Preparing for a year 2000-type scenario

I am relatively convinced that although the economy appears to be muddling along with a low real growth rate, the markets are pricing in a growth trajectory that is optimistic. We are likely to see increased volatility in the future.

There are some good doomsday type stocks, but perhaps none would be better than Fairfax Financial (TSX: FFH), who have continually prepared for a gloomier future. They have hedged their entire equity portfolio against the S&P 500 and also have purchased CPI-linked derivatives that would profit in the event of a deflation. From Prem Watsa’s annual report, he believes that any credit event in China would cause commodities to collapse (they consume 40-50% of most commodities from iron ore to copper) and it would have an impact on the mining industry. He goes on to state that world iron ore capacity has increased by more than 100% in the last ten years, mainly due to increased Chinese demand.

The excesses in the Chinese real estate market are quite well known and have been reported extensively in the past, but just like what happened in the USA from 2004-2008, it might take some time before any credit events emerge. In addition, the Chinese government has proven to be very adept at managing the situation.

While I don’t profess to if or when such a credit event will happen, if it does occur, it would be very adverse for Canadian investors holding equity and debt in such entities. Fairfax is an interesting bet for a doomsday scenario, but at CAD$470/share they are considerably priced above book value (which is US$339 at the end of 2013 or about CAD$374 at current currency rates). Given the performance of Fairfax’s businesses, one would expect a modest premium over book, but 25% over book seems a bit heavy to swallow. The company also sold 1 million shares at CAD$431 (CAD$417 after expenses) in November, but this was also in relation to their purchase of Blackberry convertible debentures.

OSFI draft guideline on residential mortgage insurance

The OSFI has released draft guidelines (B-21) on residential mortgage insurance companies. There is a comment period up to May 23, 2014. Considering that CMHC and Genworth form substantially the entire market, I do not anticipate much comment.

Despite what the media is reporting (that it would involve a marginal tightening of the mortgage insurance market), upon reading the draft guidelines I do not see this conclusion, which is little change.

Specifically for investors, the only change that will be visible will be a slightly higher amount of disclosure than what is currently provided to the public. This includes (and the bold-print is what I believe will be new):

A breakdown of mortgage loans insured during the previous 12 months as well as the total stock of insured mortgage loans, with further separation by mortgage insurance type (i.e., transactional- vs. portfolio-insured loans), for the following categories:

* Volume: The number and outstanding balance of insured mortgage loans;
* Loan-to-Value: A breakdown according to LTV buckets of 5% increments (both estimated current and LTV at origination);
* Amortization: Amortization period ranges (e.g., 15 – 19.9 years, 20 – 24.9 years, ≥ 25 years, etc.) at origination and remaining amortization;
* Geography: Geographic breakdown by province and territory; and
* Delinquencies: Breakdown of the level of insured mortgage loan delinquencies.

FRMIs should also provide a discussion of the potential impact on insured residential mortgage loans in the event of an economic downturn.

Genworth MI is down less than a percent in today’s trading, which may or may not be caused by the above pronouncement by the OSFI. It continues to be my largest holding despite being trimmed at higher price levels.

Not much to say lately

The market has been going through some corrective headaches, likely on valuation concerns of the well-known high fliers out there (including the biotech sector, which has gone bananas). This all feels like the year 2000 over again.

I still haven’t had anything pop up on the investment radar lately. One opportunity which I did identify last year as a very likely candidate to provide two or three-bagger type gains over the next two to three years has exhibited price depreciation to the point where it is trading below tangible book value. What is even odder is that this company is pretty much top in its business niche and is unlikely to lose the competitive advantage in this niche. It is only trading down because of government regulatory fears. I might write a comprehensive research report on this company, but it is something I would not want to make freely available to the public.

Canadian social networking companies – Keek, Inc.

The whole investment world sees Twitter, Facebook, Linkedin, etc., and starts to wonder what the next hype is going to be as everybody gets financially envious at those who are bailing out en-masse with shares they have at a cost basis of pennies.

In Canada, the number of choices are quite limited. Most of the social media companies (at least in the English language) originate in the USA.

However, there is one Canadian firm, out of Toronto, that I know of which seems to have potential for hyped up valuations. That would be Keek, Inc. The company is attempting to be the Twitter of video. I have no idea whether this concept will take off or not, but I am reasonably sure it is something that teenagers with too much data on their mobile data plans would find creative ways to use.

In a rush to get public, they performed a reverse merger with Primary Petroleum Corporation (TSX: PIE, now TSX: KEK). This also temporarily solved another problem that they had, mainly a lack of cash.

Post reverse-merger, once all the dilution is taken into account, the entity will have about 400 million shares outstanding. This gives them a market capitalization for a company that has zero revenues and a burn rate of roughly $20 million a year given their financial statements for the six months ended August 2013.

The reverse merger will give them about a year’s worth of cash (from August 2013!) providing they can obtain some modest returns on the sale of the oil and gas assets that Primary Petroleum had. Between then and now, presumably they are going to count on their common share prices going to the roof in some sort of social media hype, where they can do a secondary offering for a bunch of cash.

Not that fundamentals matter with social networking companies, but it looks like they already their moment in the sun – the following two snapshots are from the management information circular:

Investors in Friendster probably know how this chart feels like.

I give Keek management full credit, however, for developing metrics that make utterly no sense in real life, like the following:

Wow!  The chart is going straight up!  I must invest!

Also, when digging into the documentation even further, I come up with gems such as the following paragraph:

In August 2013, Keek entered into an arm’s length lease agreement to lease approx. 17,947 sq. ft. at 1 Eglington Avenue, East (suite 300), Toronto, ON. The Lease Term was for 10 years and 3 months, commencing on July 1, 2013. Base rent for month 1 thru month 60 would be $15/sq. ft. with base rent for month 61 thru month 123 of $17/sq. ft. Keek was granted three months free rent for both base and additional rent for the first three months. Keek has recently decided that its office space requirements over the next five years are not expected to require 18,000 square feet and therefore has engaged a realtor to sublet the space while Keek look for alternative office space of approximately 5,000 square feet. There is no guarantee Keek will be able to sublet its existing space at values that approximate its current lease arrangements.

Oops!  Nothing like signing a long-term contract for a huge amount of space you suddenly discover you really didn’t need less than half a year later!

Sadly, I will not be investing in this story, but I could easily see others doing so and taking this up to a ridiculous level that is not rationally explainable by any business metrics relating to cash flow or revenues. However, if you had to spend a hundred dollars on the Lotto 6/49 with an average jackpot versus throwing it into Keek, you might actually get a better expected value on Keek, as long as you were allowed to liquidate your shares in the near-term future.

Tragically, I am indirectly invested through this via my Pinetree Capital debentures (TSX: PNP.DB), which I gave a rather cynical analysis on back in November 2013.  Pinetree owns about 52.8 million shares of Keek and if Keek goes to a hype valuation, I would hope Pinetree management would actually liquidate some shares so they can pay off their pesky debenture holders like myself.