Marketdepth

Coastal Contacts - A Hanging Curve Ball

Every now and then you unearth a stock that just seems too cheap, regardless of what is going on in the rest of the universe.  Seeing as it is World Series time, it seems appropriate to post on the stock market’s equivalent of the hanging curve ball.  Disagree if you must, but my nominee in this regard is Vancouver-based Coastal Contacts Inc.

 

Coastal Contacts is Canada’s leading retailer of contact lenses.  In fact, after US-based 1-800 Contacts, Coastal is the second largest online contact lens distributor in the world.   Trading at $1.25 per share, Coastal might fetch twice that amount were it to be acquired by one of several potential suitors.

 

Figure 1:  Hanging Curve Ball, Meet Mr. October

 
 

Coastal is still enjoying the earlier stages of a penetration curve.  Where traditionally contact lenses were dispensed by opticians, the market is shifting towards online distribution.  The key driver, not surprisingly, is significantly lower prices.  Online suppliers charge about half of traditional clinic-level costs.  Benefits packages that cover only part of the cost of a traditionally filled contact lens prescription go much further online.  And for the increasing number without benefits, the choice is clearer still.  Consequently, Coastal Contacts continues to post mid-teens annual sales growth – not too shabby in the best of times, but almost unheard of in 2009.   And there is much more market share to be gained from dispensing opticians, who still hold more than 85% of the $5 billion global contact lens business.

 

Coastal is more than just a Canadian operation, earning more than 80% of its revenues abroad.  Coastal is the market leader in Sweden, Norway and a number of other non-US markets. Coastal’s scale supports its ability to carry over 100,000 sku’s in inventory, which allows it to deliver faster service to its customer base.  Volume leadership also provides Coastal with lower product costs and a consequently higher margin.  Perhaps even more important, leadership in specific country-markets lowers the per-unit cost of advertising, chiefly related to paying for search priority on Google.

 

One of the interesting things about the contact lens business is the inability of the contact lens manufacturers themselves to get into distribution.  Their hands are tied, in my view, by their relationship with the opticians.  If the manufacturers were to compete directly with the opticians, they would risk losing share in 85% of the market that the eye doctors control.  That is the sort of short-term pain that is difficult to stand for the manufacturers.  It is easier for Ciba Vision or Bausch & Lomb to step back and sell to both distribution channels and let the market decide this battle.

 

Figure 2:  Share Price Development

 

Coastal Contacts possesses a strong balance sheet, boasting $14 million in net cash at July 31.  This strong financial position allowed management to repurchase 18% of outstanding shares during the market mayhem of its last fiscal year.  The healthy balance sheet also supports investments required to build market share that less well-financed competitors must eschew.

 

Coastal is not your father’s internet retailer – it generates a healthy amount of cash from operations.  I estimate that Coastal will generate at least $135 million in revenue this year and produce over $5 million of free cash flow.  Growth companies rarely throw off fat cash flow streams, but by my estimate Coastal’s free cash flow yield is approaching 10%.

 

 

Danger and Opportunity

 

There are no businesses without risk and Coastal Contacts is no exception.  Aggressive US competitors are pricing very competitively in the Canadian market and may potentially win a larger share in this country.  In addition, Coastal faces an ongoing legal challenge from Canadian opticians fighting to retain their lucrative contact lens dispensary business.  While CEO Roger Hardy and his management team appear to be taking these challenges in stride, they do represent serious risks to the Coastal franchise.  Another challenge, of course is managing a multinational enterprise in a fast moving market.  Strategically it is useful to have leading market shares in New Zealand and Norway, but practically it must be somewhat more difficult.

 

Assuming Coastal can grow its free cash flow by 10% per year over the next five years, a discounted cash flow value of close to $2.00 per share appears reasonable.  Undervalued on a stand-alone basis, additional potential exists for Coastal to be acquired by one of several potential strategic buyers.  Industry leader 1-800 Contacts should be able to generate significant synergies through acquisition.  Likewise, Hamburg-based Fielmann AG, a powerhouse in European discount eyewear, could no doubt make an accretive acquisition at prices above two dollars.  Chinese players lacking Western distribution (e.g. Shanghai-based Horien Contact Lens Co.) may also be suitors for a strong, geographically diversified vendor. 

 

Traditional retailers like Costco and Wal-Mart may also be looking for entry points.  Interestingly, Wal-Mart has struck up a joint venture with 1-800 Contacts.  Surely Tesco or Aldi would entertain a play of this nature as well.

 

Management does own a sizeable chunk of stock, about 27%.  There is also a shareholders’ rights plan.  But given there are also three million options outstanding at a $1.00 average strike price, I think a serious bid of $2.50 would get pretty serious consideration to say the least.  There is just too much upside to be had in the short run.

 

Coastal Contacts is a good business.  It is arguably undervalued, growing strongly in a recession, without a controlling shareholder and surrounded by potential deep-pocketed acquirers.  I may be no Reggie Jackson, but this pitch looks worth a swing to me.

A Golden Calendar Trade

Although this space has not yet seen a post on gold, regular readers may not be surprised to discover that your correspondent here at Marketdepth is a long-standing bull with respect to the future gold/dollar exchange ratio.

 

But some recent excitement anticipating a sudden upward ride on gold strikes me as a little simplistic.  In the economies of North America and Europe which combine enormous financial leverage with massive productive overcapacity, we should first expect a climax of deflation.  And, as 2008 showed, even gold is vulnerable to deflation.

 

Figure 1:  Even Gold is Vulnerable to Deflation

 

Of course the debts and off-balance sheet obligations being generated by the big governments are too large.  Of course they will be ultimately be printed away.  But to expect the major fiat currencies to go down without a fight is unrealistic in the extreme.  The most likely expectation of what is unfolding can be summarized as “First Deflation, then Inflation.”  It is a path that has been well-worn in dozens of serious debt crises of the past hundred years.   

 

The History:  Inflation Arises from Severe Distress

 

A very short history of public sector finance on planet Earth can be outlined as follows.  There is more love than there is money.  And there is less wealth than either of the foregoing.  These truths are driven home from time to time as people re-learn the lesson that although money can be printed, wealth cannot.  Where we see governments that spend beyond their means, we eventually also find governments that default on debt and print away paper obligations.  The winners in these events own gold and the losers own bonds. 

 

There are many piecemeal accounts of such circumstances as they relate to, say, Argentina in 2002, or the US Confederacy during the Civil War, or Mexico in the 1980’s or Japan in 1945-46 or Germany between the Wars.  I always enjoy reading these accounts.  It calls to mind Tolstoy, who begins Anna Karenina with a beautiful line that “All happy families are like one another; each unhappy family is unhappy in its own way.”  Likewise, every sovereign that makes good on its debts is the same, but the defaulters each find their own formula to offload debts.  Some refuse payment outright, while others choose the back-door road of printing currency.  Some try to hold onto a punishing hard-currency peg long past the point of sustainability and are undone by riots in the streets.  But the starting point is always the same – too much debt.

 

Fortunately for those readers who do not have the patience for the individual case study, two American professors, Carmen Reinhart and Kenneth Rogoff  have produced a comprehensive analysis.  Put together in 2008, Reinhart and Rogoff’s fascinating study of more than eighty historic sovereign defaults on domestic obligations in sixty-four countries allows one to look systematically at crises which were generally regarded as a series of one-off problems.

 

Some of the most interesting data was summarized in Reinhart and Rogoff’s figure six, which shows the average length and depth of the crises.

 

Figure 2:  Economic Growth in Defaulting Countries by Year

Years to Climax of Crisis	Real GDP Index in Domestic Default Crises	Real GDP Index In External Defaults
Four years before	100	100
Three years before	99.8	101.8
Two years before	99	102.2
One year before	96.5	101
Year of Crisis	92.3	99.8
One year after	93.8	100.2
Two years after	96.4	101
Three years after	100.5	102

Source: Reinhart & Rogoff, 2008.  Note source data are displayed graphically only.

 

I also approximate the data they show in their chart figure eight, which indicates just how fast prices can move.

 

 

Figure 3: Price Levels in Defaulting Countries by Year

Years to Climax of Crisis	Nominal Price Index in Domestic Defaults	Nominal Price Index in External Defaults
Three years before	100	100
Year of Crisis	1000	150
Three years after	9000	300

Source: Reinhart & Rogoff, 2008.  Note source data are displayed graphically only.

 

My interpretation of the data with respect to the current situation would be as follows.  First, if we are heading down the path towards some kind of eventual default on government obligations in the big economies, then we haven’t nearly reached the distress level of economic decline that precipitated default/inflation climaxes in the past.  Default/inflation scenarios had large GDP declines associated with them (on average a cumulative decline of 8%) and the declines tended to take a long time (3-4 years on average).

 

The other point I would make, based on a review of the cases, is that, by the yardstick of debt as a ratio of government revenues, both the US and Japan are within the rough ballpark of obligations that led to default/inflation scenarios in the past.  In my recent post on Japan, I go over this ground in a little more detail. 

 

The Present:  Looks Like Deflation

 

There are several reasons why, after a brief and enjoyable relief, I believe deflation is not yet done with us.  

 

The first factor is an underlying economic weakness that belies our strong market rally.  Equity markets do often lead recoveries, agreed, but the stark divergence between the slumping path of the underlying economy and the soaring stock market cannot be sustained.  Against new year-to-date highs in equity indices we observe weakening consumer credit and persistently higher unemployment.  To pick the most glaring example, defaults on US commercial property mortgages are now spiking.

 

Figure 4:  US Commercial Mortgage-Backed Securities Delinquency

Period	CMBS delinquencies as % of loans
2001	0.7%
2002	0.9%
2003	1.2%
2004	1.2%
2005	0.7%
2006	0.4%
2007	0.3%
2008	0.7%
August 2009	3.2%

Source: Moody’s

Another unrelated broad-based indicator, is the Baltic Dry Index, a leading indicator for global trade.  This index peaked in May and has looked sick ever since.

 

Figure 5:  Baltic Dry Index 2006-2009

 

The isolated rays of economic sunshine we do see (such as Canadian housing starts and American auto sales) exhibit the telltale signs of pedal-to-the-metal government subsidy. 

 

 

Figure 6:  US Auto Sales Before, During and After “Cash for Clunkers”

Period	Annualized Auto Sales
2004	16.8
2005	17.0
2006	16.5
2007	16.2
2008	13.2
Jan-June 2009	9.5
July-Aug 2009	12.7
Sep 2009	9.2

Source: US Dept of Treasury

 

In reality, the fire hoses of central bank cash appear at this stage to have sparked a short-covering rally, but little more.

 

And the stimulus itself appears vulnerable. Now that the panic of the moment has subsided, people are, quite rightly, beginning to ask questions.  Who voted for permanent and unlimited government-backed mortgage lending, and how exactly did the guiding economic principle of our time become “Too Big To Fail?”  Shutting down the printing presses even momentarily to debate the validity of these policies could well exacerbate a relapse in credit and equity markets.

 

Call me a fool, but the real-time picture still looks deflationary.  And gold, a highly effective hedge against inflation, is vulnerable to a margin call like anything else.

 

A Golden Calendar Trade

 

So how does one capitalize on the current situation?  In the long run, it is hard to see a way for most major democracies to avoid printing away a significant portion of the obligations that are related either to past deficits or future promises related to entitlement programs.  In looking at the fiscal hand President Obama has been dealt, my only question is whether it more closely resembles that of Jimmy Carter, who presided over “stagflation,” or Jefferson Davis, the Confederate President who oversaw America’s only true hyper-inflation episode. 

 

But in the short run we could be looking at a fall almost as steep as that of 2008.  A last dash for cash could up-end gold, silver, oil and the rest of the hard asset trade.  One of the key insights of Reinhart and Rogoff is that it takes a long time for a financial crisis of the type we are experiencing to progress to high inflation.  In their study of dozens of such debt crises, they observed an average peak to trough period of three to four years.  As bad as it seems, our downturn is just an infant, approaching the two year mark.

 

There are a number of ways to put together a position that hedges short-term deflation in light of longer-term inflationary pressure.  One of the simpler ways to execute this would be through what the futures traders refer to as a “calendar trade.”  Selling short term gold contracts (October 2010 gold futures traded recently at $1016) and using the proceeds to fund longer term long positions (December 2013 contracts are priced for gold at $1108) is a trade in keeping with this “first deflation, then inflation” hypothesis.

 

Another approach may be just to steel oneself for a choppy six months or year, while markets test the southern end of the recent trading range.  Trading in-and-out may be hard to execute from the breathless excitement of the moment.  My own approach is to mix a pinch of the hedge within a strategy that generally takes this latter approach.

Telus Corp - Would You Bid on This Empire?

Following the assassination (in 193 AD) of the Roman emperor Pertinax, there transpired one of history’s more interesting financial transactions. The Praetorian Guard leadership, implicated in the murder, decided to organize an open outcry auction that effectively sold the Roman Empire to the highest bidder.

 

The winning bid was made by Didius Julianus, a wealthy Roman Senator.  His price – 6,250 silver drachmas paid to each of the 10,000 Praetorian Guards – would be equal to approximately $70 million today.  On a cost per acre basis, this was one of the greatest deals of all time.  However, as Julianus’ reign consisted of a mere sixty-six embattled days in advance of his own capture and execution, it may be more appropriate to consider his purchase as rather expensive on a price-per-day basis.

 

The foregoing example comes to mind as I find myself looking at the tempting 5.6% dividend yield payable on Telus Corp (TSX:T) stock.  Compared to the one year GIC yield of 0.65% that my bank currently offers, Telus dividends are clearly much higher.  But in fixating on the Telus dividend yield are we, like Didius Julianus, focusing on a misleading price signal?

 

Figure 1:  Didius Julianus Reigned for a Mere Sixty-six Days

 

Short Run Telus vs. Long Run Telus

 

In the next four quarters, Telus will surely cover its current $1.90 per share dividend.  Market share for Telus looks solid in both wireline and wireless.  Through the launch of discount brand Koodo, Telus has successfully reduced profit potential for competitive start ups in its territory without significantly eroding core profit margins in the wireless business.

 

While an overall market slowdown in 2010 could hurt cash generation, Telus also has the flexibility to cut back on some fairly elective capital spending programs such as its drive into digital TV.  Even a very conservative 2010 forecast would indicate that Telus can easily cover projected dividend payouts.

 

Figure 2:  Telus Short-Term Interest and Dividend Cover

C$ Millions	2007A	2008A	2009E	2010E (Stress)
Revenue	9,074	9,653	9,504	9,028
Growth (%)	4.5%	6.3%	-1.5%	-5.0%
EBITDA	3,589	3,779	3,558	2,785
EBITDA (%)	39.6%	39.1%	37.4%	30.9%
Capex	1,770	1,859	2,062	1,320
Capex/depreciation	1.3x	1.3x	1.6x	1.0x
Tax	233	436	290	271
Tax rate (%)	12%	21%	16%	25%
Interest	440	463	402	402
EBIT Interest Cover	4.5x	4.5x	4.6x	2.7x
Dividends	521	433	604	612
Dividend Cover	2.3x	2.2x	1.3x	1.3x

Source: Telus Financials, Marketdepth Analysis

 

However, the longer-term outlook for Telus is less clear.  As one looks into 2011 and beyond, Western Canada’s telecoms champion appears to face both strategic challenges and balance sheet uncertainties.

 

The chief long-run strategic question for Telus is how can longer-term pricing  be maintained near current levels.  Voice-over-internet (with its price per minute of zero) appears to be on the verge of breaking out as a mainstream substitute for wireline phones.  Meanwhile, wireless operators in Latin America and Asia are demonstrating that mobile service can be provided profitably at a revenue-per-minute level of less than one quarter of Telus’ rates.  It is only a matter of time before such a cost structure could be imposed by a wireless competitor in larger Canadian cities.

 

 

Figure 3:  Prices May not Get Here, But Costs Already Have

Company	Market	Monthly Revenue per Customer (C$)	EBITDA% (mrq)
Bharti Airtel	India	$6.25	41.0%
America Movil	Mexico	$13.49	40.8%
China Mobile	China	$12.97	48.6%
Telus Corp	Canada	$58.61	43.1%

Source: Company filings

 

Strong regulatory defence and clever tactical pricing moves can work for a while, but in the long run Telus’ pricing “umbrella” looks unsustainable.  Voice prices in wireless and wireline will have to move lower, eventually.  If new revenue streams don’t make up the difference, then Telus may end up in a spiral of downsizing and falling prices from which few companies have successfully emerged.

 

Telus’ balance sheet structure adds further complexity to management’s challenge.  Simply put, $7.2 billion looks like too large of a debt burden for a business with such significant strategic issues, especially as a distressingly large proportion of debt matures in the next three years.  To their credit, management is pushing to pay down debt, but is constrained by a conflicting commitment to large dividend outflows.

 

Let the Other Guy Bid

 

Finding ourselves at an open outcry auction, where our local telecoms “empire” is being offered at an incredibly fat yield, it is very tempting to make a bid.  Perhaps, in the short run, the market may reward Telus stockholders.  But from a longer term point of view, the risks seem to outweigh the rewards.  Let us learn from the mistake of the short-sighted Didius Julianus.  Let the other guy bid.

Return to Copper Mountain

As a Kelowna boy who went to UBC, I used to drive the Hope-Princeton highway to and from the Okanagan.  As a result, I know very well the hill leading to the Similco mine as one heads west from Princeton.  The mine, like the highway, used to be pretty busy.  It produced 1.7 billion pounds of copper and 730 thousand ounces of gold between 1972 and 1996.

 

Weak metals prices and diminished ore grades bankrupted Similco’s former owner.  The underlying asset was sold a couple of times over the ensuing decade.  As an interesting bit of trivia, the asset-stripped publicly listed shell of its owner (the old Princeton Mining Corporation) lived on, and eventually became the corporate entity of Glacier Media Inc, the parent company of Business in Vancouver, where some of these posts are published.

 

The Similco mine is now reborn, under the auspices of recently formed Copper Mountain Mining Corporation (TSX:CUM), who have partial backing from Japanese industrial giant Mitsubishi Metals Corporation.  With successful financing, the Similco mine is scheduled to re-start in 2011.  Should local investors take a trip down memory lane, in the hope that “this time will be different?”

 

Figure 1:  Will This Time Will Be Different?

 

The Case for Copper

 

Adjusted for growth in the supply of money, copper at its current US$2.80 per pound is  cheap in historic terms.  The 1970 copper price of US$0.70 per pound has grown by only four times.  Compare that to growth in US money supply, which has been about 14 times over the same period.

 

Copper demand in the big developed economies is uncertain.  The major uses are related to serviced building construction (a new home, for instance, uses 200 kg of copper), which arguably may remain depressed for years.  In the rest of the world, demand has not been saturated, in my view.  If demand is going to rise, it will probably come from China and India, where per capita copper consumption is still a small fraction of North American levels and buying a house on credit is still a relatively novel idea.

 

Copper’s supply picture is more attractive.  New mine development was slow to follow the uptick in demand in 2005 and was subsequently impacted by the credit crisis.  A recovery in global demand may run into the same supply constraints that analysts credited with the brief rise in copper prices above $4.00 from 2005 through 2007.

 

A final support for copper mine values may, paradoxically, be the weakness of the world economy rather than its strength.  Further emergency “quantitative easing” or money printing by central banks may accelerate the trend toward hard asset purchases by China and other holders of US paper assets.

 

Time to Back Up the Truck?

 

Copper Mountain is not your typical junior.  It has a freshly proven orebody containing over 5 billion tons of copper, and the opportunity to refresh existing infrastructure.  Also, CEO Jim O’Rourke, former President of Princeton Mining Corp., is no stranger to the operation.  And support from the nearby communities and provincial government suggest that permitting will not be a problem.

 

If Copper Mountain is successful in raising the capital required to get its mine into production, one would be looking at a prospective 100 million pound copper producer trading at about $100 million market capitalization.  Similarly-sized copper miner Taseko Mines (TSX:TKO) trades at about 4 times that level.  The difference reflects the market’s  current assessment of a bird in the hand compared to a bird in the bush.

 

While I like Copper Mountain’s chances, this investment is risky.  The re-started mine is estimated to be “third quartile” on a globally-compared cash cost basis.  In terms of sleep-at-night comfort, a small, higher cost copper mine ranks about equally with a pull-out sofa at the Pink Flamingo Motel.

 

But, for investors who have survived the market rout of 2008 and are looking to hit one out of the park, perhaps Copper Mountain is a suitable vehicle.

Welcome to Kanada

It started out, as these things often do, as a normal trip to Winnipeg.  However, after only a few minutes, it was obvious something unusual was happening with the airplane.  An odd humming sound began to reverberate all through the cabin.  Outside the sky turned an electric shade of green.  Up in the cockpit, I thought I could hear the pilot shouting “Mayday!” into his headset.  But it was already too late.  The clouds began to swirl in a giant vortex and the plane started spiraling downwards.  For a second everything went black.

 

Moments later the world re-appeared, looking very much as it had just before.  The plane landed smoothly.  Oddly, no one on the plane seemed to remember the incident.  It was only when I walked into the Winnipeg airport and saw the sign which said “Welcome to Kanada,” that I realized I had come through to the other side.

 

Figure 1:  The Clouds Began to Swirl in a Giant Vortex

  

My taxi driver was a friendly chap by the name of Dmitri.  He helped me load my bags in to an old wood-paneled station wagon.  After he started to drive, we began to talk…

 

GC:  I must be mistaken, Dmitri, but I thought I saw a sign that spelled Canada with a “K” back there.

 

Dmitri:  Oh, you must have been away from our country for a long time, comrade.  We have been spelling it that way ever since The Save back in 1972.

 

GC:  The save?

 

Dmitri:  You know, Tretiak’s big save on Paul Henderson alone in front of the net.  There were just 35 seconds left in the Canada-Russia Summit Series.  Valeri Kharlamov took the rebound and scored a few seconds later to win the game.  The winner wasn’t a bad goal but everyone still talks about Tretiak’s Save.  It was unbelievable.  Well, after that everyone in this country pretty much gave up on capitalism and joined up with the system of the future.  A lot of us changed our names, too.  I used to go by “Dave” but somehow Dmitri seemed more fitting with the new era.

 

GC:  How interesting.  How is it working out for you?  Is there a lot of unemployment?

 

Dmitri:  Unemployment? Ha! Comrade, are you joking?  Haven’t you heard of the KMHK?

 

GC:  KMHK?

 

Dmitri: You know, the big state agency, Kanada Maximizes Housing Kapital.  It’s the agency that employs, directly or indirectly, about 17% of the population.  Every time people in Kanada are in need of work the government just borrows more money and the KMHK builds more houses.

 

GC:  That sounds strangely familiar, Dmitri.  Your KMHK employs exactly the same proportion of the population as work in the private sector industries of construction, real estate finance and business/building services in my own country, Canada with a “C”.  Do the houses cost very much to build?

 

Dmitri:  Of course, comrade.  The KMHK only builds the best.  The average house price in Kanada is about $319,000, about 7x Gross National Income per Capita.  That is the highest in the world in 2009.  All the capitalist economies are in ruins due to collapse of their housing markets, but we in Kanada continue to build our workers’ paradise.

 

GC:  But who finances this program?  This KMHK?

 

Dmitri:  That is our secret weapon!  We have managed to get the capital markets to supply all the money.  In 2008 KMHK borrowed $172 Billion by persuading capitalist running dog investors to accept our KMHK insurance and securitized guarantees.  And then the government of Kanada chipped in another $25 Billion of borrowed money to make the grand total $197 Billion in state-supported housing money.  It was such a success in 2008 that in 2009 KMHK plans to underwrite more than $270 Billion in incremental state housing support.

 

GC:  Wow, Dmitri.  No wonder all the houses in Winnipeg look so nice.  But tell me, how does Kanada account for this spending?  Don’t you run a huge budget deficit in this country?

 

Dmitri:  Comrade, you are a wise man.  Many capitalist countries minimize their stated public sector influence in their economies by hiding government spending in off-balance sheet guarantees or unconsolidated debt of state agencies.  But not Kanada, we do a very straightforward set of public accounts.  Here, take a look at this table while I fill up the car with gas.

 

 Figure 2:  Government Accounts in Kanada and Canada 2009

Figures in K$ and C$ billions	Kanada (incl. KMHK)	Canada Gov’t	Canada CMHC
Budgetary revenues	216.6	216.6
Program expenditures	241.9	241.9
Public debt charges	30.7	30.7
Budgetary Balance (sub-total)	(55.9)	(55.9)
Housing subsidies:
Indirect loans to homebuyers through purchase of securitizations	100.6	n/a	100.6
Increase in high loan-to-value mortgage guarantees	30.1	n/a	30.1
Increase in guarantees of bank loans sold to capital markets	139.7	n/a	139.7
Total Budgetary Balance	(326.4)	(55.9)	n/a
Estimated GDP	1,526	1,526
Deficit as % of GDP	-21.4%	-3.7%

 

GC:  Dmitri, this looks preposterous!  Those KMHK loans and guarantees aren’t period expenses.  Those are mostly just investments by your government or sweeteners to get the capital markets to pony up money.

 

Dmitri:  Well that is a common point of view, comrade.  Maybe in Kanada, we treat things too simply.  If money gets used for something that wouldn’t happen if the government wasn’t involved, we call that government spending.  Remember, in the capitalist countries, once a level of economic activity starts occurring consistently, then people start leveraging against it.  And if the “stimulus” gets taken away then…

 

GC: …then the government has to come in and provide the equivalent cash, otherwise too many banks become insolvent.

 

Dmitri:  Now you are getting it, comrade.

 

GC:  But who orchestrates your program?

 

Dmitri:  Well, we have a Prime Minister and a leader of the Opposition, but they are just figureheads who don’t understand what’s going on.  The real power in Kanada is in the hands of an unelected politburo lead by Mr. Carnoff.  How is it in your country?

 

GC:  Well in my country we have democratically elected leadership that directs the activity of a professional public service.  If there was a major subsidy program like this going on in Canada, it would be at the forefront of public discourse.  Doesn’t your Mr. Carnoff realize he is putting your whole economy at risk?

 

Dmitri:  Au contraire, it is all part of the plan.  How can you build real socialism without a large working class that has no capital?  Carnoff has thought of that.  His idea is to lever up all the lower and middle-class people in the country into overvalued real-estate and then orchestrate a massive margin call, leaving them penniless and dependent on the state for occupation of their homes.

 

GC:  I can’t believe it.  How can anyone be so evil?

 

Dmitri:  We never start out evil, comrade.  It is just that our good intentions pave a road to hell.  Well, here you are my friend, downtown Winnipeg.  That will be ten dollars please.

 

And as I left the cab I felt the rushing of the vortex once again and I was returned safe and sound to my beloved Canada.  Let me never go to Kanada again.

Winter in Japan

In November, 2006, I traveled to Nagoya on a pilgrimage of sorts.  I wanted to meet Takeda Wahei.  Virtually unknown in the West, Takeda is the closest thing Japan has to Warren Buffett.  In fact, fairly handicapped, he may even be a little better.  It is one thing to make one’s reputation as an accumulator of wealth during the boomtimes of the American century, but quite another to do so amidst the lifeless deflation of post bubble Japan.

 

The interview with Takeda was highly memorable.  We talked about a few companies that he owned and how he encouraged management through rewards and positive re-enforcement.  However, he was most emphatic on the long-term outlook for the Japanese market.  Japan’s history, said Takeda, is divided into a number of generation-length periods that he likened to seasons.  After the debacle of WWII, Japan emerged into a spring that brought rapid growth.  The growth of the 1970’s and 80’s that culminated in Japan’s bubble economy, he likened to summer.  The period that began in 1990 he considered to be an autumn.  “And now,” he said, “it is time for winter.” 

 

 

Figure 1:  Now, said Takeda Wahei, It is Time for Winter

 

  

Japan’s Debt Mountain

 

If there is a reason to expect about a prolonged economic winter in Japan, the most likely cause would appear to be an unsustainable level of sovereign debt.  Thanks to nearly two decades of “stimulus,” Japan is burdened with debt like few other countries.  Debt-to-GDP in Japan is now almost 220%.  Netted against the large US dollar cash holdings Japan acquired in efforts to manage the dollar-yen exchange rate in the last decade, Japan’s net debt-to-GDP ratio is “only” 103%.  But the ratio will surely grow higher.  Japan’s budget deficit which had oscillated between 3% and 7% of GDP over the past five years, is running at nearly 10% in 2009.

 

 

Figure 2: Fiscal Ratios for Japan and Key Comparisons

Country	Debt to GDP (%)	Net Debt to GDP (%)	Government Revenue As % of GDP	Fiscal balance % of GDP	Net Debt multiple of revenue
Japan (2009)	217.2	103.5	30.6%	-9.9%	3.4x
USA (2009)	87.0	61.7	15.1%	-13.6%	4.1x
UK (2009)	62.7	56.7	38.9%	-9.8%	1.5x
Germany (2009)	79.4	51.2	44.3%	-4.7%	1.2x
Italy (2009)	115.3	111.8	46.7%	-5.4%	2.4x
Canada (2009)	75.4	26.1	14.4%	-3.4%	1.8x
Japan (1945)*	266.0	266.0	n.a.	-19.4%*	n.a

Source:  IMF, Reinhart & Rogoff 2008 NBER, EU, Bank of Japan. 

Note: Japanese GNP not calculated in 1945, estimated on 1944 basis.  Fiscal balance includes wartime indemnities.

 

 

It is hardly noteworthy in 2009 that the world’s second largest economy doesn’t meet the criteria to have qualified for European Union membership under the Maastrict treaty.  Few of the other major economies do either, these days, least of all the United States.  But to the simple-minded such as myself, it does seem odd that a nation with even a couple of credit metrics which rate on par with Weimar Germany and Argentina circa 2001 can hold down a “AA” credit rating.  Stranger still are 10 year Japanese Government Bond (JGB) yields of slightly less than 1.3%.

 

 

Figure 3:  Gov’t Net Debt to Revenues

(2009 vs. Selected Defaults)

Country	Net Debt Multiple of Gov’t Revenues
Japan 2009	3.4x
USA 2009	4.1x
Italy 2009	2.4x
Argentina 2001 (D)	2.6x
Russia 1998 (D)	4.9x
Mexico 1982 (D)	5.1x
Germany 1932 (D)	2.4x

Sources:  IMF, Reinhart & Rogoff 2008 NBER, EU, BOJ

 

 

Explaining the Paper Thin Yields

 

Investigations into Japan’s surprisingly low long-term sovereign rates come up against some familiar explanations.  Japan has a high savings rate and therefore the country is awash in excess capital.  Moreover, given deflation, the JGB’s provide an attractive real yield.  And finally, given that JGB debt is almost entirely domestically sourced, risk premiums that apply to other countries don’t apply to Japan.

 

There are on-again, off-again experiments by the Bank of Japan with quantitative easing (the purchase of its own bonds with freshly created money).  Now on-again, quantitative easing seems not to have scared other market participants regarding the quality of the underlying paper.  Rather, it has just added to the apparent supply imbalance that results in 10 year JGB’s clearing at a 1.3% yield.

 

Japan’s population is both shrinking and aging to a point where retirement savings are being increasingly drawn down. The savings rate in Japan has declined from over 11% in 2001 to around 2% last year. And the much vaunted Japanese trade surplus has evaporated in the recession.  These factors appear to call into question the sustainability of ultra-low domestic interest rates in Japan.  Could quantitative easing alone maintain Japan’s yield curve?

 

 

Japan in 1945 vs. Japan in 2009

 

We find similarities and differences between post-war Japan and current-day Japan.  In both periods we see exceptionally high sovereign debtloads, in excess of 200%.  While today’s Japan has a huge balance of US Treasuries that partially offsets the gross debt, it also has a huge unfunded liability related to health and pension costs of its aging population.  From my vantage point, the 1945 debt and the 2009 debtloads don’t look so dissimilar.

 

Both today and in 1945 the Bank of Japan funded deficits by purchasing its own bonds with freshly created money.  However, the degree to which this occurred in 1945 vastly outstrips today’s pace.

 

And yet, curiously, the outcomes in terms of inflation and exchange rates couldn’t be more different.  In 1945, winding up the printing presses propelled money to chase the day-to-day commodities which were then in short supply.  Japanese inflation exceeded 500% in that year, (which partially explains why it is now so much easier to become a billionaire in Japan). 

 

Combined with defaults on war-related obligations, the 1945 inflation had the effect of eliminating most of Japan’s debt burden.  With a cleaned-up balance sheet and a rock-bottom currency, all Japan needed was an export boost from the Korean war to kick start its post-war economic “miracle.”

 

In 2009, for all the computer clicks the BOJ can muster, prices in Japan continue to stagnate.  Japanese consumers leave the shelves of 7-11 loaded with its 20 varieties of green tea and instead park their money in savings accounts where interest rates are quoted in basis points as opposed to percentage points.

 

No amount of debt creates worry about the 2009 yen’s purchasing power in the capital markets either, it seems.  The corpses of many hedge fund managers lie as witness to the brutal end of the unhedged carry trade.

 

What to Do

 

Why the differences?  And what should investors do?  The billion yen question arises again.

 

One of the helpful factors of 2009 is that interest costs are so low that a debt of 200% of GDP can be serviced for only 2.6% of GDP.  If Japan’s sovereign debt cost 8% instead, then interest charges on the gross debt would be 16% of GDP, or slightly more than half of the country’s tax revenue.  But that outcome, say the experts, is so unlikely as to be hardly worth mentioning.

 

Will it always be this way?  Is the natural rate of interest really zero and the Japanese have only arrived at the destination earlier than the rest of us?  I wonder.

 

I have been wrong before.  There are things I do not understand in this world.  Yet somehow it is hard to leave this bizarre yen valuation alone.  So I will call “game on” for the yen carry trade versus government paper of better financed sovereigns.  And double “game on” for buys of the hoardables – gold, silver and grains – financed by yen denominated debt.

 

Spring in Japan may be coming, in Takeda’s cadence.  But winter beckons.

The Return of Marketdepth

In truth, the gone fishin’ period wasn’t really all that long.  In the meantime, I have done a bit of personal housekeeping. Now, with the gracious understanding of my (always unnamed) employer’s legal counsel, Marketdepth returns to cyberspace.

 

During the break I sat back and reflected a bit on why I was running the site and what I hoped to get out of it.  What I decided was that having a markets blog was fun in its own right.  Efforts to monetize the activity, through advertising or by linking it somehow to a mutual fund, might be futile and would definitely end up diluting the enjoyment.

 

 

Figure 1:  Like MacArthur, Marketdepth also Returned

 

 

 

I am still writing this blog for people charged with managing assets, otherwise known as the poor sods.  I now realize that most of the readers of the site do not have that job, but the ones who have shown up so far do not seem to have minded their lack of targeting.

 

What I’m writing might change a little bit going forward.  I still believe in putting a fact-based analysis out there on an investment opportunity (or a hedge), but I also think there is a place for some light-hearted fun from time to time and hopefully we will deliver that on occasion.

 

How is this blog different?  For one, I am not selling a fund or advice or recommending any commission-based investment.  Notwithstanding the above, Marketdepth has a resolutely practical bent.  We are here, unabashedly, to make money (or, more precisely, to increase our relative share of the world’s wealth).  The blog only serves to point out how we intend to do so.  In this respect we share some things in common with James Bond villains, who shamelessly monologue while 007 figures his way out of a straightjacket.  Thirdly, we are quite comfortable in deploying analytics and data to the extent that these are useful in making our case.  And finally, we intend not to take ourselves too seriously.

 

We live in curious times.  The world’s two largest economies (the US and Japan) are on life support.  Tax revenues represent only about 60% of federal spending this year in the US and even less in Japan.  Here in Canada, the nation’s largest-ever fiscal stimulus program (which is the CMHC’s incremental commitment over the last two years of approximately $530 Billion of guarantees and outright mortgage purchases) goes almost unnoticed by a population who smugly presume that the absence of a housing meltdown has something to do with Ed Clark’s conservative nature.

 

Meanwhile, sleeping Tigers and Elephants of the global economy are awakening.  Increasingly ready to seize the helm, they are not (yet) in command of important apparatus such as reserve currencies.  Still, we sense a coming leveling of the economic playing field, if not in national terms, at least in individual ones.

 

The whole situation reeks of turbulence ahead.  Many fortunes may be lost, perhaps. But then there are the fortunes that will be made…  Into this breach we step, poised to find opportunity.  Long or short.  Bond or stock or metal bar.

Real Estate Dreams -- 2009 Edition

A red flag – his signal – appeared last night in the flowerpot on the balcony of a well-known city hotel.  I made it to the corner of Georgia and Burrard around 1.30 AM and hastened down the stairs of a certain underground parking lot.  A smoldering cigarette butt beside the ticket meter told me he was there.  In the faint glimmer of an EXIT sign, I could see the shadowed outline of his bicycle helmet against the parkade wall…

 

 

DEEP THROAT:  Look kid, I’ve been reading your stuff.  You’re sniffing around the right areas, but you keep missing what’s really important.

 

GC:  Missing what’s important?  Hey, did you see that QLT post?  The stock’s up 100 per cent in two months.

 

DT: Forget QLT.  I’m talking about Vancouver real estate.

 

 

Figure 1:  A Smoldering Cigarette Butt Told Me He Was There

  

 

GC:  Real estate? That’s not my beat.

 

DT: Not your beat!  Listen here, compared to the residential real estate market in this town, public companies are just chump change.  Greater Vancouver has over 900,000 homes worth an average of $528,000 each.  That’s a market of about $470 Billion.  What are the local companies worth?

 

GC:  Well, “604” headquartered public companies have a combined market cap of about $120 Billion.

 

DT:  See what I mean.  Residential real estate is a market four times the size.  And I’m telling you, it’s shakier than a cup of Jell-o on the Queen of Alberni.

 

GC:  Wasn’t that last year’s story?  We’ve had our little correction and we’re coming back out of it.

 

DT:  Don’t be so sure.  The average metro Vancouver house price is still higher than the average Southern California price was at its 2006 peak.  But incomes are lower here and mortgage interest isn’t tax deductible.

 

GC:  So what’s holding it up?

 

DT:  You have to follow the money.  Where does the money enter the housing system?

 

GC:  From the new home buyer, I guess.

 

DT:  And where do they get their money? Five per cent down, maybe, and the rest from a bank.

 

GC:  So the banks must have done their homework.  It’s their money on the line.

 

DT:  Don’t be so sure, kid.  The banks have figured this one out already.  They haven’t grown their mortgage books at all since 2007.  Over 90% of the growth in Canadian mortgage lending since 2007 has come from National Housing Act mortgage-backed securities.

 

GC:  You mean the marginal home buyer is being financed by…

 

DT:  That’s right.  Ottawa.  The loans might be written at a bank, but the money comes from the government.  Pick up the CMHC's last annual report.  You’re a smart guy.  I’m sure you can follow the numbers.

 

GC:  Well, the Canadian government is a pretty solid credit.  I suppose if they want to, they can go on supporting the housing market for some time.

 

DT:  That’s the hope.  Of course they’ve had a few problems in the past.  Subsidize fishing boat construction, run out of fish.  What are the chances subsidizing home construction at the height of a speculative frenzy is a fail-safe economic plan?  As bubbles go, what the Americans had was pretty flimsy – a lot of private sector mortgage paper sold to suckers.  In Canada, we’re backing a housing bubble with the full faith and credit of the crown.  This is no ordinary bubble, it reminds me of one of those giant inflatable pigs from the Pink Floyd concerts.

 

GC:  So what do you do?  We’re in this to make money.

 

DT:  <Pauses as a car starts in the back of the parkade>  Quick, there’s not much time.    Short the lenders.  And buy undervalued assets that can’t be printed up by government.  I read your silver piece, kid.  You are on the right path.

 

 

And, with that he sped away on his mountain bike, headed for the seawall.  I think about his words, and wait, wondering what 2010 holds for this city’s most significant asset class.

Gone Fishin'

Lots going on these days and, reluctantly, I must wind things down here at Marketdepth.  Thank you to all my readers, this was an enjoyable experience.  I will keep the site up for a while, and who knows, maybe start up again someday.

 

But for now, I’m hanging the “gone fishin’” sign on the door and heading on to other things.

 

Best.

 

Geoff

Hedging Canada's Housing Market - Lessons from the South

An invisible line at the 49^th degree of latitude separates two of the most similar countries on this planet. Canada and the United States are united by language (mostly English, in both cases), by history (both populated by émigrés, from Europe first, then from elsewhere), by business and culture. 

There are a few differences of course.  Canadians say “zed”, Americans say “zee.” Americans fight wars, which sometimes they regret.  Canadians prefer to stay out of wars, but sometimes regret a dependency on America’s military strength.  And then, of course, there is housing.

America's private sector by means of complex financial mechanics inflated a widely acknowledged housing “bubble” in the middle years of this decade.  The bust has thrown the US into its deepest recession since the 1930’s. Canada, through transparent but aggressive state intervention, has managed to sustain average house prices higher than America’s bubble peak for the past three years.  Already backstopping $667B of higher risk mortgages, the Canada Mortgage and Housing Corporation plans to expand its mortgage credit exposure by a massive $271 Billion in its 2009 fiscal year.  America’s bubble, made of flimsier stuff, burst long ago.  Will Canada’s state-backed mortgage system prevent a similar house market decline?

 

Figure 1:  US Bubbles Burst; Does Canada Have Better Technology?

The future direction of house prices is a subject of intense debate in this country.  But let us avoid for the moment that specific question.  Rather, let us concern ourselves with whether homeowners in Canada can sidestep the consequences of a housing decline?  Can home equity be effectively hedged?

Hedge Construction

 

In a normal hedging scenario, such as a currency neutralization, one simply contracts to sell the precise item that one is buying.  If I buy, for example, 10,000 shares of Tokyo-listed Futaba Corporation and sell forward the commensurate quantity of Japanese yen, I can effectively eliminate my currency exposure for the duration of the trade. 

 

But for residential real estate, putting together a hedge is much more difficult.  For one thing, there is no secondary market in Canadian home equity, other than the occasional thinly-traded apartment REIT.  So there is no exact security that can be sold short to build a hedge position.  On top of that, residential real estate is heterogeneous.  Markets differ by geography, price point, and dwelling type.

 

In building a virtual hedge, perhaps it is better to think about fundamental drivers of home prices.  Real estate as an investment appears to behave as a levered play on domestic interest rates.  There are two positions which trade inversely to domestic interest rates.  The first is simply to be short bonds.  The second, less directly connected but much easier to execute for most investors, is to own precious metals.

 

A third leg of a hedge is simply to short banks.  Canadian banks write far more than half of their loans with security against residential real estate.  If the value of the security goes down, then the equity value of the banks ought to reflect that.

 

 

US Back-Testing

The United States housing market over the past ten years offers an excellent laboratory to study an effective home equity hedge.  As a proxy for the US housing market, we have the Case-Shiller index, which has ample historic data.  I have used the original 10 city composite. 

The indirect hedge construction is fairly simple.  One-third is applied to a long position in gold, one third into a short position in ten year US treasuries (I have used a zero coupon for simplicity), and one third into a short position in the heavily traded Keefe, Brunette & Woods US Bank Index.  By adjusting the weights of the hedge components on the attached excel file, one can fine-tune the hedge to taste.

 

 

Download Housing hedge jul 09 

 

The combined hedge, while not being an exact mirror image of US housing market performance, certainly performs the way one would hope.    The decline in the Case-Shiller index is 33% from the June 2006 market peak to the last full data of April 2009.  The hedge gains 40% in value over the same period.  The chart below tells the story.

 

Figure 2: US Home Prices vs. Multi-Factor Hedge 1999-2009

 

 

Canadian Market Adjustments

 

 

Making this hedge in Canada requires a few adjustments.  Rather than the KBW index, the i-Shares Capped S&P TSX Financials ETF (XFN.TO) provides a liquid and diversified substitute.  The SPDR Gold Shares (GLD.N) should be fine for precious metals exposure.  Central Fund (CEF.A.TO) with its physical metal ownership and 50% weight in silver may be a better choice, despite its routine NAV premium.

Shorting Canadian bonds is easier for institutional investors than for retail.  The retail investor might achieve this component of the hedge by locking in the trade with a matching term loan, perhaps one tied to an underlying real property.

 

Final Notes

 

Hedging exposure to a potential decline in the Canadian residential real estate market is an inexact science.  And, even if one counter-acts the impact on one’s own real estate investments, no doubt the ancilliary effects of a market meltdown would have a toll on most individuals.  However, borrowing from Mark Twain, we observe that in Canada everybody talks about a housing bubble, but nobody does anything about it.  Here, at least, is a trade likely to serve as an umbrella against a hard rain.