Hiccups in the broader markets

The S&P has more or less been on an uphill trend for the past 3 months. The last major incursion to the prevailing market trend was in June, which shook out the people with low amounts of conviction. Since then, the people that have cashed up during Covid (“let’s wait for a vaccine”, “let’s wait for case rates to go to zero”, “let’s wait for the presidential election to conclude”), etc. have been staring at stock charts of companies like Tesla, Microsoft, Zoom, etc., all rising in price. During the three month process, the temptation to buy becomes too much (“let’s board the train”), and that also starts attracting unsophisticated retail investors (Robinhood traders) into the mix.

There is still a lot of cash on the sidelines, and there is still a lot of pessimism out there in regards to Covid and the general state of the economy, so this cash will be the ultimate backstop to the markets.

However, once in awhile, the markets need to exhibit a “shake-out”, where confidence is obviously lost, and the sentiment turns short-term negative, such as the moment we got yesterday and today – what’s happening is that equity holders with less conviction are taking gains and this creates its own stampede of people that have decided that taking gains on the past three months of performance is “good enough”.

Note I haven’t mentioned a thing about valuation in this post. Of course companies like Apple, Microsoft, etc., are trading at elevated ratios. Where else are you going to stick your capital, 30-year US treasury bonds yielding 1.4%? Of course companies like Zoom and Tesla are over-valued, but over-valuation alone is not a sufficient condition for going all negative on the S&P 500. Indeed, if the entire S&P 500 index were to collapse 25% in the next week (without a corresponding change in interest rates), you’d have the media shouting about how everything is going to hell, but privately within the halls of pension funds and institutions, would be a pretty good chance to deploy cash into equities.

The underbelly of the high profile, high-PE, high capitalization stocks still shows a market that is relatively stable and doesn’t appear excessive.

I’m guessing this hiccup will be a two week ordeal, especially when combined with presidential election antics. Panicked hands will bail, and when they’re finished, we’ll begin the slow march up against the wall of worry.

Indeed, the implied volatility of the S&P 500 has spiked, where the short term contract (mid-September expiry) is hovering around the 35% mark, while the October contract is at 40%. This massive diversion is due to the anticipated effects of the US presidential election on equity markets.

In general, I would be a seller of volatility going into the election.

Finally, this is not to say there will be economic headwinds that will cause issues in the marketplace. But this is going to be a 2021 story, not 2020. All of this nearly free money provided through quantitative easing, central bank asset purchases, and the provision of massive government fiscal deficits will have consequences. The analogy is that the shot of meth has been given to the patient and the patient has been feeling really good. But this high only lasts for so long before you either have to pump up the patient again, or let the patient sober up.

Just Energy – the conclusion to the recapitalization

In regards to Just Energy (TSX: JE), after a suspenseful suspension of the recapitalization proposal meeting, a couple days later an agreement with substantially most of the shareholders and debtholders was struck.

On August 26, there was agreement to amend the following:

* pay accrued and unpaid interest in cash on the Subordinated Convertible Debentures until closing of the Recapitalization,
* issue C$15 million principal amount of new subordinated notes (the “New Subordinated Notes”) to holders of the Subordinated Convertible Debentures, which New Subordinated Notes will have a six-year maturity and will bear an annual interest rate of 7% (which shall only be payable in kind semi-annually),
* pay certain expenses of the ad hoc group of convertible debenture holders, and
* issue approximately C$3.67 million of common shares by way of an additional private placement to the Company’s term loan lenders at the same subscription price available to all securityholders pursuant to the New Equity Subscription Offering, proceeds of which will partially offset the incremental cash costs noted above.

All other terms of the Recapitalization remain unchanged.

The cash interest payment will save the debentureholders about (JE.DB.C) 1% and (JE.DB.D) 3% of par, and the $15 million debt issuance, assuming par, will be another 6 cents on the dollar. Debentures did jump up by a factor of 2 upon the recapitalization, and so did the preferred shares – clearly both classes were anticipating a CCAA proceeding.

The common shares also jumped upon the news, but traded lower from the morning spike throughout the day after approval.

Now, what is odd is that the news of the amended terms of recapitalization, coupled with the voting support agreements came by way of press release on August 26, at 8:27am, eastern time. The actual approval came on August 27, 5:32pm (after market close). On the morning of August 28, trading spiked up. There was a full two trading days where if one was alert, you could have sucked up a few bits of liquidity on the common shares and debentures:

Volume, August 26:
JE: 505,700 shares, VWAP 0.4315
JE.PR.U: 41,000 shares, VWAP 0.9997 (note: par value $25)
JE.DB.C: 113,000 par, VWAP 16.687
JE.DB.D: 139,000 par, VWAP 16.22

Volume, August 27:
JE: 349,850 shares, VWAP 0.4023
JE.PR.U: 100 shares @ 1.16
JE.DB.C: 93,000 par, VWAP 17.442
JE.DB.D: 18,000 par, VWAP 16.914

Dollar-wise, while we’re not talking about gigantic amounts of money, but for the small guppies out there, you could have made quite a few sushi dinners out of the gains from sucking up 5-10% of the average volume. Sadly I was asleep at the switch as well.

No positions, but this was rather fascinating to watch.

Apple – assimilating the S&P 500

Look at this chart since the COVID crisis period (March):

With a market capitalization of $2 trillion, they are now 6.75% of the S&P 500. You buy $100 of S&P 500, $6.75 goes into Apple automatically, without regard to its price.

Along with Microsoft, Google, Facebook and Amazon, that’s 23% of the index in 5 companies.

This is a well known fact. However, portfolio managers that are measured by performance relative to the S&P 500 will find it difficult to keep up if these five companies are the only ones appreciating while the rest are stagnating – so they’ll hedge by putting 23% of their assets in these five while playing the stock market with the other 77%.

Eventually this assimilation of the S&P 500 will get so large that the numbers become truly ridiculous – already rationalizing a $2 trillion market capitalization on an annualized net income of $60 billion – that’s a lot of growth expected from an already large baseline!

Canadian investors shouldn’t find much solace in the TSX either – the Composite’s top component right now is Shopify with 6.16% of the index. However, the rest of the companies aren’t the high-flying technology companies as seen in the S&P.

GFL Financial Scandal – or what to do if a short selling firm reports on one of your holdings

Thanks to Etienne and another that was kind enough to email me, Spruce Point Capital wrote a hit piece against GFL Environmental (TSX: GFL / NYSE: GFL, GFLU).

The allegations can be summarized as shady people, shady accounting, shady history, shady operations and shady associations. Apparently being associated with the late Toronto Mayor Rob Ford (infamous for being busted in his term in office for doing cocaine) is also is grounds for financial excommunication.

Do I believe the report? Not in its entirety. Do I dismiss the report? Not in its entirety.

The investment thesis for GFL has always been on whether they possess an ability to process acquisitions and make them more profitable. Even at the IPO their financials were a train wreck to go through, although you could see how it could be done to yield a decent amount of free cash flow, in line with major competitors (Waste Management / Waste Connections / Republic / etc.).

The report does present evidence that there have been exaggerations/creative interpretation by management, in addition to many acquisitions in the past that appeared to deliver sub-par results that were disappeared 1984-style.

One of the great things about being a small-time investor is that you can get in and out of positions (in most cases) by clicking a button. Shortly after the peak of the Covid crisis, I took a minuscule position in GFLU which I offloaded today.

Just imagine if you were an institution and have 50 million shares of this thing and the 180 day lock-up expiry doesn’t happen until August 31. Or if you were one of the purchasers of the US$750 secured bond financing, getting a paltry 3.75% for 5 years on an investment that doesn’t seem so secure anymore. Egg on your face as an institutional manager!

It actually doesn’t matter for me whether this report is true or not, simply because the thesis of any future investment in this company has changed. It is now a thesis on whether the evidence laid out in this report or not is factual enough to sink confidence in the company enough that it won’t be able to raise further financing. On balance, I deeply suspect it will survive and just like a lot of these short seller reports, they turn the most tenuous of connections into big news, just like a political “guilt by association” hit piece.

However, to deal with this in the future takes mental space that I can ill afford with a portfolio that is spread out with more individual holdings than I have ever had in my financial history. This quarterly cycle of 10-Qs and conference call transcripts just slammed me. I just do not have the mental capacity to follow the inevitable gyrations that will be occurring as institutional holders try to confirm or refute the GFL allegations in the upcoming weeks and months. Too many eyeballs are going to be looking at this, and my eyeballs aren’t going to have a competitive advantage of any worthy note. So I’m out, taken it off my watchlists, and focusing elsewhere.

This is also why I don’t get involved in any other financial scandal stocks (e.g. Herbalife), although I must say the Home Capital Group (TSX: HCG) fiasco in 2017 was most fascinating. There’s just too much attention and too many people, some a lot smarter and most of them better resourced than I, looking at these situations.

There is a valuation claim that I was suspecting from the very beginning that if GFL does have their crap together that they can head up to the CAD$50 range, but clearly that’s now going to turn into a “show me” with regards to their mammoth acquisitions they have recently made. This will take a lot of time (at least 18 months), and once the IPO lock-up period expires, there’s going to be a lot of gyration in the shareholder base. One tailwind for the company will be the inevitable inclusion in the TSX indexes (with a decent shot to get into the TSX 60 if it appreciates from here on in) which will cause its own momentum. We will see, and for those that are sticking around, I wish them the best of luck.

California Power Grid

Wow, that was quick.

I said less than two weeks ago:

One major event that will occur in the future (a matter of when, not if) will be a significant power grid failure that will have been instigated by having too much intermittent energy sources on the grid, without available backup from domestic or external grid sources. This may be caused by a freak transmission failure (cutting an intermittent-heavy grid from a dispatch-able heavy grid) or some other ‘black swan’ event. When this occurs, there will likely be a dramatic shift in power generation policy to increase the robustness of a domestic power grid.

And what did we get last Saturday? Headlines such as:

(August 14, 2020) * Stage 3 Emergency Declared; rotating power outages have been initiated to maintain grid stability
(August 15, 2020) ISO Requested Power Outages following Stage 3 Emergency Declaration; System Now Being Restored
(August 16, 2020) Flex Alert Issued for Next Four Days, Calling for Statewide Conservation

What happened?

Excuse my crappy handwriting, but I had to illustrate this. Factors:

1. Wind dies down (can’t predict the wind very well, so you have no idea what your future supply is going to be);
2. Solar gets interrupted during the peak of the afternoon due to clouds;
3. Natural gas supply is down due to plant shutdown;
4. Cannot import (other grids are facing similar demand/supply issues).
5. Record-high daytime temperatures (e.g. Riverside, CA which is a suburb about 80km east of Los Angeles, at daytime highs of 40 degrees C), which causes huge demand for air conditioning.

What do you get? Rotating blackouts.

While I wouldn’t call this a “major event”, the fact that a major jurisdiction can’t keep the lights on speaks volumes.

This issue isn’t solved by adding renewables onto the grid – indeed, having too many renewables on the grid with the lack of dispatchable power sources was the cause of the problem.

If my suspicion is correct, this is going to be the start of a paradigm shift on what was a dead power production market (ruined by floods of cheap capital for intermittent power sources). I can’t tell whether this comes in the form of further power price increases (see: California, Ontario, Germany, etc.), increases in dispatchable energy supply (read: natural gas, nuclear or thermal coal!), or energy restriction mandates (or a combination of all), but either way, there are obvious investment angles coming down the line.

My only other comment is there are operational implications when you allow your quasi “crown corporation” primary power supplier PG&E (NYSE: PCG) to be sued into bankruptcy due to wildfire transmission line risk – when you get into situations like this weekend, it is obvious they will be shutting down transmission grids which reduces the robustness of a power grid since they don’t want to get sued to death again in case a spark catches fire somewhere. I wonder when they will get sued for constructive negligence because they shut down transmission lines and caused a huge cascade power failure which caused even more economic damage. Companies that operate under heavy regulatory coverage in California live and die at the behest of the state – watch out if you’ve got capital in PCG equity!