We hate to be the harbinger of bad news, but we are not surprised that US Debt Ceiling talks have collapsed. Our analysis in our previous post explains why. Unless the game changes, both Democrats and Republicans have incentive to fight rather than co-operate.
- The Aspiring Analyst
Friday, July 22, 2011
Tuesday, July 19, 2011
US Debt Ceiling Is An Unstable Prisoner's Dilemma
We do not like to comment on politics, as politics can be a very emotional subject for a lot of people. However, we feel compelled to point to the dilemma the US finds itself in currently, with the stalemate over the debt ceiling. For those that are not familiar with the issue, here's a refresher from Wikipedia:
"Article I Section 8 of the United States Constitution gives the Congress the sole power to borrow money on the credit of the United States. From the founding of the United States through 1917 Congress authorized each individual debt issuance separately. In order to provide more flexibility to finance the United States' involvement in World War I, Congress modified the method by which it authorizes debt in the Second Liberty Bond Act of 1917. Under this act Congress established an aggregate limit, or "ceiling," on the total amount of bonds that could be issued."
The current debt ceiling was set in February 2010 when it was raised to $14.3 Trillion dollars, and unless Congress passes another increase by August 2 (the US Treasury estimates it will run out of room by this date), the US government may be forced to default on its debt obligations and a financial crisis far larger than the so called 'Great Recession' may result. Why do we care?
We care because the outcome of the debt negotiations between the Democratic White House and the Republican Congress will directly impact the value of our portfolio. We also cannot stand to watch the grandstanding that is taking place right now.
To us, the current stalemate (notwithstanding Obama's endorsement of the Gang of Six's plans earlier today) is a classical prisoner's dilemma in game theory. Let us illustrate:
Both (D)emocrats and the (R)epublicans can either choose to (C)o-operate or (F)ight. Obviously, if both sides choose to co-operate and negotiate a credible deficit reduction plan that includes both tax increases and budget cuts, the world would be a better place. But both sides would be seen to 'compromise' by their constituents, so politically, the payoff of State I is (D,R) = (1,1) (see figure below).
Democrats
R _C__ __F__
e C | (1,1) | (3,-3) |
p |_S1_ |_S2_ |
u F | (-3,3) | (X,X)|
b |_S3_ |_S4 _|
.
If either side choose to fight while the other side choose to co-operate, then the fighting side (who stands 'firm and wouldn't give an inch') would be able to claim 'victory' come the next presidential election in 2012, and their opponents would be seen to have 'caved-in'. State II is if Democrats fight and Republicans co-operate, with a payoff of (3,-3). State III is vice versa, with payoff of (-3,3).
Unfortunately, in this game, we will never get to the globally optimal State I, no matter the outcome of State IV, when both sides choose to fight and we get an eventual US default.
First, consider the case that both sides view a State IV as a political 'cop-out', allowing them to save face in front of their constituents while ramping up the 2012 presidential campaign. We can reasonably assign a payout of (-1,-1) for State IV. Since Democrats are better off choosing to fight no matter what Republicans choose (i.e., D2 > D1 and D4 > D3), they will naturally choose to fight. Same for Republicans (R3 > R1 and R4 > R2).
Even if the payout for Stage IV is terrible, i.e. a US debt default and armageddon, we still don't get to the globally optimal State I. Consider if State IV had the payout (-5,-5). As a Democrat, if we are starting off in State I (both co-operate), then it 'pays' politically to fight, since D2 > D1. Same for Republicans, it pays to fight, since R3 > R1. However, if both choose to fight, we get State IV. But if we are in State IV, D2 > D4 and R3 > R4, hence both would choose to co-operate, leading to State I. This is an unstable game, and would oscillate between Democrats and Republicans choosing to fight or co-operate (quite like real life, actually).
Although we can recognize the game, we cannot solve it. Solving it for the global optimal will require changing the game's rules and payoffs such that D1 > D2 and R1 > R3. If we can convince both parties that it 'pays' to co-operate, then the game will naturally conclude with both parties co-operating on a settlement to reduce the deficit and lift the debt ceiling. Unfortunately, politicians are not game theorists and it is very hard to change the political payout of this game.
- The Aspiring Analyst
"Article I Section 8 of the United States Constitution gives the Congress the sole power to borrow money on the credit of the United States. From the founding of the United States through 1917 Congress authorized each individual debt issuance separately. In order to provide more flexibility to finance the United States' involvement in World War I, Congress modified the method by which it authorizes debt in the Second Liberty Bond Act of 1917. Under this act Congress established an aggregate limit, or "ceiling," on the total amount of bonds that could be issued."
The current debt ceiling was set in February 2010 when it was raised to $14.3 Trillion dollars, and unless Congress passes another increase by August 2 (the US Treasury estimates it will run out of room by this date), the US government may be forced to default on its debt obligations and a financial crisis far larger than the so called 'Great Recession' may result. Why do we care?
We care because the outcome of the debt negotiations between the Democratic White House and the Republican Congress will directly impact the value of our portfolio. We also cannot stand to watch the grandstanding that is taking place right now.
To us, the current stalemate (notwithstanding Obama's endorsement of the Gang of Six's plans earlier today) is a classical prisoner's dilemma in game theory. Let us illustrate:
Both (D)emocrats and the (R)epublicans can either choose to (C)o-operate or (F)ight. Obviously, if both sides choose to co-operate and negotiate a credible deficit reduction plan that includes both tax increases and budget cuts, the world would be a better place. But both sides would be seen to 'compromise' by their constituents, so politically, the payoff of State I is (D,R) = (1,1) (see figure below).
Democrats
R _C__ __F__
e C | (1,1) | (3,-3) |
p |_S1_ |_S2_ |
u F | (-3,3) | (X,X)|
b |_S3_ |_S4 _|
.
If either side choose to fight while the other side choose to co-operate, then the fighting side (who stands 'firm and wouldn't give an inch') would be able to claim 'victory' come the next presidential election in 2012, and their opponents would be seen to have 'caved-in'. State II is if Democrats fight and Republicans co-operate, with a payoff of (3,-3). State III is vice versa, with payoff of (-3,3).
Unfortunately, in this game, we will never get to the globally optimal State I, no matter the outcome of State IV, when both sides choose to fight and we get an eventual US default.
First, consider the case that both sides view a State IV as a political 'cop-out', allowing them to save face in front of their constituents while ramping up the 2012 presidential campaign. We can reasonably assign a payout of (-1,-1) for State IV. Since Democrats are better off choosing to fight no matter what Republicans choose (i.e., D2 > D1 and D4 > D3), they will naturally choose to fight. Same for Republicans (R3 > R1 and R4 > R2).
Even if the payout for Stage IV is terrible, i.e. a US debt default and armageddon, we still don't get to the globally optimal State I. Consider if State IV had the payout (-5,-5). As a Democrat, if we are starting off in State I (both co-operate), then it 'pays' politically to fight, since D2 > D1. Same for Republicans, it pays to fight, since R3 > R1. However, if both choose to fight, we get State IV. But if we are in State IV, D2 > D4 and R3 > R4, hence both would choose to co-operate, leading to State I. This is an unstable game, and would oscillate between Democrats and Republicans choosing to fight or co-operate (quite like real life, actually).
Although we can recognize the game, we cannot solve it. Solving it for the global optimal will require changing the game's rules and payoffs such that D1 > D2 and R1 > R3. If we can convince both parties that it 'pays' to co-operate, then the game will naturally conclude with both parties co-operating on a settlement to reduce the deficit and lift the debt ceiling. Unfortunately, politicians are not game theorists and it is very hard to change the political payout of this game.
- The Aspiring Analyst
Sunday, July 10, 2011
CMHC - The Elephant In The Room
Dear Readers,
This month's newsletter takes a deeper look at what we believe is the real reason Canada's housing market performed as well as it did during the recent recession. Our research indicates that the CMHC provided over 50% of the financing for the Canadian housing market over the past few years through its NHA-MBS securitization trusts and this level of intervention has not decreased even as the economy has improved. In addition to worries about rising interest rates, real estate investors should also consider what happens when/if CMHC removes this level of support.
As always, your comments are most welcome.
Friday, July 1, 2011
Back In Business; Update On Becker Milk (BEK.B-TSX)
Dear Readers,
We are finally back in business! After a hectic couple of weeks including marrying my beautiful wife and honeymooning in Hawaii, we are finally back in Toronto doing what we like second best (second after spending time with my wife, of course!).
What a roller-coaster ride June has been. We will be providing an update and our thoughts in the next couple of days in a full letter, but let's just say our portfolio took a sizeable hit. We have reviewed our positions and given the theses remain sound, we are not too worried.
The purpose of today's entry is to provide a brief update on one of our favourite investment ideas in the last couple of months - Becker Milk (BEK.B-TSX). If you recall, a couple of months ago, we wrote that Becker Milk was a wonderful little company that has quite a bit of hidden asset value. Well, just this week, the Company announced its 2011 year-end results and it appears the auditors agree with us (although not to the same extent as we had hoped).
The actual quarterly/annual results were ho-hum, as the Company incurred some one-time expenses for the implementation of IFRS accounting standards. However, what really caught our eye was hidden in the IFRS disclosure in the MD&A, the Company reported that the Company's portfolio of real estate is worth $29.8 MM, instead of the $12.5 MM it is held on the balance sheet for. This is interesting for two reasons.
1) As disclosed in the MD&A, when the company starts reporting under IFRS in F2012 (sometime in August for Q1/F12), the investment portfolio will have to be carried at fair value on the balance sheet, meaning book value will jump from $8.80 ($15.9 MM / 1.8 MM shares) to $16.50 due to the $13.9 MM in net unrealized gain on the real estate portfolio. We agree with reader MR that Q1/F12 may prove to be a catalyst for the company as it reports a significantly higher book value.
2) The fair value appears low. Recall in March, we had valued the investment portfolio at $40 to $50 MM by using a cap rate of 8 - 10% on the rental income of ~$ 4 MM / year. What we find interesting is how did the auditors come up with a $29.8 MM fair value? A few paragraphs up in the MD&A, the company said that in May 2010, the real estate portfolio was valued using a 8.25% cap rate. Assuming it's an 9% cap rate in 2011 (unlikely, since real estate values have recovered in 2011 vs. 2010, but let's be conservative), $29.8 MM fair value means the NOI on the investment portfolio was $2.7 MM. But the rent is $4 MM. There's no mortgage. What gives? We suspect it may include some corporate SG&A and management salaries (we would love to hear your ideas?). But if that's the case, it also means a strategic buyer will be willing to pay more than $29.8 MM to acquire this portfolio, since they won't have to incur these expenses (or incur as much expense). Let say a strategic buyer can manage all 69 properties by spending $500 K instead of $1.3 MM. That means they can reasonably pay $3.5 MM / .09 or $38.9 MM or over $20 / share!
Anyway you look at it, BEK.B remains extremely cheap at these levels. On a purely book value basis, it is trading at 70% of intrinsic value with a 5% yield. If you believe in our analysis of a strategic buyer being able to offer more than book value for the portfolio, it is trading at a 50% discount to intrinsic value. Definitely a strong buy in our opinion (Disclosure, we own shares of BEK.B).
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