Blessed by the Potato

When I first talked about Freddie Mac, political risk was one of the things I highlighted that might undermine what otherwise looked like an attractive long-shot bet. The US government has been requiring that Freddie Mac (and its sibling GSE, Fannie Mae) borrow more money than they need, and pay a punitive 10% interest rate on that — a worse deal than the TBTF banks who arguably had more to do with the cause of the global financial crisis. Part of what lead to the excess borrowing was the fact that Freddie’s been over-reserving for years now. It looks as though they’re getting to the point where even the most conservative accountants realize that those excess reserves will start unwinding, which will enable Freddie to start paying back the government — and after that, the preferred shareholders.

So it looks like the main investing thesis was playing out.

Unfortunately that political risk reared it’s head this week as the government announced it would change the deal to instead confiscate all future profits. I have no idea why the government decided to nationalize the GSEs but not AIG or the TBTF banks, or why they decided to change the deal at this late stage, just as the profitability was re-emerging. I suppose I’ll just have to pray they don’t decide to alter the deal any further.

I’m not quite sure what that means in terms of the preferreds being paid back, but my first take on it is that they’ll be worthless. The market seems to be equally panicked, as most issues were down about 60% on Friday.

This is a monthly update from the Blueberry Portfolio. The events I mention below happened approx 8 months ago.

I started this update by providing a spreadsheet to the investors with the capital gains laid out. [Specifics redacted] It’s important to remember that realized gains in a non-registered account are taxable. Add the information from the spreadsheet to your schedule 3 for taxes (if you don’t ordinarily have gains to put in schedule 3, I can show you how, it’s really easy). In addition, you’ll be receiving some tax slips (T3s) in the mail around the beginning of March for the dividends that you enter into the appropriate boxes in your tax software.

Otherwise there hasn’t been much to say.

After spending some time without (m)any bright ideas, I put more cash into the ideas I did have. That broke an unwritten rule that I’d try to stay diversified with no more than 10-15% in any one stock (Chemtrade is close to 20% of the portfolio, and Canexus over 10% — and both are in disturbingly similar businesses). As soon as I do have a bright idea, these will be the first positions I look to trim to get cash to move around.

One bright idea was Poseidon: a high-risk, high-reward play on “fraccing” in the oil business, which also pays a lucrative dividend. Our timing there couldn’t have been much better: as of this message, we’re already up about 15%. I don’t know yet how much further I’ll let this one run before locking in the profits, but I imagine I’ll wait for at least double that return over the next year before getting out (unless something changes).

Since the last monthly update, the market has been more-or-less flat, while we’ve added a few percentage points. After the first day of trading in the new year, we’re up almost exactly 10%, vs the market at just about 1%.

There are some readvancable mortgages that are sometimes billed as all-in-one accounts at a few different institutions. The way they work is to basically pull together your mortgage, line of credit, savings, and chequing accounts into one product. The stated benefit is that your emergency fund and cash float from your savings and chequing accounts will be used to pay down the mortgage, but are still available for your use as needed.

All else being equal, this would be a great idea, and indeed recently Nelson at Financial Uproar had a post covering them.

The problem though is that these products usually come with a higher interest rate than you could get on a plain vanilla mortgage, about 0.5-1% more. So does the benefit of having your whole float working on your mortgage balance outweigh the extra cost of the higher interest rate? Like many things, the answer is it depends… but mostly, no.

You can grab a spreadsheet and play along at home with the full calculations if you like, but for once I’m just going to back-of-the-envelope it. There will be some minor effects from the compounding, but not enough to really worry about.

So let’s say you’re a fairly typical recent homeowner: you bought a few years ago, and just recently crossed over into having enough equity to try out this scheme. You’ve got $10k in your emergency fund, and your chequing account balance varies through the month depending on the timing of your bills and payroll deposits, but is on average about $3k. So you could potentially put an additional $13k towards your mortgage with this plan. If you’ve got $400k left on your mortgage, then the amount of interest you’d pay in a year would be $12k at 3%. With the new plan, you’d only be paying interest on $387k, but at the higher rate of 3.5%, which would cost you $13.5k. So the higher interest rate makes it a fair bit more expensive to go with this plan (and any impact of compounding would be balanced by the interest the cash would be generating in a savings account).

If you have more in cash and less owing on your house, it may look better: with $20k in cash and only $100k owing on the mortgage, you’d be paying $3k in interest the traditional way, versus $2.8k for the all-in-one. Still, you need almost absurd amounts of cash compared to the mortgage balance for it to work out.

Plus, with just a little bit of effort on your part, you could in those situations do even better with separate accounts: you can get a regular mortgage at the lower rate, put all of that cash on the mortgage, and open a separate HELOC to get the flexibility to re-withdraw your emergency fund if and when needed. All the money goes on the mortgage at the lower rate — you can even put your chequing account float on the mortgage and use the HELOC for the revolving cash needs (which sounds scary, but is functionally exactly what is happening with the all-in-one products).

I keep coming back to look at poor unloved RIM, and I keep not buying it.

At one point I was openly wondering if it was a good buy, trading a hair above book value and some ridiculously low P/E. I even thought it was good enough for the misfit bloggers stock picking competition (good enough for fake money — now there’s a recommendation!). Then it fell lower than that even, and I still didn’t buy. It wasn’t due to any squeamishness about falling knives, but rather because the business outlook kept deteriorating just as fast if not faster than the share price. Not even a year ago I had figured that even if the BlackBerry brand was losing out to Apple and Android, it wouldn’t happen overnight, and there’d still be a year or two of positive earnings. Yet now they’re already reporting a loss.

A few months ago, I reasoned that they’d be worth the cash on the balance sheet plus some generous value for their trove of patents. After all, they had paid some billions of dollars for just a subset of the patents in the Nortel bankruptcy. Except, that line of reasoning kind of fell apart as I examined it: they were the highest bidder in the auction, so the patents would by definition be worth somewhat less than what they paid. Plus, those patents are a few years older and closer to expiry now. RIM’s own core patents might be valuable (they still do have some strengths)… but Apple and Google’s device manufacturers have had no problem moving product without access to those patents. How much could they really be worth?

So now I’m lowering my sights once again and demanding a larger margin-of-safety before buying. If the negative sentiment continues and the stock price continues to suffer then there may well come a time where I’m willing to buy. But now I think that point will be when the stock is trading at a discount to their cash: where I get the patents for free, the business for free, and a cushion to insulate against a few years of losses eating into that cash hoard. From a quick back-of-the-envelope calculation, I probably won’t be putting in any bids until I see it under $4.

This is a monthly update from the Blueberry Portfolio. The events I talked about below happened approx 8 months ago.

The market has been much stronger in the last month, and we’re now up just over 6% from the beginning, vs. the market up 2.5% (in the last report, the market was down 2.5%, so both us and the market are up about 5% in the month).

Though my goal is to be almost fully invested most of the time, at the moment we have about 15% cash in the portfolio: I just don’t have any great high-conviction ideas at the moment. I’m researching some options, but haven’t had much time to put towards that. One problem is fear: we own a bit of Indigo Books & Music, which is one of the few stocks that’s down a lot since we bought it, and though it looks even cheaper now, I’m afraid to put any more capital towards it in case I’m wrong about the book and knick-knack selling business in Canada. It has really clean financials, and due to the decline in the stock price the modest dividend is now on its own an attractive feature: it’s yielding about 7% at these prices. However, they lost money in the last quarter, and the big gamble is what happens over the next few months. Will Canadians buy books, music, upscale wrapping paper, and whatever else Heather Reismann wants to sell in Chapters stores over the holidays, or has Amazon finally caught up and killed Canadian bookstores, after feasting on the carcasses of the American chains?

That’s really the key question. Indigo at the moment is trading for just a bit more than the value of their current inventory and the shelving units in the stores: if the company is at all profitable for the next couple of years, then this is a stupidly low price for it and we could make a lot of money by buying now. Historically, most of their money is made over the holiday season. If they can come out in the black again this year, then the stock will probably go up on the news. But if their losses continue into the new year, then we may be looking at store closings and the end of an era for physical books.

At the moment I view Indigo as a potential high-risk, high-reward stock. Even just getting back to where we bought it a few months ago would be a huge percentage return. So while I do seek out and invest in high-risk, high-reward situations, I try to keep the size small so that if we see the high-risk side rear its head and lose money (as we already have to a large extent on Indigo) it doesn’t hurt us too much (indeed, the returns in the first paragraph include losing money on Indigo — not all of our ideas will be winners).

As to the cash, well that’s there in large part because we’ve had a few take-overs.

One of my big ideas at the beginning was Capital Power income fund: it was in the process of being taken over by Atlantic Power. Both were power utilities paying nice, stable dividends. I was happy to own either for the long term, but an interesting opportunity was in buying Capital Power just for the takeover: we bought at $18.60 per share, and Atlantic Power was promising to buy those shares from us at $19.40 in just a few months. It seemed like a very low-risk opportunity, and so it was immediately one of the biggest positions at over 10% of the portfolio. In the end, I made a small mistake in evaluating the deal: Atlantic Power was offering a combination of shares and cash, and I thought we would be able to choose just cash and get just cash, but Atlantic Power wanted the whole deal (across every shareholder) to average out to half cash and half shares. If I was being a proper arbitrageur, I would have shorted the Atlantic Power shares at the same time I bought the Capital Power ones (short about half of one ATP for each CPA). In the end, we ended up getting the equivalent of $18.98 per Capital Power share, plus one tax-effective dividend payment of $0.145. That’s a gain of 2.8% in two months, which is fantastic (some investments don’t make that in a whole year). Still, a bit less than I had figured we’d make in my mistaken initial all-cash estimate.

Anyway, one of our biggest positions has been turned from a stock back into cash, which explains why we once again have a fair bit of cash to invest in something else.

At the moment, I don’t know what to invest it in. I’ll be doing research from my end, but remember Peter Lynch’s advice: good stocks don’t come out of nowhere, many are the companies you interact with every day as a consumer. So if you see the beginnings of a new fad (like crocs or lululemons), or ongoing good value and customer support, something that you find your friends and family talking about and recommending to each other consistently, make a mental note of it and let me know.

And especially make note of how busy your local Indigo/Chapters is this holiday season, and how that compares to previous years.