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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.

Morning on Howe Street

It’s morning again on Howe Street.

That’s right, Howe Street, the ancestral home of “pump and dump,” is rising again.  This time, however, it is not the push of aggressive promotion, but the powerful pull of fundamentals that is creating opportunity for our city’s most notorious industry.

Precious metals are soaring as gold and silver become re-established as monetary standards.  Base metal demand is set to expand rapidly in the large-population economies of Asia and South America.  Metal stocks are cheap compared to bullion prices.  The world economy is desperately short mine production.  These are the opportunities Howe Street exists for.

Figure 1: The Exchange Building on Howe Street – Early Days 
 

Howe Street’s resurgence, and the return of the speculative mining issue to mainstream portfolios, will create bountiful profits for some.  Others will make losses.  As we head into another potentially euphoric period for mining equities, it may help investors to recall a little history. 

Howe Street, The First Generation 

Until the mid 1960’s, the Vancouver Stock Exchange existed as a sleepy regional market, focussed largely on timber companies.  That changed with the strike in 1965 of a rich lead-zinc deposit in the Northwest Territories by the interestingly-named Pyramid Mines Ltd.  The company’s stock which, for its time, was relatively widely held across Canada, shot from 25c to $22 almost overnight. .  Ultimately the company was sold to a senior entity, Pine Point Mines, for $33 million.  [While that doesn’t sound like much, recall at the time that a Big Mac was 15c and Berkshire Hathaway stock was trading at $18.]  

The Pyramid Mines discovery started a bonanza that brought mining investors and promoters from around the world to Vancouver.  Amongst these was the inimitable Murray Pezim, formerly a Toronto-area butcher, who quickly became Howe Street’s promoter-in-chief. 

For a while, the momentum was unstoppable.  Buy orders placed in the morning showed profits by the afternoon.  Cars stopped in the middle of Howe Street as drivers rushed into the exchange building to place trades.  

Buy on Mystery, Sell on History

And there were other successes.  Carolin Mines was another 40-bagger gold discovery.  Dia Met and Diamond Fields also worked out well later on.  But unfortunately, Howe Street’s reputation was made mostly by the scam artists who preyed on the gullible in the decades following the Pyramid Mines success. 

The schemes were often “close-ology” plays, with promoters staking nearby tracts to large discoveries.  “Wash trades” within a close circle of insiders would drive up prices steeply in advance of the release of bogus drilling results.  Hapless investors would buy in at the peak, only to watch share values plummet.  Insiders profited from outsiders.  It was the Vancouver way. 

But by the 1980’s the inflationary fundamentals that had underpinned Howe Street’s rise went into reverse.  In the era of 20% interest rates, bonds and blue chips were far better values than $800 gold bullion or junior gold speculations.  The Dow Jones Industrials grew by more than 10x from 1982 to 1999, while the VSE Composite index tanked.  Initiated at 1000 pts in 1982, the VSE Composite closed in October 1999 at 395. 

And in 1999, just as bottom of the gold cycle was being reached, Howe Street’s exchange was disbanded and merged into the CDNX.  Ironically, the end of the VSE marked the point of extreme fundamental undervaluation of this city’s mining juniors.  Alas, by 1999 those who understood the fundamentals were so discredited that no one would listen.  Buy on mystery, sell on history. The strategy of the know-nothing retail investor was ultimately applied to the VSE itself. 

What to do now

In the last ten years mining stocks have recovered and the safe money has been made.  However, my read of this cycle is that a speculative blow-off phase lies ahead.  The gold market didn’t spend 20 years bumping along around $350 per ounce to stop at a mere quadrupling, in my view.  

Likewise junior mining stocks that can deliver reserve growth breakthroughs appear to be very fertile territory.  I spend time these days looking at the tier of juniors just below the size of companies that are eligible for the exchange-traded funds.  Within this class, companies with capable management teams and decent properties should be the basis of a portfolio that can properly capitalize on the return of Howe Street.  

I’m doing my own digging into junior miners with potential, but if any of the esteemed readers of this blog have particular names they think I should investigate or avoid I’m all ears.   

 

Vecima Networks - Liquidation Value with Growth Potential

The stock market, presented on paper as mere columns of names and prices, is not fairly characterized.  In reality, the market is a huge wheel which rotates to pull stocks from the depths of obscurity to a pinnacle of overvaluation and back down again.  Looking at companies currently riding the bottom of the wheel, one finds Victoria-based Vecima Networks (TSX: VCM), a next-generation industrial company trading at a buggy whip price.

 Figure 1:  Vecima –  Rotating Downwards, then Turning Up?

 

 About Vecima

Vecima Networks, founded in 1988 by engineering professor Dr. Surinder Kumar is in the business of creating devices that manage and transfer high volume data flows, the likes of which are found in cable networks, wireless communications systems and other similar applications. 

The company’s products bridge the final network segment that connects a system directly to end-users, commonly referred to as “the last mile”, where Vecima’s special capabilities in radio frequency are employed.  Key applications of Vecima’s technology include DOCSIS standard wireless broadband services and “QAM” (quadrature amplitude modification) that allows the simultaneous provision of video, voice and data services.  Vecima’s customers include major cable operators such as Comcast Corp (Nasdaq: CMCSA) as well as large network original equipment manufacturers like Cisco Systems (Nasdaq: CSCO) with whom the company has enjoyed a productive fifteen-year relationship. 

In addition, the company operates a nascent wireless data network operator called YourLink in Western Canada.  It also acquired Burnaby-based Spectrum Signal processing in 2007 for approximately $20 million. 

Vecima had revenues of $113 million in the year ending June 30, and profits of $0.8 million.  The annual profit represented more than a 90% decline from FY 2009 net income of $13.2 million.  Share prices have followed the decline in operating performance, dropping from $7.50/share earlier in 2010 to a recent all-time low south of $4.00. 

 

Figure 2:  Vecima Networks Stock Chart 

 
Challenges and Opportunities

Vecima’s troubles in 2010 appear to have stemmed from factors both within and beyond the company’s control.  External factors include softer than expected end-demand in the US cable market, which has led to somewhat reduced capital spending by larger operators.

Controllable factors may also have contributed.  In particular, the company’s large number of small-scale market initiatives may have diluted Vecima’s competitive positioning in key areas.  For example, there appears to be little overlap between the business of supplying capital equipment to cable operators and running YourLink, which is essentially a retail operation.  Yet these and other disparate businesses compete for management’s time and corporate resources.

To management’s credit, the project of re-focussing Vecima appears to be underway.  The company has recently centralized some distributed R&D activities and more moves of this nature could be in store.  Likewise, on the marketing front, Vecima is making a concerted push into a niche opportunity related to hotel HDTV networks.  This initiative, being pursued directly as well as through a large OEM partner, addresses a market estimated at $450 million without significant established competition. 

Valuation and Risks

While Vecima’s business is a little complicated, the valuation is easy.  This is a cheap stock.  Very solid net working capital is $48 million, property and plant (at a 50% haircut) adds $17 million, and wireless spectrum assets (based on recent transaction values) are worth a further $38 million.  Net of debts, a liquidated Vecima is worth at least $100 million, or 10% more than the company’s quoted market capitalization.  Beyond liquidation, if one believes that Vecima can recover even half of its historic levels of profitability, then an $8 share price would be well supported. 

Due to a controlling stake held by Dr Kumar, Vecima is not a takeover candidate.  However, at these levels a take-private bid would not be out of the question. 

My main concerns with Vecima are more macro-economic in nature.  The growth push into hotel HDTV networks occurs at a weak moment for hotel operators, who face continuing revenue challenges that have been further compounded by the bedbug scare.  However, if we wait for the robins, spring will be over.  Although we may not be at the absolute bottom for Vecima, I believe we are close enough to be confident of a solid return from current levels.