Canada Fiscal Monitor – July 2010

The Ministry of Finance in Canada has released the July 2010 fiscal update.

The noticeable highlights for the four months ending July 31, 2010 vs. July 31, 2009 include:

– Bottom-line deficit down to $7.7 billion ($23.1 annualized) vs. $18.3 billion ($54.9 annualized)
– Corporate income tax collection up 1.7%, despite a 5.3% drop in the rate (from 19% to 18% effective January 1, 2010).
– GST collections up 34% (indicating a significant increase in consumer spending);
– EI benefit payments down 7% (implying expiry of previous benefits and/or people finding employment)

As the government’s stimulus package is due to end on March 31, 2011, it remains quite conceivable that they will be able to balance the budget in a couple years. This bodes well for Canada because a zero deficit number will signal to the marketplace that tax increases are not imminent.

The other factor I will keep mentioning is that the corporate tax rate is due to decline from 18% to 15% by January 1, 2012. If the government does not fall between now and then, the big winners of this will be investors in profitable Canadian firms.

A top to fixed income securities?

I don’t like calling tops and bottoms – it is nearly impossible to get the exact time correct, but it is possible to get close. The way you take advantage is by scaling in your orders and waiting for the executions.

Trends in the marketplace go on further than anybody usually expects. Fixed income securities (especially bonds) appear to be quite pricey at the moment. Also, I have been noticing a lot more sentiment on the retail side toward dividend-bearing equities, and doing a cursory scan on that side of the marketplace leads me to believe that performing screens on non-income bearing securities would bear more fruit at the moment.

Portfolio movement has been mainly selling securities and raising cash, due to lack of research time. In particular, there is quite a bit of US currency available for deployment, and it is has been nearly a year and a half since I have invested in US equities.

Yield is now down, but I am very liquid.

Cinram International Valuation

I notice that Susan Brunner is doing a brief on Cinram (TSX: CRW.UN). It is in the very boring and low-margin business of printing and distributing physical media such as CDs and DVDs.

I did some fairly serious research on this company earlier this year, and came to the conclusion that while they were likely to continue to be cash flow positive, there was no way that they would overcome their debt situation without a significant recapitalization.

The primary hit in the past year was on February 1, 2010 when 28% of their revenue stream announced they were terminating a contract. The units dove about 2/3rds and got my attention when I did research.

Their big problem is that the company, as of June 30, 2010 has a $379 million bank loan (secured) and only $125 million in cash, with a business that is not generating a whole lot of cash. The bank credit facility expires on May 5, 2011. It is more than likely that the secured creditors will take over the equity, which implies that the current value of $1.00 per unit (total market capitalization about $54 million) is vastly overpriced.

I would only start looking at the company more seriously if they traded below 20 cents, and with the recognition that the catalyst for an equity purchase would be a bank giving them a sweetheart extension deal that wasn’t too punitive to unitholders. At this point you are really gambling as opposed to investing, which is why I am not really going to look at Cinram in the future other than as a curiousity to see how their story resolves.

Technical analysis of gold

Here is a chart of spot gold prices over the past 6 months. I have added in three “trendlines” to the chart, which was a rough hack job:

For technical analysis fans, here are some questions:

1. Is it a foregone conclusion that gold will continue rising, or at least no lower than $1260, plus a few dollars each day?
2. If so, what is the proper trendline to use?

Technical analysis also suggests that if the trendline “breaks” that you can no longer assume the trendline exists, and that there is some other trend that is occurring. How do you figure this stuff out without using the chart as a retrospective explanation?

The only reason why I look at charts is a measure of sentiment over time, rather than trying to derive future prices from chart movement.

How capital gains taxes impact investment decisions

There are four ways that investments are directly taxed in Canada:

1. Interest income – treated as fully taxed income;
2. Eligible Dividend income – treated as income multiplied by a gross-up factor (2010: 44%, 2011: 41%, 2012: 38%), and the net amount is reduced by a dividend tax credit (2010: 25.88% of actual dividend);
3. Non-Eligible Dividend income – treated as income multiplied by a gross-up factor (25%), and the net amount is reduced by a (lower) dividend tax credit (2010: 16.6667% of actual dividend);
4. Capital gains taxes – taxed at half the rate as ordinary income.

For this post, I will just concentrate on capital gains.

The cost basis of an investment should only be considered in the context of taxation. In all other circumstances, fair market value must be considered. The only value that the cost basis of your investment has is with respect to how much of a penalty (for gains) or reward (for losses) you will incur if you dispose of it. In a registered account (e.g. RRSP/TFSA), the cost basis of an investment is irrelevant.

Let’s take a hypothetical investment between two securities. Security ABC is a perpetual bond, paying $10 per unit. Security DEF is a perpetual bond of the same issuer, with substantively the same seniority/call provisions as ABC, paying $8 per unit. Your marginal rate (to make the math easy) is 50%.

Let’s pretend you bought ABC for $80, netting a pre-tax yield of 12.5% and after-tax yield of 6.25%. If ABC is now trading at $100/share, what price does DEF have to be in order for the decision to be a net positive? Assume frictionless trading costs, and capital gains taxes are payable immediately upon disposal.

I will answer this in a non-algebraic format to make this “readable”:

Step 1: Calculate how much capital you have at work. The answer is $100, not $80.
Step 2: Calculate how much capital you will have at work after disposal. Since your gain is $20, you will be taxed 50% of $10, which is $5. So the answer is $95 of capital.
Step 3: Factor in the yield differential. For this to be a break-even transaction, your $95 in after-tax dollars must equal the income of the prior portfolio, mainly $10. $10/$95 = 10.53%, so you must buy DEF below $76/unit in order for your transaction to make financial sense.

Note that if the market was efficient, when you bought ABC at $80/unit, you were receiving a 12.5% pre-tax yield. At this same time, DEF should have been trading at $64/unit. So when ABC appreciated 25% to $100/unit, DEF should have appreciated 25% to $80/unit. Instead, the frictional cost of the capital gains tax has required the optimal re-allocation of capital to $76/unit. If DEF, for example, was trading at $78/unit, it would be capital-efficient to swap out of ABC to DEF on a pre-tax basis (ABC = 10.0% pre-tax, DEF = 10.26% pre-tax), but not an after-tax basis.

This is why capital gains taxes result in capital mis-allocation. The larger the capital gain tax, the higher the mis-allocation. It gives investors an incentive to hold onto winning investments longer than they should.

Note this argument works in the other direction – if you had a capital loss situation on ABC, you would have received an incentive for purchasing a less efficient DEF to capture the proceeds of the capital loss despite taking a lesser percent yield.