Blessed by the Potato

In the Globe, a defence of market timing. An interesting dilemma, because I tend to say that timing is bad, and is so extremely hard to do that it’s not worth attempting. But value investing is good, and is one of the few time-tested ways of improving your returns. Yet if value investing is “buying when a stock is cheap” then where is the distinction between that and timing?

Market-timing, he insists, is nothing more than a way to lower portfolio risk. “If I show you an asset class that’s overvalued by any definition, and if you sell that security to buy one that we all agree is undervalued, is that a risk-reducing strategy or a risk-increasing strategy?” he routinely asks investment audiences. They always acknowledge it reduces risk, he says. “But if you do that you become a market-timer, because you won’t know when you’re at the top or when you’re at the bottom. You’ll have to make your best guess. … Any transaction that involves trying to enhance the value of your portfolio is a market-timing transaction. We should all stand up and applaud [it]. Yet it’s still one of the most vilified terms in the investment business.”

I suppose I have to agree with most of that. For example, I consider Toronto real estate to be “an asset class that’s overvalued by any definition” and I’ve avoided it. But the timing part is still hard: it could remain stupidly valued for years more to come.

“The fact that stocks, on average, deliver a 7-per-cent premium over inflation is a meaningless statistic. Just ask anyone who retired in the year 2000,” says Mr. Solow…

Though that I’d disagree with: it’s not a meaningless statistic. On average, they have, over decent time periods. Someone who retired in 2000 has had fairly mediocre returns since then, but had phenomenal returns leading up to that point (when they would have been in their asset allocation years). Indeed, understanding what average long-term return can be expected is one way of determining under- or over-valuation, if you believe in mean reversion.

One example is my own: I got the timing fairly wrong in the crash (too early), but did recognize that stocks were getting cheap, so I loaded up, and had shifted to 100% equities by October 2008. Then recently, Wayfare and I were discussing whether we should continue to be essentially 100% stocks. I updated this graph, and figured that, despite the massive returns we’ve seen over the last two years, things didn’t look terribly over-priced (certainly not cheap, and not generationally-cheap, but not pricey), so my thoughts were that going forward stocks should still outperform bonds, and, except for cash needed for safety and transactional needs, we should continue to keep it all in equities.

On another note, Bronte Capital discusses the current state of the market: basically, not pricey, but not cheap, which fits with my own general take on things. There is some lamenting that private equity firms have gobbled up all the bargain small caps, so that the companies that are still public are either expensive, or in some way less desirable. That would suggest that private equity has disrupted the normal state of things, where small caps offer a premium for the risk they present. This may be a bad time to put a small cap tilt to your asset allocation. However, I wouldn’t take that as gospel: private equity, leveraged buy-outs, etc., have been around since the 80’s, and small caps still seemed to do well relative to large caps even through the 90’s and 00’s (they did very well relative to large caps in the 80’s, but that’s to be expected if that’s when private equity really expanded and started bidding them up).

Note: I’ll be updating this post through the night and next few days as I try to process the transaction…

It was almost exactly a year ago that I called Canexus my “ace in the hole”. With a ~28% return, it wasn’t too shabby, but others have outperformed it. Part of that was based on the business itself, and part was on the theory that if Nexen was trying to sell its ~65% stake, it might lead to a buyer taking out the whole thing for a tidy return.

Now though, it’s been announced that Nexen has sold it’s portion of Canexus to a group of underwriters in a bought deal for a secondary offering. What that means is that the risk of selling all those shares (way more than is currently in the public’s hands) lies with the banks now. Because of that, they usually get a sweetheart price, in this case $6.40 (it closed at $7 yesterday, but was down to $6.80 today — with the trading volume, it looks like there was a leak of the news).

So, I had figured instead of a secondary offering to the public, one big company (or pension fund) would try to take over the whole of Canexus. I figured it was worth at least $8 in such a scenario (and given the cash they spin off, probably still worth that in a few years).

Now I have to ask myself, even though I already own a fair bit of Canexus (it’s something like 10% of my portfolio), do I want to take the opportunity to buy more in this offering at $6.40-ish? The cashflow and yield are still there, though part of me does feel cheated that the offering price is “so low”.

Update: Well, the take-up went well, with Canexus almost immediately trading above the offering price. I still think it offers good value, and the latest results indicated that it is going to convert to a corporation, so that distribution will become an even more tax-efficient dividend, without any cut!

Time, I suppose, for another round-up links post. Writing went much better this week, but I have completely fucked up my sleep schedule, and the diet was out the window.

Some webcomics I haven’t seen before:

Buttersafe: I will never understand bees. Pajamaforest: Zing fail, It’s a date.

A quick post at the Globe and Mail about finance pay scales compared to other professions. As a scientist, I do have to lament the misallocation of resources in our society towards the allocators of capital. Don’t get me wrong: someone has to do that job (capital is but one of the world’s limited resources), but I don’t think it’s a profession that should be sucking away our best and brightest (especially if they insist on blowing up the economy every other decade).

Xceed mortgage, a subprime lender in Canada (they do exist!) is having trouble getting financing, and is not renewing mortgages of its clients. It’s no longer accepting mortgage applications from new customers. Though I expect most people with schedule 1 banks will have no problem renewing their mortgage even if they’re underwater in the future (though I expect some loss of negotiating power on rate), this should serve as a reminder that a renewal is not guaranteed, even if you’ve made all your payments!

A neat youtube video on side-scrollers and moving your own body with a 3rd-person perception.

Whiterock (WRK.UN) is once again doing a share split, 3-for-2. I don’t know why they keep splitting the shares: $20 is not exactly dear, especially for a REIT. I suppose it might help a few investors with synthetic DRIPs get more whole shares, but these arrangements do have a cost. A trivial one, perhaps, but not zero. I don’t get why management doesn’t just wait until it’s high enough for a 2-for-1 split. Last time this happened I sold a chunk just because I didn’t like the taste of the shenanigans, even though I still thought Whiterock was undervalued (and boy was it: WRK.UN returned approx 85% from that sale). I think in an absolute sense it’s fully valued now, but since the rest of the REITs are also up huge over the last year, I still think it’s just a touch undervalued on a relative basis, so this time I won’t sell my last little chunk of it, even though I don’t like the whiff of share price manipulation that the frequent splits suggest.

Netbug shares this video of a ketchup-dispensing robot and I have to say, if this robot neatly dispensed an appropriate amount of ketchup, the video probably wouldn’t be worth watching. I don’t know what that says about the human condition, but I’m sure it’s worth reflecting on.

How stupid are US kids that these need to be banned so they won’t choke on them? What else might they choke on? Pebbles? Bits of food? Food wrappers? Screws? Cat toys? Their socks? Where does the madness end? Does the US border guard, tasked with keeping terrorists and science fiction writers in line really need to worry about a single Kinder Surprise egg? (It’s not even like she was trying to smuggle in a case of them as contrabrand).

For fans of Community: “Fact: In 100% of fake gun related shootings, the victim is always the one with the fake gun.”

Note: I am not actually alleging fraud myself in any of these cases. I have for the most part not looked into the stories one way or the other except for personal interest. Despite the fact that I love reading the stories of the investigations of short sellers, I am not myself a short seller, and hold no position in any companies mentioned.

John Hempton brought to light the case of a Chinese internet-based travel agent with a non-functional website, over the course of several posts. Though I found the reporting to be a great read, UTA is up ~40% since JH published his research. An even better time to short, or was the thesis wrong? Unfortunately I’m not going to invest the time to look into it for you, so you’ll have to figure it out yourself, or wait for the fullness of time (like me).

Kerrisdale Capital (registration may be required to view post) goes into great detail outlining another case of a Chinese private education company with again, a non-functioning website, and a teaching facility with no desks for students. It’s actually rather amazing the amount of work they went into their investigation, and to me at least, their report reads like a financial detective thriller. They also outline the mechanism of profiting from the fraud, as well as another way of spotting one: they issue more shares when the share price is high, with no concrete need or plan for the cash. The cash just sits there, despite the ostensibly high earnings growth rate.

One of the interesting parts of the Bronte Capital post was that the amount of interest income they were reporting on their income statement didn’t jive with the amount of cash they had on hand. There’s a post at Seeking Alpha on that topic.

Financial Uproar had a post recently looking at a Chinese small-cap that had my magic words “trading for less than the cash on the balance sheet.” Unfortunately, the company is mired in an accounting scandal, with class-action lawsuits mounting, and the filing of their latest quarterly results weeks late now. Using the quick John Hempton test, I looked at the most recent available data I could find: they have something like $90M in cash, and are trading at a market cap of $80M. However, that big cash stockpile made something like 25 bp of interest income in the last quarter, which is suspiciously low. Moreover, they didn’t pay down at all a revolving line of credit — why keep a LoC open with cash on hand doing nothing? Something smells funny here. If this were a local Canadian small-cap, trading this cheaply, I’d be tempted to investigate further, maybe try to figure out who was right in the accounting dispute and whether there was any business activity to back up the statements. But it’s not Canadian, it’s Chinese, so there’s really nothing more I can do but examine the financial statements, and those are now definitely suspect. Like I said at the beginning, I’m not a short seller, but I am very good at staying the hell away from stuff, and that’s exactly what I intend on doing here.

There are enough of these stories out there that I’m even worried about investing in China in general. I was going to look into some BRIC ETFs (not necessarily because I wanted to invest myself, but Netbug was asking me about emerging markets), and I have to say the lax regulation/fraud risk issue is enough for me to not bother. Besides, the Canadian market is plenty levered to the Chinese growth story anyway.

Partly for the laugh, Wayfare gave me a book of mortgage payment tables for Potatomas. For those of you not familiar with these tables, they date from a time before spreadsheets and online java calculators, when if you wanted to know what the monthly payment on a mortgage of a certain amortization at a certain interest rate would come out to, you had to run the calculation by hand. To help, tables were drawn up with the figures pre-calculated so one could just look up the value rather than calculating it. It was published in 1981, and has tables for 9% interest through 30% interest, in 25 bp increments. Interest rates below 9% were so unfathomable that they didn’t bother to print them in the book.

I’m not sure what the lesson there is: whether these current low interest rates are indeed so far below the historical norm that people should be prepared for higher rates in years to come, or the opposite: that times change, and now 9% is unfathomably high, and I shouldn’t keep trying to warn people about rates that aren’t likely to be seen again.

Anyhow, I wanted to explore a little bit the idea of risk and the housing bubble. This is based a bit upon some percolation of recurring themes here, and a bit upon some things people are saying on the internet (because no one in real life wants to talk to me about housing anymore).

First we really have to try to understand risk. Everyone has at least a little bit of gut feel for what risk is, and how some things are riskier than others. But everything has some form of risk to it: even GICs risk not keeping up with inflation, or in large concentrations, outliving your money. Volatility is sometimes used as a proxy for risk, in part because it’s easier to measure. But volatility doesn’t tell the whole story of risk, not by a long shot. If I’m talking about risk being the potential for permanent loss, for turning your life inside-out and just ruining your whole day, then volatility isn’t really a good measure of that at all.

If you look at a graph of the Toronto housing market over a number of years, it’s this incredibly smooth line moving up from the late 90’s to the late 00’s, and even beyond that there’s this smoothed bump in the 80’s and a little wiggle at the end in ’08/’09. So in terms of volatility, housing doesn’t look risky at all. Yet to my mind, it really is. One part of that is how the lack of volatility works against it when there is a crash. Go back to the last crash in ’89. If you were unlucky enough to buy at the top there, you’d see the value of your home decline some 30%, and stay down for years. It would take well over a decade to get back to break-even.

“But,” the people say, “why would I sell then?” And that’s a very strange question, because those same people often don’t have the same pragmatic zen attitude towards stock market corrections. With housing, you can be forced to sell when you’re underwater, for the usual reasons: job loss, move, family circumstances change, etc. When the stock market crashes though, you don’t have to sell your stocks (except for margin calls), unless you’re already retired. Heck, you can even rebalance and buy more.

The stock market by comparison is far more volatile, on any timescale. There have been 3 separate crashes in the Toronto stock market since the 1989 Toronto housing market crash. And the severity can also be frighteningly worse, about 50% top-to-bottom in the last crash. But, the recoveries are far snappier: not even counting dividends, someone unlucky enough to invest at the very peak of the market in 1989 was made whole by what looks* to be 1993; someone concerned with getting back to the 2000 peak found it in 5 years. Though we haven’t quite gotten back to the peak of mid-2008, in just 2.5 years we’re down less than 10%, and I’m pretty sure another 2.5 will find us back up there (and that’s not including dividends). Yeah, stocks are more volatile, but that works both ways, which means those crashes are both more frequent but also transitory. And you don’t have to buy in one chunk and get unlucky and find yourself at the peak (like with a house) — you can buy in year after year, so the real-life situation isn’t even this dire (as one would hope, since your investments are supposed to make you money). With diversification and rebalancing, you can do even better than the straight index.

But there’s still the fairly legitimate idea that stocks are risky: they can go to zero. Nortel went to zero, and that event seems to be burned into the Canadian mindset. “Can you point me to the house that went to zero?” Well, individual stocks are risky, but portfolios much less so. Even in one of the worst stock market declines in recent memory, a diversified portfolio was only down by about half, and much less if you had bonds too, and even then only for a short period of time. Think not so much of the house that went to zero, but the roof, or waterheater, or deck that became worthless. They’re just components of the overall investment, which as a whole is not as risky as the sum of its parts.

Leverage and familiarity of course play into the real and perceived risks: because of the high leverage employed these days (5% down baby), I’m deathly afraid of the potential for real estate to ruin your whole life. Because it’s strange and foreign, people in general are afraid of equities: the concept of distributed ownership in hundreds of companies is alien, and not in the daily experience of most people (or even in their educational readings), but everyone knows about houses (in fact, I’m writing this rant while sitting in one). However, the lack of volatility, and the last crash taking place when my cohort was still in elementary school can lead to some false complacency on the matter.

I’ve mentioned before that if real estate is overvalued by 30%, and if the typical family spends about 30% of their income on housing, then if they buy in too close to that peak, that leads to about 10% less money in the budget — about what people save for retirement. Even though it’s not so expensive that you can’t afford to put a roof over your head (that would probably bring an end to the bubble), it’s pricey enough to impact your financial health for essentially the rest of your life, which is why I waste so many electrons on this. It’s legitimately important, and it can be controlled.

I don’t know how to get people comfortable with stocks though, because it’s a fair point that if you don’t save and invest the difference when renting, the benefit isn’t really there (though even just saving in a savings account may be attractive if housing is overpriced enough relative to rent). On the one hand, equities are the riskiest, most volatile class of investments. Indeed, Mandelbrot suggests they may be even riskier than we first imagine. On the other hand, they’re not all that risky when diversified and held for very long periods of time (and as youngish folks, we have very long periods of time on our hands). Combined with the fact that it’s cheaper to rent right now, renting and investing the difference really looks to be the less risky path. Though the English language has the expression “safe as houses”, it’s not true all the time, and blind faith in real estate is in my mind, one of the most risky notions facing young Torontonians and Vancouverites.

* – Sorry, I just have a (not particularly great) graph for data that old.