The crazy times we live in

Another miscellaneous ramblings post.

Let’s play a mental game. Imagine if you lived in a world where the public markets consisted of only the following choices: AMC, Bitcoin, Canopy Growth, Gamespot, Microstrategy, Nio and Tesla.

There would be little purpose in investing in the public markets beyond gambling. It would more or less be a zero-sum casino for the most part (until, at least in the short term, Gamespot and AMC went bankrupt). Perhaps the public would feel more “secure” investing in a “index ETF” that would be a “well diversified basket” of these companies, but of course since they are usually capitalization-weighted, it would be like splitting your money between Tesla and Bitcoin. Who reads the fine print on these ETFs beyond their titles anyway?

Today that leads me to the next point of Tesla getting in on the Bitcoin zero-sum game bandwagon – Michael Saylor (Microstrategy) is the big winner here. However, note that $1.5 billion for Elon is approximately 0.2% of Tesla’s market capitalization, while it is more than what Microstrategy invested (at cost) into Bitcoin. I’d be really curious to know what would happen if Tesla decided to float a $5 billion convertible debenture (which would receive a very low coupon rate because of the huge implied volatility in the stock’s options) and dumped the proceeds into Bitcoin – who else would be compelled to jump in, fearing the miss-out on the bandwagon?

The good news is that because a bunch of capital is being thrown at a zero-sum asset doesn’t mean that I have to. Fortunately there are more than two options to invest in the public markets beyond Telsa and Bitcoin.

Let’s play this mental game again, and throw in some boring, relatively unremarkable positive income/cash generating company that has a very high probability of being around for the next 50 years: Fortis (TSX: FTS). What happens? Almost by default, the “natural valuation” of Fortis will rise because of the contrast provided in comparison to the other companies. Believe it or not, there are some people out there investing in publicly traded securities not for gambling purposes.

The point is that we have multiple currents flowing in the public equity ecosystem – those that get most of the attention (the Teslas and the like) versus the ones that creep a thousand feet under the surface. Right now there are enough of them, but even they, to a large extent, have been recipients of financial attention due in part to the monetary environment (low rates) and the availability of automated data screening to find them out (just imagine in Warren Buffet’s growing up days where you had to write into companies to obtain their financial statements and this was the only way to discover they are trading at 3 times earnings).

Investing in part is a choice of alternatives and priorities. If you want immediate safety and liquidity, there is cash. There used to be the GIC/government bond option for those that wanted to make a small return on their cash, but this choice is now more or less gone. You can speculate on commodities (gold, silver, oil and gas, etc.) but the underlying commodity does not give a return, although it should retain some form of value because there will be future demand. Finally, there are stocks and they provide a huge range of risks and potential rewards. I am just thankful the stock market still has companies that are trading well under the radar of the Reddit and Robinhood retail traders!

Divestor’s Canadian Oil and Gas Index

This post is for future reference.

In general, the status of Canadian oil and gas (no doubt due to ESG investors, coupled with our federal administration) has suppressed asset prices to the point that is reminding me of how Philip Morris was trading in 1999-2000 (single digit free cash flow multiples). Needless to say, I think we are in the early stages of a mean reversion process.

I introduce Divestor’s Canadian Oil and Gas Index (DCOGI), which covers a good swash of upstream production, and some downstream as well. It is a pretty simple index which covers most of the Canadian oil and gas production, and some downstream refining –

20% of: CVE, CNQ, SU
10% of: TOU, WCP
5% of: ARX, BIR, MEG, PEY

I will set the index at 100, and construct it off of a notional index of $1M invested at the prices closing February 5, 2021. No rebalancing. Dividends/distributions will NOT be reinvested but cash drag will be tracked. I’ll post more details of the index composition this weekend and track it periodically.

(Update, December 14, 2021 – I have posted a Re-Balancing Policy)

Update at the end of the trading day:
Ticker – Shares:
ARX – 7,426
BIR – 20,325
CNQ – 6,196
CVE – 24,600
MEG – 8,993
PEY – 10,482
SU – 9,066
TOU – 4,662
WCP – 19,048

The index performance can be viewed here!

The most profitable industry on the planet

At this time, the most profitable industry has to be mortgage insurance in Canadian real estate markets.

Genworth MI (TSX: MIC) reported Q4 earnings.

The loss ratio reported was 10%. The expense ratio was 21%.

This means out of every dollar recognized in revenues leads to 69 cents of pre-tax profit.

Needless to say, this is a gigantic amount of economic extraction from an industry that is somewhat protected (by virtue of the federal government taking the mountain’s share of profits through CMHC).

It is funny how the public hasn’t connected the dots on how this makes borrowing with large-ratio mortgages extremely expensive – a 10% down mortgage can incur a 3.1% mortgage insurance fee. While 3.1% may not intuitively seem expensive, it is a huge fee considering that the bulk of the risk of default in a mortgage occurs in the first 5 years (where in a typical 25 year amortization, about 15% of the loan is amortized) while the rest of the time period is generally “home free” for the loan provider. This effectively results in a 60bps accretion to a loan’s profitability (compare that to a bank that makes less spread than that on the mortgage loan itself!).

Brookfield is in the very late stages of taking MIC into its fold at CAD$43.50/share. At the rate they reported net income in 2020, that works out to about 8.5 times earnings.

Normally industries with such large profit margins attract competition. The barrier to entry is access to the Government of Canada guarantee (CMHC gives a 100% guarantee, backed by the Crown, while MIC is 90% guaranteed by the Crown, with the residual guaranteed by their shareholders), and access to the mortgage networks (which can give approvals based off of customer profiles). Not an easy industry to crack for a new entrant, and the only real basis of competition would be price.

Enbridge Line 5 and pipeline politics

It is going to be very interesting to see what happens with Enbridge and Line 5.

The reason why the Federal Government cares about keeping Line 5 operational is because it processes about half of the crude oil that is refined for southern Ontario and Quebec. You can take a car to Sarnia and see the refineries.

A shutdown of Line 5 would, needless to say, be very disruptive for the region. There isn’t a good way to get additional capacity into the area – the other routes are fully utilized.

The federal government only cares about what is good for, roughly, the traditional boundaries of Upper and Lower Canada. Any policies that are tailored for areas away from this geography is strictly coincidental.

Thus, the Keystone XL cancellation was of little concern to Ottawa. The usual lip service of condemnation by politicians, when it is so obvious they don’t mean it.

I am still somewhat mystified today that the federal government bought out the Transmountain pipeline project – most people do not know that there is an existing (profitable) pipeline in place. Its existence does not matter an iota to Ottawa.

Line 5, however, is different. It fuels Ottawa’s core geography.

It was not longer than a decade ago when this strategic and political vulnerability was identified and hence the Energy East project was conceived. After the Liberals got into office in October 2015, they proceeded to kill the project with a never-ending wall of regulation.

We fast forward today and see where such lack of strategic thinking is par for the course in Canada.

It is not my job to moralize about the inadequacies of government thinking, but rather to pick out winners and losers.

I am still puzzled why so many people are in love with Enbridge as being a staple in their yield portfolios. There is far more risk than they imagined.

The sentiment will change when there is a real connection between very poor decisions and actual hardship experienced by people. The lag between the two, however, could take many, many years and attribution of blame may be misdirected.

Likewise, few lament over how much richer we could have all been, collectively as a society, had we had our act together to begin with.

Politicians, however, are not rewarded for making optimal or efficient decisions. In fact, they have a gigantic incentive to not solve problems, lest their purpose of existence be threatened.

Dorel’s going private takeover bid increased

Dorel (TSX: DII.B) was in the process of going private. Their previous bid had been CAD$14.50, but today they announced this will rise to CAD$16.00.

This post is not to discuss the valuation of the offers, but to highlight a trend of increased bids:

Rocky Mountain Equipment: CAD$7.00 -> CAD$7.41
Great Canadian Gaming: CAD$39.00 -> CAD$45.00
Dorel: CAD$14.50 -> CAD$16.00

Dorel’s bid was already somewhat anticipated by the market, where at around Christmas they started to trade over the CAD$14.50 threshold:

One can have hope for Atlantic Power, but I’m not holding my breath!