Last week I praised Finance Minister Flaherty with regard to his comments on the fiscal surplus. There aren't many people praising him today. The changes to the taxation of income trusts have, and will continue to, generate lots of commentary and I don't want to add unnecessarily to the noise. In brief here is my take.
Do the Minister's reasons for the change make sense? The tax leakage issue is constantly being debated and I don't know what numbers to believe. I do think, however, that two of the government's concerns are valid. First, the trustification (my attempt at inventing a word) of Canada could lead to a less dynamic and innovative business community in the future. It's easy to say that new startup companies will continue to innovate, but there are instances where capital and research investment needs to come from established players that have deep pockets and scale. Second, the playing field between trust distributions and corporate dividends has been substantially leveled in recent months for taxable investors. But by moving to a model where all of the taxes are collected at the investor level (i.e. trustification), the tax burden increasingly falls on individual investors with no contribution being made by non-taxable investors like pension and endowment funds. It's particularly galling to me that non-taxable investors from outside Canada are getting a free ride when they own Canadian income trusts.
Not surprisingly, the reaction to the announcement has been visceral and will last a long time. The Minister whacked us with no warning and it was after he said he wouldn't. Adding to the emotion, of course, is the fact that almost everyone's net worth has been impacted by the changes. Some investors that have focused exclusively on income trusts are considerably poorer.
At this stage, however, investors have to put the political and emotional factors aside and decide where they go from here. Is this just a blip on the long-term charts and therefore a good buying opportunity? Or have things fundamentally changed from where they were on Tuesday?
There's no doubt the changes have a real impact on the future profitability of these companies. I don't know if the new rules take 5, 10 or 20% off of the net present value of the business, but it's real. Even with all the brain power that is being expended on Bay Street this week, I think it will take some time to sort it all out.
I've felt for years that trusts were being priced too much off of their current yield and not enough based on the value of their business. As professional investors have become a bigger part of the trust market, the valuation premium related to "yield chasing" has narrowed, but there may still be some premium left to chew through. As these securities start being properly valued again (as corporations with a four year tax holiday), there are parts of the trust sector that may go through a grinding adjustment. For example, a slow-growing, mature trust with a 10% yield and price/earnings ratio of 15 will now be viewed as expensive when compared to similar companies trading at 12 times earnings. Prior to Tuesday's announcement, it was viewed as attractively priced compared to a ten-year bond yielding 4%.
So you have to make your decisions based on the same methodology you use for buying or selling all your equity investments. If a trust is fairly valued based on its business prospects, then there's no urgency to buy or sell. You can keep collecting the income. If the trust looks cheap based on the fundamentals of the business, then it may be a good time to add more to the holding, depending on your circumstances and overall portfolio. The third scenario is the hardest to stomach. If a trust valuation cannot be justified, then you should sell, even if it already is down a whole bunch from Tuesday's closing price.