Canadian Fiscal Monitor, February 2010

The government of Canada released its fiscal report for the 11 months ended February 2010, and we continue to see considerable improvement compared to last year’s results:

In the February 2009 vs. 2010 (one month) comparison:
1. Corporate income tax collections are up 31%;
2. GST collections are up 52%;
3. Other excise taxes and duties are up 22%;

Employment continues to be weak; EI payments are up 35% from the previous year. As EI benefits will only last one year, it is likely that during the same period in 2011 that this number will be lower as employment picks up.

The next month will have tentative results that I will make year-to-year comparisons with, in addition to seeing where the government was significantly off with its fiscal projections compared to the Budget 2009 document that was tabled in late January 2009.

Fixed income and rising interest rates

The public perception is that the value of fixed income securities goes down when interest rates rise.

In a sense, this is true, but how it get reflected in the marketplace is different than what the common “retail” perception is. A better way of phrasing this is that the value of fixed income securities go lower when the there is a perception of interest rates rising.

Even though the whole planet knows that the Bank of Canada overnight rate target is 0.25%, the whole world also knows that this will increase by an amount coming June. This expectation has already been baked into the marketplace, and thus in most circumstances it should be baked into the prices of fixed income securities.

Reading the comments on some Garth Turner articles, where Turner is generally pushing preferred shares over GICs, readers are giving “blowback” stating that the price of those securities will drop when rates rise.

In the eyes of the marketplace, rates are going to rise. You can see this in the 5-year Canadian bond rate.

The question is whether the market prices for preferred securities is going to reflect this or not. In any market, you have to ask yourself about the participants, and a lot of preferred issues are dominated by retail traders. In this event, and assuming retail traders think prices are going to go down because of a flawed notion of a price impact with a rate increase, it would suggest there is a dislocation of information that can be exploited.

Preferred shares require a bit extra research than standard equities or bonds simply because they contain varying provisions which gives the holders and company certain rights that have dramatic effects on their risk profile.

Also, the intent of owning preferred shares is to provide income, rather than capital appreciation and this should always be taken into consideration – it is an alternative to putting money in a savings account, rather than a replacement for an equity (growth) component of a portfolio.

A good investor but not a good fund manager

Imagine an investment manager that is so good that they can double their money whenever they put money into the market. However, this manager is only able to do so once every five years and is smart enough to know when he is invested outside his “window of opportunity” he will dramatically underperform the market and thus will go to cash during the rest of the time. This investor would be in the top percentile of all investors by virtue of his ability to obtain a 15% compounded return, year over year (doubling your money every 5 years is very close to 15% compounded annually). However, just imagine if he had a hedge fund and investors piled on board after his first 100% year and reading his annual reports:

Year 1 letter to shareholders – We were fully invested in the market, but have now gone to 100% cash. Our performance on equities has resulted in a 100% increase in our net asset value since the beginning, a very good year. We will look for more opportunities in the future when they present themselves.

Year 2 letter to shareholders – Thank you to the new investors for joining hedge fund XYZ. We have been 100% invested in cash, earning 3% on cash. We have found nothing suitable to invest in.

Year 3 letter to shareholders – We have been 100% invested in cash, earning 2.5% on cash. We still have found nothing to invest in.

Year 4 letter to shareholders – We have been 100% invested in cash, earning 2.75% on cash. We have found nothing to invest in. Believe me, we are trying!

Year 5 letter to shareholders – We have been 100% invested in cash, earning 2.5% on cash. We’re really looking hard for investment candidates, some might be on the horizon soon, but we can’t tell at this moment.

By this time, most of the people invested in the hedge fund would have already exited. “Why bother investing with this guy when he isn’t going to be investing our money?” If the investment manager was working for a larger company, chances are the manager would have been removed, even though he was working in the long-term interest of the fund.

Of course, by the time clients have removed all of their money from the hedge fund, the manager on year 6 sees opportunity and has another year of a 100% return. People, attracted by the performance, come back to the fund in droves, only to witness their money being invested in money market instruments for another 4 years.

This is one of the big advantages that an individual investor has, assuming they are capable enough to hold high levels of cash during significant market downturns. An individual investor does not have to sacrifice their strategy for political reasons (i.e. fear that their clients will pull money out of their fund). This political advantage can be exploited by those with ironclad discipline to hold cash for lengthy periods of time.

It is usually very difficult to measure the performance of these individuals over a short time period – it would have to be measured over a lifetime. The Buffett/Munger partnership is the best example of people that were not afraid to hold onto their cash for opportunistic moments.

Mutual fund disclaimers

Bad Money Advice, written by a fellow that is apparently a Boston hedge fund manager, writes about how useless mutual fund disclaimers are. Specifically, he quotes a study saying that the insertion of the line “Past performance is no guarantee of future returns” has no bearing on the decision to purchase a fund.

This reminds me of trying to legislate warnings against smoking cigarettes – it started with a small warning on the box saying “Warning: The Surgeon General says that smoking is bad for your health”, but it has progressively stepped up to now, where half the package has a picture of some person that hasn’t brushed their teeth in a century and a picture saying “THIS WILL BE YOU”.

You can take it to the ultimate step of packaging them in black boxes called “death sticks” with skulls and crossbones all over them, and it still wouldn’t matter.

Same thing for fund advertising, except consuming mutual funds will only kill you financially.

First Uranium concludes recapitalization

First Uranium has concluded their recapitalization proposal by issuing $150 million worth of notes due to mature on March 31, 2013.

This is a very bitter pill for the equity holders to swallow – they will be heavily diluted by virtue of the conversion privilege attached with the notes, at $1.30/share. Assuming conversion occurs, this will result in 115.4 million shares outstanding more than their existing 166.8 million. In addition, to settle the contractual arrangements with another partner, they will be issuing 14 million shares extra.

All of this means that First Uranium’s existing stockholders, assuming full conversion, will have their holdings reduced to about 56% of the company. However, a significant shareholder (Simmer and Jack with 37% of the prior equity ownership) will also have $40 million of the issue of the notes, which if fully converted, will leave them with approximately a 31% stake.

Probably the only reason why they got into this offering to begin with was to salvage their ownership in the company, which was clearly going to slip away in an upcoming and very messy bankruptcy proceeding.

Gold Wheaton, a company that has purchased a fractional interest in the gold mined from First Uranium, also will be investing $20M and receiving 14 million shares as a result of a settlement on a contract that First Uranium failed to live up to. Assuming full conversion, this will give them about 10% of the company.

The Notes are guaranteed by the subsidiaries of the Company, secured by second ranking security over all assets currently encumbered by Gold Wheaton and first security over all other current and future assets of the Company, not be redeemable until maturity.

Assuming First Uranium will remain above $1.30/share, their recapitalization should be half done.

The other medium term issue for First Uranium, other than the establishment of its mining operations (and subsequent cash flow that would be produced by such operations) is that they have a $150 million issue of unsecured debentures that are due to mature on June 30, 2012, which I so happen to be holding.

First Uranium has a few options.

One is that they should be prioritizing their operations to be cash flow positive, which will make it easier to float another equity or debt offering that the market will be receptive to, enabling them to pay the subordinated debentures.

Another option, concurrent to the above, is that they have the option of paying off the debentures in shares of common stock at 95% of market price; at current market prices of $1.45/share, it would involve issuing another 109 million shares, for a grand total of another 27% dilution of common shareholders. This option will be progressively more attractive as the common share price goes higher. Such an action would be done in 2012.

Another solution is to renegotiate directly with the debtholders and sweeten the terms of debt (i.e. increase the coupon, lower the conversion price) in exchange for an extension of maturity date. This would require ratification of 2/3rds of the debtholders.

Ultimately if the company doesn’t pay up, the unsecured debtholders can force the company into bankruptcy. While their rank in the company, by virtue of subordination to this new issue of debt, will lead to low recovery, it is unlikely the owners of the company would want to proceed with this action and thus it is more likely than not that between now and the 2.2 years to maturity that there will be a way found to make the June 2012 debtholders whole. Simmers and Jack would not want the subordinated debtholders to pursue the “nuclear bankruptcy” option and thus it is more likely than not there will be a solution.

I do not believe First Uranium equity is a good risk at present prices, while I think the June 2012 debentures have probably priced in the right amount of risk and would present themselves as a speculative high risk opportunity.