Blessed by the Potato

Netbug asked how to invest in lab-grown meat (as well as a number of other emerging trends). I think that top-down investing is very difficult to do. You can be right overall, but so many factors can prevent you from making money on the call:

1. The profit source isn’t where you think it is. Maybe only private companies are in the area so you can’t invest, or maybe it’s not the guys with the mines that make money in a gold rush, but the guys selling pickaxes and lanterns (or not the guys selling 3D printers, but the stodgy old chemical supply companies with the polymer supplies).

2. The sector moves ahead while companies stumble and fall behind. The airline sector is an interesting one: you could have foreseen an age where people fly all across the globe, hundreds of flights into every major city every day of the week. And if you tried to invest in the airlines as they were founded you likely lost money on that vision. They have gone bankrupt with notorious regularity. People still fly, new airlines emerge (and old ones reorganized and brought out of bankruptcy), but that knowledge hasn’t been very profitable.

Similarly with cell phones: the omniconnected world comes closer every day. Everyone has a cell phone. People are disconnecting landlines in favour of cell phones, something that might have been unfathomable 20 years ago with the spotty service, high cost, poor voice quality, and miserable battery life of early cell phones. Yet even though the vision of a technological future you had may be coming true exactly as you pictured it (right down to that prophetic dream you had about touchscreens), it’s unclear how you should have invested in that trend. Motorola had it’s rise and fall, as did Nokia and then RIM. Apple could well be next. The carriers have done fabulously well in Canada and the US, but some European ones have barely paced their indexes. Cisco was meh while Nortel blew itself up. Maybe you would have been lucky enough to spot Qualcomm in the early nineties (though if you didn’t think about it until the late 90’s you were too late).

3. The market prices in expectations, so not only do you have to be right in your vision, but you have to be one of the few to see it (or at least one of the first). Converting a portion of our vehicle fleet to run on natural gas makes sense for emissions and because of the huge differential the past few years (and projected to remain so) between the price of NG and oil. However, everyone already knows this, so the price of Westport Innovations is through the roof. For many years pharmaceutical stocks had outrageous multiples as everyone counted down the years until the baby boomers’ health started failing.

Enough people have asked me how to invest in certain trends and I’ve banged my head against enough walls trying to figure it out that I have to throw my hands in the air and say I can’t do it. I’m just wired up to be a bottom-up investor (and at least partially as an indexer). But I also think it’s just an inherently harder problem, with more moving parts to spot.

The best macro idea I’ve had has been the Canadian housing bubble. The evidence is there, and it’s contrarian enough that it’s not priced in to a large degree. The problem is I can’t think of what to go long on for that bet, and there aren’t any good hugely asymmetric payoffs like subprime CDOs. The best I’ve got really is to short a few stocks, and the timing is just too hard to call for a straight short or expensive, illiquid put.

Home Capital Group (TSE:HCG) is an interesting company that draws very polarized views. On the one hand, there are a great many people out there who love it without digging any further into it than “it pays a growing dividend.” One of my favourite bits of astounding logic from a HCG bull when researching it was “there is no housing bubble because house prices didn’t go down last year.” On the other hand, many bears seem to stop their analysis at “there is a housing bubble, and they’re an alt lender, therefore short.” I wanted to dig into it a bit more to see if it might be worth shorting.

My main questions were: How vulnerable is it to a housing correction? What does the mortgage mix look like, what’s the credit profile and payment history of their borrowers? How are they funded, are there any debt covenants, and what capital reserves do they have? I’m not terribly comfortable with the idea of shorting something, so if I’m going to start to get really bearish on housing, I want to make sure that this is going to blow up good and proper before betting against it. Basically, reduced earnings and growth won’t be good enough: they’ll have to be forced to eliminate the dividend at the very least under a modest correction scenario for me to be comfortable shorting it — as only after they kill the dividend will the pool of surface-analysis dividend growth investors move to sell it.

What I found in a preliminary investigation is a company that is growing like stink. “Ah-ha,” I thought, “they must be spending crazy amounts of cash to advertise and give the brokers enough kick-backs to send all the business their way.” No — they have a ~30% efficiency ratio, which they claim is industry-leading (spot check: half that of BMO’s — lower is better).

Hmm, well, if they’re drumming up business and not spending money to do it, then I thought “they must have poor credit quality as they’ll just take everyone who shows up at the door. So their default rates must be awful, especially if they’re not paying any appraisers.” Wrong again: their default rate is quite low (on par with the banks right now), and even in 2009 barely breached 1% (good for an alt lender, about 3X worse than the national average at the time).

Only one option left I can think of: they’re attracting the best alt credit risks to them by discounting their rates, and people are seeking them out on a price basis. No again: they have a higher return on equity and net interest margin than BMO, despite holding more capital in reserve. A spot check on mortgage comparison sites puts them at about 3.5% for a 5-year rate vs BMO at 3.6% and the lowest-price entry at 3.4%; they’re amongst the most expensive on variable rates.

Well, it’s an enigma. I know they’re small (~5-10% of a big bank) which leaves more runway for growth, but this is unbelievable: they grow fast, without seeming to pay for it in any way (profitability, portfolio risk/defaults, leverage). Any insights into the secret of taking market share from the big 6 banks without spending money to do so? Part of the really low efficiency ratio is that they just do mortgages: branch staff to sell mutual funds and take deposits cost a lot for not much revenue; on the flip side, they don’t have the economies of scale for advertising (but that first factor will dominate). Maybe their business plan is too inherently wonderful, their management team is full of wizards, and I am a fool to even consider shorting such a beautiful business, housing bubble or no.

Or maybe there’s something I just don’t understand. I’m leaning towards ignorant skepticism at this point, and welcome corrections and explanations.

Sandi Martin of Spring (the blog) has stormed onto the PF blogosphere. I’ve added her to the blogroll on the side there, but wanted to point you to a few posts in particular.

In my book I recommended TD Waterhouse as the go-to place for new index investors, largely because of their low-cost, easy e-series index funds and because then you’d have a decent brokerage account you were comfortable with when it came time to “graduate” to ETFs. Not long after the book was e-published, a number of other brokerages (e.g., Scotia) came out with free-to-trade ETFs, presenting a competitive alternative to TD Waterhouse. People wrote to me asking if my recommendation had changed, and while I couldn’t be as singular about it, I would still recommend TDW. It was a bit of waffling about simplicity (the list of free-to-trade ETFs is fairly daunting, and misses the usual recommendations), a bit about customer service (which even if you only need it once is still important if you’re a new investor trying to get something going and you don’t even know what it is you’re trying to ask for), and a bit about e-series allowing you to optimize/maximize your investing with monthly savings plans thanks to a low minimum and the ability to invest in arbitrary increments. Sandi managed to articulate this very well in a recent post:

“…you’ll find a lot of reviews that talk about “$9.95 trades” and “great research tools”. Those features just don’t matter […] Your wish list is heavily slanted towards the cost to invest in, hold, and rebalance a portfolio of index funds, and the minimum purchase requirements for regular investment plans. “Ease of use” doesn’t even make the list, and neither does “research and education” or “personal rate of return tracking”…”

Now of course she recommended my book in this post on mutual funds, so that is going to get a link. It’s also a nice, succinct piece on why people should look to boring index investing.

She’s got a series on avoiding “the useless retirement plan” (start here), building off her experiences working at a bank.

And she mentions the deceptive “may” in the HST instructions in this post on the matter. Well we got caught in that same confusing wording, and seeing that others are also having problems with it means its time to write someone to get it fixed. So I wrote an email to my MP and a letter to the CRA (Taxpayer Services Directorate; Canada Revenue Agency; 395 Terminal Avenue; Ottawa, ON K1A 0L5), copied below:

Dear [My MP];

I’m writing you today in regards to some confusing instructions at the Canada Revenue Agency. For small businesses that collect HST, after reaching $3,000 in tax for a fiscal year the Canada Revenue Agency requires quarterly tax installments, rather than annual payments. However, the instructions say:

“If you are an annual filer and your net tax for a fiscal year is $3,000 or more, you may have to make quarterly installment payments throughout the following fiscal year” [emphasis mine] http://www.cra-arc.gc.ca/E/pub/gp/rc4022/rc4022-e.html

That “may” has caused some confusion for business owners and freelancers within my own family, as well as other cases I have recently heard of in the community. The CRA requires quarterly payments once the $3,000 threshold is reached, and does not send notice, instructions, reminders, or a payment schedule. If quarterly installments are not made, they levy interest. Yet the instructions do not make it clear that it is up to the small business to remit quarterly without further instructions — indeed, the “may” suggests that they would not have to remit quarterly unless directed otherwise.

This confusion is exacerbated by the contrast with income taxes, where the CRA does explicitly direct the taxpayer when and how to remit quarterly when they are so required.

I am not asking for the tax law to be changed, but rather for the procedures and instructions to be clarified to prevent this common error from occurring. Two potential solutions that come to mind are:

1. Change the procedure to include a notice period, and have the CRA lay out a schedule for quarterly HST installment payments (as with the income tax).
2. Change the instructions to make it clear that small businesses must remit quarterly, and should not expect advanced direction from the CRA.

Thank you for any help you can offer in fixing this for other small business owners. I want to mention that my own situation has long since been cleared up, so I do not need any personal help with HST. I have sent a similar letter to the Taxpayer Services Directorate of the Canada Revenue Agency.

Sincerely;
[Me]

Please feel free to take from this, put it into your own words, and help make a small change that can save administration work at the CRA and penalty interest and headaches at numerous small businesses.

As an aside, it makes me wonder how apropos it is that the address for suggestions is on terminal avenue…

Budgeting is a necessary part of life: resources are finite, and we have to allocate them somehow. Though some may revel in the min-maxing challenge of budgeting, it is at its heart a somewhat painful process of self-denial. So what mechanisms do people use to stay on budget? There are mechanical ones, such as using jam jars and cash, but for most people with access to credit psychological control must be exerted.

There are several coping mechanisms to deal with the psychic strain of not buying what you want. Myself, I think of life in terms of video games, with money being the points I can spend on my character, and there are simply some areas of spending that result in more happy points being accrued than in others, and I keep those trade-offs and opportunity costs in mind. I could buy this DVD, but I’d be happier saving that money for a video game next month. There are other similar rationalizing-based mechanisms out there, for instance you can focus on your long term goals and needs, and determine if a particular purchase fits into those.

Another one I’ve heard is to shift the money focus of budgeting to a dimension you may be more comfortable with, such as space in your house: if you buy whatever it is facing you, where will you fit it in your house (or hard drive)? There’s a limited amount of space, after all.

Wayfare presented me with a new one recently: when she comes across something awesome (a T-shirt on Think Geek, or a cute baby outfit in a store) she says to focus on the joy of the knowledge that it exists in the world, but know that you don’t need to have it in your house. It will still exist and be awesome and you can appreciate it even without spending money to have your own copy.

An investment idea a bit off the beaten track to discuss today: American Hotel REIT. This is a new REIT, still flush with cash from its IPO. They identified the small, economy hotel market as one that’s fragmented and where they could make a number of accretive acquisitions. It has purchased a set of low-end hotels from a private chain in the US. The neat thing about these hotels is that they are focused on serving railroad workers: Union Pacific pre-pays for the majority (74%) of the rooms so that their unionized employees can take their required rest periods, with some room-nights also booked by other railways.

I found it interesting that one of the words used to advertise their rooms was “dark” – not something you hear all the time to describe hotels, yet precisely what I want in a room where all I want to do is sleep and get back on the road.

In terms of cash flow, it’s a little difficult to say for sure because the REIT has only been operating the hotels for a few months, and only part of the cash raised in the IPO has been put to use. They are vastly overpaying because of that last factor, but I think we can assume they will build or buy more hotels, so we can estimate the payout for the long-term.

Looking at the statements from the hotels under the private label (available on SEDAR), it looks like if they can invest the remaining $26M they’ll have no problem covering the distribution with the raw cash flow. However, depreciation and amortization can’t be completely ignored – some maintenance capex will need to be put into keep these stick construction hotels up-to-date, especially since about 30% of the balance sheet is “equipment” with projected lifetimes of 5-15 years rather than real estate. Making some rough estimates as to what to reserve – the engineering report from the purchase identified ~$1M/year in projects – I figure that this portfolio is generating about $0.50-$0.70/unit in distributable cash. Assuming that the rest of the cash buys similar properties, that works out to about $0.80/unit – a bit under the announced payout of $0.90/unit.

Now, this is a recent IPO, and it’s nearly a sure bet that there will be more secondary offerings to come, so they may have purposefully set the distribution a bit high to attract investors. Personally, I’d prefer they set it too low and then adjust higher once the properties prove themselves, but that strategy doesn’t move shares on the TSX. Because of the virtual guarantee of future secondary offerings, the price isn’t likely to shoot through the roof. The newness and small size also means that it is not widely followed, possibly making for opportunity.

But if even being fairly conservative I figure they can support a 7% payout, with the only substantial risk being re-contracting with Union Pacific, then I’m pretty happy. Plus there’s a good chance that growth, synergies, and inflation can help them meet that $0.90 payout in short order – at least before deferring maintenance capex catches up to them. In this environment, an 8% yield with a bit of risk is a decent deal.

One area of conservatism is the loan on the properties: the private company holding the hotels before the purchase was borrowing at 3.5% with floating-rate mortgages, but HOT.UN’s new financing is 5-year fixed at 4.85%, which is nearly ten cents per unit of cashflow right there. Lowering their borrowing costs (e.g., by growing larger and becoming more credit-worthy) could help make the distribution safer.

Disclosure: currently long HOT.UN. Note that this is a new, small, illiquid REIT with many risk factors (e.g., actually putting the cash to productive use; subsequent/dilutive offerings).