Let’s face it, most investing decisions are made as easily as throwing a dice. I have a pretty hot temper, so I make it a point not to jump into things when it comes to investment decisions. This explains why I haven’t covered the recent Canadian Income Trusts melt-down like some of my peers have. There’s been some excellent discussions brewing. Almost a week has past, so here’s my perspective.

I’ve been a very disloyal Canadian investor. For the last 2 years, I’ve only batted eyes at U.S. companies while the Canadian indexes kept creeping higher. However, I’ve recently taken interest in beaten-up Canadian companies such as Loblaw, and Canadian oil and natural gas income trusts. My interest started with these income trusts due to their pricing issues in July and August, as well as the Amanranth hedge fund debacle. Such negative news always help to peak the interest for the contrarian in me. I can’t believe my knowledge ramp-up of income trusts have come at such a time of opportunity!

A Quick Re-cap
Not even a month ago, Forbes published an article espousing about what investors should do about Canadian income trusts. But their crystal ball prediction broke when the Canadian Minister of Finance, Jim Flaherty, unleashed a vindictive tax law to levy additional taxes on trusts. The new taxes are vindictive because the decision only came at the heels of announcement by 3 major Canadian corporations to convert into income trusts - Telus, Bell and Encana.

The issue is extremely political, as the Conservative government re-negged on their party’s pledge less than a year ago not to impose additional taxes on the trusts. By taxing trust distributions at regular corporate income tax rates, the federal government effectively eliminating the chief advantage of the trust structure as a flow-through entity. Obviously, it’s easier for the government to go after unpaid taxes by a single entity (in this case, the trust or corporation) than wait to audit all the shareholders who are receiving the pass-through dividends.

The Sell-Off Deja Vu?
The income trusts sector fell almost 20% on the first of November, plus an additional 5-6% the next day. The situation stabilized somewhat on Friday, but don’t be surprised if you see more wild swings in the next week, even month. Has this happened before? In fact, about 5 months ago the income trusts sector experienced a similar drop due to uncertainty inspired by comments from the government. A year ago, the income trusts suffered a similar bruising to their ego under the leadership of Ralph Goodale, former Minister of Finance. Will this iteration of the loop fully realize itself?

Until the law fully passes, it is still filed under uncertainty. Though Jim Flarhety appears to have the resolve to see this through, who is to say that members of their own party are not concerned with the seniors’ voting backlash all over the country? As well as the perceived abandonment of Western businesses - a traditional stronghold for Conservatives?

Does Any Good Come Out Of This?
I actually belong in the camp that believes income trusts regulations have gone unchecked for far too long. Though I saw the merits of certain businesses to payout their cash flow, it did not make sense for every business. The high payouts severely hamper profitable businesses from increasing their retained earnings, cramping their ability for further growth. Additional trust units need to be constantly issued to fund expansion plans. By forcing investors to be fully responsible for growth plans that may or may not be realized, eventually some businesses are bound to implode. I’ve stayed out of income trusts because I favour organic growth. In my opinion, a corporation, such as Bell, choosing to convert to income trusts is an admission that they no longer can grow organically and have given up on such ambitions. The reverse argument is that if a company can no longer compound their earnings effectively, then cash distributions may be the best idea.

Income Trust valuations will keep taking a beating. Lower payouts will mean lower valuations. It is absolutely possible for retiree portfolios who have suffered major setback to get beaten both in the portfolio value, and the promised cash flow for the next 2 years. Those who are getting in now, may find themselves entering at a decent support level, as long as they’re prepared for yields to drop from the high teens. But the yields themselves should remain respectable; especially if some analysts think that interest rate environments will remain stable or drop in the near future.

Any Possible Side Effects?
Dividend paying Canadian stocks have already experienced a resurgence in interest, mostly in financial stocks. However, Canadian banks have been overvalued since 2002. There is a sense that this artificial inflation will not last long, or may carry a backlash along with it. Investors may also start seeing companies move south of the border where they can operate under less tax pressures. Paying out cash flow has not really caught on in the States, and it may become the new haven for income trust companies should the axe truly fall on them. The mutual fund industry who have enjoyed selling monthly income funds may need to tweak their offerings in a hurry.

The Next 4 Years
My personal portfolio did take a hit, but not a serious one. I entered my sole position of a Natural Gas Income Trust at a good bottom, the only thing I suffered was that my 2 week 20% gain was erased. My investment principal has remained intact. I should have used a stop-loss, you say? A stop-loss would not have helped much significantly because it was a small position for me to test the waters. In fact, I’m actually contemplating buying more units, evaluating bruised trusts and enjoying their distribution for at least the next 2 years!

The Forgotten Mutual Fund Trusts?
It’s not just income trusts that have come under fire. In the early 2000s, many Canadian mutual fund companies sold funds created through the trust structure to allow them to issue distributions in a tax efficient manner. If you’ve invested in funds that include “return of capital” in its distributions, your funds were most likely structured as a trust. It is uncertain how these funds will be affected by the new tax rule. I’m sure you will not find many answers from your advisers or the mutual fund companies themselves. Everyone is basically in a wait-and-see mode, hoping that the tax laws will not pass.

The Politicians Keep Spinning!
As I researched the political ramifications of this outburst, I chanced upon the thoughts of Garth Turner. Garth was elected as a Conservative to become a Member of Parliament. He was recently kicked out of the caucus, apparently for revealing too many party secrets, and now sits as an Independent. I find it uneasy that Garth, a best-selling author of personal finance books, has kept his focus on the Pension Income Splitting portion of the new law changes. Especially considering his views (appropriately) a year ago on income trust taxation.

… Goodale created the conditions for panic. Financial markets - and seniors - hate uncertainty. The value of income trusts traded on the stock exchange started to fall like a stone, taking the trust units of retired people along with them. So far, the S&P/TSX capped income trust index has lost more than 15% of its value, or a stunning $23 billion. Ironically, this eliminated far more in potential tax revenue - in fact, nine times more - than Ottawa stood to collect by slapping a new tax on income trusts. [...] If the finance department thinks a new tax is warranted, then it should be imposed in a budget context. The last thing we need is for an entire industry to be talked down over the course of a month, destroying billions in value from units owned by grandparents.

Personally, I believe income trusts will survive just fine. But you must feel for the many Canadians that voted Conservative, who are feeling just as betrayed as Liberal Canadians did during the infamous sponsorship scandal. November 2006 was certainly a month investors will remember!