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Shoeshine Portfolio - Thoughts for 2011

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. 

Figure 1:  Thinking about Portfolio Adjustments for 2011 

Commodities

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.

 
Banks

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 4^th 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.

Better Mousetraps

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.

Mining Exploration

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.

Bonds 

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. 

Figure 2:  US 10 Year Treasury Yields 1960-2010

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.

Shoeshine Portfolio Mid Year Review and Rebalance

At the end of last year I put together the “Shoeshine Portfolio,” a non-marketed portfolio model designed to preserve wealth, and hopefully provide a little growth, in an environment that looked dangerous.  As the summer heat finally arrives, it is a good time to sip a rum punch at poolside, reflect a little on the first half’s market, and make a few adjustments going into the next six months.

 

As the table indicates, through June 30, the Shoeshine Portfolio returned just over 4% for the half year.  This is hardly the stuff of trumpets and parades, but it would rank solidly within the top quarter of Canadian-marketed funds, and ahead of either the comparative returns of market indices (in C$ terms the MSCI All Country World Index returned -9.2% in H1) or fixed income benchmarks (depending on the benchmark, C$ fixed income returned about 2%). 

 

Figure 1:  Halfway round the sun: Shoeshine +4%, MSCI World -9%

 

Performance Drivers

 

The biggest driver of returns in the first half was precious metals, a 60% portfolio weight that returned almost 11%.  The 30% weight assigned to cash did reasonably well, too, with two-thirds being allocated into US dollars and US-pegged Hong Kong dollars, both of which gained about 1% versus C$ on a capital basis and provided a few basis points of interest to boot.   A further 10% in US-dollar inflation-protected bonds grew 4%.

 

Stocks counted for a zero net-weight, but included a 50% long position spread across six stocks and a 50% short position in Canadian financial firms.  While this short position in Canadian banks and insurers was unpopular at year-end 2009, it was nevertheless successful, providing a 5% return that was diminished only partly by -2% in dividend covering.

 

The long positions in stocks, the pride and joy, were a disappointment, dropping 9% on average.  The driver here was a 56% drop in Washington state medical equipment player Cardiac Science Corp (NASDAQ-CSCX).  It seems that “product recalls” and heart defibrillators are not a winning combination.  Lesson learned.  Having said that, I expect someone will now bid for this good company with more than 50 years of accumulated experience at a price somewhat higher than the current 45c on book value.  Therefore, I hold on.

 

Portfolio Adjustments

 

On the whole I continue to favour a net long position of stocks and precious metals set against shorts in the Canadian financial sector.  This is in keeping with a general view that while short-term deflation may set in, the real risk to investors is permanent wealth destruction through inflation.

 

A few additions include a stakes in local satellite communications player Norsat International (TSX: NII), and global grains marketer Archer Daniels Midland (NYSE:ADM), both of which appear undervalued.  The stake in good but overvalued Hong Kong-based fast food chain Café de Coral (HK:341) is best sold here. Also, given my increasing unease about the Chinese economy, I will drop the HK cash component as well.

 

The portfolio is designed to gain in the event that Canadian banks will experience much larger losses than most people anticipate as a result of the unwinding of our housing bubble on the north side of the border.  I add, for a kicker, a 2% stake in put options in Bank of Nova Scotia (TSX:BNS).  December 2010 $30 BNS puts have been recently offered at $0.50.

 

In my view, this portfolio is prepared for anything, with a bias towards producing a positive result in even trying circumstances.  Now that our pruning is done, bring on the summer!

 

Figure 2:  Shoeshine Portfolio, June 30 Update

Item	Symbol	Original Weight	Simple Return	Rebalanced Weight
Cash/Bonds/Bullion
US$ cash	USD	10%	1.0%	10%
HK$ cash	HKD	10%	0.6%	--
C$ cash	CAD	10%	0.0%	20%
Central Fund of Canada (gold/silver)	TSX:CEF.A	50%	11.7%	50%
E-Tracs Platinum ETN	NYSE: PTM	10%	5.7%	10%
SPDR Barclays TIPS	NYSE: IPE	10%	4.2%	8%
Total Cash/Bonds/Bullion		100%	7.0%	98%
Stocks – Long
Coastal Contacts	TSX:COA	8.3%	(13.5)%	5%
Silvercorp	TSX:SVM	8.3%	0.4%	10%
Cash America	NYSE:CSH	8.3%	(0.9)%	5%
Cardiac Science	NASDAQ:CSCX	8.3%	(55.6)%	5%
Genuine Parts	NYSE:GPC	8.3%	5.0%	10%
Café de Coral	HK:341	8.3%	13.4%	--
Archer Daniels Midland	NYSE:ADM	--	New	10%
Norsat International	TSX:NII	--	New	5%
Total Stocks - Long		50%	(8.5)%	50%
Stocks - Short
iShares CDN Financial	TSX: XFN	(50)%	5.1%	(50)%
Total Stocks - Short		(50)%	5.1%	(50)%
Options
Bank of Nova Scotia	BNS DEC 30 P	--	New	2%
Total Options		--		2%
Return Summary
Return pre-cash flows			5.3%
Net return after cash flows			4.1%

Note: Unaudited results provided for illustrative purposes.  Total return includes interest and dividends including outgoing dividends on securities sold short.

This Curve Also Rises

A few months ago I posted a piece that highlighted the difference between the hedgehogs and foxes of the investing world.  It is still a cult hit amongst animal lovers cruising for pictures of hedgehogs.  But the key point was that there are two different kind of investors.  There are foxes who chase every bit of news in the hopes of outwitting the market in the near term, and hedgehogs, who have one big idea that if correct will more than compensate for the lack of near term detailed information.  In the animal world, the hedgehog’s big idea is that no predator, howsoever hungry, wants a mouthful of quills.

 

The hedgehog-ish investing idea I posted on back in June was that investments made at low prices tend to result in superior returns.  To this rather simple insight, I add a corollary: investments acquired at high prices tend to result in inferior returns.  It is this second point that I comment on today.  I sit as a prickly hedgehog type observing the big bubble of our era – the bond market – and ask myself, what can possibly stop long-term interest rates rising?

 

Figure 1: The Sun Rises over Vancouver – Will Rates Follow?

 

 

The Interest Rate Cycle

 

Changes in the 10-year Treasury yield have been the pre-eminent driver of our economic lives.  What has the trend been in Canadian interest rates, Swiss equity multiples, Seoul house prices, or even global business school enrolments?  Generally speaking, these values are mere derivative functions of the US Treasury yield curve.  As rates have fallen, asset prices became pumped up.

 

The most telling picture with respect to the rate cycle is the 50-year chart depicting the yield-to-maturity of the 10-year US Treasury bond (arguably the world’s most important interest rate).  Here we observe a parabolic increase in rates that started gently in the 1960’s and culminated with spikes in the early 1980’s.  This uptrend was followed by a rapid decline in rates that began during the early years of the Reagan presidency and continued with a moderating decline to December 2008, where a low of 2.1% was hit in aftermath of the Lehman collapse.

 

 

Figure 2:  US 10-Year Treasury Bond Yield 1960-2010

 
 

I offer a few observations on this chart above.  First, it appears to the hedgehog in me that there is not very much room on the chart for rates to continue to fall towards the x-axis.   If I knew nothing about the fundamental drivers of government borrowing costs (OK – I hear you, but I can’t stop now) then I would be inclined to believe that mere mean reversion might apply.  And mean reversion would suggest that over the next several years the US government may come to pay an interest rate two or three times higher than it does today.

 

The second observation I make is more technical in nature.  If you look very closely, one can see that the trendline over the past five years is essentially flat.  The great James Grant, whom I would follow into battle even if he were wrong just because he is such a great read, emphatically called a bottom on this curve in 2003 when the 10-year yield hit 3.1%.  Clearly he was wrong.  But a good market – and US treasuries were a good market – often gives you a long time to get out.  Let me follow up Mr. Grant by calling the post-Lehman 2.1% yield the second part of the yield curve’s “double bottom.”

 

The third observation is more fundamental in nature.  I am at a loss to explain why government bond prices are so high when the likelihood of eventual repayment (in real inflation-adjusted value terms) has rarely been as low.  The internet offers no shortage of treatises on the unsustainable debt of the United States and I shall not add to these here.  But my investigations into sovereign credit quality of Japan and Canada suggests that the other major sovereigns aren’t much better.  Add to this equation the fact that the largest purchasers of government bonds are not profit-seeking individuals but the governments themselves and it is hard to see how today’s bond market differs at a conceptual level from the sort of scheme being run by Bernie Madoff.

 

 

Figure 3: US 10-year Treasury Yield

Date	Yield to Maturity
Jan 1, 1960	4.72%
Jan 1, 1970	7.08%
Jan 1, 1980	12.64%
Jan 1, 1990	8.65%
Jan 1, 2000	6.02%
Jan 1, 2010	3.81%
Average during period	6.78%

 

 

Practically speaking, central bankers are equipped with the full policy arsenal available to a modern state.  Therefore, I doubt we will soon fall into a real take-to-the-streets economic crisis.  But playing Ben Bernanke’s role looks to me like trying to win a chess game against Bobby Fisher with only king and a pawn at one’s disposal.  We know what the outcome will be – rates will rise – the only question is when?

 

 

Investing Themes for Rising Rates

 

And what do we do as rates rise?  A rising interest rate environment is a different kind of investing landscape, but one with many identifiable opportunities that investors can exploit.

 

The first opportunity arises from the increased volatility that occurs in a rising rate environment.  The debts that get piled up when interest rates are low are harder for companies and their customers to bear when rates turn the other way.  For this reason it is worthwhile opening up long/short and option eligible accounts and being prepared to take significant short positions following rallies such as the one which has lasted from March to December of 2009.

 

The second opportunity is in long-term ownership of asset classes which perform well in a rising interest rate environment.  I have noted silver as a particular favourite, but commodities as a group possess characteristics which make them resilient in such circumstances.   Growth-type equities which, like commodities, are not valued off current yields should outperform equity indices now dominated by dividend payers.  I would not buy too many now, but these might be great investments to make in moments of turmoil.

 

Another successful strategy for a world with rising rates has simply been rolling over short-term deposits.  Remember, to win in investing, you don’t need to put up big numbers if others are making losses.  Short term paper will outperform long-bonds in a rising rate world and will also provide the flexibility with which to buy assets at opportune moments.

I recognize that the foregoing list contains very few of the well-loved and traditional components of most investor portfolios.  But in investing there are no permanent friends or enemies, just a persistent imperative to grow capital.  The music of interest rates appears to be changing.  Therefore, it is time for all good hedgehogs to adjust their dance steps.