December is often a reflective moment for investors. Nearing the end of the year, I look back on 2010 markets that have generally co-operated.
My “Shoeshine Portfolio,” a non-marketed, unaudited portfolio that I introduced in December, 2009 and updated in a July post, is up more than 30% in the year-to-date period. Big wins were made in gold and silver bullion holder Central Fund of Canada (TSX: CEF.A) and Silvercorp (TSX: SVM). In addition, results were boosted by a second half double in Cardiac Science Corporation (NASDAQ: CSCX) of Bothell, Washington, which was the subject of a successful takeover bid. A recent rally in Coastal Contacts (TSX: COA) also helped.
But this business is not about yesterday, it is about tomorrow. And with that in mind, I thought I would share my current “work in process” thoughts regarding portfolio adjustments and re-weightings going into 2011.
In 2010, the Shoeshine Portfolio returns were bolstered significantly by rising commodity prices, particularly in gold and silver, which formed a 50% weight (and a 60% weight if one includes the position in Silvercorp under silver).
This is one position I will be adjusting going into 2011, for the simple reason that precious metals have generally worked out too well. [As an aside, I have no particular dollar price target in mind for precious metals because I actually think about my holdings here in terms of ounces rather than dollars. The Fed and the other central banks can print as many dollars as they like and the price of the metals ought to rise in rough proportion.] But what concerns me is that the prices of a number of other key commodities (base metals, grains, cocoa, lumber and certain fuel commodities) have not kept up with gold and silver and therefore these other commodities are developing large undervaluations relative to gold in particular.
Therefore, I am planning on adjusting the commodity mix of the portfolio to include a broader basket of commodities, with emphasis on the more undervalued. The difficulty with these other commodities is that holding costs are far higher than they are for bullion. For this reason, I am looking at a variety of instruments: stocks, convertible bonds, exchange traded commodity futures funds etc., from which I hope to gain low cost exposure to undervalued commodities with a minimum of financial leverage. In January I will report back with the new commodity mix, which should still constitute a large weight.
All year long I have held a very large short position against the shares of Canada’s major banks and financial institutions. So far, I must confess, this trade has not been successful. An exchange-traded fund that tracks this sector is up about 2.5% on a year to date basis and, as a short, I have also been responsible for dividend payments that cost a further 4%.
From a portfolio structure point of view, however, the position has been a wonderful balancer. Every time the markets got worried about deflation, being short the banks was an in-the-money trade. Yet when things were going according to the Fed’s inflationary plan, few appeared eager to bid up bank shares, while precious metals, commodities and certain industrial stocks rocketed.
Going into 2011, I think the reason for the short position still exists in spades. The Canadian housing market is not nearly as healthy as it was this time last year and mortgage loan loss provisions are climbing. For instance, in its recent 4th quarter report, Royal Bank of Canada (TSX: RY) showed gross impaired mortgages at $808 million. This number, which seems to rise every quarter, is up 26% from one year ago is more than double the level in q4 2008.
The bullish argument on the Canadian banks is that potential mortgage losses do not matter due to the fact that most risky home loans are subject to CMHC insurance. But the problem I see is that the CMHC is woefully undercapitalized to cover a broad-scale housing decline such as we have been observing south of 49˚N. Against over $1 trillion of mortgage insurance, securitized mortgage guarantees and outright owned mortgages, the CMHC has less than $10 billion of equity, or less than 1% of the total value it is supposed to be backstopping.
In the event we get a sustained housing correction, the agency would need large equity infusions from Ottawa. At that point, I suspect the chances are very high that an enterprising Member of Parliament will stand up and say something to the effect of, “Mr. Speaker, in light of the $100 billion bailout requested by the CMHC on behalf of certain Canadian mortgage originators, it has come to my attention that a large number of guaranteed mortgages were in fact underwritten without being in strict compliance to CMHC rules with respect to minimum down-payment, income verification, and borrower financial positions. I request, therefore that the bailout be subjected to the condition of satisfying a Royal Commission’s enquiry into these matters before proceeding.” At which point, investors, knowing full-well that such considerations are material with respect to the status of mortgage origination in this country in the past five years, would not likely wait patiently for the outcome. Where is the bid for Royal Bank shares under this scenario? Probably not between its current 2 and 3 times book value, in my view.
So in this position, I soldier on, lonely and unrewarded, but increasingly confident of eventual payoff.
Back in the 1990’s, my early days as a student of the markets, earning returns was all about finding reasonably valued companies that were building better mousetraps and hanging on for the ride. It helped if these industrials had strong relative market positions, good balance sheets, etc., all the “checklist” items that we copied down from Warren Buffett and Phil Fisher.
Frankly, these days, I treat this category as a sideline as opposed to the main event. My general feeling is that the odds are stacked against North American companies of this type as a consequence of over-leveraged customers and generally flaccid economic conditions. If I were running Asian equities, as I did for several years in the past decade, I would be a little more inclined to dig them up, but I find commodity positions create exposure to more or less the same driver.
At the time being I like a few local growth-type companies including Coastal Contacts, Norsat International (TSX: NII), and Vecima Networks (TSX: VCM). These companies are all small, competitively advantaged businesses facing rather large market opportunities but without big valuation multiples. I am always looking for more of these, so if you know of any, do let me know. One day, when the problems of debt and currency are dealt with, I hope to return to this category as a main event.
This is a newer category for me, but I am convinced that the rise of precious metals will bring with it the return of the speculative mining issue as a mainstream portfolio component. Hoping to front-run that trend, I am actively hunting down companies with good, competent management that has a well financed mineral exploration program with an above average probability of success. Not stuff for widows and orphans, I know. But in the scheme of things an attractive risk-return opportunity, in my view.
The sector is viewed as “un-investable” by most large institutions in this country. And there is usually more money to be made from violating the various taboos of established fund managers than from adhering to them.
Speaking of taboos, I wanted to end on the subject of the government bond curves. Because markets make opinions, insofar as whatever long-term trends that prevail are taken as inviolable discovered truths, there is not surprisingly a large cult following surrounding long maturity Canadian and US bond obligations. I have handed in my objections to this trade here, here and here. Other than a small position in an inflation indexed bond ETF (NYSE: IPE), I have avoided the sector and will be eliminating even these bonds in 2011.
My best guess is that a generational low was hit in the US 10-year yield in 2009 at a hair above 2% yield to maturity. After the low is reached, there is nowhere to go but up. Bonds and equity valuation multiples will bear the brunt of the pain as nominal and real interest rates rise back towards (and probably above) historically average levels.
I am voicing my opinion on this asset class in 2011 by just leaving it out of the portfolio altogether. The best way to be short this trade is actually to take out long maturity debts to finance investments with good potential. While we can all do this personally, I won’t layer on that complexity for the point of view of Shoeshine 2011.