Archive for 2016|Yearly archive page

Book review: When The Bubble Bursts

In Investment Theory on December 1, 2016 at 2:29 pm











Book review: When The Bubble Bursts: Surviving the Canadian Real Estate Crash
By Hilliard MacBeth

Investment advisor Hilliard MacBeth’s book about the coming Canadian housing crash is well researched and engaging. It is the scariest financial book I’ve read.

He starts with the observation that whatever his retail clients are fascinated by usually ends in epic disaster. In the early 80s it was oil and gas stocks; the mid 90s featured Bre-X. Tech stocks (including Nortel) took centre stage in the late 90s. Since the mid 2000s, his clients talk about one thing: real estate. What they say to him: “It keeps going up, it can’t go down, buy now before it’s too late.” Some of his clients own multiple properties which they rent out, often at a negative monthly cash flow in the hopes of future capital gains. Sound familiar?

MacBeth uses research and data to back up his arguments for a coming housing crash:

1. Over long periods of time, real estate tends to keep up with inflation. It doesn’t perform much better than that. Periods of price growth beyond basic inflation matching are unusual and often turn out to be bubbles. Canadian real estate, especially in major cities (Vancouver, Toronto, Montreal), have risen three-fold since 2000 which seems unsustainable; incomes and prices of other goods have not risen in proportion. Canadian house prices in relation to average household incomes have risen to some of the highest in the world, higher even than in the US at its housing bubble peak.

2. The bubble could burst for any number of reasons including higher interest rates or a recession. Interest rates are currently at historical lows. At higher rates, many people wouldn’t be able to afford their mortgage payments. In a recession, people who lose their jobs will be unable to meet their mortgage payments.

3. Structural shift. The large wave of baby boomers downsizing will create a large supply of homes. Boomers won’t want the upkeep, won’t be able to climb stairs, and will want to use those assets for retirement. This supply will be added to large supply that has been added in recent years due to the building boom. Taken together, this supply will overwhelm demand and prices will fall.

MacBeth tears apart commonly held opinions about real estate. These include the ideas that renting is wasting money (it’s cheaper than owning and the savings can be invested in stocks or bonds), that real estate always goes up (not true, look at USA/UK/Ireland/Spain/Japan/etc.), and that the Canadian market is somehow unique and immune from a downturn (sorry, it’s not).

MacBeth points to the government run CMHC mortgage guarantee program as one of the reasons mortgage lending and personal debt levels have gotten to this point. Without this program, banks would be more conservative in their mortgage lending because they would bear the risk of loss. In economics, this is called a moral hazard.

The people that will be most hurt by the crash are retiring baby boomers hoping to cash out and pay for their retirements, new buyers with high loan to value ratios, landlords trying to make money renting out condos, shareholders of Canadian financial institutions, those in the construction industry and last but not least the Canadian taxpayer (who will foot the bill for the CMHC losses and bank bailouts). But those won’t be the only groups affected. As housing is usually by far the largest asset for most households, the consumer, who drives our economy, will be negatively affected in a big way. Rather than continuing to enjoy the wealth effect from rising home values, they will feel poor. In response, they will start saving and spend less resulting in a dramatic effect across the Canadian economy.


Market leader in diabetes medication hits two-year low; Novo Nordisk (NYSE: NVO) shares reach $34

In Investment ideas, Uncategorized on November 7, 2016 at 7:38 pm


By any metric, Novo Nordisk (NYSE: NVO) , the world leader in diabetes medication, is an outstanding company. It commands a 28% global market share in diabetes drugs, one of the largest buckets within specialty pharma. Returns on shareholder’s equity last year was a whopping 45%.

The company is also growing fast. Over the last decade, annual growth rates for revenue and operating income were 15% and 23%, respectively.

Novo is very focused on just four disease areas: diabetes (79%), obesity (<1%), hemophilia (10%) and growth disorders (11%).


Diabetes is clearly its major focus. Diabetes is a medical condition that has affected mankind for millennia. It is currently experiencing rapid growth due to the lifestyle factors associated with modern urban life: western diet and lack of exercise. Type 2 diabetes, also known as adult onset diabetes, makes up 90% of the diabetes market. There is no cure for this condition except purchasing expensive insulin products from Novo, Sanofi and other drug companies.

As India and China urbanize and develop a middle class, there could be a large pool of new customers. Even the United States is a great growth opportunity; according to the American Diabetes Association and the CDC, if current trends continue, 1 in 3 American will have diabetes by 2050.

Novo is highly profitable. Last year, gross margins were 85%. Operating margins were 45%; that is an incredible number and beats almost anything I’ve seen (Coca-Cola’s is 20%, Starbucks’ is 19%, Walmart’s is 5%).

Due to pricing pressures in the US and European markets, management has reduced long-term revenue and operating income targets to 5% from 10%. This is a very sharp reduction and has led to a steep drop off in the share price. Shares reached a two year low today at close to $34.

At this price, the trailing 5-year P/E is 22x (a little pricey) and the forward 2016 P/E is 15x (quite reasonable). The shares sport a 2.79% dividend yield.

Based on my analysis, long term total returns on common shares (share price appreciation plus dividends) are expected to be 10-11% going forward. However, if shares are purchased below today’s prices or growth exceeds the new 5% target (quite possible), your results could be even better.

Despite setbacks, Deere will recover

In Investment ideas on September 23, 2016 at 1:11 pm


They say nothing runs like a Deere. Established in 1837, John Deere (NYSE: DE) is the market leader in agricultural equipment. Due to a challenging environment for farm incomes over the last few years, Deere’s sales and earnings are down. As a result, Deere shares are cheap. The Company has seen its sales trail downwards from a peak of $36.1B in 2012 to $28.8B in 2015. Due to low crop prices, farmers don’t have the money to buy new tractors and gear.

Deere generates 69% of its revenue from the sale of agricultural and turf equipment. More than half of that is in North American market. It has a dealer network that is unmatched in North America with around 1500 dealerships. This is a big competitive advantage because it means that customers who need equipment serviced can do so quickly and conveniently. I experienced this firsthand purchasing a ride-on lawnmower for a commercial property I managed in rural Nova Scotia, Canada. We chose Deere because of the local dealership’s proximity for service repair in addition to the brand’s reputation for quality. Another big competitive advantage for Deere is its large in-house financing department.

Deere enjoys high returns on equity with ROE averaging 20%+ over a 20 year period. Over the same period (1996-2015) the company never reported an operating loss in any year. The company is also remarkably shareholder friendly, returning more than 100% of owner income (CFO-capex) to shareholders in the form of dividends and share buybacks over the same 20 year period. Due to buybacks over that period, share count was reduced by 36%.

Management (CEO / CFO) have long tenure with the company as do other senor executives. And all senior managers (dozens of key people) are required to maintain large personal shareholdings in the Company, which is unusual.

Crop prices will rebound at some point in keeping with the agricultural cycle. In addition, tractors and other equipment wear out and will need to be replaced at regular intervals; thus most sales can be delayed but not entirely foregone. Also interesting, new technological advances (self-driving tractors) could mean a greater demand for next generation products.

Berkshire Hathaway bought some Deere stock ($1.7B) around $80 per share in 2015. At $84 per share, Deere has a market capitalization of $26B and around a 3% dividend yield. This price represents a 11x multiple on 5 year average EPS. Deere’s sales are expected to recover in 2020 to about $45B. At this time, EPS could be about $11/share. At 12x P/E ratio, this will result in a share price of $132. Total returns – share price appreciation plus dividends – could be 44-96% for an approximately 5-year holding period.

Berkshire 2016 AGM Q&A

In Investment Theory, News, Uncategorized on June 8, 2016 at 10:03 pm
Berkshire Hathaway 2016 Annual Meeting

Berkshire Hathaway 2016 Annual Meeting

The annual “Woodstock” of capitalism, Berkshire Hathaway’s annual shareholders meeting was held in Omaha, Nebraska on Saturday April 30, 2016. The meeting was open only to investors in the Company and required meeting credentials to attend. But for the first time ever, Berkshire decided to live stream the event via Yahoo! Finance. You can watch the whole thing from the comfort of your living room right here:

And, as been the case for the last few years, some wonderful soul has painstakingly recorded every word said and made the full transcript available for download. Check that out here:

The highlight of the meeting is a six hour question and answer period with the Chairman and Vice-Chairman, Warren E. Buffett and Charles T. Munger. These are two of the brightest minds in investing. The Q&A session is entirely unscripted and shareholders from around the world who attend the meeting can ask almost anything they want. For six long hours, Warren and Charlie do their best to answer these questions whilst sipping Cherry Coke and munching on See’s peanut brittle.

Some abridged highlights:

Q: “In your 1987 letter to shareholders, you commented on the kind of companies Berkshire liked to buy: those that required only small amounts of capital. You said quote; “Because so little capital is required to run these businesses, they can grow while concurrently making almost all of their earnings available for deployment in new opportunities.” Today the company has changed its strategy. It now invests in companies that need tons of capital expenditures, are over regulated, and earn lower returns on equity capital. Why did this happen?”

A (Warren): “Well, it’s one of the problems of prosperity. The ideal business is one that takes no capital but yet grows. There are a few businesses like that and we own some, but we’d love to find one that we can buy for $10bn/$20bn/$30bn that was not capital-intensive and we may, but it’s harder and that does hurt in terms of compounding earnings growth. Obviously, if you have a business that grows, gives you a lot of money every year, and it isn’t required in its growth, you get a double-barrel effect: from the earnings growth that occurs internally without the use of capital, and then you get the capital it produces to go and buy other businesses.

A (Charlie): “Well, when circumstances changed, we changed our minds. In the early days quite a few times, we bought a business that was soon producing 100 percent per annum on what we paid for it and didn’t require much reinvestment. If we’d been able to continue doing that, we would have loved to do it. But when we couldn’t do it we went to Plan B. Plan B’s working very well…”

Q: “You’ve explicitly stated that you’ve not considered diversity when hiring for leadership roles in board members. Does that need to change?”

A (Charlie): “Years ago, I did some work for the Roman Catholic Archbishop of Los Angeles. And my senior partner pompously said, you know, you don’t need to hire us to do this. There’s plenty of good Catholic tax lawyers. And the Archbishop looked at him, like, he’s an idiot and said, Mr Peeler, he says, ‘last year, I had some very serious surgery and I did not look around for the leading Catholic surgeon’. That’s the way I feel about board members.”

Q: “With the rise of and others, there’s been a shift from push marketing to pull marketing – from millions of catalogues having been sent out in the past, to consumers now searching online for what they are looking for. What is your take on how this shift [affects Berkshire]?  ”

A (Warren): The development is huge – really huge – and it isn’t just Amazon. Amazon is a huge part of it and what they’ve accomplished in a fairly short period of time, and continue to accomplish, is remarkable.

We don’t make any decision involving even the manufacturing of goods, the retailing, or whatever it is without thinking long and hard about what the world will look like in five, ten, or 20 years. With that hugely powerful trend that you just described, we don’t look at that as something where we’re going to try and beat them at their own game. They’re better than we are at that.

The effect of Amazon and others that are playing the same game…the full effect on the industry is far from having been seen. It is a big force, which has already disrupted plenty of people and it will disrupt more.