SharperDingaan

You might want to ask that when you're range bound, why is it not better to be out entirely? P/E shrinkage, a falling market tide, and any kind of sudden panic work in your favour - & most would argue that over the forseeable future a market fall is more likely than a rise. SD

Only because we’re waiting for a suitable entry point. MFC’s basic business is relatively straight-forward & reasonably well run. The problem is the MTM accounting impact on the ALM of their seg fund liabilities, & the fact that they took on a material quantity of new seg fund liabilities near the top of the market. Unrealized gains/losses on the guarantees are immediate P&L hits, but realized gains/losses on the liabilities are actuarial gains - amortizing forward & over the remaining life of the actuarial liability. Yes it sucks today, but it will be very useful tomorrow. Should the market suffer a 10% drop, there will be another big hit to P&L. At a 15% drop, it is highly likely that equity dilution & a total dividend cut also come into the picture. While hedging will reduce the impact, & there is very little ‘real’ possibility of insolvency – if there is a 10-15% drop, Mr Market is unlikely to perceive it that way. Obviously there are positives as well, but we’ll decline to comment until we have our position. SD

The guy with the 80% cash is just continually buying enough burgers for the next week or so. The freezer gets filled up when they hit 30-35 cents; & he can afford to wait for those 30-35 cent burgers with relatively little adverse impact. The 'aggregate' consumer aggressively repaying debt, is essentially that guy with the 80% cash. And if those 30-35 cent burgers are 'sirloin' burgers ... the basic burgers are only 20-25 cents; the highest price you could charge the hurting burger eater. The 30-35c burgers are selling because they're replacing the 70c T-Bone steaks. Quality (BMW, Mercedes, cars etc) & junk (GM cars [no disrespect to GM]) both sell; but the quality sells because its become cheap, the junk sells because there's no other choice. The paradox of thrift. SD

Not so sure its improved; just looks different. - Absent trading gains & US bank earnings are essentially flat; ie the artificial spread income (FED intervention) has been covering mortgage write-offs as the banking sector de-leveraged. Very smart policy, but the problem is that seriously deficient mortgages have tripled over 2010 YTD, & that spread can now no longer keep pace. When they go, some of the banking sector will either go with it - or get another bailout. - The UK deficit has forced drastic cutbacks on the UK civil service. Either the US, with a similar problem is somehow immune, or the same thing starts happening in the US in 2011. We're with the cutbacks. - Graham was right, but he also ran out of money before he could prove his belief; ie value investment works - IF you pay attention to liquidity. That great deal is actually a loss to you if you cant hold it. - If you hedge & you're wrong, you stay alive. If you don't hedge & you're wrong, you're in a very deep hole. SD

Most folks would suggest a reasonable S&P P/E in the current climate is 10-12x. If the `consensus`earnings estimate of 760 is reasonably accurate;the S&P should be around 7600 to 9120 - yet it closed on friday at 11,528. We should see a S&P drop of at least 21%. QE2 would not be initiated were there no pressing reason. Most would suggest it has more to do with boosting market liquidity than lowering interest rates. When liquidity is high price levels are high; when it isn`t, prices drop (liquidity discount prices in). Yet the day after the QE2 announcement the S&P dropped 200+ points (2%); if anything the market should have risen, and the additional liquidity reduced the drop over what it would otherwise have been. Dodging a bullet is one thing, but when the other guy has a machine gun you will eventually lose. SD

There is a different way of seeing this. The reality is that FBK is rangebound in a turning pulp cycle. It can not go up materially or change its structure unless FFH agrees to the divestment, take-out, restructuring, etc. It can not go down materially as the illiquidity discount will cripple any material seller. Therefore its stay as they are, improve the cost structure to reduce the break-even, & maybe a tuck-in acquisition here & there where there is clear & immediate benefit. If there were no changes & they made a base 30M next year, EPS would be $0.23. Interest savings of 4M would add $0.03, 50% realization on the anticipated 7M of Quebec pulp savings might add another $0.025. 2011 earnings of maybe between $0.23 & $0.285. Were you to offer 5X earnings, at best - the price could only get to $1.15 to $1.43. At $1.29 average; roughly a 30% one-year return, or not that bad. The reality though is that its worth far more `restructured`; so its really a 30% one-year return with a cost free call option on any gain from an intervening event. It may not be the investment you thought it was, but if you have the liquidity - its certainly not the worst investment either. SD

Interesting US tidbits from the last few weeks: (1) Absent the census impact & US employment has essentialy been flat for all of 2010 YTD. Head-count is constant, but retirements & firings are being replaced with part-timers. Most would suggest that is unlikely to change much over the next 6 months. (2) Since Dec-2009, the total $ of seriously deliquent mortgages have tripled over 2010 YTD. These are mortgages that are in the advanced stages of foreclosure, & which will trigger significant write-offs when they go under. (3) Municipalities & state governments are starting to enter their 2011 budget processes. Most would suggest that the collective 2011 impact is going to be the widespread use of wage freezes, 4-day workweeks & job sharing to minimize layoffs. All this if there are NO additional economic shocks. Most would suggest that if there is a shock it can only get worse. Hence it should not be a surprize that the worsening condition is not being broadcast, or that QE2 is increasingly getting traction. SD

Technically the rights proceeds are after the Jun-30 close date of these financials. Therefore dont count. The reality though is that the extra $ are there as of today, so the net cash cost of a share (yesterday)is even lower. You should another $.31 to the projected minimimum values - the $1.69 becomes $2.00. SD

Agreed. The 42.94M of cash is $.33/share; at $1.06 you're getting FBK for $0.73 net - or 21% of BV. More noticeable is the Q2 vs Q1 2010 incremental change. The incremental EBITA margin was 34% - 2.5x the average Q2 EBITA margin of 13.5%. Should have paid up for that extra 200,000 shares ;D A cheap bastard might try to buy at 1/3 of BV, or 1.45/share [.333 x $3.40 BV + $.33 cash/share]. Most though would recognize that they would bid up to at least 40%, or 1.69/share [.40 x $3.40 + $.33 cash/share]. We thought $1.50 + maybe 15% for Q2 earnings was a reasonable guess, or $1.73. That same number seems to be coming up an awfull lot ;D Should be an interesting few days SD

Modern finance asserts that you can sell any asset at a low enough price, there is liquidity. VaR is so sure of it that it can assert with 95% probability that you cant lose more than $X, 19 times out of 20. And because JPM & pretty much every CFA has had this drilled into them - it can only be so! Long Term Capital blew up because they forgot about credit risk. Credit default swaps got invented to hedge the risk ... but everybody missed that you`re reliant on the liquidity of the counter party. That mistake blew up all 5 US I Banks. GS proved that if you could stack all the gold on the floor, & get yourself blessed (WEB), you could survive a run. But ... regulators don`t let you count 100% of the MV of a CCC asset for regulatory purposes. Basel II & III now have much higher VaR capital multiples than they used to. ..... because even they recognize that liquidity is a problem. Heat water from 99C to 100C and it takes a lot of additional energy to overcome the latent heat of evaporation & get the liquid to turn to steam. In the financial market that `latent heat`is central bank provided liquidity. When you don`t have it you get a collapse (UK in 2009) SD

Imagine you have $41 of asset supported by $40 of debt & $1 of equity. In grossly basic terms you have 40:1 leverage ($40 debt/$1 equity). Now imagine that you manage to 'de-lever' by selling $18 of asset for a net gain of $.10 - you now have $23.0 of asset, $21.90 in debt, & $1.10 in equity, or 19.91:1 leverage. You`ve reduced debt by 50% but not really improved your equity - which is what actually increases your economic responsiveness. Redo the calculation iteratively, but assume that on every $2 of deleverage you make a progressively larger gain (as you can progressively afford to wait for a higher bid). Plot equity (highest on the bottom) on the Y axis against leverage on the X axis. The shape should look familiar. The unusual Y axis is simply to make the plot more obvious. SD

Assume that you & everyone other western PM is convinced that Europe is done for, & the emerging market is where its at. The western $ inflow is 5x the local demand for the EM stock, the price goes up, & rapidly. Why? the market is flooded with idiots willing to give up increasing amounts of cash for a diminishing float of stock. It is liquid, it is overliquid. One year on, & our western PMs are convinced that Europe is where its at & EM is done for. But the market is populated with only a few local people, that are willing to give up progressively less cash for the increasing float of stock. The price drops like a brick because it is illiquid. In very simple terms, the liquidity discount is the (price paid - price received)/price paid. The discount occurrs because a seller has to get out, you're the only bid, & you're willing to give up cash. If you were to simply exchange one turd for another (to establish a 'market' price for valuation purposes) there would be either no discount, or something very nominal. SD

Nothing like a contoversial comment or two! Keep in mind that the optimal hedge is 50% cash. Go above or below this & you're taking a directional position. You get zero P&L impact, and a change in both cash and cost base. The cost of cash is the T-Bill rate + the liquidity discount on whatever you want to buy (not in the textbook). Yes a central bank can reduce the T-Bill rate to near zero, but removing the liquidity discount is a lot harder; as the very high TED & euro spreads of last year proved. Liquidity is also very like the decay on a call option where the X axis is leverage and the Y axis is economic responsiveness. Reduce from 40x to 20x and leverage goes down, but economic responsiveness doesn't improve by much. In the real world we mostly are not liquid. Lots of bids but you cant sell the asset (will your spouse really let you sell the house?). It is because we can't sell that the option markets exist. Understand liquidity, & much of the 'angst' instantly dissapears. SD

We're probally exceptionally unusual, but some things we've learned. (1) All boats sink in a crash, the quality of the boat is irrelevant. If you think there might be a material adverse macro event within 'X' months, why are you holding the boat at all? (2) At 100% cash, the worst that can happen is that you miss a run up and suffer an inflation loss. If you see the market rising, are you really going to do absolutely nothing for an entire year? And if inflation is maybe 1-2% at best, does it really matter? Were you a PM I'd fire you for doing this. As individual investor inflation is my, & not my PMs 'do nothing' cost. (3) When everyone owes money & needs cash to repay, shouldn't that demand make cash the pricey asset? I have it, you don't, & you have to sell your asset to avoid a default? And then why should I not use that opportunity? Dont be afraid of cash. SD

Keep in mind that a value investment 'buy & hold' is a long term strategy; & it's most profitable when the local economy is improving. Over time, inflation + GDP growth produce positive earnings growth that is magnified by P/E expansion. If there's a friendly business climate, even the dogs will make money. But what if the business climate is not friendly? and it goes on for 5-10 yrs? What if inflation + GDP only ranges from -2% to +2%? You will not make as much, but you'll own lots of quality at cheap to 'historic' prices. When the economy turns around you'll do well, but untill then? There is a lot to be said for liquidity, and the trading of liquidity as & when the opportunities present themselves. SD

Its actually a very good idea. Its virtually certain that a large number of US munis are going to default over the next 6-18 months. When they do, all munis will find financing very expensive or impossible to get - unless MBIA can actually cover the defaults. To realistically do so they would have to sell their investments in quantity, & the net buyer would effectively have to be the Fed. The alternative is a collapse in the US bond market, not unlike the Greek Sovereign crises (California alone is roughly the same size as Greece) . You're buying a future cash flow at a deeply distressed discount, & you have an implied fed backstop driving that discount even higher. If it gets nationalized you win as the CF discount drastically declines. Same thing if the implied backstop becomes explicit. Long term, Munis don't default & this is a very profitable business. Along the way its highly likely there will be debt/equity conversion, & an existing bond/equity holder will end up with a substantial chunk of the company. If you're patient you win, if you trade you win, but you're not necessarily the same investor. There's been growing talk of the need for a 2nd US fed intervention to keep the US economy going. Most would think that MBIA would be a highly likely recipient. SD

There was also an article entitled "Event Horizon" in this months CFA magazine. European PM's see Europe as high risk, & are indiscrimanently selling Europe to move into Emerging Markets. Despite EM valuation being highly leveraged to liquidity (currently high re the herd mentality) & quality differences between a German and Italian instrument are not being recognized. A sudden European liquidity demand could very quickly end in tears. SD

Not pumping, just mathematics. [(200,000 rqd - 95,000 bought)/(95,000 bought)] x 10% change per 100,000 bought (Fridays actual outcome) x Fridays close price. But because folks are now aware, to get the extra shares you'd have to increase your bid. Still profitable but this time around you'd have to work for it. We had suggested patience a day or so ago, & cited that something like this was a distinct possibility. Since arbitraging, our common cost base is 1.01. Same as everyone else. SD

Arbs are rolling out of CFX and into FBK. More interesting is that to get about 100K shares they had to bid the price up by roughly 10% - & the small lots indicate that those shares came primarily from individuals. To make a 100K gain on a 50c spread they'd need 200K+ shares; & to pay approx 1.15-1.20/share (weakest hands have allready sold) SD

Most people would suggest that the Q2 market valuation going forward should not be any less than the Q1 market valuation was, just before the Q1 earnings release. About 1.50/share with todays larger share base. Most people recognize that Q2 was probably an improvement, & that upcoming guidance should be pretty good (refinancing impact, etc.). Worth, maybe a 15% increase?, or 1.73/share. If nothing else happened & someone made an offer for the entire coy, there would be a buyout premium. Usually around 30%, or 2.24/share. Management is incentivised @ 3.50/share, or roughly 2.42 under todays larger share base. So what if Q2 is good? If you could trade it for 1.70 & buy it at 1.00 you'd have a 70% gain, but to get it you'd have to act quickly & be sure you wouldn't be stuck with it later. If you continued holding for a takeout/restructuring @ 2.25 there's an additional 32% gain. Most traders would wait for a trigger (CFX earnings?) to confirm the thesis, & then act very rapidly. Most institutions would have gone the rights route @ 1.01.share. Patience. SD

We're on the same page, but might add: Its highly like that the rights issue was related to the debt restructuring done last year. We said at the time that it was reasonably probable that others (FFH, Quebec Government) were also in the room, & all those players were present at this refinancing. Most would summise that the refinancing was simply deferred for a year, & that it was an advantageous decision. Worst case is FFH does a takeout for the entire company & breaks it up. The cycle is turning & its unlikely that we'll see much of a peak beyond the next 2-3 months; its highly likely that a modest premium following the digestion of Q2-2010 results would win the company. There is very clear value to a long term & patient investor, & institutions have had the opportunity to average down enough to be reasonably certain of a gain. SD

Missed the FFH notice - since arbing our common holding, we haven't paid much attention. We still think the re-engineering isn't done yet, but at this point it's going to be asset sales and/or fiber purchases to get security over feedstock. That said; FFH has increased its position 34%, the remaining institutions have collectively taken up additional shares (oversubscription), there was insider buying in Q2, & pulp prices moved up materially over the quarter. Q2 results/guidance should be interesting. SD

You might want to be a little cautious on Cdn RE. It can/will decline but you also have an active BOC with the balls & clout to both arrest the worst of the decline, & slow it down. Better to bet on those with weaker regulation. SD

Did anyone notice what this press release is actually saying ? May 19, 2010 Information Circular, p16. FFH held 17.443M shares, or 19.37% of the 90.473M shares o/s. The rights issue produced 39.604M new shares (40M/1.01). Total new shares are 130.077M (90.473+39.604). If FFH holds 25.85% they now have 33.625M shares, an extra 16.182M shares. They got 3.742M via the rights issue backstop (8.549M rights/2.2845 rights), & must have bought 12.44M out of the market. 7.635M of these shares was to replace the subscription they gave up. Of the 7.635M shares available for oversubscription, 2.996M (39.3%) got taken up by other than FFH (assume all institutional) In short: FFH increased its position by 34% ((25.85/19.37)-1), & the 'other' collective institutional holders increased their position as well. And all of this ahead of a Q2 earnings release due out in roughly 3-4 weeks (mid august). SD

You might want to keep in mind that risk management is very different for a personal personal portfolio. It is not textbook institutional management. 1) The cash equivalent component should hold a minimum 6 months of living expenses. If it is in T-Bills assume 95% recovery, 70% if you're holding it in high quality bank paper. 2) The equity component should be in options & stock; the options will be either long puts/short calls on your employers industry, & enough to offset whatever options your employer has given you. For most people that will be most of the equity position. 3) The FI should be almost entirely high quality prefs, & zero coupon sovereigns. Get laid off for insufficent work & it doesn't really matter. You have cash to cover you, & a portfolio hedge that retained the value of your employer granted options. Keep your job & the insurance cost is relatively small while the economy is essentially stagnant. If the economy takes off you have cash to deploy. What should be apparent is that there's a minimum size. If you're below the minimum you should be either repaying your debts (cards, mortgage, etc) or sitting in mutual funds. Of course, none of this is in the textbook ;) SD