Newsletter August 20, 2005

InvestorsFriend Inc. Newsletter August 20, 2005

Income Trusts and the Future

A recent newspaper article pointed out that a money management firm was considering converting to an Income Trust model. The article indicated that the company was cyclical and therefore not an ideal candidate to become a Trust. However, the article indicated that the income tax savings and valuation increase are so compelling that it still made sense for cyclical companies to convert. They could attempt to levelise the distributions across boom times and lean times to some extent.

The article suggested that perhaps almost any company should consider converting, even large banks.

This raises some issues. The article mentioned that as more companies convert the Federal Government is likely to do something at some point to make conversions less attractive. This could mean finding a way to tax the trusts or perhaps allowing regular corporation to pay dividends out of pre-tax earnings.

I was thinking about why some companies might refuse to become Income Trusts. It could be that some companies just have a bias against them. Maybe they refused to convert earlier and doing so now would seem like an admission that they were wrong to have refused earlier.

Or maybe some controlling owners and managements think that there is something fundamentally distasteful about Income Trusts. After all they are clearly an income tax avoidance vehicle. And maybe some people would even view them as a tax evasion vehicle. In many cases the actual business of the Income Trust is conducted through a corporation. Income tax on the corporation is often avoided by loading it up with artificially-high-interest-rate debt (and with very little equity) with the interest payable to the Income Trust. This is certainly a very contrived looking structure. I think a legitimate argument could be made that there is indeed something quite distasteful about this structure.

On the other hand, Income Trusts have many redeeming features. Even if Income Trusts smack of a distasteful level of tax avoidance I would not for one minute suggest that investors avoid them for that reason. (Income Trusts will exist and avoid income taxes whether you or I invest in them or not). However, investors should be aware that there is a risk that the government will eventually move to close or change the tax loophole.

Canada may be ahead of the curve because of Income Trusts. Peter Bernstein writing in the Financial Analysts Journal in the March/April 2005 edition wrote that the economy would be fundamentally more efficient if the law required that all corporate earnings be distributed to shareholders. That way if the company wanted to re-invest the earnings it would first have to go back to the shareholders and try to raise that money. There would be no automatic right of management to invest earnings as they saw fit. Mr. Bernstein who works in New York City seemed to be quite oblivious to the fact that Income Trusts in Canada pretty much do what he was suggesting.

A better way to do what Income Trusts do would be to make dividend payments a tax deduction for all corporations and end double taxation. This would eliminate the need to contrive structures such as Income Trusts.

Ironically, as more and more corporations convert to become Income trusts we can expect that competition will force these businesses to pass along the income tax savings to customers.

For more Information on Income Trusts, see my Income Trust article which I recently updated.

Approaches to Investing

There are many approaches to investing. However, almost all investing approaches fall into one of two main camps

  1. Attempts to make a return that matches the market average
  2. Attempts to do better than the Market Average

Recently approach 1, (targeting the market average) has become increasingly more popular for a variety of reasons. Firstly, it is an indisputable mathematical fact that the average investor will not make a return above the market average (in fact the average investor will trail the market average because of commissions and  other trading costs.) Secondly, society, especially in Canada, increasingly finds the pursuit of excellence to be politically unacceptable. It has gotten to the point where striving to be above average in any field is frowned upon. In order for one investor to beat the market by “X” dollars, other investors have to lag the market by “X” dollars, that is a mathematical but perhaps (to some) distasteful fact. Investors are increasingly advised that any attempt to beat the market is just not worth it because it carries with it the risk of trailing the market.

Thirdly, academics are very supportive of the idea that you can’t reliably beat the index, at least not without taking undue risks. Fourthly, financial advisors have incentives to steer you away from attempting to beat the market. If you beat the market you win big while your investment advisor gets only a small amount of extra commissions.  But if you trail the market in a big way then you might sue your advisor for allowing you to take such a risk. Many Investment Advisors begin to see attempts by clients to beat the market as a game of “heads the client wins and tails the advisor loses”. Because of this we are seeing the advent of “closet indexers”. A broad based equity mutual fund might ostensibly be attempting to beat the market but the reality is many of them will hug the index in order to avoid criticism if they should under-perform.

It has got to the point where market index crowd is openly hostile to anyone attempting to beat the market. Recently a National Post column talked about the myth of active investment. They seem to think that the fact that the average investor cannot beat the index means that essentially no one can.

My view is that indexing does have merit for many people. And if you are going to follow an index approach then it is probably best to look for investments that will track the index at a low cost. There is no point paying for active management if you are not getting it.

Methods that attempt to beat the market fall into many categories including charting techniques, growth stock investing, value stock investing, momentum investing and other strategies. Any strategy that involves picking individual stocks is logically an attempt to beat the market index. However, if you do set out to beat the market then it makes sense to choose a method that has a good track record of beating the index. It is undeniable that most who set out to beat the index will fail to do so.

My performance figures indicate that I have been able to substantially beat the market average index on a consistent basis. For those of us that have consistently beaten the index, committed indexers will simply attempt to explain us away or dismiss our results, but that is their prerogative.

No-brainer Investing.

A number of very successful investors have used an approach of concentrating their investments in a few extremely well-selected stocks. This is pretty much the opposite of diversification. This method goes against academic theory by suggesting that you can both increase your returns and lower your risks by choosing stocks that seem to have a lot of potential up-side and little down-side. Warren Buffett, the world’s most successful and respected investor uses this method. He uses a baseball analogy and points out that in investing you don’t have to swing at every pitch, instead you can wait as long as you want to for that perfect fat pitch. The idea is to find a few stocks that are very simple to understand, highly profitable, likely to continue to grow for many years in the future and available at bargain or at least reasonable prices. When available at bargain prices, I describe these as no-brainer stocks. They are difficult but not impossible to find.

In the past few years I believe I have identified a number of  stocks that would qualify as no-brainer investments at a particular point in time. Some examples follow.

At the height of the tech bubble, there were certainly many old-economy stocks that were trading at very attractive multiples. I remember buying Canadian Pacific, back when it was a conglomerate, for about 12 times earnings and thinking, why wouldn’t I buy it, with the market average trading at over 25 times earnings. It turns out, it would have made a fantastic investment at that time. Stantec at that time was available at a price earnings multiple of about 10. In early 2000, Canadian Western Bank was available at just 1.12 times book value and at 9 times earnings. Other stocks moved into deep value territory when they hit temporary problems, these include TransCanada Pipelines and Telus.

While I have done quite well with my investments, I could have done better by virtually restricting myself to investing in these type of no-brainer stocks. In the past few years I have begun to concentrate my portfolio more and more into my strongest picks and this has paid off in much improved results.

If you have money invested, then consider subscribing to our stock picks so that you can tag along as I search for today’s no-brainers.

Market Size Matters

Market capitalization refers to the total market value of a company. This can be calculated as the stock price multiplied by the the number of shares that exist.

In Canada a company with a market capitalization value of about $1 to 2 billion or more is usually considered a large-cap company. Small cap may refer to companies worth less than $1 billion in total stock market value. Micro-cap would generally refer to companies worth less than $100 million. Mid-cap might refer to $500 million to about $3 billion. As you can see there is some overlap in the definitions.

Generally speaking very large-cap companies are considered to be less risky but tend not to grow quickly. Smaller-cap companies are considered to be more risky but often can offer greater growth rates.

I believe that a market cap around $200 million to $300 million may be a “sweet-spot” if the company is fast growing. The reason is that companies this size can have many years of fast earnings growth ahead of them. And as such a company grows in market value, it will at some point begin to attract institutional investors (who often find companies under about $300 million in market cap to be too small to invest in). At that point the market multiples of price to book value and price to earnings often go up fairly dramatically due to the attention of institutional buyers. This can easily lead to a market value gain of 50% in a short period of time over and above the growth generated by earnings growth. Sweet!


In 2005 the Performance of the stock picks on this Site have done very well and have pushed ahead almost relentlessly week after week. This is all the more satisfying given that the stock picks do not include any oil and gas stocks (save for a small amount of the energy index in the model portfolio).

Historic Perspective:

I believe that one of the most important articles on this Site is the one that graphically looks at the performance of stocks versus bonds and cash in different 20 year slices of time going back to 1926. While the stock index has soundly beaten the bond index over that 79 year period, it is also important to note that the various 20-year slices of time can be very different. I have recently revised the graphs in this article to make it easier to compare the performance in different time periods.

You can access previous editions of this newsletter here.


Shawn Allen, CFA, CMA, MBA, P.Eng.
InvestorFriend Inc.