Double Blind

There are a lot of exchange-traded funds out there that have commodities as their primary asset. I would not “invest” in any of them, although they are perfectly good trading instruments if you don’t want to dabble directly in the future exchanges.

Some person wrote a simple article explaining why correlation to these exchange-traded funds is not perfect. Keep in mind that the natural gas fund invests in futures, opposed to the physical product. Apparently the gold ETF (37 billion in assets and rising) has it in physical product.

All of these ETFs make a fortune by skimming a fraction of a percent in management fees – the Gold ETF takes 0.4% a year, while the natural gas ETF takes 0.6% a year.

I suspect most of the slippage of the ETF is due to traders sniping away at the funds that try to roll over the future contracts – without having the outlet of taking delivery it makes it incredibly difficult to keep a front-end position without encountering significant slippage – and this shows in the performance of the fund.

In the case of gold, if you want to invest in it for the long run, you would be better off buying the physical metal and storing it in a safety deposit box or some other secured location. For natural gas and crude oil, your best bet would be to invest in companies that have large, proven reserves of oil or gas. There are quite a few companies in Canada that would easily fit the description.

My commodity of choice is crude oil – as long as sustainable fusion doesn’t get invented anytime soon, crude oil continues to be the most convenient and economical source of energy. Crude oil is very useful, unlike gold. It is also unlikely that we will be gravitating away from gasoline over the next 30 years as the primary fuel for transportation.

At the end of today, there were 150 issues of debentures trading on the TSX. Note that a single company can have multiple issues of debt.

As of today, out of these 150 issues, 123 of them have a last trade price at or above 90 cents. 106 of these issues had some trading volume.

I am currently facing an unrealized loss position with my late August US interest rate futures bet; while my trade was placed at 2.2%, it is currently at 1.74%.

Unfortunately, both the markets and myself have now ratcheted down future interest rate speculation.

I am now of the opinion that US rates by the end of 2010 will be no higher than 1% and will most likely be 0.5%. I am also of the opinion that by mid-year 2011 that the rate will most likely be around 1-1.5%.

These are under existing market rates, and thus I will be attempting to close my position at an opportune moment. Usually the opportune moment comes when some piece of news floods the market with respect to an outperformance in the US economy, or some federal reserve official spouting off above when interest rates will rise again.

In Canada, it is evident that rates will be increasing slightly in mid-2010, but I do not expect rates to go higher than 1% by the end of 2010. It will most likely be around 0.5% and will be in lock-step with the US federal reserve.

I am always puzzled by people that say they want to purchase property in the United States for investment purposes, especially in the markets that have been depressed roughly 30-40% by foreclosures (e.g. California, Nevada, Arizona). While there is nothing wrong with the premise on speculating on such property, it is so much easier to do so with proxy investments such as REITs.

In addition, the purchase and sale of property in the states, as well as Canada, is a royal pain in the rear – you have liquidity concerns, you have to deal with agents and find buyers in a very slow process, you have to pay for property taxes and upkeep (which takes time that most professional organizations have automated) and you have to pay the dreaded IRS foreign alien withholding tax when you do dispose of your property and claim it back through a less-than-intuitive system.

The big “selling” point for me is liquidity. I absolutely despise investments that you can’t get rid of with a click of a button.

This post can also be titled “Why frequent trading is bad for your financial health”.

When reading Goldman Sachs’ quarterly report, the chart on page 123 struck out at me:

This is the amount of money that Goldman has been able to put to its own books through providing liquidity.

It effectively amounts to a tax on trading – Goldman is using algorithms that leverage the information that flows through its firm, and is able to extract that to the maximum. There is no way that an individual day trader can possibly match this distribution, even when a trader has 1,000 times less capital to work with than Goldman.

Mathematically, it is probably better to just walk to a casino and play 99.5%-return video poker than to trade against Goldman. The only other competition is Morgan Stanley, and this is all that is left in the winner-take-all game of being the primary liquidity maker in the US capital market.

This capital is effectively earned from hedge funds, mutual funds and pensions that are trying to out-wit each other with investment decisions. Indirectly, if you are part of a pension plan (and most employed Canadians are by virtue of their participation in the Canada Pension Plan), you are paying this tax.

Warren Buffett is making a huge bet on Burlington Northern – he owned about 22-23% of the company yesterday, and today he announced that he wants to acquire the entire company for $100 a share, or about an aggregate value of $44 billion ($34 billion equity, $10 billion debt).

Burlington was expected to earn about $5.50 a share in calendar year 2010, which means Buffett is paying about 18 times earnings (5.5% earnings yield – the math is easy and I didn’t have to pull out a calculator on that one because the acquisition price is $100/share!) and can expect around 10% earnings growth out of the business. In a low interest rate environment, 5.5% on $34 billion of invested capital is likely going to turn out to be a winner providing that the business doesn’t blow up. Buffett is likely slightly overpaying, but ten or twenty years from now this will look really smart.

This is also an implicit bet on the following:
1. Coal power still being prevalent (can you see the strategic fit with Midwestern Energy?)
2. Rising oil prices (railroads are more efficient than trucks).
3. Continued transport of raw goods (coal, grain, etc.) throughout America.

In the USA, there are two large railways that primarily service the western half of the country – Burlington Northern and Union Pacific. A map of Burlington’s network is as follows (click for a larger view):

I have earlier that railways are a great store of value simply because of their irreplaceable ownership of right-of-ways in major urban centers (and cross-country). In Canada, we have CP Rail and CN Rail, and both are slightly up on the news of today’s acquisition.

If I had to pour my entire net worth in any single security for life, it would be equity in CN Railway. Barring a military takeover of Canada or the USA, it will be there for my lifetime.

Thank you once again to Nelson for pointing out an article titled “Rise of the kitchen table traders“, roughly about some guy that discovered he was up a massive percentage and is starting his own firm doing algorithmic trading. Later on they got some executives to warn the world that you are fighting the big banks with their computers and information.

However, what got my attention was in the comments. Probably the biggest load of garbage that I have seen floating around academia and literature of financial advisors is the following quotation:

Asset allocation(equity vs fixed income) is what drives returns and volatility. It dictates 90% of your returns and that should be the biggest focus when investing.

This is absolutely untrue. As a quick and non-technical counterexample, will equity in a government-regulated utility company have a different return and volatility characteristic than equity in a development-stage biotechnology company?

Amazon announced a quarter that was higher than analyst expectations. Its shares today launched up about 25%, closing at around $118 per share.

Readers of this weblog will know that the price per share is irrelevant; market capitalization is the important number. Amazon has about 441 million shares outstanding, which means the market values the company at around $52 billion. The company is expecting fourth (Christmas) quarter sales to increase by between 21-36%, so a mid-line estimate would be around 28%. Net income is expected to be around $840 million for year’s end.

Doing the math, you are paying $52 billion for $840 million in income, or a ratio of 62, or a yield return of 1.62%, assuming no further growth in income.

How much would Amazon’s earnings have to increase to warrant such a valuation? By taking an operation such as Walmart (whom has racked up $400 billion in sales, and $13.3 billion in net income after taxes) and looking at its valuation – approximately 13 times earnings we can get a hint. Amazon at 13 times earnings would be expected to earn about $4 billion a year. Both operations have extremely slim margins – about 3.3% for Walmart, and about 3.4% for Amazon in 2008. Assuming Amazon, by virtue of its business model, can get its net margin up to 4%. It would have to increase sales to $100 billion or about four times the levels it will achieve in 2009. This is a very elementary analysis, but it clearly shows that Amazon’s valuation is priced very highly.

Will Amazon be able to achieve $100 billion in sales? Perhaps in 8 to 10 years. Is there any reason to buy shares in Amazon when this growth is already priced in? Not at all.

Never confuse a company and its shares – a company can be great like Amazon, but its shares can be a horrible investment. Another company in the same category (although it is less ridiculously over-valued, but still slightly over-valued) is Costco.

Nelson pointed out to me (earlier than I actually read the headline) that one of my holdings, Harvest Energy, agreed to a CAD$4.1 billion takeover by Korea National Oil Corporation. I do not own equity in Harvest Energy, but I do own debentures. The relevant portion of the press release is the following:

In accordance with the terms of the indentures governing Harvest’s convertible debentures, KNOC will make an offer to purchase all outstanding debentures for a cash consideration equal to 101% of the face value thereof, plus accrued and unpaid interest, within 30 days following the effective date of the Arrangement. Likewise, in accordance with the terms of Harvest’s 7 7/8% U.S. Notes, KNOC will make an offer to purchase all outstanding Notes for a cash consideration equal to 101% of the face value thereof plus accrued and unpaid interest, within 30 days following the effective date of the Arrangement.

Most of the debt of Harvest Energy I have acquired earlier this year was between the prices of 40 to 50 cents on the dollar. My TFSA, for example, has exclusively Harvest Energy debt. I have grown my TFSA from $5,000 to somewhat over $12,000 in less than a year, and I guarantee that this rate of growth will not continue. As I do own Harvest Energy debt outside the TFSA, there are tax considerations for me to examine, and other variables.

The variables are as follows:

1) The actual takeover is subject to government approval, but it is likely the Canadian government will not step in. It is clear that the acquiring company will be investing further into the company, and this will mean jobs will stay in Canada. In addition, the acquirer (a Korean “crown” corporation) is from a country that we have good relations with. The risk of the takeover falling through is minimal.

2) The acquisition will take place in late December, but it could be early next year. What gives the debt security value is that once the change in control takes place, the acquiring company is legally obligated to offer 101 cents on the dollar (cash) to the owners of debt securities within 30 days of the change of control. Of course I will be accepting this offer – I can get my money today, or I can get it in 3-4 years; I will take it today, and the cost of this is that I will not be getting a 6.4% or 7.25% coupon from this particular investment after I sell the debt back to KNOC.

3) It is advantageous for me to hold the securities until at least January 1, 2010, where capital gains taxes can be deferred until April 2011. It is also an income balancing tool – if I sell in 2009, these are capital gains taxes that I will not have to pay in 2010.

4) The debentures will continue to accrue interest until they are bought out, which means that there is a cost to selling them and getting an immediate cash conversion. Right now the debt securities are trading at 98.5. Let’s review the math.

Per $1,000 face value of debt (6.4% coupon), I am locking up about $985 of capital. This is still a current yield of 6.5% on investment. In addition, there will be a $25 increase in capital, which spikes up the absolute reward to 2.5%. Realistically, if the offer to repurchase debt is extended to January 31, 2010, then I would have to wait 3.2 months to obtain $25 in capital appreciation and $17 in additional interest income. Math-wise, this is about 4.3% over 3.2 months, and I would have to find an alternative investment candidate that would yield better than that to make selling at current market prices any sense at all.

In other words, if I do not think merger failure is a risk, I am still being paid quite handsomely to hold onto these debt securities. This is actually better than the equity itself, which is priced at a 2.15% return if the deal is consummated (based off of a share price of CAD$9.79, which will receive CAD$10.00 per unit when the transaction is concluded).

If I were to do some merger arbitrage on this deal, I would borrow some serious amounts of money to purchase the convertible debentures. It is not too efficient – if I borrowed $1,000,000 and used it to buy as much debt at 98.5, I would be able to extract about $32,300 minus financing costs (about $4000) over a 3.2 month period. The second the Canadian government gives approval to the transaction, the debt should trade slightly higher than 101 because of the extreme certainty of investors being paid off.

Unfortunately, I do not have the capacity of borrowing $1,000,000, and also the low probability risk of a merger failure would make such a transaction excessively risky. However, certain portfolio managers specialize in merger arbitrage and undoubtedly will be taking advantage of this pricing.

My main problem at this point will be reinvestment risk, although I now have a huge cash injection coming up early next year, I will have to find a place to invest it. Right now my candidates are marginal at best, and I do not like investing in marginal situations.

There are subtle differences in the valuation of Gold when one looks at it scaled in Canadian dollars vs. US Dollars:

Price of gold: Canadian Dollars / 100: (e.g. 9.5 = CAD$950)

Price of gold: US Dollars:

The quick conclusion is that the low for Canadian dollar purchasing power was in the middle of the economic crisis (early 2009), while now the US dollar weakening is no longer putting gold at all-time highs, unlike what is happening to the US currency.

Purchasing a precious metal, and not real estate, is probably the ultimate bearish bet on the economy – although you won’t be getting a return by buying a slab of gold, you certainly won’t be destroying your capital either. With interest rates at nearly zero, it is not surprising why the price of gold has increased.