The Crypto crash – Luna!

(Update, May 14, 2022: Lots of educational comments given to this article – much thanks everybody)

Long-time readers of this site know I have not been a fan of cryptocurrency.

This might be a bit of sour grapes on my part since I’ve been writing about Bitcoin since 2011 (yes, when it was still US$10/coin) and wasn’t a fan back then, and still am not today other than strictly the amusement factor of seeing people attempt to trade it.

Back in 2011 when Bitcoin was the only game in town, I wrote the following:

There is also the issue of “counterfeiting”, even if the bitcoin system is technically secure. One problem is that you can create an identical digital currency and call it something different. So in this essence, counterfeiting is a very relevant concern – not direct counterfeiting, but copy-catting. Bitcoin does have a “first mover advantage” which may mitigate against this.

I try not to pay much attention to the sector, but I have been amused to know that many asset managers out there consider cryptocurrency to actually be an asset class that one should keep in their portfolio at some low fraction of assets, like the arguments one would make for holding precious metals. There have also been other developments such as the concept of “stablecoins”, and crypto algorithms that apparently guarantee payouts, etc. I have not kept up to speed on the specifics of the developments and have generally tried to quarantine my brain from it, similar to how I would regarding the trading of Gamestop equity.

But this one really caught my attention – the demise of this cryptocurrency called Luna.

It is my understanding that Luna was tied to another cryptocurrency called Tether (May 14, 2022 edit: Terra), which itself is apparently backed by actual US Dollars in some bank somewhere (audit confirmation pending!). The difference is that Luna apparently pledged that you can get a 20% return by investing it in. Please be warned I could have gotten this completely incorrect, but if it is the case, wow.

So I dredged up a chart of Luna and saw the following:

At one point in the history of Luna, they had a market capitalization of US$775 trillion. Wow. Just wow! Am I reading this correctly? Somebody please educate me in the comments! (May 14, 2022: It wasn’t in the trillions, but in the few tens of billions. Apparently the high number of coins outstanding were automatically created by its algorithmic link to Terra)

What the heck am I doing investing in stocks? Time to go fully into crypto for the next Luna – whether this will be long or short, who knows!

Bank of Canada speech – headline vs. reality

Globe and Mail: Interest rate trajectory will depend heavily on housing market, Bank of Canada deputy governor says

Bank of Canada: The perfect storm

Quite the difference!

Read the speech itself, and THEN the Globe and Mail article – by reading the news article first, you expose your brain to potentially getting swept away into some narrative which may or may not be a reflection of the intended communication.

Going to the speech:

As a result, we expect the recent increase in commodity prices to boost the level of business investment in Canada by less than half of what our models generally predict based on historical relationships.

All in all, the commodity price shock is expected to generate a modest positive impact on the growth outlook for Canada—smaller than we have seen in the past.

The Bank of Canada is surprised that commodity companies are contributing less in capital investment despite the price environment. I wonder why!

More importantly, a slowdown in growth does not have to mean high unemployment, which was the hallmark of the stagflation period of the 1970s. Right now, job vacancies are very high, which means employers are trying to hire still more workers from a declining pool of labour. By cooling overall demand, we can reduce the demand for labour and the degree of labour shortages in the economy. Employers could stop looking for new workers but keep the ones they have—with little impact on the unemployment rate. That is a scenario that delivers a soft landing.

Good luck! This is like the macroeconomic equivalent of trying to thread a needle while wearing heavy-duty construction gloves.

First, what might lead us to pause our policy rate increases as the rate enters our estimated range for neutral of 2% to 3%?

Now we will get to what caused the Globe and Mail headline to print:

Another factor that might lead us to pause is that many households have taken on more debt to get into the housing market. At the end of 2021, the household debt-to-income ratio was 186%, above the pre-pandemic level of 181%. And rising interest rates are designed to slow the economy by making borrowing more expensive. That tends to slow sectors like housing. But this slowing might be amplified this time around because highly indebted households will face high debt-servicing costs and will likely reduce household spending more than they would have otherwise. Our base-case scenario includes a slowdown in housing activity. But we could see a larger-than-expected slowdown due to higher indebtedness and unsustainably high housing prices.

There were a whole bunch of reasons rates will level off at the “neutral rate”, and reasons why rates would continue to rise, but the Globe and Mail cherry-picked this paragraph for their desired headline.

I’ll leave it up to you to digest the rest of it. The important signal of this speech is that we will see central banks give out this “Well, there is going to be a limit to rate hikes” mantra which will attempt to stop what has been a slow motion stock market crash in recent months. The Federal Reserve is likely to follow suit with their forward guidance (‘speeches’).

The reach for liquidity

The Federal Reserve has raised 75 basis points since last March and the markets have already gone into a liquidity seeking mode, purely on the basis of setting expectations of increasing interest rates. There is an implied expectation of another 200 basis points worth of increases in the next year but this expectation has already traded down as the markets have tanked.

Recall that the amount of cash in the system does not materially change in any given day. Only the asset price changes on any given day.

When participants want to pay off their debts, they have no choice other than to seek liquidity in their assets – convert the asset into cash. Globally, this has been reflected in the mass depreciation of other currencies, including the Euro and Japanese Yen:

The Canadian dollar, by comparison, has had limited depreciation, presumably due to our trade links and also commodity export:

The underlying point is that the markets are seeking liquidity, and specifically US dollar liquidity. This has had a negative effect on the entire market, including precious metals (Gold and Silver have been sold down during this process – people want the US dollars and not the shiny metal stored in their safes!).

The one commodity that has exhibited signs of stability has been energy – oil and gas has retained most of their value during this market meltdown. This may not continue – if the rest of the market causes consumption of fossil fuels to decrease beyond the ability to supply them to market, then energy prices will drop. There is a huge amount of margin of safety in energy equities at the moment (e.g. Suncor at half of the current price for spot oil is still profitable with dividend intact) but clearly a continued high commodity price environment coupled with low equity prices is the formula to accelerate returns through cheap share buybacks.

Most technology companies, especially unprofitable ones, have been slammed in the past half year. Most of them, even the ones trading 75%-80% below their November 2021 peaks, in my estimation still have rich valuations. That said, markets are volatile beasts and there could be a lot of “regression to the mean” type of investors coming up given the carnage seen in the marketplace. I don’t have much commentary other than that if you were leveraged long on companies like Palantir from last November, chances are at around this point you would have been cleared out of your margin account. Don’t even get me started on the amount of leveraged capital that must have been present and taken a severe bruising in the cryptocurrency space!

First quarter review of oil and gas – and a look at Suncor

This is a brief review of the companies that have reported their quarterly results to date in the oil and gas space – specifically the ones in the Divestor Canadian Oil and Gas Index. (ARX, CNQ, CVE, MEG, SU, TOU, WCP have reported).

When your spot commodity exposure charts look like this, you know things are looking good:

The amount of bullishness out there in the previous week was a bit nuts and ripe for a correction. When markets ascend for this much time for this duration, there is a natural process where momentum and technical analysis players get cashed out, regardless of any fundamental underpinnings.

The financial market moves much, much, much faster than what goes on at a glacial pace in reality. While the amount that has evaporated out of my portfolio in the past week is impressive, it goes with the nature of finance that things will indeed be volatile, but the intrinsic value of the portfolio remains intact, reflected by real-world economics instead of financial economics.

All of the companies in the oil and gas index have been reporting record free cash flows, but most notably all of the players have been quite tight on growth capital in the sector – the free cash flow for the most part has gone into debt reduction, dividends and share buybacks. Now that most of these companies have reached their leverage targets, they are now continuing to deploy more cash into share buybacks, or (in the case of TOU) special dividends.

The financial mathematics of companies giving off sustained free cash flows (key word being ‘sustained’, noting that fossil fuel extraction is a cyclical industry) is interesting to analyze. I will use Suncor as an example.

Suncor guided in Q1 that their income tax payments will go up from the lower $2 billion range to $4 to $4.3 billion (note that income tax is a function of operating income minus interest expenses and after the removal of royalties, which is another huge layer of money given to the government!). Suncor does not have a material tax shield so they will be fully paying cash corporate income taxes. The Canada and Alberta corporate tax rate combined is 23%, and they have other operations in other provinces and overseas, so we will assume 23.5% as a base rate, which puts Suncor at $17.7 billion in pre-tax income ($13.5 billion after-tax).

Those with an accounting mindset will ask whether net income translates directly into free cash, and Suncor’s capital expenditures are roughly in line with depreciation. My own on-a-paper napkin free cash modelling also corresponds roughly to this $13.5 billion amount in the current commodity price environment.

Suncor has 1.413 billion shares outstanding as of May 6, 2022, so the upcoming year of income is $9.55/share. Suncor trades at $44/share as I write this, and has an indicated quarterly dividend of 47 cents per share ($1.88 annually). Although management has hinted this will go up over time, for now let us assume it is a static variable.

Deciding between debt reduction, dividends and share buybacks usually are a dilemma, but when the math is this skewed it is not.

Suncor’s debt currently costs them about 5.25%, or 4% after-tax. A share buyback not only alleviates the company from paying out the 4.27% dividend, but is also purchasing a 21.7% return on the equity.

This is a no-brainer decision from an optimization standpoint – every penny after regular capital expenditures, should go into a share buyback. The dividend should be brought to zero and shares should be bought back with that amount instead, until such a point where the return on equity goes below a particular threshold (my own personal threshold if I was calling the shots at management would be 12% or anything below $80/share in the current price environment!).

However, there are other variables to consider.

One is that the commodity price environment might not (and indeed is very unlikely to) last forever. There is a pretty good case to made that this particular price environment will last longer than most (instead of spending on capital expenditures like drunk sailors, companies across the grid are shockingly being very disciplined about limiting the amount of growth in production), and also the margin of error of the price level itself is quite high – West Texas Intermediate is at US$100 and even if it goes down to US$75, my models still have Suncor making around $8 billion in free cash. My $80 threshold price for share buybacks would drop to $47/share in this scenario – very close to the current market price.

So the argument to reduce debt is not out of financial optimization, but rather reducing the brittleness of the financial structure of the company. Hence the decision to allocate the residual 75% of free cash minus capital expenditures and dividends to debt reduction, and the other quarter to share buybacks. Although it is not financially optimal if you assume the current environment exists, it is a safe decision. They will do this until they go to under a $12 billion net debt position, which will happen at the end of Q3/beginning of Q4. (Note that Suncor introduced a new conservative fudge factor by adding in lease liabilities into this definition which inflates the net debt number).

After they reach the $12 billion net debt figure, then 50% gets allocated to debt and 50% to the share buyback. At the current commodity environment and share price, they will be able to complete nearly the 10% full buyback with this regime. After they get down to $9 billion in net debt, then the debt reduction goes to 25% and share buyback will go to 75%. I just hope that management has the prudence to taper the buyback and increase the dividend if their share price gets too high.

The other variable is the dividend. While the tax inefficiency of dividends are well documented elsewhere, it does provide a “bird in the hand” component to the stock, and also gives the buyback itself some metric to be measured against. While other people consider a dividend to be very important, I am agnostic about a particular dividend level, except in context of alternatives.

Obviously if a company has capital investment opportunities, you do not want to see a dividend. You instead want to see them deploying this capital in productive ventures. However, in the fossil fuel industry, there is a very good argument to be made to just keep things as-is and just go on cruise control – this is exactly what is happening for all of these companies. They are paying down debt and allocating cash to dividend and share buybacks, especially when all of them are giving out 20%+ returns. There is no reason not to.

The ultimate irony here is that in such an environment where cash flows are being sustained, it works incredibly in the favour of investors that the market value of these companies remains as low as possible, to facilitate the execution of cheap share buybacks.

This leads me to my next point, which is that it does not take a CFA to realize that on paper, many of these oil and gas companies are perfect candidates for leveraged buyouts. Only the perceived toxicity of fossil fuels and ESG has prevented this to date, and I am wondering which institution will be making the first step in outright trying to convert a leveraged loan (even in the elevated interest rate environment, they can get cheap debt) to buy out a 25% cash flowing entity. It is inevitable at the current depressed market prices.

The first warning shot on this matter (which is cleverly disguised as a strategic performance improvement scheme) comes from Elliott Investment Management’s Restore Suncor slide deck. They can’t outright say what they’re thinking – let’s LBO the whole $60 billion (market value) firm!

Needless to say, an investor in this space makes most of their money “going to the movies”, as Warren Buffett said about one of his earlier investment mistakes (selling a company too early). I think this will be the case for most of the Canadian oil and gas complex.

What, stocks can go down too??

The jaw-boning of the central banks (every word out of the Bank of Canada and Federal Reserve are both to the tone of interest rates to rise forever) have finally had their desired impact – a suppression of demand in the asset markets, which will likely transmit itself to the overall economy, lessening inflation rates.

They’ll probably shut their mouths at some point in time when enough damage has been done. This is reminding me of the trading that occurred during the year 2000 in the Nasdaq – an incredibly volatile year, and the Federal Reserve at that time had the issue of how to withdraw its liquidity stimulus that it pumped into the market in 1999 (remember Y2K?).

Most of the technology starlings, including Shopify (TSX: SHOP), and the like are all sharply down over the past half-year. Psychologically speaking, for those that have held the stock anytime from April 2020 to today, they are now underwater. For those that bought in 2021, they are down roughly 75% on average. How much pain can they take before cutting out?

This is the challenge of investing in companies with projected cash flows in the far future – with Shopify, you have to take a shot in the dark as to when you’ll actually achieve a return on investment (i.e. the company generates positive cash flows which can be subsequently distributed to investors):

This re-rating of Shopify’s future non-earnings, coupled with the speculatively suppression of higher interest rates, clearly has had a very negative effect.

I am just picking on Shopify because it is Canadian, but this is also exhibited by all sorts of other technology darlings of the past. Today, for example, Palantir (PLTR) has been hammered 20%, on the basis of a very tepid quarterly earnings report (which more or less reported a break-even quarter which had all sorts of ‘adjustments’ to claim a positive free cash flow balance).

Don’t get me started on the effect of rising interest rates on cryptocurrency, where you’re going to have every investor on the planet realize that Bitcoin has a carrying cost (why hold onto BTC for zero yield when you can give your money to the Bank of Canada for a year and get 2.5% out of it for nothing?). You don’t hear too much about the scarcity of available Bitcoins these days! We’ll see if Michael Saylor at Microstrategy (MSTR) is forced to liquidate his stack of 129,218 Bitcoins and if so, that will be the margin call of the year for sure. One look at MSTR’s balance sheet and you do not need to be a Ph.D in corporate finance to figure out that his leverage situation is even more precarious than Elon Musk’s reliance on Tesla stock being sky-high.

In these environments, however, the best cliche used to describe things is that babies get thrown out with the bathwater. There are companies out there in the technology field which get lumped in with all of the ETF selling (go look at the holdings of ARKK here!) that do have value (beyond the obvious such as the Microsofts of the planet which will continue to have vast earnings potential due to their wide moats).

However, current free cash flows speak volumes. Companies trading under 5 times free cash flows are going to make mints for their shareholders by continued purchases of their own equity, and for those companies generating cash, shareholders should be cheering for continued lowering prices to generate excess future returns. Those that have prudently managed their balance sheets will be in a much better position to be opportunistic.

Finally, a word for those thinking that commodity investing is a one-way ride – in markets, nothing ever is! Yes, this includes Toronto residential real estate. There has been a lot of what I call ‘energy tourists’ and they have latched onto many of these stocks during earnings time (fossil fuel companies in Q1 have reported insane amounts of profits). There is an urge by many to over-trade and to shift portfolios away from quality into more speculative names (various < 50,000 boe/d with operations of more questionable characteristics) in order to torque up their return profiles. In a rising market, it is the lower quality companies that tend to exhibit the higher percentage gains, while in a flat or declining market, it is the quality firms that will have the sticking power. Stick with quality. It will let you sleep better at night in times like these, much more so than a pre-build contract for a 450 square foot Toronto condominium.