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November 8, 2006
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The Politics of Investing
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The role of diversification in a political.
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Typically, income trusts are companies in mature industries with steady cash flow and limited growth prospects. If you are managing a company like that, the best way to enhance shareholder value is to distribute as much of that cash flow as possible. Because it makes more sense to put the money in the hands of shareholders than to re-invest it into assets with limited growth prospects.
Is that not what capitalism is all about? On a macro basis, capital is being moved from mature companies into the hands of investors, who can then re-deploy that capital either by spending the money, or re-investing into other companies with greater growth prospects.
In the last five years, income trusts have grown to a point where they collectively account for a market cap of $200 billion. When you add TELUS and BCE Inc. to the mix, that total market cap would eclipse $250 billion.
Obviously the concept of re-deploying wealth has merit. The problem was the extent of this re-deployment. The government believed that the explosive growth of income trusts posed serious threats to the Canadian tax base. To the tune of $1 billion per year if you believe the government’s numbers.
Not surprising then, when TELUS and BCE Inc. announced that they were transitioning their businesses to income trusts the government had to take action. Some thought, since the initial promise was to leave income trusts alone, that the government might actually reduce the tax burden on traditional corporations to effectively level the playing field.
Instead the government played its own game of trick or treat by introducing a new tax on income trusts, disguised as “tax fairness.” That announcement, that by the government’s own figures should add $1 billion in tax revenue, effectively wiped out $25 billion in net worth for Canadian investors. Apparently, that is a fair trade-off.
Beyond the tax implications, investors need to recognize that individual companies, as well as the broader stock market, are always vulnerable to surprises. Such is reality: surprises happen, markets react. For investors who purchased 3 million-odd shares of TELUS & BCE on October 31st, it was no doubt very difficult to wake up the next day to double-digit losses. Especially when it was the result of an event that could not have been predicted.
Unfortunately, situations like that are more the norm than the exception. And I am not talking about government pronouncements per se. But rather about how events that have the greatest short term impact on your net worth, can never be predicted.
Knowing that, investors would be well advised to focus on the things they know, and can mange. For example, owning shares of companies with investment grade credit ratings, consistent earnings growth and consistent dividend growth. Note that Canadian banks, which fit that bill, actually went up during the period when income trusts were collapsing. As did preferred shares and bonds, further supporting the position that a well diversified portfolio can defend your net worth during periods of shock and awe.
How Did These Changes Affect Your Portfolio
The government intends to categorize exchange traded income trusts for purposes of this legislation as publicly-traded Flow Through Entities (FTEs).
In order to understand how this tax change will impact investors, we have to look at it from a couple of perspectives; the taxable investor and the tax-exempt (i.e. tax deferred) investor. In both cases, the amount of the distributions will decrease, probably by 30% to 35%. Also, the value of the investor’s portfolio will decrease as the market adjusts FTE market prices to reflect the reduced distributions.
However, a taxable investor will benefit from lower taxation on the distributions, which means that on an after tax basis, the payout should be the about the same. Tax exempt investors end up with a lower distribution but no offsetting tax treatment. So they lose on both fronts; lower distributions and lower market value.
Investors were most affected by the decline in value of their net worth. To the tune of about $25 billion in market capitalization, as the market readjusts how it values the discounted cash flow from the FTE.
That’s no different than how the market values any stock. A stock’s value is just the present value of a series of perpetual payments. Whether those future payments come in the form of dividends or distributions is irrelevant.
By 2011, the cash flow from existing FTEs will be lower. The market knows this, and will discount those reduced payments, to arrive at a reasonable market price for the FTE. That was the bloodbath we saw on November 1st and the follow through on November 2nd.
The Longer Term Impact
For existing FTEs, these new rules will not take affect until 2011. There should be no change in the current distribution models. As well, a part of some FTE distributions is a return of principal. That was not taxed before and will not be taxed under this legislation.
Real Estate Investment Trusts (REITs) will not be affected by this legislation, so if you have REITs in your portfolio, nothing will change. In fact, REITs may get a boost over the coming weeks, because their yield will be higher.
Some analysts like the new rules because at least they have been defined. However, I am not sure about that. On the one hand, I suspect that this legislation will be challenged in court. I also think we will see some extensive lobbying by Canadian oil companies, where 75% of their business model fall into this structure. Look for the government to bend on some of the rules, particularly as they are applied to oil and natural gas trusts.
Finally, what happened last week re-enforces the position that one should never have too many eggs in one basket. Hence, the portfolio matters.
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