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The Shoeshine Portfolio - 2010 Edition

 

When I was a kid growing up in Kelowna, we used to have a summer fair called the Regatta.  Originally oriented around sailboat races, by the 1970’s the Regatta’s main attraction was its fairground rides.  Long lines always formed in front of the huge red and white Salt and Pepper Shaker, which towered over City Park.  I can still remember clinging to my seat straps – in complete terror – as the Salt ‘n’ Pepper Shaker’s passenger capsule plunged towards the earth while spinning, before rocketing back skywards.

 

 

Figure 1: The Salt ‘n’ Pepper Shaker Towered over City Park

 

 

 

As an investor looking into 2010, this scary ride is brought to mind unaided.  No doubt we will survive this coming year just as we survived the questionably maintained fairground rides of the 1970’s.  However, I make no promises about our condition upon exit.  Given the economic turbulence that appears likely to come our way in 2010, losing our lunch strikes me as a definite possibility.  The trick, as always, will be to avoid losing our shirts.

 

Avoiding Real Estate, Seeking Liquidity

 

For next year, a critical strategy will be to insulate oneself as much as possible from a long-overdue housing bust north of the 49^th parallel.  Forget the bloggers, warnings about a Canadian housing bubble are now coming from bank presidents.  Adding urgency, the federal Minister of Finance now seems intent on kicking out the legs from under the housing market by reducing the mortgage credit availability that drove prices into the stratosphere in the first place.

 

A second key theme for the 2010 portfolio is liquidity.  In the long run asset prices rise, driven largely by growth in money supply.  But in order to prosper in the long run, one must first survive a succession of short runs.  There are too many people in Canada between 30 and 50 years old who have some home equity, a lot of mortgage debt and precious few other assets.  In order to make it through to the “other side” of a housing bust these folks need to line up liquid assets or sources of guaranteed borrowing that could see them through a rocky patch.  Insolvency (owing more than you are worth) is unpleasant, but it is not financially fatal unless combined with illiquidity (having no cash).

 

Shoeshine’s 2010 Portfolio

 

As for what to own, I offer the Shoeshine Portfolio, a hedge fund in a box.  I have covered many of these securities in recent posts and present a summary rationale here.

 

Figure 2: The Shoeshine Portfolio for 2010

Category	Symbols	Name	Weight
Cash and Equivalents	C$, US$, HK$	N/A	30%
Precious Metals	NYSE: SLV NYSE: PTM NYSE: GLD TSX: CEF.A	i-shares Silver Trust E-TRACS Platinum SPDR Gold Central Fund	60%
Inflation-Protected US Treasuries	NYSE: IPE	SPDR Barclays TIPS	10%
Equities (Long)	TSX:COA TSX: SVM NYSE: CSH NASDAQ: CSCX NASDAQ: GPC HK: 341	Coastal Contacts Silvercorp Cash America Cardiac Sciences Genuine Parts Café de Coral	50%
Equities (Short)	TSX: XFN	iShares CDN Financial	-50%
Total			100%

 

 

Cash is not held for a return at these rates, but because it may come in handy.  I prefer US dollars to Canadian cash these days for the simple reason that a US dollar has more purchasing power without a materially worse fiscal position.  Cash in fundamentally undervalued currencies pegged to the US dollar (like the HK$) also looks sensible here. 

Precious metals in the long run will be worth much more than cash and so deserve a bigger weight.  My value favourite in this category is silver, but all should do well.  US inflation-protected Treasuries are an alternate means to preserve capital.

 

And as for equities, I’m happy to own a boatload, provided I offset my favorites against short positions in the handmaidens to Canada’s housing bubble that populate iShares Canadian Financial index.  In their stead, I propose a selection of businesses that earn money from online contact lens sales, silver mining, pawn broking, auto repair and fast food meals in China.  For good measure I add a Washington state business (Cardiac Sciences) that trades well below cash value.

 

Are you ready for the Salt ‘n’ Pepper Shaker of 2010’s financial markets?  Hold on tight, it should be quite a ride.

So Shall We Reap

An eerie calm fell over Canada’s financial markets one year ago.  Battered by collapsing equity markets worldwide, and further hampered by falling commodity prices, the Canadian economy ground to a screeching halt.  A decade of growth fueled by expanding debt was about to be unwound.  Or so it seemed.  However, into the breach stepped the Canadian government with a stimulus program of mammoth proportion.  Though dormant in the spring, by the summer we saw a few green shoots emerge.  And by the autumn of 2009 we began to harvest debt-fueled growth in this country once again.

 

This post does not quibble with the growth we see.  It is there for all to observe.  If we dare to ask a question it is only regarding the less studied subject of the durability of a rebound built on government largesse. Simply put, does the Canadian government have the borrowing capacity to keep on priming the pump?

 

 

Figure 1:  By the Autumn, We Harvested Again

 

I ask the question because the consensus opinion appears to be that government policies that add heavily to the long-term debt burden in Canada do not impact in the least our nation’s future borrowing ability.  But will the bond market always be so accommodating in funding deficits?

 

To reach an answer, I believe it is important to get a full view of the facts.  Of particular interest to me is the question of exactly how big is the consolidated debt burden that weighs upon the backs of Canadian taxpayers.  If you go by the headline numbers, Canada’s $519 billion debt forecast for the end of the March 2010 fiscal year is relatively small by international standards, a mere 34% of GDP.  That compares US debt-to-GDP of 74% and over 100% in Japan.

 

However, if we were a lender conducting an analysis on a corporate debt issuer, we would not be content with a number that accounts for only some of the total debt, we would want to know the fully consolidated number.  And, in my view, the headline debt number in Canada is very far from being the whole picture.

 

The first addition to make would be provincial debtloads, which are a far more significant factor in Canada than sub-national debt is in other countries.  Adding on provincial debt, even after netting out the surplus funds held by the sheikdom of Alberta, puts another $365 billion onto the national total.

 

The next step, if we were looking at a corporate debt issuer would be to consider other long-term financial liabilities such as pensions.  Doing this for Canada is a bit tricky because the Canada Pension Plan only publishes its funding statistics every three years and the separately constituted Quebec Pension Plan does not publish this at all.  However, even taking the 2006 picture of the CPP’s funding status shows a gap between the present value of the obligation and the fair value of plan assets of $620 billion.  If we were to update the numbers to allow for growth over the past three years and throw in Quebec on a pro-rata basis, the net unfunded pension liability that needs to be borne by this country’s taxpayers is approximately $850 billion.

 

It is true that pension liabilities aren’t exactly debt.  But when you are paying current recipients through new borrowings and the CPP’s own forecast calls for a $27 billion increase in annual benefit outlays over the next ten years (as the baby boomers retire), it feels pretty much like the same thing.

 

Beyond that, it seems fair to assess some significant contingent liabilities of government agencies.  The most significant source of contingent liability on the Government of Canada books is the CMHC (call this agency ‘Cannie Mac’), which either owns or guarantees approximately $900 billion of high loan-to-value mortgages.  Maybe Canada’s housing market will never suffer the 40% price decline observed in the US or Spain.  But if it did, how big would the Cannie Mac bailout have to be?  Given CMHC’s equity is only $8 billion, a bailout in the order of $100 billion doesn’t seem impossible.

 

 

Figure 2:  Canada’s Debt – Consolidated Stress Test

Item	C$ Value	% of GDP
Official Debt	$519 billion	34%
Provincial Net Debt	$365 billion	24%
CPP/QPP Deficit	$850 billion	56%
CMHC Contingency	$100 billion	7%
Other Contingency	$150 billion	10%
Total	$2,000 billion	131%

 

 

All told, throwing in the blanket guarantees on private pensions recently made by the government of Quebec and a myriad of similar promises extended to farms and other special cases across the country, a stress-tested debt burden on the Canadian taxpayers is closer to $2 trillion or 131% of GDP.

 

The question investors need to ask themselves is how much public debt is too much for a country to bear?  Who knows, maybe market participants will still be snapping up 30-year Government of Canada bonds even if our debt-to-GDP was 200%.  But sooner or later I expect a risk premium will arise in the form of higher yields on longer-term Canadian government debt maturities.  Might that risk premium begin to emerge in 2010?  We shall see.

Shoeshine: Investing with the Tao

In a confusing market, I turn for advice to Shoeshine, who works the chair in the basement of that old hotel.  He knows me only by my pseudonym, Mark Depp of Marketdepth.  On a quiet afternoon last week I found him at his post…

 

Mark Depp:  Shoeshine! Am I ever glad to see you.  Is it the right time to get back in the stock market?

 

Shoeshine:  Why do you think this is the time?

 

MD:  Well, Shoeshine, all last year people were selling stock and there were no buyers.  So prices got crazy low.  But now, things haven’t turned out as bad as we feared, so everyone’s sitting on a big pile of cash.  When that cash starts buying stocks it’s going to drive up stock prices maybe higher than they were in 2007!

 

Figure 1:  Why is now the time? asked Shoeshine

 

  

SS:  With all due respect Mr. Mark, I think you may misunderstand certain market mechanics.  When “people” were selling last year, to whom were they selling?

 

MD:  Well to other buyers, of course.

 

SS:  And from whom will this year’s optimistic buyers make their purchases?

 

MD:  Um…From other sellers, I suppose.

 

SS:  So you see, Mr. Mark, the amount of buying is always matched equally by the amount of selling.  And so, it is not the transactions themselves that move the prices, but changes in the market participants’ estimation of fair value.

 

MD:  Hmm, you know Shoeshine, I had never really thought of it that way.  Of course you are right.  So I guess I should rephrase my question.  Should I switch my cash into stocks because I have realized today that the stock market is trading below fair value?

 

SS:  My poor Mr. Mark.  Your life must be so difficult, trying to find moments when the entire market is over- or undervalued.

 

MD:  What other approach is there, Shoeshine?

 

SS:  Have you ever thought about making smaller decisions on which you have more complete information?

 

MD: Well, the other day I was offered an $800,000 two-bedroom apartment in Yaletown, but I didn’t buy because I thought the price was too high.  And the week before that there was an end of season sale at the pool supply store so I stocked up on Floaties at half price.

 

SS:  Very good, Mr. Mark.  You see, in your day-to-day life you make relatively rational decisions about whether to be a buyer or a seller based on an understanding of prices and value.  Why don’t you take that same approach with your investment book?

 

MD:  But Shoeshine, if I could be either a buyer or a seller of any particular investment on any particular day, then…then…every day I would be facing the same opportunity!

 

SS:  And so you do, Mr. Mark.

 

MD:  Ooooooh, my head is spinning!

 

SS:  As you find overvalued assets, like the Canadian banks, be a short seller.  And whenever you unearth bargains like silver or Coastal Contacts, be a voracious buyer.  Your life is better in two ways.  First, you avoid the need to make an overall market call.  But more importantly, you will convert a book of speculative positions into a balanced portfolio that earns the spread between over-valued and under-valued assets.

 

MD:  Ah, Shoeshine, I believe I finally understand.  Now I notice an interesting picture hanging beside your booth.  There are three men standing in front of a pot of vinegar.  They have touched the vinegar and are now sucking the sour taste from their fingers.  The first two men’s faces are all contorted, but the third man – he looks a lot like you – is calm and smiling.  Why is he smiling?

 

Figure 2:  Three Investors Taste the Market

 

 

SS:  He is smiling, my friend, because is following the way of the Tao.  He recognizes that the vinegar tastes as sour as it is supposed to.  Therefore he is calm, even happy if you will.

 

He has made peace with a market that sends hoards of new real estate agents to chase commissions just before a housing crash.  He smiles as honest analysis is ignored while manias are fanned by improbable claims.  He understands that men can no more prevent the loss of fortunes from bursting bubbles than bacteria can prevent themselves from declining after a period of exponential growth.  He realizes, Mr. Mark, that the universe has been around forever.  Therefore he knows that if problems of this nature were solvable, they would already be solved.

 

MD:  And the other two men, I have seen before, but where?

 

SS:  Mr. Mark, you will see these tortured faces everywhere and at all times.  You will notice that the first man looks a lot like Mr. Bernanke.  From his face you can see his intelligence.  From his demeanour you may observe his power.  Yet his face is screwed against the bitterness of a reality he cannot manipulate.  For all the money he can print, he creates no wealth.  For all the good news he can manufacture, he is powerless against simple truths that sprout like weeds on an empty field.

 

MD:  And the other man?

 

SS:  When is the last time you looked in a mirror, Mr. Mark?  For this other tortured soul...It is you.

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.