Life, death and taxes… and taxes after death!

Federal Budget 2024 made headlines yesterday, primarily for the reason that the capital gains inclusion rate is increasing from 50% to 66 2/3% for corporations and trusts, and for individuals reporting capital gains above $250,000.

Two broad implications:

1. The concept of “integration” between the income earned in a corporation vs. that earned individually is further broken – it is significantly more advantageous for an individual to take the first $250k of capital gains. Small corporations now have an increased disincentive to engaging in activities that will net them capital gains (the net reward after such an action will be lessened with the increase in the inclusion rate);
2. This change is very obviously a tax grab for estates, and to a lesser degree, will disincentivize sales of non-primary residences.

In particular, the cited reason for individuals (“tax fairness”, i.e. an excuse to tax more) was in the following chart:

For most individuals, there are two common triggering events that will cause capital gains going over $250,000: the disposal of a non-principal residence property that has been held for a considerable period of time, and death.

While it is true that Canada does not have an inheritance tax, there is a functional equivalent of it – the deemed disposition upon death.

In Canada, when you die, your capital assets undergo a “deemed disposition”, where it is assumed for tax purposes they are sold and re-acquired at the fair market value of the time of death.

For many people, this will result in a significant capital gain pushing estates above the $250,000 threshold. This especially applies for long-held assets that have had their nominal values increase over time due to inflation, but the real value has remained constant (say a cottage out in Ontario, or shares held in the Royal Bank for the past 20 years). The entire slab of capital gains becomes payable in a single tax year and the only element of taxation strategy is to choose to die early in the calendar year instead of later when you have a bunch of other (pension) income accumulated in the year!

By the time of death, there are few tax planning options to “smooth” this out. You inherently have to predict your passing in advance to construct an optimal tax plan. Needless to say, this is a morbid exercise, but one that potentially made much easier with one industry in Canada that is exhibiting huge growth rates – Medical Assistance in Death (MAID), AKA assisted suicide!

Eyebrows are perking up… just a little

Today we are getting some more fear headlines out of the usual places:

The entire commodity complex was on fire earlier in the morning, but ended trading down, along with a rise in volatility.

In particular, gold got a huge bid, but ended up down for the day:

The lesson here is that the nanosecond before a crisis materializes, the only safe asset is cash. It’s not gold or Bitcoin. I don’t know if this is a correct metric or not, but one possible indicator of cash demand is the (TSX: HSAV) ETF. It is trading so much higher than NAV – rationally it doesn’t make a hell of a lot of sense.

Today’s trading action was fairly pronounced in that the commodity complex companies that have been trending from bottom-left to upper-right charts over the past month have been exhibiting whip-saw trading action. It’s as if you have a bunch of hedge fund managers taking a look at their trading screens on Friday morning and deciding this is a good time to take some chips off the table, all in unison – which seems to be the easy trade. Easy trades are most typically not correct.

There are a bunch of other firms on my watchlists, some of which have gone down sharply, that are catching my attention. Not close to buying them, but just paying more attention than I was a couple days ago. When I see synchronized price action (most of it on the downside) like today, it makes me wonder what will happen if we truly had a liquidity crisis in the markets. VIX has perked up a few percent from the previous couple weeks and if those headlines above come to fruition, coupled with other stress in the markets, might create a fertile environment for some tactical capital allocation.

Late Night Finance – Episode 27

Date: Wednesday April 10, 2024
Time: 7:00pm, Pacific Time
Duration: Projected 60 minutes.
Where: Zoom (Registration)

Frequently Asked Questions:

Q: What are you doing?
A: Quarterly review, economic thoughts, and more crystal ball gazing, and finally time permitting, Q+A. Please feel free to ask them on the zoom registration if any questions.

Q: How do I register?
A: Zoom link is here. I’ll need your city/province or state and country, and if you have any questions in advance just add it to the “Questions and Comments” part of the form. You’ll instantly receive the login to the Zoom channel.

Q: Are you trying to spam me, try to sell me garbage, etc. if I register?
A: If you register for this, I will not harvest your email or send you any solicitations. Also I am not using this to pump and dump any securities to you, although I will certainly offer opinions on what I see.

Q: Why do I have to register? I just want to be anonymous.
A: I’m curious who you are as well.

Q: If I register and don’t show up, will you be mad at me?
A: No.

Q: Will you (Sacha) be on video (i.e. this isn’t just an audio-only stream)?
A: Yes. You’ll get to see me, but the majority will be on “screen share” mode with MS-Word / Browser / PDFs as I explain what’s going on in my mind as I present.

Q: Will I need to be on video?
A: I’d prefer it, dress code is pajamas and upwards.

Q: Can I be a silent participant?
A: Yes.

Q: Is there an archive of the video I can watch later if I can’t make it?
A: No.

Q: Will there be a summary of the video?
A: A short summary will get added to the comments of this posting after the video.

Q: Will there be some other video presentation in the future?
A: Most likely, yes.

Canada Convertible debentures – near maturities

The issuer market for Canadian TSX-traded debentures has been very muted. In past times, issuers would typically roll over debt with 6-12 months remaining in maturity by issuing new debt and calling the soon-to-mature issue. Today, these rollovers have been exceedingly rare, presumably because everybody and their grandmothers have been waiting for lower interest rates!

We have the following issuers that have maturities coming in less than three months, coupled with some point form notes:

AD.DB – Alaris – Likely to mature for cash, paid for with room in the company’s credit facility
AFN.DB.F – Ag Growth – Likely to get rolled over with a new issue – AFN.DB.J (3.7 years out) is 16% away from the money and is trading at 108, it is likely they can get an acceptable coupon price… AFN.DB.G is not further away with a year-end maturity and both might be done with a $150 million or so debt offering (disclosure: I own some shares here).
AI.DB.C – Atrium MIC – will likely mature and be paid by the bank line of credit
ALC.DB.A – Algoma Central – will mature for sure, the question is how much will get converted to equity? (they are 2% in the money at present)
EFN.DB.B – Element Fleet Management – will be converted to equity (conversion is well in the money at present)
TF.DB.C – Timbercreek Financial – will be paid off with the secured credit facility

With the possible exception of Ag Growth, all of these debentures will vanish from the TSX and be absorbed.

When examining the overall debt market (and also the preferred share market), very little strike me as potentially interesting. The price inflation in relation to potential risk is quite unattractive to me at present – the companies trading at low prices are generally doing so for very good reasons. They are also competing against risk-free cash at around 5%, which does not make their relative valuations look good – why aim for a risky 7-8% when you know that the liquidity associated with that 7-8% will be crap when there is a real market crisis, when you can just sit on your rear end with a safe and liquid 5%? I’m not reaching for yield – not being paid enough.

Modelling commodity companies

I’m not much of a technical analysis guru but here is my depiction of the trendline of Cenovus Energy (TSX: CVE):

Will this go on forever and end the year at $70/share? I wish, but incredibly unlikely unless if we’re heading into Weimar Republic inflation.

Despite this price rise, the company is still relatively cheap from a price to free cash flow metric. You don’t need to have a CFA in order to do some basic financial modelling:

This is from their IR slides and they will be spending $4.8 billion on capital expenditures in 2024. At “Budget”, which is WTI US$75, and US$17 differential to WCS pricing, the company will do roughly $10 billion in operating cash flow, leaving $5.2 billion of it free. They also have a sensitivity of $150 million per US$1 of WTI.

Everything being equal (it is not, but this is a paper napkin modelling exercise), at today’s closing price of WTI at US$86.75, they’re looking at a shade just under $7 billion in free cash flow. It won’t be quite this high in reality, but that puts the company at around 8.5xFCF to EV even at the current price. If you were smart enough to buy it at $20/share back in mid-January, at the price of WTI then (US$72/barrel), your FCF to EV ratio would have been… about 9x.

In other words, the price appreciation is strictly a result of the commodity price improvement, coupled with a very small multiple decline (which the truer computer models out there which algorithmically trade all these fossil fuel companies on a formulaic basis perform).

For the fossil fuel components in my portfolio, I have pretty much given up on any other smaller companies other than the big three (CNQ, CVE and SU) simply because I have little in the way of competitive advantage to determine which one of the smaller companies have better on-the-ground operations and superior geographies to work with. They all trade off of the commodity curve one way or another. The “big three” are low cost producers and will generate some amount of cash going forward, barring a Covid-style catastrophic environment.

They are basically the equivalent of income trusts at the moment. Remember the old Canadian Oil Sands (formerly TSX: COS.un) before it was absorbed into Suncor? That’s exactly that these three companies are – they all have gigantic reserves and very well established low-cost operations, and capital allocation that is simply going to dump cash out to dividends or share buybacks.

Risks inherent with all three:
1. A common regulatory/governmental risk being located in Canada, and mostly Albertan operations.
2. Fossil fuels may be subject to displacement if we actually see some sort of renaissance on nuclear power (there are whiffs of it here and there, but going from speculation to reality is another matter entirely).
3. The usual cyclical supply/demand factors.

With point #3, I see in the presentation decks of most of these companies (especially the smaller ones) that they are very intent on increasing production. Despite the fact that TMX is going to be operational in a month, the egress situation out of Canada will once again saturate. No more refineries are being built and thus the demand-supply variable will likely push WTI-WCS differentials higher at some point in the near future. With balance sheets of all the companies stronger than they ever have been, there will likely be some “race to the bottom” effect coming in due course, similar to how the domestic natural gas market has been saturated – both AECO and Henry Hub commodity pricing are quite low and LNG export pricing is back to its historical levels (around US$9.50/mmBtu spot).

I think what will happen is that the higher capitalization companies will use their relatively stronger balance sheets to pick away at the entrails of the smaller, higher leveraged operations when the price environment goes sour. Given the overall under-leveraged bent most of these smaller companies have been taking as of late, this process going to take awhile and a lower commodity price environment to achieve. These are not “forever hold” companies, but certainly at present their valuations continue to look cheap.