Blessed by the Potato

It is an eternal debate: do we live for today or save for the future? Some kind of balance needs to be found, as living a hedonistic, spendthrift lifestyle only to end up spending your autumn years on government assistance is no good, but neither is playing the miser through your younger, healthier years just to die and leave it all behind.

I always thought I managed to walk this line fairly well: I work hard and save for the future, with a plan to retire earlier than 65 (after all, who knows what kind of shape I’ll be in by 60), but still enjoy the moment. I’m aware of the power of compounding, and have internalized the math that saving & investing a dollar today means I can spend three in retirement. Inversing that, taking a year off from work now might mean I’d have to tack on 3-5 more working years at the end of my career before retiring.

That’s pretty simple logic on the opportunity cost of taking time off — and it gets even worse when you consider the potential damage of a gap to my career. So I’ve never really considered taking time off without a damned good reason to. Heck, even on my vacations I tend to find side projects to work on, even if they’re not the most profitable post hoc (e.g., book). But now that Blueberry is on the scene I start to wonder.

I missed my daughter’s first steps today. That’s not such a surprise, as even Wayfare has missed some of her firsts (she seems to show off for grandma), and I’m at work all day. Yet it kind of puts a sharp focus on something that’s really been bugging me about my job: I spend so much time commuting and working that I hardly see the whole reason I’m going through the whole mess. A few months ago when she was into her “stranger danger” phase, I went a full week without seeing her, and when I finally did she freaked out and cried because she didn’t recognize her dad. So missing her first steps is a moment that does make me — for perhaps the first time — step back and seriously consider taking some time off from my career.

It’s also a bit of a timely issue because Wayfare’s mat leave has run its course, and yet Blueberry is still too young for daycare, leaving us searching for childcare options. It is heart-wrenching to even think of handing over our little girl to some stranger to watch over, yet it is also difficult to get by on just one income, particularly in this city. I know eventually she will have to go off to spend more time being raised by strangers than with us — at school if not daycare — but it doesn’t stop me from wondering if taking a year off now and draining my savings might be totally worth it. It sure seems nicer to spend some time at home taking care of my baby than to be able to take more time off at the end of my career, when the house will be cold and empty.

And this is the age when I want to be there for her: at 12 she won’t want to see “Da”, she’ll be at school for most of the day and then want to disappear into her room with a book or video/holo game when she’s not. Right now she’s thrilled to have me around, and the world is a magical wonderful place full of adventure and discovery. I want to be there to see her point to a bird singing in a tree and exclaim “Bir!” or to a passing jet and do the same*. I want to watch her dig through her bag of toys until she finds a match for whatever’s already in her hand, and then merrily bang the two similar items together. When she’s a teenager she’ll likely just infuriate me if I see her at all.

But the cold math is the same: Wayfare and I make more than a nanny or daycare service, so Blueberry goes off to the strangers’ arms while we work to keep our heads above water in this crazy world.

An alternative to quitting or taking a full leave of absence — indeed my preferred solution — would be part-time work: ideally I’d work 3-4 days a week, Wayfare would work 2-4, and with one of us having the flexibility to work weekends plus occasional childcare from the grandparents we’d be set. But unfortunately it’s tough to find part-time work — I doubt I’d be able to swing it at my current job, the HR system isn’t really set up for it. Indeed, a 9-day bi-weekly work option (adding ~1 hr to each day and then taking a day off every other week) is a recent experiment there, and that plan’s only around for the summer. Plus there’s too much for me to do to just cut back (though they could almost use another 0.5-0.8 FTE, so perhaps hiring a full-time person and dropping me down to 4 days a week would work for everyone if only the money in the budget could be found).

Health insurance is another hurdle: I get it, Wayfare doesn’t, so it made and continues to make some kind of sense for me to try to keep a stable full-time job while she gets to take the mat/pat leave and spend all the time with Blueberry, even though she’s actually the higher-earner in the family. The value of group insurance for someone so sickly nearly covers the spread in gross pay.

Taking time off would be an easier decision if I had more freelance experience and could use that as essentially a part-time career. Part of what makes me consider it so closely is that I do have some margin of safety in my planning: pushing a planned retirement age from say 60 to 65 is not so bad, not like moving it from 65 to 70 — it’s not like I’d be cutting things so close as to be taking major risks on my ability to work later in life (health, etc.).

Though really as I get more comfortable (even as I write this out) with the idea of sacrificing disposable income and retirement savings to spend time with Blueberry, the big remaining fear is the gap on my resume. It took months to find a decent non-academic job in the first place, and that included accepting the dreaded subway commute. It did kind of backfire on me: part of the reason I went for a non-academic job was to have more stable hours to spend time with my family, and here I am a year later lamenting how little time I manage to spend with my family. Part was for better (short-term) pay: it would have been a lot tighter on a post-doc’s salary, yet here I am considering throwing the financial plan out the window for shits and giggles (literally). With such a gap on my CV and publication record I doubt I would have the option of trying to pursue an academic career now — will it be the same for a non-academic career after a year of being a homemaker?

I just don’t know what to do. I suspect that all my considering and weighing will lead me back to the default choice: keep working, let the woman take the mat/pat leave, and after that let her work part time with hired help to cover the rest of the childcare. It’s kind of sad, but I don’t really see another path…

* - It is apparently babies who confuse birds, planes, and Superman.

There is a legitimate reaction of fear and disgust when a dividend-paying company cuts their payout. The cut can often just be the first of a series, and after all, companies that are growing with steady profitability don’t need to cut so it must be a clear sign of trouble. However it’s far from a certain sign: sure, Priszm and Yellow Pages went through a series of cuts before becoming worthless, and investors who bailed at the first cut (or earlier) were in the right — there was not just one cockroach. On the other hand, many companies have a clear plan and future path to follow with a dividend cut, and an over-reaction to the news can be a great buying opportunity.

Superior Plus was recently featured in the Globe and Mail with a very bullish article, yet just after cutting their payout nobody loved it despite the attractive price (indeed, it’s almost doubled from that point). The business was not growing, but it was not crashing at the time of the cut, either. The problem had been too much debt taken on in the past, and no wiggle room with a 100% payout ratio to get it paid off. By slicing the dividend in half, SPB laid out a plan to start paying that debt off in a meaningful way. This was in my opinion the wiser use of their cash, especially given the interest rates they had to pay on the debt. It shouldn’t have been the first cut of many — just a one-off cut, that would likely last for five years or so before going back up. Investors liked the company at $10 before the cut, then even though the underlying business hadn’t changed, were only willing to pay $6 for it after the cut (and now, back to $12).

Similarly, HR.UN had to cut their dividend when capital markets froze up in 2008 and they were caught with their pants down and a half-finished building. They used the cashflow they would have given to unitholders to fund the construction, with a plan to reinstate the dividend at the conclusion of the project. Partly due to this, and partly due to general market uneasiness, there was a point at which you could have bought H&R for roughly a quarter of where it is today. Even if you factor in that the overall market was down roughly 50% at the time, H&R had shed an additional $3/unit. So there might be some value to looking into companies that have recently cut their dividends in case there is an over-correction in the price.

I think Extendicare might fall into this category now. I bought some a few months ago on the thesis that their payout ratio was near the edge: they had refinanced some debt into low-interest long-term form, which is good, but profitability concerns with Medicare cuts left them dancing around the 100% payout mark. I figured they could go either way on a cut, but it would likely be shallow (to get them down to an 80% payout ratio), and that the US and its insurers were likely done trying to squeeze care homes for additional savings. Now clearly I was wrong on the depth of the cut, and possibly on the rounds of cost-cutting coming to an end, but I don’t think this is just the first of many: in the conference call they say that basically they can now fund the payout entirely from the more stable Canadian operations. That should make EXE a pretty decent buy at these levels (<$6). I wouldn’t be too surprised if 2 years from now it’s back at $8 and that’s when all the bulls come out of the woodwork to exclaim in the press about what a great buy it is at that price.

Any other potential over-corrections to look into out there?

Here is a recent TED talk on philanthropy and advertising you should go watch.

This is an interesting perspective. As someone who is currently “overhead” I can, to a certain extent, agree. Besides my current day job, I also recently picked up an interesting freelance gig. A donor hired me to rewrite and revamp a fundraising brochure for a local hospital. Because I’m being paid directly by the philanthropist and not the foundation, my fees will not appear in their books as overhead, though I hope that the work that I’ve done indeed helps multiply the donations they eventually receive regardless. (You can see a PDF of the brochure here.)[Update: I did a second related one.]

To some extent there is a need for scale in philanthropy. A charity attempting to say fund research looking for a cure for cancer is not going to be able to make much of a dent with an annual budget of $100k — that’s barely one research grant (and even then the lab has to have some other source of core funding). It takes millions to be able to have enough to get together a panel of peer reviewers to examine grant proposals, or to buy expensive pieces of infrastructure such as PET scanners. And that takes some kind of investment to scale up — whether resources for advertising, or the volunteer effort to go viral on the internet.

But there’s a limit. At some point you could just be raising money to pay people to try to raise more money. In the talk he mentions that charitable giving has been stuck at 2% of GDP for decades. If there is some sort of mechanistic reason for that — it’s the amount people are capable of giving, or some sort of unconscious philanthropy budget in the population as a whole — then pushing for more overhead is just shifting the charity spending around, and in fact a net negative due to the overhead. It is possible that, by being able to tackle large challenges smaller organizations could not, we would be better off with one (or a few) massive billion-dollar charities spending a total of $240B than with a bunch of smaller million-dollar charities spending $275B with lower overhead costs. But if outcomes are directly related to dollars spent, more overhead would indeed simply mean more waste.

Consider a parallel with investing: you could pay a brilliant manager some percentage of your funds under management, and they might be able to beat the market for you. But there’s only so much return out there to be had: if everyone else hires an investment manager then everyone is on an even footing and is back to getting basically average returns… less the overhead to the managers.

There were three other points of his I want to discuss.

The first was on compensation. The big unanswered question for me was whether you would get value for that extra $300k spent on talent in his hypothetical. Perhaps everyone is better off if the MBAs pursue for-profit $400k salaries and donate $100k to the charity, who can then hire an $87k/year executive. If the charity tried to hire someone for $400k, would they get more than the ~$300k difference back in value? Charities, after all, don’t have all the things to manage that for-profit businesses do: maybe the extra money buys you advertising and capital markets experience, which you just don’t need as a non-profit. And why doesn’t that logic apply all down the chain? We pay grad students and post-docs a disgraceful pittance for trying to find the cures to our modern medical ailments, but brilliant technically-minded and driven people can make far more in the private sector. Would we have long since solved this pesky cancer problem if we were only willing to retain top talent in the research enterprise by setting post-doc starting salaries at $400k, and grad student stipends at $75k?

The second was on the whole comparison of the for-profit and not-for-profit sectors. You see, the two are very different fundamentally. When I give my money to Coca-Cola for a beverage, or to Amazon for a book, I am transacting with them for something. I don’t care how much they spend on overhead, because I am making my decision on whether or not to give them money based on what they are giving me in return at that moment. I need to only extend a small amount of trust to them (trust that Coca-Cola hasn’t diluted my Coke Zero, trust that my book from Amazon will arrive undamaged in a under a week), and I have recourse if my trust is violated: I can demand my money back, sue for breach of contract, etc. But once I send my money to them and receive my item, it is no longer my money. It’s their money, they can do with it as they wish.

Giving money to a charity is a completely different thing. I’m not getting a thing or a service, I’m giving my money to the charity to make the world a better place. I am trusting them to put my money to good use. Though the money is out of my hands and I have no recourse to get it back once I give, at no point do I consider it “their money” to do with as they please. Maybe they could give me a better “product” if they spent three times as much on overhead as I had reasonably expected — but that is a lot of trust for me to give. While only people donating staggering amounts of money expect to be able to direct their donations precisely, I still expect that, in general, my donation will be used for the stated purpose — ultimately mostly directed towards some kind of program spending rather than churning overhead or as risk capital. Their use and governance of the money will continue to be the concern of the donors, and so there is a very real reason for spending on overhead and risky activities to be perceived differently than in the for-profit sector.

In an analogy to investing, let’s say that there was a company that raised $100M in a stock offering to pursue a business idea. They went out the first few years and spent $90M of the money doing what had to be done (hiring people, renting office space, advertising etc.). After a few years of losing money they discover that the business model is just not viable. To continue is to throw good money after bad so they wind up operations. As a shareholder, through the first few years you would have been obliged to let management take the risk and pursue the business, spending your capital on whatever “overhead” was needed to do so. After it failed, you would expect that any residual money ($10M in this example) would be returned to you as the business was shuttered, and promptly. If they dragged their feet in the wind-up, paying salaries for years, burning through your capital with no purpose you would rightly be pissed at that loss.

In the not-for-profit sector, overhead spending that is going to have a multiplicative effect is difficult to discern from the telemarketer full employment program. How do you know whether you’re in the phase of risk capital spending that is pursuing the innovative business model with lots of potential, versus the phase that is basically the insiders stealing from the other contributors of capital? The risk-reward equation is not the same in the not-for-profit and for-profit examples, and the governance is different: profits are much easier to measure than “impact” or “do-goodery”. And as unethical and despicable as it was for the executives in the hypothetical example to burn the remaining shareholder capital after it was clear nothing would come from it, it is even more morally repugnant to live large off people’s charitable donations — hence the aversion to overhead spending.

And the last point I wanted to discuss was that of spending more overhead as a percentage to scale up. In the presentation he just kind of implicitly assumes that to scale up an organization might have to spend a larger percentage on overhead. But should this be so? Shouldn’t scaling up offer economies of scale? If instead of spending $100 to raise $1000 at a bake sale, a charity should spend $100M on organizers for a massive event and TV air time, then shouldn’t that investment be expected to pull in $1B for program spending, rather than just $250M as his 40% figure would indicate? Now again, maybe the efficiencies come on the spending side (perhaps spending $250M in one organized way with a unifying strategy does more cumulative good than spending $1B in separate $1M chunks).

So while I can see some of his points about needing large-scale charities to tackle large-scale problems, and that sometimes investments have to be made (to train people, to build infrastructure, etc.) and sometimes more overhead has to be spent (for strategy, for advertising), I do not fully agree. Sometimes overhead is just money not going to program spending, and I would hope that scaling up would bring about more efficiency rather than less. The not-for-profit and for-profit sectors are have larger fundamental differences than he suggests. And when you come right down to it, I want to be able to know that my charitable donation is going towards the stated purpose and not to the Canada Foundation for Telemarketer Employment. Maybe looking at the percentage of spending on overhead is not the best way to choose where to donate — perhaps we need some impossible measure of impact per dollar donated — but we will naturally gravitate towards metrics that are easily enumerated.

Cyprus has been in the news a lot lately for the seizing (”taxing”) of some assets. Some have questioned whether the same could happen here. The sad truth is that there is always the possibility of the government deciding to seize your assets; whether they’re insured or not, in a bank account, mutual fund, or real; through legislation, crooked courts, or by military force.

But it is not an event that happens often or lightly. In general, governments do not suddenly seize assets — that’s not what good governance is about. Of course, if the hole is big enough and the options limited (as in Cyprus) they may not have a choice, which gets into a moral lesson about not choosing “bread and circus” leaders.

There’s a slightly higher chance of loss with more “virtual” assets and those that can be divided for tax (e.g., the income trust Halloween massacre). But the government could decide to appropriate your house, eliminate your principal residence capital gains exemption, or tax your assets instead of just your income.

This knowledge may not help you sleep well tonight. Do remember that it is quite unlikely. Ideally, your government would be open and logical, so you could anticipate such moves (or rather, sleep soundly anticipating the lack of such moves). Of course, for the Harper government that was my big beef with the income trust fiasco — not that they decided to tax them, but that they broke an explicit promise not to do so, with no justification given. How were we to know what the next materially important decision would be? Ditto with strategically important takeovers — there was next to no way to anticipate what might or might not be allowed. In the depth of the US financial meltdown some (e.g. John Hempton) complained that the FDIC just stepped in and closed certain banks over the weekend, arbitrarily deciding to make bondholders whole while wiping out equity and preferred holders — though in a more controlled liquidation and wind-up, it’s likely that either the bondholders would take a haircut, or the preferred shareholders would be left with some value. The process is often just as important as the outcomes…

The debt-to-income ratio in Canada has been breaking new records for the past few years, and a little while ago surpassed the lofty level reached in the US before their housing bust. There have been a few slightly alarmist articles in the press about that, but even more that brush it off. The latest (and what made me decide to write this post) comes from Robb at B&E:

“The rising debt-to-income ratio makes for splashy headlines, but all it means is wages have been flat for a few years while cheap borrowing rates fueled a huge increase in low interest mortgage debt.”

Robb makes light of the record reading in debt-to-income, and I think I know why: it’s a difficult metric to wrap your head around, as evidenced by the fact that the rest of the post talks about matters on the single-household level. The debt-to-income measure is however a population measure, so it’s hard to interpret thinking about it as though it were any given household.

Indeed, with the measure at “only” 164%, it sounds downright low if you approach it with the right mindset. If you’re at the stage of your life where you purchased a house at a fairly prudent 4X your income and put 20% down, your debt-to-income from the mortgage alone would stand at 320%, so it’s hard to see why a national figure at half that is alarming.

To interpret it, you must first remember that it is a population measure. It includes those people earlier in their lives with massive mortgage debt loads as well as those who are near retirement, and should have peak earnings with minimal debt. Even then, saying that any one level has meaning is quite difficult, as you then have to parse the demographics, figure out how many old people you have and what their debt-to-income should be, how many young people, etc.

Fortunately, the second important thing to keep in mind with population measures like this is that changes over time are often more important than the absolute level. And that is what makes the recent readings in the debt-to-income measure alarming. Just 8 years ago (2005) the metric sat at 120%. That implies that Canadians have, on average, increased their debt loads by 37% in that time, or about 4% per year (relative to incomes, or in real terms).

On top of that, we have to consider how we would have expected the ratio to change over that time. One big factor is demographics: as the baby boomers near (and enter) retirement, we should expect a larger portion of our population to become debt-free — leading to an expectation that since 2005 that debt-to-income measure should have been trending down, not up. That means that we have some combination of seniors getting much closer to retirement with debt or even entering retirement with debt, and young people taking on disproportionately more debt, so much that it is swamping the demographic effect (mostly the latter).

Another influence over the past few years has been decreasing and record-low interest rates. People have suggested that it’s fine for people to be taking on more debt relative to measures like income because low rates have lowered the servicing burden. On the other hand, if people had been prudent, the low rates could have meant the same payments on the old debt would retire it even faster, another factor that might lead us to expect another incremental decrease in the population measure of debt-to-income. An increase instead means that we now have more debt that is even more interest-rate sensitive. Sure, it’s fine and dandy and easy to manage as long as interest rates stay low, but it implies an added risk to the population should rates increase in the future.

In the context of a housing bubble, this is even more meaningful. Much of the increased debt load has been mortgage debt, used to pay for houses that have increased in price. This is debt that will be long-lived, giving rates lots of opportunity to increase and make repayment difficult. If boomers are carrying debt into retirement, it may be due to a plan to hold onto more real estate — and the associated mortgage and HELOC — for the time being and downsize later, building more pressure for a future crash. The point of it all is that debt-to-income is a measure of risk.

Some have asked why another metric isn’t used, such as debt-to-assets, or reformulated, debt-to-equity. And the reason is that it doesn’t give the same warnings on risk. Yes, if you have assets to support your liabilities, you could in theory sell your assets to settle the debt. However, people in general don’t do that so debt must ultimately be repaid with income. It’s tougher to use debt-to-assets to identify risk (or changes in risk over time). In asset bubbles the debt remains after the assets correct, so you could be refinancing appreciating assets to use more debt to buy more assets, keeping the same amount of equity on the way up. Unfortunately once the asset stopped appreciating, the debt remains, and only after the fact would you see the debt-to-equity ratios move. By way of example, you could save up $25k on a $50k salary and buy a $250k house with 10% down, giving you a 90% reading on debt-to-assets and 450% debt-to-income reading — high on a population measure, but not outrageous for a single, young household. If the house appreciated to $350k, you could sell it and move up to a $1.25M house and still have 10% down, giving you the same 90% debt-to-assets measure. Yet now your debt-to-income is a whopping 2250% — it is clear that you will never pay that mortgage back on a $50k salary.

Nelson at Financial Uproar is once again organizing a stock picking contest, with no shorting. Kind of a shame as for a no-consequences contest like this I think I could come up with some short picks this year much more easily than longs.

Poseidon was a strong choice in the race last year, only to blow up right before the finish line — a move that earned me the booby prize of a bronzed toilet. While I’m not going to touch it in real life, I’m tempted to make it a pick again this year just to see if there’s a bounce… but a repeat would be boring. So instead, my picks are:

HNZ.A: This one had a run up to the $30-level not so long ago. That was a bit over-done IMHO (though not quite so over-done that I thought to sell into it), but it could happen again with a strong contract to replace the Afghanistan work. In the meantime, a decent balance sheet and well-supported dividend.

URB.A: A closed-end fund that invests in exchanges trading at a bit of a discount to NAV. With the recent announcement of the sale of NYSE-Euronext, there should be some cash coming into Urbana, which may help close the valuation gap.

AIG: one of the biggest blow-ups from the financial crisis has had a hell of a run in 2012 — and is still quite a ways away from book value, with what look like much calmer waters ahead.

CLC: CML Healthcare is a last-minute pick. I think they will cut the dividend, but maybe not quite as much as the market is pricing in. With a ~7% dividend and a slight bounce after the uncertainty is removed, this might give a decent ~10% in what I am anticipating to be a much tougher competition than last year.

I had to make a last-minute change before submitting my picks to Nelson on New Year’s Eve: I had originally put in Iridium (IRDM), but it put in almost all the expected return I was hoping for in the last week of the year. It was kind of a borderline pick anyway: it looks undervalued after being (rightly) punished for a stupid insider-benefiting warrant repricing move while the core business is still ticking along. Of course, the growth is not coming in as well as I had first projected, so I didn’t expect huge gains to come from it.

(Disclosure: I am long every one of these except Poseidon).

And to put everything in one post, my investing returns for 2012 were 22% — including active and passive components of the portfolio (vs a passive benchmark of 8.2%). Even combining that with last year’s existential crisis-inducing underperformance it isn’t too shabby. Interestingly, bounce-backs in the losers I called out in that post were largely responsible for this year’s out-performance (IDG, SPB, NFI). In one case I was even smart/lucky enough to decide to average down early in the year.

Despite that, I find that between my full-time writing job, my part-time subway* pole inspector job, and spending time with Blueberry I don’t have as much time or mental energy reserves to pore through annual reports. I’ve been moving more towards passive investing for that reason, and am slowly working at taking down some positions in the active portfolio. The last few years I’ve ranged from 24 to 31 positions, and it’s just too many to follow these days. However, with a decent 5-year track record now it’s certainly worth giving up a few weekends to pick stocks, so I don’t want to get completely out of it. I’m aiming to move a good portion over to passive ETFs, and focus on a smaller number of active picks, perhaps more like 10-12 (the active portion will be more concentrated, but the overall portfolio won’t be — at least not much).

* - Aside: I’ve tried to take advantage of the ride to do analysis, but it just can’t be done. I need to spread out a bit more and the way I work means I’m constantly looking things up on the internet. I briefly considered switching to the much more expensive GO train (which might allow me to use my smartphone and sit), but I’d need to be assured of a continued 5+% alpha to make it worthwhile for me, and that seems unreasonable.

Poseidon (PSN) got absolutely creamed this week after announcing its Q3 results. I was lucky enough to have taken my profits in PSN and managed to avoid the 65% drop, and let me stress that it was luck: I had no idea such a hit was coming. With my last sale in September, it was a near thing, too.

For those who don’t recall, their business is in providing fluid handling tanks for oil & gas fraccing operations. They make made ridiculous margins for what is ultimately a fairly low-tech business with low barriers to entry, and they were growing like stink. But, they were the first, and their solution offers more than enough cost savings to also make it attractive to their customers. For a long time running, many have expected that the margins would get trimmed as competition entered and that growth would stall as the market matured. I personally had thought that by the time that moment arrived their volume of business would make up for it, allowing them to maintain that juicy dividend with a stable number of tanks operating on a reduced margin.

Well, the margins contracted faster than many thought, and the growth has stopped. The company plays this up as a good thing: they’re flexible enough to stop producing more tanks very quickly, but the fact that they had to is what tanked the stock. If you go back to my old post, the most pessimistic scenario I ran was $200k/tank in EBITDA. They’re almost there already, with $26.5M of EBITDA in the quarter on 500 tanks. The margin squeeze is significant.

But that’s a company-specific issue, and doesn’t really worry me that much. I could puzzle over it and try to figure out how far down it would have to drop before becoming a good buy again, but that’s not going to keep me up at night. What worries me was this little blurb in the release:

Poseidon’s tank utilization and revenue in the quarter were further affected as we renegotiated terms on several long‐term agreements with specific, strategic customers due to changes in their project schedules and capital budgets. Meanwhile, several other long‐term agreements lapsed without renewal or were suspended as certain customers’ activities were reduced due to macro considerations or capital budget constraints. [emphasis mine]

PSN wasn’t the only company this quarter that found long-term contracts were not as secure as they thought. Fortress paper (FTP) has also been sold off on poor results, including a renegotiation of terms:

Dissolving pulp markets softened during the third quarter due to weak textile demand and increased supply of dissolving pulp from new entrants. Among other factors, the weakening viscose staple fibre market in China has driven down dissolving pulp prices to below US$1,000 as at the end of September 2012. Given existing market conditions and in order to maintain good customer relations, a significant portion of our sales orders for the fourth quarter is expected to be below the floor prices set forth in our supply agreements with our three major Chinese purchasers. These supply agreements are currently under review with the counterparties to reassess each party’s obligations going forward.

I had read somewhere (likely a secondary source) that this was because the partners couldn’t continue operations if they had to pay the contracted price. Is the economy even weaker than we had been led to believe? I only follow so many companies, so to see this happen twice in a quarter really threw me for a loop. Is it a more common occurrence than I’m aware of?

Kobo has changed the way authors can self-publish, streamlining the process to be more like the Amazon Kindle store. As a result, Potato’s Short Guide to DIY Investing is now available in the Kobo store. From my point of view, it’s better if you buy the book directly from me as I get to keep more of the gross, but for you the price is the same whether you buy from Amazon, Kobo, or me: choose what’s most convenient for you.

And speaking of my book, I got some great heart-warming fan mail recently. One of the first people to read my book and switch over to do-it-yourself investing with TD e-series has reported back a year later that things are still on track and that she did her first annual re-balancing all on her own.

A more recent reader wrote in the very same day she bought a copy:

I just bought & looked through your book Potato’s Short Guide to DIY Investing after signing up for a TD Waterhouse Discount Brokerage account and being confused by the interface. The walkthrough for buying the e-Series funds helped me out a lot. Thanks!

I’m very happy that people are finding the book useful, and I’m thrilled that they took the time to send me such wonderful emails!

Finally, I’d like to thank Ellen Roseman for mentioning the book (and the associated coaching service) in her recent column on investment coaches.

You’ve all heard about “supply and demand” even if only as a back-handed excuse given for why something costs so much. It’s pretty basic economics stuff: even a scientist can follow it. As the price of something goes up, suppliers will be willing to sell more product (and will make changes or substitutions to bring that product to market) while consumers will demand less (and find way to substitute other goods for the expensive ones). Graphically, that looks like:

The shape of the supply and demand curves vary depending on exactly what system you’re talking about, but they have that general property of supply moving up and to the right while demand goes down as you move up in price. (Note that economists usually treat price as the independent variable, and thus have their graphs backwards, but let’s leave that alone – the relationship works either way around). Where the lines meet should be your equilibrium: the same quantity coming to market for both the supply and demand side at a certain price point.

You can then do things to those curves to find what the new equilibrium would be. For instance, if the above graph represents the market for potato chips, we could imagine what might happen in a scenario where say Nelson’s chip truck breaks down. With less supply available, the supply curve would slide to the left, and the price would go up while fewer bags of chips were sold.

For housing, the demand curve is very flat: most people go through their lives without ever really analyzing the largest purchase they’ll make (and a again, remember the backwards axes of economists – a “flat” curve is actually nearly vertical). They simply get to a point where they figure they can afford it, and they go out and pay whatever the price is to get a house because that is what one does. There are a small number of people at the fringes who can’t afford to buy as prices go up (giving the slight negative slope through the middle), and prices would have to go down a lot before anyone would consider buying a second house. But through most of the range of typical prices, the quantity of demand is pretty stable.

Supply is a little less flat, but still fairly stable compared to many other markets with more substitution options and more responsive supply sources. Above a certain point and you can keep your construction crews operating profitably so away you go. As prices start to get really high supply can start to really ramp up as people get drawn away from other professions to recover supply from the margins (fixer-uppers) or subdivide existing large single units into multiple smaller ones (as seen not only in condos going up over SFHs, but also in Vancouver row houses).

But it’s never this simple in the real world. Supply and demand can be perverse when speculation comes into play. Then you have not just prices versus number of units sold, but also price history as a factor.

If prices were to rise too far too fast, our simple model of supply and demand suggests that more supply should come into play and demand should drop because of the influence of high prices, creating pressure to bring the market back to the equilibrium point. In a mania though, the opposite happens: the price history turns rational buyers and sellers into speculators. Buyers buy more, either borrowing demand from the future in the form of the buyer who’s afraid of being priced out if prices continue to go up, or from speculators buying multiple units with dollar signs in their eyes. Supply is a little more complicated, as it does definitely respond to the higher prices – that’s evidenced in the real-world by the plague of cranes in Toronto and Vancouver slapping together ever taller and smaller condos. But supply also shrinks a bit with strong price history in what’s referred to as “speculative holding” (at least relative to the supply dump we’d otherwise see). With prices on the up-swing, those moving (or moving in together) decide that rather than sell the old place, they’ll hold on to it, sometimes explicitly for investment purposes, but there are anecdotes of those who do it “just in case” even though they would have never considered that holding if price history was less favourable.

So we see that as prices move up, both supply and demand can increase in proximity to each other, feeding the beast ever upwards (no equilibrium restoring pressures), and the whole time it will superficially appear as though supply and demand are in balance.

What happens when prices stop rising at a break-neck pace? When they go down a bit – or even just stop increasing – in the so-called soft landing? In a normal market, the lower prices should bring more buyers out of the woodwork to support the new equilibrium. However if it’s not a normal market, but rather one driven by mania and attention to price history, then declining prices are not seen as cheaper but rather a shattering of the speculative world-view. Instead of finding new support for the equilibrium, the speculation in the market dries up. The demand snaps back to the inherent demand curve (which at the high prices, is a lot less quantity) while the same happens to supply (speculative holdings flood the market and listings go up). Supply and demand are – very suddenly! – far apart and there is a lot of pressure for prices to drop back to the original equilibrium.

It is my firm belief that the decline in sales volumes seen in Toronto and Vancouver this summer/fall are the first stages of that.

Now, many are saying that sellers won’t accept lower prices, that they will pull their listings rather than sell at a lower price. This is supported by our conventional view of supply-and-demand, and indeed this is what I expect will happen in the short term. But the speculation also affects the sellers. Those with speculative holdings may no longer be quite so enamoured with the land-lording life (or worse yet, the cash-sucking vacant “just in case” condo), so they may sell a bit below the peak (though the early ones will walk away with personal profits). As price momentum turns negative, the thoughts of holding out for better days turn to fear that negative price movements will persist, and panic sets in. Meanwhile, the builders who pulled out all the stops to meet the crazy demand of last year can’t stop on a dime.

There are many pundits out there with a basic understanding of “supply and demand” and who try to change their vision of the real world to fit that – in other words, they play up evidence that demand is legitimate (whether from immigration or a secular shift in how much of their paycheque the average Canadian is willing to put towards housing expenses) in order to explain high prices. But that simple model doesn’t really leave room for bubbles, manias, and speculation. Of course, I might be wrong – I still have to stop and think about those damned backwards axes every time – but at least the mental model I’m working from has the possibility of generating a bubble. For some bulls, they don’t think there’s a bubble not because of the weight of evidence, but because an overly simplistic model of supply and demand simply doesn’t allow for the possibility.

Someone asked me a few days ago if I thought he should buy some Netflix stock, based on a report that Microsoft was rumoured to be interested in taking it over. I gave him an emphatic no. Not because I had any idea as to what would happen with Netflix — it might very well go through at a really high premium — but because a take-over rumour on its own is no reason to be buying something.

For one, even if the take-over talk is legitimate, by the time the rumour has percolated to you (usually through some form of mass media) it’s too late and everyone has already acted on the news (i.e. the stock price is already up).

For another, there are like 5 take-over rumours for every take-over that actually happens (if the ratio is even that good). Heck, just searching for Microsoft take-over rumours turns up the ones on Netflix, but also Nokia, RIM, something called Yammer (which turned out to be true), Activision Blizzard, Rdio, Glu Mobile, OnLive, EA, Adobe, and two separate ones on Yahoo (one of which was a legitimate offer by MS, and another an unfounded rumour years later).

Of the take-overs that did happen, such as Microsoft buying Skype, I don’t think there was any hint of it in advance.

If the only reason to buy a company is because of a take-over possibility/rumour, and the price has already moved up a bit because the rumour is out there, then you could lose money if/when the take-over is finally denied (see: Yahoo) and the price reverts. If the takeover does happen, then often the price will jump even higher – but a 1 in 5 chance of making 20% doesn’t really work as an investing strategy.

Now that’s not to say that you shouldn’t buy a company just because there’s a take-over rumour swirling: some companies are good values and odds are another company will recognize that and take them over. But if it’s a good value, you likely won’t care one way or the other (indeed, you may wish there wasn’t a take-over so you could still own them – I’ve often felt that way about Teranet and a few other little companies like that that were scooped up by the pension plans in the last 5 years).

Take-over rumours just aren’t a good basis for making investing decisions, one way or the other.