Blessed by the Potato

Things are bad in the automotive sector. GM and Chrysler seem to be circling the drain, and Ford is not far behind. Toyota’s profits were down massively, though it was still at least a profit.

The “domestic” automakers are approaching any government they can for bail-outs, and it gets me thinking. If they’re nearly bankrupt anyway, and our government is going to foot the bill (and is owed hundreds of millions in dollars in loans already)… why not buy out (or repossess) a few different Canadian factories from different automakers and create a Crown corporation to make Canadian cars? It would give the government the stability in the auto sector that they seem willing to pay through the nose to get, and without the leasing/executive arm, there might even be some decent cost savings (though CAW would probably just rape a government negotiator). Plus the government can fast-track those hybrids it kept trying to get the automakers to build in Ontario.

If you’ll recall way back to 2006, the Ontario govenrment was quietly trying to get the car manufacturers to build hybrids in Ontario. CTV broke the story of Ford agreeing to build their Edge hybrid here before Ford had finished designing it (and the long-promised edge and fusion hybrids still aren’t on the market). Ontario offered R&D assistance, too. Part of it was to encourage more activity to take place here, but a good part of it was to foster a move away from guzzlers. The government was offering to pay up to $10 million, which would be matched funding of 1/3 for any research or design project into alternative fuels and transportation, where the research was conducted in connection with an Ontario university. I don’t have the exact results of that program, but I recall that none of the automakers took the government up on their offer.

All this leads me to think that just maybe the Ontario government is more qualified to run a car company than the yahoos running GM, Ford and Chrysler.

This is one of my irregular “Potato Wedges” columns, originally posted to The Moneygardener. There’s some great discussion going on about this one in particular over there… I’ll copy a few points from my comments to the bottom, but head over there for the full discussion.

The market has been a little insane lately. The market can stay irrational longer than you can stay solvent, as the saying goes, and one is often instructed not to catch a falling knife. Nonetheless, I couldn’t help but plow the money I got from Q9 being taken over right back into the market, specificically into some high-quality income trusts that I think are just ridiculously under-valued at the moment. Quarterly results have just been released, and while I recognize that they are lagging reports (for the period ended Sept 30, though the markets and economy didn’t really go totally batshit loco until October), they seem to underline just how non-catastrophic some sectors are.

Yellow Pages income fund (YLO.UN) had very strong results: they are well on track to keep up the modest ~4% revenue growth needed to maintain their distributions after a conversion to a corporate structure. They had impressive improvements in their margin, so net income was up even more, 19%, helped also by the growth of their online business. If a temporary bump in the road comes along, the distribution is less than 80% of their cashflow, so there is a safety factor there. I know that the coming recession hasn’t really hit them yet, but at the same time, keeping up your ad in the Yellow Pages is pretty much necessity for any small business. Advertising spending may get chopped next year, but the part of it that goes to YLO will surely be the last to go. MG likes and owns them as well, and just had a post on averaging down. Right now YLO is down so much it’s yielding about 15%.

H&R Reit (HR.UN) is a real estate investment trust that has commercial real estate (office space, industrial buildings, and retail space) that it leases out. It has a preference for long-term leases with large, stable companies. To go with that, it has long-term fixed mortgages, so the credit crunch shouldn’t really affect them much. Nonetheless, it’s down to below the value of the real estate it owns (though the balance sheet values of real estate holdings must be discounted in this market) and is also yielding about 15%. They haven’t released their quarterly results yet, but I would be incredibly surprised if it was anything other than “steady as she goes”. Their payout is a little higher at 90%, but they don’t need to build up the tax cushion other trusts do (REITs are, AFAIK, immune to Harper’s tax).

Why did I bold the 15% yields? It’s because they are, to my senses, screaming for attention. The gains for the market as a whole will likely average about 10% per year over the next decade or two, a prediction by John Bogle that Canadian Capitalist recently commented on. I personally expect equity nominal returns to be somewhere in that range as well, possibly a little lower on a 20-year timeframe (unless inflation is high). So when these stable companies are offering a 5% premium to that (or put another way, a third higher), which can be continued (hopefully) indefinitely, and moreover, predictably — the payout comes every month, despite what the market may do (and that ~10% prediction is going to feature lots of ups and downs along the way) — I sit up and take notice. To top it off, once Yellow Pages converts, that regular, lucrative distribution will become a dividend, which will have the added benefit of being favourably taxed.

Then, there was a question about Pizza Pizza Income Fund, which is also getting a high yield:

First off, I just wanted to say that the yield is only part of the story. Also important is how sustainable it is, how sound the underlying business is, etc.

PZA.UN is yielding about 12.5% today. They get royalties from Pizza Pizza restaurant sales, but are set up so that they avoid most of the risks involved with selling pizzas (food input costs, etc). They also have next to no debt. Pizza Pizza is a franchise and a brand that I like: there’s a Robert J. Sawyer book where “Food Food” is the dominant delivery restaurant in Toronto’s future, and I can totally see that.

However, their payout ratio is very high, ~90%, and their growth is not on track to get them to the magic <70% number for 2011 when they have to start paying tax. So there looks to be a distribution cut in their future. I’d estimate that their sustainable distribution is probably something more like $0.82/unit, which is still a decent 11% yield at these prices.

There are trusts out there with yields that look downright crazy, but there are often real fears about distribution cuts there. IMHO, the fears around YLO verge on paranoia, so I think that the premium it offers over something like PZA is compelling. If however you think there’s more risk in publishing dead tree directories than in pizza sales, then PZA may be the way to go.

And then, a comment about the high payout ratio of trusts, and that a rule of thumb suggests not to invest in a business with a payout ratio higher than 60%, in part to protect against cuts. I said:

The payout ratio is an important thing to look at, but it means different things to different companies. First off is the safety of the dividend or distribution: you of course want a small safety factor to smooth out the bumps in the road so that there isn’t an unnecessary cut. But a cut in the distribution in and of itself isn’t necessarily a terrible thing, as long as you know it’s coming and can price it in. You also want to be sure that the company isn’t cannibalizing itself or its future for the sake of maintaining a distribution.

You also want to be sure that the distribution is appropriate: start-ups or companies that are expanding rapidly or are taking on more debt shouldn’t be paying out dividends. If a company can get more return by keeping money in the company than an investor can get outside of it, then they should hold on to the money.

But there are diminishing returns to growth for a company. At some point a business is going to reach the limits of its core competency, and it makes more sense to give cash back to investors than to reinvest it just for the sake of reinvesting it.

For many companies, your rule of thumb of retaining >40% of their earnings for growth and reinvestment is probably appropriate. But for some companies, they can spin out essentially all of their cash flow because they are at the end of their growth cycle. It’s these companies that were ideally suited to becoming trusts. Yellow Pages already delivers a print directory to virtually every home and business in the country, what more is spending on growth going to do for them? Likewise, some downside protection and stability is important, but it does cost investors something. IMHO, a 10-20% cushion is probably enough for most cases across most years. Occassionally, the fecal matter hits the ceiling aerator and that’s not sufficient. In those cases you’re left sucking the cut, and hoping that the underlying business isn’t hurt in the process.

Above, I poo-pooed Pizza Pizza Income Fund for its high payout ratio, saying that a cut in the distribution would likely come once the trust tax kicked in. So that’s important to look at and consider when you’re valuing this thing. But at the same time, as likely as a distribution cut will be 2 years down the road, it makes no sense for PZA to retain those earnings between now and then just for the sake of a lower payout ratio. They wouldn’t do anything with the money because there is nowhere for their business to go as a royalty trust.

To keep all the comments in one place, I recommend you go to the Moneygardener to comment.

Obama handily won the election in the States, and among many of the things he promised to do was to come up with an exit strategy for the war in Iraq.

That led me to think: what is the exit strategy for my stocks? I’m mostly a buy-and-hold-forever investor, and so far most of my selling has been due to forced sales by takeovers (golftown, Q9, IPC), or bankruptcy/going out of business (Surebeam, FXI). However, this year I made a number of trades on what was essentially an ad hoc basis. I think I should probably come up with a more thought-out exit strategy. First off, I’ll review the sales I’ve made over the last year:

Q9: I’ve traded this one like crazy this year. I bought in a number of years ago and just held on, until there was a spike in the stock price that was downright euphoric. After the stock dropped about 20% from the peak, I sold half my holdings, still at a 50% gain from where I originally bought them. This was in January, when things were looking bleak, too. I picked that half a holding back a few months later a fair bit after it bottomed out and was halfway up again (I waited for the quarterly results to come in), and then sold again after another 10% runup in the price through the summer. Finally, the takeover went through in October, taking away the half of my position that I had held onto from the beginning.

Russel metals: I bought into this one thinking it was undervalued at $24. It fell a bit after I bought it, but quickly rebounded to hit my target price of $30, where I sold out.

Opti: This was another case of selling out after a rapid rise. It had jumped about 12% in less than a week, and I sold out, thinking that was as good as it was going to get. For the next few months, it went substantially above my sell price… but has come crashing down to earth so hard this last month that it feels really good to not be in it.

BMO: In mid-September I was getting very illiquid, and also wanted to jump on what I thought was a bargain on HR.UN (hint: it wasn’t, but I think now HR.UN is a bargain…). I figured that the banks were not going anywhere any time soon, so I sold my BMO at a loss (~8%) more to sell something than to sell BMO in particular. I got lucky there, as it’s down another 12% last month.

TD: I sold my TD back in January, basically because I was spooked. I bought it back in the summer for slightly less than I sold it at, which is good, I suppose, though there were many better times to get back in (including right now).

So looking at all these sales, I basically sold whenever a stock ran up in price more quickly than I was expecting it to (and once due to emotions/unease). I spend a lot of time here talking about and analyzing individual stocks, and that’s because I believe that when markets get insane like this there are real opportunities to be found. However, I still believe that there’s a lot of value in the indexing approach, and indeed I have been slowly buying up index funds with my monthly savings this whole time too… but that’s not as much fun to blog about. So I tend to only buy a stock when I think it offers something beyond what the index promises: either higher returns, or more stable returns. When a stock runs up quickly, it makes me think that the undervaluation has been detected, and it’s then back in line with the index. At that point, why take the risk the individual stock presents?

That leads me to my very general exit strategy: if a stock runs up to the point where I think it has become overvalued, I’ll sell. If it runs up quickly to the point where I think it’s fairly valued, I’ll sell (on the theory that a fast rise might precede a pull-back). If the business conditions change to where I think the stock will underperform (or where the new valuation would be overvalued), I’ll consider selling. Otherwise, I’ll sell when I need the money: hopefully not until retirement!

It’s good to have your moves in the market well-thought-out: it’s very easy lose money by making impulsive moves. I was tempted to quantify some of my exit strategy pondering: for instance, a 20% rise, or a very quick 10% rise seems to be enough to get me into profit-taking mode, and I was thinking I should just make that a rule guideline for myself. The thing is, it’s all relative to what I think the market might do, and just how much further I think a stock has to go. A lot of things are down to the point where they would need a doubling or more just to get back to where they were this time last year — in which case, a sale after rising 20% in a month, as decent as that would be, might be hasty.

If you’re interested at all in the Teranet (TF.UN) story, then you’ve probably already heard that Borealis/OMERS has decreased its hostile takeover bid from $11/unit to $10.25, to reflect the downturn in the markets. That has… displeased me. These guys seem to be screwing around just because they can, and it’s not going to end well for anyone. The downturn in the markets had made their original hostile offer gain the blessing of management, but then yanking the rug out from under them is not going to lead to a smooth takeover. It’s not like they would have been getting a raw deal at $11: they’d get a good 7% tax-free yield (an artifact of the Con income trust tax grab is that it doesn’t affect pension funds). Personally, I think the fund is a decent buy at $10.25, and I’m not just saying that because my cost base happens to be $10. It’s a cash generating machine with a government-sanctioned monopoly for another 5 years. It yields 8.5% now, or 7.4% at the original $11 bid. Their payout ratio is getting down below 70% — the magic number where they can maintain distributions after 2011; for the pension fund, they could theoretically extract the entire distributable cash amount, yielding 10% on the original $11 bid, 11% on the revised bid.

I know things are in the crapper lately, but I just can’t wrap my head around why OMERS would make such an opportunistic, dishonourable course change. Unless a big holder out there is in trouble (and there might be some who bought in after the hostile takeover bid was announced and paid $11 in the hopes of a bidding war), I can’t see them getting the support they need to bring this deal to a close. I know that I would rather just hold on and continue to collect my 8% for another decade than give it up for $10.25, even if the current market conditions mean that there are lots of safe trusts out there with yields above 10% I could move to. If the buyout fails, then Teranet will probably drop to join them, and then I’ll just buy more. Heck, if we figure that the fair market value of Teranet is about $8 right now (so it yields about the same as IPL.UN is right now), and that OMERs should pay a premium of about 30% to take them over, if only from the tax treatment alone, then we can see that the $10.25 bid is lowballing it…

Ah, well, reputations are cheap these days, whereas credit is not, so I guess I can’t blame OMERS.

Well, the Weather Network has changed its front page, and in the process dropped London, Canada’s 10th largest city, from it’s short list of cities to click on without having to search by name. I feel kind of snubbed, now. Thunder Bay has also gotten the boot.

The weather network is running a contest to win a skid school driving lesson, which is kind of neat. Enter here.