Friday, June 23, 2017

Buying good assets at a good price – aim for 6% plus inflation returns – tax efficiently

What is investing?  At its core, investing is allocating money to things that make money in terms of appreciation or income or… both. A liability is something that costs money. A person is a liability in terms of living expenses but it can be an asset in terms of its ability to earn money or create value. Typically a car is a liability unless it is required for earning money then there is a trade-off.
Children in developing countries, after the initial costs of bringing them up, provide the parents with care and even income once the kids are adults. Overall they are a financial benefit. Children are assets.  In the West, children often are expensive to bring up and apart from the joy they often bring in a parents life, the money they earn typically remains in the child’s pockets. As such, in the West, children are a financial liability (everything is relative). Best form of birth control!
But investing is about allocating money to assets and hopefully increase the investor’s net worth and financial means to a level that makes him/her independent of employment. In this blog we call this latter stage: Financial Adulthood. If you love your career nothing stops you to pursue it until the end of times (financially) and if you have a nasty boss or client, you can tell him to take a hike.  In my consulting business, being financially adult, I have the option to price my services based on the ‘pain factor’ a client may pose. This is a subtle way of telling a client who poses too much of a pain factor, to take a hike. To some degree we have the option to set the terms of our ‘employment’ and I can tell you that that is quite a luxury in the current state of the oil patch. We love to work and provide good quality services for our clients and we do so taking their best interests into account. But we won’t work under abusive circumstances and we don’t get taken for a ride by ‘nickel and dimers’. This makes life very pleasant. Today I took time off, writing this blog on my condo’s terrace in a nice shaded area with nothing but green around me. Oh, that reminds me: I badly need another cappuccino. 😊
So what is a good investment?
For me, it is an asset that every month throws of a bit of cash flow and that appreciates over time. If the average annual return of my portfolio is between the 5 to 7% plus inflation then I am happy. Using the rule of 72 and estimating average inflation of 2%, it should take 72/(6+2%) = 72/8=9 years to double my net worth.  So If at age of 40 I own $ 1 million dollars then at 49 years I own $ 2 million and at 58 I own $ 4 million and by age 67 I own $ 8 million plus my Canada Pension. Not bad.  Of course, this also requires that you don’t pay a lot of taxes.
Hmmm….  So how does one minimize taxes?  Not by applying illegal tax avoidance tricks or putting your money in shady overseas tax havens. Buy a ‘good asset’ and never sell it!  The result is no capital gains taxes over your life time.  Fill up your TSFA to the max. You may say TSFA that’s only a measly $5500 per year.  No that is wrong thinking.  Since inception of the TSFA, with ok returns, that TSFA is now reaching $70,000 to $80,000 in value.  If you’re 25 years old and you make nominal 8% returns, at age 67 you have accumulated tax free $1.7 million. Ooops!  Yes, Oooooooops!
An RRSP is a lot riskier. This depends on the tax rate at which you make a contribution and the tax rate at which you withdraw from your RRSP.  So if your investment income at time of RRSP withdrawal places you in the top tax bracket you likely lose.  Especially considering that you don’t get dividend tax credits and that you cannot recoup your capital losses. From my point of view, RRSPs are evil instruments of the government to suck even more money out of the unsuspecting investor.  No wonder, Justin Trudeau stopped Steven Harper’s increased TSFA contribution. He wants people to stay dependent on the government and force them to work longer as wage slaves.  Really, the liberals are not the friend of the savers and of the middle class. (Ooops was that a bit of ideology on my side?)
A good business throws off cash flow and appreciates year in and year out. You make a product or provide services at a return on equity rate of 8% per year. Now a lot of public companies don’t make those returns without a bit of financial engineering. Neither does real estate. Since real estate is one of the simplest business models let’s use that as an example.  Real Estate typically appreciates just a tiny bit better than inflation. Say at 3% per year. It also provides cashflow – my target is a cap rate of 3%.  That means, its net annual cashflow should be 3% of the property's market value. Say, a building is worth $100,000 than after all costs, it should net you 3% or $3,000 cash every year. There are some tax advantages that you can use to make this 3% virtually tax free. BTW cap rate is kind of similar to EBITDA for corporate financials. 
In our example net rental income is typically tax free (better: deferred) for around 20 years. Of course your appreciation is also tax free as long as you don’t sell. So you’re making 6% tax free returns annually.  Now, how can you increase (financially engineer) your return to say 8%?  Simple, use leverage and take out a small mortgage. The interest on the mortgage if used for investment purposes is tax deductible.  If you are in the top tax bracket that means the government pays half your interest.  Isn’t that nice!  So we’re making (3 + 3% =) 6% or $6,000 per annum on a $100,000 investment.  To make 8% we need to make that $6,000 on how much equity? Right $6,000/8% = $75,000.  How do we get our property for $75,000 instead of $100,000?   By taking out a $25,000 mortgage say for 5 years at 2.4% or 1.2% after tax interest. 1.2% interest on 25,000 reduces our net cash flow by $275 per year that is virtually zero costs especially if you take into account that the $25,000 in terms of purchasing power decreases every year at the rate of inflation by another 2%. So really, you get that $25,000 basically for free. That is the world of negative interest rates today.
Of course leverage has its dangers. Never over-leverage because if you get trapped into too much debt in a falling market, your financial life may come quickly to an end (Think Peter Pocklington, Campeau, Olympia & York, etc.). 
Look no further than the stock market where senior management pumps often up their debt to increase the company's net income to the max until the day things turn sour. But management, by then, has driven up the stock value to the max, cashed in their options like bandits and then run while shareholders are holding the empty bag. Of course, those shareholders demanded maximized net income as well and didn’t care how management achieved this. Well investors in over-leveraged oil and gas companies have found out how debilitating too high debt can be. Their shares are our now worthless and all the senior management departed. To ad insult to injury, with golden handshakes to top off their cash haul.  Yes, expertise is soooo hard to find!
Good business are like good real estate. But often real estate cycles and stock market cycles are a bit out of sync. So are precious metals and other commodity cycles. When one market does do well, another may be in the doldrums or worse. This, of course, provides buying opportunities for investors with strong stomachs and cash-on-hand. This is also why a good investor has a ‘diversified’ portfolio – something that doesn’t makes you ‘seasick’ of the roller-coaster markets and that is good when you have to buy with knots in your stomach at the bottom of an asset market.

This is what investing is all about. Not gambling or speculating. But buying good assets at the lowest possible price and keeping them as long as you can. The example, par excellence, in this game is Warren Buffett and last week’s investment in Home Capital. 
So next time, first ask yourself if what you buy is an asset or a liability; is it helping your portfolio to achieve the desired returns (6% plus inflation) and can you buy it for a truly good price (say at the bottom of a bear market)?

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