Links and after-tax calculations

I will preface this post by thanking Mark Goodfield at the Blunt Bean Counter for mentioning this site. I am quite happy to link to high-quality writers of Canadian finance that use their real names, and Mark has been on my very small list of site authors on the right-hand side underneath the “Canadian Finance” header.

In particular, I found his off-topic post about golfing at Pebble Beach to be highly entertaining. Since I am one of the world’s worst golfers, I can only live through the experience through other people and I note in sympathy of him having to be stuck in a foursome with an incapable golfer at Spanish Bay.

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My topic on taxation deals with the statement of before-tax and after-tax amounts. Taxation must be factored into all financial calculations (despite how much we dislike paying them), but most people intuitively think in terms of before-tax rather than after-tax amounts.

Here is an example: If you were given a choice of having $100,000 cash in a non-registered account or $120,000 in an RRSP account, which would you take?

Most people would take the $120,000 RRSP account.

However, the answer is not so clear. For example, if you decided to take the RRSP account and pulled it all out in one year, assuming no other income and a BC residence in 2011, you would be left with $86,425 in after-tax money to deal with.

If you split your withdrawals into two $60,000 batches, assuming the 2011 rates apply for 2012, you would still be left with $96,366 after-tax. Structured over three years would leave you with $102,043.

That said, if your goal is to invest the capital and generate income over a long period of time, it is far superior to do it through an RRSP than a non-registered account, where in the latter your returns will be whittled away by having to pay the CRA each year. With the RRSP, you would have a larger capital base to deal with and also the advantage of tax deferral.

However, if your primary method is to increase your wealth through capital gains, there are multiple scenarios where doing it through a non-registered account is superior to an RRSP – especially if your holding periods on your assets are of very long duration. For example, if you chose well and invested in something that returned 10% a year for 20 years (note this is exceptionally difficult to do!), spontaneously liquidated at the end of 20 years, you would have $566,733 at the end of the day. In the RRSP account, after withdrawal, you would have $473,639 after-tax.

Also note that if the investment is determined to be grossly over-valued at a point in time, that the penalty of “spontaneous liquidation” in an RRSP is zero, while the tax liability in a non-registered account increases as the value of the investment increases – there is a significant penalty for realizing a capital gain and an investor has to factor this into their calculations (which I did on this post). I find it personally very frustrating to hold onto investments that have appreciated beyond what I consider to be its fair value, but “prevented” from doing so because of the capital gains taxes that would be incurred as a result.

Financial modelling of the RRSP vs. non-registered scenario as I outlined above is not a trivial issue to answer. The specific variables involved include (but certainly are not limited to):
a. When you need money out of your RRSP (a function of age and personal situation with respect to financial needs);
b. Your tax situation for the next X years (including how the government will change rates over that period of time, how much other income you will generate during that time);
c. Your method of investment (as it impacts how taxes are applied, expectations of future returns).

One other component of before-tax and after-tax calculations concerns the implied rent in a rent-vs-own scenario in a real estate purchase. For an individual, a rent payment comes from after-tax funds, which means that if your rent payment is $10,000/year, the before-tax income required to generate such a rent payment, using a 30% marginal rate, would be $14,286 before-tax.

Assuming a GIC returns 10%, one would intuitively think that they would be indifferent if they invested $100,000 in a residential property vs. the GIC (note this excludes all other costs, such as maintenance, insurance, property taxes, etc.) since the “return on investment” is $10,000/year. However, either the GIC rate must be translated into the 7% after-tax figure ($10,000*10%*(1-0.3)), or the after-tax rental amount must be translated into the $14,286 pre-tax figure ($10,000/(1-0.3)).

It is important when doing these financial calculations that all figures are translated into either before-tax or after-tax numbers, otherwise there will be significant errors in comparative calculations.

TD Bank raises $612M in equity offering

A few days ago, TD Bank (TSX: TD) raised $612M in gross proceeds in an equity offering of 8 million shares at $76.50 a share. This was in conjunction of them acquiring MBNA’s credit card portfolio in Canada, announced in the middle of August.

I have stated in the past that when financial companies raise capital it generally is a yellow flag event that suggests something else negative is going on. However, this intuitively (without seeing anything but basic numbers) seems to be a wise decision by TD.

I find it interesting that the exact amount has not been disclosed. It would be interesting to see how much capital in excess of the MBNA purchase has been raised by the bank. TD Bank has 890 million shares outstanding and so thus this equity offering would be less than 1% dilutive to existing shareholders. At the existing dividend rate, TD will also experience a cash outflow of $21.8M more a year in after-tax dividends.

Hiding in the Financial Bunker

I have not been an active writer in the past couple weeks, in part due to taking an extended break, but in part due to the fact that I am trying to await this financial storm and pick a point of maximum negative sentiment, which will be at the point where the perceived risk is the highest, and hence lowest price. My history suggests I am fairly good at picking bottoms, but I do not believe that time is at present. I am sitting at a 75% cash position.

Volatility is very high – in the past month there were many days where the absolute percentage change in the major indicies was greater than 2% – timing the gyrations is an impossible task. Implied volatility on the S&P 500 has also been around 30 to 45%, and the volatility of the volatility has been high. Suffice to say, anybody trading this market will have to have nerves of steel and very well-functioning computer models.

There are a few indications out there that things are worse than what markets are currently pricing in. Right now, we have a Canadian 10-year bond yield trading at 2.21% and the US bond yield at 1.92% – the both of which are lower than the 2008-2009 financial crisis. The bond market is pricing in a financial disaster that is awaiting us.

Remarkably, major US financial firms such as Goldman Sachs, Bank of America, JP Morgan are trading at yearly lows, which suggests that equity markets are banking on something bad happening. It is suggested that most of this is a result of what is happening in the European Union. A very quick proxy for the disruption in the European financial markets is looking at junior bank debt – an example of which is ING Group’s hybrid debt (NYSE: ISG – and take a look at the 5-year chart to see the impact of the 2008-2009 financial crisis). Equity in European banks are also more volatile than the debt securities, e.g. Deutsche Bank (NYSE: DB).

Political analysis is an area that gives me an advantage over the market, but there are two well-known events that have already been somewhat factored into the marketplace: Finland recently elected a new parliament, but the True Finns party basically ran on an election platform of “Don’t bail out the EU” and managed to gain a whopping 15% in representation in parliament. The other event was in Germany, where the existing CSU/CDU government (which has previously been on the side of trying to preserve the Euro and support a bailout of bad soverign debt of some form) has lost significant voter support in their recent batch of local elections against the SDP.

Since there is only a monetary and not political union, it makes it highly unlikely that the European Bank will be able to facilitate any quick fixes to their financial situation, relative to the problems in the USA with the federal reserve. However, the spillover to international financial institutions is continuing to be felt. My guess is that there needs to be a mass liquidation of some sort, similar to what happened in early August when somebody obviously hit the “sell everything” button on their billion dollar portfolio.

The central bank of Switzerland (Swiss National Bank) earlier in September also declared war against all currency speculators with it announcing that it will not tolerate less than a 1.2 Swiss Franc to Euro ratio, citing a gross overvaluation of its currency. Some traders must have received the margin call of the year when you look at this chart:

The Canadian dollar, in relation to all of this and relative to the US dollar, has remained around the 1.00-1.05 ratio against the US dollar. I do not have strong feelings about the Canadian dollar, but I would suspect it will remain vulnerable against US currency, which despite all of the country’s dysfunctionality, remains a short-term safe haven. Since Canada’s economic fortunes are strongly linked to commodity markets, there is vulnerability and correlation to a slowing world economy and commodity pricing – hence, not as diversified as the US currently is.

Are Canadian Banks (TSX: BMO, BNS, CM, RY, TD) vulnerable? You would think with the leverage on their balance sheets (e.g. a very quick look at BNS, you have $20B in tangible common equity leveraged against $560B in tangible assets, or a 1:28 ratio – I realize this is a very elementary analysis that ignores a whole host of other mitigating factors including the fact that consolidated statements are inappropriate for this type of conjecture) that if there is a minor amount of loss that they have to take against these assets (4%) that you are going to wipe out the bank’s equity. The risk-reward for Canadian bank equity seems to be highly skewed towards not being worth the risk.

Generally, forward valuations appear to be extremely attractive, especially in the large cap sector. However, these valuations do not take into consideration the deleveraging that we are seeing and the impact of market psychology when you have a stadium of financial participants that are all trying to reach for the exits at the same time. The easy play seems to be investing in low-P/E, low-P/B companies, but even these entities are going to get trampled if/when the stampede occurs. There no long appears to be any risk-free assets other than cash – and even that has the risk of being whittled away by the significant inflation that is being imparted with quantitative easing and its various forms. The state of world economics at the moment appears to be a game of financial musical chairs where you have a hundred players reaching for eighty seats, and the music is about to end.

In terms of translating this into investment possibilities if/when we see another 2008-2009 style meltdown, I will leave this for another post.

Bank of America / Berkshire Hathaway

The decision to purchase $5 billion of preferred shares (with an under-market value of a 6% coupon, albeit with bonus provisions) in conjunction with the 10-year warrants to purchase BAC shares for $7.142857 (7 and 1/7th for those that do not recognize the string of numbers after the decimal point) has been analyzed to death by others.

The warrants are the golden part of this agreement – it is essentially a binary bet on the bank – if Bank of America does not go belly-up, it should be able to produce sufficient cash after a ten year period to justify a stock valuation significantly higher than $7 1/7 per share. If the company does go belly-up, Berkshire should be able to retain some residual interest in the preferred shares while the common shareholders get wiped out.

There is about $150 billion in tangible equity on the balance sheet to clear through before this would occur, which is why I suspect that this deal is a very good one for Berkshire and Warren Buffett.

I generally do not like it when financial companies raise capital – this is no exception. It makes you wonder how well JP Morgan is doing in terms of their solvency and liquidity situation. Analyzing big banks such as BAC or JPM is essentially a leap of faith more than an informed investment decision.