Berkshire and commodities

Two observations – Berkshire announced that it will repurchase its own shares at no more than a 10% premium to book value. The stock went up about 8% in trading during the session to roughly this level. Book value is $163 billion, while the company has 1.649 million class “A” equivalent outstanding for a book value of about $98,850 per share. Add 10% and this gives a value of roughly $108,700 per share, not too far from the closing price.

I find this interesting simply because Warren Buffett is now a net seller of his own company and he is quite good at using his mouth to talk up or down the market when it suits his purposes – there tends to be a media aura that he is relatively altruistic. I am not convinced that Berkshire makes a compelling value as its analysis is not that easy – essentially an insurance operation with a series of fully-consolidated subsidiaries and a hodge-podge smattering of equity in various well-known companies (including Burlington Northern). When at the scale of Berkshire, the rules of engagement are considerably different since it takes forever to build and exit positions – not as easy as plugging in a market order to buy 100 shares of Microsoft.

The last time Buffett talked about buying back his own shares was when it was trading at $40,000 at the peak of the tech bubble. He graciously offered anybody that was willing to sell at that price can call him up and sell it to him at the prevailing bid on the NYSE at the time. Nobody took him up on that offer.

The other observation is commodity prices appear to have developed a “spike” on the charts. Observe the following:

Although I am hardly a technical trader, my best guess at this time is that the three commodities will head up for the rest of the week or so before declining again and “retesting” the bottom of that spike and likely trending down. There was clearly some sort of liquidation that has been occurring and the market is not that deep.

The close of the quarter

Here are a few things I am asking myself – I do not think these are unique to myself at the moment:

1. How low can 10 and 30-year bond yields go? 1.81% and 2.87% are the current yields, respectively. Why would somebody want to lend the US government money at this rate when the entity they are investing in has its only escape route in debasing its own currency?

2. How low will commodity markets go? Copper has cratered about 25% over the past two months, silver has been taken out and shot in the past week, and even gold is starting to wobble. How much pain can investors in commodities take before they start getting cold feet and bail out en-mass more than they have done currently? My suspicion is that this is the beginning.

3. What should be on my watchlist that will do the best in the event of a recovery? In the 2008-2009 crisis I concentrated heavily on corporate debt investments, but I suspect that whenever the bottom of this market is hit that investors in equities that are zero yield will fare better.

Too many questions, not enough answers. My outlook still continues to remain negative and requiring defensive action and also of the belief that we will continue to see sharp rallies and even sharper declines. There still isn’t enough panic out there. Although VIX is a quantitative measure that a good sector of the population uses, there are some other metrics out there that still show there is complacency.

There is no safety other than in cash

People looking for a safe outlet for capital in the marketplace are not going to see anything except in the form of cash and cash equivalents. Typically commodities were used for the safety outlet, but notably today we see that the S&P 500 is down about 2.8% and gold is down about 4.5%.

Notably, today is the first day where the safe haven of gold is getting compromised in a market downturn. Previously gold used to hold its own against down equity market action.

One day does not make a market, but this trend is something to watch.

Technically you also see safety in 30 and 10-year government treasury bonds (Canadian or US, take your pick), but getting a 1.8% yield for the next 10 years is quite obviously a temporary solution for capital. While this might work best for a fund manager, for an individual cash is much more practical.

Notably, the Canadian dollar got pounded over the past couple days – currency traders have seen a 4% decline in the Canadian dollar:

US dollar strength to a lesser degree has also been witnessed in other major world currencies, including the Euro and Yen.

I continue to remain very skeptical of the markets and am still in a preservation of capital mode – today is the first day in awhile that I’m looking at the dry powder keg and thinking of how I will be deploying it. But that time is not now. The only minor exception I made was in the preferred shares and debentures of Yellow Media (per my previous post) simply because the liquidation of those securities by its existing investors is a mostly independent event of the present market meltdown we are currently witnessing.

It is very difficult to be an index-beating active investor without the ability to side-step market crashes. By side-stepping crashes you can keep your capital freed up for those very brief and opportunistic time that the market is desperately asking for your capital. The market signals this to you with low prices, intense volatility, high bid-ask spreads and desperation. The last real time this happened was in late February/early March of 2009. There was a one week window of opportunity that you had where you could catch the bottom. It is very easy to identify in retrospect, but very difficult to get correct in real-time. Excessive outsized returns over a relatively short period of time (i.e. 200%+ returns on investment) can only be realized with ridiculously low entry points, which in turn requires financial nerves of steel to be the only buy hitting the “buy” button when the rest of the world is liquidating.

If your capital gets caught up in a market crash, it is a simple matter of mathematics to prove why you will not be able to gain much – in the 2008-2009 financial crisis, your average index investor was down 60% from peak to trough, which means in order to just break even you had to see a 150% return from the trough. If you can limit your damage to 10-20% of your portfolio and invest your capital at a more opportune time, it obviously will do wonders to your overall performance, just as how I nearly doubled my capital base in 2009.

A recent 21st century innovation is also that if you carefully analyze the tape, you will also see probable computer program traders that are set on a “fast liquidate” setting by relentless bid hitting. While it doesn’t have to take four years of electrical engineering education to perform a formal analysis of the trading signal, having some quantitative aptitude does assist in the process.

You can get a hint of what you are competing with simply by doing some mental work on how you would program such a trade algorithm, but Interactive Brokers conveniently has some simple algorithmic trade types that give you an idea if your mind blanks out.

It is time to do research on quality securities that will get needlessly hammered by a market downturn, but not nearly time to buy – yet.

Here’s a hint: I would not look at commodity companies.

Bloody hands catching the Yellow Media falling knife

With the recent plunge of all securities of Yellow Media (TSX: YLO) I have decided to get my feet wet in purchasing a small mixture of the C, D preferreds and some convertible debentures.

Suffice to say, this is not a low risk investment. These securities are trading as if very, very, very bad things are going to be happening to the company, if not outright bankruptcy. The winning condition for an investor at these prices is that the company does not declare bankruptcy in the medium term future.

The business story is quite well known. The company is in the throes of a massive reorganization from print to digital and this has created tremendous risk.

The solvency of the company will be tested around the 2013 timeframe, when they face maturities of some of their Medium Term Notes and their credit facility. The upcoming maturities of the Medium Term Notes between 2013 and 2016 are the following (noting the values are as of December 31, 2010 – the company has repurchased some of these notes):

– $130 million of 6.50% Series 9 Notes maturing on July 10, 2013 priced at par, for an initial yield to the noteholders of 6.50% compounded semi-annually
– $125 million of 6.85% Series 8 Notes maturing on December 3, 2013 priced at par, for an initial yield to the noteholders of 6.85% compounded semi-annually
– $297.5 million of 5.71% Series 2 Notes maturing on April 21, 2014 priced at $99.985, for an initial yield to the noteholders of 5.71% compounded semi-annually
– $260 million of 7.3% Series 7 Notes maturing on February 2, 2015 priced at par, for an initial yield to the noteholders of 7.3% compounded semi-annually
– $387.4 million of 5.25% Series 4 Notes maturing on February 15, 2016 priced at $99.571, for an initial yield to the noteholders of 5.31% compounded semi-annually

Yellow Media Inc. has in place a senior unsecured credit facility consisting of:
– a $750 million revolving tranche maturing in February 18, 2013; and
– a $250 million non-revolving tranche maturing in February 18, 2013.

Notably, the credit facility has a covenant of a minimum ratio of Latest Twelve Month EBITDA before conversion and rebranding costs to cash interest expense on total debt of 3.5 times. Obviously if the financial performance of the company continues to dwindle they will be compelled to pay this off before the MTN’s. They have $636M outstanding on June 30, 2011 in these facilities.

The difference in capital structure between the preferred series and the convertible debentures is relatively minor – the debentures are $200M of face value (maturing October 2017) which have priority over the preferred shares. The higher price paid for the seniority is reflected in the fact that an investor is likely to continue receiving coupon payments (until if/when the company defaults on its more senior debt).

Finally, with the sale of Trader Corporation and the net proceeds of approximately $700M, the company will have further financial flexibility to maneuver around its credit facility covenants and be in a position to use its cash to repurchase debt. At current prices, such repurchases will be highly yielding – for example, if the company did a dutch auction tender for its convertible debentures at 40 cents a piece, every million dollars tendered would save the company from $162,500 of pre-tax interest payments.

The other trading note is that the PR.C series of shares has a slightly lower coupon than the PR.D series (6.75% vs. 6.9%), but the PR.D has typically traded at or lower than PR.C prices. There may be a liquidity premium as there are more PR.C shares outstanding. In addition, spreads are quite high until the computer algorithms put in very small bid and asks and since other algorithms are hammering the bid this tends to create quite a bit of price gapping. The last trading note is that every fund manager on the planet will be embarrassed to show these securities in their quarterly statements, so the “window dressing effect” will likely mean that they will be jettisoning their securities before the September 30th date (3 days for trade settlement means they will be getting rid of them by early next week). Since there is a lack of liquidity in the preferred series, this has resulted in dramatic price drops.

I anticipate the common shareholders are not going to be too happy when their dividend will get severely cut again and diluted by the preferred share conversions. However, the company will have to take these drastic steps to save itself and to de-leverage. Deleveraging is always a very, very painful process when it is forced.

I highly suspect that an opportune time to catch the falling knife is very close. Stocks are most volatile at their highest and lowest points and this appears to be a low frenzy. Time to get my hands bloody.

Cosmetic Issues

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