Verdmont Capital

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 http://www.royalgold.com/business-model/overview/default.aspx.

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 http://stansberryresearch.com/investor-education/royalty-companies-safe-returns/.

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.

Friday, February 6, 2015

Oil Volatility / Oil Futures Curve / Oil Stocks we have Bought

Man, it has been a crazy ride for oil speculators. Look at the volatility over the past few days. If you are a finance minister at one of the oil  dependent countries, you must be having a few stiff drinks in the evening to calm your nerves.

WTI Oil,  Daily % Change – 7 Days

If you are looking to play physical commodities with ETFs and ETNs, you always need to be mindful of the futures curve.

All these ETFs and ETNs do, is sell their futures positions before they expire and then buy them further out on the curve.  The price difference between near dated prices and prices further out on the curve is an automatic hit to the ETF/ETN if the futures curve is in contango.  The futures curve for the oil market is currently in steep contango, meaning that future prices are far more expensive than near.

If you are locked into selling lower and buying higher, you will find out pretty quickly that it is not a winning strategy. You can see that oil ETFS/ETNS are fraught with oil yield risk at the moment. Have a look at the WTI Oil curve below. Do to the curves steep contango, you are getting pinched as these ETFs/ETNs rebalance before there futures contracts expire.

Consider yourself warned!

WTI Oil Futures Curve – Feb 6, 2015

Please give us a shout if you want a better option on how to position yourself for an oil bounce and/or a stabilization of price volatility.

Last Friday, when Oil made a $3/bbl. move, we bought a handful of super beat up oil stocks. The trade has done well thus far, but we have to admit, we have been blessed with a bit of luck.

Our though process at the time was that a $3/bbl. move higher was a key reversal day after weeks of super negative sentiment. There were far too many articles out there discussing “how far is oil going to fall?”

The oil sector is an area you want to own at some point. Demand is inelastic and the elevated cost curve on the supply side is still completely relevant. The recent collapse is a buying opportunity in our opinion, not indicative of a bubble bursting or a paradigm shift in the market.

So, we are trading around, trying to catch a floor. We are maintaining tight stops to protect our capital in an effort to keep some cash on hand for the next attempt if this one proves futile. If WTI oil holds $50/bbl. over the next few days, we will be more comfortable with the positions we have on and may even boost them if we see sentiment turning substantially.  Right now, the oil trade is still a risky proposition.

As a group, we are comfortable shouldering this risk with our speculative capital.  Last week we bought Precision Drilling (PD.T:$7.17), Penn West Petroleum (PWT:$2.76) and Bankers Petroleum (BNK.T:3.18) for the oil bounce. So far so good, but it could end in tears. So, we are employing tight stops.

Friday, January 30, 2015

Aptose Biosciences Inc. (APS.T:$6.16) - Great Company, Bad Stock - For Now

Our investment in Aptose Biosciences (APS.T:$6.16) has been a huge disappointment thus far.

We began buying Aptose Biosciences in the second half of 2014. The company jumped out at us given its novel clinical stage drug, excellent management team and a slew of near term catalysts that were due to bring more attention to what we viewed as an underappreciated/misunderstood stock. 

The small cap biotech sector had been on a tear and APS.T appeared to be well positioned to enjoy a heightened degree of interest in the sector.

MSCI AC World Biotechnology Small Cap Index – 3 Years
Source: Verdmont Capital S.A., Bloomberg

Our position in APS.T has been a bummer thus far  – to say the least. Although the small cap biotech sector has had a sizeable run, APS.T has been going the other way. In simple terms, we have been dead wrong with our APS.T call. Looking at the below graph, we find ourselves saying  “ouch” under our breath.  

Aptose Biosciences vs. Small Cap Biotechnology Stocks – 1 Year
Source: Verdmont Capital S.A., Bloomberg

Unlike other stocks that have gone the wrong way on us, this one stings a tad more. To start with, the biotech sector has done exactly what we were hoping it would do. Furthermore, at the company level, all of the events we were banking on have taken place. The company has successfully listed on the Nasdaq, they began dosing patients in their 1b clinical study of APTO-253, management has been aggressively spreading the story in the US and the company has enjoyed a significant boost in analyst coverage. When we first looked at the APS.T, there were only 1 or 2 analysts following the stock and there are now 5. Note how analysts have an average price target north of $20/share.

APS.T – Analyst Recommendations and Target Prices
Source: Verdmont Capital S.A., Bloomberg

These target price assumptions are very aggressive. Although we are typically leery of analyst recommendations, in this case, we believe they provide some comfort to our view that we haven’t missed anything fundamental with the company.

With biotech companies, the research is largely bottom up, meaning they are not tied to bullish calls on a slew of unpredictable macro variables. Furthermore, most of the above mentioned analysts represent fresh eyes on the story. This means they are not rationalizing former bullish calls based on prior financings. Further to this, the company has more than enough money to fund their current operations, so these generous price targets are not necessarily an effort by investment bankers to position themselves ahead of a pending raise (yes, this still happens).

So, what are we missing?

One of the main drivers behind the sell off from what we can ascertain has been the misfortunes of Pinetree Capital (www.pinetreecapital.com). Pinetree holds roughly 900k shares of APS.T, which represents about 8% of the outstanding shares.

Pinetree is currently restructuring as a result of breaching its debt covenants, which had a debt/assets limit of 30%. There has been a management shakeup at the top level and the creditors have formed an oversight committee to try and scrape back some of the money that they are owed.

When these investment companies hit the skids, the sharks start circling in short order. They know that there are bound to be fire sales as creditors and the remaining management team begin dumping positions to raise cash. Speculators have gone after APS.T, and with a thinly traded stock, it can move lower relatively quickly.

You can see that the selloff in APS.T commenced on November 10, 2014, which is the same day that Pinetree announced that they had violated their convertible debt covenants. We don’t think that this was a fluke and this event has destroyed all of the momentum we had been enjoying in the name.

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

In addition to real-time selling, Pinetree’s issues place ongoing pressure on APS.T due to the uncertainty associated with what the oversight committee will choose to do with their position moving forward. When  you have an overhang of close to 900k shares, in a stock that has a daily average trading volume in the area of 10k shares, it represents a significant amount of selling pressure the market needs to chew through.

The oversight committee has its hands full as it tries to claw back its money. Looking at the most recent breakdown of Pinetree’s holdings, you can see that the company’s natural resource related positions have been decimated. The only bright spot has been their allocation to “technology and other”, which APS.T would logically fit into.

PNP.T – Holdings Breakdown, September 30, 2014

The junior natural resource sector is on its knees. Speculators, particularly in Canada, have been wiped out by their positions in small cap commodity plays. The one saving grace had been the oil sector, which we all know has now taken it on the chin. With commodity prices remaining shaky, and a lack of fresh money to be deployed to space, it could be some time before a bid comes back to this segment of  the market.

This means that Pinetree’s non-resource related positions are on the chopping block, as they have been a rare bright spot in the company’s portfolio of assets. Although APS.T has been under pressure as of late, you can see it has still done amazingly well from Pinetree’s perspective.

APS.T, PNP.T, S&P/TSX Venture – 3 Years (Normalized)
Source: Verdmont Capital S.A., Bloomberg

So, unfortunately, APS.T will be under pressure until Pinetree sorts out its issues. It is very tough to tell if the stock has already discounted this pressure or not. Given that the company still owns close to 900k shares based on recent filings, common sense would suggest we are not out of the woods yet.

As APS.T shareholders, we hope that Pinetree’s oversight committee arranges a block sale of their APS.T position. As with all these liquidity events, they begin with an inflated degree of optimism about the value of the underlying assets. Those brought on to help organize liquidity, often employ the view that they will “sell the crap” and hang onto the “good stuff.” More often than not however, there is no liquidity for the garbage (that is why it is garbage) and the restructuring committees have their hands forced to let go of the winners. Time works against them in these situations.

Selling a block of APS.T works for both the shareholders and the creditors in our opinion. As shareholders, a huge uncertainty is lifted given that the share overhang is gone. From the creditor’s standpoint, if they get greedy with the APS.T position, it will go nowhere. Arguably, it will fall further and they will have to trade a block at a lower price anyway. Hanging onto the stock will only serve to kill any momentum that the company can muster at this critical stage of development.

As we have learned with a bad trade, as the creditors have made, it is best to get flat immediately. You have already miscalculated the value of Pinetree’s assets when you made the loan. Why compound this mistake by trying to be cute on the margin? Take the money, realize the bad trade and move on.

In light of the above comments, we believe that APS.T remains a great company. We have a situation where a great company is being bogged down by a sloppy stock. The company continues to deliver as we had hoped, yet extraneous stock related issues have worked against them in a bad way. These are typically the times you look to buy as an investor. Over time, the stock related issues work themselves out and you end up acquiring a sound company at depressed levels.

We will be looking to add to our APS.T position when there is evidence that the market has discounted the Pinetree related selling pressure.

Monday, January 19, 2015

Verdmont Capital : Weekly Stories of Interest - Week Ended Jan 18, 2015



EQUITIES

Notable Stories for the Week:

- The Swiss National Bank is different from most central banks in one critical way.

- China stocks plunge amid regulator crackdown on margins.

-European stocks rise third day amid expectations of ECB stimulus.

-Bank losses from Swiss currency surprise seen mounting.


FIXED INCOME

Notable Stories for the Week:

-Wrong on oil, wrong on CAD, wrong on forecasts and concerned about a weak Canadian economy. I guess the currency analysts don't talk to the bank analysts.                               

-Bond outperformance has been shocking. No one would have envisioned 10 year yields falling below 2% again this year. A year ago, there was a lot of optimism that the 10 year would breach 3% as yields have been due to normalize for some time. Economic data in the US has been "strong", but you wouldn't think so looking at the long end of the curve. The bond market is pointing to additional economic weakness. The equity market is telling us the opposite. Who is right? The bond market tends to be a better predictor over time. We shall see.              

-An article highlighting the pressures on the euro. There are significant structural problems plaguing the Eurozone. They will in all likelihood continue to follow their path of quantitative easing. Remember, this was a huge shock to the system as the ECB had been completely against QE measures up until the second half of last year. This was a drastic change of course, which has translated into a swift correction in the euro. Where it lands is largely like trying to time the oil selloff.                                                        


ENERGY

Notable Stories for the Week:

-The oil crash has provided a once-in-a-generation opportunity.

-OPEC’s future seen in mining slump as oil price pummeled.

-Saudis kept oil exports at 7-month high as OPEC met.

             
PRECIOUS METALS

Notable Stories for the Week:

-Gold trades above platinum as bullion ETPs gain on haven demand.

-Gold regains premium to platinum as Swiss move rattles investors.

-Gold futures ease back from four-month high.


BASE METALS

Notable Stories for the Week:

-There goes copper... lends credibility to the case that the oil selloff is largely forecasting slower economic growth and driven by strong USD... not just over supply. Remember, the market is currently forecast to be oversupplied by as little as 1.52Mil barrels per day. In the past, over supply has been much greater than this and you didn't see a 55% correction in prices. All part of a massive commodity unwinds. The collapse in oil also lowers the cost floor for many commodities. This is why oil leads the complex.                                     

-Nickel falls as surplus persists for fifth month; copper slips.

-Aluminum, copper fall along with oil ahead of China data.


AGRICULTURE

Notable Stories for the Week:

- Hedge-fund bulls retreat from soy as silos fill up: commodities.

-Russia says wheat exports were 16.9M tons this season by Jan. 14.

-Rising palm output seen suppressing prices with crude slump.



OTHER TOPICS OF INTEREST

-Too bad this chick didn't make it. She had balls!              

-Oxfam claims the richest 1% will own more than half the world's wealth by next year.

- This table shows the terrifying scale of the emerging market credit boom.

-U.S. envoy heads to Cuba for first time since Carter amid reset.


Thursday, January 15, 2015

THE ROYAL BANK OF CANADA IS A SHORT (RY.T : C$75.20)

The Canadian banks face significant headwinds moving forward. Our top name to short is the Royal Bank of Canada.

Canadians love the Royal Bank. Coming out with a short call on RY.T is akin to saying Wayne Gretzky is an ankle bender – you just don't do that up North. Like the Great One however, no one organization or individual is invincible, we can all get caught with our head down and pay the price https://www.youtube.com/watch?v=EahfnX8LGUU

The Royal Bank is over loved, over owned and its stock continues to trade close to all time highs. We do not believe that the Bank's current operating environment justifies its lofty share price.

The market is beginning to sniff out weakness in RY.T. The stock is breaking down after having a monster run over the past 15 years. The Bank has done especially well given the relative robustness of the Canadian banking sector, strong commodity markets, low short term interest rates, a strong dividend, a surge in Canadian housing values and a Canadian consumer more than willing to mortgage away their future. The dynamics supporting these factors are unwinding and we do not see a clear catalyst or relief valve for the Canadian banks.

RY.T – 15 Years
Source: Verdmont Capital S.A., Bloomberg

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

Making a call on Royal Bank is a massive endeavor. There are so many moving parts with the company. Not only are you looking at company specific fundamentals, you have to factor in interest rates, currencies, the yield curve, commodity prices, the Canadian housing market, consumer behavior, the US economy and so on and so on. This makes it next to impossible to have an expert opinion on each variable driving the Bank. We would argue however, that the inherent opacity of evaluating the state of the Bank creates an opportunity at the present time. Too many analysts and investment managers spend their time discussing the trees, when really they should step back and evaluate the state of the forest.

Looking at the forest, things are not good. Commodity prices are collapsing, global economic growth is lackluster, interest rates are falling, the yield curve is flattening, the loonie is getting smoked, the housing market is overstretched, the Canadian consumer has more debt than the Americans did pre-2008 and analysts have insanely lofty expectations regarding the company's prospects. 

Against this backdrop, RY.T continues to trade close to all-time highs. We may be missing something with our call, but given where the stock is trading, we can afford to be wrong on a number of small variables and still get the short call right. RY.T is in a tough spot.

KEY MACRO HEADWINDS

Commodities

Oil is collapsing - NO ONE EXPECTED THIS. We have read many analyst reports indicating that this will not have a large impact on RY.T's operating environment. We believe this is counterintuitive. The reverse argument was made on many occasions over the past few years - that the Canadian banks should fare well relative to their global counterparts given their exposure to natural resources. You cannot have it both ways. 

Oil specifically was expected to remain elevated for many years, given its cost curve and the assumption that global supply was scarce. The relationship between RY.T's share price and the price of oil is highly correlated. Many are explaining this away at the present time, but that is always the case when a large unexpected shock occurs – the numbers don't fit neatly in a spreadsheet, so they are rationalized. There will be blood.

RY.T vs. WTI Oil – 5 Years (Normalized)
Source: Verdmont Capital S.A., Bloomberg

Investors are also beginning to recognize that the oil sell off is not driven solely by some proxy supply war between the Saudi's and the States. We like to remind people that the shale boom did not play out overnight and that OPEC has always been comprised by a wacky group of characters. 

Much of the oil selloff can be attributed to US dollar strength and a corresponding slowdown in global economic growth. This means the selloff could be stickier than most are assuming. 

The recent collapse of copper supports our view. Clearly the oil sell off is not specific to the  oil complex and there are other macro factors at play.‎ The correlation between RY.T and copper has broken down as of late, but it serves to illustrate how RY.T is trading in no man's land relative to "Dr. Copper." Funny how no one discusses copper's predictability when it goes south.

RY.T vs. Copper – 10 Years (Normalized)
Source: Verdmont Capital S.A., Bloomberg

With both copper and oil cracking, we believe it is only a matter of time that the Canadian economy begins to feel the impact. We are seeing very modest estimates out there about the total contribution of natural resources to the Canadian economy. People are slicing and dicing GDP data and coming up with very meager estimates in the range of 5 – 10%. This is too low in our opinion.  

It is very difficult to measure the indirect impact that natural resources have on the Canadian economy. Think of all the auxiliary business that results from activity associated with natural resource development, production and transportation. This would feed through to many different sectors of the economy like trucking and transport, various industrials, engineering companies, construction companies, law firms, housing and financial service companies; to name only a few.

GDP numbers also fail to capture many intangibles like consumer confidence and the wealth effect of losing money in the stock market. Remember that natural resources directly comprises upwards of 40% of the TSX/Capped Index. When these sectors take a hit, people are bound to rein in the spending. Additionally, 40% is a pretty hefty number, which increases our skepticism towards the view that oil only comprises 5-10% of Canadian economic activity.

S&P TSX Capped Index – Sector Weights %
We believe that Oil's relationship with the Citigroup Canadian economic surprise index underscores our view that energy's role in the Canadian economy is being underestimated. The economic surprise index measures the percentage of economic data points that are surprising to the upside relative to consensus expectations. We have found it to be a good leading indicator for the Canadian economy and stock market in the past. 

Note how the price of WTI oil tends to lead a drop in the economic surprise index by a couple of months. This indicates to us, that when oil turns over, there is a pause before the market digests its impact. History suggests that expectations about Canadian economic prospects are due to sour. 

Oil vs. Citigroup Economic Surprise Index – 5 Years
Source: Verdmont Capital S.A., Bloomberg

The Canadian Dollar

The Canadian dollar is also pointing to economic weakness in the Great White North. There has historically been a tight trading relationship between RY.T and the loonie. Currency analysts are talking up future weakness in the Canadian economy - why are they saying that the oil selloff is a big deal, whereas bank analysts are arguing otherwise?  http://www.bloomberg.com/news/2015-01-09/loonie-strategists-already-tearing-up-2015-forecasts-currencies.html.

RY.T vs. The Canadian Dollar – 10 Years
Source: Verdmont Capital S.A., Bloomberg

We believe that analysts follow prices with their view. The currency analysts are following the Canadian dollar lower and moving their targets in concert. We believe this will play out in the Canadian banking sector. Just like RY.T's relationship with oil and copper, you may notice that the correlation between the loonie and RY.T has broken down over the past 2 years. Once again, you could use this dislocation to suggest that RY.T is exhibiting strength and take it as a bullish signal. We would argue that it is another sign that RY.T is being mispriced by the market. Look for RY.T to follow the loonie lower.

Long Term Interest Rates

Long term interest rates are pointing to further economic weakness. The long end of the interest rate curve has historically been a pretty good indicator of future global economic activity. 

From a bottom up standpoint, when the long end of the curve comes in, it hurts banks as it squeezes the margin they make on their loan book. Note how RY.T has a pretty tight relationship with the US 10 year Treasury yield and this relationship has also broken down.

Source: Verdmont Capital S.A., Bloomberg

BUSINESS LINES

Below is a summary of RY.T's main business lines. Note that their main businesses are personal & commercial Banking, capital markets and wealth management. They have minor exposure outside of these segments, but we believe that these operations are largely irrelevant in terms of the company's overall prospects given their size and indirect exposure to the same end markets.

A : Revenue and Earnings Increase / Decrease 2014 vs. 2013– Year End October 2014
Source: RBC 2014 Annual Report


B) Earnings by Business Segment and Revenue by Geography – Year End October 2014
Source: RBC "RBC at a Glance – Q4/2014"

Personal and Commercial Banking (50% of Bank Profits)

The prospects for Royal Bank's lending business have deteriorated greatly in our view.


First and foremost, the yield curve has flattened significantly. Remember, at the end of the day, that the banking business is pretty straightforward. You borrow money from Grandma June and Grandpa Charlie via their deposits and offer them a short term yield on their investment. You take their money and lend it further out on the curve in the form of personal loans, mortgages, constructions loans, business loans, etc. etc. When the yield curve flattens, this means that long term interest rates have fallen, while short term rates have remained largely the same. In other words, the money you make as an organization falls because the return you can make on your loan book shrinks. Smart guys call this the net interest margin and this is the meat of a banking business.

Not only has the yield curve flattened, it has come in significantly. This traditionally happens alongside deteriorating economic prospects as the bond market is discounting modest inflation and slower growth. From a bottom up standpoint, it means that the available return on a bank's loan book has deteriorated significantly in relation to its cost of sourcing that capital. It is a very bad development.

RY.T vs. The Canadian Yield Curve (10yr – 2yr) – 5 Years
Source: Verdmont Capital S.A., Bloomberg

A bank also makes its money on the growth of its loan book. As it lends more money, it makes additional revenue as individuals and businesses service these loans in the form of interest and the payment of various fees. We believe that loan growth is due to slow more than is currently being discounted by the market.

The Canadian consumer is tapped out. Some of the data points out there are downright shocking. Canadians are perceived to be conservative by nature, which is often trumpeted to bolster a bullish view on the Canadian banking sector. In terms of their finances, this could not be further from the truth. 

The below chart from our friends at BCA is the most important chart you will see regarding the Canadian economy over the next year. Note how household liabilities as a percentage of disposable income in Canada far surpasses that of the US before the credit crisis in 2008. Wow. 

Also, note how housing values have been on a parabolic rise as the consumer piles on more debt. House prices in Canada are off the charts when measured against income levels and rental costs. Canadian house prices also dwarf those witnessed in the US before their housing market entered an epic nosedive.

Can Canadians continue to take on massive debt loads into perpetuity with no repercussions? Can house prices rise to infinity? The laws of economics suggest otherwise and the collapse of the US housing market is case in point. We believe that a slowdown is inevitable and it is only a matter of time. The unexpected collapse in oil could just be the catalyst to kick things off.

Canadian Household Debt and Housing Values – 25 Years

In terms of business lending, it is also set to cool in our opinion. 

Firstly, as the Canadian consumer begins to feel the heat, this will directly impact the Canadian economy. As the economy cools, the demand for business credit will follow suit as it always does. 

Secondly, as we discussed previously, the impact of the oil sell off on the private sector in Canada is being underestimated. When oil sells off, and the economy cools, capex plans are shelved and companies go into cost cutting mode. Their demand for credit diminishes. 

The impact of this is currently being downplayed by bank officials and various analysts, but we think the bond market is more believable. Note how junk bond yields in Canada have spiked. Yields are an unbiased measure of what the market is forecasting in terms of credit worthiness and corporate debt demand. The bond market is saying there is trouble in Dodge when it comes to the corporate debt markets in Canada. A 2.5% rise in junk bond yields in a span of 6 months is a significant event.

RY.T vs. Canadian High Yield Corporate Debt (Yield) – 2 Years
 
Source: Verdmont Capital S.A., Bloomberg

Capital Markets (23% of Bank Profits)

The Bank's capital markets division is comprised of trading, securities brokerage and underwriting and advisory.

Trading and securities brokerage is a very volatile line of business. It tends to ebb and flow with the performance of the broad stock market, which provides little support were the Canadian economy to cool. Both businesses and consumers will trade less in the event of an economic correction in Canada. When confidence takes a hit, due to an unexpected crash in commodities for example, risk taking dries up.

We would argue that these lines of businesses are already under serious pressure due to decreased trading volumes, heightened regulation and increased competition. 

Are any of the big banks actively trying to hire quality traders and brokers by giving massive upfront bonuses and huge packages? There may be the odd exception, but those days are long gone. Have a walk down Bay Street in Toronto one morning. People are absolutely miserable after their 3 hour commute to their very quiet trading floors. Were it not for their gallon sized cups of Starbucks coffee, these people appear as if they might fall over or be swept away by a stiff breeze. If they still have a job. 

Volumes are down, fees are getting squeezed due to electronic trading and there is no need for a broker's opinion because Joe Blow trader has all the information he needs on the internet. Also, with the Canadian junior market on the ropes, no one is investing at the present time. Don't count on trading and securities brokerage to act as a shock absorber for Royal Bank if it hits the skids.

A big chunk of the Bank's capital markets exposure is from underwriting and advisory. Some may call it investment banking. Once again, we do not see bright prospects for growth in this segment. 

The impact of the oil collapse on investment banking is once again being explained away by various analysts. We believe the impact will be far greater than is currently expected. A recent report from CIBC estimates that oil and gas related investment banking is actually a pretty significant driver of aggregate Canadian Bank investment banking activity. One could argue that the indirect exposure makes it that much more significant. CIBC's numbers are higher than most analysts and more accurate in our opinion.

Investment Banking Oil and Gas Exposure for the Big 6 Canadian Banks

Wealth Management (12% of Bank Profits)

Wealth management is less volatile than that of securities trading and brokerage, so it is considered to be relatively sticky revenue. That said, when viewing a bank's prospects and valuing a company, it is the growth that is important. Once again, we don't see a bright future for the growth of wealth management profits in the event of an economic slowdown.

The wealth impact of losses in the stock market will pinch the pool of investable funds in Canada as people invest less. Remember, upwards of 40% of the stock market in Canada is directly exposed to natural resources.. Naturally, a big hit in these areas saps the size of investment portfolios and an individual's propensity to take on risk.

Furthermore, the key for a wealth management business is the growth in assets under management. The Bank charges investors an annual fee for putting them in various investment products like mutual funds and/or discretionary investment programs. When the stock market sells off, that means the pool of money you charge fees on shrinks. The stock market leads profitability in a given bank's wealth management business. 

Given the theme of this piece, we are looking for a weak Canadian stock market, which translates into muted growth for RY.T's wealth management business. Note how the Canadian stock market has been on a tear. Even if you do not expect an outright crash, do you think the returns of the past 2 years are sustainable? With housing overvalued, the consumer stretched and the commodity investor getting smoked? We do not.

iShares Core S&P/TSX Capped Index – 5 Years
Source: Verdmont Capital S.A., Bloomberg

ANALYSTS FORECASTS

Given the breakdown of various key economic variables, and bleak prospects for growth in the Royal Bank's underlying businesses, we believe the stock should fall. 

What is interesting, is that next to no other analysts share our view. This presents a great opportunity. 

Look for analysts to chase the stock lower with their price targets and earnings expectations. Their moderating view should put pressure the stock because they are behind the curve. This is the same thing as saying sentiment about the Bank's prospect is way out of line.

Aggregate Analyst Earnings per Share Estimates

Here are the rolling 2015 full year aggregate analyst earnings estimates for the Royal Bank. Analysts have continued to raise earnings forecasts for 2015. Current earnings estimates are C$6.55/sh. There has been no adjustment for the oil sell off from what we can see. This makes absolutely no sense to us.  

RY.T vs. Aggregate Earnings per Share Estimates for 2015
Source: Verdmont Capital S.A., Bloomberg

Aggregate Analyst Price Targets

Analysts have been boosting their RY.T stock price estimates throughout 2014. Many have propped up these estimates quite recently. Below are the rolling 12 month aggregate analyst share price estimates for RY.T. It appears to us like they are currently zigging when they should be zagging.  Note how there are no sell recommendations on the stock at a present time (red bars below).

Source: Verdmont Capital S.A., Bloomberg

Here are some of the larger outfits in Canada who cover RY.T and their 12 month forward share price targets. They highlight how the majority of analysts at the large financial firms in Canada have been boosting share price estimates as of late. Once again, this is counterintuitive to us when we look at the banks deteriorating operating environment.

Cormark – huge pop in RY.T share price estimates in 4Q 2014. RY.T is also names as a "top pick."
Source: Verdmont Capital S.A., Bloomberg

CIBC – recently moved from a buy to a hold, raising share price estimates.
Source: Verdmont Capital S.A., Bloomberg

BMO – 12M price target of $90/sh. This was raised substantially during 2H 2014.
Source: Verdmont Capital S.A., Bloomberg

Scotia Capital – big lift in price target during 2H 2014.
Source: Verdmont Capital S.A., Bloomberg

In these guy's defense, it is a tough job covering bank stocks. Firstly, it is impossible to forecast accurately how these bloated behemoths will do. Total mugs game. Furthermore, even if you think they are a sell, good luck getting the autonomy to freely express that view. Bank stocks tend to lead the overall market, and having a negative view on the banking sector, would indicate that a given institution was bearish on the Canadian market and economy in general. Having a bearish bank analyst sends a bad signal for those institutions trying to sell various financial products linked to economic growth.

So, look for history to repeat itself in the form of analysts reducing earnings and price targets for RY.T as the stock continues to sell off. This will be a key driver of the stocks short term underperformance in our view.

CONCLUSION

As we mentioned, making a call on the Royal Bank of Canada is a massive endeavor. We have admittedly focused on the forest as opposed to the trees in this piece. We have not touched on many key drivers, like potential loans losses on the banks books due to the oil sell off. Some topics were left out because they are irrelevant and some, like slicing up the banks loan exposure, involves a lot of guess work and gets us bogged down in the minutiae. Unlike the Bay Street Analysts, we believe that the big picture is what matters here. RY.T's share price does not reflect the company's deteriorating business prospects and the market is looking the wrong way.

We are not necessarily calling for an all-out collapse in RY.T and the Canadian banks. Our argument is that they have yet to reflect the economic reality they are facing. That said, weakness tends to beget weakness, which means a sizable selloff is not out of the question. The Canadian economy is at a pinch point here, with commodities under pressure, a stretched housing market, an over indebted consumer and a deteriorating business environment. Against this backdrop, we believe that RY.T trading close to all-time highs is out of touch.

For those looking to play this call, please call your Verdmont Representative for the best options to do so. The position you take depends on your risk profile and time horizon. You may want to short the stock, buy put options or place a pair trade of some sort. Each of these positions have various pros and cons that investors need to evaluate seriously before taking any action. Also, there are many risks associated with this call and some variables that could certainly work against us. These can be discussed in greater detail with your advisor.

In terms of timing the trade, we believe it makes sense to put on half of your position at current levels and add to it in the even that RY.T has a relief rally. The stock has sold off over the past couple of weeks during the acute stages of the oil collapse. A short term bounce  in the share price could play out as the market starts talking about the commodity market stabilizing and falling prices being good for the consumer.  Furthermore, the Bank of Canada could indicate they are willing to lower short term rates, which would also prop up the Canadian Banking sector over the short term. We believe these drivers will prove short lived, which would provide on opportunity to become more aggressive with your short position in RY.T.