Dream Office Or Office Nightmare

Dream Office or Office Nightmare

I don't own dream office directly but for a while there have been a few entities that I do which have stakes in it. This has led me to follow it as a de-facto position. I've compiled a few thoughts on valuation and strategy.

Stated NAV 'must' be pointless

I say this with a little sarcasm and a little seriousness but NAVs in this market must be pointless. Normally, I'd suggest that NAV is a guidepost for something like a REIT as they can always trade units/shares for assets or assets for shares in the gap is too wide... that's assuming the NAV is accurate and there is liquidity to transact on both sides. Recently however, either due to liquidity, volatility or credibility, NAVs seem to be in a prolonged period where the market completely disbelieves them.

Most public REITs seem to trade at some sort of discount to their net asset values. It seems like the public market has marked real estate to a significantly higher cap rate than the private market. I'm not sure how that resolves... if public valuations increase, private decreases or both? It does seem like the public offers a better risk reward in the meantime. That said, a discount to NAV should probably be measured relative to other discounts in NAV... and ideally, NAV should be judged further than what the company says. I could add a few sentences about discounting the discounts vs other discounts... but that was confusing me as I was writing it... sufficed to say NAV & discounts can be a messy measure. I may refer to it and use it but in isolation it's usefulness is limited.

I suggest that NAV must be a pointless measure because if the buildings were sellable at what NAV's supposed to be, the answer to making a ton of money would be impossibly simple. Sell a fraction of the assets and buy back a majority of the shares. Similar to the DIR transaction... and the last asset sale, except more. With +30% of the float already in insider hands & the price at least than 0.3x book, they'd only need to sell 20% of their assets to own the whole thing. (And no, it's not riskier to own more office in this way because they could then sell additional assets to further reduce risk)

Now, my math isn't great, but 100% of 80% is a lot more than 30% of 100%.  So there's obviously no easy way to advance in this direction... which in turn means stated NAV probably isn't helpful to investors. 

One area however, where it'd be helpful to have as high an appraised NAV as possible is when measuring the LTV for asset leverage. It's also unclear how much less the assets may be priced at if a sale was pushed today. 1%? 50%? I don't know. Maybe they would be stressed seller discount makes that strategy not work. It's possible the values are fair but there's no liquidity at the moment. I could make a case based on past sales and private market data that this could be the case but I mentally can't make it fit with the rest of the picture that I'm going through today.

One thing I will say about NAV is it catches something that cashflow metrics miss. If you have an empty Office or piece of land in a good location, it'll show up as a drain on cashflow and provide no income. That land can still be worth a lot of money. You might even be able to develop the land by pulling equity from it or JV it into something.

Overall, I think a better approach is to use a fresh set of assumptions.

The problem then becomes what do you want to use... or how do you want to weight the various components. I want to look at "What you'd be buying" in Dream Office.

Breakdown

Units Outstanding 38M

Market Cap (@$10) $380M

Enterprise Value $1.69B

Industrial

13.5  Million Units @

$12= $162

$13= $175.5

$14= $189

$15= $202.5

$16= $216

$17 (NAV)= $229.5

That's $4.25 to $6 per unit

Residential

Using what was suggested on a recent conference call, 

2200 Eglinton should be worth $200M at Dream's share as condos.

74 Victoria is also zoned residential. I don't know the size for residential development but maybe $50M+

$5.25-$6.50 per unit 

Potential Residential 

30 Adelaide could be worth $300M if it can be rezoned residential

(Almost $8/unit)

Office

That essentially leaves the remaining 18 downtown Toronto office properties 

Plus 7 offices in other markets

All this 

2.5 million square feet of downtown Toronto office plus 1.5M square feet elsewhere...

That are combined worth a negative 300M... or Negative $8/unit

If Toronto core office is worth +$400/sq ft and other is worth +$200 it would more than cover the debt. As of Q2, the average selling price for Toronto offices was $600/sq foot.

From another perspective, you'd need $480/sq ft & 240/Sq ft to cover the entire enterprise value today and get the residential and industrial for free.

A third perspective would be take $450M Industrial + Residential, then office would be valued at roughly $380 & $190. 

Note, don't take much from my 2:1 ratio I'm just using it as an example as I think Toronto core likely deserves a premium for quality and stability. I'm less sure what that should be.

Debt

The problem with this situation and most discounts, is debt. Obviously the real estate is worth something... even if it's only something speculative. With debt however, the risk can always be is the something less than the debt. Further, if something is 50% levered, if the value drops by 25%, the equity value drops by 50%. So there is a multiplied effect of value declines.

As long as the debt is in mortgages, the value can't really go negative. The building may be lost if it can't service the debt alone and doesn't have any equity left... but it won't drag down the other assets.

If the debt is at the company level it could... depending on the terms and collateral.

In this case, it looks like the portfolio is given negative value... as in not even enough to cover the companies' liabilities.

The drawback currently with what I've mentioned above in the residential NAV is I guess that the market is saying that those values aren't the REIT's equity in those projects so much as gross value.

How to realize value

The simplest way to "do something about it" would be to buyback more units... but with so much of the cashflow directed towards distributions, that's easier said than done.

I was half thinking that the SIB tender might be a way for DREAM Unlimited to move towards taking the thing private. Own 100% of a smaller portfolio. Sell assets and buy shares until they owned all of what was left. Instead, they sold into the SIB to bolster their own liquidity. They still own a large stake but it wasn't a great sign.

What some have suggested is to do something with the DIR units and de-lever the portfolio a bit (because office is at risk). I couldn't disagree more... if your worry is office at least. I'm not opposed to deleveraging but think it would make more sense to de-lever with office assets wherever possible if that's the worry. That said, if navs are close to accurate, it makes far more sense to allocate to buybacks than deleveraging. 

What I'd do is try to structure the leverage within the company on the asset level. Make it so that the offices have to pay for themselves or go bust INDIVIDUALLY. Avoid the domino potential of one really bad office outcome dragging down a perfectly fine asset. If they can't earn their cost of capital they're probably not that big of a loss. This is how a portion of the liabilities are structured today but I'd want to try to further separate fall back value and risk value.  

This way you can let the stuff that doesn't have an existential threat be around as a fallback incase office completely dies. If it does being 10% less levered probably won't help much anyway.

From there work on balancing resources between leverage and buybacks. The problem with asset sales is that some of the value must be used to de-lever, it's not simply a $100M sale means buyback 1/4 of the units. Couple that with a forced sale likely being at a (Multiplied) discount and it's tricky to 'just do'... what seems 'obvious.' It would also be unfair to act like they haven't done anything. They sold an asset for actually above what it's NAV was at the time & did the giant substantial issuer bid buying back 1/4 of their shares. That would have seemed very bullish to me if it was accompanied by insiders increasing their stakes.

Confidence 

The problem with the situation is that nobody seems to have any confidence in any values. Ideally, this is when you'd want to see insiders putting their own money into shares. Or at least some action being taken to benefit from the discount. In this case DRM and Cooper have stated that they're not sure what the future of office holds. Further still, Dream office is limited with their liquidity at this point. So is Dream Unlimited who also arguably has better options for places to put capital as other vehicles also trade at large discounts and have less questionable futures. Also... are we done with rate hikes yet? Market isn't sure.

The thing that really stops me from thinking, "maybe NAV is accurate and they can arbitrage that for massive value creation," is the fact that so much was sold at half NAV (into the SIB). That to me makes the whole transaction much more bizarre. If you're so concerned about office that you're selling at half 'NAV,' why are you essentially levering up on office (making a greater concentration of assets be office buildings.)

I mean at $13-$14/unit, the asset value of the industrial units would be in the range of $338M-$364M vs now $175M -$189M. Maybe I'm the odd one here because a few people seem to like the idea of selling the rest. To me, that's something you do if you're very bullish office. If not, or if you're unsure, I'd want diversification or some type of value backstop incase office goes exceptionally wrong.

I have nothing but the utmost respect for Mr. Cooper and his candidness about his view of the office situation. It has certainly looked correct so far in public markets. I do wonder at what point price or redevelopment potential might support the idea that the possibility of narrative overshooting reality. His stance did have me confused about the SIB situation. It could easily have been step one to a take private via asset sales and share buyback on discounted units that (if NAV was accessible) would have been immensely accretive. Clearly it's believed that values are at least at-risk.

More asset sales (at ~NAV+) and buybacks would probably work towards proving out and simultaneously adding to fair value per unit. For the time being, most of the office space is trading like a big levered uncertainty that nobody knows what to do with.

Distribution at Risk?

I always find it weird when an executive says that the dividend isn't at risk... everything is a risk... in some scenarios. I guess that would sound bad in an interview. I'm referring of course to a peer with a similar yield stating their distribution was safe. The problem is you can never know. What's not at risk today might be excessively risky if interest rates double. 5% interest rates were a very low risk scenario 5 years ago.

In Dream Office's case I think they should be able to keep it... or at least that was their belief a few months ago. I don't know if that's still the case if rates go to 6% (or long end goes up to high 5s) or if vacancy drops further or rents decline. A delay of redevelopment also hurts.

In other words, should be more workable as of last quarter and if things play out well with rates. But if a small number of things go poorly it's at significant risk (at least until they improve). That said, I have no idea if trying to keep it as long as possible is the best idea. I'm not sure what management is thinking on the subject or what suits shareholders. I think there's value potential here but I'm not sure the best way to access it is to try to extract every last cent in cashflow from distributions.

REITs have different rules. They need to distribute a large portion of their tax liability. 99% of the time that means paying income to unitholders... but it doesn't necessarily mean they need to give them cash. A REIT can keep the cash to use for different purposes (debt paydown or buyback) and just distribute the tax liability. Most hate this so they almost never do it. I don't think it will happen in this case but I mention it because it was done by an American office peer quite effectively when the stock got too cheap.

Rents

Oddly, rents have remained solid in the face of increased vacancy. If that persists, the offices more so be able to hold their own value better than what the market is pricing. I suppose that means the market suggests they won't.

My Office View

I'm not sure I share Mr. Cooper's view on offices. Of course that means I'm probably wrong... Sure there's a change and some will be sticky but I also have seen a fair amount that makes me feel that work from home can often be BS. Lots of people are immensely unproductive and frequently more disruptable. Not to mention I'm not convinced it's healthy long term.

Plus, if you think about utilization rates, offices used to be packed with people 9-5 Monday to Friday. Compare that to other types of real estate, a restaurant for instance which is still economically viable with much less operating/busy hours. I think the utilization rate can decline and still have similar net square footage demand.

Additionally, I think between 2.5% population growth and housing demand, it wouldn't surprise me to see supply shrink after current (past) construction cycle completes. (Side note: That should also open up labor for housing construction. I think in Canada in general labor will loosen which will work against the idea of workers being able to dictate that they can work from anywhere) I don't think it'll be tremendously quick but if we're ever going to need more offices, replacement cost will matter again. If we don't, then presumably the need to keep stuff zoned office or have replacement for teardowns would also diminish. Central downtown land with residential zoning sounds like hundreds of millions, if not billions in potential value.

Conclusion

My personal view on Offices from a few years ago was wrong for multiple reasons. 1: I thought return to office was going to be fuller and swifter. It was pretty apparent to me and most I spoke to working at home that productivity was a disaster... if people were working at all.

2: Getting rugged by interest rates.

I'm still in the "I don't know" camp. But I think we're definitely at the point where an entity with the right debt structure can make a lot of sense. The problem is that everything is discounted and uncertain. We live in a world of 'what its.' In the most confusing sentence I will write today I ask... What if, What if office goes to 0 turns into what if it doesn't? 

Disclosure: I don't own any units in Dream Office directly but I have stakes in two public entities that do.

Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

Monetary Policy Around The World

Monetary Policy Around The World 

Today, I'm going to briefly comment on a few monetary policies that I find interesting for various reasons. Either they've done something different or there's some abnormal idea that comes from their situation.

Including: Brazil 1, Canada 6, Japan 2, Poland 4, Switzerland 3, & The United States 5.

And some global commentary & energy comments.

***SARCASM WARNING!!!***

Brazil

Brazil is a *fun* one... they went way overboard with their hiking (in my opinion) and took real interest rates to nearly 10%... yes... that's 10%... REAL. That said, the leverage in their economy is fairly low vs many more developed markets. Still you saw the ripples globally when international companies like Nutrien essentially said it makes no sense to invest in retail in Brazil because the immense cost of working capital destroyed their margins.

But look, with Brazil's history of inflation, I can understand why they panicked with such extreme hikes. I don't think it was necessary or helpful to the people of Brazil. It has probably been a factor in the sustained strength of the Brazilian currency.

Now however, inflation has rebounded on a year over year basis back above their target, with the last half year would be well below.... Despite this rebound in headlines, they're easing. They've now cut their interest rate by 100 bps in the last 2 meetings (50 each). It's still insanely high at 12.75% vs 4.6% headline inflation. (Heading towards 5 on base effects) Headline will probably be in the 2s or 3s in a few months. I think rates need to fall by at least +600 bps to be reasonable and they'll probably fall by +800. The high cost of capital is a hindrance to local businesses and favors large international players with cheaper money who can undercut locals due to better financing terms.

It's a weird mix of early panic unlike much of the world... and now, even thought inflation is higher than Canada for example, they're more aggressively easing why we all freak out about similar misses to targets. (Literally about to see 5 vs 2-4 target vs Canada at 4 vs 1-3 target)

Japan

Ah yes Japan... the answer to the question of, "Whose data should we ignore to keep pretending that the old thinking makes sense?"

Japan didn't raise rates at all in the face of inflation... so by everything I've ever heard, people should be borrowing money at real negative rates to spend... inflation should be accelerating and sticky etc.

Well, it's fallen from 4.5% to 3.2%... despite the currency taking a monumental beatdown. I could make the argument that if the rest of the world hadn't jacked up rates (potentially needlessly) and Japan's currency hadn't been slaughtered, their inflation would probably be even lower... by that line of thought, rate hikes may not actually bring down inflation. All the inflation comes from foreign rate hikes hitting the currency. So if they didn't need rate hikes to tame inflation... what if others didn't... and didn't hike. Then you'd have this bizarre 'impossible' scenario where inflation falls everywhere without anyone hiking. To the "that's impossible, it's not how inflation works" argument that some are certainly thinking... check out what happened after the second world war... exactly that.

Sure it's still above target and higher than in many years. As I mentioned, that's probably partially on the currency. Another element that's almost comical is that Japan is actually stimulating their economy!!!

A point I made long ago is that if cost of living goes up more than incomes... the increase in cost of living isn't sustainable. Higher prices would revert. Japan on the other hand... it TRYING to make their inflation sticky. So they're trying to have their stimulus offset the unaffordability of increased prices... to try to make their inflation stickier. Still, inflation is cooling. The multi-month trend is something like 2.4% annualized... despite the murder of the YEN, lack of hikes and the stimulus. More than 2/3 of their inflation is food (which has global prices and has recently been slowing). Tokyo Core CPI has declined to 2.8% YoY... Not "Solved"... but enough to confuse A LOT of people.

On the subject of sustainability, that's why I was adamant that a lot of the inflation we were seeing would abate (be transitory). The causes were one off factors almost across the board. The stimulus, the supply chain, the prices going from desperate seller to incentivizing supply. the rate of change on none of those was sustainable... not at 0% interest rates or 15% interest rates. Stop paying people to not provide supply, fix supply chains, let incentive prices bring on supply, let the tech companies layoff labor to rebalance with the other sectors and the inflation virtually stops. If something isn't sustainable... it won't sustain. Some countries panicked... and raised the cost of production (making some of the inflation stickier than it needed to be... others didn't)

But here's the distinction that western economists cling to... unemployment. It MUST be that Japan has enough slack in the labor force that wages aren't a problem for cost push inflation and rising prices. Yes, it must be because... Their... ummm... 2.7% unemployment rate provides ample slack.

But let's just go on believing that you NEED to raise rates to bring down inflation. You NEED less people employed to stop it too.

Switzerland

Switzerland, the debt capital of the world apparently, didn't 'need' raise rates much. They only took interest rates to 1.75% and inflation is back down to 1.7% from a near 3.5% peak. Ok...

In a bizarre fact for the "well people would just borrow to keep spending theory" Swiss inflation peaked while interest rates were still negative.

It's almost like low interest rates prevent inflation. (Obviously that's not correct and there are numerous other factors... but if you look at supply and demand from the bottom up, there's something to this.)

It wouldn't surprise me if they're back to 0 rates and fighting deflation again in a few years. It also seems difficult to get there.

In an inexplicable turn of events to the "interest rate differentials drive currencies" crowd, despite this lagging on rates vs the rest of the world, the Swiss Franc has been too strong if anything... yeah, I don't know. I guess maybe, just maybe, you don't need to murder your own economy to save your currency.

Poland 

Poland made headlines a few weeks ago by making a later than expected rate cut despite headline inflation being a whopping 10% YoY!!!

That seems insane until you realize that over the last 4 months their combined inflation rate was -0.2% (-0.6% annualized). 

The currency did take a hit on the surprise scale of the cut. That's gotta be expected as markets react to news. What I'm curious about is if it means persistent bleeding or if that was a one-off readjusting to policy. I think many places think they're locked into bleeding out their economy because if they don't inflation will persist via the currency. That's... in my mind the only rational reason some places can even consider more hikes at this point. If a early actor... (Poland) can disprove that it would be good to know globally.

Hence, I'm instantly rooting for Poland.

This was particularly interesting due to the high headline number and the fact that interest rates remain well below it. My belief is that the rolling off of high comps will make headline inflation fall despite the easing. What I don't know is if it will fall to 0, negative, 2, 4... whatever. It is very likely that it'll look much more reasonable... and it may be fun to poke fun at traditional thinking about what central banks need to do in order to tame inflation as inflation falls along side rate cuts after real rates were never even positive to boot.

United States

The US's mix of high debt and high duration mortgages makes them positioned differently from the rest of the world. Higher rates are passing money from the have nots to the haves. Interest on government debt is helping stimulate the economy to counteract some of the higher rates. Mortgages aren't resetting at higher rates so new slowing is only on incremental mortgages.

I do think that they're still feeling negative effects of higher rates. The term risk is heavier on the banking sector, and the banking sector is the transmission mechanism for money through the real economy. They're also not immune to changes in global demand.

Inflation measures are so obviously lagged that it's a bit of a joke to look at headline numbers. It missed the entire down cycle in rents/OER while still catching up to the last up cycle. The largest component in CPI is only now essentially caught up. Where it does next, I don't know but the momentum has cooled well beyond what is currently measured in CPI. It may still be moving higher as a category but much slower because changes in the situation aren't amplified by broken supply chains and stimulus.

One thing that has seen only minor discussion in passing is the MASSIVE surge in capex in the United states. Capex is short term inflationary, long term deflationary... It takes a lot of money, spending and labor to build something, then less labor to add supply which pushed XYZ prices down as the cost of the plant is paid off. So as that capex becomes opex, it's another headwind to inflation.

I think inflation is heading lower to the mid 2s probably. I think that would and should be enough to stop hiking. We'll probably have to watch from there. I think there's strong underlying demand but with the pressure on the banks from the bond market, prices are now effectively so high for anything that needs to be financed that demand is being deferred.

I think stability on the rate front and time would allow mortgage spreads to come down making even these rates less cumbersome. 

Canada

Most of my other pieces reflect on the BoC so I'll try to be brief.

All our problems are self induced stupidity. 

Trying to satisfy a 1.2M population growth with 250k housing units because we keep attacking our housing development & affordability with rate hikes is beyond insane. That's WHY our rent inflation has started exceeding the US.

The top 2 causes for inflation are what we do to fight inflation, so we're hoping to break other things to more than offset the damage we're doing with our actions. It flies in the face of logic and bottom up economics.

Why? Because people seem to think it's the only thing we can do... I'd think "if you're in a hole, the first thing to do is stop digging" but what do I know.

We should have stopped hiking 8 months ago... we'd have more housing supply & less rent inflation... less mortgage interest cost inflation. If we had food that was in line with global averages at the same time (instead of our Canadian supply management + carbon tax special) that would be another 0.5% off inflation taking us to a very reasonable roughly 2.7%. (4.0 - some food, MIC & rent). I'm sure some would argue that those are causing price reductions elsewhere... I mean that's not what's happening in the rest of the world... but hey if it fits conventional economic theory... let's go with that.

You know, if your goal is to reduce sales volume by killing demand... that also requires sellers to get higher prices to operate... But that's another can of worms.

But... because we've committed to absurdity as a policy... it looks like we're going to hike at least one more time. More developed projects shelved to help rent inflation.👍

Globally

Reshoring was an interesting story coming out of COVID. I think some of the deflation we're seeing out of China comes from the slower growth and overcapacity from supply chains shifting elsewhere. I don't know where China goes from here but remaining overbuilt with a declining population has me questioning what their economy can do. Even a highly managed economy and currency may have trouble with such a large pivot.

I think this is what's causing the big boom in Mexico and US-Mexico trade. With labor tighter in the US "as the narrative goes" Unions are trying to exert their force. Honestly, the ask on this UAW stuff reads "fire us and go to Mexico but I think they may be not quite seeing that as it often seems like professional socialists (unions and further left political parties, have this amazing hole in understandings of economics... or at least pretend to.

Energy Crisis

Some would suggest that an energy crisis will lead to sustained inflation. There could be one which could prolong inflation. I don't believe there has to be one or that it'll inevitably lead to prolonged stagflation. Many places can produce a lot more at $80-90. Canada can add a bunch next year when new pipes come on. People might argue that no one will do crude by rail due to the increased cost. Crude by rail is currently 100kbbl/d down from 400k/d. I'm just going to say that if someone thinks oil will spend any extended time at +120 and Canadian producers won't ship crude by rail because of a $15 discount, I'll take the other side of that bet. Similarly, I know people argue that demand is inelastic but on the margin that's nonsense. Oh, I didn't even get to Brazil or Africa when talking about supply growth potential. Price and time solve this, at some prices there are unsolvable deficits. At other prices there are unsolvable gluts. Meanwhile, recently we've seen Crack Spreads normalize for gasoline... Finally. So yeah, if someone decides to really break S/D there could be an issue. Absent something extreme, we don't need much more energy contribution to inflation before a lot more production can start progressing.

Was I Wrong?

Was I Wrong about inflation being transitory? Yes & No. I mean we've seen in both places that jacked up rates like crazy & places that didn't, inflation come down quickly without too much stickiness. It's also lasted much longer at above target levels than I was thinking. Even now, we've fallen lower and further than the 70s (what some of the sticky crowd feared). I think we could have handled so many things better. If you recall I was critical years ago that they kept blasting QE wayyyy too long. I was also bullish on inflation back when we were handing out cheques & commodity prices were too low. So I guess I'll admit to not predicting the second wave (the war) but even with that or absent that, I think we'd have been even more transitory than the mostly transitory that we got. I also missed the impact of broken supply chains and the second wave of COVID in China.

I was early also in suggesting that rate hikes wouldn't help (which will always be debatable either way). Slowing supply doesn't fix a supply shortfall. Not in Lumber, Steel, Energy, Housing, you name it.

That said, one thing I absolutely got wrong is that rates got here. I still think there's no reason for them to be this high and that they aren't particularly helpful on the inflation front. I thought we may get to 2.5 or 3 percent but am shocked at where we got and still not definitively stopped.

END

How naïve I used to be... thinking that investing was all about buying a good company at a good price. In truth, a good company at a good price can be a terrible company at a terrible price when the people in control of the decisions above triple interest rates to force a needless recession. So much is so arbitrary, so often.

I leave you with a question. Is economics a science, a pseudoscience, or a giant appeal to authority?

Disclaimer: This is not investment advice

Auto Parts... Still Picking Up The Pieces

Auto Parts... Still Picking Up The Pieces

When we left our heroes things were finally looking bright. They had finally worked their past the endless disru... Never mind.

This UAW strike now further delays whatever a normalization would look like. The average length of a strike is roughly 41 days. This time feels especially contentious and perhaps especially large in scale. Still it is unlikely to last forever and what I've heard suggested about the impact is that historically, volumes get made up. Still it's a pain for a sector that's faced endless challenges over the last 5 years now.

Maybe the fear of this strike has been why the stocks have remained historically discounted recently. Maybe they'll be irrelevant in 3 months. For now all that can be done is watch the situation hoping for a resolution.

I'm going to discuss  Martinrea, Linamar, Wages, Capital Moat & answer a question.

Martinrea

I'll be honest, I was very much enjoying Martinrea's 40000 share per day buyback. At that rate, I'd own the last share of the company in 400 weeks... and I'd be a billionaire. Hard to be too upset with that. Ok so that wouldn't happen & the buyback would max/black out before we got too far into that. Still it was easy to see how things were not only getting better by the day but benefitting from the continued discount when the buyback was running.

There are a number of ways I could measure the "Yield" on the buyback... and maybe I'll write more about this someday... but for now let's call it the earnings yield on the shares begin bought. That means that a 5x earnings company would yield 100/5 = 20%. That's pretty decent prospects for sitting on a cheap stock.

When the strike was basically imminent they paused the share repurchases. I understand why... uncertainty about scope or length... risk to short term guidance & looking like fools when they buyback before a miss. Perhaps some wish to preserve liquidity for if things last longer or some opportunities open up for acquisitions. I get it.

It was interesting that Rob Wildeboer bought another $100k right after the buybacks stopped. My read is that he still liked the value even if it was prudent on the company level to pause.

I honestly don't know how impacted Martinrea has been or will be by the totality of the situation. I'm not surprised that GM and Stellantis are moving towards short term layoffs. It was obvious that they'd be necessary the second UAW decided to be tactical with their implementation of the strikes. As the last few years has shown, if you're missing one piece, vehicles can't ship so if the XYZ -99 engine assembly plant is stalled, anyone assembling any part of those cars is useless.

I hope there's a resolution that doesn't end up sending the companies to bankruptcy in the future as that's not good for anyone's business or employment. Hopefully it comes in a few days or weeks.

I've suspected recently that the potential strike was probably weighing on the otherwise cheap auto stocks recently... and by extension probably keeping the parts manufacturers from rerating back to their fair value. Once that plays through I think there'll be less of an excuse for the low price... on the other hand I'm sure we'll find something. If we don't rerate, hopefully MRE can get back to the aggressive buyback.

Pre-Strike 

Martinrea was on pace to be doing quite well. The breakdown of how their free cash flow was set to play out this year meant that more than 100% of it was going to be in the second half.

That should have taken net debt down to near 800M, even with a continued 1.5 months of buybacks.

Their quarterly adjusted EBITDA was coming in in the 150-160M range so the debt was moving to a very reasonable level.

It was a great setup for next year when debt moving below target was to meet free cash flow's ability to compound the cheapness of the stock.

My fair value assessment and outlook hasn't changed much from when I last wrote about them. I can calculate normalization I'm a bunch of different ways but they all seem to give similar fair values of roughly $27 today and hopefully above $30 in 12 months.

Linamar

Linamar has been back to their old ways. They've now quietly put USD$400M to work on acquisitions in the second half of this year to compliment a full capex regime. On one hand it's what should be expected from them and what they did well a decade ago. On the other hand, it's frustrating that they're going out and buying things as prices that look like significant premiums to what they're trading for...(or what my other auto parts stock is trading for).

I'll hold off judgement until we see how the plan comes together (we won't). It looks like they got excited about the structures group they're putting together. Maybe it leads to scale, growth opportunities, synergies and other good stuff... for the time being I think it's fair to ask what kind of returns and immediate earnings power the acquisitions bring in especially considering the first was essentially funded by 6% yielding term debt. I'm sure it makes sense but does it make more sense than buying more of existing businesses at a 20% OE yield?

The whole auto division hasn't been doing well recently and the improvement has been slow. Perhaps that's part of why putting capital there at full price+ has been less exciting. It's almost like, the second they buy them at 1x sales they get lumped in to something the market values at basically 0. I'm not one to appeal to what the market cares about at the moment but I'm having some difficulty understanding the appeal vs some other options. It is understandably hard to plan business around numerous changing prices.

One bright spot has been the industrial segment after the annual price resets. The performance in the agricultural segment has been solid and the volume ramp in Skyjack continues as past capital investments start paying off. Using a midpoint of normalized margins on trailing revenues the operating earnings of the segment should be just above $380M. That could easily be +$400M in 2024. I still contend that's easily $4B in value right there... or ~$64/share. As difficult as this may be to believe, in theory the mobility segment should be even more valuable... or at least generate more earnings. Using the same calculation with the Mobility's normalized margins, they should have $560M of OE. That's before the most recent acquisitions. $600M of earnings power on a go forward basis (not expected to be immediately achieved). That's maybe $9.50 per share in pre-tax earnings power... gotta be worth something.

The unnormalized results were as follows. If you can forgive my backwards charts (most recent quarter on the left).

Note: The MacDon acquisition was near the first data point

You can see results with numbers going back to 2017. As you can see, COVID hit both hard but for a while the supply chain impact on industrial was worse for a while. Mobility rebounded quickly with stimulus before the supply chain broke & inflation bit. As I mentioned above, Mobility 'should' be basically at the top of the historical levels.

*TTM = Trailing 12 Months *MRQ = Most Recent Quarter (on left)

The combined picture basically explains why we haven't seen new highs in the stock in +5 years.

This final chart has one added data point which is what things 'would be' with normalized margins in the past year. Adjusting for prior peak stock prices, share counts debt levels, recent acquisitions etc... i could estimate a number... but it doesn't matter until they actually do it.

Basically, the stock tracks earnings. It's also noteworthy that, after the MacDon acquisition there was a significant amount of debt reduction that slowed down the operating earnings growth (IE: operating earnings showed up immediately but the debt burden didn't in those charts, time was needed to reduce that burden)... along with the GM strike, COVID, etc. Again, the clean balance sheet of early 2023 is potential earnings growth.

Linamar was hit hard by the GM strike in 2019. For that reason alone I have on the back of my mind that they may be at increased risk today. That said, given how much value the market is currently putting on the entire mobility business I don't think the share price risk 'should' be significant. Despite whatever I think, history seems to suggest that it's an auto stock when you don't want to be an auto stock and a diversified industrial when you do.

While I could debate the merits of where it goes, Linamar continues to generate relevant amounts of earnings... and even more earnings power relative to their market cap. They're using that to add value by the day. Some days that's buying businesses others it's generating capital. Hopefully the higher interest rate environment is allowing them to get more bang for their buck with purchases.

*Q&A*

In my last post about Linamar, someone commented that LNR's Free cash flow/ EBITDA ratio is erratic and asked what I think about that.

I think that's a good thing that the market will treat as a bad thing. I dislike free cash flow as a metric for the simple reason that absence of free cash flow can be better or worse than the presence of free cash flow. The erratic FCF simply means that sometimes there are good places to spend capital investing in PP&E... and sometimes there are less. This means they invest when there's something to do but don't for no reason. That's the theory at least. Capital investment getting a 1% return get just as removed from Free cash flow as capital investments generating a 20% return. One you do all day, the other is never worth it and drains resources. It's good that they're not forcing poor investments... but the market prefers stability and consistency.

Wages

One thing that suppliers pointed out when asked threats to wages in response to UAW results is that they were actually ahead in that regard. They saw the wage pressure in 21 and 22 and were already eating that expense vs expectations. The prior union contract was actually locking UAW below market. That's why the UAW offer and ask look exceptionally high. (The 20% offer vs 40% ask).

The wages that UAW employees received before the raise they're about to get would be considered quite high in Canada and astronomical in Mexico. This is one of the holdups in the whole "reshoring" initiative. Wages and availability of labor make it cost much more. The half answer is Mexico... probably why they're doing well. I'd love to throw Canada in the 'we could be a good idea' ring but our wages aren't that much more favorable than the US (I mean +30% is big but much less than other places) and cost of living & union culture isn't helpful. A more elaborate solution might be automation. The higher wages go the more that makes sense. Don't get me wrong, it can work in Canada and even the US but it obviously means higher prices.

Capital Moat

It sounds a bit ridiculous to consider... a moat in a low margin, cyclical, metal bending industrial. It is until you realize that all businesses have some kind of moat. Today, although not a traditional moat, I'd suggest looking at how capital can be a moat.

I mean, "I can get 6% guaranteed, why would I want to spend a lot of money and take lots of risk to try to earn 10% on money I'm going to put towards a new auto parts business?" Martinrea vocalized this point well a few conference calls ago when they said, "now with these interest rates our ROIC hurdle his higher." In other words it would stand to reason that the returns on capital in capital heavy industries would increase with increased competition... from treasuries.

I get why value investors seem to love higher rates. It's worse for economic growth and the consumer but when it comes to the random/average business (aka value stocks) it makes their investments and cashflows more valuable (even if their valuation decreases). It's more expensive to compete. Don't get me started on the topic of inflation. It's not a full, lasting or permanent moat but, for the time being it should work to partially offset the decreased demand from higher financing cost for autos.

Disclosure: 

At the time of this article I own both $LNR.TO and $MRE.TO as well as have sold some puts so many be buying more later this year.

Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

"Dead Money" a Brief Look at CIBC

"Dead Money" a Brief Look at CIBC

"Dead Money." The term for a stock that has gone nowhere or will go nowhere for an extended period. CIBC, Canada's 5th largest bank has now provided no share price appreciation since 2007. You could basically have invented a product and turned it into a multi-trillion dollar company in the time that it has taken CIBC to go... nowhere.

Now for sure, there have been relevant dividends paid over time but how could a large, profitable staple of the Canadian economy go over 15 years without adding any value?

Well, the short answer is they did add value. The significantly longer answer is: What is value? Yes that's a question but realistically what's the right way to measure value? For me, it isn't exclusively stock price. So in an exploration about what's different between now and then (cause it sure isn't the stock price) let's explore what the books say the company should be worth. Don't worry I won't be going line by line through a bank's financials. I would however distill it to one thing, Book value per share.

Rewinding to 2007, CIBC was trading at just over 3 times book. Today we may look at that and wonder what possessed people to want to pay 3 times book for a bank stock but we did back then. I think, what possessed people was the fact that the banks were doing great. Those book values were growing by ~23% per year, making that 3x book something like 15x earnings. If you were to extrapolate what you saw back then (excluding dividends) it would look like paying a reasonable multiple for a company growing 20% CAGR. After all, why should a bank with nearly 20% earnings growth only have a 10PE/ 'bank' multiple? In that light, it seems a little less stupid.

Now CIBC trades at ~1.0 times book. Which today makes sense because returns on that book value have fallen and the market seems to think may be at further risk.

This also happens to be nearly the lowest valuation for them (and many banks) since the 90s. The other similar periods were when the economy shut down (COVID and GFC).

I'm sure some bears would point out the declining trend in Returns on Equity in addition to the dubious macro. It's possible that the trend will continue lower but my thinking is that much like 99, 02, 05, 09 & 2020, the earnings power will eventually spring back to the mid to high teens. Ideally for shareholders, perhaps even spend more time there.

CIBC also holds the distinction of being the only major Canadian Bank to record a YoY negative return on equity (a loss on a year over year basis) in the last 20 years. And as a matter of fact... they did so twice. 

I'll be honest, when I look at the 7 Canadian banks that I follow closest, I have 2 classifications. Good (3) & ok (4). CIBC fits the OK category. This doesn't mean that I don't want to own it (I actually do own a small amount) it just means it's one that I believe deserves a lower P/B multiple. I actually think the OK's are basically indistinguishable from each other, so if I'm interested in buying banks, I add to the cheaper end. The ok ones present an interesting conundrum (half explained above)... what if they're actually good? 

All the major banks were earnings high ROEs in 2007 and all had 'deservedly high' P/B multiples. There's not a good reason why they can't get their efficiency metrics back to the 'good' levels. Will they? No idea. I do think there's room between here and 3x here for reasonable appreciation. Even if not an 'appreciated appreciation' perhaps the stock might be even cheaper than it currently appears (able to add more value quicker). Remember also that back then we weren't just extrapolating nothing... the companies were adding value very quickly. That require a better valuation to be good.

Certainly things can get worse from here too or at least stay challenging for a while. Looking at 2007 however gives us a great analog of the ironic part of markets. Things were great for CIBC, roughly 'never better' so naturally, it was a terrible time to buy the stock. You don't want to buy high expectations. I think current expectations are beatable. Could they lose money next year? Yes. But they also could... and literally did then too.

The big banks don't cut their dividends very often. It's probably happened but I can't think of a case off hand. So I really look at the bank stocks similarly to how I might look at a cap rate. A base case for yield and probably eventually some growth and appreciation. I appreciate the yield which provides something that much of my portfolio is lacking. I think the market is pretty negative on the banks and eventually without any warning we'll find ourselves through the worst of 'it.' For now I don't mind sitting on the dividends even if the stock remains... well... dead money.

Disclosure: At the time of this article I own shares in $CM.TO as well as direct and indirect stakes in other entities mentioned in this article.

Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

EQB Inc

A Look at EQB Inc

I'm starting this unsure about how much I'm truly going to be able to say. Long ago, someone once mentioned that I have a knack for simplicity. When I look at this company, it's a case of well, that looks interesting but if you don't see it I'm not sure what I can say. Even still, let's discuss and see where we get.

EQB Inc or EQ bank or Equitable group is a small 'challenger' bank in Canada. Ok... so I've now lost 100% of my non-Canadian readers... and 50% of my Canadian ones.

The simplicity of the pitch is that this looks like a company that generates high teens returns on equity trading near book value. For reference a 16% ROE for a company at 1x book would amount to a 16% CAGR. Excluding impact of share issuances/repurchases, whether it trades at a large discount or a large premium to book, the long term expected returns should be tied to book. ROE is effectively, how quickly book value increases.

To me, this kind of results would suggest that I was looking at a good company. The next question would be, what am I paying for it?

That looks like a reasonable amount, relatively average vs it's recent history. It looks like you'd be paying what amounts to, in normal times, a premium of a few months to asset value. This compares to 2015 where you'd be paying a premium of 4 years to book value at the high end or 2021 where it would be a premium of 3 years. Both of those points weren't points where you needed to exit as much as points where patience was required to let the company work off the premium. That takes us to now where although near the middle of the range, a 50% appreciation would be needed to return to the 'wait' point. 

My father would be quick to point out that the on the low end the valuation has hit 0.8x book multiple times which could represent 25% downside to where you may be able to get a better entry. That is of course, possible, as is any number of 'worse' scenarios. One could also suggest that, now in a higher rate environment, that lower valuations are in order. At 0.8X book someone would say that book is about to decrease due to losses... at 1.6x book someone would say it might be cheap at 8 time earnings. All of these theoretical opinions can be right... The point is, Nobody knows what's going to happen next... ever. Still let's examine the would-be point of my father... if this is valuation range bound would it not be a better risk/reward to wait for the bottom of the range? Yes and No. It depends when. If it's going to be 0.8X book tomorrow, then that's obviously a better price. Assuming normal course of business (or thereabouts) the value will increase by roughly 15%-17% per year (excluding dividends). So in 2 years, the company might be worth 1.3 times what it is now and 0.8x book then is more than 1x today's book.

In fact if you thought that on average a company were to generate 15% ROE for the next 10 years, then you could even pay 1.5 times book (10 times earnings) and still generate 10% CAGR returns even assuming that you'd lose 1/3 of the valuation and end at 1.0 times book. Valuation risk is mostly a shorter term phenomenon for better companies. Of course, valuation risk is far from the only risk.

Base Case Math

My base case goes something like book today: ~$70 

As stated above, 1.5x book would be roughly right to target 10% returns... except, because of current market conditions... or some difficult future year, I want to assume that in one year the earnings may be $0 (offsetting losses in difficult market etc)... So (70*1.15^9)/(1.1^10) = $95

So $95 is probably what I'd call fair value TODAY... or roughly 10x trailing earnings.

That could be $110 next year and $125 the year after that... If they keep proving themselves to be the same caliber of company.

This is effectively a budget discounted cash flow. The reality is I have no idea how to predict any single year of the next 10. I'm making a guess that on balance the future will be similar to the past. Obviously the market believes the future will be different from the last 20 years. I could pretend I know the probability that the average of the next 10 years is 12% ROE or that 8 of the 10 will have 17% ROE, one 12% and one 15% but I don't have any idea.

For me, by this point it seems like there may be something here as it checks the boxes of

Above average company

Below average price

Growth runway

Next of course is to hunt down the details.

Basics

The average age across +$1B Canadian banks is probably something like 100 years old. Our banking system is smaller and funded effectively quite differently from the US. The funding and lending is much shorter term. That reduces the SVB style term risk. There are also far fewer options from deposit flight. Historically, despite the millions of charts that you see our there about how impossible it is to afford housing in Canada, defaults and delinquency are frequently much lower in Canada than the US... like 1/8th. Additionally, there are many more stress tests and a requirement to insure low equity loans.

Last Quarter Some peer banks reported that 90+ day delinquent loans

Mortgages 0.14%

Personal Loans 0.63%

Credit Cards 0.61%

Secured Lines of Credit 0.22%

International & U.S. is regularly much higher

Source: (1) Statistics Canada, Federal Reserve Board, RBC Economics. (3) Canadian Bankers Association, Mortgage Bankers Association, RBC Economics.

That's not to say there's no risk, of course there is, mostly in credit. My point is that the Canadian banking system is usually a lot less volatile than many places... even if it's ridiculously unaffordable.

Comps

It's interesting to sometimes try to compare the companies I'm interested in with popular ones. I'm not going to go into great detail here but I did have a few relevant thoughts. You could probably find companies with lower returns on equity and growth rates for closer to 25 times earnings (in other industries) BUT I wouldn't expect bank stocks to attain those valuations. Maybe it's the leverage, maybe the business type, maybe they're just not worth that much. I don't know. That's not really an issue for Canadian owners of banking peers.

The current closest ROEs among CAD banks are probably Royal & National. Someone once said of EQB, "It'd be weird to own a financial with such a low dividend yield." I think that's half the reason for the discount (the half I hope they don't change yet). The other half is that they're 1/10 the size of National... which is 1/5th the size of Royal. They're small and less established. I do think that from a valuation agnostic perspective all are interesting companies.

Dividend

They don't pay much of a dividend, and if they can keep growing at this rate, I hope they continue to not pay much of a dividend. I suspect that they'll raise their dividend to 0.40/share per quarter when they next report/declare.

Their dividend is roughly 2%-2.5% of their equity (so with 15% ROE they'd keep 12.5%-13% to grow and pay out the rest of the earnings). This means that there's been some decent growth and that will probably continue.

Provisions for credit losses.

Despite the bank's good results in recent quarters they have actually been increasing their PCLs. Obviously people are thinking that that will need to further increase as things deteriorate. Provisions have doubled in the last 18 months and are now more than 20% above COVID levels

Growth

EQB has been fairly consistently growing all the categories that an investor would want them to grow; Deposits, loans, EPS, book value per share, dividends, Revenue...

While impossible to grow things like Return on Equity and CET1 ratios, forever, even they have been trending in the right direction recently.

How to get to losses

Given the primary knock on Canadian banks is that they have lots of exposure to the Canadian "housing bubble," I want to look at what's needed for the bank to lose money.

1: Decline in property prices

Given that mortgages with less than 20% equity get insured by the CMHC, you'd first need a decline of more than 20% to be at risk... 

Except: Over the first 5 years where rates are mostly locked in (at a supposedly stress tested affordable level) mortgage holders are scheduled to pay off ~10% of their principle. So you'd actually need closer to a 30% decline over a few years to risk getting to a power of sale situation.

Then you figure that most of the portfolio of 25 year mortgages weren't purchased at the perfectly wrong time. IE: some people were 25% + in the money by the time the price peak hit so a 25% drawdown takes them back to flat except that they've built 15% more equity over that time too etc.

Ok so if prices drop +30% and the mortgage-holder (who can't contribute more equity) bought at virtually the top and they weren't adequately stress tested...the bank can lose money.

Also remember that as time passes older loans have more equity and newer loans have fresh 'buffers'. Essentially, house prices meandering sideways or creeping slowly in a direction may be derisking the loans over time.

Then you approach the question of how much... because I mean in the end the banks are kinda at risk of having to buy a house 30% off...

I want to be clear, I'm not making light of this scenario. It can happen to some unlucky people. There's also plenty of possibility for loss of earnings from lower volume, affordability, or the busting of some insured mortgages. I'm saying that if we figure a small amount of mortgages reset each week/month, the stress from the rates is slow and incremental. If the pipe were to burst in a deflationary shock hopefully central bankers would perform their main useful (non sarcastic) function and loosen monetary conditions before we repeat the great depression... but in the end I suppose you never know. Can't imagine too many stocks would do well in that scenario.

Capitalization

EQB is pretty decently capitalized. The degree to which that equates to safety however is always more in question. As of last Q, EQB's CET1 was 14.1%.

For context (not comparing quality of lending only CET1)

TD 15.2

Royal Bank of Canada 14.1 (pre HSBC)

JP Morgan 13.2

Bank of Nova Scotia 12.7

Bank of America 11.4

Wells Fargo 10.8

*Canadian banks are generally well capitalized.

Negative Amortization

Of note in the recent fixation on the negative amortization-pocalypse... EQB doesn't offer products structured in that way. On their variable rate products when rates increase, payments increase. As such they don't have mortgages with over 30 year amortization schedules.

Fundamental Backdrop

Some of you have read some of my other stuff where I discussed this so I won't go into too much depth here.

Essentially I think that population growth is acting as a significant buffer against a negative economic environment and it means lots of demand for housing... meanwhile, I think supply is far closer to the cost of production than many proclaiming 'housing bubble' are willing to admit. Individuals suffering isn't the same as the economy suffering.

Most of the remaining inflation is rent and mortgage interest cost. Rent denotes very strong demand for housing. And Mortgage Interest Cost, aside from being artificial, denotes that a tremendous amount of stress is already being felt and it hasn't yet resulted in a violent decline.

Other Lending

EQ does lend more than residential mortgages. It does represent approximately half of their lending portfolio with the rest being commercial of various types.

Their deposit base is also diversified with:

Brokered Deposits 54% EQ Bank 26% Deposits Covered 8%

Bonds Corporate and Institution Deposits 1% Credit Union Deposits 5% Deposit Notes 6%

Risks

I'm not the biggest bull on the Canadian economy right now... so do I really want to own a less established bank stock? That's a fair question. Especially with the big banks trading at close to their lowest valuations in 30 years. I think the market is reflecting some of this in price. It may reflect more of it in prices again. Last time it did it turned out there wasn't a fundamental reason for it. It traded down to a price that turned out to be a very low multiple of forward earnings. I think it's less helpful to predict what the market may think and more helpful to look at fundamental risks...

Losses, bankruptcy, sustained loss in earnings capacity... that kind of thing. I don't know if we see outright losses in coming years. My base case as stated above is essentially "no but" as in not net annual losses but we do see a year's worth of profit go towards offsetting other losses. This could happen over 6 months or 5 years of reduced earnings... I expressed it as one missing year for simplicity. Last quarter they were quite far from that while (impressively) still growing provisions.

I obviously don't think something like bankruptcy is likely.

Disclosure: At the time of this article I own shares in $EQB.TO as well as direct and indirect stakes in other entities mentioned in this article.
Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

Canadian Market Outlook

Canadian Stocks

Maybe you've heard... Canada isn't in a great place. Interest rates have started biting the Canadian economy & without a change in course, that will get worse by the month as mortgages reset for the next 2-3 years. Further still, the Bank of Canada is still deciding if they want to make it worse or not.

Productivity is bad & inflation has been staying higher than wanted. We should probably be in a pretty bad recession already... which should in turn cause worse damage and rate cuts, further damaging the currency... causing more stagflation etc etc etc....

But we're not... and honestly the same reason we're not is why we might not. Population growth.

People want to blame population growth for stress on the housing market and rental affordability. The reality is they're bailing out a financially sinking (because of increased rates) property owner. The fact is... and many people need to hear this... despite the averages "Top 10% salary can't afford the average house!!! (*with no trade up equity and average heavily weighted by most expensive markets... but let's avoid talking about that*)" and what you hear about Canada, Toronto and Vancouver. You can still buy a brand new 3 bedroom, 2.5 bathroom house for 450k (USD$330k) near Calgary, Edmonton, Regina, Saskatoon, Atlantic Canada etc. That's because despite the "immigration making housing unaffordable," when builders can build, prices follow the cost of production. As a reminder, this is EVEN AFTER a decade where "low interest rates made housing unaffordable." In my opinion, at 2.5% interest, $1800/month as a mortgage payment on such a home is affordable. Immigration is obviously not the problem... but it does amplify what the actual problem is. The actual problem being the time, cost and difficulty of building. Also, it's crazy how many people will complain about affordability but when given 5 affordable options, look down on those locations in some form. The averages are warped by people's perceptions about frankly what's not Ontario & B.C. Another issue the MASSIVE take governments reap from inflated land transfer taxes and other such costs. The problem is almost entirely artificial and self induced. Population growth is bailing out our economy from home made stupidity. It's 'easy' to point the finger but it's not the problem. Same with "low interest rates."

Recession or Not

I don't know if we enter a recession. GDP growth has sucked for 6 months & could easily slip negative. On the other hand with adding 25k jobs per month (probably hurting productivity) we've already added 0.5% to our unemployment rate. By year end, that could easily be 1% off the lows without a recession. If we had 0 job growth, unemployment would rise 0.2% per month which would be a similar pace to the GFC. If you believed that inflation was caused by tightness in the labor market... this sounds deflationary... even adding 25k jobs per month sounds deflationary. Also, if we're going to look at wage growth with immense fear "omg still 5.2%" well, I believe we are about to witness some favorable base effects in that regard. 

In the last 8 months January to August, wages went from 33.01 to 33.47. In the last few months of last year, wages went from 31.67 to that 33.01 in January. That's a 1.34 increase that gets lapped vs a 0.46 increase over the majority of this year.

In any case, recessions are transitory. Plus, most of the time by the time everyone agrees it has arrived, the market is looking past it.

We're already in a non-recession... recession.

Believe it or not, I started this not really wanting to discuss macro factors. I wanted to talk about some stocks. I did however want to make an important point. That is, in the discussion about Recession... economic collapse... bubble bursting etc. It's important to realize that the pain & stress is already being felt. We are adding growth potential... companies are adding long term value... the economy is stagnating for now but adding potential. We're not growing but in suffering this (higher rates and higher unemployment) without collapse... we gain the potential value of; 

What if yields normalize at inflation +50bps... 

What if more people find jobs... eventually 

That could mean higher growth, higher cashflows, higher valuations.

I don't like the near term Canadian economy... and think there are real risks there but also think... to use a horrible cliché... what doesn't kill us, makes us stronger... now the key of course is... not dying. (Or suffering permanent damage). I think we need to look South... and West... if the Fed can be done and investment in Oil can bail out our currency we could be surprisingly ok. If the Fed presses onward and our currency gets caught between a rock and a hard place it could push a bad situation towards a very bad situation.

Banks

Ok so... housing bubble... inverted yield curve... possible recession... economic stress etc... who in their right mind would go out and want to buy bank stocks? That's a valid question that many are probably asking. I don't have a good answer... or I should say wouldn't have a good answer if we were talking small 1/10000 banks at full price with marginal equity cushions.

In Canada we have maybe 10 worth a look... 6 that every Canadian has hear of... all heavily regulated and capitalized like a GSIB ( Global Systemically Important Bank) most of these have been adding to their PCL (Provisions for Credit Losses) aka reduced earnings and is at a P/B multiple comparable to COVID or mid GFC. So yes... we may see the implosion of the Canadian economy through gross incompetence... but a normalization of bank performance over the next 5 years could generate something like a 25% IRR... from owning the big banks. That would mainly require enough population growth to avoid a Recession. 

The Canadian banks have been around for many years:

Bank of Montreal 206 

Bank of Nova Scotia 191 

Royal Bank of Canada 159

Toronto Dominion 68 [merger of Bank of Toronto (would be 168) and The Dominion Bank (would be 154)]

Canadian Imperial Bank of Commerce 62 [merger of Canadian Bank of Commerce 156 & Imperial bank of Canada 150]

National Bank of Canada 164 (or 43)

Not to mention Laurentian Bank which has achieved much less in their 177 year history. 

The point being that these banks survived the great depression and the GFC along with 20% interest rates and many difficult environments. That's not to say that they're invulnerable... but they are pretty resilient.

Canada doesn't have the same MBS problem that the US had in 2008. We also regularly have 1/5th to 1/10th the mortgage delinquency rate of the US. Further, a large percentage of mortgages are insured or have a large equity cushions. Then remember we've already seen some decline in construction as prices don't satisfy return thresholds for new supply. 

What I think happens is somewhere in the middle. A few years of reduced earnings before gradual improvement. I don't think dividend cuts are likely so when I run through some possibilities it's an area that looks interesting from a DCA, collecting a few shares perspective. Particularly because my portfolio is light on the yield. I don't like buying things exclusively for their yield but I think that in a few years those dividends will return to growth in that environment I think there's relevant capital appreciation potential.

Oil

There's a lot to like about Canadian oil. (...but)

Maybe OPEC extends cuts or is near their production limits... maybe the Permian has peaked... maybe the Canadian dollar falls apart. I honestly have no idea... but with a bunch of these companies continuously saying they can make money at $45 oil... I continuously wonder why they aren't putting even more capital to work at $70+

In Q2 we had 10.4B of capex... that was the third most of any quarter since the big oil collapse of Nealy a decade ago. Plus, now their balance sheets are much stronger. Capex is still at roughly half of last cycle. Frankly as a Canadian & someone with significant investments in Alberta, I hope the capital keeps going in. The alternative is basically worse on all fronts.

The problem from a stock perspective is that the volatility of earnings and the depletion type of business isn't necessarily a good long term idea. Now they can grow assets and long term value quickly but that won't always be the case. Investments currently pay back quicker and leave income streams beyond that so it makes sense to invest... and leave the company with more residual value when it no longer makes sense to. This won't remain the case forever because it's a cyclical industry. That's why for energy companies I think one metric that you can't lose sight of is book value. If an oil company trades at 2x book (it's more so asset value than book but...) it might be possible to put a fresh $1B to work and have it be worth $2B. Eventually someone will do that. Whether that's capex from an existing company or a pool of investors putting their dividends to work or a management team with their buyout proceeds... it doesn't matter someone will eventually do it and make a ton of money. Doing it sooner will allow you/your company to make more of the excess profits... doing it later is more likely to miss some excess profits...that's the only difference. Maybe the company can quadruple it's long term value first... maybe more or less is lost to taxes, maybe it takes 1 year, maybe 10... maybe price goes high enough to reduce demand... maybe price is flat... I have no idea but eventually the investment gets made... and at a company level it makes much more sense to do it early.

The stocks are probably a decent hedge for more pain in Canada but too much pain here or globally can backfire in many ways. I like the sector and think there's a lot of profit left to be had in Canadian Oil. I don't think it's as cheap as some nor am I a believer in sustained $100+ oil. But I think the sector is well positioned especially for as long as Saudi wants to give up market share.

Rails

One area of interest for "permanent capital" in Canada might be an investment in one (or both) of our two railroads. Ideally an entry point with a mid teens multiple starts getting quite interesting from a long term perspective. Both rails have been around nearly 100 years and stand a shot of being around for another hundred.

Grocery Stores

Grocery stores are another Canadian oligopoly that's been moreso in the news recently. On one hand I believe they're very stable business and probably have some upside with population and GDP growth longer term. That said, I've continued to be skeptical that the recent pace of growth is realistic. These are very low margin business. That means they do and must pass on price increases quickly. So any nominal price increase that's not their fault results in earnings growth. The hilarious irony of our current government blaming grocery stores for higher food prices is that their very carbon tax has pushed the cost of food higher... and... higher nominal prices mean more profit (although a similar minimal margin). Then the government threatens 'take prices down' (they can't) "or we tax them more." Which could arguably push prices even higher. Before I turn this into a political commentary I'll move on.

The good news is that 'whatever' the factors that pushed food prices this high, globally, food inflation is fading HARD... at least... good news for us, perhaps less for food stores. Supply has responded to higher prices. Part of this feeds in to why I suggest inflation is likely less of a concern than some suggest. Food inflation at 7.8% YoY is roughly 1.2 of the 3.3% add in 0.8 from mortgage interest cost... both of which should quickly roll off should more than offset some rebound in some other components. In fact most other components that went up as quickly as food eventually saw negative YoY numbers. Then figure that if inflation was deemed to be under control, and rates were reduced, that +0.8 could flip to negative too... then new development makes sense and rents don't need to increase anymore... more inflation gone.

Reflexivity. If we believe inflation is gone it will be (with some time). If we keep creating our own inflation it'll stick around. (Higher rates = inflation + need for higher prices = inflation= taxes = higher prices = inflation= rate hikes = inflation.

I got slightly off topic in my attempt to say that food price inflation disappearing will likely mean slower growth for supermarkets. But with reasonable valuations I think the outlook is fine.

Utilities

The utilities and pipelines are another interesting sector. They have been double hot by the rise in interest rates. The highly levered utilities now face a wall of more expensive capital upon maturity. They also face the fact that with higher rates and the availability of yield on GICs, there's less value/demand for high dividend stocks. This is a similar challenge for real estate. Both may now be in a position to reset with a new baseline of assumptions which they can perform against... in other words, if rates peaked and decline, you get the revaluation higher & improved cashflow fundamentals from lower refinancing cost. I think we're somewhere in the repricing. I don't think all of them have fully priced in higher rates persisting but I think most are in the process of slowly assuming that maybe rates will remain a bit higher for a bit longer. I don't think they should fully price in higher rates (that view comes from my personal opinion on rates). The more that they do price in, the more asymmetric the investment. The companies are mostly fine but the appeal of the price of years ago wasn't what investors hoped. There will probably be a stretch of less growth while debt is managed. It's a place where there's probably some time but may be worth picking up some long term holdings over a few years.

REITs

Real estate is in a weird spot. From a price to book/NAV perspective, it's extremely cheap. (There's a rather significant discrepancy between public and private prices.) From a 'I can get a 6% GIC' perspective... less so. 

The two things that matter most are interest rates and NOIs. If rents/incomes keep rising then existing debts can incrementally be retired and long term values can be fine. If occupancy or rent falls then we have a more complicated situation... especially if funding becomes more expensive.

We haven't seen yields like this out of REITs in many years. It is possible that they stay here... or are cut. It's complicated and can't be answered with blanket statements. I suspect with catch up rents and incremental deleveraging, the new set of expectations is probably pretty low. The discount to NAV simply means they are much cheaper then their private/I traded alternatives. They may or may not be extremely cheap... it depends where interest rates settle.

Miners

At the risk of repeating myself, mining is a difficult business. While not apparent in the same way as for REITs and Utilities, miners are similarly worth less in this kind of environment. Inflation = cost inflation too. And interest rates make the capital more expensive.

On the other hand, and this is something I've been mentioning for a while but goes directly against traditional economic thinking... in commodity -like capital heavy industries, capital is your most. It's not a great moat and it will be overcome eventually but it is some moat. This is because you need (Risk free rate +) for the investment to be worth it. The more capital costs, the bigger that number needs to be. Higher rates need higher prices to get the same returns... and higher rates mean even higher still prices are needed to justify taking the same risk.

I want to be clear, I'm not saying higher rates are purely Inflationary... they remove capital availability too (that's deflationary) what they do is make people poorer and life less affordable.

Gold, I don't have a strong view 

Silver is roughly fair value

Copper, I'm bullish on demand longer term but think price is higher now than bulls give it credit for & has two way risk short term. My history has taught me that you really only need to buy these when the metal has been flushed.

Lithium there's very little on the TSX but I'll say. Lithium price was ridiculously too high, it's now decently high. It's demand longer term is pretty obvious but I'm less sure how much that translates into price from here. Most companies can make their projects work with prices at half of current levels, so the odds are pretty good that eventually prices fall by more than 50%. Maybe the stocks make 1000% first, that I don't know.

Exporters

One area that I think has more potential is export companies. In the Oil segment, I mentioned in passing that maybe the CAD falls apart. A weakening currency would be a tailwind to companies that cost in CAD and sell in USD. It's funny actually, the other day, prior to a discussion that got to this point, I saw someone tweet a weird boast. They said they converted a bunch of CAD to USD at 0.65 back in the day but that's good because now they have USD investments that give them USD cashflow. I immediately thought... ok... why not just own Canadian businesses that sell into the US (oil qualifies) if you want protection against a falling CAD. It's hard to find many pure-plays of this as most have diversified operations as well as sales. Still, at present it's a more interesting area because A: you don't have to deal with struggling Canadian clients... B: if the currency sucks more, you're hedged as margins should improve.

That said, I don't know if I've ever gotten a currency related trade right... there's always more to it or expectations than what I imagine and I have no idea how to measure prices or what the market is saying. There's economic strength, rates, trade, inflation and so on already built in and evolving, most of the time I just figure, currencies go up, currencies go down... I'll never know why. Even still, there are times when I appreciate a more global sales exposure & other times when being regional is nice.

'Cheap'

On a price to earning basis... as well as a price to book basis in many places... the Canadian market looks cheap. Or at least, cheap relative to recently or relative to the U.S. That is however, not the be all end all of security analysis (despite what some may say). It's the market's message that current earnings or asset values are in danger. Maybe that's transitory earnings capabilities, margin normalization, pending recession-related losses, maybe end of cycle pricing...etc

This pessimism may or may not be misplaced. I would suggest that, commodity companies and tech stocks shouldn't trade at similar multiples. Asset heavy businesses have growth constraints that other companies don't. Being that capital and balance sheet capacity is often the limiting factor, the risk for such business is often tied closely to marginal changes in the economy. I mention this because Canada has a lot of asset/balance sheet heavy businesses. First and perhaps most relevantly when looking at Canadian stocks... the banks... then oil etc.

I think that a lot of Canada is set to perform well at some point but I think things need to point in the right direction first... or at least stop pointing in the wrong direction. This can be especially annoying because some things are moving in the right direction but sentiment is not and has capped them. There's a lot of torque in the Canadian market's earnings. With bad things happening they can easily fall a lot more that the US and that what central banks keep trying to cause. If we could get past that to an actually good economy like the late 90s or mid 00s the entire picture can flip. What is now '20% discount to book because of losses coming' can become '2x a 40% higher book' the difference there may be 2 or 3 x in earnings multiples (more in some cases) but 300% in stock price. We could be at the start of a decade of outperformance or the start of a multi year brutal underperformance. I think the current expectations are skewed to the pessimist side, but I also think at these rates, our economy is in an awful position in the short term.

Bonds

Bonds are tricky too.

I think short rates need to move lower... but I don't know if they will. (Yes you heard that right)

I don't think the long end needs to go lower... but I can't bet on the front end going lower without thinking the same event would push the long end lower.

I also don't know when or how much because the whole thing isn't a bet of what should happen or what makes sense, it's a bet on the choices of parties that seem completely illogical. 

I don't believe low rates are bad. I think there's a massive "back in my day rates were" bla bla bla ... "those were the good ol' days of 11% unemployment and 10% interest rates when we nuked our own economy because of an exogenous oil shock," out there by people in positions of authority. When you get into logic of how rates actually helped anything be better back then, the arguments fall apart... they turn into "well if nobody could afford it and everyone was struggling then things would be better for everyone." The honesty of the matter is most people should just say "I want to make 5% on my money for taking no risk; because I have money."

The problem is, with today's taxes, costs, demographics etc I don't think the country functions at +3.5% interest rates. I think it leads to very bad things, economically, socially, politically etc. I also think that things are comparatively fine at 2% interest. We could have great growth and prosperity without problematic inflation.

Any prediction needs to be a mix of will and should... so if I were going to make one it would be something like: YoY is probably almost 4 before October data... so they may panic and do one more hikes before realizing in ~March that inflation is falling very quickly and by ~April that they're way too restrictive. Then they start cuts around then... probably (as I mentioned above), once they start cutting there's probably a long way to go. Probably +250bps of cuts over many quarters because they'll stay concerned about a rebound. However, this basically assumes they act like headline chasing trained monkeys. If thought goes in to other data, they could easily move the timeline up 3 months... I mean if they really were concerned with data they could move the timeline up 8 months... but evidence suggests that's unlikely.

Wrap Up

When I talk to people, many seem to think we are in a lose lose situation. For lower rates, they believe we need a recession. A recession has historically meant catastrophe earnings felines/losses by sensitive companies. In other words it is believed that companies need to do poorly in order for the pain & unsustainably higher rates to end. I don't know if that's accurate. It does seem to be what the market is looking at in a few places. I think Canada is buffered by the ability to export to the US... and simultaneously at added risk because of Currency on imports. Buffered by population growth and at risk because that masks the true pain some are experiencing. This might mean no recession or a very mild one... or cause the BoC to go massively overboard and do severe damage. I do think that there is a tremendous amount of pent up demand in some of our more rate vulnerable areas. The incremental relief at some point could do wonders.

Everything is to a large degree... interest rates. So far that has been a running shock. In some ways the economy handled it well, in others we've handled them terribly. Led by our debt and mortgage resets I think that rates are already too high for much of the country. I've given up on believing that what should happen will or that there's consideration of factors beyond headline inflation. There was plenty to suggest that we should have stopped before 4%... it seemed insane to resume after the pause at 4.5... they did. So yes, I think we've gone far further than necessary. If food reverted to global averages and we excluded Mortgage Interest Costs we'd have BELOW target inflation... I digress. Other parts of the country/economy are completely survivable and doing fine. The yield curve also matters, what discount rate is used? 5% or 3.5%. The higher a number you can make work, the better the odds of success. 

That said, if you're asking my opinion of what eventually happens. 

Let's look at it this way. The people who currently own the 10 year bond at 3.65% probably think that short end rates are going lower (if not they'd roll short treasuries). When that happens they believe that long rates will go lower and long bonds will become more valuable. In other words, they expect long rates to drop and short rates to drop to an even lower level than that lower long end level. So a 3.65 10 year is probably a suggestion that the short end may go to 1-1.5% and the long end would be 2-2.75% or something. This is basically what bulls of the 10 year are thinking. If that happens, real estate and other supply can react, affordability can improve and the economy can function properly. The one thing preventing us from getting there is patience (inflation). I say patience because, there are no signs of a wage price spiral, the economy is incredibly clearly not overheating... so what we need is time for the volatile/incentive prices to roll off and stability to return to the supply side. You know, it's ironic that central banks claim they want to achieve price stability yet their actions are essentially trying to crash some prices thereby creating volatility.

We're clearly not overheating... we may be stagflating but I think at some unknow point the Bank of Canada will regain sense and stop intentionally hurting the economy. On a lag from that point there are a lot of companies out there that to varying degrees are pricing in the pessimism that I spoke about. I don't know exactly when the point of peak pessimism will be but keep trying to look beyond that at the 'next cycle' and think we're starting to see some interesting longer term prices.

Canada may not be in a great place right now... but you really can't find many people that think it's doing too well... and it shows.