of its book value (about 10% if you exclude intangibles);
– No debt or abnormally large deferred revenues;
– Cash is just above 1/3rd of market cap;
– Enterprise value to sales of about a half;
– Profitable but not excessively so;
– Market took it down considerably due to the growth trajectory over the past couple years clearly abating and competitive margin pressures are rising somewhat. Clearly pessimism has set into the market – the chart has been trending down for the past half year. Most of the bad news is likely baked into the stock price;
– Short interest is relatively high.

So far this is just a tiny position, but if it continues to go down I will accumulate more shares.

(Update, February 14, 2014: I got about 1/7th of my desired position. It’s pretty clear short sellers are covering into this.)

Genworth MI – Q4-2013 review

The earnings release was about what I was expecting. There was a slight increase in the expense profile but this was due to some stock-related compensation expenses (cash flow statement has it at $11.2 million for the year) but this is due to the stock itself increasing in value.

For the year, net premiums written were $511 million, while revenues recognized were $572 million. These two will have to converge eventually. This has been the trend for the past few years now – revenues recognized was $621 million back in 2010. Premiums earned in 2014 should be around the $550 million level.

The $5.4 billion portfolio continues to remain dull (a good thing) with a 3.6% yield, 3.7 year duration.

The loss ratio continues to remain exceptionally low, at 22%. Management continues to focus on Quebec and the Toronto condominium market, which is correct.

The bottom-line operating EPS is $3.60/share. Looking at tangible book value, I get a value of $32.34/share with a diluted share count of 94.9 million shares.

Balance sheet-wise, the company continues to remain over-capitalized with 222% of its required regulatory minimum capital, and well above its 190% internal target. There are regulatory changes which I have outlined earlier that the company is awaiting for before deciding what to do with its excess capital. They bought back shares when the stock was trading lower, but now they are holding onto their cash instead of buying back shares (a smart decision).

The only item of any distinction in the financials is the following paragraph:

On December 20, 2013, the Company, through its indirect subsidiary PMI Canada, entered into a retrocession agreement with Merrill Lynch Reinsurance under which the Company assumed reinsurance risk for up to $30,000 Australian dollars if the losses on claims paid by Genworth Financial Mortgage Insurance Pty Limited, an Australian company (“Genworth Australia”) exceed $700,000 Australian dollars within any one year. The term of the agreement is 3 years. Genworth Australia has the right to terminate the reinsurance agreement after the first year of coverage.

Under the excess of loss reinsurance agreement, the Company is required to collateralize its reinsurance obligations by posting cash collateral equal to the maximum exposure under the agreement in favour of Merrill Lynch Reinsurance. As at December 31, 2013, the Company has posted $30,000 Australian dollars, equivalent to $28,482 Canadian dollars, under the agreement. The collateral is recorded as collateral receivable under reinsurance agreement on the Company’s condensed consolidated interim statement of financial position.

Re-measurement adjustments arising on translation of collateral receivable under the reinsurance agreement and any reinsurance receivable balances from Australian dollars to Canadian dollars are recognized in net investment gains.

This is functionally a bet by management that the Australian real estate market is not going to crater. While I am not thrilled that the company appears to be engaging in gambling outside of the Canadian sphere, I do note that the history of paid claims in Australia appears to be considerably below this:

2013 – AUD$185 million
2012 – AUD$287 million
2011 – AUD$112 million
2010 – AUD$171 million
2009 – AUD$173 million
2008 – AUD$146 million

It would appear that it would take a disaster for Australia’s paid claims to be above the AUD$700 million threshold, but if this was the case, then why did Genworth Australia make this agreement with a sub of Genworth Canada?

Reading between the lines on the conference call, it sounds like management is tinkering around with the idea of deploying their excess capital in reinsurance of mortgage insurers. This doesn’t sound like a bad idea, until it blows up, like it almost did for the parent Genworth (NYSE: GNW) entity.

In absence of any better investment alternatives and also in absence of any looming Canadian real estate crisis, Genworth MI is still in my portfolio as a large fraction. It is or more less a proxy for a bond fund at this point and I am comfortable with the relevant risks regarding the Canadian real estate market. I also believe the equity is in the middle of what I consider to be its fair value range. If they execute as they have in 2013, the stock should go up another 10% or so on the basis of increased book value alone.

The critical sensitivity continues to be the state of the Canadian economy. Our country is export-oriented, especially in the commodity sector. As long as this remains active, we are unlikely to see spikes in unemployment that would cause mortgage defaults. Interest rates are also projected to be low and this will not create an additional shock in the market.

Rogers Sugar – Freefall

I used to own shares in Rogers Sugar, back in the days when it was still trading as an income trust. I had a slab of units in the mid 3’s and sold them in the mid 5’s, citing that the upside was probably limited from that point. This was one of the companies that I loaded up on during the economic crisis and it paid off. My selling timing wasn’t ideal as they’ve managed to get up to about $6/share before moderating:

rsi

I’ve been asked whether this company is a buy or not. Normally I don’t entertain these requests, but since I don’t need to do any additional research on this company that I’ve already written about, I’ll comment.

The quick answer is that they are trading within my fair value range. They’ve been well over my fair value range for the bulk of the last couple years. My theory here is that they were perceived as a safe stock with a safe yield, and lumped into every income fund manager’s portfolio as something reliably yieldy but “without risk”. I would say the assessment of income is correct, but the assumption of risk is not, and the market clearly has shown that over the past two weeks of trading.

I’m not sure why they got killed as badly as they have. Their last quarterly report (the catalyst) was not good, but the stock didn’t deserve the 20% bludgeoning they took. There is clearly a lot of other technical factors going on here (stop losses, value investors dumping, margin players dumping, etc.).

Market-wise they are facing a few adverse factors (the crops down south have been better than usual, which will cause over-supply and hence no exports for this year), and also Redpath is seemingly getting good at marketing and beating Rogers – heck, I even notice their product in the local Costco. These margin pressures are not good for the company, but this is the nature of the industry and it has been this way for a long, long time.

They will have to go down further before I’ll consider buying shares.

Also for those wanting to do some fundamental research on the company, just note that reading the GAAP income statement is nearly useless due to the use of derivatives the company engages in to hedge natural gas pricing.

When interest rates rise

Constructively speaking, the federal reserve is engaging in raising interest rates, without actually raising the short term rate. The theory of what to invest in when rates rise is functionally the correct strategy here.

There is not a lot that is going to thrive except for US cash.

The federal reserve is likely to continue in the normalization direction for quite some time to come and as a result, volatility will be prevalent. Buying volatility is likely to be a winner.

Marginable vs. non-marginable equity

There is a lot of borrowed money out there. Even on the retail level, you can get Canadian currency for about 2.5% at Interactive Brokers, or if you’re going to borrow over a million dollars, you’re good at 1.5%. For US currency, it is currently 1.57% and 0.57%, respectively.

Borrowing money to invest makes you look like a genius when the markets are rising, but it adds a tremendous amount of pressure when things go south.

Interactive Brokers, in their most recent quarter, announced that year-to-year margin balances have increased 38%, while customer accounts grew 14%. This is not terribly dissimilar to the statistics reported by the NYSE – while they have yet to post December balances, looking at November-to-November they have a 29.6% increase in margin balances. It is significantly higher on a percentage basis if you net the margin debt with the credit balances available.

So let’s say you’ve borrowed to the hilt, and the markets experience a 4% decline and you start to feel uncomfortable about your 2:1 leveraged position. What do you trim first to avoid the dreaded margin call?

The answer is non-marginable equity. Each dollar you raise from a non-marginable stock contributes a full dollar that can go toward the minimum equity required to maintain the account. If you decided to dump one of those 30% margin stocks, you’d need to dump $3.33 of shares to get the equivalent of one dollar.

It is likely that there are a higher frequency of bargains in the non-marginable equity rather than the full margin equity (e.g. large-cap stocks) – forced liquidations have a tell-tale sign on charts which I am sure clever software programs are consistently looking for to ensure they extract the maximum amount of pain on those that are forced to sell.

Being human, however, restricts you to keeping a good quality watchlist, having done some fundamental analysis in advance to ensure you’re still not getting ripped off on valuation, and just paying attention.