Saturday, March 24, 2012

2012 Top Investments - On Fire

So far my 2012 Top Investments are on fire, mostly due to the strong rally in financial stocks (Read 2012 Top Investments).

top 2012 investments canada














Click on the image to make it larger. 

Year to date the S&P 500 is up 11% while my top 5 investment picks are up 34% on average.  Best performers are Bank of America (+77%), Goldman Sachs (+40%), & Sears Canada (+31%).  Laggards are First Niagara Financial (+15%) and Speedway Motor Sports (+9%).  My safe & cheap pick for the year, Wells Fargo, is up 22% year to date. 

Personally I don't find the results all that exciting yet, as Bank of America and Goldman Sachs are still both about 25% underwater from when I first recommended them in 2011.  To make a long story short, they are still undervalued by a substantial value. 

For those who have invested in financials, the fall in prices last year can be seen as either negative or a positive, depending on how you look at it.  Negative if you bought in 2011 have held on and are still underwater.  Positive on the other hand, if you took advantage of the situation to buy even more at even better prices, like I did. 

If you were able to separate your emotions from your thinking late last year, you're likely making out like a bandit this year. 

Current Commentary

As I have said before, you must constantly be on alert for investment risks.  Generally this means I am constantly on the lookout for those who have opposing viewpoints or see different risks than I do.  Risks in 2012 definitely are the Chinese real estate bubble (bursting) and the current bond bubble.  Beyond those two items, another huge risk is the Economic Cycle Research Institute (ECRI) is standing behind their recession call from September last year (Read Here). 

Who knows if the ECRI will be right or not on their recession call, but either way I'm not going to be ignorant.  Basically the argument from ECRI rests on the fact that the consumer is tapped out.  Given the recent uplift in the economy it's getting harder and harder for ECRI to justify that position. 

The bond bubble and commodity bubble (China) definitely represent actionable ideas.  I am actively looking at ways to go short commodities in a shotgun approach.  I haven't reached any conclusions yet.  My recommendation to anyone from Canada is get out of the TSX since Energy, Materials and Financials make up 26%, 20% and 31% of the index respectively (78% of total).  Needless to say I expect some carnage in the Energy and Materials sectors over the next few years. 

Anyone have any suggestions for any overvalued and over leveraged Energy or Material companies in Canada? 

Besides avoiding Canada I would suggest investing in the US markets for a couple reason.  First, the US markets are fairly valued with high quality large caps representing decent value.  Secondly, coming fall in commodities will make the Canadian Dollar fall relative to the US Dollar.  Theoretically this should add to you Canadian Dollar returns by holding US dollar denominated assets. 

If you absolutely must invest in Canada I would recommend Fairfax Financial or natural gas producers.  Fairfax, let by Prem Watsa, seems to have a handle on these numerous issues in the global economy.  Natural gas (NG) producers have fallen on hard times due to the warm winter.  This has caused current gas prices of less than $2/mcf in Canada, and have averaged $2.20/mcf year to date. 

Natural Gas

I finally took my head out of the sand and sold the majority of my natural gas related stocks last year when I changed my mind on the supply and demand situation.  The timing, while definitely a fluke, couldn't have been better (thank goodness for falling financials). 

NG is very oversupplied and those who think a quick return to $4-5/mcf gas prices will occur anytime in the near future need to recheck their assumptions.  Many NG producers are realizing the majority of their revenue from "wet" gas by stripping out the liquids which realize much higher prices.  For Peyto Exploration, the lowest cost producer in Canada, this means that even if NG prices went to zero ($0.00/mcf) they would still realize $2/mcfe from the liquids production.  Given that their cash lifting costs are $1.35/mcfe, they haven't shut in production although they just announced $1/mcf NG prices will be when they start shutting in production. 

For those long Oil, you should realize that NG will change the game in the long term.  If the US converted all 8 million heavy duty trucks from diesel to NG, US consumption of oil would fall by 3 million barrels a day.  The US currently imports 8 million barrels per day and 5 million barrels per day from OPEC.  This NG conversion would reduce 60% of OPEC daily imports, and account for 4% of worldwide demand.  For those who don't believe this is possible, you should be aware that the US has 3 times the amount of NG than Saudi Arabia has oil on an energy equivalency basis. 

Anyway, enough for now.  Back to my favorite pastime, reading. 


Best Regards,

Kevin Graham

Disclosure: Long: FFH, WFC, GS, BAC Warrants Class A, PEY

Books Recently Read - The Big Short (Michael Lewis), 7 Habits of Highly Effective People (Stephen Covey)
Books Currently Reading - Six Pillars of Self Esteem ***highly recommended*** (Nathaniel Brandon), & The Relentless Revolution (Joyce Applyby)
Books In the Cue - Predictably Irrational (Dan Ariely)

Tuesday, March 13, 2012

US Bank Stress Test Results

Here is a graph that looks at the relative strength of the US banks bases on the Federal Reserve Stress Test Scenario (CCAR 2012).  The weakest would be on the left, strongest at the right. (Click for larger image) 


The blue bars are the years of Pre-Provisional Net Revenue (PPNR) that would have to pay for losses if the economy tanked has hard as the Federal Reserve tested them under.  The stress test assumed over 13% unemployment, 50% drop in the stock market, and roughly a 20% fall in real estate.  Basically if they are under 1 year, the bank would still be profitable under this scenario.  The green line represents the median for all banks.  On average, most of the banks would be fine.  I would disregard the Morgan Stanley results since the data was erroneous.  They had negative net revenue, due to other expenses.


The red bars represent the tier 1 common ratio assuming no additional capital actions.  This creates more of a level playing field since some planned no dividend increases while others did assume increasing dividends and share buybacks.  The red dashed line represents the median for all banks.  Note banks have to maintain a 4% tier 1 common ratio.  Ally Financial failed this test. 

Good Decisions. 


Best Regards,
Kevin

Disclosure: Long WFC, and BAC Class A Warrants

Saturday, March 10, 2012

Canada: A Storm Brewing In China?

I was speaking with someone about commodities last night so I can't help but sound the alarm again. As I read the Fairfax Annual Letter to Shareholders this morning, I was reminded of the following quotes from Prem Watsa, CEO of Fairfax (FFH).  I have collected them over the past couple years:

Where do you see speculation in the markets today?

Clearly in the commodity markets. The price of gold and oil and whatever commodity you want to look at—corn, wheat, agricultural commodities, mining commodities—have all gone up in parabolic curves. Say you are a gold producer with gold at US$1,500 an ounce. You cannot hedge today. No gold company will hedge that gold production. They could guarantee a huge amount of profits, but they won’t do that because they think it will be going higher. You would have been wrong if you tried to hedge at US$900, US$1,000, US$1,100, US$1,200, and US$1,300, so people will not hedge. They will not hedge oil. I can think of only one company that hedges its oil. And very few will hedge the price of copper at US$4 per pound despite that fact is has rarely been at this price. The cost of production is very low, so you can make a lot of money if you hedge your copper price. But almost no one will hedge today, and that is an indication of speculation.

Speculation in China

We met people in China, even ordinary people, who owned three and four apartments. I would say to them, “If you sell one apartment, you’ll have a million dollars, free and clear. And you’ll still have three more apartments.” All of these prices have gone up fourfold in four years. You know what the person says? She says, “I can’t do that because I sold one two years ago and it doubled after that. So I am never doing that again.”

And you see the same thing in commodities today?

There is a ton of speculation in commodities. There is over-inventorying. Whenever the price goes up, people buy more than they need because they think it will continue to go up. So there are inventories. I can’t prove that to you, but experience will suggest that there are inventories all over the place—of copper and zinc and nickel and gold. Everyone is buying gold, and in fact, ETFs have been created with something like 30–40 percent of gold in the form of paper.

So what is the tipping point?

This is the beauty. You never can tell when the music will stop. I can’t tell, but you know it will end. In this case, it might end because the economy weakens and China goes into a little bit of a hiccup. Commodity price speculation will end as certainly as you and I are having this interview today. It will end, and for people who have speculated, it will end badly.

From the 2010 Annual Report

Meanwhile we have concerns over potential bubbles in emerging markets. Consider, for instance, what we learned on a recent trip to China: many house (apartment) prices in Beijing and Shanghai had gone up almost four times – in the past four to five years!; many individuals own multiple apartments as investments with the certain belief that real estate prices can only go up; and maids are taking holidays so that they can buy apartments also. “Buy two and sell one after it doubles to get one for free” goes the refrain! In his essay in Vanity Fair, “When Irish Eyes Are Crying”, Michael Lewis says, “Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash.” We agree!!

Infrastructure and construction spending in China accounts for more than 40% of GDP – a number rarely seen in the past in any economy. In fact, this demand has resulted in commodity prices going up in a parabolic curve. Combine the increase in commodity prices, substantially from Chinese demand, with hedge funds and others again trying to allocate money to these very illiquid markets, and you can understand why some of these commodities have exploded in price, as shown in the table below.

                            2000  2008   2010
Oil – $/barrel         27      45       91
Copper – $/lb.      0.83   1.39     4.35
Nickel – $/lb.       3.09   5.31   11.23
Wheat – $/bu       2.80   6.11     7.94
Corn – $/bu         2.25   4.07    6.29
Cotton – $/lb.      0.62   0.49    1.45
Gold – $/oz.        274     870  1,405

Even onions and chilis went up 64% and 38% respectively in 2010!! We shy away from parabolic curves, so we continue to maintain our equity hedges!

From the 2011 Annual Report (just released yesterday: Click Here)

As for China, late in 2011 the Chinese bubble in real estate burst. Developers have reduced prices by 25%+ to sell apartments in Shanghai – causing riots by angry buyers who paid full price. Expect apartment prices in China to come down significantly in the next few years. This may result in a hard landing in China, again with major consequences for the world economy. As the table below shows, the parabolic increase in commodity prices has stalled in 2011 and many commodities like copper have begun to decline:
                              2010   2011
Oil – $/barrel            91       99
Copper – $/lb.        4.35     3.45
Nickel – $/lb.        11.23    8.49
Wheat – $/bushel    7.94    6.53
Corn – $/bushel      6.29     6.47
Cotton – $/lb.         1.45     0.92
Gold – $/oz.          1,405   1,531

Cotton is down 37% and may be a harbinger of what is to come!

Of course if commodities, particularly oil and metals, come down, Canada will not be spared. Canada has benefitted greatly from the commodity boom and our housing sector, particularly in Toronto and Vancouver, has gone up very significantly. As George Athanassakos, Chair of the Ben Graham Centre for Value Investing at the RichardnIvey School of Business, said in his recent article in the Globe and Mail, this time is not different for Canada’s housing bubble. There are more condos in construction in Toronto than in the 12 major cities in the U.S. combined, including New York and Los Angeles!! Caveat emptor if you own many houses or condos in Canada.


If you choose to invest in commoditities, I wouldn't be ignorant of the facts above. 

Once again Mr. Watsa has called another bubble.  If you think he's a one hit wonder I would recommend checking the record.  I have a document of every market call he's ever made (since 1986) and quite frankly if you ignore him you do so at your own peril.  If you would like a copy of that document, send me an email (click on contact tab above).


Regards,
Kevin

Disclosure: Long FFH