The Priszm Income Trust soap opera continues

I have been writing a lot about Priszm Income Fund – a horribly broken trust going through massive financial restructuring.

Today, they announced:

TORONTO, Jan. 19 /CNW/ – Priszm Income Fund (TSX: QSR.UN) (“Priszm” or the “Company”) reported today that the Company has executed a forbearance agreement to extend the maturity date of its senior debt facility, including the payment of all interest accrued but unpaid to January 31, 2011. In addition the senior debt lender will temporarily suspend action to exercise its remedies for the Company’s defaults in respect of the existing terms of its senior debt facility. As part of the agreement, the Company is not permitted to make payments in respect of obligations that are subordinated to the senior debt facility, other than those relating to the direct operation of the business in ordinary course.

The senior debt lender and the Company also executed a separate short-term financing agreement that provides the Company a supplemental facility of up to $4 million to ensure the business has sufficient liquidity to continue operations while a longer-term plan is developed. The facility bears interest of 10% per annum with a maximum one draw per week and matures January 31, 2011.

Translating this into English, the company received a $4M bridge loan in exchange for the creditors not pushing the company into bankruptcy. As part of this loan, the company cannot make payments to subordinated obligations, which would also include the subordinated convertible debentures, amongst other things.

After my January 8, 2011 post regarding the convertible debentures (TSX: QSR.DB), I entered into the market on January 10 and bought $20k face of the debentures at 19 cents on the dollar. My expectations were that the debentures would settle at a value of around 30-35 cents on the dollar. I was aiming for a bit more size on the position, but QSR.DB is illiquid and I did not catch many liquidators on the bid. Today, I sold $19k face for an average of 21.95 cents on the dollar, approximately a 9% gain over my January 10th purchase. After commissions, this will pay for a few sushi dinners. I still hold $1k face value (approximately $230 market value) for entertainment and educational purposes – I want to see how this drama resolves itself. There is also a very slight (and I emphasize very slight, as in less than 5%) chance that the debentures will be redeemed at par by June 2012.

My theory about the valuation of the company changed significantly after some subsequent research and deeper analysis – when the company announced it was exploring a “sale of all assets”, any cash flow generation would have been likely gutted out of the company, leaving purely administrative expenses associated with running a publicly traded company. The company does not have a massive amount of future tax assets which ordinarily gives such unprofitable operations some market value. Assuming the $200k/franchise level that was achieved in the previous sale applied across the 200 remaining franchises would have rendered the company with approximately $40 million further cash, which would have not been enough to pay liabilities, let alone the debentures.

When you bake in costs of restructuring and/or bankruptcy, there is not much value in the debentures – they will likely be given some sort of settlement offer at a deep discount to face value to get them out of the way. This is when I will get rid of the other $1k face value I own.

Minimum needed to invest in stocks

I do note with amusement that a former Member of Parilament’s “real estate bubble” website is advocating some strangely risky financial strategies. Apparently he has forgotten that ETFs derive their value from their underlying holdings, which contain precisely the amount of risk that he declares that people with only a million dollars and above should be engaging in. Here’s my phrase of the day: Diversification is for investors that don’t know where to find value. Diversification also does not mitigate against systemic risk, as most investors in the second half of 2008 discovered.

If your portfolio size is a modest fraction of annual after-tax income, putting all your eggs in a single basket (i.e. putting it all on a very well-researched company) is an acceptable strategy if one believes in maximizing both their risk and reward. As the portfolio size appreciates above annual income, maximum position sizes need to be trimmed down to avoid what I call “blowup” risk, but financial academics call unsystematic risk. With commissions as low as they are, people can invest reasonably with as little as $5k – with $10 commissions, you can diversify into five positions with a 1% expense ratio, or better yet, choose two and keep your expense at that of a typical index fund.

Especially for young people, it is vitally important to learn how to lose money in the public marketplace before making money – making mistakes that cost you 20% of your portfolio means a lot less when you have $5k in the account than $500k. You learn exactly the same lessons, but with a lot less money.

The worst thing that can happen to a beginning investor is that their first three trades are wildly successful.

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.