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Trapeze Asset Management – Climbing Walls Carefully

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Trapeze Asset Management Climbing Walls Carefully (PDF Format)

It’s been said that bull markets climb a wall of worry. This one clearly has since the crash lows of March ’09, but recently the bull seems to be climbing a wall of optimism. We worry about the optimism. The markets have been making new highs and investor sentiment is high too. Margin debt recently made record highs, though it had its first decline in March after 6 months of rising. And there are clearly some speculative excesses from the bubble stocks, the Tesla Motors Inc (NASDAQ:TSLA)s, Twitter Inc (NASDAQ:TWTR)s andLinkedIn Corp (NASDAQ:LNKD)s. Corporate insiders have continued to be significant net sellers in this period. Time to be wary of a market correction.

Tempering Economic News

Economic news has been improving but it often needs to be tempered when one examines the details. U.S. unemployment just hit a recent low of 6.3%, but was helped by a poor labour participation rate (at a 30-year low) as discouraged people leave the workforce, as when their unemployment insurance entitlements end and they are no longer obliged to seek work. And, average hourly earnings are not rising. Opportunities for young people are weak. Obamacare costs and the potential for a higher minimum wage won’t encourage hiring either. Canadian unemployment remains even higher, at 6.9%, with job losses in April.

While U.S. housing prices have reached new highs, housing activity is slowing, from the lower affordability from higher prices and mortgage rates. And, while sales of existing homes rose in April by 1.3%, less than expected, they were 6.8% below the year earlier level. More young people are opting to rent than buy. And the Federal Reserve is concerned over the weakness in housing.

While corporate profits are at a record high it is essentially from record profit margins, abnormally high and likely unsustainable in the longer term. Moreover, the percentage of profit and revenue growth has not been impressive. And productivity output per hour worked is weaker, falling in Q1, the first drop in a year.

While corporate balance sheets are strong, capital spending is anemic. And household debt remains high, which could impede consumer spending. Although April retail sales were stronger, consumer sentiment for May was lower than expected.

Q1 GDP growth was a paltry 0.1% compared to an expected 1.2%, even allowing for the poor weather which was also built into the expectations. And it may even be revised downward to a negative number from a smaller than expected decline in the trade deficit. A drop in both exports and imports hasn’t helped. Overall this has been one of the weakest economic recoveries following a recession.


Global economic growth is disappointing too. In the second largest economy, China, its growth and manufacturing activity are slowing, impacted by falling exports, and it’s at risk of a serious property market decline. The emerging markets are still in difficulty. Economies such as Brazil, India, Turkey and South Africa are all struggling with negative growth. Clearly, the Ukrainian crisis is impacting the Russian economy and could impact the Eurozone too.



The New Normal?


But economists have assured us this may be “the new normal.” Historically low interest rates and low inflation. Well, the Fed is striving to “normalize” by continuing to cut its Quantitative Easing $10 billion per month, now down to $35 billion, but nonetheless assuring that interest rates will remain low for the next two years. Overall prices rose only 1.1% in March from a year earlier, below the 2% Fed target. The Fed is surely concerned about the low inflation and even the potential for deflation, anathema to economic growth as it causes consumers to defer spending.


Inflation in the Eurozone was even lower, 0.7% (compared to its target of 2%), bad for growth and jobs, sparking the European Central Bank to also consider cutting interest rates and other stimulus measures, to combat inflation and to address its concern about the high Euro currency. And the exceedingly high unemployment in Europe. 10-year bond yields in Germany recently fell to their lowest point in a year and 10-year U.K. bonds are at their lowest yield since October. German business confidence just declined.


The U.S. economy and bond and stock markets have been sustained by artificially low interest rates. And when the Fed eventually pulls the plug, who knows? Keeping rates too low for a lengthy period could have negative implications.


The U.S. 10-year Treasury bond yields a measly 2.5%. Low indeed. But imagine, Canada recently issued its first ever 50-year bond, with a 2.75% coupon, and it was oversubscribed. Talk about the new normal—a bond bubble. Most economists expect interest rates to rise in the next several months. This new normal can’t last, anomalies don’t, and inflation should pick up, perhaps significantly. Remember, renowned economist, Milton Friedman, instructing us that inflation was always and everywhere a monetary phenomenon. But more inflation and higher interest rates will be bad for long-term bond prices and may be a negative for the economy and for stock prices. Higher interest rates can’t be good for the Fed and the U.S. government with record high debt levels to service.


Economy Improving Slowly


Don’t misunderstand, things in the economy aren’t worsening, they’re still improving, but slowly, and are not as good as the headline numbers would lead one to believe, nor as good as the stock market has obviously embraced. Importantly, based on our own Trapeze Economic Composite (TEC™) we do not foresee a recession in the near future. But we do anticipate continued slow growth. And, we do believe that the markets are fully valued, and in need of a correction. We aren’t expecting a bear market, just a healthy overdue correction from a fully

valued market. Indeed, some stocks are hugely overvalued. A prelude to a correction did manifest itself recently as investors on April 10 unloaded shares of high flying biotech and Internet companies for the worst daily decline for the NASDAQ since 2011.


An enormous amount of cash on the sidelines has been driving the market, with the quantum of shares available shrinking, from corporate buybacks and M&A activity and fewer new offerings.


It’s time, we believe, to hold some cash, have some overvalued short positions (in accounts that authorize it) to hedge the decline, and make sure that what we own is adequately undervalued and can potentially withstand a correction.


Our All Cap Portfolios – Key Holdings


Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and, generally, lower volatility. Importantly, they tend to recover back to their fair values much faster. We have increased our large cap weighting and foresee a continuing increase. However, our small cap positions are cheaper as they trade far below our fair value estimates and therefore our All Cap portfolios still hold a significant position in small caps.


Manitok Energy (OTCMKTS:MKRYF) remains our largest equity holding in most All Cap accounts. Though thecompany continues to add to its underlying value, the share price is still below our estimated value of over $4.50 per share, more than 70% higher than the current share price. Production guidance for the company exceeds 7,000 boe/d by the end of this year which should provide a cash flow run-rate of over $80 million or about $1.15 per share.


The stock price has underperformed the performance of the business for a host of reasons since last fall. Primarily, there have been concerns, which we believe are wholly unwarranted, about the company’s Entice land acquisition and the former COO’s departure. Market participants are waiting for Entice results and we expect the company to announce initial well results from Entice in the next few weeks.


Entice, which has the potential to add considerable value, along with continued drilling at Manitok’s Stolberg core area, should push value to over the $6 per share level over the next year, versus its $2.47 share price, assuming a valuation of $65,000 per flowing barrel (transactions to buy production have been taking place at much higher prices). A decline in the price of oil, which we do not anticipate, remains the main risk for the company. Assuming $85 oil (our conservative figure), in just 3 years Manitok should have annual cash flow of more than $1.80 per share, and a reasonable valuation of 5x cash flow would justify a share price more than 3x today’s level.


Specialty Foods Group, held in our taxable accounts, is also a key holding. A third-partyvaluator boosted the valuation significantly in mid ’13 and at the end of last year after the company delivered solid results. The valuation is now mostly from the company’s substantial

cash balance (over $50 million). The company should now be in a position to return capital in a tax-efficient manner to its stakeholders. It will likely sell its remaining brands/operations and then return capital to shareholders. We expect the amount of capital returned will exceed our current carrying value as the third-party valuation was conservative. We recently exercised our warrants (for a negligible cost) and now hold common shares entitled to the return of capital.



Corridor Resources (OTCMKTS:CDDRF)’  share price has bounced significantly since last fall; however, we believeit still doesn’t reflect the fair value of the company. Even at today’s higher share price, the value of the McCully field, its infrastructure and net cash alone (now about $35 million) are worth more than the share price. Therefore, the significant potential from Corridor’s three megaprojects is still essentially free.


Natural gas prices have rebounded to $4.50 per mcf as the cold winter and lessened drilling led to drawdowns of North American supplies. Corridor’s primary market, New England, was extremely undersupplied in the winter months and the company typically receives a premium of about $2.80 per mcf over prevailing prices that should be sustainable for several years. The company has already locked in part of next year’s production at over US$11 per mcf— providing an estimated CA$10 per mcf netback during the key winter months.


Meanwhile, Corridor continues to seek partners for its Frederick Brook gas shale project and its Gulf of St. Lawrence offshore Old Harry project. The Anticosti Island project now has partners—the Quebec government and Maurel & Prom, a mid-tier international oil company— who will spend up to $100 million drilling on Anticosti Island beginning this summer. Corridor has a carried interest, meaning it is not required to spend on the project over the next couple of years yet it retains 22% of the project. Anticosti Island, Quebec has a projected 33 billion barrels of oil equivalent resource in place—if a mere 5-10% is recoverable it will be successful. The risked value to Corridor is multiples of the current share price. Though, even with extremely promising core samples to date, analogous to the prolific Utica shales of Ohio, lots of work is still required to ascertain whether the project is viable.


Corridor’s share price has been bolstered by the company’s cash balance and rising cash flow which are sufficient to grow the company again at its core McCully field and to spend modestly on the Frederick Brook shales too in order to attract a partner for that megaproject. Frederick Brook, at over 1,000 metres of depth, is amongst the thickest gas shales in North America and simply needs a partner to advance it, now that gas prices have recovered. If the LNG export facilities being discussed in New Brunswick and Nova Scotia go ahead, each of which would require Corridor’s gas feed, it’ll really be a “game on” event.


Old Harry has a potential 2 billion barrels of recoverable oil and could also land a partner before long, now that the government environmental assessments are forthcoming.


St Andrew Goldfields (OTCMKTS:STADF)’ production remained near record levels in Q1. While overallproduction is expected to decline in ’14, increasingly, production is coming from the lower cost Holt mine (all-in, including sustaining capital expenditures, costs are below $1,000 per oz.). And drill results from the Taylor mine project continue to be


impressive. In 2015, production is expected to exceed 100,000 oz. per year with Holt growing and the Taylor mine likely also contributing. St Andrew should deliver respectable cash earnings in 2014 and much more attractive figures next year—about $25 million. Meanwhile, the company’s financial position is strong with about $19 million of cash after the company just repaid its remaining bank debt.


The share price still trades at a substantial discount to its reserve-only based net asset value— an apparent anomaly considering its next door neighbour, Brigus Gold, was purchased in December at a fair price which justifies a substantially higher price for St Andrew, trading at less than half of its estimated net asset value. Lower gold prices could diminish earnings but gold prices, already below the global marginal cost of production, appear unsustainably low. Our 3-year target for St Andrew remains over twice the share price, assuming a 6x cash flow multiple and somewhat higher gold prices that we reasonably expect.


Orca Exploration (CVE:ORC.B)’s share price appears to be coiling for a move upward. Underlying valuekeeps growing and there is light at the end of the tunnel for the inability of Tanzania to satisfy its financial obligations that have plagued the company. The key risk for Orca is the one that’s depressed the share price thus far—a prolonged period of uncertainty. Orca has been restrained by a host of factors; however, each should dissipate in the next several months. The


World Bank’s involvement, assisting the government of Tanzania, is well underway. TANESCO, the national power utility, has had better income and with some direct funding is in a much better position to repay its substantial obligations to Orca and other suppliers. The new pipeline in the

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Trapeze Asset Management

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