I was on BNN's Market Call this past Monday April 25th. You can view the entire show on our In The News tab.
To say I was shocked during the show would be an understatement. 90% of the calls/emails were on penny stocks I have never heard of but the other 10% of the calls were on the Preferred Share market. I suppose, given what has happened to the pref market, and what I know of prefs, I shouldn't have been stunned into a state of incredulity. We could argue whether prefs are even Fixed Income (they are really senior equity), but the bottom line is, they have been sold to individual investors as Fixed Income for years (reasons for that below). We at High Rock do have 2-3 prefs in our Fixed Income models (along with true fixed income/bonds) , but they are very small % weights and they are Insurance prefs and are fixed rate. We have not, and likely will not own bank prefs, bank common stock, bank sub-debt, for the reasons below... read on.
The pref market got pasted over the past year for two very good reasons. I will get to both reasons in a minute. But first, what I have known for decades about the pref market is equally as interesting...it is a 100% retail market. That is to say, Investment Advisors at the Banks/Dealers get paid an awful lot of commission upfront (3%!!!) to the sell their clients new issue preferred shares. And they do so saying "They are fixed income and have the banks credit". Really?
So why did the market get hit so hard the past year?
1) Because a big portion of the pref market is in rate-resets. What this effectively means is that a lot of prefs had their reset dates coming up and the coupons reset the past year. The new coupon typically resets based on the 5yr Gov't of Canada bond rate. Well, that 5yr Gov't of Canada rate is a not-so-stout, ~.75%. That, plus the spread on the reset, left all of these prefs with total coupons at reset that were half of what they were the past 5yrs. Brutal. You gotta know what you are buying...or what your Advisor is selling you (reading that prospectus should be the Advisor's job).
2) Because bank capital calculations have changed dramatically since 2013. This is largely being driven by the Bank for International Settlements (BIS) and called Basel III. And then each country takes Basel III and adopts their own version (but in compliance). Now I don't claim to be an expert in Basel III and the new Canadian bank capital calculations, but I have a very good friend who is. I have spent over two years picking his brain, reading research, creating spreadsheets etc all in the name of actually understanding what we were investing in (or, in the case of prefs, not investing in). To not do this research and just assume that the pref market was "safe" is the definition of insanity.
I won't completely bore you with all the details but will list a few:
1) Since 2013, all Canadian banks start losing some of what is called Common Equity Tier 1 (CET1) capital. They loose a certain % each year over the next 5yrs. They therefore need to issue securities that qualify for CET1 each year so they are onside of the new CET1 calculations.
2) The new securities that count for CET1 include prefs. So, you guessed it...these banks need to issue a ton of new prefs. Our research shows they need to issue about $5bln/yr over the next 4-5yrs to get onside of the new capital calculations as required by our Canadian Bank Regulator, the Office of the Superintendent of Financial Institutions (OSFI). So what we saw last fall was BMO repricing the market with a Institutional private deal of $650mm at a new coupon of 5.625%. Yes, the pricing on prefs is garnering more Institutional discipline than before. And Bank Sub-debt also counts for CET1 capital. so careful with those too.
3) Prefs and Bank Sub-debt are called Non-Viability Contingent Capital (NVCC). What this means, very importantly, is that if OSFI decides that a Canadian bank is no longer viable, they will declare a "trigger event" and all of this sub-debt converts to common equity (stock) at a ratio of 1.5:1 and prefs convert at 1:1. The reason why OSFI has declared this is so that if there is a bank failure, it will be the common shareholders who bear the brunt of restructuring the bank, not tax payers. So, if that were ever to occur,and you thought you owned a bank bond or a pref, you would be converted to stock.
4) Now the probability of a Canadian bank becoming non-viable and a triggering event occurring is probably pretty slim, however, what has happened is that "spreads" on both sub-debt and prefs have widened out because a) the freight train of supply and b) the very fact that bank securities (sub-debt and prefs) now have asymmetric risk, at least compared to 5+ years ago.
Research. That is one of the cornerstones of High Rock Capital. It takes time, knowledge, hard work, experience and a network/team to share ideas and our research findings with.
We could tell you we go deeper in our research because we have a Fiduciary Duty to all of our clients to always do the right thing by them and that means doing our best every day (including spending the time to do research), and that is all true, but don't forget, unlike most, Scott and I are investing our own capital here so we care that much more than others (and our wives would kill us if we didn't).
Ask your current Advisor to explain his views on NVCC and the Pref market and compare notes to what you now know.
(I am not nearly the writer my partner Scott is, so if this isn't clear enough or you want even more depth, please call or email me).
Well, it has been about three months since I last had a conversation with my wife on the topic of investing our client money, and that of our household.
Last week, we were on a semi-vacation in Copper Mountain, CO watching one of our sponsored athletes, snowboard racer Darren Gardner, rip it up and win the US Nationals (we watched him win the Canadian Nationals in March) along with the Nor-Am Cup, making him the fastest man on a snowboard on the entire continent. (If you want to learn more about Darren, his most recent success and/or to get involved sponsoring this potential Olympic Medalist, go to www.darrengardner.ca). Although Darren was part of the reason we went to Copper, the main reason was to watch our 15yr old son race in the US National Snowboard Championships as well (in his age group, although next season he will likely race against his snowboarding idol, Darren Gardner!) Although we are very proud of our son Nicholas, our middle son, Harrison, laughs that if Darren were racing side-by-side with Nicholas, he could probably stop to have a beer and a hamburger and still beat Nicholas...that is how good Darren is.
Anyway, my wife, Nancy, Nicholas and our eldest son, Macallum (who was a ski racer and apparently is still good enough to be the best skier on the mountain, unless Lindsey Vonn shows up), went down last week to ski, cheer and ...discuss my wife Nancy's portfolio performance. So after having my legs ripped of skiing at 13,000ft with Macallum and watching Nicholas try to topple some 16yr old Colorado racers, there was time to discuss her portfolio n the pool and hot tub.
Here is how our conversation went:
Nancy: I remember January was a horrible month in the stock markets for everyone but you seemed happy enough then but how did the first quarter of the year end up going?
Me: The start was horrible for most but remember that we were sitting on substantial cash positions so January was relatively kind to us. We kept very high cash positions through the entire quarter with our average client ending the first quarter with about 33% cash. Even with that high a cash weight (which pays us 1.3%) we were still able to outperform some of the Indices we follow (ACWI was +.43% and XBB was +1.23% so a 60/40 Global Equity/Fixed Income split would have been +.75%) by a small amount with the average client being +1.00%. We had some clients who were slightly negative and some that were up as much as +3.4% for the quarter. Remember that some clients have different goals and objectives and therefore different models so performance can vary a bit.
Nancy: That is not so bad +1.00% if January was so bad.
Me: Not bad? It is excellent! I think the S+P 500 was -10% at one point in January and ended the month at -5%. If we can match or even slightly beat the Index with 33% cash, we are doing a fabulous job of managing risk. Plus our clients, on average, owned about 10% in Government of Canada bonds which typically move in the opposite direction of stocks, so in bad times, even better than cash. We are always 100% focused on "risk-adjusted returns".
Nancy: What exactly does "risk-adjusted returns" mean?
Me; It means that we want to have the least amount of volatility in our portfolios. Volatility is commonly referred to as risk. If we can create returns that are as good, or even better than the market, then we are creating stronger risk-adjusted returns for ourselves and our clients. Recall how I have said that some people who have Investment Advisors are simply happy with their Advisors because they are :"making money"? Well, it is simply not enough to "make money". We want to know exactly how much risk we are taking to make that money. And across all types of risk. We need to focus on foreign currency risk, interest rate risk, duration risk, individual company risk, credit risk, portfolio risk and market risk. Anyone managing money who is not looking at and managing all of this risk is, quite simply, not managing risk. Managing risk pays off especially during the bad times. Part of our goal in managing money is to manage that risk all the time so that during the bad times we don't have really bad negative periods or what are called "draw downs". If we can avoid losing a lot in those bad times, we will be in much better shape over the long haul. So what we do to manage risk and determine the best risk-adjusted returns is plot historical returns on an excel file and then graph them to see where the ideal portfolio mix lies. As I always say, "numbers don't lie".
Nancy: OK, but why not spend all the cash and you would have been up even more?
Me: Because then we would have been taking way more risk and our job is to create returns while taking the least amount of risk. Remember that most dividend paying stocks only pay around a 3-5% dividend. With volatility in the market so high, you can see your dividend yield wiped out in one day! And those are stocks that pay dividends. We own some stocks that don't pay a dividend at all so our only hope of making money is if the stock actually goes up. So our objective is to achieve our collective investment objectives and goals while taking the least amount of risk possible. Sometimes it pays to not own a lot of stocks. This is one of those times.
Nancy: Well why is it so bad owning stocks? Don't you think they will go up right now?
Me: No we don't. Scott repeats this in his blog and the weekly webinar...corporate earnings are dropping at the fastest pace since 2009 and yet the stock market is a hair's breathe from all-time highs. Something has to give. We do a lot of work on this stuff and will not get sucked in when the fundamentals of the market are so negative.
Nancy: OK, so how did you manage to outperform the market if you were long so much cash then?
Me: Good question. For two main reasons: First, we have well-diversified portfolios across different asset classes like government bonds (which act as flight to quality instrument when things get really bad like January) and across different geographies. Second, we had some pretty decent trades go through that added some of that incremental, out-performance value.
Nancy: What trades?
Me: We had a few but, most-notably,we had done a lot of fundamental research on Rona and bought stock when it was falling and got close to the recent bottom. Shortly thereafter, Lowes came in and bid to buy the entire company at about double what we just paid. And even more importantly, we bought stock in a company I know pretty well and do a lot of work on, Paramount Energy. We bought near the bottom and watched it almost triple. Trades like that can make the difference.
Nancy: Can you do more of those trades?
Me: It ain't easy and every time we buy a stock or a corporate bond we are taking risk. We try to decide which trades to put on that exhibit the best risk-adjusted returns. It takes time, deep fundamental research, reading, patience and some gut feel. We still have about 4 positions on in our Tactical model that we think will unleash some value if things play out as we think they will. There are never guarantees but we continue to look for those types of trades that give us the best risk-adjusted returns.
Nancy: Risk-adjusted returns thing again?
Me: Always. We do lots of work on these specific companies to see if there will be some sort of catalyst to drive those returns while assuming the least amount of risk. That is how I spend my days when I am not skiing, watching Nicholas and Darren race and swim/hot tub to discuss your portfolio.
Nancy: OK. Let's talk again in June and make this a quarterly discussion.
Me: As we say to all of our clients, we can talk about this any time you like. It is a 24/7 job and a privilege to manage people's money. You don't even have to email me to discuss this stuff...
One of our sponsored athletes, Snowboard racer Darren Gardner, just finished off the season on a huge high-note. After a brutal ankle break at the end of last season (I saw the video....so you don't need to), Darren worked diligently to get back his form. After some early struggles, he apparently found his form, and then some. He ended up winning: the Canadian Championships, the US Championships and the overall Nor-Am Cup! This means he is effectively the best snowboard racer on the continent. Next stop...the 2018 Winter Olympics. Good Luck Darren.
Check out Darren's update and a few new photos: DG 2016 Update