Continuing to divest

One of the tricks that you learn in the marketplace over a decade of experience is that you make money by buying when things go lower, and sell when things go higher. It sounds awfully cliche, but doing this correctly is an art and will never be a science – sometimes the markets do something “crazy”, and taking advantage of craziness is how you make a substantial sum of outsized gains – whether it is buying at a crazy low, or selling at a crazy high.

While I would not call present conditions crazy, I do consider them frothy and have been lightening up positions since the beginning of September. Having a high fraction of the portfolio in cash is always boring, but I am fairly firm in my belief that cash will be outperforming most asset classes after the winter is done. There is just not enough reward out there for the risk. I still have enough in the market to participate in further gains and to profit in case if things do become “crazy”.

Until then, I wait. Boring, boring, boring.

Canadian Tax Expenditures and Evaluations Report

The Ministry of Finance released their Tax Expenditures and Evaluations Report for 2010. Although this reading is quite technical for most people, there are a few takeaways in terms of the changes of government tax policy.

For large corporations:

Due to corporate tax reductions, retained earnings and equity will be the most efficient way (with respect to total tax burden) to raise capital, although it is very close with raising debt capital. In the USA, equity is much more expensive than debt, mainly due to deductibility of interest (while dividends are punished by relatively high rates of taxation).

On small business corporations:

Equity and retained earnings remain cheaper than debt financing, once again due to low tax rates. When factoring in the lifetime capital gains exemption for the sale of eligible small business shares, the total tax burden decreases even further.

Further in the report is an interesting analysis on the elasticity of tax rates and actual reported tax collections.

Bank of Canada holds steady

The Bank of Canada holds the overnight target interest rate steady which resulted in a very mild decrease in the Canadian dollar as traders positioned themselves when reading the language in the statement.

Specifically:

Underlying pressures affecting prices remain subdued, reflecting the considerable slack in the Canadian economy. Core inflation is projected to edge gradually up to 2 per cent by the end of 2012, as excess supply in the economy is slowly absorbed. Inflation expectations remain well-anchored. Total CPI inflation is being boosted temporarily by the effects of provincial indirect taxes, but is expected to converge to the 2 per cent target by the end of 2012.

This is “fed speak” that is likely “We’re not going to do anything on our next meeting as we see how things unfold.”

BAX Futures have nudged slightly up in reaction to the statement:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 FE 0.000 0.000 98.590 0.000 0
+ 11 MR 98.620 98.625 98.575 0.050 23240
+ 11 AL 0.000 0.000 98.520 0.000 0
+ 11 JN 98.380 98.390 98.350 0.040 29808
+ 11 SE 98.150 98.160 98.140 0.020 14591
+ 11 DE 97.940 97.950 97.940 0.000 13813
+ 12 MR 97.770 97.780 97.780 -0.010 6012
+ 12 JN 97.630 97.640 97.640 -0.010 1493
+ 12 SE 97.250 97.580 97.520 -0.010 814
+ 12 DE 97.350 97.410 97.370 -0.010 36

I still maintain that long-term rates maintain much more relevancy – 10 year benchmark bond rates are at 3.25%, and it is likely that in order for the Bank of Canada to raise short term rates that the long-bond will need to go higher. It is my guess that the BOC has a silent objective to keep a 2-2.5% yield spread between short term and 10-year rates.

How to generate income from investments

If I had to select people to manage my money, there are only two people that I can think of that I would trust sufficiently to generate good performance – James Hymas and David Merkel. One can easily tell by how they write that they have very disciplined and narrow-focused techniques for generating market-beating performance.

On Merkel’s site, he has a small gem of a paragraph which seems to be quite relevant to increasingly aggressive investors that are chasing yield at any cost:

[…] total return matters more than current income. Income can be generated by liquidating small amounts of funds expected to underperform.

Apparently hordes of retail investors are out there just looking at the “dividend yield” number and using that as a basis for investment, which it should only be used to determine how effective management is at allocating capital. For example, if you have a debt-laden company that continues to give out distributions far beyond cash flow generation, it is probably a good sign you shouldn’t be investing in that company.

Investors in many income trusts that went public during the 2006 income trust mania learned this lesson.

(Addenda: I wonder how long it will be before you have “experts” trying to get retail investors to sell covered calls on their equity portfolios for additional income.)

The Priszm story continues

I wrote last week about Priszm Income Fund (TSX: QSR.UN) earlier, especially about their near-bankruptcy situation they are currently facing.

Today, they announced that the transaction to liquidate over half their franchises was proceeding, but subject to approvals by two consenting partners, the franchiser (YUM Brands) and the senior creditors. Notably in the release there were two statements:

Although there is no guarantee that the required approvals will be obtained or that the remaining conditions will be satisfied, the transaction is scheduled to close on February 28, 2011 unless the parties agree otherwise.

Presumably February 28th was the mutual date that the various parties agreed to in order to see if they could pursue something a little more substantial, alluded to in the next paragraph of the press release:

The Company also reported that it remains in discussions with its senior debt lender and franchisor on various options to restructure the business which may include the sale of all assets. The Company’s interim agreement with its franchisor, YUM! Restaurants International, with respect to the franchise agreements for 70 restaurants expired on January 15, 2011 as did its interim agreement to defer unpaid continuing fees. The Company continues to work with the two key stakeholders to come to both short and long-term resolutions that are mutually satisfactory.

As of September 5, 2010, the company has a senior credit facility of $65 million to pay off; the aforementioned agreement to sell over half the franchises would result in gross proceeds of $46 million. The company also has about $41 million in other current liabilities and accruals. The subordinated debentures amount to $30 million face value.

It remains to be seen whether the company can generate enough cash through asset sales to pay off the creditors and liabilities; at the current trading price of 21 cents per debenture, the residual value predicted by the marketplace amounts to $6.3 million.

There were 432 franchises as of the September quarterly release, leaving 200 franchises after the execution of the sale agreement.