Bank of Canada sending out a warning signal

The Bank of Canada kept their target interest rate steady at 1%, but ominously sent out a signal as follows:

Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be withdrawn, consistent with achieving the 2 per cent inflation target. Such reduction would need to be carefully considered.

The Greenspan-esque interpretation of the tea leaves will point out that prior wording stated “eventually will be withdrawn” while this press release states that it is approaching if the rest of the financial world does not implode.

When reading the more detailed Monetary Policy Report, two charts came to mind:

Total CPI is increasing significantly – it is no surprise to hear this as commodity prices continue to shoot up like a rocket and prices are passed along the supply chain.

Finally, BAX futures shot down for the year-end interest rate – at 98.46 (1.54%) compared to 98.61 a week ago. This is projecting a near-certainty of a 0.25% rate increase by years’ end.

If short term interest rates rise and the yield curve continues to flatten (10-year rates are still at 2.89% even after the bank rate announcement), this will start to have interesting effects on “yieldy” equities as the leveraged bet starts to become less profitable. There are also implications for the real estate market that I won’t be getting into at this time.

Shaw and Netflix – Bandwidth vs. Content

This is probably old news to a lot of people, but I’m awfully curious how the competition dynamics between Netflix vs. the bandwidth providers (e.g. Shaw/Rogers/TELUS) will play out. Shaw announced a streaming movie service recently.

I look at a company like Netflix (Nasdaq: NFLX) and ask myself how many more legs the company has before it starts to hit a competitive wall like TiVo (Nasdaq: TIVO) did.

I’m not going to call winners here, although I am quite aware that it is necessary for bandwidth providers to exist in order for companies like Netflix to exist; the question is where is the most profit to be obtained in the value chain? Is it about the bandwidth, or the content?

The biggest pure play on bandwidth has to be Level 3 (Nasdaq: LVLT), which has successfully been losing money since its history and is a darling of Southeastern Asset Management and the Canadian Berkshire-equivalent, Fairfax (TSX: FFH).

Time will tell, but I’m sticking to the sidelines.

Microcap fishing – Audiotech Healthcare, Spot Coffee

I have spent the better part of the day doing some screening and research on microcap companies (generally those with market capitalizations of under CAD$50 million). I discarded most of the energy and mineral-type firms as these firms are generally impossible for third-parties to get any sort of edge on.

Finding good microcap companies reminds me of the process of mining for bitcoins – you can spend hours (and days) doing it, but still end up with nothing. That was pretty close to what the last half day of my life feels like.

When doing some intermediate analysis on 9 companies, one managed to clear the necessary thresholds for “interestingness” on my watchlist, although this was not a case that screamed at me as a company that will see 5-fold increases in its equity prices. It would be considered a value play. I set a price target that was roughly 20% under what it was currently trading as this would be a valuation that I would be interested in doing some more extensive due diligence for a potential purchase (although it would be a small allocation if it ever got to that point). I will receive an email if it reaches this price threshold.

However, there were two interesting “discards” that I will share.

The first company is Audiotech Healthcare (TSX: AUD), which operates a few hearing clinics in more remote areas of BC, Alberta and the USA. They are family run and family-controlled and stable and profitable. Their balance sheet is in OK shape, with sufficient cash on hand to cover upcoming debt maturities and otherwise not polluted with massive goodwill (indeed, none). Management is relatively respectful of shareholder value (likely due to its significant economic interest in the company) and related party transactions are at an acceptable level (the worst of it is a dead real estate lease in Calgary which will likely be off the books soon). Valuation is relatively cheap, with recent business performance in the last fiscal year producing $347,000 in free cash flow on a (undiluted) market capitalization of $2.38 million. They are ripe to go private or to be consolidated by a larger player.

Unfortunately, their shares are completely illiquid. With $10,000 in volume traded over the past 30 days, a single trader can probably take the stock price up 50% in a day. Hence, this company is in the “interesting but not practical” list of investment candidates.

The next company that I had to do a double-take on is a little more strange. Spot Coffee (Canada) (TSX: SPP) operates coffee franchises, not too dissimilar from Blenz, Waves, Second Cup and Starbucks, in locations in Western New York state, Toronto and one location in Florida. The only difference is that they appear to be larger scale than the typical Starbucks chains and they also serve slightly more complex food offerings.

What is particularly strange is that when you read the management/director biographies, you ask yourself “What the heck are these people getting into this business for?”. I will post the following from their most recent management information circular and let you come to your own conclusions:

The company itself seems to be financed mostly with equity, with the company raising equity capital through private offerings as the need arises. The last private placement was at 10 cents per share for $500,000 and warrants to purchase shares at 15 cents a piece expiring in 3 years. The current market value is $8.6 million and 13.5 cents per share. Operationally they are losing money, but this is due to the lack of economies of scale associated with having such a geographically dispersed operation and relatively low numbers of operating coffee shops.

Gross profit margins have been improving – the most recent quarter being 73%, which is a good improvement over the previous year. Presumably if they manage to scale up their sales in other locations they can actually start to make money, but I haven’t bothered doing the breakeven calculations. This is investing in an industry that is already well established.

Although I won’t be touching the equity on this company, something makes me suspect that this company might be the recipient of some “hype valuation” if they continue opening more stores, sort of akin to Caribou Coffee (Nasdaq: CBOU).

That concludes my investment research for the day – little to show for it.

Interest rates show nothing exciting

Government 10-year bond yields are sitting at 2.95%:

December BAX Futures are at 98.61; with the current 3-month banker acceptances at 1.20% (98.80), there is a moderate expectation of a 0.25% rate increase. However, I do not believe this will come to fruition and it is highly likely the Bank of Canada will continue to keep the short term target rate at 1% until such time that 10-year yields rise above 3.5%.

Since the markets are awash in liquidity and credit is very cheap, investors will continue to chase yield. When will this party stop? If I gave you a million dollars for 10 years at 2.95%, do you think you can do better? I’d take all the money I could at that rate and fixed term.

Keeping currency conversions factored

It should be on the back of an investor’s mind that the appreciation or depreciation of US currency is a significant factor in commodity pricing – as the US currency as depreciated significantly over the past 10 years, this has lead to disproportionate increases in commodity prices when you scale the charts for Canadian currency. Over the past year, the Canadian dollar has scaled up 10% against the US dollar:

When looking at increases in gold and oil pricing, the change is less dramatic when priced in Canadian dollars:

Spot WTIC Crude in Canadan Dollars
Spot gold in Canadian Dollars

I have been looking at my US dollar exposure and have generally asked myself why I have kept any exposure at all and simply not hedged myself. One reason is that I don’t have a clue how to predict currency movements. There always seems to be more variables at play than one would typically think (interest rate, economic, stability, geopolitical factors to name a few). The other reason is that Canada does 75-80% of its trade with the USA. As long as we have this much economic exposure to the USA, the US currency will always be a relevant factor in a Canadian’s life.

Finally, one might actually think there will be a faint hope and that the USA will get its own domestic economic act together. I know such thoughts are stunning and frightening to even assigning an above-zero probability.