Blessed by the Potato

I saw someone on BNN make Bennett Environmental (TSE:BEV) a top pick this week. I had never heard of the company before, and I like the phrase “classic value play ala Benjamin Graham” so I decided to have a look.

Irwin Michael isn’t just talking his book in the normal sense — he’s a major shareholder with ~18% control (or rather, his fund is). There was a recent proxy battle with a new board eventually being installed, and the proxy circulars are surprisingly good reads: describing a drama where the old board had next to no ownership stake, and was allegedly trying to get the company to use its cash hoard to buy a company related to a director, or make otherwise bad deals. And speaking of a cash hoard, they have a pretty hefty one: the stock closed Friday at $2.22, and had about $1.65 in cash.

Operationally, the company’s in trouble. When they have business, they generate tons of cash and look fantastic. But the technique they use for soil remediation is energy-intensive and costly, so it only makes sense to fire up the equipment for a large batch of soil. Thus, they stockpile contaminated soil until there’s enough to run a batch for a few months at a stretch. They shut-down in September (10 months ago!) and are still only 3/4 of the way to having enough soil stockpiled to begin another processing run. It’s not a very attractive business if they’re only making money in alternate years, and burning ~$7M/year twiddling their thumbs the rest of the time. Though even then, if they were trading closer to book (i.e., <$1.75) I might take a small position just to see what happens. I won't even bother putting this one on my watch list to see if it gets that cheap though, because with a billion dollars to play with, if ABC Funds wants to put a floor under it at ~$2 they easily can. Mr. Irwin's point was that with a new board and that big pot of cash, they'll go out and buy some other company which will improve their position: maybe something in a related industry that isn't quite so crushingly cyclical. It could be an interesting ride, but I'm not seeing enough safety at these prices to buy in on the what-ifs of an as-yet unidentified acquisition and the merits of a new board and management. Plus, there's a huge question with acquisitions like that: maybe they'll buy a company and the synergies or the price of the deal itself will return more than the cash value to the shareholders. Or maybe they'll over pay for something, burn through the remaining cash while they wait for contaminated soil to pile up, and have to declare bankruptcy. Or maybe something in-between: an acquisition that brings value, but only just enough to make up the difference between the $1.65 in cash and the $2.20 share price, leaving anyone who buys now somewhat disappointed. Anyway, interesting story, but not for me.

Out on the Island there’s a minor fad in putting giant decorative stars on the sides of houses, and more recently butterflies/dragonflies. We asked around to try to see if there was a reason why people had these stars on their houses here, if it was some kind of local tradition, superstition, or signifier. It’s apparently a common question from tourists, and there’s no real answer. The stars don’t signify anything in particular (though one person suggested it may have started as an Acadian thing), they’re simply decorative. It’s just a fad that happens to have caught hold here, but not back in Ontario.

The vacation was very much needed. Very much. I didn’t take my full vacation in 2010, and the week I took off I didn’t go anywhere, so it was good to just get out and sit by the ocean and read some books completely for pleasure, as well as play through some video games and watch the Game of Thrones mini-series. I can’t say that I’m fully, completely de-stressed from the thesis/future career uncertainty stress, but I no longer find my heart seizes and jumps 3 inches higher in my chest every time my email goes “boo-woop.”

Even on my vacation I had a to-do list. Some of it was merely playful: the top few books/games I wanted to read/play through (Girl with the Dragon Tattoo, Leviathan/Behemoth, Portal 2, Assassin’s Creed), some of it was things to do out east (garlic fingers, biking, visiting relatives, and garlic fingers), and some was to be somewhat productive in a non-thesis related way (enter a short story competition, draft a few posts to have a backlog for when my time is precious for the thesis, write some cover letters). While I got through most of the reading/playing list (didn’t get to a few books or Assassin’s Creed), I didn’t even touch the writing part of the to-do list.

I’ve already burned through many of my reserve drafts, and that was with a nearly complete shut-down of posting while I was gone. I expect then that I’ll only post once or twice a week at most for the rest of the summer, unless someone says or does something stupid that I can’t resist commenting on. Oh please say something stupid! Anyway, this post will have to last you a while. Fortunately, it’s long. Also, the comments have been re-enabled now that I have a stable internet connection to clear out the spam folder every day or two.

Speaking of internet connection, tethering to my BlackBerry was reasonably useful. For most of the trip I could access the internet, and it was reasonably fast to load (often a long latency time before it started, then the page would snap in pretty quickly). But as the trip went on, it got more and more screwy: taking longer and longer to resolve DNS requests, and often failing at that. It would give me a message about a hardware error in the modem and disconnect (i.e.: lost connection between PC and BB). Then one night the internet just went dead completely, even on the handset itself, though the signal meter still showed one bar (down from 3/4). Then, mysteriously, my BB displayed the red message light on solidly and shut itself off. I thought it was dead, but it came back to life not too much afterwards and I could connect again with the handset, but with less luck on the PC. So except for those last few days, it did work quite well. Haven’t received the bill yet to say how much Bell ended up deciding to charge me for the tethering.

Book mini-reviews:

Spoiler warning start!

A Game of Thrones: A Song of Ice and Fire: Book One: A fantasy book, with undead creatures and dragons present in the universe, but not making much of an appearance, so mostly court intrigue and betrayal. Knights and war and honour and blood. A very large set of characters seemed really well laid out, with depth to every one. In particular though, George R. R. Martin has no qualms about who lives or dies, or where the plot may take us. He is ruthless, and I have to say I was genuinely surprised at the plot twists (last chance before spoiler-ville!): for most of the book he seemed to be building up the Dothraki threat, even giving Drogo a good reason to get good and mad and charge across the narrow sea. I was so sure that that was what the book was building towards… when all of a sudden he’s felled by a common infection. The HBO min-series was also great: very true to the book, and in the few places where it wasn’t, I thought the show offered some improvements. For example, Catelyn Stark wasn’t as mean to Jon Snow in the show, which made her more likeable off the bat, and I much preferred “white walkers” to “the Others”. Who uses such a vague term as “the others” for a menace? I hated it in Lost, too. Very well-cast all around, too.

If you’re a fan of fantasy, or even just fictional political intrigue (and can at least tolerate swords and a fictional medieval setting), then I recommend it. And I’m highly looking forward to finishing the rest of the series.

End of spoiler warning section!

Girl with the Dragon Tattoo: This has been a pretty popular book, with two movies made of it now (a Swedish-language one, and a Hollywood version). It’s a murder mystery thriller, and it was pretty good, though I’m not sure I’d have even bothered to write about it if it weren’t already popular (and perhaps sadly, it’s popularity means my opinion matters even less). There are definitely some points in the book where you can tell it’s a translation. My favourite was the “and he was up for the Big Journalism Prize” — presumably translated from a named Swedish prize that English readers wouldn’t recognize. But it does read well. I liked the main characters, and the suspense built, making it a real page-turner. However, it’s not for the faint of heart: the crimes involved are vicious and graphic. The sex scenes are plentiful, and the morals are loose. Indeed, if it weren’t for the fact that it was already an international bestseller with lots of publicity, I wouldn’t feel comfortable recommending it: though it was a good murder-mystery novel, it wasn’t spectacular enough for me to want to come out and recommend it in light of the subject matter. If you have a sensitive personality, you may want to give this one a pass, despite the hype.

[Note, the above links are to my affiliate link at Amazon, and at the moment, Game of Thrones is on a pretty good sale. I do get a small kick-back if you buy via that link, but it doesn’t affect my enthusiasm for the books.]

A site I hadn’t seen before, Metal Augmentor put up a thorough look into some of the background issues with Sino-Forest, including the confusing terminology. Indeed, quite aside from any fraud issues, MA points out that I made one of the mistakes mentioned, over-counting the amount of owned plantations (where seedlings are planted and money is made by patience and silviculture) based on the company’s confusing use of terminology.

I was just having an off-line discussion about the Sino-Forest issue, and how the MW report had at least a few mistakes, while the company’s response was lacklustre, so it was hard to say what the truth of the matter was. Though I had a passing interest in the many hunters of Chinese frauds, and had heard of MW before the scandal broke, MW wasn’t one of my most esteemed detectives. The person I was talking to was interested in making a small bet on SF, and I said that if one were in a gambling mood, perhaps this could be the one sketchy-looking company that was indeed real. But, I warned, while I might bet on MW getting this one wrong, I wouldn’t bet against Hempton. Wouldn’t you know it, the next bloody day Bronte Capital has weighed in on the side of shenanigans in a series of posts. John says:

“As for analysis of the accounts – the Sino Forest accounts contain enough red-flags to make any eagle-eyed observer cautious. I am sympathetic to making an investment without looking at the accounts at all because limited time and shortcuts often make that an efficient way of behaving. […] But if some analyst really did a detailed look at the accounts and did not spot the red-flags then they are incompetent. For that I have no sympathy at all.”

Well, I guess I have to publicly admit I’m incompetent. I’m an amateur and lack experience, granted. But before I bought I was looking (albeit with a much more limited time budget than a full-time professional fund manager) specifically for signs of fraud. I’ve been up on my game enough in the past to avoid a few doozies (though never gone short), and to follow along with the analysis of some other alleged frauds, but totally missed this one. Indeed, I still can’t see it as clearly in TRE as these guys allege. I’m merely confused, as I was before, which is how I ended up making an investment based on a weak heuristic.

This post also happens to come at basically the half-way point of the year, so I figure I’d update my spreadsheets and see how I was doing. I thought it would be absolutely dismal: I took a bath on Sino-Forest, and lost nearly as much on TEPCO. I’ve been holding Yellow Media since 2008, and it’s had yet another bad year — down some 60% (not including dividend). Was it really just a few months ago (when it was trading around $4.50) that I said you couldn’t get much more contrarian sentiment? Yikes. Though I mercifully kept my positions in TRE and TEPCO small, I can’t say the same for YLO, so I figured that those three big losers would pretty much sink me here.

Indeed, I did underperform my personal benchmark (50/50 TSX/S&P500) by a noticeable margin, but not as badly as I feared. I was saved by a few good moves: Canadian Helicopters was up ~50%, TD was up 10% YTD, and up 16% at one point (where I sold half so locked in some profit). A few other positions had modest returns, in particular Canexus and Veresen — though the moves weren’t big, the positions were (and I’ve since trimmed them both down, trying to not let any one position get over 10% of the portfolio). My Freddie Mac preferred shares are up nearly four-fold in the last six months, but since it began as a small position and was down 65% in the first place, that big percentage gain was small in absolute terms, and just barely balances one of the TRE/TEPCO losses. Overall I’m down less than 1%, compared to the TSX up about 1%, and the S&P500 up about 5% in CAD (I’ve estimated the dividend yield since I don’t know of a good site for total returns stats, though in the past I took the time to create a model portfolio with XIC & XSP). So a miss of about 3.5%. Not terrible for having made some truly godawful investment decisions recently, but not the kind of performance I can keep up if I’m going to continue attempting active management. Unfortunately I don’t see any catalysts for outperformance through the rest of the year, so I don’t think I’ll be making it up this year.

One thing I did do right was my rabbit analogy for the way the TFSA works. Someone even called it “perfect” in a recent CMF thread, which is a nice ego boost :)

Oh, and finally: I have a defense date! Just another month and a half, and I get to run the Gauntlet of Science and prove myself a true doctor. Or you know, fail miserably or whatever. Either way, it’ll be done before the end of August!

What makes a good investment? I would say we can all agree on a definition along the lines of something that will be worth more in the future, finding some balance between maximizing return while minimizing the risk of loss.

There’s lots of room for discussion about which asset classes best meet those definitions, how to go about finding them, and how to balance the potential returns with the risks.

But, is the ability to touch an investment a quality that makes for a good investment? I’ve heard many times about how real estate is an attractive investment because it’s tangible. Yet I’m left wondering, how does being able to touch it make it improve my future returns? Maybe it can be seen to reduce the risk of loss since it’s unlikely to be worth nothing in the future (313 excepted), but a liberal sprinkling of leverage eliminates that benefit.

And of course the grand counter-example: was real estate in the US in 2006 a good investment (hint: the answer is no). Was it any less tangible though?

I’ve heard that about gold now, too. I’ve got a 1-oz silver coin here. There, I just touched it. I don’t think that helped the value any. Indeed, I also have some cash, and having it here in my wallet so I can touch it makes it a worse investment than making it intangible in a HISA.

Tangibility can play into the importance of understanding an investment, but really comes down to satisfying an emotional need. Being able to touch your investment, to sit under its roof, to improve it with your own hands, or to clutch it tight and whisper “my precious” can make you feel better, but it doesn’t make it a better investment. And as we’ve learned so many times already, emotions are best left at the door in investing.

I keep following it thinking I’ll dive back in, but I haven’t yet, and likely won’t until after the results are released next week at the earliest.

I liken it to when you’re afraid there might be a spider in the shower: before you get in you shake the towel and have a scan around, and it looks clear, so you get in. Once in, I might have ignored banging at the door or the water turning cold, since I wasn’t afraid of the Psycho or broken hot water tank scenario, but if I so much as see a black hair that might resemble a spider leg poking out of the drain, I’m running out of there screaming.

So before I bought Sino-Forest, fraud was my biggest fear, and I didn’t allay it by obtaining first-hand concrete knowledge, which would have given me the confidence to see something like this as a buying opportunity. Instead, I relied on weak heuristics and an analyst report that claimed the governance was good.

Then the MW report hit, alleging fraud, and it all fell apart: exactly what I was afraid of. MW had a good hit rate (~3 for 4) with these Chinese RTOs, and I had heard of them before this broke, so I wasn’t about to just dismiss them as a short-seller with dreams of market manipulation.

On the other hand, MW is the noisy kid brother of the cottage industry that is exposing RTO frauds. I don’t want to just attack the source, since that’s not a strong foundation for investing, but he strikes me as someone more interested in market manipulation than justice. His reports haven’t seemed as thorough or solid as say John Hempton’s*, and so far the frauds have been low-hanging fruit. Sino-Forest, if it is a fraud, is a step up. His best part of the analysis (both playing to his strengths and making SF look bad) was the one about how impossible it was to harvest all those trees Sino-Forest sold… but that was smacked down with the first release that said it was a sale of standing timber. I’m not sure tracing related party transactions and capital flows into and out of the country is really his forte. Then the paper reports that he spouts off about having all this other evidence on the analysts’ conference call he hosted, yet he hasn’t released it. Maybe waiting for another Chinese holiday for maximum impact.

I still don’t know what to think. The company has released some documents (though it took a few days). The bank statements look real enough, complete with hand-written notations (presumably linking transactions to entries in the ledger/accounting system). But we’ve learned with other frauds that the companies can and do fake bank statements: you have to get an auditor to go down to the bank and confirm with the bank that the money is there as specified.

Various analysts have said they’ve physically gone over to view the operations, but Poyry might have had the same problem: they can say there are trees there, but who owns them? Plus other, much smaller, less well-executed [alleged] frauds have put up the potemkin factories for analyst visits before, only for private investigators to find the sites empty or idle weeks later.

Fraud is insidious. It’s quite difficult to prove something isn’t a fraud, particularly when there is so much suspicion after all the recent cases, and from halfway around the world with a massive language and cultural barrier. You can’t believe anything the company says without 3rd party verification, and the balance sheets become useless — if it was a matter of pine beetles or wildfires, banks not lending or demand drying up that hammered the share price to a third of book value, I’d probably be buying like crazy. But book value is unreliable if there’s a chance it’s all a lie anyway.

I forget his name, but one talking head on BNN put it [approximately] thusly: “What else were they going to say? It’s like they went to I’ve been targetted by a short seller dot com and printed off the fill-in-the-blanks press release.” The company’s been doing the dance, and releasing some of the documents is a bit better than par, but it’s still not fundamentally different than the dance that an actual fraud would do. That’s partly because there isn’t much more for them to do. Offering the analyst tour in July and specifying that the analysts could pick the locations was a good step at helping to remove the potemkin element. The Dundee analysts’ comments after the close today were also heartening.

So I’m not buying yet, but I keep turning it over in my head, and think I might if there was some good 3rd party evidence of authenticity: an auditor in a bank branch verifying cash, or signing off on the annual report, or maybe a supplier of eucalyptus seeds/seedlings confirming that SF is indeed buying sufficient quantities to do the planting they claim they are. I feel close to having the confidence to buy in again.

Plus I have to bear in mind that my bias is to want to believe. After all, I bought in and lost money, so deep down inside, I want to be vindicated on that prior decision and have this one come out fine in the end. That forces the rational part of me to be extra careful before buying back in.

* – Though John did say that he “was in awe” of MW’s report, but that may just be because of the size. And he hasn’t commented at all since Sino-Forest started posting responses. With MW I read and I think and wonder if he’s wrong. If it was John Hempton alleging fraud, I would be out and gone and never look back: his track record at research and alleging fraud is too good to bother trying to second guess to find value.

On Friday, I was pretty upset with Sino-Forest: their release was somewhat weak, engaging in ad hominem attacks rather than reassuring me. They had two good points, but if the sale of standing timber was a fictional trade to a related party, it didn’t much matter whether it was standing timber or cut. Most importantly to my mind, was that they were late. They promised investors to have a release before market open (i.e., 9am or earlier), and didn’t get it out until 10:30. I am very understanding of lateness in preparing documents, particularly long ones that tell the tale of your research program for the previous 5 years (ah-hem), but this was a two-page press release with not that much substance. I have to admit that my expectations were raised a bit by the lateness: perhaps they were waiting for the bank to open so they could drag an auditor down there to prove the cash was still in place?

Anyhow, as you read in the last post, I sold until I could get a better handle on what the truth of the matter was.

On the one hand, back-of-the-envelope calculations about harvesting a certain number of trees in a single year being impossible have been the kind of thing Muddy Waters has excelled at in previous cases. If that was what lead them down the rabbit hole in the first place, then the clarification that it was a standing timber sale helps. Honestly, I can’t sort through the almost entirely Chinese documents alleging that the transactions were with related entities and/or shams. That doesn’t give me much confidence in Sino-Forest, but also makes me wonder how strong MW’s case is then.

However, it makes me think that if there is a case that MW is going to get wrong, it’s this one. Many people are calling for proof of ownership of the trees to disprove the allegations. That would indeed be strong proof, and it was frightening that the BMO analyst said it was asked for previously and not provided. I’m willing to grant to the company that there may be a good reason for that. How do you prove ownership of hundreds of thousands of hecatres? Start pulling out all the deeds? A hundred separate Chinese-language contracts to plow through? That would be the best evidence, but it would likely take too long.

I really just want to see the cash.

Frauds exist to siphon shareholder money out of the suckers’ hands and into those in on the deal. It’s possible to do this with money in the company accounts, and just engage in some back-and-forth phantom transactions with related parties to inflate the share value, then sell your shares, but that’s a lot of work compared to just taking money that’s in the bank. Proving the money is there wouldn’t be strong proof that the company is real, but it would be quick, and I think it would be enough for me to buy back in (and risk losing more).

The company put out a release this morning (before market open this time):

Cash on hand
As at December 31, 2010, the Company had approximately US$1.26 billion in cash, cash equivalents and short term deposits as reported in the audited consolidated balance sheet. As at March 31, 2011, the comparable amount was US$1.09 billion. The sources and uses of cash for the period ending March 31, 2011 will be further detailed in our quarterly report for the period ending March 31, 2011 expected to be issued on June 14, 2011.

Sino-Forest has released today on its website a summary schedule of cash and cash equivalent and short term deposits along with a detailed listing with copies of its bank statements confirming the cash held within the Company as at that date. The Company has conducted business in the ordinary course since then and made ordinary course expenditures, and its cash remains intact with the majority of it in banks in Hong Kong.

Ok, here we go, that’s a little better. Now, we learned in previous RTOs that it’s not enough to just look at the company’s copy of the bank statements: you need someone to go down to the bank and verify that the money is indeed in the accounts as indicated. Unfortunately, the documents are behind a registration wall on their website, and you have to email to get a login, which may take up to 12 hours to receive.

Seriously? These guys are just shooting themselves in the foot with that one.

Updates:

TD has finally updated its report.

While many allegations in the Muddy Waters report demonstrate a fundamental misunderstanding of Sino-Forest’s business model, others are material and are impossible for us to refute or verify at this time. We appreciate the time constraints involved, but we hoped for a more comprehensive response from management on Friday.

That’s well said, IMHO. I still don’t think I have the information I need to make an informed speculation here and buy back in, as much as I want to believe the company. Today’s release was better, but saying the bank statements are on the website, locked up behind a registration wall I’m still on the wrong side of at the moment, doesn’t bring me any joy. Any Hong Kong bank executives amongst our readership, by chance? Is the money there?

Oh, and I meant to mention insider trading on Friday but didn’t get around to it. There was a lot of insider selling in TRE back around December 2010. That was somewhat worrisome, but I brushed it off when buying, in part because the selling was at a much higher price. The VP finance exercised some options and immediately sold the shares (he apparently doesn’t believe in owning the company he works for). The CFO exercised options and sold twice as many shares (cutting his ownership way down). The CEO sold a large dollar-amount of shares, but only about 11% of his holdings.

From the Bronte Capital client letter (John Hempton is much better at identifying frauds than MW):

Chinese frauds are the richest vein of non-market correlated profit Bronte has ever discovered. When we started, John could read the accounts of a reverse-takeover stock and within twenty minutes determine it was a fraud. Complex analysis was not necessary. We got short dozens of different companies and almost everything we touched we made money on. […] In some cases we found fraud in under five minutes. We simply could not understand why anyone held these stocks – but alas major mutual fund groups and sometimes even sophisticated hedge funds held the stocks. We made good money on stocks we shorted after five minutes analysis (determining that there was fraud) and by the time the stocks collapsed 80 plus percent we had forgotten what it was that made us convinced it was fraudulent. We just had the stocks marked as frauds, shorted them and forgot about them. […]
Alas the major frauds taking five minutes to detect are gone. Almost all of those stocks have collapsed. There are one or two small positions remaining – but the gig is up.
There are still plenty of frauds in China – however it is no longer like fishing with dynamite. Precise analysis is required to pick the right stocks to short. Longtop took an intense week of work. The ones we are doing now will require two weeks. We will do the analysis – and many of the weeks will be wasted because we will work and not be able to prove fraud.
It is likely we will actually buy some of the companies we can’t find fraud in. After all people are shorting without doing our level of analysis – and those people will buy back on similarly thin analysis. Some the stocks could be a wild ride both for the shorts and for the longs.

That suggests to me there will be no easy answers with Sino-Forest.

Oh, and the stock opened at ~$8 this morning, so I do look quite the fool for bailing on Friday. Ah well, I had to work with the information I had.

Update 2: I just got my login for the Sino-Forest web page data dump. Lots of realistic-looking scanned-in bank statements. But if this is a convincing piece of performance art, the statements are not that hard to fake. How do we know that there’s actual cash in a bank somewhere to back it up? Still, better. Though this should have been out on Friday. I want to be fairly certain down in my gut if I buy back in that I’m right and the shorts are wrong, and then go in with authority (because it’s an opportunity, not to try to chase losses). But I’m not there yet, so no position at this point.

Update 3: An interesting article in the Globe about the other reasons some people were short, prior to the MW report. Some of these were concerns I had thought of before buying, some didn’t really even cross my mind.