Saturday, September 15, 2012

Defensive Investing

I received an email from an aspiring value investor.  He was inquiring about how and where to start on his value investing journey. 

Here is my initial response. 


We'll your background sound a lot like mine but I'm sure you didn't lose as much (percentage wise) as I did when I started.

Taking responsibility for your own investments is a very wise move because there are ways to invest that will save you a lot of money in the long run.

For example, if you invest in mutual funds, you are basically giving away 2-3% of your money every year for expert money management. The problem is these so called professionals don't really care about you. All they care about is their job. You see the biggest risk to them is losing their million dollar a year job. So what they do to minimize that risk is to perform as close to the index as possible. If their performance is to far below the index people will pull their money out and if they are relatively close nobody will pull their money out. So they don't really care about you doing well or outperforming in the long run.

The solution to this problem is quite easy. Fire all advisors and just buy a very low cost index fund, like a vanguard fund or a TD e-series fund. These index funds effectively get you the same thing without the huge fees and expenses.

Now the next question is if you want to be an passive or active investor. Ben Graham used the terms defensive or enterprising investors in his book.

If you want to minimize the time you spend on investing you would be a defensive or passive investor. If you want to do this I would recommend three investment options for you. They are, in no particular order, investing in Fairfax Financial common stock, investing in the Horizons HAV ETF, and lastly investing in Chou mutual funds.

With that said, it appears that I have gone against what I have said above regarding mutual funds. The major differences are in the cost and value you receive. Always remember price is what you pay, value is what you get. When you buy the Horizons HAV ETF you are paying a relatively low fee of 0.7%, I believe. Now that is a very low fee but what you are getting is top notch investment management by Vito Maida, a proven value investor. His long term record speaks for itself and he is ultra conservative. Don't expect huge gains but you will achieve steady long term growth.

As for the last option, Chou mutual funds, you are again getting top notch investment management from a great value investor. Francis Chou has slightly higher fees but again you are getting a good money manager. He doesn't buy stocks just for the sake of buying them. He is disciplined to buy when they represent good value and isn't afraid of going against the crowd. He can and does underperform at times but so do all value investors. Value investors are patient and wait for bargains. That said, Mr. Chou has an outstanding long term track record.

Last and certainly not least is Fairfax Financial (FFH). You can buy the common stock in CAD or USD on the TSE. Put your money in Fairfax and sleep soundly at night. Fairfax is run by Prem Watsa who is sometimes referred to the Warren Buffett of Canada. Fairfax is similar to Berkshire Hathaway (Warren Buffett's company) in that they are predominately insurance companies, Fairfax more so. When you match an insurance company with proven value investing, what you get a cash flow machine. This is proven in Fairfax's long term record. The have grown book value at something like 24% for the past 26 years. Now don't get too excited because the past is the past. Looking forward expect them to grow book value at 10-15% over the long term, not the short term.

If you want an even better strategy, buy or dollar cost average into Fairfax when it trades below book value. Be more aggressive the lower it goes. The rest of the time just keep accumulating cash in your savings account. Fairfax's stock price, like all companies, move up and down based on expectations of fear and greed. When it sells below book value people are fearful, and when it sells for 3 times book value people are greedy. With that said, Fairfax will likely only sell below book value when it appears the sky is falling and all the pundits on TV are screaming sell, sell, sell. It takes courage and a willingness to stand alone when everyone else is heading for the exits.

Now if you want to be an enterprising or active investor that is another story... (to be continued).


Disclosure: Long FFH

Wednesday, September 12, 2012

Peak Oil is a Myth

I just read an interesting article in the Globe and Mail on U.S. oil production.  Here is the quote that I found most interesting.

The coming change, according to Bentek, is startling: By 2016, the U.S. will surpass its 1970 oil production peak of 9.6 million barrels a day; by 2022, it will have leapt to 11.6 million barrels a day.

So much for peak oil, it's clearly a myth. 

When you don't account for changes in technology and prices, sure peak oil sound reasonable.  The problem is you can't treat a dynamic situation as a static analysis.  Assumptions make for pretty formulas but don't reflect reality. 

For the full article:

In other news, the North Dakota Department of Mineral Resources just reported record oil production of 20 million barrels in July.  That is up 59% from the year before.  If you step back and look at the big picture, oil production in the state is up 7 times in 7 years.  Remarkable.   


Saturday, September 8, 2012

Canada - Headed for a Crash

I thought I would write down a few thoughts on the markets, specifically macroeconomic themes.

For those who have read this blog for any amount of time will understand that I am quite worried about the collapse of the commodity bubble.  I know some disagree that we are in a commodity bubble and that is fine.  China, a huge consumer of commodities, has started to falter lately and GDP growth estimates keep falling.  The housing bubble in China has recently collapsed.  That will lower demand for all commodities.  Goldman Sachs just issued a warning regarding Chinese growth as well.

For a refresher I would suggest reading the comments from Prem Watsa on China/Commodity bubble that I posted earlier this year.  Much of what he has said is starting to come to light today.

What worries me is the spillover into Canada, which will not be spared.  Vancouver real estate appears to begun to falter as seen here:

I believe Canada, Australia, and most of the mining sector is in for much harder times.  This isn't really surprising given the record high profit margins all these commodity companies have enjoyed for the past several years.  A number of companies such as BHP Billiton, Rio Tinto, Teck and others have recently issued warning about falling demand. 

As for positives here in Canada I don't see much.  I own a select few stocks from Canada and could generate a solid list of short candidates, starting with the banks. 

How about positives?

So what areas do I see as a positive going forward?  In no particular order:

US homebuilders and Mortgage Originators are good bets.  The sector is going to have nothing but a tail wind behind it going forward.  I own the largest mortgage originators in the US and one of the largest homebuilders. 

I like the US banks and I would sell the Canadian Banks.  The US banks have strongly recapitalized themselves and could suffer huge losses before running into trouble.  I know most people shy away from the sector because the financial crisis is fresh in their mind.  That is perhaps the biggest reason for bargains to be found in the sector. 

On the other hand, the Canadian banks sell for much higher valuations and are loaded up of over-leveraged Canadian consumer debt, some worse than others.  The graph below makes this point rather clearly. 


The problem is that Canadians have been using their houses like ATM machines, much the like the US did in the run up to their correction.  In the US, home equity withdrawls peaked at 8-9% of personal disposable income in 2006.  Here in Canada we apparently didn't get the memo that this is a problem and is not sustainable.  Since 2006, Canadians have been using their home ATM at a rate 8-9% of personal disposable income.  That will end... and it will end badly for our economy. 

South of the border the US real estate markets appear to be on the mend.  Housing prices have bottomed and most regions are up marginally.  This bodes well for the healing necessary in the housing market.  As Warren Buffett has said, the unemployment rate will fall dramatically once the housing sector begins to rebound. 

As noted in my previous post, natural gas is at very low prices and that is showing up strongly in the reduction in drilling.  Investing in any commodity that is selling at prices below the marginal cost of production is always a good bet to take.  I own the lowest cost explorer and producer of natural gas in Canada. 

One theme I particularly like but haven't actively invested in would be companies that buys commodities and sell a brand.  These companies are the most likely beneficiary of lower commodity prices as margins are likely to expand in the short to medium term.  If you have any suggestions feel free to email ("contact" tab above) or add your comments below. 

I think insurance companies are a good bet as interest rates rise.  That said, I don't expect interest rates to rise any time soon.  The debt deleveraging process has only begun and I believe we are in the midst of a debt deflation period.

As for stocks that I believe are cheap, Fairfax Financial (FFH) just hit a 52 week low this past week, JP Morgan (JPM) is a no brainer with an easy 20% upside from here even in sideways market.  Magna International (MG) appears quite cheap and auto sales are on the rebound.  General Motors (GM) looks interesting as cash on the balance sheet almost equals its market cap.  A number of technology names look cheap such as Dell (DELL) and Intel (INTC) now that the stock has come down again.  I have mentioned Speedway Motorsports (TRK) here before and now the the stock has come down again I think the price is reasonable. 

I have looked into at least 30 small caps over the past month and haven't found anything to get excited about (mostly in Canada).  I believe most small caps to be overvalued at this point in time because of the fragile nature of the economy.  With so many cheap, high quality, large caps available today I don't see much reason to look elsewhere.  Many of the large caps have strong balance sheets, can and have been issuing debt at record low interest rates recently, and can weather any storm in the economy much better than smaller competitors. 

So far, year to date, my portfolio is soundly outperforming the S&P 500 and trouncing the S&P/TSE index.  Because of the strong markets, I am in the process of reducing most of my holdings and keeping the proceed in cash.  That said, I don't tend to make wide changes in my portfolio and this year I have only made a few select purchases.  I will be looking at short ideas for Canada in the near future.  Suggestions always welcome. 


Disclosure: I am long FFH, and JPM TARP warrants.

Sunday, September 2, 2012

US Oil and Gas Drilling

Here are a few interesting graphs on the Natural Gas (NG) supply situation.  The current oversupply has led to a sharp drop in exploratory and development drilling for NG in the US.  Also show is the record levels of US oil drilling. 

(Click on image for a larger view)

Exploratory drilling in the US has come to a complete halt.  In both May and June not one exploratory gas well was drilled in the US.  Since March of this year only 14 exploratory gas wells have been drilled. 

Meanwhile exploratory drilling for oil is at the highest level in 27 years. 

As seen in the above graph, development drilling for gas has finally fallen to decade lows. We have not seen this low of a level of development drilling since the mid 1990's. Low gas prices are finally starting to have an impact.

By comparison, oil development drilling is at a 26 year high and for good reason, oil prices are in a bubble.  This has led to an explosion in oil production in the US.

Crude Oil Production US Lower 48

Due to the strong exploratory and development drilling for oil, crude oil production in the lower 48 is at a 23 year high as seen above.  The increase in production over the last couple years is quite remarkable. 

So much for peak oil, as many bloggers have aptly named peak idiocy.  I have commented before how peak oil theorists misunderstand basic economics, especially how price impacts both technological advancement and substitutionary effects. 

The bottom line is that oil production is strong and growing in the US.  Couple this with weak global demand, especially from China, crude oil is likely to fall.  I can't tell you when but it will fall. 

As for NG, low prices have finally taken their toll as exploration and production companies have nearly stopped drilling.  One of the main exceptions to this trend is Peyto, who has 8 rigs running as of the end of August. That makes them the second most active driller in Alberta for 3000+ meter rigs. 

It will be interesting to see how fast the production response will be to the decreased natural gas drilling.  The sooner the better, I hope. 


Disclosure: Long PEY

Saturday, September 1, 2012

Inflation or Deflation?

I have been thinking lately (go figure), and I have been trying to understand the whole inflation/deflation debate.  My question is below.   

Almost everywhere I look I see comments that all the money printing by the US Federal Reserve will lead to inflation.  Despite tripling their balance sheet inflation hasn't shown up at all.  The data actually points to slowing inflation. 

Are people making a flawed assumption that the money printing at the Fed will lead to inflation? 

That brings me to my second point, it appears that we are more likely headed toward deflation instead of inflation.  That seems at odds with conventional wisdom, but the Japanese experience of the 1990's comes to mind.  Add to this the fact that Fairfax Financial has some derivatives bets on deflation, they must feel deflation is a higher probability. 

What I find interesting is that people automatically link money printing to inflation, but is that a flawed assumption?  Don't get me wrong, I do believe it will have long term ramifications but in the short term we see some fairly astute investors (at Fairfax) betting the other way.  What gives?  Is the huge amount of debt in the system going to lead us toward deflation? 

Any Thoughts? 

I have some ideas on the subject but would like to see others think about this.  You can comment, anonymous comments will be allowed, or you can send me an email. 


Disclosure: Long FFH