Posts from the ‘Community Bankers Trust (BTC)’ Category

Jan 2

Letter 26: A Move in ACFC, the end of tax loss selling for gold stocks, Mispricing of Aurizon Mines, and All the Devils are Here

All the Devils are Here (though most have probably moved to Europe)

Over the winter break I read the book All the Devils are Here, by Bethany Mclean and Joe Nocera. The book essentially traces out all the strands that culminated in the panic of September 2008. The book identified the following factors:

A reliance on ideology instead of analysis. In particular this applies to the Federal Reserve and Alan Greenspan, whose ideological “market is always right” view permeated the decisions of the Fed and to some extent those of the other regulatory bodies. But more generally, ideology, specifically free market ideology, seemed to permeate through all the political and financial institutions to the point that it replaced a sober look at reality. Similarly, for many traders and investment bankers, an ideological reliance on “the model” often led to an ignorance of the potential risks of an outlier scenario
The absence of regulation. For a variety of reasons (the power of the lobby groups, the political infighting between the regulatory bodies, the ideological free market view of the participants and the myopic focus on regulators on Fannie and Freddie) an attempt to regulate the subprime industry was hardly even contemplated until it was too late.
The development of securitization. The most important consequence of the innovations to pool mortgages, to tranche pools, and then to create pools of pools (CDO’s) was that the lender and the borrower became further and further divorced by more degrees of separation. The securitization process created so many layers of intermediaries between the party who actually ended up with the loan on their books and the party that took the money that risks were easily lost in the translation.
The rubber stamped AAA status provided by the ratings agencies. Some books focus on how the rating agencies didn’t understand what they were rating. Mclean and Nocera point out that the revenue structure of the agencies was doomed to be corrupted. A system where the raters are paid by the producers of the securities they rate might be considered to be an insane one. The result was that the agencies were played off against one another by the investment banks; market share went to the most relaxed rating. Add to this the fact that the agencies, particularly Moody’s, became focused on profits at the expense of their inherent conflict of interest, and you had a situation ripe for abuse.
Greed. Politicians more concerned with their own campaign donations than with promoting sustainable public policy. Company executives intent strictly on their own promotion and profit. Mortgage originators with essentially no moral compass at all. The system was (and is) corrupt.
A lack of understanding. The same characters at play as with greed. So few people saw the disaster coming. Sure some did, there were a few regulators and a few hedge funds that saw how unsustainable the leverage being piled on in the mortgage sector was. But the vast majority didn’t have a clue. Even the supposed smart money didn’t really get smart until 2006-2007.

It is this last point, the lack of understanding, that I think is most relevant to what we face today. It really surprised me how little the people in influential and powerful positions understood the concepts that they were making decisions with regard to. Even Hank Paulson, who is actually portrayed in quite a positive light, was completely blind to the corruption and leverage being amassed in the mortgage market.

This naturally begs the question of Europe: how many of the politicians and bureaucrats in the EU really understand the situation they are trying to navigate? Do they really know the risks inherent in the decisions that they are making? Do they even really understand the banking sector they are trying to protect?

The last 6 months for me has been an education in how the modern banking system works. I have been trying to read all that I can, all the boring, technical aspects. And I don’t think for a minute think that I’ve wrapped my head around it. There are so many moving and interdependent parts. It’s also not a very tangible subject. It simply isn’t something that is easily understood.

Thus I think it’s a legitimate question as to whether the bureaucrats of Europe have the understanding required to navigate the minefield of sovereign defaults and banking bankruptcies. As Lehman showed, it only takes one mistake to create a loss of confidence that spirals uncontrollably.

How can you take on risk with this in mind?

The end of (tax loss) selling?

The week after tax-loss selling is always an interesting one. It provides the first glimpse into whether a security has been facing unrelenting selling because of investors simply wishing to take their losses (and their tax breaks) and move on, or whether something more nefarious is at play. Along the lines of the former, this week provided a rather marked jump in a number of the regional bank stocks that I have initiated a position in. Most conspicuous of these moves was that of Atlantic Coast Financial.

A Take-over Imminent for ACFC?

ACFC had a rather astounding 50%+ move this week. I really have no idea what precipitated the move. To take it with a grain of salt, the volume for the stock this week was less than spectacular, though the same could be said for almost the entire move down.

As I pointed out last week the stock is a bit of a flyer; the bank is a mortgage lender in one of the most crippled mortgage markets (Florida), they have bad loans coming out their wazoo, and a stock that has fallen from $10 to $1 in less than a year generally does not do so on speculative panic alone. Nevertheless, part of the story is the book value, which even with 3 years of bad loan write-downs lies at a rather surreal $19 per share (versus a share price of $1.70 when I bought it).

The other part of the story is simply the realization that what is going on with this bank (and many of these little community banks that got caught up in making bad loans at the wrong time) is a race between the write-downs of their past transgressions and the earnings of their current performing loan book. With ACFC it is not at all clear to me that the bad loans will win out; in fact I tried to make the case last week that with a little luck (and an improving economy) the performing book may very soon be able to out-earn the losses on a consistent basis. If this happens, the shares are clearly worth more than 10% of book value. Even if it just becomes a possibility, a shrewd competitor may be tempted to take a plunge. I constructed the chart below to try to see where ACFC is in that process. The chart compares earnings before provisions (black) to the quarter over quarter change in non-performing loans (red). Its basically a look at whether the company is out-earning the loans going bad each quarter. The 3rd quarter was the first in four that the black won out.

Community Bankers Trust: Another Regional Bank with a Move of its Own

While ACFC was the best of the lot of regionals, there were others that showed signs of life. Community Bankers Trust surged on Friday. The stock remains at about 1/3 of book value. If it were not for Europe and the ever-impending doom there, I would add more. As well, Oneida Financial continues to push higher. Unlike ACFC, BOCH and BTC, Oneida is a terribly boring bank trading at about book that is probably going to do nothing but increase in price by 10% a year and pay a 5% dividend until one day it gets bought out. At some point I might get bored with with relatively low return, but in this environment, I am happy to take a reward with so little risk.

Will Gold Stocks Rise now that Tax-loss Selling is over?

As for the golds, Esperanza, Canaco and Geologix all are showing classic signs of a let-up in tax loss selling. All are well above where I bought them. Aurizon, on the other hand, continues to be sold rather indiscriminately. Yes, I realize that the price of gold is getting clobbered on a regular basis. I can appreciate that investors may be questioning the wisdom of holding gold as a hedge to anything given the fact that it seems to dramatically underperform on risk-off days.

Still, I scratch my head at Aurizon. Here is a low cost gold producer that is comparatively less correlated to the price of gold than most of its competitors. For one, if you are low cost you are by definition high margin. Thus, a $30 move in the price of gold is of much less impact to a producer with $1000/oz margin (like Aurizon), than say a producer with a $500/oz margin. Yet Aurizon regularly trades down MORE than your average gold producer on the down days.

Going Short Argonaut Gold and long Aurizon Mines

So confounded have I been that in order to hedge my risk with Aurizon I have decided to take a short position in a fellow gold producer, Argonaut Gold. To be sure, there is nothing wrong with Argonaut Gold. I wrote the company up rather glowingly a couple months ago. However that was at $5, and now AR trades at $7, while in the same time Aurizon has fallen to less than $5. Below is a comparison of the key metrics of both companies.

So to briefly summarize the above, Aurizon produces more than twice as much gold, it produces over double the cash flow, and to top it off, Aurizon’s 3^rd quarter was stronger than Argonaut’s. Argonaut potentially has a better pipeline of projects, but this is more than nullified by the fact that Aurizon trades at almost half the price on a per producing ounce basis, produces those ounces at $50-$100 cheaper, and has over $1 in cash on its balance sheet while Argonaut has a mere 30 cents. It simply doesn’t make sense.

While I remain bullish the price of gold, I also remain wary that I am not very right in this bullishness at the moment, and so it seems like the prudent thing to do to short what seems relatively over valued and buy what seems relatively undervalued. Anyways, that is what I did.

I also bought back OceanaGold for another run. Its getting to be repetitive, but it has been a consistant source of profits. Buy OceanaGold below $2.20 and sell it above $2.70. I must have done this 3 times already in the last 9 months.

Portfolio

Dec 18

Letter 24: Risk and Reward, Atna Analysis, More Community Banks

Last week I wrote that I did not understand why the market was reacting as favourably as it was to the European proposals that came out of the Dec 9th summit.

A tweak here, a tweak there and pretty soon you have… well not a whole lot to be honest.

In a way I felt vindicated by the market collapse that occurred in the early part of this week. In another way I felt sick to my stomach, because though I have been creating an evermore conservative weighting to my portfolio, when the shit hits you still feel it.

Kyle Bass was on CNBC this week giving some more detail on his doomsday-like expectations:

The observation that deposits are leaving Greek banks at an annualized rate of almost 50% is somewhat frightening. Clearly this crisis is going to come to a head soon.

John Mauldin publishes a great conversation between Charles Gave and Anatole Kaletsky. It is quite provoking, and its hard to walk away after reading it without feeling the impending doom that awaits the Eurozone. Kaletsky and Gave both make the quite reasonable point that perhaps Germany would prefer a break-up of the Eurozone. If you watch what Germany is doing, and ignore the platitudes they are saying, you might question their motives. Kaletsky points out that of the necessary measures to fix the Eurozone, Germany seems to be steadfastly opposed to both Eurobonds and to ECB intervention. Absent those measures, what hope does the Eurozone have? Perhaps that is the plan all along.

Gold Stocks – I should went all out

Gold stocks got CREAMED this week. I had been lightening up on my gold stocks the week before in anticipation that something might be about to hit. I didn’t like the way gold was going, I didn’t like the fact that the WSJ was penning articles describing a dearth of Indian demand, and I didn’t like that Draghi talked tough during the EU summit, suggesting that money printing was still some time off.

Nevertheless being that I was not fully out of gold stocks, I got smacked about pretty good over the course of the week. Atna, Aurizon, and with Lydian all performed quite miserably.

What’s Wrong with Aurizon?

Aurizon is a surprise to me. I expected the stock to hold up better than it has been. I might have expected its performance to be closer to that of Alamos. Both are low cost producers. Both are single mine operations. Yet the valuation difference between the two is somewhat staggering.

I can only guess that there is a strong seller of Aurizon out there that wants to be out of the stock by year end. I can only hope that the new year will bring some sanity to the stock.

While reviewing Aurizon, I began to wonder how much having a AMEX listing hurts the stock. Anecdotally it appeared to me that the Canadian stocks with AMEX listings are much more volatile then those without. I decided to take a closer look.

I grabbed price data since August 1st for 9 stocks, 5 with AMEX listings and 4 without. From the web I grabbed a visual basic function that calculates volatility based on the following Black-Scholes formula.

For purposes of Black-Scholes calculations, volatility is the standard deviation of the periodic percent change in prices, divided by the square root of time. Volatility is emphatically NOT the same as “beta”, which measures the correlation of a security’s price movements with those of the overall market. Neither is volatility simply a measure of the standard deviation of a security’s closing prices over time.

Here is the volatility of each security:

Is there a correlation? Perhaps, though its not as clear a one as I had suspected. The distinction is most clear between Aurizon, Alamos and Argonaut Gold. There is no reason, in my opinion, that Aurizon is so much volatile than these other two stocks. But apart from that, volatility seems similar between stocks on the two indexes.

I bought back some of the shares of Aurizon at $5.07 that I had sold at over $6 a few weeks ago.

The NPV of Atna

Another stock to get clobbered this week was Atna Resources. I mentioned a couple weeks ago that I had finished an analyses of the company and would post shortly. I never did that post, until now.

Below is the after tax NPV10 that I calculated for Atna at various gold prices.

I based my model on the following assumptions:

Briggs:

A 11year mine life, at 40,000 t/d
Total produced ounces of 476,000 oz over LOM
0.017 oz/t resource over the mine life, strip ratio of 4 and with 80% recoveries
Resulting in gold production of 39,700 oz per year
Mining costs of $1.30/t mined, milling costs of $4/t milled and G&A costs of $1.7/t mined
Cash costs of $898/oz over LOM

Pinson:

A 15 year mine life, beginning at 350t/d and ramping to 750t/d by year 4.
Total produced ounces of 940,000 oz over LOM
0.4 oz/t resource over the mine life, diluted by 30% with 90% recoveries, resulting in gold production beginning at 50,000 oz and ramping to 75,000 oz.
Mining costs of $110/t, milling costs of $50/t and G&A costs of $11/t
Cash costs of $687/oz over LOM

Reward:

A 8 year mine life, at 24,000 t/d
Total produced ounces of 292,000 oz over LOM
0.026 oz/t resource over the mine life, strip ratio of 4 and with 80% recoveries
Resulting in gold production of 36,400 oz per year
Mining costs of $1.30/t mined, milling costs of $4/t milled and G&A costs of $1.14/t mined
Cash costs of $560/oz over LOM

Columbia and Cecil:

To the current resource of each I assigned a simple asset value per ounce of $40/oz measured and indicated and $20/oz inferred on the total resource of both properties

Atna is, in my opinion, is one of the best gold stock investments out there. As demonstrated above, the stock is trading at about 1/3 of its NPV 10 at $1500 gold. If I wanted to get more aggressive in my evaluation, I would note that many companies are moving to value feasibility on NPV5. On an NPV 5 basis Atna is worth $3.86 per share at $1500/oz gold. That number jumps to almost $8 per share at $2100/oz gold. Clearly there is upside once the momentum begins to build.

I added to my position in Atna on Friday at 78 cents.

Taking Advantage of the Collapse

In addition to Atna and Aurizon, I also added new positions in a few juniors. Call it the beginnings of a basket; I added a couple of non-producing juniors with deposits to my portfolio this week:

Geologix was recommended by Rick Rule as a takeover candidate on BNN about a year ago. Since that time the stock has fallen significantly. The company has a very low grade copper-gold deposit called Tepal in Mexico. The PEA that was published on Tepal a few months ago put the NPV5 of the project at $412M based on $1000/oz gold and 2.75/lb copper. Geologix has $14M of cash on hand. With 145M shares outstanding, the market capitalization of the company was $28M at my entry price of 20 cents. That puts half the market cap in cash and the other half in a project with an NPV that is nearly 10x the value of the company. Something has to give here.

Esperanza Resources is another old Rick Rule recommendation. Rule doesn’t talk much about specific stocks anymore, but there is some evidence that he is still interested in the company. http://www.investmentu.com/2011/September/why-gold-mining-stocks-will-skyrocket.html . The company certainly fits the bill of the sort of stock Rule likes. Esperanza has 1Moz of gold in Mexico. It’s a heap leach project so it should be able to be brought on production without a massive capital requirement (about $100M). Like Geologix, the company has almost half its market cap ($100M) in cash on hand ($50M).

I plan to add more to both of these stocks in the coming weeks.

Regional Banks: A Position in Community Bankers Trust

Community Bankers Trust (BTC) hit my bid when it sold off back down to a dollar this week. BTC is trading at 27% of tangible book value. This is, of course, partially because of the large number of non-performing loans on their books. Non-performing loans make up 8.9% of total loans in the Q3 quarter. This was down from 10.1% in Q2. In fact, there are some encouraging signs that the worst of the loan losses are behind us. The company has shown 3 quarters of lower loan amounts 30-89 days past due. This trend is beginning to show up in the total non-performing loans, which decreased for the first time in a year in Q3.

Moreover, as I have pointed out previously, insiders continue to buy the stock. Third quarter purchases by insiders were a little less than $50,000.

And Another Regional Bank Position in Atlantic Coast Financial

To be perfectly honest, I might have made a mistake here. I’ve only put a very tiny amount of capital at risk, but even that may have been too much. Atlantic Coast Financial (ACFC) is a lottery ticket. I bought the stock at $1.70 on Friday. There is just as much chance that it will go to zero as there is that it will double.

ACFC is a former Mutual Holding company that did their second step bank in February. The second step added cash to the balance sheet and resulted in a bank trading well below book value. ACFC trades at a rather crazy 10% of tangible book. Clearly there is more to the story.

The more to the story is that the bank is centered in Jacksonville Florida. They primarily make residential real estate loans. Real estate in Jacksonville has not done particularly well over the last few years (though it appears to be bottoming).

The falling real estate prices have led to skyrocketing non-performing loans. Those non-performing loans have not shown any sign of peaking yet (thus the possible mistake on my part).

The questions are, how many of these nonperforming loans will eventually be written down, and will there be value left in the equity once the non-performing loans are written down.

What drove me to take a small position in the stock was in part that an improving economy, and stabilizing home prices in Jacksonville, may mitigate further deterioration of the bank assets. As well, the bank is generating decent earnings before provisions. Ignoring provisions in Q3, the bank earned $1.16 per share. In Q2 that number was $0.55.

What is going on at ACFC is something akin to a tug-of-war, whereby on the one hand loan losses strip away value every quarter, while on the other earnings power of the performing loans adds value back. The share price is so low that it doesn’t take much a a shift in the dynamic between these two forces to change the value equation substantially. Its easy to see how a stabilization in non-performing loans could quickly allow the earnings power to win the race and shareholder value to go up substantially.

The other factor in my decision to buy was the recent announcement that the company was looking into strategic alternatives.

On November 28, 2011, Atlantic Coast Financial Corporation issued a press release announcing that its Board of Directors has engaged Stifel, Nicolaus & Company, Incorporated to assist the Company in exploring strategic alternatives to enhance stockholder value

Part of the reason that the company is looking for options is that they are not in compliacne with the Individual Minimum Capital Requirement (IMCR) agreed to by the Bank with the Office of Thrift Supervision on May 13, 2011. Under the IMCR, ACFC agreed to achieve Tier 1 leverage ratio of 7.0% as of September 30, 2011. Tier I capital at the bank is 6.22% right now.

It is a far from perfect scene. Nevertheless, an improving US economy and stabilizing housing prices could give me a decent return on the stock. The book value of $19 is unrealistic, a return to $3 is not.

Portfolio Composition

Dec 11

Letter 23: Thinking it Through

Let’s Start with Europe (again)

The unfortunate reality of investing at the moment is that you cannot make a decision without first appraising the situation in Europe. Correlations of most stocks, most asset classes, have gone to one. The ability of the ECB to buy Italian debt, or the liquidity position of Societe Generale weighs as much on the price of Coastal Energy or Arcan Resources as does the success of their next well.

Its a bizarre new world.

This week Europe had their latest summit installment. The response of the market to what transpired was confusing. The market crashed mightily on Thursday, only to rally just as mightily on Friday. Italian and Spanish bond yields spiked on Thursday but then dropped modestly on Friday.

Given the confusing signal sent by the market, I want to take a few minutes to step through what was agreed to at the ECB and among the EU members. Hopefully we will be able to draw some useful conclusions as to what it means to the stocks we invest in.

The Fiddling of the ECB

A tweak here, a tweak there and pretty soon you have… well not a whole lot to be honest. Let’s take a look at what the ECB did:

They lowered the rate for banks to borrow money from the ECB
They increased the types of collateral that banks can use to get liquidity from the ECB
They extended the period for banks to do long term borrowing from the ECB to 3 years and suggested they would facilitate such loans in unlimited amounts.

While these actions are somewhat helpful, what the ECB failed to do (at least directly) was to agree to buy significant quantities of government bonds. This failure was likely responsible for the collapse in the market on Thursday.

Some have argued that the change in long term borrowing requirements will effectively let banks buy sovereign bonds on behalf of the ECB, effectively skirting the rules. From the horse’s mouth:

There is no need to be a great specialist to understand that tomorrow, thanks to the central bank’s decision, the Italian state can ask Italian banks to finance part of its debt at rates which are undeniably lower than today’s market rates,” Sarkozy told reporters at a European Union summit on Dec. 9. “I take Italy but I could take the example of Spain. This means that each state can turn to its banks, which will have liquidity at their disposal.”

What Sarkozy is talking about is theoretically possible, however I am skeptical that it is going to be very meaningful in practice. For one, the EU banks are already in the process of deleveraging. By all accounts they are already too leveraged. The process described by Sarkozy just adds more leverage. For two, you have to think that the last kind of assets that the EU banks want more of are questionable sovereign bonds. Finally for three, if the banks decided to leverage up with even more sovereign debt all you’ve really done is doubled down on eventualy bailout that will be required when that sovereign debt goes bust. You haven’t actually solved anything.

One of the last gasps of a Ponzi scheme is to use one investment vehicle to start purchasing the assets of another at an inflated price. In other words, once you run out of outside suckers, you try your best to shuffle around the funds to appear solvent. Needless to say this typically doesn’t last very long.

In all I don’t think that what the ECB did amounts to much more than a temporary blip of increased demand. The problem of too much debt remains, liquidity to banks only helps solve the banks liquidity crisis, and the ECB still refuses to get its hands dirty by buying that debt in bulk. However, if you want another opinion on this, on the bullish side, I think there was an excellent summary written by Savannahboy on Investors Village.

What did the EU do?

Describing what the EU did is trickier. It is easy to get caught up in the market move upwards on Friday and assume that something significant must have happened at the meetings. Well, I did a lot of reading and if something significant did happen, nobody told the journalists. I suppose that the existing “plan of a plan” got tweaked and even pushed forward a couple of steps. Yet it still remains a long way off from being a clear path to solvency.

A good Globe and Mail article by Eric Reguly reported the following summary of what was accomplished:

At least 23 of the 27 countries in the European Union – soon to be 28 with Croatia’s apparently suicidal desire to climb aboard the listing ship – agreed to a new, long-term fiscal pact designed to ensure that the euro never again gets hit with an existential crisis. (Britain isolated itself by refusing to join the deal, for fear that it would have to sacrifice the safeguards on its banking industry.)… On top of that agreement, the EU is strengthening its roster of financial stabilization tools. The EU will lend about €200-billion ($272-billion) to the International Monetary Fund, co-sponsor of the bailouts of Greece, Portugal and Ireland, to boost its firefighting capabilities. The European Stability Mechanism, the permanent bailout fund, is to launch next summer, a year earlier than originally planned, and its lending capacity is to be increased.

Reguly goes on to make what I think is the very valid point that all of these moves will do nothing to deal with the fact that the peripheral countries are not growing.

Look at Greece. Two years of austerity demanded by the EU and the ECB – read: Germany – with the IMF at their side have pushed the country to the verge of failed state status as economic activity vaporizes. The rest of the EU is slipping into recession.

With no growth, budget deficits everywhere refuse to disappear. Debt is going up. Perversely, the German-inspired response to the persistent deficits is demand for even deeper austerity. This is self-defeating, vicious-circle economics. At its worst, the lack of growth will erode the ability of the weakest countries to service their debts. Once investors figure that out, their sovereign bond yields will soar again, to the point their funding costs become unsustainable. Italy is getting close to that point.

This is key. Markets are almost exclusively focused on what bandaid can be created to keep the banks from going belly-up next week. Perhaps the summit made some strides in this regard. We should be able to make it through Christmas without anything catastrophic occuring. But nothing that is being done about growth.

Jane Jacobs and the Feedback Nature of Currencies

The reality is that the fundamental problem in Europe is what brings it together in the first place: the existence of a single currency. Italy, Greece, Spain, etc, cannot compete with Germany on a level playing field. These countries need to have a way of leveling that reality out. The primary (perhaps the only market based) mechanism for doing so is the relative value of the currency of each region. If there is only one currency, there is no way to rebalance between the Eurozone countries.

This was the salient point made by Jane Jacobs years ago in her great book “Cities and the Wealth of Nations”. In that book Jacobs begins with the basic premise that a currency is a feedback mechanism. She goes on to argue that the problem with a country based currency is that it doesn’t allow for proper feedback of the individual cities that make up that country. Cities within a country have a wide range of productive capacities. What needs to occur in order to correct imbalances between cities is a readjustment of each city’s currency.

Jacobs provides a number of examples of how national or imperial currency regions usually results in one or two economically powerful cities, and a number of other dependent cities, usually requiring transfer payments of some sort to survive.

Speaking particularly of Europe she says (remember this was written in the early 1980’s):

In Italy, as time has passed since the unification of the country a century ago, the economics dominance of Milan has grown only more marked, not less so. Even Rome itself has only a meager cioty region, vanishing a few miles south and east of the city where, immediately, the poor south of Italy begins. In Germany before its postwar partition, Berlin had become ascendent…In France, only Paris has a significant city region now, unlike the country’s so-called eight great peripheral cities: Marseilles, Lyons, Strasbourg, Lilli, Rouen, Brest, Nantes, Bordeaux.

Outside of Europe she points to the example of Canada (Toronto and central Canada has typically grown briskly and propped up the weaker maritimes provinces), the US (cities of the northeastern corridor typically being much stronger then those of the south), and Britian (where “the passage of time simply widened the economic gulf between [the rest of Britian] and London”) to name a few.

What Europe has embarked on with the Euro is the exact opposite of what is needed. Currency regimes need to evolve to produce better feedback, not worse. The Euro currency feedback mechanism is skewed by the strength of the German economy (actually more exactly the economy of its one or two prime export replacing cities, Berlin and Frankfurt). Peripheral countries like Italy, Greece, Spain and Portugal are doomed to receive faulty feedback rather than the natural “export subsidy” that would occur if those countries had (lower value) currencies of their own.

US Housing Market

Getting away from Europe, I spent some time this weekend listening to an interesting debate at the AmeriCatalyst Housing conference. I was introduced to this conference when I discovered some of the videos of Kyle Bass being interviewed at it. As it turns out there is a lot of interesting stuff at the conference, not the least of which is the discussion below about the state of US housing. This is a debate / information session put on by experts in the mortgage and housing industry.

Probably the most interesting aspect of the debate was with regard to shadow inventory. I’ve never been totally clear on just what shadow inventory was, and it seemed to be a number that varied significantly depending on the conclusion the purveyor was trying to draw, so it was interesting to hear the comments of these experts on the concept.

The truth is that the magnitude of shadow inventory depends as much on the definition as anything. A couple of different estimates of shadow inventory are made by different analysts. Laurie Goodman (who I first learned of from ftAlphaville fame) pegged shadow inventory at 11M (which is an amazing 20% of housing mortgages outstanding). Mark Fleming pegs it at 2M. Both analyts are using the same data.

How is this possible? Its all in the assumptions. Shadow inventory is really just houses that are expected to go into default at some point. There is nothing particularly nefarious about the concept, even though the name suggests it is some sort of inevitable flood of housing supply. It may be, but it may not. It depends on what happens. Laurie, to come up with her 11M number, assumes a fairly large number of prime mortgage defaults, including some that are currently with LTV (loan to value) of less than 100%. Laurie also looks at 60 day past due as her “bucket” from which to extrapolate current nonperforming loans. Mark on the other hand, uses 90 day past due, and does not include currently performing prime mortgage defaults.

As Mark Fleming puts it, the true shadow inventory is “behaviorly perception driven”. In other words, if the housing market begins to be viewed as bottoming, if the economy is perceived as improving, the impetus to default will be less and the shadow inventory will be on the lower end. If the view is another lengthy recession, then expect a lot more inventory to come out of the shadows.

What it Means to the Portfolio: Lightening up on Gold

I sold out of Newmont Mining earlier this week, and I lightened up on my position in Aurizon Mining. I remain bullish of gold stocks, just not as bullish as I was.

I have been expecting that the European problems would precipitate ECB money printing. I still believe this is going to happen, At some point that is; as I pointed out the structural flaw in the Euro currency union means that there simply is no way that Italy, Greece, Spain and Portugal (maybe even France) are going to grow themselves out of their debt.

Nevertheless Draghi’s comments this week suggested that money printing may be a little further off into the future than I had hoped. Without that, gold remains vulnerable to the headwind of its own price appreciation, and the damage that has done to jewelry sales.

The WSJ had a good article on this:

India’s wedding-season gold demand has nearly disappeared as the yellow metal’s local prices have climbed to near-record levels because of a fall in the rupee’s value, sparking a rush to sell scrap during the usually peak buying period.

“There is virtually no demand for gold,” said Prithviraj Kothari, president of the Bombay Bullion Association.

I feel reasonably comfortable holding story stocks like Atna Resources and Lydian International (I also started a position in Esperenza Resources this week, though not in my online portfolio). I feel less comfortable with Newmont, which is basically a play on the price of gold. The same case can be made to a lessor extent with Aurizon Mines (though the reason to hold onto Aurizon is an eventual consolidation of the gold sector).

Buying the Banks

While I am reducing gold, I am buying back some of the regional bank holdings I sold off after beginning to be concerned about Europe. The truth is, the regional banks have faired better than I would have expected during the past 6 months. The recent bottoming of the ECRI weekly leading index, along with decent jobless claims data, suggests to me that the US economy does not have its bottom falling out. I suspect that a muddle through for the US should be good enough to see decent price appreciation in some of these beaten up regionals.

Bank of Commerce Holdings

A bit of a punt here.

I was listening to BNN last week and I caught Contra The Herd’s Benj Gallander’s top picks. One of them was Bank of Commerce Holding (BOCH on the Nasdaq). I did some work this week on the company and it looked cheap (less than 10x earnings, trading at about 50% of tangible book), it had a reasonable level of nonperforming loans (3.3%), and it has the potential for better earnings in the future once it works its way through its loan loss write-downs. So I bought some.

The worry about this regional bank is its region.

The Company conducts general commercial banking business in the counties of El Dorado, Placer, Shasta, Tehama and Sacramento, California.

This is not-exactly-but-close-enough-to the inland empire that didn’t fare so well during the housing bust:

Given the circumstances, the company has done an admirable job of keeping their loan book clean thus far:

Nonperforming loans to total loans 3.33 %
Nonperforming assets to total assets 2.30%

As well ROE has been decent, particularly if you consider that the number includes the provisions to losses the company has taken:

Return on average assets (ROA) and return on average equity (ROE) for the three months ended September 30, 2011, was 0.91% and 7.45%, respectively, compared with 0.67% and 5.95%, respectively, for the three months ended September 30, 2010. ROA and ROE for the nine months ended September 30, 2011, was 0.75% and 6.45%, respectively, compared with 0.70% and 6.61%, respectively, for the nine months ended September 30, 2010.

I estimate that if you looked at ROE ex-provisions, the number would be very close to 10%.

Bids in for Oneida Financial (ONFC) and Community Bankers Trust (BTC)

While I managed to pick up a position in BOCH quite quickly, I have bids in for, but so far haven’t been able to purchase, too many shares of ONFC and BTC. Rest assured I will wait patiently until I do. Both of these banks represent good value, and unlike BOCH they are both in areas with stable economies and housing (Virginia for BTC, Central NY for ONFC).

In the case of Community Bankers Trust, the 3rd quarter brought the first profitable quarter in quite a while. It also showed a continuation of the trend towards less charge-offs.

BTC trades at less than a third of tangible book value ($3.67) at this point. Meanwhile, insiders continue to buy shares.

Oneida Financial is a NY based bank with stellar loan performance (well under 1% nonperforming assets to total assets), strong earnings performance (should earn in the neighbourhood of $0.80 this year), and is trading slightly under tangible book value of $9.10.

I am particularly impressed with Oneida’s consistency of earnings throughout this tumultuous period.

Oneida also pays a dividend of 5%.

Portfolio Composition

Aug 25

What I’ve Been Doing

On the weekend I posted the reasons why I am very afraid that the situation in Europe is about to get a whole lot worse. At the end of that post I highlighted a number of things that I planned to do to deal with this risk. Over the last 3 days I have mostly completed these items.

Get out of Gramercy – I sold out of Gramercy today at $2.56. In retrospect I could have waited and sold out 10 cents higher. We can’t know which way the market will go on any given day. I may regret this. Gramercy is likely coming ever closer to the day they settle their Realty division issues with their lending consortium. The stock could make quite the pop on that day once the deal is announced. I will be watching the news very closely for that day and will pounce if it settles positively.
Trim Oils – I did this in my actual account but not in the practice account. In my actual account Arcan, Coastal and Equal Energy were all trimmed by 10%. I am dealing with somewhat larger positions in my actual account, so trimming is a more reasonable proposition. I have found that using my strategy of taking off little bits at a time leads to extraordinarily high commissions with the practice account. If and when I get to the point where I want to trim these positions to 25%, I will do the same in the practice account in one move.
Cut the Banks in half – Oneida Financial was cut in half. I held onto all the Community Bankers Trust that I own. I sold all of Xenith Bancshares. I don’t think I will regret these moves. The US economy, at best, will be sluggish for the next few months. I don’t expect big moves in the banks for a while yet.
Cut Leader Energy Services by as much as I can – In my actual account I cut the position by half. In the practice account I had a stink sell order at 69 cents and low and beyold it got filled today so I am out of Leader entirely there. Some might say this is hypocritical. How can I write up Leader a few short weeks ago and then suddenly turn around and liquidate my position. All I can say is that when the facts change… look I underestimated the crisis that is occuring in the Eurozone. Leader Energy is in a cyclical business and has a lot of debt. This is a good company to be in during a economics expansion and especially during a time when oil prices are highly profitable. This is not a good company to be invested in during a time when debt markets tighten.
Watch Gold Stocks Closely – I haven’t done a lot here, though I did lighten up on Jaguar on Monday and add to Argonaut Gold today. I’m still of the mind that gold stocks are breaking out and have higher (maybe much higher) to go. But I reserve the right to change my mind here. I am wary of how far this gold correction will go. However, the stocks never priced in the move anyways. To take an example, should Newmont be crushed as gold moves from $1900 to $1600 when its price is lower than when gold was $1200? Its ridiculous.

We’ll have to see how the next few days play out and what Bernanke announcement comes out of Jackson Hole. But for the moment I feel a lot more secure after having made these moves.