Week 28: Outperformance of the Regional Banks, Buying Xenith Bankshares, Gramercy CDO-2005 and I admit I was wrong (and originally right) about Argonaut Gold
If the regional banks are outperforming…
Donald Coxe had a very good conference call last week. To be honest, I think his calls have been pretty boring for the last 6 months. He doesn’t have any better grasp on the Euro-crisis then anyone else, yet the situation in Europe is of such a systemic nature that any insight he provided on anything else, always became prempted with the caveat: Assuming all goes well in Europe.
Well last Friday he broke from this mold and made his first endeavour into the terrain of bullish sentiment in some time.
The main reason for his bullish outlook is the outperformance of the regional bank index, the KRE. As Coxe said:
When you get 3 months of outperformance while the S&P is itself recovering that is a powerful sign that the market has digested the bad news and that things will get better.
The KRE has indeed been outperforming.
I must admit, I’m tentative to proclaim my outright bullishness just yet. Tto be fair to Coxe, he qualified his own bullihs stance by pointing out that there was still a lot else that had to go right for the bullish call to play out.
I do admit, however, that the signs are beginning to accumulate. Jobless claims are trending down, the ISM is looking more stable, news out of China (particularly that inflation has fallen) is starting to sound more positive, and heck, even the Italian and Spanish 10-year yields are trending down at the moment.
So what do you buy if you are bullish?
Well, on the conference call Coxe proclaimed (once again) the supremecy of the commodity stocks. A bit of a broken record is he, but why stop with what works. Well I am long oil, long gold, thinking about how I might get long copper or coal (but more on that below). I have those bases covered. Perhaps the more specific question you might ask, is what does one buy when the KRE is outperforming?
And the logical answer to that?
…buy the regional banks
I’ve been accumulating the shares of a number of regional banks over the past few months. What is my thesis?
- The lows of August felt like a bottom
- There is volume in some bank stocks that typically have had no volume whatsoever (is somebody starting to care?)
- The housing market in some regions is bottoming
- The write-downs at many of these banks has peaked
- How much further below book value these businesses can go?
I’ve been listening to this mortgage broker and originator podcast called Lykken on Lending on my bike ride into work for the last 3 months. Its interesting stuff. The first thing that’s interesting is just how intertwined real estate is with regulation. They actually have a regular segment on this show that is dedicated to new legislation being considered by congress or the senate. Its crazy! Second thing that is interesting; there is starting to be some signs of life in the mortgage market. For the first time we are seeing private lenders getting back into the game. They had a company on a couple weeks ago that was funded by Lew Raneiri (the godfather of securitization) and that is looking for loans that are just below the level of what passes for the GSE’s.
It’s starting again!
In this short clip below, Jim the Realtor, prominently featured on CalculatedRisk, makes out the bull case for a barn-burner spring. Says Jim: “I think we get into spring time – if rates are still this low – it’s going to be a real frenzy.”
Kyle Bass and MGIC
Another favorite of mine, Kyle Bass, recently bought a large stake (just under 5%) in MGIC. I stepped through MGIC over Christmas and will review the work I did another time, but to make a few brief conclusions I determined the value certainly might be there but I just don’t understand the business (the mortgage insurers are hugely levered companies with massive amounts of housing liabilities against them) well enough to pull the trigger. Specifically, the solvency of MGIC and the rest of the insurers seems to depend as much on the ability of the insurers to mark their liability per payout (in other words how much they owe for the foreclosure they insured) as anything else, and that appears to be a bit of black magic to me.
Nevertheless, MGIC has moved substantially higher since that time, something that seems unlikely if the housing market were about to (triple?) dip again. Here is what Bass had to say about MGIC and the housing market a couple of months ago. From the WSJ:
Mr. Bass said that while the housing market was still around two to three years from firmly “bottoming out,” he said any future price declines would be quite modest. “I don’t anticipate a huge decline,” he said.
I think he’s right. Residential housing is closer to a bottom then a top. And its bottomed in some markets.
The Housing Market Turns?
Residential housing is the lifeblood of most regional and community banks. A turn in those markets could turn the fortunes of these companies.That’s why I’ve picked up shares in the following stocks over the last couple of months:
- Oneida Financial (ONFC)
- Bank of Commerce Holdings (BOCH)
- Atlantic Coast Financial (ACFC)
- Community Bankers Trust (BTC)
Apart from Oneida, these stocks are not for the faint of heart. I know there are plenty of well capitalized but fairly valued banks out there that can return you 10-15% per year in all likelihood. I want a bit more than that though. So I am willing to step out on the limb a bit further to get it.
Xenith Bankshares and the problem with RBC practice accounts
I’m going to get into Xenith in a second but first let me say something about this RBC practice account.
Great idea. The idea to be able to put fake money into an account, to have it count commissions and to be able to make buys and sells in real time is super.
The problem lies in the execution. First there was the problem placing orders. This started back in September. I wrote them about it. They said they would fix it. They wrote:
Here we are in January, I still have to do this clugey workaround where before I can place an order I have to start it through my margin account and then at the last step switch the practice account.
Now, just yesterday, another problem. Apparently I can’t place an order for select NASDAQ stocks. In particular those that are NASDAQ:CM (capital markets). This just started. I phoned RBC. Luckily I’m on their gold plus customer plan or whatever its called so I get some service. They look into it, see what’s wrong, but now they have to send it to their “back office people” to fix it.
We shall see.
Thus it is that while I own XBKS, I do not own XBKS in my practice account. I don’t know when that will happen. If any of my readers knows of another better service for tracking a mock portfolio, please email me.
Anyways, that’s the story, onto the stock.
My latest bank pick: Xenith Bankshares
Xenith Bankshares is a community bank centered out of Richmond Virginia.
The bank specalizes in making commercial loans, which make up some 88% of their loan book.
Xenith was involved in two transactions during the summer, buying banks from two other distressed Virginia lenders (Paragon Community Bank and Virginia Business Bank or VBB). In the case of VBB, the bank was bankrupt and the transaction took place through the FDIC. In the case of Paragon, Xenith just took over the Richmond based operations of the banks. In both cases, the company is only responsible for the performing loans on these banks books.
The history of Xenith and these two transactions have already been written up in two excellent posts on a website called Frog’s Kiss, here and here. I will not dwell on the details of the bank to much further, because all the information is there.
Xenith is aggressively growing their loan book in Virginia, both through transactions like the above, and organically through new loans. They have done a good job of making loans, and so far nonperforming assets are not a significant threat.
And yet you aren’t paying much for this growth. The company has a tangible book value of a little over $65M, whereas at the current share price of $3.70, the market capitalization is a little under $40M.
Why so cheap?
Well for one, the bank isn’t profitable yet. Xenith has been losing about $1.5M per quarter all in for the last couple of years. For two, it is a bank and after all no one wants to own a bank, right?
Of course that might be about to change.
Part of the bet here is that the management at Xenith can integrate these recent transactions and bring their profitability up to the company’s standard. The company was created originally with a takeover of First Bankshares. This was a sleepy little commercial lender that had a fairly weak interest margin. The management at Xenith have been successful in increasing the NIM significantly since that time (see below). The expectation is that they will do something similar with the newly acquired loan and deposit base.
The second part of the bet is that Xenith has a lot more room to grow. The company’s tangible equity (as noted above), is about $64M. Loans and securities and other risk assets are about $360M. So the company is only employing about 6x leverage. They should be able to raise this to around 10x over the course of the next year.
If they do, and are successful in their lending endeavors, you might expect the company to deliver a return of somewhere around 1% to 1.5% return on assets. Taken another way, you might expect the company to deliver somewhere between 8% and 12% return on current equity when its all said and done. Projecting either of these metrics leads to a fairly cheap earnings multiple (somewhere between 4x and 7.5x earnings depending on their success. This suggests that as this plays out over the next couple of years, you could expect the stock price to at least double (and optimistically quadruple if the banks become loved again) from current levels as they move ahead.
Gramercy Capital: CDO-2005 passes the over-collateralization test?
With Gramercy, as much sleuthing that I am doing of the company, I feel like I do almost as much sleuthing of other investors. With Gramercy, one of the best to follow is PlanMaestro. He posts a blog called Variant Perceptions, also posts on yahoo, investorshub, and corner of berkshire and hathaway. In this case the relevant piece comes from the latter. Says Plan:
Jameson Inn was already written off 100% for OC purposes and CDO 2005 passed again its most recent test .
As those of you that read last weeks letter would know, I pointed out that CDO 2005 was unlikely to pass any time soon if it was only curing its undercollateralization with interest payments. To have passed again, one of two things must have happened.
- About $100M of the assets held were paid back, with the proceeds being used to pay out the senior CDO holders
- One of the written down loans began to reperform
To discuss the possibility of the latter, there was news this week that the Vegas Hilton, which is in receivership and which has been 60% written down by Gramercy in CDO 2005. For some time now Goldman Sachs, which holds the mortgage on the LVH along with Gramercy and another party, have been trying to convince the courts to let them run the hotel and gaming operations while it goes through the foreclosure process. The problem is that the gaming license is owned by the previous owners Colony Resorts. Colony Resorts had been fighting back saying that if their gaming license was used by the receiver, they could be liable without having any oversight control.
The issue was very recently brought to the court, which ruled that the receiver would only have non-gaming authority. But then the Nevada Gaming Commission passed its own contrary verdict, allowing for the casino to operate under the existing license. The matter went back to the courts and just last week news came out that the ruling was in favor of Goldman.
Given the information I have, I can only speculate that this contributed to the change in the collateral test. The loan sat on the books of CDO 2005 at about $29M as of March. It was apparently written down 60%, though I have no confirmation of that figure. CDO 2005 was about $18M short as of last October. Putting that all together, it seems very unlikely the loan could have had that big of an impact on the collateral test. Still its an interesting exercise to go through, and a positive development both that the CDO 2005 is now passing, and that the LVH loan is likely accruing some interest again.
Argonaut Gold Pulls together a Strong PEA
This whole short Argonaut Gold trade didn’t exactly work out.. In fact, I don’t know what I was thinking. I need to start reading my own press clippings.
To recap, two weeks ago I shorted some Argonaut against part of my long of Aurizon Gold. My reasoning was that if gold continued to fall Argonaut, being much more highly valued then Aurizon and at the same time having less cash, would have further to tumble.
I’m a little embarrassed that I made this suggestion. It was only two months ago that I had been arguing that Argonaut was one of the better gold stock investments out there. I had it right originally. That thesis, which is available here, was that Argonaut had very strong growth opportunities and those growth opportunities could be accomplished with minimal CAPEX. If there is one thing the Street loves, its growth. If there is another thing the Street loves, its not having to put up a bunch of cash up front to get that growth.
Today the company released the PEA it had completed on the La Colorada project.
The PEA showed the following highlights:
- Initial Capital Expenditure for the project is estimated at $14.5 million with a Sustaining Capital of $11.7 million.
- Operating costs of $620/oz over the LOM, including $1.50/t mining costs, $2.36/t processing costs, and a 3.4:1 strip ratio
- Gold equivalent production of 53,000oz per year over 9 years
- Pre-tax Net Present Value (“NPV”) of $278 million using a 5% discount rate at $1500/oz gold
Overall the numbers would be mediocre if it were not for the capital costs, which at $14.5M is chump change for a project this size. This is even less than the my estimate of $25M to which I commented: There are not many companies that can boast near term production potential with so little up front costs.
When I had shorted Argonaut against a portion of my Aurizon long it was with the idea that the quarterly results might show disappointment and the idea that the gold price might be susceptible to an even bigger pullback. El Castillo has underperformed the last couple of quarters, and with a mine that is of as low a grade as El Castillo the operators run a very fine line between success and failure.
That could still be the case, but having witnessed the stocks continuing rise I am reluctant to wait and find out. I got out Monday when the PEA came out. At this level ($8) the stock is too expensive to buy. I have to just admit I made a mistake by selling it in the first place (I owned both Aurizon and Argonaut back in October, but sold Argonaut after poor 3rd quarter results), and move on.
Is Aurizon a Value Trap?
How bad was that decision I made back in October to sell Argonaut and hold Aurizon? Well, I owned both stocks until the middle of October, when I sold Argonaut after less than impressive 3rd quarter results.
This is a painful chart for me to look at.
Nevertheless, pain is a necessary condition of learning, and it helps some time to agonize over your own stupidity for a while, just so that its really grilled into you not to do the same thing again.
With that in mind, what did I do wrong?
Aurizon Mines: Visions of Joanna someday
In contrast to Argonaut, Aurizon does not seem to be in much of a rush at all to bring Joanna into production. This timeline says it all:
May 12th 2008
Aurizon first commissioned a pre-feasibility study on Joanna.
November 11, 2009
Aurizon finally received that pre-feasibility study and proceed to a full feasibility study.
September 14th 2010
Aurizon notifies shareholders that the original recovery process assumed (called the Albion process) would show lower recoveries and higher costs than first anticipated. Additional metallurgical test work would be done and the study delayed until mid 2011. http://www.aurizon.com/English/News/News-Releases/News-Releases-Details/2010/Aurizon-Reports-On-Progress-Of-Joanna-Feasibility-Study/default.aspx
August 11, 2011
Aurizon delays the feasibility study for Joanna again, saying: “the projected capital and operating costs appear to be significantly higher than previously anticipated. The increased scope of the project, as a result of the expanded mineral resource base, has increased capital costs, including those associated with an autoclave process. The costs of ore and waste stockpiles, tailings and of materials and equipment have also all been trending higher, along with the gold price.”
January 11, 2012
Another update giving an ETA: Feasibility study work on the Hosco deposit will continue in 2012 with completion of the study anticipated by mid-year. The feasibility study will incorporate a reserve update based on the increased mineral resource estimate announced on June 13, 2011, together with results of metallurgical pilot tests, a geotechnical study, updated capital and operating cost estimates, and other relevant studies.
Its been almost 4 years since the original pre-feasibility study on Joanna was complete! At this rate they should be mining by 2100.
As is obvious from above, there have been some metallurgical difficulties with Joanna. Was I too optimistic with my analysis?
To compare, the original pre-feasibility study assumed $187M in CAPEX. The operating costs were estimated at $434/oz. My analysis assumed $215M CAPEX, and operating costs of $717/oz. I think I have been safely conservative on the operating costs. I may turn out to be less so with the CAPEX.
The more fundamental point is that when I invested in Aurizon I strayed from my usual criteria for choosing mining companies in a couple key respects. Both of these have come back to haunt me:
A. Look for miners with a strong pipeline of growth. The market likes growth. It does not always appreciate value. The reason there is supposed “value stocks” is because the market does not appreciate value in itself.
B. Capital costs must be low and mining methods must be simple. The best mine to invest in is a simple heap leach deposit. High capital costs tend to get higher. Complicated mining and recovery processes tend to underperform to plan.
So what am I going to do about it?
Unfortunately there is not much I can do. Argonaut is $8 and Aurizon is $5. Most of the move in AR has been done. I’m not going to chase it at this point. Aurizon is probably much akin to OceanaGold, which I have played much more intelligently by buying the stock at $2.20 and selling it at $2.70 again and again. With Aurizon those numbers are probably around $5 and $6. Indeed I did sell some Aurizon around the $6 range the last time it was there but I think that its time to recognize that without a strong feasibility study for Joanna, that $6-$7 is about all you can expect here.
I’m getting too many stocks in my portfolio. I am also seeing my cash position dwindle because I keep picking up new stocks without selling old ones. I am still extremely cautious about Europe, and being so, I am getting uncomfortable with both of these trends in my portfolio. In the next couple weeks I am going to reevaluate what I own and start paring where I need to. The problem, as it always is, is that I like the prospects of all the stocks I own. Unfortunately, as I think I showed rather clearly in my last post describing my 2011 performance, I am just as often wrong about that as I am right. The likelihood of my own fallibility must never be underestimated.
If Joanna feasibility study went smoothly then you would not be able to buy Aurizon at $5 and instead have to pony up $7 or $8 thus maybe not even being able to buy it in the first place. Yes, it is a slower value play but the risk at these prices is extremely low. Their mistake was to make 65% investments on several grassroots exploration plays (Marban, Fayolle) that would take years to just prove out a deposit and then many more years for feasibility and mine construction for realistically ten years. Maybe mistake is too strong a word because those are projects of merit worthy of investment. But in addition to such grassroots investments Aurizon needed to purchase an advanced stage asset ready to go into production from a company that either had limited cash or the inability to obtain financing. Since 2010 they needed that near-term stop gap in their production pipeline until Joanna was able to kick into production which at that time was not until late 2013. Today the timetable is possibly mid to late 2014 for Joanna production assuming they hit their latest mid-2012 feasibility deadline. I think the new CEO realizes the past error of the ex-CEO and has gone on record as to actively looking for a decent sized near-term production acquisition.
The upside from all of these management mistakes is the higher probability of Aurizon receiving a hostile takeover bid. Because all of the ingredients are there: large cash position that is rapidly building, one solid long life mine in operation, a second asset that appears to be even bigger than their first mine, undervalued pricing of their stock in the market, and no significant shareholder. If conditions persist then this gets put into play sometime after Aurizon announces Joanna feasibility study results. Just my speculation.
Those are fair points. I agree about the takeover potential. I just have sat through too many situations that should’ve but never did to hold out too much hope on that. The JV’s are what they are; if one actually hit on something big it would be a different story. Thus far success has been lukewarm at best. Let’s hope the value begins to get recognized.