Double Blind

Small businesses have until March 31, 2010 to remit their annual GST collections (assuming they make less than $1,500,000 in taxable sales a year), assuming their regular year-end is December. Assuming such a corporation makes less than $500,000 in taxable income, they also have until March 31, 2010 to remit corporate income taxes and fill in form T2, which is a significantly more complicated version than the personal income tax form (T1).

Since interest rates are going to be nothing between now and March 31, 2010, I decided to spend a couple hours of my weekend and do my taxes to get it out of the way. My home-brew accounting system (essentially a sophisticated excel spreadsheet) already has a provision for making sure I properly and accurately account for holding back enough GST and income taxes so that I’ll be able to pay the government.

The largest government impact between 2008 and 2009 was the reduction of small business taxes in British Columbia, which went down from 4.5% at the beginning of 2008 to 2.5% on December 1, 2009. The weighted average rate for BC in the 2008 year was 3.9167%, while the average rate in 2009 was 2.5%. While a 1.4167% difference does not seem large, it does result in a non-trivial savings in tax. This capital I can either choose to plough back into the business, or take it out in the form of a dividend, depending on how comfortable I feel about investing my company’s capital or my own capital.

The provincial government apparently wants to reduce small business taxes down to zero, which would result in a further 2.5% savings on corporate income.

I have said this before on this site, but if you can shift your income from employment to business income, there is a significant tax benefit involved – first because you don’t have to pay CPP and EI, but secondly because your after-tax pay will be somewhat reduced – by about 3.8% in the lowest tax bracket, and about 2% in the highest tax bracket. So if you are a low income earner, you stand to alleviate yourself about 10% of taxes (3.8% income and 6.7% for CPP+EI premiums) that you otherwise would have paid as an employee.

The downside of incorporating is paperwork – at a minimum, you have to register with the government ($325), file a $45 annual report, maintain a corporate bank account, maintain accounting records, and file income taxes/GST yearly. Assuming you can do this cheaply, it is worth looking into.

This post is cross-posted with the one at Divestor.

Portfolio review, 2009

The portfolio performance in 2009 can only be described as a home run. Using a crude adjustment for withdrawals and deposits (i.e. assuming they were all made on January 1, 2009), 2009 was a +104% year. If I used a proper method (i.e. a net asset value system) this percentage would be higher.

The TSX in the same period was up 41%, while the S&P 500 was up 28% in 2009, so I suspect a lot of people that have stayed in the market in 2009 will be feeling a bit better – especially if they had made purchases in early March, they would have been up about 70% or so if they did so in March and held on until the end of the year.

What I find particularly more stunning about the portfolio is that the bulk of these gains were accumulated through fixed income transactions, which are lower risk securities than investing in equity indexes. The bulk of the portfolio gains were accrued through debt purchases between March and May.

There was little leverage employed in the portfolio – at no point in time was margin (loaned money) was ever more than 10% of the entire portfolio value. I would estimate that average margin employed was roughly 2-3%, quite a conservative figure. I distinctly recall thinking of aggressively going on margin in April, but decided against it. It makes you look really good when it works, but it also does a good job of bankrupting you the markets turn the other way. If I had cranked up my leverage up to about 20-25% margin, it would have had a disproportionate effect on my returns (I would have been able to goose up my returns to around 150% for the year) but this is complete retrospect thinking – every good trade wants to be larger.

The portfolio is ending the year with a 4% cash balance, and that will go to around 10% when my Harvest Energy debenture sale transaction finally settles (January 2010). Adjusting for this, the portfolio is roughly 25% short term debentures (maturing in less than 2.5 years), 27% long term corporate debt (maturing in approximately 20 years) and 37% equity/income trusts. My currency exposure is roughly 75% Canadian, 25% US. The current yield is slightly under 9%.

Just as an interesting side note, in 2009, I spent 44% less than what I spent in 2008 on trading commissions. In terms of percentage of assets, it is slightly above what you would pay for a cheap index fund, but leagues below your typical actively managed Canadian fund (around 2.5% when I last checked).

There is also a lot in the portfolio for the Canada Revenue Agency to be happy about – in the form of unrealized capital gains. These represent future tax liabilities, but it also gives me some flexibility to smoothing out the income for the future. Hopefully they will still be unrealized gains instead of realized losses when the time comes to sell the investments or see them mature.

Financial Outlook for 2010

I do not believe the portfolio performance of 2009 will be repeated for a long, long time. I would be delusional to think otherwise. The market, however, can remain irrational longer than anybody expects, and this is the feeling I get going into 2010. It makes proper positioning much more trickier than in 2009 where it was a very easy decision to pile into bonds.

The economic numbers for the first half of 2010 will look good, but they are being compared to against very adverse 2009 numbers. I tend to think most of the equity rally has successfully priced in the recovery, but markets rarely stop at rational valuations – they overshoot it. In some cases, like Amazon, they have likely overshot by 50% or so. It is very difficult to determine where market sentiment will take prices. On the balance of probabilities, however, the market appears to be heading higher for the early part of the year. People will see the index funds delivering very good performance on equities, compared to fixed income, so money will likely flow toward the equity portion.

Not helping the case for bonds is that yields have been compressed significantly from last year – they are not quite at 2007 levels where they were trading a few pips above government, but bond yields today are significantly less compelling. Just as an example, 6% 38-year General Electric senior bonds were trading at 48 cents on the dollar in early March. An investor at this time could have collected 12.5% annual interest payments, year after year, as long as GE did not go bankrupt. Today, that same bond is trading for 97 cents, which means you will be collecting a paltry 6.2% instead.

There are too many examples of this type in the bond market to go through in detail. Suffice to say, the huge screens that I had that prompted me that I should be investigating the purchase of the entire bond market in March of 2009 is now telling me that there are only a couple of instruments in fixed income that could be considered for purchase. They still come with higher risk.

The bonds that I picked up in 2009 will get closer to maturity and will subsequently trade closer to par if there is no credit crunch looming. I can settle for this and just collect coupon payments in the meantime. Even if I make 7% on something trading at par, it is better than nothing to keep my capital parked there while looking for superior returns elsewhere.

A theme of 2010 will be “chasing yield”. Smart investors will avoid chasing yield – it is exactly the trap that Canadian income trust investors got into during the last period of very low interest rates. Chasing yield is to be avoided at all costs – although short term cash will earn you at most 2%, it is a far better option to hold cash than it is to lose money when yields rise due to increasing uncertainty. For example, I look at something like Rio-Can – right now your yield on their trust units is 6.95%. If you had to throw your money at something, it is almost better to bite the bullet and invest in those General Electric bonds mentioned above with respect to the risk vs. reward equation – taking equity risk in Rio-Can for an extra 0.75% doesn’t seem worthwhile. What I find amazing is I can see investors bidding up Rio-Can to 6% ($23/unit from $19.85 currently). But to trade on this is pure gambling – and I would feel more comfortable gambling at a casino than the stock market.

My advice would be – if you want to park cash, park it in cash. Don’t park it in a proxy investment for an extra percent or two since it is likely not going to be worth the risk of principal. If you must, go up the seniority chain – to preferred shares if you want better tax treatment or better yet, senior bonds.

In any event, the Bank of Canada is going to likely increase interest rates in July from the basement level of 0.25%. My guess is they will use the four meetings remaining in the year to raise rates 0.25% each meeting, leading to a year-ending rate of 1.25%. While this is still lower than historical rates, it will be soon be somewhat more rewarding to hold cash.

The topic of gold comes up occasionally. At US$1090 per troy ounce, there is no compelling reason for me to look into it. If the price did correct some 30% from present as the survivalists retreat back into the woods (to roughly US$750) I might look at it, but I am always very aware that the marginal costs of extraction are below this value. Crude oil is my commodity of choice – as long as I see airplanes flying (despite terrorists trying to do otherwise) and cars driving, the black liquid will continue to be the true gold – at least you can use it, while with gold bars you just store them in a safe area. Unfortunately, others seem to share a similar opinion about crude and while I think the major Canadian oil companies are strategically in the right space, their valuations reflect this. Looking at some of the smaller players will be worthwhile.

On the balance, I do not see a compelling investment environment for equity – while I suspect the equity markets will rise in the first half, the current valuations we see are already assuming a significant recovery in earnings. One can snipe away at individual (smaller) issues and probably do well, but I will remain skeptical of the broader indexes. I also still see a low interest rate environment and do not see long term bond valuations increasing too much, nor do I see the threat of inflation coming on this year. The theme, as I see it right now, is raising cash and concerning myself with inflation-proofing later.

The situation is very fluid and continuing to watch it is the most prudent course of action. I am always vigilant to look for specific opportunities (mainly on the equity side) but I am not finding anything that screams at me. My current estimation is that I would be very lucky if my existing portfolio delivered me more than 9%. Still, this is healthily above the risk-free rate.

ING Direct raised their short term interest rates on savings from 1.05% to 1.2% on December 15th. While this is not a huge difference, it is interesting to note in light of the fact that there have been no underlying rate changes coming from the Bank of Canada.

My guess is that the competition, such as Ally (offering 2.00% on basic savings) is starting to encroach on their business. It is a trivial matter to setup an electronic funds transfer link to move short-term money to the highest savings account.

The other reason is that I suspect ING Direct is losing cash deposits from people that are starting to feel “comfortable” again in investing in other financial products, such as the stock market, gold, or real estate. The difference between 1.2% and 1.05% should make little difference to people.

I’ve personally allocated my own capital elsewhere. There are just too many superior alternatives to cash. This will change in 2010 – look out for headlines that start saying “cash is trash” and equivalent. Once you start seeing those sorts of headlines, it’ll probably be a good time to bunker down with a high bank account balance; 1.2% is better than a negative 25% return elsewhere.

I have posted on Divestor an article of “What makes Vancouver Real Estate so expensive?“. I’m sure there are some holes in my analysis, but it was interesting to write it up and go through some variables of my mental modeling of the real estate market.

One of the reasons why it is so expensive is that people don’t translate dollars into yearly income – if you gave me a stack of money today, I could translate every dollar into an income stream of 10 cents a year with a reasonable amount of risk. So when looking at your typical Greater Vancouver detached home of $749,808, one is actually giving up a future income stream of $74,981/year to purchase that home. Assuming you don’t make any other money, that would be $58,500 after taxes in 2010. If one were to rent a place for half that amount (about $2,400) and continue investing the rest of it at 10%, there is a high degree of probability that you would be up even after factoring in missed capital gains on a home purchase.

It is strange how the president of a company that stands to make money with outstanding mortgage debt is expressing concerns at mortgage leverage of ordinary people.

For consumers with 35-year amortizations, which ING sells, he advises that they accelerate their payments.

“That way if you have a $300,000 mortgage, instead of owing $280,000, maybe you only owe $200,000 when rates are higher. It prepares you for difficult times,” said Aceto.

Right now a variable rate mortgage at ING Direct is given at the prime rate. Presently that is 2.25%. If you had a decision between banking cash in a GIC (earning 1.25%) versus putting it into the mortgage, it is a superior decision to put it in the mortgage, especially when one considers that the GIC interest is taxed. A potentially superior financial option is to earn a higher return than 2.25% and then pay off the mortgage with surplus capital when rates rise.

Alternatively, one can structure their mortgage to be interest deductible – there is a ton of literature available on this topic (such as the Smith Maneuver). Doing the math on a 2.25% variable rate loan and putting it into some tax-favoured preferred shares earning 6% a year yields a compelling story.

The interests of the bank president are somewhat aligned to what he is preaching – the concern for banks should be return of capital, not return on capital. If they had all their clients paying back their mortgages, they would be in fairly good shape.

There are a lot of exchange-traded funds out there that have commodities as their primary asset. I would not “invest” in any of them, although they are perfectly good trading instruments if you don’t want to dabble directly in the future exchanges.

Some person wrote a simple article explaining why correlation to these exchange-traded funds is not perfect. Keep in mind that the natural gas fund invests in futures, opposed to the physical product. Apparently the gold ETF (37 billion in assets and rising) has it in physical product.

All of these ETFs make a fortune by skimming a fraction of a percent in management fees – the Gold ETF takes 0.4% a year, while the natural gas ETF takes 0.6% a year.

I suspect most of the slippage of the ETF is due to traders sniping away at the funds that try to roll over the future contracts – without having the outlet of taking delivery it makes it incredibly difficult to keep a front-end position without encountering significant slippage – and this shows in the performance of the fund.

In the case of gold, if you want to invest in it for the long run, you would be better off buying the physical metal and storing it in a safety deposit box or some other secured location. For natural gas and crude oil, your best bet would be to invest in companies that have large, proven reserves of oil or gas. There are quite a few companies in Canada that would easily fit the description.

My commodity of choice is crude oil – as long as sustainable fusion doesn’t get invented anytime soon, crude oil continues to be the most convenient and economical source of energy. Crude oil is very useful, unlike gold. It is also unlikely that we will be gravitating away from gasoline over the next 30 years as the primary fuel for transportation.

At the end of today, there were 150 issues of debentures trading on the TSX. Note that a single company can have multiple issues of debt.

As of today, out of these 150 issues, 123 of them have a last trade price at or above 90 cents. 106 of these issues had some trading volume.

I am currently facing an unrealized loss position with my late August US interest rate futures bet; while my trade was placed at 2.2%, it is currently at 1.74%.

Unfortunately, both the markets and myself have now ratcheted down future interest rate speculation.

I am now of the opinion that US rates by the end of 2010 will be no higher than 1% and will most likely be 0.5%. I am also of the opinion that by mid-year 2011 that the rate will most likely be around 1-1.5%.

These are under existing market rates, and thus I will be attempting to close my position at an opportune moment. Usually the opportune moment comes when some piece of news floods the market with respect to an outperformance in the US economy, or some federal reserve official spouting off above when interest rates will rise again.

In Canada, it is evident that rates will be increasing slightly in mid-2010, but I do not expect rates to go higher than 1% by the end of 2010. It will most likely be around 0.5% and will be in lock-step with the US federal reserve.

I am always puzzled by people that say they want to purchase property in the United States for investment purposes, especially in the markets that have been depressed roughly 30-40% by foreclosures (e.g. California, Nevada, Arizona). While there is nothing wrong with the premise on speculating on such property, it is so much easier to do so with proxy investments such as REITs.

In addition, the purchase and sale of property in the states, as well as Canada, is a royal pain in the rear – you have liquidity concerns, you have to deal with agents and find buyers in a very slow process, you have to pay for property taxes and upkeep (which takes time that most professional organizations have automated) and you have to pay the dreaded IRS foreign alien withholding tax when you do dispose of your property and claim it back through a less-than-intuitive system.

The big “selling” point for me is liquidity. I absolutely despise investments that you can’t get rid of with a click of a button.

This post can also be titled “Why frequent trading is bad for your financial health”.

When reading Goldman Sachs’ quarterly report, the chart on page 123 struck out at me:

This is the amount of money that Goldman has been able to put to its own books through providing liquidity.

It effectively amounts to a tax on trading – Goldman is using algorithms that leverage the information that flows through its firm, and is able to extract that to the maximum. There is no way that an individual day trader can possibly match this distribution, even when a trader has 1,000 times less capital to work with than Goldman.

Mathematically, it is probably better to just walk to a casino and play 99.5%-return video poker than to trade against Goldman. The only other competition is Morgan Stanley, and this is all that is left in the winner-take-all game of being the primary liquidity maker in the US capital market.

This capital is effectively earned from hedge funds, mutual funds and pensions that are trying to out-wit each other with investment decisions. Indirectly, if you are part of a pension plan (and most employed Canadians are by virtue of their participation in the Canada Pension Plan), you are paying this tax.