Liquidity made me do it

The rationale for the market rally since March 09 has been liquidity pumped by the Fed. The interesting point is that the market decline from summer 2008 to March 2009 has been also explained by the disappearance of liquidity. The disappearance of liquidity was caused by over levered banks.

I am not going to agree or disagree about the causes of the market rally because I can't. I distinguish between causation and correlation. The latter is easy to detect by statistical methods, however the former is almost impossible to prove. So arguing that point is irrelevant. One suffice to note is liquidity can disappear overnight but can't appear in same speed. It takes time.

Most investors, as evident by the decline and rally of the market, value liquidity. They attach a premium to it making liquid assets somewhat expensive to illiquid ones. I am agnostic to liquidity therefore I am not willing to bid more for it. However price is more important. I was a willing buyer from October till May, although in retrospect, regrettably, not enough. Now I am not. Back then the cyclically adjusted PE was around 10, now it is 19, above the long term average of 17. See chart courtesy of Dr. Robert Schiller.

At these levels I am more risk averse. I have sold several positions over the past few weeks for a summary see here and here. I have also wrote calls in American Express (AXP) at $40 which should take out of that position by it expiration next week. Moreover, Burlington BNI have been taken over by Berkshire which should close by early next year. So my cash position is rising so what to do.

In an fair valued or overvalued market I concentrate exclusively on event driven positions, like takeovers, spinoffs, bankruptcies and reorganization and liquidations. My favorite is spin-offs. Some of the opportunities I am looking at:

• AOL spinoff from Time Warner
• Madison Square Garden (MSG) spinoff from Cablevision
• Cloud Peak Energy coal spinoff from metals giant Rio Tinto
• Pharmaceutical Product Development, Inc. (PPDI) Spinoff of Compound Partnering Business.
• SixFlags post bankruptcy equity
• Lear Corp post bankruptcy equity

In an over valued market where you look can be different than an undervalued one, where businesses sell far below their normal earning power value.

Exit from Peyto

I sold out of Peyto Energy @ $12.26 (35% return) due to changes in competitive structure of gas supply. Pipelines are raising significantly their fees to carry natural gas. This will spell increased operating costs for gas producers and will lower asset values.

Demand for natural gas occurs in the north eastern of this continent and supply, typically, comes from western provinces like Alberta. So transportation costs is big chunk. TransCanada pipeline will raise fees by some 50% next year, which will make western Canada gas uncompetitive compared to closer sources. In the past there was not many sources close to the northeastern market but now they are abundant. There is two new sources that can supply that market maybe at lower costs with transportation costs are rising signifiacntly:

1. New shale gas basins that are coming online are much closer to northeastern states like natural gas from the mega Marcellus shale play that extends to west virginia, is likely to grow to 1.0 Bcf/d.
2. LNG gas coming from overseas as Europe does not need as much gas as previous years due to economic slow down.

The reduced operating profits at gas producers as Peyto will lead to lower credit as bankers set credit lines based on estimates of their NAV or reserves in the ground. Those estimates are facing a double whammy: lower gas prices and higher operating costs. Many will see their credit lines reduces in March 2010 and will scramble for liquidity.

I will come back to Peyto as it is my favourite in the space once something changes in the fundamentals.

BNI buyout by Berkshire

Berkshire acquired BNI earlier in the week for $100 consideration. I will not detail the offer as most media have done it with better detail. However the post is about my view and my future action.

First my view on the transaction. I am really disappointed that BNI is going private, you can read my posts on the company here. I had visions 10 years down the road to see my investment in BNI to have risen by 1000% or more, so to be deprived from such investment, to say the least, is disappointing, albeit my return from holding BNI is 50% plus dividends, so I am always thankful.

The price is low relative to the value of BNI. BNI has tremendous land holdings that are not realized in its balance sheet. Also, BNI is not just a good business with competitive advantage, it is a protection against inflation and oil prices. BNI does well when oil is high or low. When oil is high their rates go up in lock step however if oil prices are declining so is their costs. BNI also is a good hedge against inflation as it rates and assets can compensate investors for rise in prices.

Second, I will opt to take the cash. I do not understand Berkshire and Buffett is not going to last forever. To preempt any comments, I did not say Berkshire is bad business but it is too complicated for me, that is all.

Thrid, I will tender my shares for cash rather than sell due to several factors:

1. I want to postpone my capital gains till next year,
2. in the unlikely event the acquisition fails,
3. I am not leaving $3 on the table, and
4. There is a dividend payout coming up before closing that I want.

Fourth, BNI represented more than 10% of my portfolio so I will have a lot of cash coming back to me to reinvest and that creates some problems. First, the market is at fair value which makes finding ideas a bit difficult. Moreover, the risk in this market is to the downside currently. Second, most railroads have shot up on the acquisition so replacing BNI with another will be difficult as a lot of people are emulating Buffett and bidding their prices. I do not like crowded trades. But I will follow some railroads to take advantage of any weakness. Two of my favorites are Canadian National (CNR) and Union Pacific (UNP). I am also looking at Canadian Pacific, where it could see some improvements in margins with better management. Third, good ideas like BNI are rare.

The other alternative is to invest in Intermodal companies. Those companies use multi modes of transportation on behalf of shippers to get goods to their destination. Intermodals obviously need access to the rail networks through agreements with railroads. Some Intermodal companies own a fleet of trucks to handle what is called last mile transport or the final link from rail to the buyer, or can contract this out to independent truckers.

Pacer International (PACR) is

...asset-light North American logistics provider. The Company provides transportation and logistics services to numerous Fortune 500 and multi-national companies. The Company provides its transportation services from two operating segments, its intermodal segment, which provides intermodal transportation services principally to transportation intermediaries, beneficial cargo owners and international shipping companies who utilize intermodal transportation, and its logistics segment, which provides truck brokerage, truck transport, supply chain management services, freight forwarding, ocean shipping and warehousing and distribution services to a range of end user customers.

Pacer had a bad run lately as its contract extension with Union Pacific, where the majority of its freight revenue come from, was uncertain and weighted on the stock heavily. I liked that situation. I bought at $3.16 last week to take advantage of investors flight due to uncertainty. Although the stock has shot up some 50% since their earnings and contract renewal two days ago, I think the potential to move to $8-10 per share is reasonable.

I admit I did not finish buying to establish my desired position and rather to have bought before the move but the risk/ reward thesis is still valid. The stock should drift higher as investor buy again into it after the uncertainty has been removed.

I will share more thoughts on Pacer some other time.