Blessed by the Potato

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?

Please note that PSGtDIYI has been superceded by The Value of Simple

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.