Blessed by the Potato

Nelson at Financial Uproar is once again organizing a stock picking contest, with no shorting. Kind of a shame as for a no-consequences contest like this I think I could come up with some short picks this year much more easily than longs.

Poseidon was a strong choice in the race last year, only to blow up right before the finish line — a move that earned me the booby prize of a bronzed toilet. While I’m not going to touch it in real life, I’m tempted to make it a pick again this year just to see if there’s a bounce… but a repeat would be boring. So instead, my picks are:

HNZ.A: This one had a run up to the $30-level not so long ago. That was a bit over-done IMHO (though not quite so over-done that I thought to sell into it), but it could happen again with a strong contract to replace the Afghanistan work. In the meantime, a decent balance sheet and well-supported dividend.

URB.A: A closed-end fund that invests in exchanges trading at a bit of a discount to NAV. With the recent announcement of the sale of NYSE-Euronext, there should be some cash coming into Urbana, which may help close the valuation gap.

AIG: one of the biggest blow-ups from the financial crisis has had a hell of a run in 2012 — and is still quite a ways away from book value, with what look like much calmer waters ahead.

CLC: CML Healthcare is a last-minute pick. I think they will cut the dividend, but maybe not quite as much as the market is pricing in. With a ~7% dividend and a slight bounce after the uncertainty is removed, this might give a decent ~10% in what I am anticipating to be a much tougher competition than last year.

I had to make a last-minute change before submitting my picks to Nelson on New Year’s Eve: I had originally put in Iridium (IRDM), but it put in almost all the expected return I was hoping for in the last week of the year. It was kind of a borderline pick anyway: it looks undervalued after being (rightly) punished for a stupid insider-benefiting warrant repricing move while the core business is still ticking along. Of course, the growth is not coming in as well as I had first projected, so I didn’t expect huge gains to come from it.

(Disclosure: I am long every one of these except Poseidon).

And to put everything in one post, my investing returns for 2012 were 22% — including active and passive components of the portfolio (vs a passive benchmark of 8.2%). Even combining that with last year’s existential crisis-inducing underperformance it isn’t too shabby. Interestingly, bounce-backs in the losers I called out in that post were largely responsible for this year’s out-performance (IDG, SPB, NFI). In one case I was even smart/lucky enough to decide to average down early in the year.

Despite that, I find that between my full-time writing job, my part-time subway* pole inspector job, and spending time with Blueberry I don’t have as much time or mental energy reserves to pore through annual reports. I’ve been moving more towards passive investing for that reason, and am slowly working at taking down some positions in the active portfolio. The last few years I’ve ranged from 24 to 31 positions, and it’s just too many to follow these days. However, with a decent 5-year track record now it’s certainly worth giving up a few weekends to pick stocks, so I don’t want to get completely out of it. I’m aiming to move a good portion over to passive ETFs, and focus on a smaller number of active picks, perhaps more like 10-12 (the active portion will be more concentrated, but the overall portfolio won’t be — at least not much).

* – Aside: I’ve tried to take advantage of the ride to do analysis, but it just can’t be done. I need to spread out a bit more and the way I work means I’m constantly looking things up on the internet. I briefly considered switching to the much more expensive GO train (which might allow me to use my smartphone and sit), but I’d need to be assured of a continued 5+% alpha to make it worthwhile for me, and that seems unreasonable.

The Globe has an article out this weekend on Emili, CMHC’s automated housing appraisal system.

To break it down, when someone wants to take out a mortgage, they go to the bank and say something like “I’d like to borrow $500,000 for this house that I just purchased for $550,000, and I’ll pay the other $50,000 with my own money.” The bank then has to make sure that the $500k they lend will be paid back, by looking at the income and creditworthiness of the borrower, and also at the value of the house, so that if there is a default that the value will cover the mortgage. Even with 10% down, a loan for $500k is not very secure if the property is only worth $400k. Emili is an automated system to determine that house value (and, as I understand it, some of the other aspects of the loan), which makes the whole process a lot faster and more efficient than sending an appraiser to check out the house.

The problem pointed out by the Globe is that Emili is too generous. There are lots of reasons given in the article as to why, including this gem:

A CMHC spokeswoman said that staff are aware of “a handful of cases” in which Emili approved a mortgage for a non-existent house.

But let’s think about it logically. Emili could be perfect, always assigning the correct value to the house. Personally, I find that unlikely for many reasons mentioned in the article, such as that Emili can’t see inside the house to assess the state of repair or the level of renovations, and that known errors exist.

Emili could be good enough, but with a few mistakes made here and there. That’s a fairly likely scenario, after all many times those small matters of internal shape are not that important to the valuation, especially if there’s a decent margin of safety built in or if the land value is a significant component of the valuation. If Emili is mostly accurate with a few inescapable random errors, then we should see mistakes made in both directions. We should hear reports of buyers caught in the emotion of a bidding war, only to find their mortgage rejected because Emili won’t support the valuation, or of Emili erroneously denying a mortgage because it reports a vacant lot after a house was destroyed by fire (not having the record of the replacement), or coming in too low on valuation for some other reason. I’ve been keeping my eyes open for these sorts of anecdotes for years, and haven’t seen them.

That leads me to what I believe is the actual situation: Emili systematically over-values real estate.

Now, some over-valuation is to be expected. Lenders don’t want to turn away business by cutting the appraisal too fine, and the insurers will build this into their models. They may also assume that prices generally go up (at a modest rate), and since it generally takes time for a default to occur some upward bias can be tolerated. But when extreme dislocations occur — such as bidding wars leading to “winning” offers hundreds of thousands of dollars too high, or certain neighbourhoods seeing annual appreciation way above the norm (like 20%/year) — then the system should be flagging those as problems and denying the loans. That would act as a natural brake on a bubble.

Though it is important on a national, system-wide basis to avoid bubbles, nobody on an individual level has much of an incentive to implement brakes. The banks want to lend (especially if they have CMHC covering their butts), the buyers want to buy, the sellers want to sell, and the ancillary agents want transaction volume. CMHC is one of the few entities that could play the role of a disinterested, rational appraiser, yet they too have no political will or desire to stop housing momentum and break deals by being strict with qualifying criteria. Indeed, contrary to Robert McLister’s opinion that “CMHC knows the risk of it botching property valuations en masse. It has the public, press and regulators breathing down its neck around the clock,” I’d say that the public, press, banks and mortgage brokers are breathing down its neck to allow transactions to proceed. So instead, Emili accounts for many things including the “…housing market conditions in which the property is located…” which to me reads as “becomes loose and permissive in hot housing markets.”

Rob McLister of CMT counters:

“Inevitably, people will read the Globe’s story and think that CMHC is using some back-of-the-napkin formula to judge property risk. That’s so far from the truth. Emili is not some 100-line computer program written by a college intern. It is multi-million dollar mission critical technology benefiting from the best available data and over two decades of R&D.”

For what it’s worth, I don’t doubt that. But it’s not open source, and we don’t know the assumptions that went into making that expensive, sophisticated valuation engine. For example, does it implicitly assume that buyers are rational? A single over-heated bidding war might raise a flag, but would 3 or 10 in an area upgrade the valuations of everything, as it’s then a pattern? Though fraud becomes less likely, the loans really are no more better supported in the long run. Similarly, in assessing risk the core assumption seems to be that valuation changes affect severity, while unemployment affects default rate — the two factors combining to make up the losses that CMHC may face, and the two factors being completely separate and orthogonal. Yet in the aftermath of a bubble, valuation changes also affect default rate as speculators walk away (even though they may remain gainfully employed), and unemployment as well (as construction grinds to a halt). But if that wasn’t observed in the dataset used to build the models, then it may not be accounted for.

As a parallel, consider the subprime mess in the US. I’m sure the ratings agencies had expensive teams of people and fancy computer systems to come up with the “mission critical” ratings for CDOs, yet every AAA handed out was in error, due to some flawed underlying assumptions and a lack of checks. For instance, an underlying assumption of building many of the CDOs and securitized portfolios is that not all the crappy subprime debt goes bad at once, so you can have a AAA slice from something made up of junk. Michael Lewis also highlighted one of the other flawed assumptions: that “average credit rating” meant something, when in fact a pool of 100 mortgages to people with a credit score of 650 is rather different than 50 mortgages to people with a 700 and 50 to those with 600.

I think that based on first principles and the housing market insanity we’ve seen in the last few years, it’s clear that whatever is inside the black box that is Emili is biased to the upside in its valuation methodology. While that doesn’t cause a housing bubble, it allows it — a tragedy given that CMHC is the ultimate holder of risk and should have its systems tuned to be more conservative.

The housing bubble has spurred a huge increase in building over the last decade in Toronto. Massive new condo towers now crowd the lakefront, highway 7, Yonge St., and along the Sheppard subway. The suburbs have grown by leaps and bounds: not so long ago, Canada’s Wonderland was in some kind of magical hinterland north of the city. You had to drive by farms to get to it. Now, the McMansions are packed next to each other, fully covering the rolling hills nearly to King township. And it’s the same in the other directions too.

When I left Toronto, nearly 10 years ago, it was not exactly an empty place: the subway was standing room only for several hours of the day, and rush hour was a nightmare. Now, the subway is standing room only at most times. Most mornings the train is so full people can’t fit and have to wait for the next one as early as Sheppard (just the 3rd stop along the long trek downtown), and people are seriously getting up in my personal space. Traffic is a nightmare at almost all points during the day — even at 4 am, closing a few lanes on the 401 can cause backups — and forget about trying to nip out at 6 pm to grab some grub even up in North York or Markham; it’s gridlock until after 7. Toronto might not be quite as populous or densely populated as New York or Tokyo, but it’s up there, on par with Chicago.

I think New York is a bit of an outlier on our continent, and that it’s not necessarily the goal to shoot for; this isn’t Sim City, we don’t get points for cramming people in just because we can, and we’re not about to turn the CN tower into an arcology.

Toronto’s been growing at about 2% per year, almost double the population growth of Canada as a whole. That sounds like “modest” or “reasonable” growth, but it’s actually quite high for a city that’s as mature as Toronto is. That would mean that in 35 years, 11 million people would call the GTA home. I don’t know about you, but that sounds ludicrous to me. Importantly, consider whether our infrastructure capacity has also grown at 2%/year? I don’t have the data handy, but I recall a decade of service cuts at the TTC, and just a few gains on the GO; I don’t recall any major projects to expand our sewage or water-handling systems. The closest we’ve come is the bare minimum geographical expansion as the borders of the city grew.

And those other large American cities, according to Wikipedia, have not been growing at anywhere near that kind of rate: Chicago topped out somewhere in the 1930’s and has been fairly steady or even shrinking in size since then. New York and LA have been growing at a fraction of the rate the GTA is.

I think it’s time to accept that Toronto is full.

Though that in itself may be a great and lively debate, I think the real question is what to do once that fact is accepted. Toronto hasn’t been growing because of land grants and baby bonuses, and it makes no sense to try to set up a “Toronto quota” to forcibly keep people out. But perhaps it has been just a little too easy to build a massive condo complex in the city — are the development charges anywhere near appropriate for the increased infrastructure costs?

As an aside, I think the city missed a great opportunity with the massive build-out along certain corridors: as long as the ground was being dug up all along Queen/King or the lakeshore for condos, subway lines could have been being built as part of the foundations, stipulated as a necessary part of the design. Then a new subway line (or lines!) would not only track the developments so it would be where the population density was, but would require minimal work from the city itself (connect the fragments together, bridge the area that was already built-up around University).

Back to the question of what to do: I think one goal should be the diversion of growth to the other great cities in Ontario: Hamilton, Guelph-K-W, Kingston, Barrie, Windsor, and of course my adopted hometown, London.

Now, how to redirect the growth there?

I think we can start by throwing incentives right out the window: paying people to move out of Toronto just won’t work, and will be expensive to boot. How do I know it won’t work? There’s already a big economic incentive to not live in Toronto: car insurance is higher, food is more expensive, and the big one: houses are more expensive (you can get more for less than half the price in London) — though a large part of that is a temporary artifact of the housing bubble. All-told, I estimate that it’s about 30% more expensive to live in Toronto, and that’s before lifestyle inflation and the unspoken psychic cost of the godawful commute.

So let’s instead examine why someone possessed with rational thought and a bit of a frugal streak would want to live in Toronto, and try to play off that. Enter Wayfare: she’s got a master’s degree, is not against saving money, and has spent time in London to see that it is an awesome place with ducks and decent transit, so she’s not blindly biased against the mullet perception. Why then did she want to move to Toronto?

• The network effect: her family is in Toronto, and even though London is only a 2-hour drive to go visit, and Hamilton under an hour, she wants to be closer (to be fair, her family has been super-helpful with Blueberry and drop in for a visit twice a week or even more often). A high population begets more population.
• The two-body problem: though there’s a lot of high-tech research, education, and health care in London, it’s tough for a professional spouse to find gainful employment. This is, I suppose, another facet of the network effect of large cities.
• Certain infrastructure is better in Toronto: though London is a regional medical centre, and you can get an MRI or an oncologist really easily there, good luck trying to find a GP to give you a regular check-up. For some reason even though UWO churns out plenty of doctors, all the GPs want to move to Toronto to set up practice. London has a few good restaurants, but Toronto has so many that you can go around stiffing waitstaff on tips for years before you have to revisit a place and risk having your food spat upon.
• The prestige of the big city: I think this is something that mostly affects the female mindset, perhaps because of the giant phallus anchoring the city, but I have been told that there is just something “magical” about Toronto: London has some decent malls, and you can buy anything you want there (or from the internet, like civilized geeks), but “the shopping is better in Toronto”. London has movie theatres and sports teams, and for the number of times most people (including us) actually go to the ROM/AGO/Canada’s Wonderland/Ontario Place/Jay’s game/fringe/a musical, it’s no problem to make the short drive down. Yet somehow it’s not enough to know that it’s possible to get to all that occasional stuff when you want it, it has to be right there, just in case.
• Putting down roots: the flip side of the godawful commuting is that commuting is taken for granted in Toronto. I could quit my job, and likely find a different job that’s also in Toronto, and then commute there… even if it’s on the other side of the city. That would be considered normal. A lot of changes can take place without having to move. Conversely, as nice as London is, if I were to quit a job there odds are my next job might not be in London, or it might involve a move within the city to be closer (because you don’t live in London to commute).

I know that Toronto is full. I believe that the growth rate is going to crash sometime in the next few decades as people find that reality inescapable. Whether because it just gets too expensive and run-down for people to continue to pour in (the New York model), or because the reeking masses of humanity start to turn to crime and rioting (the Detroit model), or because people just can’t keep up an intrinsic reproductive rate when they’re all living in 400 sq ft shoeboxes… but looking at that list, I have no idea what can be done to try to redirect the population growth now, before it gets worse. The network effect is hard to break: the government can move more functions to London, Hamilton, and Kingston, but that won’t necessarily create jobs for lawyers, salesfolk, or librarians. Paying businesses or people to move is expensive (and ineffectual).

There’s the cargo cult approach: build the trappings of a world-class city in the hopes that people will show up. Though I think something practical like a subway might help, the art galleries, theatres, concert halls, and museums of smaller centres have been little more than money pits. After all, someone who’s actually attracted to a city for its “culture” isn’t going to be fooled by Orchestra London, and Hamilton theatre snobs will still just drive to Toronto for their Mirvish or fringe fix.

We could try the stick approach, but the League of Shadows didn’t look so friendly in the Batman movies…