Verdmont Capital

Thursday, March 19, 2015

Energy Infrastructure Plays - KMI:$41.52, EMLP:$26.83 - Strong Tailwinds and Hefty Dividends

Keep an eye on the oil storage companies. The following article outlines some of the significant tailwinds underpinning the space.

Have a look at Kinder Morgan (KMI:$41.52, The stock has had a decent run as the energy infrastructure trade is certainly no secret. That said, there could be more gas in the tank. Haha. If KMI goes to new highs, it in all-likelihood will represent the start of another decent leg higher.

KMI – 1 Year
Source: Verdmont Capital, S.A., Bloomberg

There are some massive shifts going on in the oil and gas sector and these changes still remain under appreciated in our opinion. Storage and transportation related companies should enjoy a favorable operating environment into the foreseeable future. These companies also typically have a decent dividend yield given their relatively stable business models.  For example, KMI has a dividend yield of 4.3%. Not too shabby when one considers that you are only getting paid 1.9% to lend your money to the US Government for 10 years.

If you want a more diversified play on the space, you can buy the Frist Trust North American Energy Infrastructure ETF (EMLP:$26.83). EMLP is a diversified basket of oil infrastructure companies and has a solid 3.3% dividend yield as well.      

EMLP – 1 Year
Source: Verdmont Capital, S.A., Bloomberg
The energy infrastructure sector is a relatively conservative play within the oil and gas complex. You will not get a massive pop in these names if oil enjoys a notable rally. You should however, be able to ride out the storm in these names and get paid a decent dividend yield while you wait.

Please call your Verdmont Representative to discuss these names and our current view on the market.

Wednesday, March 18, 2015

Brazil - Mismanagement and Corruption Coming Home to Roost - EWZ:$30.61

Here is a good interview on the current state of the Brazilian economy and a brief background on what has gone wrong.

It is worth keeping an eye on the country as it is a great example of how corruption and poor management can scuttle an emerging market economy. The state of affairs in Brazil also highlights how unstable some emerging market economies are at the present time and how disastrous a sustained rise in global interest rates would prove to be.

Emerging market economies next to always run into severe problems after enjoying some sort of financial boom. In Brazil’s case, they benefited from elevated commodity prices and low interest rates as the fixed income market stretched for yield. Low borrowing costs and strong commodity prices masked what has been complete and utter mismanagement and enabled those with their hands on the controls to dip into the collective cookie jar.  

These booms tend to unwind violently as the imbalances they create begin to expose the hollowness of the underlying economy. You are then left with massive debt loads, a falling currency, rising inflation, rising interest rates, economic uncertainty, political instability and a disillusioned populace. Unfortunately, it is always the average Joe, or in this case Pedro, that ends up holding the bag.  Wash, cycle, repeat.

Brazil is a the tail end of the cycle and the walls are closing in on it. All of the late cycle factors mentioned above make it more difficult for the country to rollover and service its debt. The cost of debt, especially in foreign currency terms, translates into skyrocketing borrowing costs. As borrowing costs rise, the economy itself is cooling considerably. This serves to  place additional pressure on the Country’s balance sheet.

Brazil is struggling even though global interest rates remain close to all-time lows. One can only imagine what will happen if the US dollar continues to rise and US policy makers make good on their promise to gradually raise rates. Keep an eye on Brazil, because we believe it is a microcosm of the emerging market trade and what we believe are some massive pressures building in the system.

We are watching the real, credit default swaps and 10 year yields for a glimpse into what direction Brazil is heading. As of right now, things are not looking good.

Brazilian Real – 5 Years

Brazil – 5yr Credit Default Swaps

Brazilian Government 10yr Yields – 5 Years  

We hope for  Pedro’s sake they turn things around quickly as Brazil is such a great country and the people very welcoming. When we see glimmers of hope, we will buy (EWZ:$30.69), which is the iShares MSCI Brazil Equity Fund.

iShares Brazil Equity Fund – 5 Years

Unfortunately for Pedro, it appears as if we have plenty of time to wait it out.

Tuesday, March 17, 2015

Got Water?

There has been a lot of chatter regarding the droughts in California. Officials there continue to place water usage restrictions to battle a shortage of water. This highlights the themes underpinning what many believe is a pending global water shortage. The following article outlines what ETFs are available to play the water market. .

This segment is unique, in that really isn't a true play on “water” per se. You can’t buy it like you would a mining asset or a commodity on the futures market. Most of the names in this sector are industrial or service related companies. That said, the water theme continues to be underpinned by what appear to be solid secular themes, so the entire segment is attractive for long term investors.

Water related stocks have had a sustained long term rally, like everything else. So, finding oversold segments of the equity market is a dicey task at present. That said, you have to play the cards you are dealt, and attempt to scrape out some additional gains where you can.

Looking at some of the more popular water linked ETFS, like the First Trust ISE Water Index Fund (FIW:$31.39), you can see that they have trailed the broad market over the past year. Global stocks have gone to new highs, whereas FIW has been sucking wind.

FIW vs. MSCI World Index – 2 Years
Source: Verdmont Capital, S.A., Bloomberg

Like most segments of the market at present, water plays don’t jump out at us as a screaming buy. They do however represent an attractive theme, that has been underperforming as of late. Typically, when sectors with strong tailwinds underperform the broad market, there is an opportunity there.

Given that we are relatively cautious, we would only buy FIW if it breaks out of its current trading range. This would indicate that this segment of the market is due to go to new highs, in concert with the overall equity market. If FIW fails to hold its trend of higher-lows, we may have to wait to gain exposure to the water sector.

FIW – 2 Years
Source: Verdmont Capital, S.A., Bloomberg

Friday, March 13, 2015

Our Royal Bank Short - Game On

We bought more put options on RY.T this week. 

Subsequent to our original short thesis on RY.T, we have had a surprise earnings beat, a rate cut from the BOC and a relatively stable oil price. RY.T should have gone much higher. 

Although we have yet to be proven right on this, we should be, and have used recent strength to add to our position. That was the plan.

We admit it is a balsy call, because the easy one to make is that RY.T “always goes up.” Which has been accurate, but highlights how the Bank is over loved and over owned.

RY.T – 30 Years

We think the Bank is in a tough spot. A very tough one. Commodity markets are getting smoked, the Canadian consumer is tapped out, aggregate wealth has been pinched by the resource stock selloff and housing values are insane.

These pressures may take some time to reverberate through the Canadian economy. In our opinion, it is only a matter of time before they do - game on.

We will be wrong if RY.T breaks through the $78/sh range, highlighted by the red line below. We will be very wrong, if the stock goes to new highs.

RY.T – 1 Year

Friday, February 27, 2015

Gold Stock Performance / Resource Royalty Companies / First Mining Finance - A Great Team, Novel Approach at an Opportune Time

Gold Stock Performance

It is no secret that investors in the small cap metals and mining sector have had an extremely rough time. The underperformance has been shockingly bad, on both an absolute basis and relative to pretty much any comparable that you can imagine.

Looking specifically at the performance of precious metal stocks serves to underscore this point. Note how both large and small cap gold stocks are down over the past 10 years. They have also underperformed gold bullion by a wide margin.

Gold Bullion, LC Gold Stocks, SC Gold Stocks – 10 Years (normalized) 
Source: Verdmont Capital S.A., Bloomberg

Said differently, companies operating in the gold sector have destroyed capital, as opposed to generating wealth on behalf of their shareholders. There are of course a whole slew of reasons given as to why this is the case, and if you are attending PDAC this year in Toronto, you will no doubt hear them expounded upon at great length.

Resource Royalty Companies

There has been one segment of the precious metals equity market that has worked. Those companies employing a royalty model have done extremely well over the past cycle, and continue to do so, even during recent weakness in the precious metals complex. A good description as to how a royalty company works, along with the inherent benefits of the business model, can be found at Royal Gold’s website

Looking at the performance of two of the better known royalty companies, Franco Nevada (FNV.T:66.29) and Royal Gold (RGL.T:90.26), it becomes clear that something is working and that something is working quite well. Note how these names have outperformed gold bullion and have substantially outperformed their traditional gold mining counterparts. 

Gold Bullion, LC Gold Stocks, Franco Nevada and Royal Gold – 10 Years (normalized)
Source: Verdmont Capital S.A., Bloomberg

There are many qualities embedded in the royalty model that lend themselves well to the current mining environment. The following link to a past interview with John Doody, who we have had discussions with through the years, sums up these advantages quite nicely

In our opinion, the most important and differentiating feature of a royalty company is that they are focused entirely on generating near term cash flow for their shareholders. They take an interest in a diverse set of projects, at what are typically very favorable terms, and are rewarded by reoccurring revenues without taking on the majority of risks associated with the traditional mining model. It is a very novel approach and it has proven to be quite profitable when executed properly.

This brings us to our discussion on First Mining Finance (FMF).

First Mining Finance (FMF)

First Mining Finance (FMF) is a private Canadian company looking to go public in March of this year. The company’s mission is to take advantage of what are deemed as depressed valuations for precious and base metal mining assets. Management aims to acquire a diverse suite of mining projects at a fraction of their intrinsic value and “bank” them until valuations in the sector normalize. The company’s goal is to spend a minimal amount of capital advancing the acquired projects for the purpose of re-sale, JV, royalty structures or a combination of different revenue models. First Mining Finance currently has an interest in over 18 projects at various stages of development and several projects in the evaluation stage.

Now, first and foremost, we want to point out that FMF is a different animal than the well-established resource royalties companies listed above. It is still early days for FMF and its risk profile is relatively significant as a result. Anyone reading this piece needs to be keenly aware of that.

We highlighted what has been chronic gold stock underperformance, and the relative rigidity of the resource royalty model, to underscore two points as it pertains to the First Mining Finance story.

Firstly, investors in the mining space, particularly the junior mining sector, are exhausted from hearing the same stale stories being told by mining executives and the litany of promises that have yet to come to fruition. At the present time, there is next to no investment interest in early stage mining stocks given poor company performance and the associated crushing of capital. This creates an opportunity as there is a dearth of funds in the sector and junior mining companies are fighting to stay alive. This has translated into very cheap valuations for early stage mining assets and it has also created the need for a novel approach to what is currently an industry on the ropes.

Secondly, we discussed the performance of the royalty companies, because it illustrates that not all is broken in the sector. There is still a strong appetite for those companies that focus solely on generating tangible returns for their shareholders. The royalty model, although not a direct link to FMF’s approach, is driven largely by the same underlying goals and industry themes. Management aims to take an interest in various projects at depressed levels and monetize these assets over time by investing a minimal amount of capital. The sole driver of the capital allocation decision is to maximize the near term return for the underlying shareholders. Said simply, management wants to spend the least amount of capital possible, get the company’s money back as quickly as they can and receive the greatest payment in doing so.

Please have a read of the First Mining Finance company presentation for an overview of the organisation. It provides an introduction to the management team, the company’s objective, the current corporate structure and the assets that FMF presently has an interest in. As with any investment, please make your own opinions about the merits of investing in FMF. If you have an interest in learning more about the company, we welcome you to give us a call for a more thorough discussion.

From our standpoint, there are many standout elements to the FMF story. We believe that the company is positioning itself to take advantage of some of the key themes we are seeing in the junior metals and mining space. There is no question that the metals complex is seeing a heightened degree of volatility and FMF’s approach is well suited to capitalize on this uncertainty. Some of the highlights as we see them:

  • FMF’s goal is to take advantage of depressed valuations and asset values in the mining space. As companies cut back on capital expenditures and exploration budgets, it presents an opportunity to acquire assets at very cheap prices. 
  • The company will act as a “mineral bank,” acquiring early stage gold and base metal assets that are currently priced at 20 year lows. They will spend a minimal amount of money on these projects, essentially warehousing them, for when the market turns and capital returns to the sector. 
  • The FMF model is quite unique and is arguably a quasi-private equity or mutual fund type of investment. Shareholders are paying management to acquire a suite of quality mining projects on their behalf. Via a position in FMF, shareholders will be investing in numerous precious and base metal assets in a multitude of countries. This differs from traditional mining exploration and development companies, which are typically focused on a single property/project in one given region.
  • The company's aims to have an interest in numerous projects that will be diversified by commodity, region, mine type and revenue stream. We believe that this diversified model reduces the company's risk profile in relation to a traditional junior mining company.
  • FMF will be focused on the preservation of cash, which further differentiates its business model from a typical junior mining stock. The customary approach of a small cap mining company is to spend a tremendous amount of capital on an exploration and development program. FMF’s treasury will be utilized primarily to evaluate the potential of early stage assets and pay for the subsequent costs associated with holding onto them for when the market turns. 
  • The company hopes to monetize its assets via various revenue models in the future. As mentioned above, we particularly like the potential for them to employ a royalty approach, as company’s utilizing this novel structure did extremely well over the past decade. When the cycle does turn for the better, we believe that investors will go to those names and segments of the market that have worked, and the mining finance space is one of those areas. 
  • The management team, outlined in the presentation, truly is a top-tier group. Management is comprised of mining professionals that have a longstanding track record of success. The guy leading the charge is Keith Neumeyer, who was the founder of First Quantum Minerals and First Majestic Silver. Both of these companies are tremendous success stories and very well-known in mining circles. Along with Keith, the management team has a proven ability to evaluate and acquire attractive early stage mining assets. 
  • FMF management will have a considerable position in the company, which creates a desirable alignment of interests. In addition to management, First Majestic Silver owns 32% of the shares outstanding and Sprott Asset Management owns 4%. We believe this is a strong shareholder base and lends confidence to the story. 
  • The company currently has an interest in 18 projects and upwards of 60 early stage mining assets on its radar, meaning that FMF is already advancing its business plan. 
  • FMF should get considerable attention in the market as it moves forward. As mentioned, management is very well-known, they have a truly unique approach and are supported by a strong shareholder base. There should be a healthy amount of news flow when the company begins trading and starts to acquire various assets. 
All in all, we believe that FMF has a novel business model that is very well suited to capitalize on the prevailing weakness we are witnessing in the metals and mining sector. Management has the ability to source attractive assets and the experience required to monetize them if and when the mining cycle turns for the better. We are confident that the FMF team will stick to its goal of preserving capital and will allocate funds only when it is in the best interests of the underlying shareholders. This approach greatly differentiates FMF from the majority of mining companies that we follow.

For those looking to invest in FMF before or after it begins trading, it is extremely important to know that it is a high risk investment. An investment in a private company of this nature is only applicable for accredited investors and those willing to should shoulder a significant degree of risk. As with anything, please conduct your own due diligence before making an investment decision (i.e. commonsense). Below are some of the specific risk factors and considerations as we see them.

  • The substantial risks associated with private equity investment and junior natural resource companies apply. 
  • The key milestones discussed above or outlined in the corporate presentation may not be met. 
  • The company is a private company and the pending RTO agreement may not be completed. 
  • The highlights of investing in the company mentioned above and in the presentation are based on many assumptions and there is no guarantee that they will occur. 
  • It could take a considerable amount of time before the metals and mining sector stabilizes - if at all. 
  • There is considerable key person risk in this story given Keith Neumeyer’s importance to the company. 
  • There is a significant degree of finance risk. If the company fails to raise a desirable amount of capital, it would severely hamper the company’s ability to execute its business plan.

Friday, February 20, 2015

Deere & Co (DE:$91.14) - Stalking the Deere

Deere (DE:$91.14) is setting up to be a nice trade in our opinion.

Deere has been trading sideways over the past three years, whereas the broad market has been on a tear.

Deere vs. the S&P 500 – 3 Years (normalized)
Source: Verdmont Capital, S.A., Bloomberg

Deere has been bogged down with the rest of the “commodity trade”, as agricultural commodity prices have corrected substantially.

Corn, Wheat and Soybeans – 3 Years
Source: Verdmont Capital, S.A., Bloomberg

We believe that agricultural commodities should fare relatively well moving forward, and unlike some of the other segments of the commodity market, we have a reasonable degree of confidence in the current bottoming process. If the grains continue to stabilize, it should remove a large chunk of uncertainty associated with owning Deere at current levels.  

Note how grain prices have corrected substantially and are down an average of -50% peak-to-trough. In the crash of 2008, the grains fell by a similar degree, which ultimately lead to a sustained rally in DE.  You will also recognize that grain prices are bouncing off of well-established floors, which held during the acute stages of the credit crisis.

Deere, Wheat, Corn and Soybeans – 10 Years
Source: Verdmont Capital, S.A., Bloomberg

It is worth highlighting that a correction in agricultural commodities in the area of -50% is historically significant. Looking back 35 years, a sizeable peak-to-trough correction would typical be in the range of -30%. Note how Deere has a tendency to rally after the grains take a hit of that magnitude.

Deere vs. Wheat – 35 Years
Source: Verdmont Capital, S.A., Bloomberg

The above analysis alone would not be enough for us to pull the trigger on DE. We would need some indication that sentiment is beginning to turn, or that the company is beginning to outpace battered expectations. Which we happened to get today.

Deere announced Q1 2015 earnings this morning and lowered guidance for 2015 as farmers have been buying less equipment. Despite the dampened guidance provided to the market, DE is actually up on the day. In the past, we have often found that when a stock rallies on bad news, it is indicative of a stock that wants to go higher.

Looking at analyst recommendations on DE, you get a better sense of why the stock is up today on bad news. Currently, only 40% of analysts have a “buy” rating on the company. This is very low percentage for a multibillion dollar company in the US. Note how this percentage is also the lowest it has been in the past 15 years (green bars below). We believe that these depressed analyst ratings signify that sentiment towards Deere is quite depressed.

Deere vs. Aggregate Analyst Ratings (%) – 15 Years
Source: Verdmont Capital, S.A., Bloomberg

Lastly, we want to point out that Deere’s valuation is also very compelling. The company’s trailing P/E ratio is at the bottom of its historical range and the stock’s multiple relative to the broad market is also ankle-high.

Trailing P/E ratio and Relative P/E to the S&P 500 – 10 Years
Source: Verdmont Capital, S.A., Bloomberg

We believe that Deere is due to play catch up with the broad equity market. Deere is a quality company that is out of favor at the moment. Look for the stock to follow the equity market higher as negative sentiment unwinds and agricultural commodity prices continue to stabilize.

Although you should be more than comfortable with owning DE over the long term, we are looking to trade DE in here. From a trading standpoint, we would look to buy DE if it breaks to new highs (white line below). This would be confirmation that our above outlined thesis is on the mark. Given DE’s severe underperformance relative to the broad market as of late, we believe this trade could be quite profitable if it plays out as hoped.

Deere – 5 Years
Source: Verdmont Capital, S.A., Bloomberg

Please call your Verdmont representative to discuss this trade idea in greater detail.

Friday, February 13, 2015

Oil Comments : Closed Positions in BNK.T, PD.T, PWT.T : Oil ETFs to Play Oil Strength

We have had numerous queries about what our preferred stocks are to play an oil bounce.

The discussion as to whether or not the oil complex has found a bottom is a lengthy one. We will look to tackle that topic at a later date in a more formal note.

From a trading standpoint, we have been in and out of various oil names. In fairness, our attempt to play oil stocks on the long side over the past few months has resulted in a “C grade” at best.  We were wrong on WTI oil finding a floor in the $65/bbl. range, but we managed to get back into the black this year as it jumped from ~$45/bbl. to current levels of ~$53/bbl.

WTI Oil – 1 Year

We played the bounce via positions in Bankers Petroleum (BNK.T:$3.51), Penn West Petroleum (PWT.T:$3.07) and Precision Drilling (PD.T:$7.52). We made a decent profit on these stocks as they had a nice rally off of their multi-year lows.

BNK.T, PWT.T, PD.T – YTD 2015

We have gone flat in these names because they were losing momentum, even though there has been an increasing degree of confidence that oil could hold in the $50/bbl. range. You can see that WTI oil has been making higher lows at these levels.

WTI Oil – 6 Months

There have been some positive developments that could propel oil higher over the short term. Sentiment towards the space is very sour, the US dollar is beginning to look toppy, and risk assets in general have been doing better in conjunction with easing concerns about Greece exiting the euro.

If you are itching to have a position in the oil complex, there are some good ETFs for you to express that view. An ETF makes sense in this situation, because you are making a broad call on oil. It would sting to be correct on the physical commodity, but get your stock selection wrong. A diversified position via an ETF would limit the risk of this taking place.

There are some good junior oil and gas ETFs out there if you are looking for enhanced leverage to oil. We like the BMO Junior Oil Index ETF (ZJO.T:$18.89), which replicates the Dow Jones North America Select Junior Oil Index. This segment of the energy market has been particularly punished as of late. We would recommend a stop in the $18/share range. If ZJO.T fails to hold the $18/level, it would be representative of a false breakout in our opinion.

ZJO.T – 1 Year

If you are employing a longer term view, we recommend the Market Vectors Oil Service ETF (OIH:$35.29).  We have been buying this ETF for our wealth management clients under the assumption that oil prices will be higher in 12 months. OIH is a relatively conservative vehicle because it is comprised of well-capitalized large cap companies. These stocks are well suited to ride out any short term weakness if the oil recovery takes longer than expected.

OIH – 1 Year

Please call your Verdmont representative if you have any questions about these ETFs. We are always available to discuss our current house view on the oil and gas market and commodities in general.