Blessed by the Potato

I put the link up on the right, but I also just have to give it a direct mention here to give it the attention it deserves. It’s a Joss Whedon production with Neil Patrick Harris starring as Dr. Horrible, a quirky, shy, evil mad scientist who’s trying to pull off a major heist to get into the evil league of evil when he runs afoul of his nemesis, Captain Hammer (played by Nathan Fillion, of Firefly fame). It’s hilarious and awesome and I want to buy the feature-length movie now (please: make the feature-length movie, pleeeeeease). Go watch it, it’s only like 13 minutes per act, and at the moment there are only two acts up (it looks like the 3rd act will finish it off).

Netbug, of course, found it (how, I do not know) and sent the link on to me, so of course props to him. And naturally, both our MSN quotes at the moment are from it…

The stock market is in the pits at the moment, and I’m seeing values everywhere. I started the year with a bit of cash on the sidelines, and bought in on the downward slide. Now I’m tapped out in terms of cash, but think it’s probably a good idea to keep buying more (not necessarily right away, just a month after my last buy-in, but through the rest of this year and next). Of course, I can’t buy without more cash… or can I? By borrowing money to invest, I can keep buying more stocks/ETFs. If the market is getting close to the bottom and ready to turn around, I could increase my returns substantially. This is known as leveraging.

If I buy $100 worth of stock with $50 of my own money, and $50 of borrowed money, and then next week the stock is up to $110 and I sell, then I’ve effectively doubled my return: I’ve made $10, bringing me to $60 after I pay off the loan, but only needed $50 of my own money to invest. By the stock going up 10%, my return went up 20%.

It’s this magnification effect of leverage that made buying a home such a great investment over the last several years: with 20% or even 0% down, you could grab a home, and even modest increases in price would lead to you walking away with a tasty handful of cash, because you could leverage yourself to a very large degree with a mortgage.

Of course, leverage cuts the other way, too. If my stock went down to $90 instead, and I had to sell there, I’d pay off the $50 loan and find I was only left with $40 — a 10% decline in the stock lead to a 20% decline in my wealth. To lose everything, that stock would “only” have to go from $100 to $50 (a feat CIBC amongst others has managed recently). If it went bankrupt and went to $0 before I could sell, I’d end up with nothing and owe the bank $50, doubling my potential loss from the $50 I had in cash to invest in the first place.

So leveraging is a way to increase your returns, both positive and negative, at the cost of increased risk. I’ve avoided leveraging so far because it just didn’t fit with my risk appetite. Lately I’ve been thinking more and more about it, and am considering whether a 5% leverage (buying $100 of stock with $95 of my own cash and $5 of the bank’s money in the form of a loan) would work for me. In addition to potentially goosing my returns, it might also help me build up my credit rating. On the other hand, the financial markets are a mess right now, so that risk aspect is very clear.

When buying on margin like this, the risk can be magnified even more by what’s known as a margin call. You see, if you buy your leveraged positions with a margin account at your broker (as opposed to taking out a general loan or home equity line of credit), then there are rules as to how much money they can loan you — you must have skin in the game. For example, if the limit is that you must front the cash for 50% of the price of the stock, then you need to keep that much equity handy. You could, for example, put in $60 and borrow $40 to buy $100 of stock. As long as things are going up, then all is hunky dory. However, if a stock goes down to below the threshold then you will have to either provide more cash so that the value of your loan doesn’t go over the limit, or your brokerage will forcibly sell some of your stocks to cover. So if your $100 of stock goes to $80, then your $40 loan is 50% of the value of your holdings. If the stock goes lower to $79, then you are borrowing too much for the equity you have. You will have to immediately (maybe, if you’re a good customer, the brokerage will give you 3 days) provide cash or sell shares to cover the difference. That can really hurt, not only because the leverage has increased your downside risk, but also because the forced sale means you don’t even have the option of waiting out a downturn — your shares will be sold and you won’t participate in any rebound, if it occurs. These margin calls are part of what sometimes drives the stock market to overshoot and oversell a stock — if the stock starts dropping and enough investors find that they don’t meet their margin requirements, they can be forced to sell something, driving it yet further down.

My examples here are quite simplistic — you will naturally have to pay interest on that loan, whether it is from your broker or a separate loan or line of credit. This interest will reduce your bonus gains a bit, and increase the amount you have to pay on the downside. Margin accounts from a broker are generally “interest only”, which keeps the cost of maintaining the leverage low, whereas you’re generally expected to pay back at least part of the principal back with a traditional loan a bank (not sure about a HELOC, I think that is flexible so it can be interest-only if you want it to be). Borrowing to invest, as long as your investments produce income, should make the interest tax-deductible, but I am not a tax expert and in fact this means very little to me given my tax bill as a grad student.

So what are your thoughts on margin and leveraging? I thought I was fairly pessimistic, at least relative to what I was hearing in the media, about what this year had in store back in January. Then things started to get into my value ranges and I started buying. Now things are a fair bit lower than I estimated the bottom would come, so perhaps things will turn around, or at the very least we might see a dead cat bounce. Do you think I should take on the risk of leverage to try to wring some performance out of this market? For a margin account, TD presently charges 5.75% interest to buy Canadian stocks. There are a number of companies out there that are presently paying out that much in distributions or dividends, so I could buy one and have the payments cover the interest while I wait for capital appreciation. On the other hand, the market might continue to go down and down for years to come, and being leveraged would just magnify my losses. That interest rate is also variable, and could go up at any time: possibly quite soon given the fears of inflation lately, adding to the risk. What do you think? Do you have any thoughts on a margin account versus an investment loan or line of credit? To start you off, here are two posts by Canadian Capitalist, Thicken My Wallet on leverage.

You ever have that nightmare, the one where you miss the first day of school? Yeah, today’s the second time that’s happened to me. The first was the special JBO tutorial in 3rd year that they only seemed to tell the physiology students about (it was a joint class and all of the physicists, IIRC, missed the first one). And now today I missed my first intro to CCPM class because I… simply forgot. Didn’t even think it was starting in July for some reason. D’oh!

A wedding is supposed to be many things. A family reunion, a chance for your parents to show you off, and of course indulging a certain someone’s princess complex fantasy. But it’s also supposed to be a grand old party where the special couple gets to call the shots, and get all their dear old friends and family out in their finery to rock the night away. So it was really sad to see everyone, on a saturday night, play the “old” card and quit the wedding early the night before last. Sure, the new parents have a decent excuse, since it’s tough being away from (or keeping) a youngster to that late at night, and I’m sure even the ones who were getting sloppy drunk on the open bar came up with some kind of excuse for cutting out early — some before midnight even! Even some of the people in the wedding party were heading off for bed before the end of the night, which was scheduled for 1 am. I don’t know what is up with that. It was not so very long ago that we started a night out (or in) at 1 am. Shit happens, and it’s usually ok if one or two people have to leave early for whatever reason. However, somehow everyone left early, and that starts to look bad.

Not only did this put a bit of a damper on the giant celebratory party thing but it also meant that there was a constant trickle of people leaving all through the night, all of whom had to stop and say their individual congratulations and goodbyes to the happy couple. This resulted in them spending almost the entire night saying goodbye, rather than partying hard at their own fete and then getting kicked out as the lights came up and saying a big goodbye as they got into the limo. Instead of a big crowd sending them off and cheering after the car, they were virtually the last ones to leave.

I’m an understanding guy. I understand that you have external demands on your time. I understand that it can be difficult to arrange a day off when you only have a year’s notice, or that you don’t want to eat into your limited vacation time for a wedding. I understand that you need your beauty sleep to function properly the next day. But understand this: the bride spent the last year of her life (in Teresa’s case, the last two years) planning the perfect party to celebrate her once-in-a-lifetime event. When you leave early, it says either that she didn’t do a good job in the planning, and you’re just not having a good time; or that you have better places to be, that there’s something more important out there than her special day.

Just fair warning: this will not happen at Wayfare’s wedding. Yes, it’s selfish of us, but you’ve been warned. Play it safe: tell the sitter you won’t be back until 3, or pump some breast milk and tell granny you won’t be back at all. Book the next day off work if you are stuck working on Sunday, or learn to cope with 5 hours of sleep for one day. Decide not to cut back on caffeine that day. I don’t care if I have to break the fire code and bar the doors, but no one under the age of 60 will be leaving before we do. At the end of the night, we will rush out to the car, and you will follow and cheer and wish us well, and you will smile. The only acceptable alternative is a weepy farewell, and then only for Ryan and the aunts. Now, Wayfare has a hell of a time staying up until 1 am, so we understand some of the difficulties involved, and we’re going to try to work with you as much as possible. But remember: if she can do it, you can do it. We’ve scheduled the whole thing so that the ceremony starts late in the day and goes straight into the reception, without you having to figure out what to do with yourself while we’re off getting photos taken. It won’t take up the whole day on you, and you won’t have to wake up early. You’ll have lots of time to relax and nap through the day, or even get a full day of work in if you skip the ceremony and jump straight to the reception. The reception is centrally located in North York, close to the 404 so the Torontonians and Markhamites can get home quickly without having to factor in much in the way of travel time; we’ll try to arrange decent rates at a nearby hotel for those from out of town. We’ll work with you to make sure that you can make it through that grueling marathon of merriment, good food, and dancing. Let us know why you had to leave so early the night before last. Was it a car issue? We can arrange cabs for everyone. Was it too hard to go up to the open bar? We can send out more waitresses with more free booze. Too much hootch, and you were ready to pass out by 10? We can hold the alcohol until after dinner, or indefinitely. We can get rid of the dessert table if that temptation was overcoming your willpower and you just had to leave to avoid scarfing down a whole cake. I know a lot of doctors, if you need a note to take a sick day at work. If the narcolepsy’s got you down, I’ll see if my dad can bring the camper van so you can catch a few zzz’s in the parking lot and still pop back in for the last dance.

I’m not big in the way of arbitrary traditions for “showing respect”. I don’t care if you wear a suit, or bring a gift, or bow to the altar, or wear uncomfortable shoes, or can’t wait your turn and just start incoherently yelling out a speech you’ve prepared in the middle of the ceremony. Show up in shorts and a T-shirt with some flip-flops. Don’t even take your hat off in church, it’s a nice look on you. If you don’t like the food, go ahead and order in a pizza, I’ll even chip in for a slice of plain cheese. I don’t care if you throw a tissy fit like my dad did about the guest list or the seating arrangements. I don’t care if you follow the seating arrangements. They’re a suggestion, sit where you want, just sort it out with the person whose seat you’re taking. I want you to be comfortable, have a good time, and moreover I want you to be there to share our big day with us. But if you can’t block out 8 hours of your time a year in advance for Wayfare, then that will be disrespecting my wife.

The stock market is a very interesting place where shares in the ownership of a great many companies are traded and priced on a daily basis by investors. For almost any corporation you care to name, you can find someone willing to buy its shares for some price. Even people who owned shares in Bear Sterns managed to find buyers as the company was going down in a liquidity crisis and being snapped up by JP Morgan.

Often, as a small-time investor you will want to own a well-diversified collection of truly excellent companies. Ones that will have good returns for many years to come. Quality stocks.

One of the easiest ways of doing this is to buy the index, which often represents some of the largest household names out there. It’s very difficult to beat the index, especially when the market is “efficient”, when nearly everything is going up and when nearly everything is priced rationally according to accurate information about the business environment. There’s a lot of information out there about index and passive investing, including a few previous entries here. In general, I recommend it. Part of my portfolio is indexed via the TD e-series funds, and it’s the only part of my portfolio that’s growing at the moment.

However, I don’t think the market is “efficient” at the moment. It’s in chaos. Things are down, then they’re up, then down again. There’s a lot of fear, a lot of uncertainty about what the future holds, even some uncertainty about what the current balance sheet holds, and more than a few margin calls going on. The quality stocks are being sold off with the junk, and even the mediocre companies look to be oversold. This to me seems like the time to try to “outsmart” the market and look for values. Note that this is, essentially, gambling: I’m taking on more risk to pursue higher rewards.

I’ve already talked a fair bit about some companies that I think are really good companies in general, but possibly under-priced. GE I think “should” be at least $32 by this time next year, and YLO.UN “belongs” in the $11 range, like, now. I won’t talk too much more about those ones, especially since I’ve been wrong so many times before, and they continue to slide down no matter how much I jump up and down. Come back to this entry in a year and odds are good that I’ll be wrong again.

I mentioned earlier that every company’s shares get priced on the market. That goes for poor companies and mediocre companies as well. Generally, you want only want to own quality, but if mediocrity is cheap enough, it might be worth looking into. Virtually everything is a buy at some point, even if its just to buy up the shares and liquidate the assets. That brings me to Priszm Income Fund (QSR.UN). They run a number of KFC, Taco Bell, and a few Pizza Hut restaurants in Canada. This is not exactly a huge growth business: you’re not going to wake up in a few months and find 6 new KFC restaurants opened and bustling in your neighbourhood. In fact, they’re downsizing and selling off some of their restaurants. The future does not look particularly bright for QSR, and sales were down 4% from last year. However, the market can factor all of this into the price of a stock. It can even overcompensate, pricing a mediocre stock too low and turning it into a potential gem. Priszm is an income trust, so essentially it sells delicious-smelling chicken with 11 herbs and spices and redistributes the money to unit holders. QSR is handing out $1.20/year at the moment, and with the stock at $3.50, that’s a 34% yield. It’s crazy, I know, and that’s of course because they can’t possibly keep that kind of distribution up with the way their business is going (the payout ratio is, according to TD, about 140% at present). A distribution cut is obviously priced in right now — but has the market gone too far? A few months ago, TD’s analyst estimated that the distribution would have to be cut to 7 cents/month ($0.84/year), which is still a very attractive 24% yield at this price. Even if the distribution was cut in half to $0.60/year that would be a yield of 17%, which is pretty nice. Of course, since it looks like they might continue to lose sales for the next few years, there might be further distribution cuts after that one. Being an income trust, it’s fairly amenable to being analyzed as an annuity: how much would I pay for a distribution of 84 cents this year, and which goes down by 5 cents/year every year thereafter? What is the present value of that? Well, if my target rate of return is 15%, that kind of payout would be worth about $3.60. Not bad considering I didn’t include any mention of book value, and that there is a chance that the management of QSR will stop the bleeding before the distribution drops to zero. The high target return rate and the book value help give some downside safety to that analysis of value…

But of course things could be worse. At that rate of decline, they’d still be in business (or at least have a positive cash flow) for another 17 years. What if it dropped 15 cents per year, putting them out of business in 5-some years? (Present value: $2)

They could also go tits-up like the Colonel himself. So what are the odds of that happening? Unfortunately, I can’t really say. At this point, the market seems to be anticipating not only that Priszm will cut its distribution, but that the cut will be huge, or possibly that it will cease to have positive cash flow all together. My dad says that they’re never going to stop selling fried chicken, and he might have a point — but that won’t necessarily stop these restaurants from getting to the point where they can’t spin off cash to the investors. While KFC is a bit of an icon, consumer tastes do seem to be slowly shifting away, especially since they were slow to get away from trans fats, and even slower to get broiled/grilled/toasted chicken on the menu (this year!). So I’m a little negative on the long-term prospects of this company. I think it’s not one of the top-quality stocks that everyone always wants to have in their portfolio; it doesn’t have this insurmountable economic moat, or brilliant growth prospects (or really, any growth prospects at all — just a hopefully long, graceful decline with many years of continued profitability yet). However, at this price I can’t help but see some value there. Take that, my precious few readers, with a giant grain of salt: I’ve been seeing value in Priszm for a while, and thought it might make a good buy at $5, too. It’s quite possible I’m missing signs of more serious financial trouble at that company and am being a retard for talking this up as a value. As the saying goes, a cheap price is not necessarily a value; or, sometimes you get what you pay for.

Of course, with the market the way it is, I’m seeing values almost everywhere. My problem now is not lack of values but lack of cash. I couldn’t buy any more Priszm if I wanted to, nor could I snatch up a tasty piece of GE, YLO, TD, or CNR along with some oil, either (oops! the market found CNR today [Jul 8] – up 5.5% already!). The only place I’m having trouble seeing value right now is Potash. Don’t get me wrong, I like the Potash “story”, and think it’s probably still a good investment… but mistake though it may have been at the time, I didn’t see the “downside protection” at $100, and at $200 it seems a little too speculative to me (despite the fact that I don’t feel the same way about oil, oddly enough). Sure, I could easily see it hitting $300 by next year or the year after, and that’s awfully attractive, but I can also see the potential to drop back down to $100, so I don’t really feel the need to buy any outside the little bit that I already own in my index. One has to also consider the possibility that I am letting psychosis interfere with my financial analysis. Do I not see value in Potash because I made a mistake last year in not buying it, missing out on a huge growth story, and so continue to not see value there, justifying my earlier decision to myself? Do I think Priszm is worthwhile because I bought some at a (much) higher price, and am missing something obvious to the other investors, perhaps that management might not have much foresight if they continue paying out a distribution from cash they don’t have? Am I suffering from confirmation bias?

Finally, I’m rethinking my stake in CanWel building materials. CanWel (CWX.UN) is a distributor of housing materials. For some reason completely unknown to me, the stock price started going really wonky a few years ago, getting stuck in the $4.25-$5 doldrums (my cost is $6.70/share). The distributions have been consistent, and it’s currently yielding almost 16% (with my yield-on-cash-invested being about 10%). They sell building materials (lumber and hardware) to stores like Rona and Home Hardware, as well as to some customers in the US, and some housing manufacturers directly. Because of the housing downturn in the states, sales are off by about 8%, and that’s what really has me worried: the housing market is nose-diving in the US, and the Canadian market does not look far behind. Moreover, this stock hasn’t been completely crushed by our current bear market (down 16% compared to HR.UN down 26%, compared to RON down 49%). That makes me wonder if I should get out while the getting out is good. True, I’d realize a loss and miss out on a pretty decent distribution. I am afraid that distribution might be cut, and I’m going to model that in just a bit, but at the same time they just had a bonus distribution a few months ago. That to me doesn’t speak of a management team that expects a distribution cut or is running short on distributable cash. My dad is still keen on CanWel, but had this bit of advice “If you’re not comfortable, just sell. The $29 commission is pretty cheap insurance.” So let’s run some numbers.

Despite falling sales, their distributable cash flow and margin have increased over the last year. This is largely due to better inventory management, so I don’t expect continued margin improvements. The payout ratio is 91%, which is a good place to be in a general sense, but in these uncertain times means that there’s no cash flow cushion to keep up distributions if sales sag. Using my ghetto spreadsheet/annuity analysis, and choosing a target rate of return of 15%, at its current distributions (and assuming they can be maintained past 2011), CanWel is worth about $4.80 — very close to the current share price, which of course is because the yield is about 16%, above my target rate (and then the buy price gets a slight boost from the book value in my reckoning). Now, sales are down 8% already just from the US housing market slowdown, but this is a Canadian company. A slowdown here could knock sales down 25-50%. Heck, maybe more, what do I really know? Running the 25% and 50% reduction scenarios, with a recovery to present levels by 2014 (arbitrarily chosen so I’m not overly negative), and I figure the worth goes to $3.90 and $4.30. At the current price of $4.40 then, some of these coming decreases might already be factored in — or I might be too optimistic in my calculations, or worse yet, completely out of my depth and doing meaningless Excel massaging. Assuming that $3.90 does represent a potential bottoming out for decreased sales/distributions, then that’s only another 11% downside. In that case holding on and collecting the cashflow is probably the best answer.

However, those calculations are cold comfort, and I can’t get over that nagging gut feeling that something nasty might be in store for CanWel, especially as the new CMHC guidelines might put a very sudden damper on the market. It is a very thinly traded stock — even my meagre holdings if liquidated would affect a typical day’s volume. So what I think I might do is put in an ask at my “fair” price of $4.80 and see what happens.