Flow-through shares have been the financial life blood for Canadian natural resource companies, providing $10 billion in exploration funding over the past 25 years. During recent years, flow-through investors have realized returns that were exceptionally outstanding or shockingly poor depending on the year or even month they invested. Those few who courageously bought during the market turmoil in late 2008 typically saw gains of 50% or more within six months as the stock markets rallied off their bottoms. Yet most who bought in late 2010, soon felt the pain of entering near the apogee of resource stock prices. Such volatility has left investors confused and wary about investing in flow-through shares. However, December 2012 may prove to be one of the best opportunities to buy flow-through in history.
There are a number of things that investors should know about flow-through before investing. First, is to understand how these investments work. Most Canadian resource companies are engaged in exploration for metals or energy and typically have large upfront exploration costs with little or no revenue. That means they don't need the tax deductions they would incur as income-generating companies. To finance exploration, they can issue shares and allow the tax deductions to "flow through" to investors. This is done through a flow-through share offering or a limited partnership offering to the investing public. For example, a resource company that requires capital to undertake exploration will typically “flow-through” their Canadian Exploration Expense (CEE) to investors by offering flow-through shares. The process is illustrated in Diagram A (see images at right).
Investors will typically be able to claim 100% of the value of the purchased shares against their taxes for that year. From a tax-deduction perspective, the investor receives a similar tax benefit as making an RRSP contribution (a reduction of line 236 on their tax return). However, one difference is that a flow-through investment is purchased and held outside a registered plan. In addition, it is important to note that when the flow-through is sold, a zero cost base is applied in calculating the capital gain. Table 1 shows the benefits of flow-through for an investor in the top marginal bracket.
Flow-through investing is most appropriate for high-income investors. Through the initial tax deduction and the impact of capital gains tax when the investment is sold, investors gain almost 30% downside protection on the value of their investment. When the assets are eventually sold, the 50% inclusion rate on capital gains will mean a tax hit of 23%, assuming the investor remains in the same tax bracket and the value of the flow-through does not change.
In the past, when market volatility was much lower, the 30% downside protection was sufficient for investors to expect to at least break even on an after-tax basis. In recent years, high market volatility meant that investors had to be very selective about timing their purchases. Having experienced a high variance in comparative returns from year to year or even month to month, many investors have become wary of purchasing flow-through shares. Yet there are a number of ideal conditions that exist today which provide clear signals for flow-through investors to invest immediately. These conditions are applicable to investors who buy either individual flow-through shares or units of flow-through limited partnerships.
The first ideal condition that exists today is the obvious lack of investor demand for junior resource stocks. While this phenomenon may discourage most investors, those who take a contrarian approach recognize it as an opportunity. There are hundreds of Canadian exploration companies whose share prices have vaporized to multi-year lows or levels well below the exercise price of insider’s stock options. Some companies are trading below their cash value. For the past few months, Bay Street has been awash in private placement offerings that have been passed over by dozens of disinterested brokers and their clients. Some mining CEOs are simply giving up and canceling their share offerings until more rational times return. Others have suspended exploration indefinitely as issuing additional shares at low prices would not be in the best interest of current shareholders due to excessive dilution. Demand for resource stocks appears to be near a low and logically share prices for these companies must also be near a low. This is precisely the environment where savvy contrarian investors flourish. Flow-through investors can take advantage of these low share prices and have their risk further reduced by the tax break they will receive. The tax savings will increase the likelihood of positive returns even if these unfavorable conditions persist for an extended time period.
The second condition giving a buy signal today is directly associated with the first. Junior resource shares have plummeted on lack of investor demand since early 2011. During the past nine months alone, the S&P TSX Venture Composite Index has declined 25% creating paper losses in portfolios. Diagram B shows the 2 year decline of 50%. As a result, there are many investors who may sell in the month of December 2012 to realize capital losses for the 2012 tax year. This may place additional pressure on junior resource company share prices and signal the absolute bottom. This near term sell off may create a perfect opportunity to buy.
Even if investors recognize December 2012 as a strategic opportunity to buy junior resource stocks, they may not have the free capital to act. These investors may be hesitant to raise cash by selling losing positions in their portfolios today and instead wait for prices to recover. This is human nature and this may be a mistake. Instead, high-income investors, who have unrealized capital losses in their stock portfolios, should consider selling losers now and immediately invest the proceeds into a flow-through limited partnership. The purchase of the flow-through will reduce 2012 taxes payable on income while the capital losses can be carried forward to offset the taxes payable upon maturity of the flow-through. Portfolio risk should not change significantly as the money is essentially moving sideways. Table 2 illustrates the tax savings.
The third ideal condition encouraging investment may be attributed to a characteristic of flow-through investors themselves. That condition is the high level of taxation many are experiencing from combining their salaries with investment income. Due to volatile markets over the past 5 years, investing in stocks for capital gains has become an unreliable strategy in the minds of many investors. Today there is an unprecedented mania to buy income producing investments such as bonds, REITs or high yielding dividend stocks. These investments appeal to investors whose mindset is that the world is about to face another round of severe market declines. Despite no supporting evidence, the common belief is that these income investments will fare better than growth investments during recessions and bear markets. There is a high price to pay for these emotion-based investment strategies. Many investors who own such investments are facing high taxation rates as interest and dividends are added to their 2012 incomes. Investors who have followed the herd into income producing investments can utilize flow-through to recover much of the tax payable.
In addition, investors who favored real estate in lieu of stocks for the past several years, may desire to take profits as home and condo prices begin to soften. Some may be hesitant to sell as this may result in considerable capital gains taxes payable. Those investors may take comfort in learning that by adopting flow-through strategies they may reduce their tax burden and flee before the current real estate bubble bursts. Table 3 is a simplified illustration showing how an investor who realizes a capital gain of $200,000 may utilize flow-through together with their RRSP to nearly eliminate capital gains tax payable.
The tax savings on flow-though can be remarkable. Yet investors should be selective on which products they buy. Whether an investor chooses individual flow-through shares or limited partnership units, it is always prudent to consult a professional financial advisor who is experienced with these types of investments. When selecting a limited partnership, seek out managers who have a history of getting good returns. Consider the portfolio's mix as well. Some may have a narrow focus or be diversified across many different types of natural resources.
Before buying a flow-through limited partnership, investors should examine its fee structure. Some pay a sales commission to advisors (usually about 4-6% of the original investment), plus upfront or ongoing management fees and/or performance bonuses. Other partnerships charge a small annual management fee (1%) or none at all, and then charge between 10% and 50% of the profits in excess of a certain return on the portfolio. Most limited partnerships require that investors hold their units for 18 to 24 months. While individual flow-through shares usually have a 4 month escrow period. Based upon Provincial securities laws, some investors may not qualify to buy flow-through shares or certain limited partnerships. A financial advisor can clarify if an investor meets the criteria.
Still, flow-through shares are not for everyone. The resource sector is cyclical by nature, and exploration is risky. Investors need the fortitude to tolerate the volatility. However, as investors have learned, timing can make or break investment returns. There clearly have been times when conditions were at an extreme and buying a flow-through resulted in substantial gains. During such times, very few investors felt as though flow-through investing was a prudent move. December 2012 may prove to be one of those very profitable opportunities.
— The author is an investment advisor with MGI Securities Inc. in Toronto.
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