Blessed by the Potato

Poseidon (PSN) got absolutely creamed this week after announcing its Q3 results. I was lucky enough to have taken my profits in PSN and managed to avoid the 65% drop, and let me stress that it was luck: I had no idea such a hit was coming. With my last sale in September, it was a near thing, too.

For those who don’t recall, their business is in providing fluid handling tanks for oil & gas fraccing operations. They make made ridiculous margins for what is ultimately a fairly low-tech business with low barriers to entry, and they were growing like stink. But, they were the first, and their solution offers more than enough cost savings to also make it attractive to their customers. For a long time running, many have expected that the margins would get trimmed as competition entered and that growth would stall as the market matured. I personally had thought that by the time that moment arrived their volume of business would make up for it, allowing them to maintain that juicy dividend with a stable number of tanks operating on a reduced margin.

Well, the margins contracted faster than many thought, and the growth has stopped. The company plays this up as a good thing: they’re flexible enough to stop producing more tanks very quickly, but the fact that they had to is what tanked the stock. If you go back to my old post, the most pessimistic scenario I ran was $200k/tank in EBITDA. They’re almost there already, with $26.5M of EBITDA in the quarter on 500 tanks. The margin squeeze is significant.

But that’s a company-specific issue, and doesn’t really worry me that much. I could puzzle over it and try to figure out how far down it would have to drop before becoming a good buy again, but that’s not going to keep me up at night. What worries me was this little blurb in the release:

Poseidon’s tank utilization and revenue in the quarter were further affected as we renegotiated terms on several long‐term agreements with specific, strategic customers due to changes in their project schedules and capital budgets. Meanwhile, several other long‐term agreements lapsed without renewal or were suspended as certain customers’ activities were reduced due to macro considerations or capital budget constraints. [emphasis mine]

PSN wasn’t the only company this quarter that found long-term contracts were not as secure as they thought. Fortress paper (FTP) has also been sold off on poor results, including a renegotiation of terms:

Dissolving pulp markets softened during the third quarter due to weak textile demand and increased supply of dissolving pulp from new entrants. Among other factors, the weakening viscose staple fibre market in China has driven down dissolving pulp prices to below US$1,000 as at the end of September 2012. Given existing market conditions and in order to maintain good customer relations, a significant portion of our sales orders for the fourth quarter is expected to be below the floor prices set forth in our supply agreements with our three major Chinese purchasers. These supply agreements are currently under review with the counterparties to reassess each party’s obligations going forward.

I had read somewhere (likely a secondary source) that this was because the partners couldn’t continue operations if they had to pay the contracted price. Is the economy even weaker than we had been led to believe? I only follow so many companies, so to see this happen twice in a quarter really threw me for a loop. Is it a more common occurrence than I’m aware of?

The world was a new, scary place, divided at first into mommy and not-mommy. She just wanted to be swaddled and held, and to sleep the whole thing away.

Then she stared to get used to the world, and found it was kind of a neat place she could explore. She recognized certain snuggly people who weren’t mommy, but also nice. She smiled.

One day something clicked in her brain, and the world suddenly lost its scariness. It was an exciting and wonderful place, full of things she could put in her mouth. Plus, she had just figured out how to use her hands, things she could use to bring other things to her mouth to chew on and tongue. And when nothing else was around, she could put her hands in her mouth on their own!

She is now coming to the realization that the world is full of things she can’t put in her mouth. There are those that her mean parents won’t let her chew on, and also those that are physically impossible to place in her mouth for interrogation by her tongue. Indeed, I think the reason she hasn’t learned to crawl yet is that she spends the time on her face trying to find a way to eat the floor — and gets frustrated when it refuses to go in her mouth.

Wayfare thinks that right purple part should be a much much smaller sliver, if it’s showing at all. The set of everything in the world should perhaps completely intersect the set of things she wants to put in her mouth. “Have you actually found anything she didn’t want to put in her mouth yet? There may be something, but I haven’t found it yet. This morning she tried to put the following new things into her mouth: another little kid, the library carpet, and some man’s shoe. Turns out that Blueberry has the same reaction to other little kids as she does to the cat: A lot of arm flailing with her mouth wide open as she tried to lunge mouth first at the child.”

Please note that PSGtDIYI has been superceded by The Value of Simple

Kobo has changed the way authors can self-publish, streamlining the process to be more like the Amazon Kindle store. As a result, Potato’s Short Guide to DIY Investing is now available in the Kobo store. From my point of view, it’s better if you buy the book directly from me as I get to keep more of the gross, but for you the price is the same whether you buy from Amazon, Kobo, or me: choose what’s most convenient for you.

And speaking of my book, I got some great heart-warming fan mail recently. One of the first people to read my book and switch over to do-it-yourself investing with TD e-series has reported back a year later that things are still on track and that she did her first annual re-balancing all on her own.

A more recent reader wrote in the very same day she bought a copy:

I just bought & looked through your book Potato’s Short Guide to DIY Investing after signing up for a TD Waterhouse Discount Brokerage account and being confused by the interface. The walkthrough for buying the e-Series funds helped me out a lot. Thanks!

I’m very happy that people are finding the book useful, and I’m thrilled that they took the time to send me such wonderful emails!

Finally, I’d like to thank Ellen Roseman for mentioning the book (and the associated coaching service) in her recent column on investment coaches.

You’ve all heard about “supply and demand” even if only as a back-handed excuse given for why something costs so much. It’s pretty basic economics stuff: even a scientist can follow it. As the price of something goes up, suppliers will be willing to sell more product (and will make changes or substitutions to bring that product to market) while consumers will demand less (and find way to substitute other goods for the expensive ones). Graphically, that looks like:

The shape of the supply and demand curves vary depending on exactly what system you’re talking about, but they have that general property of supply moving up and to the right while demand goes down as you move up in price. (Note that economists usually treat price as the independent variable, and thus have their graphs backwards, but let’s leave that alone – the relationship works either way around). Where the lines meet should be your equilibrium: the same quantity coming to market for both the supply and demand side at a certain price point.

You can then do things to those curves to find what the new equilibrium would be. For instance, if the above graph represents the market for potato chips, we could imagine what might happen in a scenario where say Nelson’s chip truck breaks down. With less supply available, the supply curve would slide to the left, and the price would go up while fewer bags of chips were sold.

For housing, the demand curve is very flat: most people go through their lives without ever really analyzing the largest purchase they’ll make (and a again, remember the backwards axes of economists – a “flat” curve is actually nearly vertical). They simply get to a point where they figure they can afford it, and they go out and pay whatever the price is to get a house because that is what one does. There are a small number of people at the fringes who can’t afford to buy as prices go up (giving the slight negative slope through the middle), and prices would have to go down a lot before anyone would consider buying a second house. But through most of the range of typical prices, the quantity of demand is pretty stable.

Supply is a little less flat, but still fairly stable compared to many other markets with more substitution options and more responsive supply sources. Above a certain point and you can keep your construction crews operating profitably so away you go. As prices start to get really high supply can start to really ramp up as people get drawn away from other professions to recover supply from the margins (fixer-uppers) or subdivide existing large single units into multiple smaller ones (as seen not only in condos going up over SFHs, but also in Vancouver row houses).

But it’s never this simple in the real world. Supply and demand can be perverse when speculation comes into play. Then you have not just prices versus number of units sold, but also price history as a factor.

If prices were to rise too far too fast, our simple model of supply and demand suggests that more supply should come into play and demand should drop because of the influence of high prices, creating pressure to bring the market back to the equilibrium point. In a mania though, the opposite happens: the price history turns rational buyers and sellers into speculators. Buyers buy more, either borrowing demand from the future in the form of the buyer who’s afraid of being priced out if prices continue to go up, or from speculators buying multiple units with dollar signs in their eyes. Supply is a little more complicated, as it does definitely respond to the higher prices – that’s evidenced in the real-world by the plague of cranes in Toronto and Vancouver slapping together ever taller and smaller condos. But supply also shrinks a bit with strong price history in what’s referred to as “speculative holding” (at least relative to the supply dump we’d otherwise see). With prices on the up-swing, those moving (or moving in together) decide that rather than sell the old place, they’ll hold on to it, sometimes explicitly for investment purposes, but there are anecdotes of those who do it “just in case” even though they would have never considered that holding if price history was less favourable.

So we see that as prices move up, both supply and demand can increase in proximity to each other, feeding the beast ever upwards (no equilibrium restoring pressures), and the whole time it will superficially appear as though supply and demand are in balance.

What happens when prices stop rising at a break-neck pace? When they go down a bit – or even just stop increasing – in the so-called soft landing? In a normal market, the lower prices should bring more buyers out of the woodwork to support the new equilibrium. However if it’s not a normal market, but rather one driven by mania and attention to price history, then declining prices are not seen as cheaper but rather a shattering of the speculative world-view. Instead of finding new support for the equilibrium, the speculation in the market dries up. The demand snaps back to the inherent demand curve (which at the high prices, is a lot less quantity) while the same happens to supply (speculative holdings flood the market and listings go up). Supply and demand are – very suddenly! – far apart and there is a lot of pressure for prices to drop back to the original equilibrium.

It is my firm belief that the decline in sales volumes seen in Toronto and Vancouver this summer/fall are the first stages of that.

Now, many are saying that sellers won’t accept lower prices, that they will pull their listings rather than sell at a lower price. This is supported by our conventional view of supply-and-demand, and indeed this is what I expect will happen in the short term. But the speculation also affects the sellers. Those with speculative holdings may no longer be quite so enamoured with the land-lording life (or worse yet, the cash-sucking vacant “just in case” condo), so they may sell a bit below the peak (though the early ones will walk away with personal profits). As price momentum turns negative, the thoughts of holding out for better days turn to fear that negative price movements will persist, and panic sets in. Meanwhile, the builders who pulled out all the stops to meet the crazy demand of last year can’t stop on a dime.

There are many pundits out there with a basic understanding of “supply and demand” and who try to change their vision of the real world to fit that – in other words, they play up evidence that demand is legitimate (whether from immigration or a secular shift in how much of their paycheque the average Canadian is willing to put towards housing expenses) in order to explain high prices. But that simple model doesn’t really leave room for bubbles, manias, and speculation. Of course, I might be wrong – I still have to stop and think about those damned backwards axes every time – but at least the mental model I’m working from has the possibility of generating a bubble. For some bulls, they don’t think there’s a bubble not because of the weight of evidence, but because an overly simplistic model of supply and demand simply doesn’t allow for the possibility.

Someone asked me a few days ago if I thought he should buy some Netflix stock, based on a report that Microsoft was rumoured to be interested in taking it over. I gave him an emphatic no. Not because I had any idea as to what would happen with Netflix — it might very well go through at a really high premium — but because a take-over rumour on its own is no reason to be buying something.

For one, even if the take-over talk is legitimate, by the time the rumour has percolated to you (usually through some form of mass media) it’s too late and everyone has already acted on the news (i.e. the stock price is already up).

For another, there are like 5 take-over rumours for every take-over that actually happens (if the ratio is even that good). Heck, just searching for Microsoft take-over rumours turns up the ones on Netflix, but also Nokia, RIM, something called Yammer (which turned out to be true), Activision Blizzard, Rdio, Glu Mobile, OnLive, EA, Adobe, and two separate ones on Yahoo (one of which was a legitimate offer by MS, and another an unfounded rumour years later).

Of the take-overs that did happen, such as Microsoft buying Skype, I don’t think there was any hint of it in advance.

If the only reason to buy a company is because of a take-over possibility/rumour, and the price has already moved up a bit because the rumour is out there, then you could lose money if/when the take-over is finally denied (see: Yahoo) and the price reverts. If the takeover does happen, then often the price will jump even higher – but a 1 in 5 chance of making 20% doesn’t really work as an investing strategy.

Now that’s not to say that you shouldn’t buy a company just because there’s a take-over rumour swirling: some companies are good values and odds are another company will recognize that and take them over. But if it’s a good value, you likely won’t care one way or the other (indeed, you may wish there wasn’t a take-over so you could still own them – I’ve often felt that way about Teranet and a few other little companies like that that were scooped up by the pension plans in the last 5 years).

Take-over rumours just aren’t a good basis for making investing decisions, one way or the other.