Tuesday, January 17, 2017
Expat Cape Bretoner. Learning to live in a de-leveraging world. Better suited to the crusades. CFA & FRM charter holder.
Joined Jun 23, 2015
62 Blog Posts

CONTRACTS FOR DIFFERENCES (CFD) MAHEM

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The U.K. Financial Conduct Authority (FCA) sent shivers down the spines of CFD (aka spread-betting) providers yesterday with the release of their consultation paper, outlining plans to crack down on the sale of certain derivative products, including CFD’s and binary options to retail clients.

https://www.fca.org.uk/publications/consultation-papers/cp16-40-enhancing-conduct-firms-contract-difference-products-retail-clients

IG Group Holdings, formerly a £3bln + market cap player in the space was the biggest “mover” on the news, and as one might expect, the move way not up. IGG.L fell 38% to 485.1p, shaving £1.4bln off their market cap. Their market cap stands at £1.7bln.

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Another notable decliner was CMC Markets (CMCX.L) which also fell 38% on the day, closing with a market cap of £330mm. Plus 500, another provider noted a “significant financial impact” on their UK business after the FCA proposals, estimating a 20% reduction in revenues on stricter rules.

Background:

From the Australian Securities and Investments Commission (ASIC): thinking-of-trading-in-contracts-for-difference-cfds

CFDs were born in the U.K. in the 1990’s, the brainchild of UBS Warburg staffers. Retail began to get involved in the late 1990’s via a firm that was eventually bought by MF Global. IG Markets and CMC Markets are credited with expanding the popularity of the product from 2000 onwards.

CFDs are currently available in Australia, Austria, Canada, Cyprus, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, The Netherlands, Luxembourg, Norway, Poland, Portugal, Romania, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, United Kingdom and New Zealand.

The most popular head office domicile for providers include the US, Cypress (regulated by CySEC, the Cypress Securities and Exchange Commission), and the U.K. The only actual US based, CFTC regulated provider in the US that I am aware of is Nadex  (North American Derivatives Exchange) https://www.nadex.com/ , former known as HedgeStreet, which was formed in 2004 and bought by IG Group in 2008.

IG has a long history. It was formed by Stuart Wheeler in 1974, Investors Gold Index as a way for retail to trade gold prices as an index instead of trading the underlying commodity. The IG group is now one of the UK’s top 200 firms (up until yesterday at least) and is listed on the London Stock Exchange and the FTSE 250. IG posted net income of £131.9mm on revenues of £427mm in 2015. For 2016 through May they have a £207.9mm profit before tax on revenues of £456.3mm.

Regulation:

In the United States, under the Dodd-Frank Act, CFDs are considered to be “swaps” or “security-based swaps,” depending on the nature of the underlying on which they are based, and are subject to the regulatory framework for those products established by Title VII of the Dodd-Frank Act. For example, a CFD on Apple common stock would be a security-based swap (SBS) subject to the regulatory framework for SBS established by the Dodd-Frank Act. Under the Dodd-Frank Act, among other things, transactions in SBS with or for retail investors must be done on a registered national securities exchange and offers and sales of SBS to retail investors must be registered under the Securities Act of 1933. The CFTC has taken swift action when players misstep and market to US-based investors. http://www.cftc.gov/PressRoom/PressReleases/pr7341-16

Many jurisdiction, including the U.K., regulate CFDs and binary options under their respective online gambling rules (fixed odds gambling). The U.K.’s FCA has signaled via their consultation paper that the rules for binary options will be moving from being regulated by the Gambling Commission to the FCA under their interpretation  of the scope of the Regulated Activities Order of MiFID ii (The Markets in Financial Instruments Directive). The U.K. remain uncertain of what investor need is addressed by these products (30 seconds to 1 week time frames typical) and noted that 82% of clients lost money.

CFD providers expanded into binary options as the competitive landscape changed. Some are also offering a suite of leveraged ETFs for less aggressive traders.

It remains to be seen if the move in IG Group stock has been a overreaction.

It is said that there are 3 ways to lose money. Farming is the most certain, but gambling is the quickest. JCG

Follow me on Twitter; Caleb Gibbons @firehorsecaper

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INDIA’S DEMONETIZATION PLAYBOOK

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Narendra Modi was even accused of trying the steal the thunder from the US Presidential election with the timing of his demonetization campaign. Trump was having none of it, but it is still the biggest news you have largely ignored over the last week. India has effectively invalidated 80%+ of the legal tender in circulation into coupons that can only be exchanged in specific places and quantities (INR 4,000 initially), with the requisite identity proofs. With the unbanked estimated at 50% of the population and the unpapered estimated at >1/3rd, one can just imagine the mahem that has ensued. USD/INR = 68.56, hence the 500 rupee note is worth US$7.40. Apparently honest people have no need to worry, but in concert with daily limits on ATM withdrawals the public are forming orderly queues, at their gold dealers. The basis between financial gold and physical gold is reportedly skyrocketing in India, a trend that could have legs as other jurisdictions phase out their high denomination legal tender.

Singapore announced the phase out of their S$10,000 (US$7,067) banknote in early 2014. The ECB has plans to stop printing the €500 note (1/3 of € in circulation by value) by the end of 2018. All of these moves are defended as another quiver in the fight against tax evaders, organized crime and terrorists. In India, Naxalite, a Communist guerrilla group, mostly associated with the Communist Party of India, are target #1 of Modi’s demonetization plan.

Many fear the war on global cash could have unintended consequences. Some currencies are more fiat, by nature, than others. The USA holds 8,134 tonnes of gold, representing 76% of forex reserves. There has been talk of the US abolishing the $100 note which represents a full 75% of the value of banknotes in circulation, $969bln of $1.3tln. The majority of US$100 bills are held outside of the contiguous US States. I can see Trump eliminating the penny and nickel on economic utility grounds before the $100 is touched, but clearly anything can happen in the Upside Down. India holds 558 tonnes of gold, representing 6% of foreign exchange reserves. The ECB in comparison holds 505 tonnes of gold (28% of forex reserves). The largest gold ETF GLD is backed by 935 tonnes of gold, but the actual gold is unallocated (i.e. financial gold).

Tax collection rates in India are abysmally low, due in large part to agriculture at 60% of GDP being a tax exempt sector. As one would expect with a billion + populace, VAT (Value Added Tax) receipts dominate. Demonetization has come on the heels of a disappointing tax amnesty program that was touted as having the potential of outing 30 tln rupees worth of “black money” (625.5bln was recovered onshore, > $100mm USD).

Allocated gold is likely to catch a bid in the current environment, regardless of the trajectory of financial gold. JCG

Follow me on twitter; Caleb Gibbons @firehorsecaper

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$PVG : PRETIUM RESOURCES – THERE’S GOLD IN THEM THAR HILLS

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The $5 trillion gold market has, yet again, become a head scratcher for market participants.

Bears, esp. on technicals grounds, call for further downside. There are two distinct scenarios which have yet to play out fully. The move in gold over the 9/11 – 12/15 could be a correction in a dominant bull market (my current positioning/thinking). Alternatively, the 12/15 – 9/16 gold rally could be a correction in a dominant bear market.

Bulls point to supply/demand fundamentals and likely ongoing support from global central bank shenanigans. The current geopolitical environment is what one would call supportive of higher prices. Think USA/Russia Cold War 2.0., N. Korea (nukes), the South China Sea (China, or “Jhina” as Trump appears to pronounce it) and Mosul, Iraq (ISIS).

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Bitcoin has been quietly rallying and currently trades above $635. The best explanation I have heard thus far for the phenomenon of bitcoin is that it is a solution looking for a problem. Gold has been singled out as nature’s bitcoin. The forthcoming bitcoin ETF (Q1 2017 approval?) from the twins; Winklevoss Bitcoin Trust, ticker COIN has been touted as a reason for a skyward trajectory in the leading cryposcrip going forward. Truth really is stranger than fiction. I would fade that move, although the underlying blockchain technology clearly has merit. The recently approved IEX exchange (The Investors’ Exchange) will be utilizing blockchain technology with partner/spin-out TradeWind to roll out a safer, more transparent gold trading alternative. I for one would prefer to trade gold on Katsuyama-san’s portal and give fictional Satoshi Nakamoto-san’s fraud fraught bitcoin rabbit hole a wide berth.

The LBMA gold conference here in Singapore kicked off Monday. It appears ICE got the jump on LBMA for a gold future to help clear the London daily auction (central clearing via ICE). If the fixed income derivative market is any guide, 1st mover advantage is important and to the victor go the spoils. Watch this space.

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I have written a couple of posts on the gold market in 2016 and way to play it. January 10th would certainly have had you in early on the 2016 move, but as if often the case, gold equities are not for the faint of heart. Most names are 20% off their 2016 high print.

http://ibankcoin.com/firehorsecaper/2016/01/10/gold-get-some/

http://ibankcoin.com/firehorsecaper/2016/04/15/franco-nevada-corporation-a-gold-royalty-play-to-ponder/

PRETIUM RESOURCES:

This follow up post will be on Pretium Resources, PVG on the NYSE the TSX in Canadian Dollars. PVG closed up 6.21% on 10/18/16 to close at C$12.83 in CAD. PVG in the US closed up 6.41% to US$9.80. Market cap US$1.8bln.

2016 YTD performance; PVG +94% (21% off YTD high of $12.41), GDX +76%, GDXJ 111%.

Latest Pretium investor presentation (required reading):

http://s1.q4cdn.com/222336918/files/doc_presentations/2016/denver-gold-forum-2016.pdf

Pretium is a Canada-based (British Columbia) development stage gold mining company, slated to move to production by mid-2017 of their 100% owned Brucejack project in Northern B.C.. Brucejack’s Valley of the Kings (VOK 6.6mm) and the nearby West Zone (0.6mm) have proven and probable reserves of 7.5mm /oz. of gold. An 18 year mine life is assumed. All-in sustained cost (AISC) per ounce of gold is US$446 (several majors are > $1,200 as a comp). Target production is just over 500,000 oz. per annum. The project IRR with gold at $1,250 exceeds 35%. The project also contains a lot of silver, the bulk, 26mm oz. P&P, at the West Zone with an additional 4.6mm oz. of silver from VOK.

What makes the Brucejack site and hence Pretium so compelling?

High grade deposit. Gold at 14.1 g/t. It is not an exaggeration to say that Brucejack is one of the highest grade gold discoveries of the last 1/2 century. This is both good and bad in that high grade deposits tend to be uneven. Grade varies considerable overly the broader deposit. The road to 7mm ounces P&P has at times been harrowing for investors. A relatively large scale 10,000 ton bulk sampling conducted by Snowden Mineral Services in 2013 netted 4,215 ounces of gold (versus 4,000 oz. expected). Strathcona at one juncture in October 2013 burst Pretium’s balloon, sending the stock down nearly 30% to sub C$3.00 by stating, “There are no valid gold mineral resources for the Valley of the Kings zone, and without mineral resources there can be no mineral reserves, and without mineral reserves there can be no basis for a Feasibility Study.” Snowden Mining Industry Consultants took over the study from Strathcona at the direction of Pretium management, employing Pretium’s preferred bulk sample method (i.e. run the full sample through the mill and see what comes out, hard to argue with as it is difficult to cherry pick a 10,000 tonne sample). Pretium have reported some intersections grading as high a 1,000 grams of gold per metric tonne. Impressive indeed.

As an aside, Strathcona have retained a very strong reputation in their field. Their report on the now famous Bre-X scam in May 1997 laid bare the record setting fraud that had been perpetrated on global investors. At its peak, Bre-X had a $6bln market cap.

http://www.wsj.com/articles/SB86279977155130500

A full quarter before the definitive Strathcona report the stock fell from C$20 to the mid $2’s when the proposed 15% partner Freeport McMoRan Inc. (FCX) found scant amounts of gold from their independent testing of samples drawn by drilling parallel to Bre-X’s. I was a buyer for size, not believing that a scam of this magnitude could be possible. The meticulous detail required to salt over 3km of core samples over an extended period and have them tell an intelligible story seemed to me a stretch. The report was to come out on a Friday and the stock had levitated modestly to a 3 handle. “Dr. No”, as Strathcona’s Farquarhson was known, put a scare into me given the highly spec nature of my stock wager with that days horoscope putting me over the edge. I sold 10,000 of my 12,000 shares and saw them open the following Monday (post report – no gold) at 8 cents. I had clearly dodged a bullet and did what any 30 yr old punter in the same situation would do. Hanging my hat in Japan at the time, I walked into a Harley Davidson dealership and pointed to the two-tone silver/black 1997 Softail Custom. ¥2.1mm changed hands and I kindly asked the proprietor to point me the direction of central Tokyo as the 2-wheeled beast sprung from the captivity of the showroom.

Managements’ vision/acumen. Robert Quartermain is Pretium’s Founder, CEO and also acts as Chairman. Quartermain’s history with the Brucejack site is very interesting in and of itself. While at Silver Standard, where he spent 25 years of is 40 year mining career, the Snowfield/Brucejack assets were purchased for $3mm (5 cents per ounce of silver in the ground). Pretium’s IPO at C$6 raising $283mm in 2010 provided the capital to allow the company to purchase the assets for $450mm and Pretium’s market cap now stands at $1.8bln. At 0.63% of NAV and commercial production less than a year away, I do not think the story has fully played out yet.

Operations; permits / funding / construction. Permitting is a huge issue in all jurisdictions. The delays can be staggering. A decade ago a time frame of 3-5 years would be typical for the requisite environmental assessments and permits. Today estimates would be 7-10 (The Canadian  government recently approved the BC domiciled Pacific Northwest LNG project with 190 conditions, mercy me).

The full project cost (through production in mid 2017) of US$686mm has now been fully funded, $540mm financing package (largely debt) and $146mm via equity. The amount of support infrastructure required for such a remote location is daunting and all observers have been impressed by the progress Pretium has made to date. To put this capital budget in context, Toronto is spending C$3bln ($2.3bln) for 1 (one) subway stop in Scarborough (Manhattan’s Second Ave. line will have a comparable cost at $2.23bln/mile, but at least it has 3 stops!).

Top Shareholders (%): Van Eck Associates 9.97 Silver Standard Resources 9.50, Zijin Mining 5.04, Black Rock Asset Management 4.97, Orion Mine Finance 2.57, Pretivm Management 2.00 (41% institutional ownership). Franco Nevada Corporation have purchased a modest royalty interest in the Brucejack project.

Given the site is open in all directions there certainly exists the possibility of an increase in the reserve numbers over time. Most see the likely catalyst as being M&A related as the majors are keen to fill gaps in their production profile and average down their ASIC in low risk jurisdictions. Post permitting, Canada certainly fits the bill.

Analysts are bullish on the Pretium story, with targets as high as C$20 one year out (vs. C$12.83 spot, +55%). I think it could eclipse the all time high of $18.24 and reach $20 which would be good for a double from spot $9.80. It certainly will not get there is a straight line, but hopefully it will be devoid of the high wire peril evident in 2013. The story has been effectively de-risked, as much as a small cap gold mining stock can be.

Hopefully the toys will be funded is a more traditional fashion this time around. Street bikes are now off limits (wifey), but maybe a Nissan GT-R?

JCG

Follow me on twitter @firehorsecaper

Disclosure: Long 1/4 portion PVG in Canadian dollars, usually hold in USD as well. High beta gold play.

Note: Gold – a good delivery bar (think central banks and bullion banks) contains 400 troy ounces (12.4kg. or 438.9oz). A kilobar (preferred in Asia and with individual investors) weighs 1000 grams and contains 32.15 troy ounces. An ounce of gold contains 31.1 grams.

 

 

 

 

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EMERGING MARKETS – EQUAL WEIGHT IS 32%

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I had the pleasure of hearing Singapore based Mark Mobius, Ph. D. (Economics, MIT) Executive Chairman, Templeton Emerging Markets Group keynote speech at the Asia PE-VC Summit 2016 held 30 September 2016, run by Deal Street Asia / mint asia.

http://www.dealstreetasia.com/stories/mark-mobius-54493/

Dr. Mobius was born August 17, 1936 (six years younger than Warren Buffett, born August 30, 1930). Nobody can rock a baby blue two piece suit and white shoes better than Mobius. Style and substance are rarely brought together in such a seamless fashion. At 80 year young, he is beyond sharper than a tack and offered a great deal of insight to a crowd, on average 45 year his junior.

Templeton has $28bln invested in 70 global EM markets at present, sprouting from a kernel of $100 million circa 1987. In South East Asia, the focus has been on PIPE deals (Private Investment in Public Equity). EM is up 1848% over the 1987-2016 period.

What keeps Mark up at night, other than travails of being 80, can best be summarized as the three i’s;

1.) Interest rates – Global Central Banks are the classic non profit maximizing counterparty and Mobius thinks they are destined to “make a mess” of it. Negative interest rates are far from a rational state. In terms of rational equity valuation, almost any p/e multiple can be justified in an environment of negative rates, 100 OK, 200 sure. Mark questions the mentality of said central bankers, overly influenced by academia,  economist and other charlatans (my term). Specifically called out was Ken Rogoff’s “Curse of Cash” as poppycock.

2.) Isolationism – Both with respect to trade and investments. A damaging trend. Little comment required on this point. Mobius grew up in Boston, Mass. but long ago relinquished his US passport and holds a German passport (his father was German and his mother was Puerto Rican) and a Singapore tax domicile.

3.) Internet – On-going game changer, especially in EM. Largely a mobile phenomenon.

China, still a monster growth story. It is all about the absolute numbers. Growth is slowing, but the absolute numbers are bigger every year (10% growth in 2010 is smaller than 7% in 2015 given the absolute size of the economy).

Biggest take away:

The people you are dealing with is the most important factor in investing, over the long haul. Having  a legal agreement is of course required, and governing law important, but typically if it gets to the stage of lawyers and the courts, the result is a big zero for all involved. Word to the wise, word to the wise indeed.

My current public market favorite instrument for EM exposure is WisdomTree’s Emerging Market High Dividend ETF, DEM, yielding 4.15%, ytd 2016 performnance +20%, AUM $1.6bln. No home country bias, as a global citizen. JCG

Follow me on twitter; Caleb Gibbons @firehorsecaper

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ESG : SOCIAL INVESTING = INVESTING

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Even the Asian elephant in the room is endangered.

Over 80% of the market value in the S&P is attributable to intangible factors (environmental capital, sustainability governance and stakeholder relationships). Less than 20% is accounted for by physical and financial assets.

Global sustainable investing assets grew by 61% over the 2012-2104 period and now stand at $21.4 trillion. The domicile of these assets is telling; 99% are in the United States, Canada and Europe.

Environmental and social issues affect both valuation and financial performance. If your investment decisions focus only on financial disclosures, you will not be getting a complete picture of the drivers of value.

Global ethical principles have never been more important or, it appears, more wanting than in current times (i.e. VW, Phoney Express aka Well Fargo, global Trumpism, and global lawsuits imperiling not just returns but the very viability of global commerce beyond national borders).

Community manager education world tree concept with colorful abstract leaves and earth icon illustration. EPS10 vector file organized in layers for easy editing.

The UN supported Principles for Responsible Investment (PRI) ,a not-for-profit organization, held their 10th anniversary conference in Singapore last week (Sept. 6-8th) which I attended. No conference bag full of binders and junk mail at this conference, your 1 page agenda fold up into your name tag and all meals were vegetarian, a subtle but effective message. Forbes Magazine The conference domicile was not chosen by chance. Asia has been termed the cradle of disorder for a reason, it is home to 5 of the world’s 7 billion population and on metrics of social investing if the game has even started it is is the 1st inning. When a region has practices like dynamite fishing and farmers still clear land with a match much work lies ahead.

Chris Sanderson, Co-Founder of The Future Laboratory focussed largely on the sustainability of the capital markets. He characterized global citizens as being tired of austerity, wary of politicians and perhaps even more wary of brands. Backlash culture; http://shop.thefuturelaboratory.com/products/backlash-brands-report.

Elliott Harris, Head of the United Nations Environmental Program (UNEP) gave a rousing speech on environmental and social sustainability. The end game is that all investments will be social. Elliott introduced the concept of thick profit versus thin profit, a concept akin to quality, hard to define, but you know it when you see it.

Georg Kell of Arabesque Partners Arabesque spoke of  Generation S, a cross-section of all age groups working towards making the world a better place, one worthy of handing down to future generations. While ESG (environmental, social & governance) alpha may prove illusory, ESG smart beta appears to have legs.

Millennials were of course discussed with the most shocking realization being that the oldest ones (born 1990) are in their mid 30’s now! Generation D (Digital), whose only need or want in life is wifi and lithium, was out in full force, albeit well behaved and overall attentive. The 600 conference attendees were largely baby boomers, representing approx. 50% of global financial assets under management (AUM), signatories to the PRI whose mission states, “We believe that an economically efficient, sustainable global financial system is a necessity for long term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole.” Clear, concise, devoid of the typically mumbo jumbo one gets when issues like climate change and the environment are normally tabled.

The session run by GS alum David Blood, Managing Partner at Generation Asset Management Generation Investment Management was excellent. Al Gore is the Chairman of Generation Investment Management. If Obama delays the election to allow Clinton to get her legs perhaps they could run as a Third Party choice? Could not lose with the ticket “Blood & Gore”. Both men can readily point out Aleppo on a map too. In any event, David’s sage words rang true to all in attendance. Finance and capitalism is not working for everybody was a key statement. The transition to a low carbon economy will clearly not be an easy one. A full 1/3 of aggregate world equity and fixed income market value lies in the cross hairs. We can do this the hard way or the easy way, but de-carbonization is a trend now moving under its own power. Mr. Blood noted that while the majority of global asset managers in attendance (120 signatories, 50% of global AUM) were managing to sustainability factors, those not present (i.e. non PRI Signatories) are largely American. The reasoning to date for USA firms reluctance is that becoming signatory could put them in breach of their fiduciary duty. We must collectively get the remaining 50% on board as priority #1.

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Investing for the long term. Short termism. A great panel on investing for the long term had some serious panel power. The headliner was Hiro Mizuno, CIO of Government Pension Investment Fund, Japan (GPIF), the world’s largest funded pension plan. GPIF manage their liabilities to a 100 year time frame. Their most recent result showed a loss of ¥5.3tln (US$5.2bln) for the current fiscal year through March 2016. The fund’s quarterly loss through June 30, 2016 was > ¥5tln (-3.88%). They run ¥130 trillion (US$1.27 trillion) leading Mizuno-san to characterize the latest qtly loss as peanuts. The joke was not well received, perhaps because it was so unexpected, leading Hiro to quip that perhaps there were Japanese pensioners in the audience. The fund increased their allocation to equities in recent years. Global equity investment totals US$600bln, 80% of which is allocated in a passive fashion and 20% ($120bln) of which is actively managed. All investment are mandated to external manager, counter to the global trend in the pension arena of in-sourcing. Fellow panelist Paul Smith, President & CEO at the CFA Institute noted that one advantage of being old is that “you see everything twice” with such decisions as out-sourcing vs. in-sourcing set to very long term market cycles.

Several panels touch on infrastructure finance with GPIF mentioning their joint investment effort with Canada’s CPP on ESG brownfield infra projects. Mizuno-san noted the challenges of crafting/originating greenfield projects as funding challenges often drive the cheap option and the cheap option is usually dirty (materials, supply chain, etc.). GPIF will not finance dirty deals, full stop.

A deeper discussion ensued on better was to measure and compensate performance with a general aversion shown to managing to qtly earnings guidance. The average hold period for SPY, the > $100bln S&P 500 SPDR, the largest ETF tracking the benchmark for US stocks is 5 days. In the last 15 years 52% of the Fortune 500 companies as no longer in existence. In 1955 the average Fortune 500 company life expectancy was 55 years, in 2015 it is 15 years. Traditional valuation metrics clearly must evolve to address the realities.

ESG toolkit for Fund Managers: http://toolkit.cdcgroup.com/

Q&A with Author of the PRI’s Practical Guide to ESG Integration for Equity Investing

The ESG investment construct must be turned on its head, to my mind. Social investing = investing and “dirty” or non-socially minded investment should be the type requiring explicit sponsor/board/member approval. JCG

Follow me on twitter @firehorsecaper

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Shenzhen “beach” September 2016

Mark Carney, Chair, Financial Stability Board (FSB). Awesome 30 minutes of your life, watch it. Carnage, indeed.

 

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$DB DEUTSCHE BANK – HERE BE DRAGONS, NOT

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“Here be Dragons” means dangerous or unexplored territories, in imitation of the medieval practice of placing dragons in uncharted areas of maps. With respect to considering an investment in Deutsche Banks’s (DB) equity, I would argue we are instead dealing with “known unknowns”, as Rummy would put it.

Much of the risk and potential upside going forward hinge on non-financial risks, legal being #1. DB has now paid $9bln in fines, 1/2 their current market cap of $18.2bln, for various settlements post GFC. No opinion to provide on the validity of any given case from a merit or $ perspective, but clearly through a process of elimination, DB is closer to the end of the financial spartan race. The ability of John Cryan, chief executive of DB, to reduce the dominance of litigation charges from results going forward will dictate the very survival of the bank that led the financing of Germany’s economic miracle post WWII. Those drawing parallels to Lehman are data mining in my view, DB is too important to the German, European and Global banking/financial system to be euthanized.

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€31bln of Level 3 assets remain on balance sheet, but this is down 65% from the peak of €88bln in 08′.

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2015 was the kitchen sink year for Deutsche Bank. Litigation costs and re-structuring charges led to a €6.8bln reported loss. GM was once appropriately described as a health-care company that also made cars. DB is a law firm that dabbles in the capital markets and asset valuation. Modest earning are expected for full 2016 ($1.11 per share), but the first “clean” year expected by chief executive John Cryan is in 2018.

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Fixed Income Currencies & Commodities (FICC) has become a dirty 4 letter acronym for many players in the capital markets in an environment of ZIRP, since trumped by NIRP. The transition from Anshu’s Army (once responsible for 85% of DB “earnings”) to Cryan’s Janitors has clearly hampered returns. DB was a top 3 players over the 2008-2014 period, earning approx. 20% “share of wallet” in FICC. This share has slipped to 17% and is not trending well, with share ceded to venerable competitors like JP Morgan (JPM is now trading at 1x book versus 0.25x for DB). Approximately 1/3 of the slippage has been expected as DB exited high risk weighted asset (RWA) businesses they no longer have an edge in. Risk reduction efforts include improving the leverage ratio (CET1/total adjusted assets) to 4.5% by the end of 2018 and 5% by 2020. DB has run with leverage as low as 2% previously and the leverage ratio currently stands at 3.4%. Daily VaR (99% confidence interval), has dropped 57% since 2007, from €86mm to €37mm. Liquidity reserves (HQLA- cash and highly liquid government, agency and government guaranteed bonds and other Central Bank clearable securities) as at Q2 2016 stand at €223bln, up 243% from 2007’s €65bln. As a result DB’s liquidity coverage ratio (LCR) stands at 124%, well ahead of the 100% required by Jan. 1, 2019 under B3.

Price to book and price to tangible book have become somewhat interchangeable terms in analyzing bank stocks post GFC. Few have sizeable goodwill yet to be written down. To temper expectations, DB would likely be over the moon if they could get back to 0.6x P/TNAV by the end of 2017 which would put the stock back in the high 20’s, roughly a double from the US$14 it stands at now (NYSE listing). This would put DB in line with where Citi trades, on a metric of price to tangible book. The list of  global banks that trade > 1.0x book is dominated by the Canadian and Australians (i.e. RY at 1.9x and WBK at 1.7). Wells Fargo & Company is the rare American that trades at a premium, 1.4x book at present.

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The “to do” list for DB by the end of 2018  is long, but achievable; a 10% return on tangible equity, a leverage ratio of 4.5%, a 12.5% CET1/RWA (10.7% at present), efficiency ratio of 65% (perhaps the most challenging metric to achieve, low 70’s arguably more achievable interim step), and achieving €3.5bln per annum in cost savings by cutting 30,000 staff and the exiting 10 non-core markets. In their home market of Germany, plans include selling their remaining stake in Deutsche PostBank AG and closing >25% of their 700+ retail branches.

DB is currently rated Baa2 with Moody’s (Senior Unsecured Debt), BBB+ with S&P, and A- by Fitch. The most recent 5 year CDS level for DB was 216bp (JPM in comp. is 60bp).

The largest dragon investors worry about with respect to DB is their sizeable otc derivatives book. The focus on headline notional exposure of €46 trillion materially overstates the true economic risk. Looking at the €46 tln notional amount of contracts across fx (27% of net exposure), rates (54% of net exposure), and index/equity (12%) can be daunting, but as with other areas noted, steps are being taken to reduce the size and improve the liquidity of their derivative books. DB intends to exit the CDS business for one and has novated over 2/3rds of their book to other cptys since 2015 (JP Morgan the biggest CDS player by wide measure). The previously noted number for level 3 assets include level 3 derivative related assets (DRA). As with the rest of the market, the vast majority of DB’s derivative contracts are centrally cleared. Those contracts not centrally cleared (i.e. bi-lateral contracts) are typically collateralized above rating based mark-to-market threshold amounts. A Credit Support Annex (CSA) is the legal document which regulates credit support (collateral) for derivative transactions. A CSA is one of the four parts that make up an ISDA Master Agreement, but it is not mandatory. Some classes of cpty are legally restricted from posting collateral and even impose 1-way CSA against their Bank cptys, although such instances are much more rare than pre-GFC. Banks are keen to renegotiate such legacy ISDA/CSA’s given the spike in the cost of funding their DRAs. 85% of DB’s net derivatives exposure of €41bln (after consideration of master netting arrangements and the €72 bln in aggregate collateral pledged to them, split €58bln in cash and €14bln in liquid securities) is with investment grade counterparties. Further, DB have disclosed that they actively manage their net derivatives trading exposure to further reduce the economic risk. This practice is common across the street where the credit valuation adjustment (CVA) desks are often one of the most active credit customers, given the immense scale of their books and their diversity as to cpty.

It appears a floor is in on DB equity. Near term, a lessening of the legal risk is the biggest factor in building capital to 12.5% from 10.7%. While a return to former glory is not likely in the cards, the combined view of Deutsche Bank is too pessimistic at present, in my view. DB is down 42% year-to-date in 2016 and 91% below their all time high of $159.59. The short interest in the stock is 1.68% of the float.

Less risky bank plays certainly exist, ING at 0.7x book on a move to 1x (they even make money in Germany, think FinTech) being one. JCG

Disclosure: Studying investable European banks. Long RBS pref shares and Lloyd Bank common shares. No current position in Deutsche Bank.

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$CXW, $GEO REIT – DOJ THROWS AWAY THE KEY ON PRIVATE PRISONS

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Investors in listed private pension companies Corrections Corporation  of America (CXW), and The GEO Group, Inc. (GEO), got murdered yesterday. $CXW fell nearly $10 to close $17.57 (mkt cap $2.1bln), down 35% on the day, with $GEO closing down 40% to $19.50 (the smaller of the two, mkt cap $1.44bln).

Most articles published since that I have read focus on the morality issues, but IBC readers have their own steady compass on that front, the Peanut Gallery is here to guide your investment thinking and analysis when tape bombs like Deputy Attorney General Sally Yates memorandum to the Bureau of Prisons (BOP) hit the wire (link to actual letter at top of post). Amazon’s Washington Post broke the story that stated the US Justice Department plans to end the use of private prisons.

This is a big deal and should not be discounted as a driver of the valuation of these companies going forward. The Democrats have had this issue on their radar for some time. Obama has been keen to push reforms of the criminal justice system in the US, acknowledging the fact that the US incarcerates too many,almost 0.7% of the entire population (the “1%” nobody likes to talk or think about) with an undue weighting of African-American inmates (2.7% versus 0.5% for other races). It is clearly too late for “Obamabars” or whatever catchy reform slogan they might come up with, but Hillary is clearly ready to take the baton and she is not likely to miss the hand off. In her well publicized tweet of November 2015 Hillary tweeted, “We need to end private prisons.” The aforementioned prison outsourcing stocks were down 4-6% of the day of the tweet, but bounced back in the absence of immediate follow up. Enter Sally Yates.

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The typical legacy contracts which granted private prison operators 20 year terms with 90% occupancy will be no more. More lucrative deal which were negotiated on a “set price” basis, irrespective of occupancy levels, will likely be re-negotiated.

The Bureau of Prisons (BOP) contracts for Federal prisons and have traditionally have up approximately 1/2 of the revenues for both $CXW and $GEO. State and Municipal contracts make up the remainder and while BOP’s directive will have sway going forward, the pace of contract roll-off will likely be measured due to tight budgets.

While only 8% of Federal prisoners are housed in private prisons, 62% of immigration detainees are housed in private facilities. Immigration & Customs Enforcement (ICE), a division of the Department of Homeland Security (DHS) are the ones that contract for immigration detainees. Immigration offenses now exceed drug offenses in absolute number and full 1/3 of all Federal criminal cases are immigration related.

Politicians, regardless of level of government, do not like having things blow up in their faces. When the US already spends 6x more on prisons than on education, cost containment will be key as BOP figure out the optimal way to respond to the clear DOJ directive (a 5 year run-off period has been assumed).

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Private prisons are officially in the “sin” category along with tobacco, liquor, and casinos.

What to do. My focus will be on $CXW; Correction Corporation of America. For those, like myself, without current exposure to either name this is a time for study and analysis.

Brave analysts to comment thus far appear to be in the buy the dip (BTD) camp and appear to have a modest preference for $GEO over $CXW, speaking to the listed equity. Looking at the capital structure, $GEO has more debt, $2.23bln with Senior secured rated Ba3 and Senior Unsecured rated B1. CXW was upgraded by Moody’s to Baa3 in June 2015 and has $1.4bln in debt.

CXR 4.625% May 2023’s were not immune from the carnage of yesterday’s trade, falling from $102 to $85.50 (-16.2%) on the day. My expectation would be for the equity to rebound from the current levels and for the bonds to drift lower concurrently. The catalyst for a sharper move in the debt would be loss of investment grade rating by Moody’s. Assuming the debt is taken back (i.e. downgraded) to Ba2 (speculative grade) from investment grade there may be an opportunity to buy the debt ($70.00ish) on a hedged basis, shorting $CXR equity to the expected recovery rate on the bonds. As this opportunity unfolds, I would expect there would be cuts to the dividend on the common shares which would reduce the negative carry on the hedge.

The closest proxy I could come up with in analyzing private pension debt is military housing debt. To be clear, no analogy is to be drawn between criminals and brave service men and women that protect the nation, this is purely an asset valuation exercise. A large portion of the USA’s military housing has been privatized. The debt issued is not municipal debt, an important distinction, but is supported by the “Basic Allowance for Housing” (BAH) that is earmarked annually as an appropriation from the Federal budget by the Department of Defense (DOD), the world’s largest employer. On balance, the location of the private military housing complexes is favorable (something to think about as bases get slated for closure on occasion) to private prisons. Military housing has a much better alternate use as well, including civilian use and/or re-purposing.

The fix is in, it would appear. Private prisons will be as popular as a coal seam in the Appalachians. Trade accordingly. JCG

 

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GFC REMEMBRANCE – WE’VE COME A LONG WAY BABY

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The U.S. Financial Crisis 2007-2008, The Global Financial Crisis (GFC for short) and the Great Recession 2008-2012 all seem to have become interchangable terms. I recently came across some journal notes I made at the peak of the crazy in 2008. The reason for the note timing was my thought was that we were going through an unprecedented time in financial history that would have clearly have a deleterious effect on the world at large. I had just read some diary excerpts from my great-great-grandmother Henrietta’s diary, written circa 1905-1908, which got me thinking I should get pen to paper in case this page of history was of interest in another 100 years.

4 September 2008

“Ruthless markets continue. Dow < 300, NASD < 65. Merrill Lynch has now taken write-downs equivalent to 25% of all of the money they have made since they came into existence.”

We all had little idea that we were in the relative early innings. The S&P which was at 1217 coming into September 2008 would eventually fall another 45%.

5 September 2008

“If you find a path with no obstacles, it probably does not lead to anywhere.”

10 September 2008

“What a week! Sunday the Fed took over Fannie and Freddie Mac. Monday the Dow was up 300. Tuesday Lehman was down 45% and the Dow off 300. No trending markets to report.”

11 September 2008

“9-11 anniversary overshadowed by carnage in the financial markets today. Lehman sub $4 (was $17 on Monday). It does not look good for them.”

15 September 2008

“One of the most dramatic days in the history of the financial markets. Lehman Bros. files for bankruptcy, Ch. 11 late Sunday. Bank of America bought Merrill Lynch for $29 (1.8x book) in an all stock deal. Merrill Lynch closed at $17 on Friday past. Lehman to zero, incl. the pref I bought as a punt (oops). The risk reward was very good.”

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17 September 2008

“This is getting comical, if it were not for the massive wealth destruction left in its wake. Last night the Fed took the reins of AIG, replacing management and taking an 80% stake in return for $85bln 2 year bridge loan at Libor + 8.5%. Wow. Yikes. Mommy.”

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8 October 2008

“Quite a gap in my notes due to a new level of fear in the global markets. A truly scary time for all. No country or company is being spared here. Very glad to have my health, and to be young (relatively).

28 October 2008

“The smashing of dreams is not over. A wild month with everything cut in 1/2, read down 50%. The only currencies trading up are USD and JPY. USD/CAD from parity to 1.30. Trying to remain positive.”

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Fast forward – 17 August 2016

The current relative lack of volatility in the financial markets, masked in large part to the continuing largesse of global central bankers, makes the perilous 2008-2009 lows seem further back in history than the scant 7+ years it has been. The 17-month equity bear market which ran from October 2007 – March 2009 resulted in a near 50% drawdown in the S&P, finally basing at an ominous 666 on March 6, 2009. The return over the ensuing 7.45 years to the present S&P level of 2178 is a 17.25% compounded annual return. Nobody knows where we go from here. The thumb on the scale from central banks makes traditional metrics all but useless in charting the future course. The financial outcome will likely come to be inextricably intertwined with geopolitical outcomes.

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NIRP has been a certified global failure. The banks are in triage. Only the Canadian and Australian banks trade > 1.0 book. Both Bank of America and Citi trade < .6x book and they are expensive compared to the European banks which are further behind in their capital raising efforts (DB price to book 0.26x). Global insurers are in the waiting room and feeling ill. A concerted move by the Fed, the ECB and the MoF to 1% would do a lot more to cure the ills of the global markets than to use the little remaining runway they have on the false hope of fighting the ogre of deflation in their theoretically walled nation(s).

Trading based on global interest rate differentials is poppycock as the hedging methodology for global fixed income is 100% clear. FX is ALWAYS hedged in foreign fixed income as the the vol of the fx moves dominate the vol of the underlying bond returns. Those thinking UST are a buy because Bunds or JGB’s are yielding negative need to give their head a shake and look at the empirical evidence.

This relatively recent phenomenon (on a 100 year time line) of allowing the non-profit maximizing players (i.e. central banks) to call the shots for a prolonged period will end in tears for all involved. JCG

 

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$CXRX CONCORDIA INTERNATIONAL CORP. – SHAREHOLDER ATTENTION DEFICIT DISORDER

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$CXRX IPO January 3, 2014.

Concordia International, regarded as the Canadian little sister of Valeant, was taken to the mat in Friday’s trade after a disaster of a Q2 2016 earnings report. Including after hours action, a full 40% was taken off the market cap of $CXRX ($510mm now). A $0.04 earnings miss (“adjusted” earnings of $1.38 vs. $1.42, < 3%) does not normally elicit such revulsion, but in concert with horrendous un-adjusted (i.e. GAAP) numbers, reduced forward guidance, departure of the CFO, and abolition of the dividend, all that was missing was a crow’s foot from this steaming mess of a report.

The qtly GAAP loss was -$570.5mm (-11.18 per share), largey due to the write down in the value of Plaquenil and Nilandron, both of which are under assail from generic drug competitors.

Founder, Chairman & CEO Mark Thompson formerly worked at Biovail, before Valeant tucked them under their wing in 2010. Concordia has been highly acquisitive since their formation, spending $5bln since 2013 (Covis and AMCo being the largrest). The focus has been on buying legacy drugs (i.e. buying spent oranges and extracting more juice from them) and tweaking the pricing (i.e. not lower).

A great deal of debt was assumed to finance the aforementioned m&a binge. Total debt is $3.3bln. The benchmark (cusip EK849878) US$735mm 7% April 15, 2023 , issued in 2015 to finance the Covis aquisition, broke through $80.00 in Friday’s trade to settle in the high $70’s. I would expect the rating agencies to take action, now that the horse has left the barn, in the coming weeks. CCC, aka “fish hooks” are likely in the cards. Credit ratings are alphabetic, it should be kept in mind. A is good, C much less so and D stands for default. Expect analysts that have not yet suspended coverage to turn their attention to recovery rates. The base case recovery rate assumption on Concordia debt, in a tap out situation, will likely not have a 7 handle, as in 70 cents on the dollar.

There are many unknowns for equity holders. The trading range on $CXRX has been a wide $9.65 (Friday’s intraday low) to $89.10, sitting 88% below their all time high. The margin for error on execution going forward is very low. Jesus take the wheel. I’d give it a wide berth. JCG

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INCOME FUND – PIMCO FUNDS GLOBAL INVESTOR SERIES; $PIMCMEI.ID

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All investors have been extremely challenged to select plausible investments for the fixed income portion of their investment portfolio in the current environment. With so much of the world sovereign bond markets trading at negative yields, it is certainly a perilous time to be a fixed income investor. Alternative fixed income and unconstrained funds are all the rage.

This brief article introduces PIMCO’s venerable offering which is a global multi-sector fixed income fund. PIMCMEI is an open ended fund, incorporated in Ireland. The fund seeks and delivers high current income, 4.06% monthly at present. The fund duration is a modest 3.1 years.

PIMCMEI is up 4.81% year to date in 2016, compared to 7.43% for the S&P. This return  comes with a lot less drama of course, as anyone long equities through February 2016 can attest.

The MER for the retail fund is high at 1.45%. PIMIX is the institutional version with a more modest MER of 0.45% but for $1,000,000 plus invested. The standard deviation of PIMIX is 2.81% and the Sharpe Ratio is a remarkable 2.01. The Sharpe ratio calc first subtracts the risk-free rate from portfolio return then divides the result by the standard deviation of the portfolio return. As a point of reference the S&P 3 year std. dev. is 11.23% and the 3 year Sharpe ratio is 1.02.

Pimco’s Daniel Ivascyn, CIO is the PM for the fund (est. 12/2012), assisted by Alfred Murata. Ivascyn, not yet 50, took over from aged Bill Gross as the “Bond King” at Pimco. The retail targeted PIMCMEI manages > $15bln and PIMIX has > $60bln in AUM.

I’m also long some of Gunlach’s Doubleline funds, but nowhere  near the scale.

Wealth managers like the consistent Pimco Income Fund returns and offer up to 4x leverage on investment in the fund at Libor +50/+75 depending on the size of the relationship one has.

Clearly this fund gets many things right. The brain trust at Pimco is substantial and all PM’s benefit from the rigorous Secular forum, run annually, which looks out 3-5 years. The sister Cyclical forum takes a 12-18 month view and between them have allowed Pimco to get to the carrot first,  in size.

For non-US investors, the PIMCMEI fund attracts no withholding tax and is not subject to US estate taxes given the Ireland domicile.

The fund fact sheet can give you a good window on where Pimco currently sees value. Weighting in high yield are low in comp to emerging markets. The highest weighting is in US mortgage backed securities at present.

Don’t write off fixed income just yet, you just have to dig.  JCG

Disclosure: Long PIMCMEI levered 1:1. Leverage to be reduced as 3 month Libor setting reaches 1% (mid 2017?).

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