Opening up the Mailbag

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n this bloated, gas-filled, pass the Zantac edition:

  • Feature: Opening Up the Mailbag; topics include income trust taxation, oil and gas investing, business trust uncertainty, Canadian REIT trading, bond fund choices, the joy of high-interest savings, and fun with the big banks.
  • Market Guy’s Closing Bell: Mugs and chains and markets, oh my!

My inbox is stuffed with notes pertaining to everyone’s favourite topic: the recent Conservative decision to tax income trusts. The reactions that I’ve read so far include the following: anger, disappointment, depression, resentment, disillusionment, itching, rashes, full body hair loss, projectile vomiting, gigantic eyeball, tail growth, possession by the Prince of Darkness, and the condition known as hot dog fingers. I feel your pain. We’ve been down similar roads before (see this column from 2005, which feels weird to read now. It’s been such a roller coaster since then) but none have been quite like this. Clearly, it’s time to open up the old Market GuyMailbag…but first, let’s deal with some thoughts arising from the last edition of the column (MG #32).

Letter #1: Duncan in Toronto writes:
I think the column on what you learned about investing from watching Miami Vice was inspired! Pieces like that give me hope, in a strange sort of way.

MG: It’s just part of my never-ending efforts to make this world a better place. It’s a burden that I must bear and a bear that I must cross.

Letter #2: Dan in parts unknown writes: 
OK, so you mentioned buying Reitman’s and the fact that you like their commercials. Writing about women’s clothing commercials may necessitate the removal of the “guy” from “ Market Guy .”

MG: Good one. Yes, I enjoy the Reitman’s (RET.A) commercials. I also miss the Canadian Tire couple, consider myself a pottery enthusiast (I don’t know enough to be considered a “buff”), welled up during a Wonder Years re-run on TV-Tropolis, and have openly wondered why Abba can have Mamma Mia, but there’s still no musical based on the stylings of the Village People. To balance things out, I will now work on the car, watch some TSN, and research several heavy equipment makers.

  It was a great series. Remember the episode when Winnie was in an accident, kept Kevin at a distance, but he wouldn’t be denied seeing her, so he climbed the side of her house and they both mouthed, “I love you” through her bedroom window, while Bob Seger’s “We’ve Got Tonight” played in the background. Oh shut up! Here’s theYouTube clip.

Letter #3: Bob in Montreal writes:
I’ve been a conservative voter since the Diefenbaker days and had been feeling good about the early returns from the current Harper government. Finally, we have some decisive leadership and some fresh ideas. Then along comes their decision to tax the trusts and I have the worst investing day of my lifetime. I expect politicians to break promises from time to time and appreciate the difficult nature of the governing enterprise. However, this broken promise has cost me dearly and I can’t get past it. I’m going to have to hold my nose when voting for another party, but I don’t see how I can reward Harper for this most ill-conceived action. I also don’t understand their rationale for punishing investors at a time when so many of us are looking for yield to help fund our retirements. This is a slap in the face to seniors and the investing public. What are your thoughts? I have to assume that your readers feel the same way. Keep up the good work.

MG: Thanks Bob. I’m not going to harp on this, in large part because this is well-travelled ground and others have identified the issues in more eloquent fashion that I ever could. OK, maybe I will harp on it. Here are a few thoughts:

In taxing the trusts, the Conservatives have been arguing that the situation changed once BCE and Telus announced conversions and Encana was on the way. The fact of the matter is we all knew that eventually, some larger corporations were going to convert to the trust structure. It was only a matter of time. Several commentators had been calling for BCE and a number of other companies to make the switch for many, many moons. Heck, there were even rumours of a big bank floating one of their divisions into a trust. The trajectory was clear and I’d like to think that Harper and Flaherty were following the markets when they promised not to tax the trusts. So by saying the situation changed, either they were being dishonest, stupid, or ignorant. At least when it comes to the income trust issue, the Conservatives presented themselves as Scarlet Johansson, but we ended up with Paris Hilton; definite downgrade all around.

I also find it interesting that some people are suggesting that by taxing the trusts, the Conservatives had the courage to do what the Liberals failed to do all along. Well, if the Conservatives really were a courageous lot, then why didn’t they support the Liberal suggestion of inhibiting the business trusts? Or even just stay on the sidelines while the Liberals performed their various consultations? Instead, they presented themselves as the righteous defenders of income investors and framed the Liberal approach as targeting the savings of seniors. They established the taxation of trusts as a fundamental point of difference between themselves and the Liberals…and then introduced a scheme that went far beyond what the Liberals had been hinting at in the first place. Plus, in the days after the announcement, the Conservatives spent a fair amount of time trashing the Liberal record on trusts. Let me get this straight: They claimed the high road in protecting the trusts and then claimed the high road in trashing the trusts; this is completely, utterly untenable. Instead, shouldn’t they be apologizing to the Liberals and suggesting that, “hey, you guys were right and we should have backed you when you tried to do something about trusts a year ago…sorry about that.” So now our list of dishonest, stupid, and ignorant has a new member: incompetent.

On an issue level, I’m not convinced about the productivity and tax-loss arguments that have been raised by the anti-trust lobby. This year I’m supervising a host of fourth-year honours essay projects and students are required to use the empirical evidence to substantiate a central claim. If the Conservatives were enrolled in my class, they would have failed the project. They have yet to provide a clear and empirically substantiated rationale for making these moves. All of this being said, I have come to understand why it’s desirable to avoid the Canadian market being dominated by business trusts and creating a market that’s unusual on the world stage. I also appreciate that many investors had come to rely too heavily on trusts and were not paying adequate attention to having a truly diversified portfolio. However, the manner in which the trusts were dealt with leaves me feeling even more cynical about politicians and policy makers than I ever thought possible. Plus, we still don’t have clarity on how all of the different sectors in the income trust universe are to be regarded by the tax people. So we continue to be faced with considerable uncertainty. In the next election I’m hoping for a candidate named, “None of the above.”

  Upon seeing an income trust investor bending over, Prime Minister Stephen Harper and Minister of Finance Jim Flaherty prepared their thumbs for action.

Letter #4: Martin in Hamilton writes:
Thanks for the column…very unique. Anyway, I’m guessing that you’re upset about the whole trust taxation situation and won’t be voting conservative in the next election. I just can’t see how they’ll be able to deal with the fallout from investors. The income trust coalition will be working hard to unseat Harper in Alberta , and with all of the royalty trusts based there, I can see a rough ride. Let’s hope so….bunch of bastards.

MG: The fact of the matter is, the Conservatives could nominate a houseplant in Alberta and it would still get elected. How about a philodendron appearing as “Phil O’Dendron” on the ballot? Sounds like a winner to me. Harper and Flaherty are smart enough to know this, so all of the campaigning by the income trust advocates is for naught.

The other element is that most of the electorate couldn’t give a rat’s ass about what’s good for investors. The Conservative’s poll numbers barely budged in the weeks after the decision came out. Plus, all of the stories of income trust investors losing tens of thousands of dollars were often met with, “must be nice to have all that money to lose.” Certainly the majority of my friends and colleagues don’t care about this stuff. As my buddy Lamont in Hamilton so aptly put it, “I only read your column to see if I’ve been mentioned.”

And let’s be honest…money has a short memory. If the Conservatives eliminated capital gains taxes (or moved decisively in that direction), the majority of investors would be humping Harper’s leg in no time. As Kevin O’Leary reminds us, it’s all about the money. Besides, many of the trusts have recovered significantly and the overall Canadian market is up since late October. This whole episode has actually been a bonanza for those holding traditional dividend-paying stocks, which tend to be widely held. In other words, the effects of the decision have been significantly reduced over the past few months.

  Ladies and gentleman, the new Conservative Member of Parliament from Calgary Southwest: Mr. Phil O’Dendron!

Letter #5: Dick in Ottawa writes 
I’ve recovered some of the losses, but still lost 9% of my portfolio thanks to Flaherty. How did you make out? What about Market Dad?

MG: Well, diversification offered some protection and my losses the day after the tax announcement tallied just over 3%. Market Dad was hit a little harder and this made for one of his better phone rants, followed by a tour de force rant over dinner. It should be noted that retired guys can be counted on for three things:

  • Keeping a kick-ass lawn.
  • Clearing the driveway after a snowfall, way before anyone else in the neighbourhood.
  • Offering highly-enjoyable rants.

Come to think of it, they’re also really good at writing letters, with Market Dad firing off a beauty to his local MP. Our MP (Pierre Poilievre) was quoted in the Globe and Mail downplaying the income trust issue. He said income-splitting would make up for any capital losses incurred as a result of the income trust decision. In other words, we beat the crap out of you but it’s OK because we sent flowers the next day.

Letter #6: Norm in Edmonton writes:
I’m invested in ARC, Enerplus and a host of other oil and gas trusts. I have no idea what I should be doing with these investments, given Flaherty’s bombshell. Do you still hold any of these trusts? I resent being placed in a position of having my investing strategy so heavily dependant on the actions of government. I have yet to figure out why the oil and gas sector wasn’t exempt from these changes, especially given the obvious benefits for investors and the productivity of the sedimentary basin. Any comments would be appreciated. Please write your column more often.

MG: Thanks for the feedback Norm. I’ll do my best. I share your frustration over government interference in the capital markets (whether it’s by Conservatives, Liberals, Hobbits, or Klingons) and abhor the uncertainty that this government has created. As mentioned, I can understand the desire to control the growth of business trusts. However, the case against oil and gas royalty trusts makes very little sense. The trusts were making economical a host of fields that were of little interest to traditional oil and gas companies who have very different expectations for their wells. In other words, converting to a trust made real differences in terms of how business was conducted in the patch. The model also promoted capital spending, production, Canadian ownership, various efficiencies, and considerable investor interest in the juniors. What’s the punch line? The trust structure was well-suited for the oil and gas sector.

However, there’s no reason to pine about what should be, when it clearly won’t be. So how am I conducting myself as an investor? Perhaps surprisingly, I haven’t made any changes to the oil and gas trust allocations in my portfolio. I’m guessing 2007 will see plenty of activity via mergers, acquisitions, and other corporate events. However, unit values will continue to be dominated by the prices for oil and natural gas. In other words, it’s a case of same old, same old. In any event, I still believe the oil and gas trusts represent the best way for me to have energy exposure for my portfolio. I’m still being paid every month and will continue to hold. My largest holdings in the sector include Bonavista (BNP.UN) and PennWest (PWT.UN). I’m kicking the tires on a couple of names (one with a natural gas focus) and will consider initiating a position if prices continue to slide. As always, I’m looking for a conservative business model, relatively low payout ratio, below average debt, solid property base, and a decent valuation. Even with the new tax regime coming, these are still a few of my favourite things. I simply remember my favourite things, and then I don’t feel so bad. On a portfolio level, even a new purchase will leave me underweight energy.

Letter #7: Jane in Toronto writes: 
Do you still own Yellow Pages or any other business trusts? I’m worried about their ability to sustain the payout.

MG: As always, keep in mind that I’m just a putz with a website. That being said, it’s entirely possible that in advance of the new taxes in 2011, many trusts (business and royalty) will be able to grow their distributable cash per unit to a point where taxation won’t make a difference. Some will be able to do this and some won’t. We’re also left with possible mergers, private equity takeouts, conversions to the corporate structure or some other entity, or business as usual. In other words, there’s a lot of uncertainty. The only thing we know is that it’s going to take a while to figure these things out.

My exposure to business trusts has been light for some time, however October 31st saw me with three positions in the sector: Yellow Pages (YLO.UN), Interpipeline Fund (IPL.UN), and the closed-end Sentry Select Diversified Income Trust (SDT.UN). Over the past two months I’ve liquidated my position in Yellow Pages and pared back my exposure to Sentry. Yellow Pages used the trust structure better than anyone, and were always able to use their premium valuation to fund acquisitions and handle their debt. Now it’s hard to tell if they’re just another media company with few growth prospects, a fair amount of debt, and an indifferent marketplace. The position was originally obtained in 2003 at the IPO price of $10. I took my profits just south of $13 and enjoyed the 3 years of tasty, wonderful, increasing distributions…but it’s time for me to move on. I’ve heard speculation of a private equity takeout, but can’t govern my portfolio on speculation. In terms of Interpipeline, it’s really an energy infrastructure trust and it’s still not clear how these will be treated under the new tax regime. There are similar structures operating south of the border, so let’s hope the Conservatives remember this when drafting their legislation. I’ve held the position for 4 years and continue to like their assets.

I pared back my holdings in the Sentry closed-end fund, largely because I still want some exposure to the broader trust market but don’t feel like making too many individual picks. This fund is managed by uber-trust guru Sandy McIntyre, a frequent guest on ROB-TVs Market Call. In addition to some business trusts, his fund is allocated to REITs, energy trusts, and infrastructure plays. Of particular interest is that he chooses business trusts with defensive characteristics; this resonates with me. I also like that SDT.UN is a closed-end fund, so the manager won’t be forced to liquidate positions in order to fund redemptions. In any event, much of the original position was acquired at prices south of $4 and this has been a solid investment from the beginning. There are other options in this space, including several funds designed to track the trust index. However, these funds are heavily tilted to the energy names and I’m not interested in being overweight oil and gas. It’s going to be challenging for many of these funds to carve out a new identity given the new world order. However, I’m going to let Sandy show me what’s he’s made of by maintaining a position in his fund…albeit a smaller one than I had entering 2006.

  Market Gal doesn’t find Sandy’s commentary to be very exciting. When she finds something boring, it’s usually a good investment.

On a somewhat tangential note, here’s a little something that I’m not reading about: current payouts are largely dominated by return of capital and other income. After converting to a corporation, many trusts may decide to remain as high yielding equities that pay dividends. As such, we need to remember the nature of the dividend tax credit. Even with a substantial reduction in payouts to account for the added taxation, the dividend tax credit will help blunt the impact. If investors fail to appreciate this, then we may have some decent buying opportunities. Am I wrong about this? Hey, yield is important and that’s not going to change anytime soon. Let’s not go off and do something half-cocked (or fully-cocked, for that matter).

Letter #8: Carole in Huntsville writes: 
After Flaherty’s decision, I bought shares in Riocan and plan on holding for the long term. Do you hold any REITS at the moment?

MG: I thought about piling in on the REITs, as many of the names that are likely to be exempt from the tax measures were down in the very early going after the announcement. By the time I got around to it, the rebound was already taking place and I missed a decent opportunity. I have substantial exposure to the REIT market, with names such as Calloway (CWT.UN), Primaris (PMZ.UN), Extendicare (EXE.UN), and Dundee (D.UN) in the portfolio. Dundee was one of 2006’s top performers in the sector and speaks volumes of acquiring positions in overlooked REITs with high quality assets and improving balance sheets. The challenge will be finding more of same. There may be some opportunities in some of the junior names.

In terms of Riocan (REI.UN), I really like their recently-announced collaboration with Chartwell Seniors Housing (CSH.UN) and the joint venture with Ramco in the States. These guys are doing everything possible to grow their business and making some smart and creative bets along the way. I only wish the units were a bit cheaper.

Letter #9: Kelsey in writes: 
How do you approach fixed income investments? Do you hold any funds or ETFs or do you purchase specific bonds?

MG: This was a very timely email. As regular readers of the column may know, 2006 was a year of profit-taking in Canada and continuing efforts to maintain a diversified portfolio. On several occasions this meant deploying freshly-minted profits into international markets (e.g., the RBC O’Shaughnessy International Equity Fund and the recently closed Mackenzie Cundill Recovery C). Overall, I’m pleased with how it all turned out.

However, over the past few years I’d let the portfolio grow without paying much attention to my fixed income investments. Like many of you, I’ve owned TD Canadian Bond and TD Canadian Real Return Bond for years (I’m not smart enough to establish a ladder of specific bonds, so I’ve gone the fund route). They’ve been rock solid and provided my portfolio with some diversification and stability. But as the portfolio grew, the percentage allocated to fixed income was decreasing each and every year. New money was always being sent elsewhere and bonds were clearly in the periphery. Noticing that my portfolio was becoming unduly influenced by my equity investments, I decided to make a purchase in the bond market. The easiest thing to do would be to plough more funds into my existing holdings and call it a day. However, I decided to take the path of most resistance and poke my way around the GlobeFund and Morningstar databases.

To begin, there are several fund options covering specific bond types and durations, but again, I’m not smart enough to time the fixed income market. Instead, I was looking for a fund providing exposure to a wide variety of corporate and government bonds of long and short durations. I also wanted lower than average expenses and a decent track record. As always, I used my Fantastic Five criteria for selecting funds.

My screening turned up the usual suspects including a couple of actively managed offerings from PH&N and TD. Also on the list was the iShares Canadian Bond Index Fund (XBB on the TSX), an exchange traded fund designed to track the Scotia Capital Bond Universe Index. After letting the choices percolate on the gray matter, my options were narrowed to my existing TD fund and the iShares fund. So which would it be? Both offer a diversified portfolio of bonds and exhibit average volatility scores for the asset class. Both have lower than average MERs (TD = 1.07%, iShare = 0.3%), top quartile performance across 3-year and 5-year terms, and exhibit solid ratings. Of course the iShare is an ETF so any purchase comes with broker commissions, so that needs to be factored into the cost picture.

Given all of this, would I merely add to my existing holdings in the TD fund or initiate a new position in the iShare? Which fund was worthy of my new capital? Would the iShare be granted the honour of standing in my portfolio, fighting for goodness, truth, and the pursuit of wealth? Had it earned the right of being included alongside other longtime portfolio builders such as TransCanada (TRP on the TSX)? Was it worthy of being part of a proud tradition of investing? In the battle of the bonds, in this fracas of fixed income there can be only one. Given the considerable similarities between the two funds, it all came down to fees and the iShare begins the year with a 77 basis point advantage. With these funds yielding around 4%, that’s a lot of ground for the actively managed fund to cover. I’ll maintain my existing holding in the TD fund, but the new capital goes to the iShare at a price of $29.

  Congratulations to the iShare. You’re now in the registered portion of theMarket Guy’s portfolio.

Letter #10: Ben in parts unknown (wouldn’t it be so much better if we knew where Ben was from?) writes: 
E*Trade’s Cash Optimizer account yields 4.15%, so ING is old news and the ING Guy is a shadow of his former self. Put a fork in him, he’s done.

Nice to see some big news since my last column on this issue (see MG #31). ING still leaves the big banks in their dust, but have done little to remain competitive with so many of the new high savings entries. E*Trade’slatest initiative has really upped the ante. ING’s behaviour is really disappointing, as they were the pioneers in the market and really showed us some love back in the early days. You also have to be impressed by E*Trade’s $9.99 commissions on stock trading (provided you have $50 000 in assets or are an active trader). Keep the cash in their high interest account until it’s time to trade and then simply transfer the money to the brokerage account. Where’s the downside? Keep in mind, of course, that when it comes to money, we should have no loyalties. If another firm offers a consistently better arrangement, then drop E*Trade faster than Lindsay Lohan downs a shot.

Letter #11: Michele in Stratford writes: 
Do people write in about the banks? Being a Canadian, you must own one, or several, or all. I’m holding Scotia and CIBC and have been very satisfied with their performance. Love the column, although I don’t understand many of the pop culture references.

MG: Thanks Michele, you’re not alone. Most people struggle to tolerate the pop culture references so not understanding them is probably a more peaceful place in which to be. Anyway, a couple of years ago everyone hated CIBC. It was the year in which the bank faxed customer information to a small business in the States, negotiated the Enron settlement, was embroiled in a bizarre sex scandal involving the Toronto Maple Leafs (OK, I made that one up), and was essentially a laughingstock. The shares underperformed and analysts were writing about the lengthy period of time it was going to take for CIBC to regain favour with investors. Well, guess which of the big banks had the best performing stock in 2006? Yup, CIBC (and the analysts still don’t really like it). Before that it was Royal that everyone disliked, owing much to the bank’s missteps south of the border. Of course the stock lagged for a brief period, received poor ratings, and subsequently outperformed. So which of the big banks is currently in the doghouse? That would have to be Bank of Montreal. The stock underperformed in 2006, trades at a modest discount to the sector, and offers the highest yield. Their last quarter was disappointing and raised concerns about earnings growth and risk profile. All of this bad news makes the stock interesting…let’s just say it’s on my watch list. I’d really like it to head lower.

I currently own TD and have for many years. The stock underperformed for a while, outperformed for a while, and was middle of the pack in 2006. It trounced BMO, edged out BNS, but lagged Royal and CIBC. Fair enough…and I’ll take it.

The Market Guy’s Closing Bell
Each and every year the Market Gal tries to get me in the holiday spirit by purchasing investment-related stocking stuffers. One year it was a holiday ornament of a stock chart; another year it was a series of reframed pics from some of my annual reports; this year she came through with the following delightful, highly festive items:

For the market geek in your life: A NYSE mug and keychain! It shows you care enought to send the very best.

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets…so do your homework before making any investment decisions. Basing any decisions on his column would be really, really stupid. He recently purchased a fondue pot. The pot is nice, but fondue is really all about the sauces. Go ahead and be saucy over at