CE Course: Red flags for equity investors

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“Red flags for equity investors ” is eligible for CE credits. See Accreditation details for more information.

Course summary: Dr. Al Rosen and Mark Rosen of Accountability Research Corp. identify red flags investors should watch for when assessing company stocks.

SECTION 1: Problems with revenue recognition

Revenue. It’s the top line on financial statements, and arguably the most important. But, revenue is not always comparable between companies, since the amount reported depends on when the company recognizes the revenue as earned, not when it’s received. What constitutes “when” can lead to significant debate. Improvements in accounting rules have been announced, but advisors will have to wait until 2018 before seeing their full impact.

The current challenges

Any company can use the new rules on a voluntary basis. Investors need to look for early adopters, while also remaining vigilant of the shortfalls in the current rules. How companies transition to the new rules will also significantly impact trend analysis and any quant-based models or systems.

Revenue recognition rules have traditionally had two problem areas: multi-year projects and multi-component transactions.

1. Projects that stretch over multiple years

For instance, long-term infrastructure projects can have fixed or variable costs, multiple deadlines, and uneven cash receipts and expense payments. They can also provide a mix of both goods and services. These factors make it difficult to estimate when revenue should be recorded, and in what amounts.

Construction programs, such as those for new aircraft, can span decades through stages that include design, testing and delivery. Sometimes, design costs can be shared across various programs. Similarly, entertainment projects can involve shared costs from both production and marketing departments.

2. Products and services with multiple deliverables

A prime example of multiple deliverables can be seen in technology companies that provide a combination of hardware, software, consulting, servicing, support, upgrades and warranties—sometimes all at once. These products and services can be interdependent, so it’s difficult to measure the revenue that’s earned every quarter over an extended period.

While these descriptions only scratch the surface, one of accounting’s guidelines has always been that revenues should be matched to expenses. For this to occur, the costs need to be known and measurable. This often results in cash payments being timed differently from when revenue is recorded.

What the new rules address

The new rules were finalized in 2014, so 2015’s annual reports were the first opportunity companies had to disclose the rules’ potential impact on their financial statements. Not all industries or companies are affected—and some may see no impact.

For instance, the new rules only alter the accounting for specific situations and more complicated scenarios. Even companies in the same industry can be different in substance and product offering, so investors will need to focus on the corporate level to avoid making analytical and comparability mistakes when it comes to valuation. Some companies will see their revenue and topline figures altered significantly, and others, not at all.

Apple Inc. has changed its revenue recognition policies in the past few years, since it provides free software upgrades to customers after they’ve made purchases. As they started to do so, the company began to defer an increasing proportion of revenue related to each device sold. This was a forward-looking voluntary change that impacted reported revenue growth and profit margin—both key factors monitored closely by the market.

Another industry expected to see major impacts from the changes is telecom. Currently, cell phone providers sign many customers to contracts that are tied to new handsets. There are cost subsidies involved, and some phones are sold for free (no money down, in actuality).

Previously, companies generally broke down revenue based on the price of the phone, as opposed to its actual value. While this difference seems subtle, the impact will be significant, unless the industry reduces the subsidies handed out to customers.

Under the new rules, their accounting would have to break the bundled contract into deliverable parts, so the fulfillment of providing the phone to the customer would constitute revenue generation in the amount of the estimated value of the handset. Companies would end up reporting significantly more revenue up front, not later when the customer actually pays for the phone in installments. This may seem counterintuitive, and could be regarded as a significant drawback to achieving the stated goal of greater accounting harmonization. Telecom providers, in particular, lobbied hard against the accounting changes (indicating the quantum of the disruptive impact the rules will bring).

While the new rules improve IFRS and harmonize reporting with U.S. guidelines, there will still be significant challenges regarding implementation. There will be debates over who the actual customer is in certain situations.

Other transactions will be bogged down by details, like whether something constitutes a product warranty or a service warranty. So, these issues will need to be resolved with significant estimations and judgment calls by management, likely degrading some of the comparability that was the primary aim of the decade-long accounting project.

SECTION 2: Dual-class share structures are making a comeback

Even though dual-class share structures have been long reviled by corporate governance pundits who live by the mantra “one share, one vote,” the structures are regaining popularity, driven in part by high-profile examples of superior stock performance.

Aside from capping foreign ownership (e.g., in telecom and airlines), dual-class share structures exist to provide one group (usually company founders) with voting control over the direction of the company. That can be done through super-voting shares, where one share of equity has multiple votes, or with non-voting shares for the majority.

During the height of the revolt against these structures in Canada a decade ago, the TSX revamped its ticker symbols, hoping investors could identify stocks with inferior voting rights. Problem was, everybody strained to recall tickers like TEK.SV.B (the symbol for one class of Teck Cominco shares), or to make the distinction between multiple, subordinate, limited, restricted and non-voting shares. The new tickers were abandoned not long after.

It was never clear why some corporate governance pundits thought plain disclosure wasn’t sufficient warning for investors, or why they believed company founders should surrender the economic value of their voting control for free. After all, investors can vote with their feet at any time. In truth, it seemed the biggest complaints always came from activist investors or institutions with large illiquid ownership interests who were facing buyer’s regret.

Luckily, times have changed. Advisors need to be aware that dual-class shares are enjoying a rebirth. Several recent Canadian IPOs have sported dual-share structures, including Cara Operations, Shopify and Spin Master.

Successful companies

At least some of the resurgence in dual-class structures is due to the success that many companies and investors in the U.S. have enjoyed, especially in the tech realm. Google Inc. (now trading as Alphabet Inc.), with a market cap of roughly US$540 billion as of December 2015, has had a dual-class structure since its IPO in 2004. The stock has also appreciated at an annual rate of 29% per year since. Founders Larry Page and Sergey Brin control the company through super-voting shares, which outweigh the combined power of the regular-voting and non-voting listed shares.

While being a cash machine doesn’t hurt in convincing the market that the founders should have sole control of the reins, Google has also remained responsive to market input. In August 2015, the company announced a corporate restructuring that will provide greater financial statement transparency, which is almost always better for stock performance.

Google is far from alone. Facebook has risen 34% annually since its IPO in May 2012. Founder Mark Zuckerberg controls the company with 55% of the votes while owning just 20% of the company.

Then there is Warren Buffett, who has defended dual-class shares, not only at his holding company, Berkshire Hathaway, but also at several public companies in which he has invested.

Despite these successes, proxy advisory firms still routinely urge investors to vote in favour of proposals that ask founders to surrender the value of their superior voting shares with no compensation. Generally, listed shares with superior votes trade at a 2% to 6% premium to their inferior counterparts. The value of complete control is usually much greater than that.

The flipside of dual-class shares

The blanket corporate governance stance of the advisory firms is somewhat understandable. For every Google or Facebook, there seems to be a Magna or Bombardier.

Magna famously paid Frank Stronach $1 billion to collapse the dual-share structure at the auto-parts maker in 2010. Stronach held two-thirds of the votes with less than 1% equity. As bitter a pill as it was for investors to swallow, the shares are up 250% since the deal was announced.

Recently, the dual-class structure at Bombardier has been thrust back into the spotlight.

The share price sank by 70% during 2015. The stock enjoyed a brief respite when the market thought the company might sell off its rail assets for a handsome sum. But the company poured cold water on the idea, preferring to seek alternative funding arrangements and a long-term investment in the rail business.

Time will tell whether the company needs a firm hand on the tiller with a long-term vision, or whether investors would be better off with a large, one-time transaction to significantly boost shareholder value in the short term.

Hard to let go

The general reason for providing founders with voting control is to allow them to fulfill their long-term vision for the company while still accessing the broad funding of the public markets.

But even after 10 years as a public company, Google’s founders won’t let go. Also, they restructured the share classes in 2014 to allow the company to issue only non-voting shares in the future, potentially entrenching the founders’ voting majority for good.

The founders of Alimentation Couche-Tard are following a similar path. The retired executives, including chairman Alain Bouchard, are set to collapse their super voting control in 2021. Recently, the company withdrew a proposal to shareholders to extend that control for an undetermined period That still might not be a bad idea. It’s questionable whether Couche-Tard’s highly successful and transformative purchases, like SFR in 2012, would’ve been constrained under the quarterly watch of impatient shareholders.

Don’t like it? Leave

There’s nothing wrong with surrendering voting rights, as long as investors have faith in the founders’ long-term vision. If that faith wavers, investors can always vote with their feet, sell their shares, and leave the complaining to activist investors and corporate governance pundits.

SECTION 3: Buybacks vs. dividends: which is better?

Corporations are continually faced with capital allocation decisions. Investors, however, rarely have the information to know if management is making the right moves, since public financial statements don’t shed light on internal rates of return. But, when management returns cash to shareholders, investors can better assess the chosen approach. Companies tend to return excess cash as dividends or share buybacks.

Dividends and buybacks

As far as dividends go, extra cash can be returned to investors as an increase to the regular payout, or as a special, one-time distribution. The market prefers increases to regular dividends for good reason—they offer more stability and transparency, and promise ongoing discipline.

Dividends offer greater flexibility, since investors can decide where to spend the cash (essential for clients who rely on income generation). The downside of getting cash now is that dividends can trigger a taxable obligation, whereas buybacks allow for potential tax deferral.

The biggest risk is when investors get hooked on the income, and reach for higher yields that aren’t sustainable based on the underlying cash flows of the business. Advisors also need to be wary of overpaying for names that seem to offer sustained dividend growth.

Meanwhile, in the U.S. and Canada, buybacks have exploded in recent years. The biggest impact has come from the technology, healthcare and consumer discretionary sectors. S&P 500 companies repurchased shares worth $553 billion in 2014, up from $400 billion in 2012, and $300 billion in 2010.

Much of the growth in buybacks is a result of low interest rates. Many companies have issued ultra low-cost bonds simply to repurchase shares. But, it’s important to draw a distinction between companies optimizing an underleveraged capital structure (i.e., Apple) versus those pushing leverage as high as possible. When a company stretches its balance sheet to the point of affecting its credit rating, advisors have to question whether management is artificially boosting EPS. With CEO tenures shrinking, there’s a drive to focus less on the longer term, and more on immediate results. When natural growth slows, executives have little time to make an impact. The market also appreciates a myopic approach when it results in higher share prices, and the easiest way to get that is to cancel shares and show better EPS, even with flat earnings.

In the last few years, all the pieces have fallen into place. Similar to the way investors enjoy the flexibility of dividends, management loves the greater flexibility of buybacks. Buybacks have the ability to affect share prices and EPS, separate from the fundamental performance of the company.

So it’s tough to watch companies launching buybacks just because management thinks the share price is undervalued. It’s reactionary and ill-planned from a strategic perspective.

The market is adept at working out inefficiencies in value. Investors don’t need a management team swaying the market based on what they think is a flagging share price. For instance, Marathon Oil spent $1 billion repurchasing stock in the first half of 2014 and then suddenly stopped, even though management was authorized to buy more. The company’s decision to time the market meant shareholders missed the opportunity to capitalize on the decline in share price, which fell to 30% below the average buyback amount. So, it’s better to see companies returning cash through buybacks as a recurring practice. It works for investors and companies, and is akin to dollar-cost averaging.

If an investor comes into a windfall, advisors will counsel him to wade into the market slowly, so he doesn’t miss lower prices later. Management should do the same when investing the money shareholders put in their company. In turn, advisors must avoid companies with management teams that are intent on timing the market with share repurchases, or too focused on boosting EPS.

Best of both worlds?

Focusing on companies that extend their buybacks over multiple years is borrowing a page from dividend investors, who are attracted to spreading out cash on a regular basis. This approach is stable, disciplined, transparent and tax-advantaged. It takes some of the flexibility out of the hands of management, which is a good thing from a behavioural investing perspective.

But, monitor how repurchases are cancelling out shares that have been issued to management as part of their overall compensation. Keeping the share dilution under control is good, but over time, it masks how much of the company is being transferred from investors into the hands of insiders. The accounting impact of this maneuver also should not be lost on investors because it can artificially inflate free cash flows over the long term. Some companies prefer to use both buybacks and dividend increases to spread extra cash around, because the cash outlay for the buyback is partially offset by the reduced dividend payout from the lower number of shares.

The dual approach can also offer investors the same opportunity that some executives receive. Enrolling in a direct investment plan allows investors to take extra shares, instead of cash, as dividends. The dilution of shares can then be offset over the longer term by regular buybacks, which provide investors who are enrolled in the DRIP with a higher relative equity interest, and greater exposure to company earnings.

SECTION 4: Be wary of REITs’ reported numbers

The way REITs calculate their results can vary across the sector, making them difficult to analyze.

In fact, investors will generally ignore a REIT’s net income because of complications created by IFRS accounting rules. Instead, they’ll focus on measuring cash flows, including how cash flows compare to distributions.

It requires effort to transform the IFRS numbers into something usable for investment purposes. While REITs don’t grow their distributions as much as telcos, banks and pipelines, they also don’t suffer as much from dividend cuts, like those seen in the energy sector of late. Of course, cuts are not unheard of for REITs, so advisors must focus on the margin of safety in the distribution. This is best seen through a payout ratio, where the denominator focuses on cash flows.

Choosing a cash flow measure

Using the reported “cash from operations” figure in the financial statements is not wise. That’s because cash from operations (taken straight from the cash flow statement) can vary widely in its composition among companies.

Some REITs choose to exclude interest expenses from the calculations of cash from operations, which inflates their results relative to peers who choose more traditional reporting conventions. Under IFRS rules, companies have the option to count interest expenses as either part of investing or financing cash flows. They never had that choice under the old Canadian GAAP accounting rules.

This variance makes it better to focus on Funds from Operations (FFO), which is a non-IFRS number, so its oversight falls outside the purview of financial statement auditors. There’s some industry guidance that companies can follow when calculating FFO. The Real Property Association of Canada (REALpac) has filled part of the void by recommending a standardized calculation of FFO.

Here’s how it works. Start with the IFRS-calculated net income. Then, REALpac outlines 20 different adjustments to net income, focusing on adding back non-cash accruals. These cover depreciation and amortization, non-cash taxes, realized and unrealized gains and losses, and adjustments for non-controlling interests. Not every REIT needs to make every adjustment. Here’s an example.

H&R REIT and H&R finance trust – MD&A – December 31, 2014

Funds from operations
	Three months ended December 31		Year ended December 31
(in thousands of Canadian dollars except per unit amounts)	2014	2013	2014	2013
Property operating income	$208,261	$212,308	$803,276	$749,922
Finance income	223	257	901	2,108
Finance cost – operations (excluding exchangeable unit distributions)	(73,622)	(77,932)	(300,793)	(295,662)
Trust expenses (excluding the fair value adjustment to unit-based compensation)	(3,114)	(3,880)	(11,519)	(12,716)
Current income taxes expense	(436)	(19)	(920)	(471)
FFO from equity accounted investments (page 19)	12,437	11,084	45,694	29,183
Realty taxes accounted for under IFRIC 21	(6,948)	(7,708)	–	–
Incremental leasing costs	1,658	–	6,042	–
FFO	$138,459	$134,110	$542,951	$472,364

Advisors should keep in mind that these types of accounting cash flows still might differ from actual cash flows, and they’re only a proxy for investment purposes.

With this in mind, REALpac advises against using its FFO measure to assess dividend sustainability, but realizes a defined starting point is helpful to both issuers and investors.

When you remove so many accounting expenses from FFO, you could miss relevant cash outflows. Investors try to compensate for this by focusing on adjusted FFO (AFFO). It represents a better proxy for cash flows and is more akin to the free cash flow measure used in analyzing other industries. It’s also sometimes referred to as “funds available for distribution.”

One of the major adjustments that must be made to FFO to arrive at AFFO is to deduct an amount for maintenance capital expenditures. Since management only estimates what portion of total capital expenditures are needed for maintenance, investors have to assess the reasonableness of the figure for themselves. It’s likely that different management teams have different approaches to measure maintenance capex.

For instance, measuring the cash flows needed to maintain the revenue stream of current assets might differ from what is needed to maintain the overall quality of those assets, especially in a rising rental rate environment or when vacancies are low. Companies can spend less on maintenance when vacancies are low, and still generate the same revenue on assets that are slowing deteriorating.

REALpac stops short of recommending a calculation for AFFO, stating “there is not adequate consensus among preparers and users of reporting issuers’ financial statements to allow agreement on a single definition of AFFO.”

The securities commissions monitor and approve the presentation of AFFO only, and not the actual composition of the calculation. This leaves the discretion of AFFO up to individual company management, which creates comparability problems for investors.

Little external oversight

According to the OSC, 24 of 30 Ontario-based REITs use AFFO, as well as FFO, to present their payout ratios. The remaining 20% use FFO only, use distributable cash or use nothing at all.

Unfortunately, the OSC requires that REITs reconcile their AFFO calculations to cash from operations, instead of FFO or net income, which reintroduces the lack of consistency that exists for cash flow reporting under IFRS.

So, advisors need to monitor both FFO and AFFO in assessing payout ratios. In addition to monitoring for potential distribution cuts, investors also scrutinize and compare payout ratios to estimate which REITs have the most room to increase their distributions.

Given that REITs are supposed to distribute the majority of their cash flows to comply with tax rules, it’s not unusual for REITs to report AFFO payout ratios in the 90% and higher range. This leaves little room for error in comparing which REITs are better. It also casts more attention on the amount of discretion that management has in determining the adjustments that are made to base FFO in order to calculate AFFO.

Occasionally, REITs will report payout ratios higher than 100%, but this should only occur on a temporary basis if rents are stabilizing due to an acquisition. If the overage is a result of a dividend reinvestment program, advisors need to keep an eye on the trend in AFFO per share. If it’s declining, the DRIP is diluting the value to existing shareholders.

SECTION 5: Look at energy companies’ writedowns

Going into last year’s annual report season, investors might have expected to see more writedowns on the value of resource assets on company balance sheets. After all, from September 2014 to March 2015, the price of Brent crude dropped 40% and WTI was off by about 50%. Further, economic conditions remain challenged for companies in the mining and energy sectors, with financial instability in Europe and questions of growth in China still lingering. But, with earnings season done, there weren’t many writedowns seen. Why?

Companies can ignore market conditions

Firms have significant leeway when estimating whether their assets have been impaired, and to what degree. In fact, companies don’t test every asset every quarter, or write down the value of their assets to current market prices. Under IFRS accounting rules, impairment testing is a two-step process. First, management considers whether there are any factors that may have caused an impairment. These are known as triggers. If management doesn’t believe that any triggers exist, then that’s the end of the process; no impairment test is even carried out, and no writedown takes place. If a trigger occurs, the second step is to calculate whether an impairment exists.

The question in this market is whether the huge drop in energy prices represents an event that could trigger asset impairments. While the common sense answer is “yes,” the accounting answer is “maybe.” This stance is one of many release valves that are built into the accounting rules. The rules usually leave room for executives to wiggle out of situations, if they desire. For instance, how could management claim that a near halving of oil prices doesn’t trigger an impairment?

Background on oil

It’s generally accepted that Saudi Arabia (through OPEC) initiated the plunge in oil prices by targeting a production level that was designed to drive high-cost producers out of the market. Specifically, many shale gas producers have caused global supply to outstrip demand in recent years. In order to drive these producers out of the market, OPEC needs to push prices down and to keep them down for as long as it takes to force companies to make structural changes that can’t be easily reversed.

Given what some regard as artificial short-term price manipulation, it’s arguable that energy prices will rise again (as soon as the market regains some balance), either through lower production or increased demand.

This belief means management can look past the current low prices, and focus on where they think energy prices will be over the longer term. To do this, companies can point to forward price curves and estimates, or contemplate stopping production until prices return to higher levels. But, when prices stay low for a long period, companies have to undertake an impairment test, which determines the recoverable amount of the asset. Then, they’ll have to write the value down to that level.

With mining and energy companies, impairments tend to occur in long-lived assets, including exploration and evaluation assets, reserves and resources, intangibles, goodwill, and even property and equipment.

One reason companies don’t like recognizing writedowns is because if the conditions that caused the impairment reverse, the accounting rules require the impairment to reverse also (except for with goodwill). For instance, if the oil price rises back to $100 a barrel, an oil company would have to reverse its writedown of a resource property. No company wants its results tossed around every quarter based on gyrations in commodity prices.

What’s the recoverable amount?

The recoverable amount is the higher of the fair value, less costs to dispose (FVLCD) or the value in use (VIU). Each quarter, companies can choose whichever measure better helps them avoid an impairment charge.

The FVLCD approach is based on comparable prices, while the VIU represents a discounted cash-flow method. In both cases, however, the rules allow management to make optimistic assumptions about the future, which can keep value estimates high enough that they don’t trigger impairments.

For instance, the FVLCD method allows management to assume restructuring or investing in an asset will cause it to rise in value. The VIU approach is even more pliable, and allows management to consider the cash flow impact of synergies, including synergies that are not available to other market participants, such as close proximity to other company-owned assets or properties. Management can also assume that it has knowledge of its own assets that the market is not aware of. In effect, management has the ability to value an asset at a much higher amount than any other entity would pay for it.

Beware of latent impairment

The IFRS accounting rules provide management with significant ability to avoid writedowns of resource assets. When companies have taken writedowns in recent years, they’ve often been for impairments to goodwill. That’s because it’s more palatable to investors than writing down resource assets, and there is no requirement to reverse the impairment in the future, which would create volatility in reported results.

Advisors should be wary of the latent impairment of resource assets that could be slowly building in the books of some energy companies. Given that some writedowns have clearly been delayed, a prolonged downturn in energy prices will eventually trigger impairment tests, and start a deluge of writedowns and red ink.

SECTION 6: Executive psychology can impact financial results

Most investors can recall a time when they’ve fallen victim to their own psychology. For instance, many have held a stock for too long, making their loss bigger or their gains smaller.

Why does this happen? Let’s take a look.

The endowment effect

Part of the reason behind an investor’s behaviour comes down to the endowment effect, which is simply the tendency of people to value a good they already own at a higher amount than they would pay for it. One experiment involved the trading of coffee mugs. Half the people were given mugs, while the other half were not. When it came time to establish a value for the mugs, those who owned them set the offer price at twice what those without the mugs were willing to pay. Other experiments have shown an even greater disparity between the so-called willingness to accept and the willingness to pay. The creators of the experiment, led by Nobel Prize winner Daniel Kahneman, credited the behaviour to the idea of loss aversion: people fear losing their belongings.

It would seem to go beyond human nature and is even hardwired into our brains at a basic level, with the effect showing up in monkeys as well.

While the impact of behavioural tendencies is widely discussed in the investing world, it’s rarely mentioned in the accounting world. So, what impact does the endowment effect have on executives? Beyond the transactions they make, or the opportunities they miss, company management is responsible for making assumptions that impact the reported value of the company’s assets and income every quarter.

Why does nobody suggest we take the psychology out of accounting? Rather than fixing the problem, accounting has actually moved in the opposite direction in recent years. IFRS has made accounting more fraught with uncertainty and more open to the influence of the endowment effect. Two major themes of IFRS remain a concern, as they relate to potential pitfalls of executive psychology.

1. IFRS promotes the importance of the balance sheet, making it the primary focus even at the expense of making the income statement less reliable.

Management is now tasked with fair-valuing or marking-to-market assets, with the consequence of recording unrealized gains on the income statement. Because the assets aren’t being sold, but instead are being revalued every quarter, the endowment effect has a greater influence because executives will tend to overvalue their own assets.

2. IFRS is principles-based, as opposed to rules-based.

Since rules tend to be more objective, and principles more subjective, it worsens the potential impact of the endowment effect. IFRS pundits tend to lean heavily on the idea that management knows its company and assets best, allowing them to value the assets as they see fit, instead of holding them accountable to prescriptive rules for valuation.

This marks a separation from the endowment effect as seen in investors, who overestimate the value of their investments before reality intrudes on a timely basis.

By contrast, while executives have the ability to ascribe higher values in the financial statements, it could be years before the market becomes aware of any overvaluation (because an actual sale might not occur for some time).

What investors can do

Investors should identify which industries could see the greatest impact from the endowment effect on reported financial results. Both the accounting guidelines and the general valuation metrics used by the market combine to determine what sectors are most at risk.

The issue comes up frequently with REITs, energy companies and conglomerates that hold a variety of investments. Within the REIT sector, there is often reliance on net asset values, which are derived directly from the balance sheet. Sometimes, investors will focus on a company that’s trading at a discount to its reported NAV.

They believe the gap will naturally close, producing an increase in share price. However, that belief can be wrong and costly if evidence surfaces later that a company made unrealistic assumptions about the value of its real estate. Investors need to concentrate on whether the company has recorded losses on previous asset sales, which is a red flag with respect to the reliability of management estimates. For instance, two apartment property owners (CAPREIT and Milestone Apartments REIT) reported losses on actual property dispositions in 2015, while reporting significant unrealized gains on the rest of their portfolios, based on management assumptions.

The same issue can exist in the energy sector when companies report their annual reserve results, which determine the assumed value of their resource base. These assumptions work their way into target prices, and can create unrealistic expectations for investors.

Conglomerate companies that combine several private-equity investments can be especially vulnerable to the endowment effect because it’s difficult to value diverse and sometimes non-comparable private-company investments. Difference Capital is an example. In its first six months of 2015, it recorded a loss on the disposal of certain investments and marketable securities of $8 million. This was offset by an unrealized gain on other investments and marketable securities of $12.2 million, to produce a reported net gain of $4.2 million for the period.

So, clients should be aware of which industries are vulnerable to the potential impact of the endowment effect in executives. The objective way to check management valuation assumptions is to be mindful of the outcome of actual asset dispositions, and whether they support the unrealized gains reported in financial statements.

SECTION 7: CRA action against companies could lower stock prices

The potential intervention of the taxman continues to be an underappreciated investment risk—but not in the way you’re used to hearing about in headlines.

Most advisors concern themselves with legislative changes in the way investments are taxed, whether those investments are stock options, insurance policies or trust structures.

Often forgotten is CRA’s influence on corporate taxes and the disruptive effect that it can have on the share prices of companies owned by clients.

Silver Wheaton Corp.

In July 2015, Silver Wheaton surprised the market when it announced that it had received a proposal from CRA to reassess the company’s 2005 to 2010 tax years. A proposal letter is like a heads-up that an actual reassessment is coming. The shares closed down 12% on the news.

CRA was seeking to increase Silver Wheaton’s taxable income for the period by $715 million, which would result in taxes owing of $201 million. Added to transfer pricing penalties (more on that later) and interest, the total amount owing under the proposal was $353 million.

Because CRA doesn’t normally reassess all years at once, the general market assumption has been that similar taxes will eventually be owed from 2011 to present. So, the total amount owing could reach $600 million, depending on further penalties.

The potential hit to the value of Silver Wheaton shares is not just in the cash amount that it might owe, but also in the fact that the cash outlay could delay future acquisitions, potentially slowing growth. Further, if the transfer pricing agreements are disallowed, that could affect the company’s future after-tax margins.

In September 2015, the company received the reassessments, which were consistent with the proposal. The company will likely receive reassessments for additional years sometime in 2016. The process will be slow and, if the company takes the issue to court, it could be many years before a resolution is known to investors. Silver Wheaton has officially filed a notice of objection to the reassessments and the company has stated that its tax returns are consistent with Canadian law.

Transfer pricing

If the transfer pricing issue seems familiar, it’s because Cameco Corp. is currently embroiled in an ongoing battle with CRA. Back in 1999, Cameco set a $10 uranium transfer price between its Canadian and Swiss divisions, which CRA alleges has resulted in excess revenue shifting to Switzerland (see “Tax games: Are some companies playing with fire?”).

Transfer prices are what one division of a company will pay another for a good or service (an intercompany charge). Since management chooses the transfer prices, they effectively determine the income of each division, and can shift income from one division to another. The goal, so to speak, is to minimize tax by shifting more income to international subsidiaries with lower tax rates.

As Silver Wheaton notes in its latest annual report, “A significant portion of the company’s operating profit is derived from its subsidiaries, Silver Wheaton Caymans, which is incorporated and operated in the Cayman Islands; and historically, Silverstone Resources (Barbados) Corp., which was incorporated and operated in Barbados, such that the company’s profits are subject to low income tax.”

Silver Wheaton is a fairly unique company in the mining sector because it’s generally regarded as one of the founders of the streaming industry.

Streaming businesses pay operating mining companies for their production of by-product metals. For instance, Silver Wheaton will purchase the silver production from a gold miner, or the gold production of a copper miner.

In exchange for a large upfront payment that usually helps the miner finance its project, the streaming company (Silver Wheaton) will buy the future production (usually at a low per ounce cost) for a set amount of time.

In this manner, Silver Wheaton avoids many of the risks of operating the mines, and takes on mostly financing and investment risk. Most of its operations are, therefore, in the management realm: identifying opportunities, raising financing, and marketing and selling the resources acquired.

Qualified personnel located in lower tax jurisdictions can legitimately carry out some of these functions. Canadian employees also carry out many of the key functions. Silver Wheaton management decides which subsidiaries performed the work.

CRA argues that much more of the key functions, assets and risks were actually attributable to the Canadian operations, and the transfer prices should have reflected that and resulted in more taxable income occurring in Canada.

Given a July 2015 court ruling in the Cameco case (which is at a more advanced stage), it will likely come down to CRA identifying what it believes are the appropriate transfer prices, and whether Silver Wheaton is amenable to a settlement. Ultimately, there is no single agreed-upon process for determining the transfer price. And the situation is complicated by the fact that there are fewer comparable streaming deals versus what would be available for analysis amongst more traditional mining transfer-price cases.

Identifying problems early

No one wants their stocks to fall due to a surprise intervention by CRA, so advisors need to be aware of the tax rates of the companies that they buy for clients. You should flag any that seem to have exceptionally low effective tax rates—in the single digits, for instance.

There are sometimes other tip-offs that the CRA might audit a company and deliver a hit to the share price. Some CRA cases have themes. Often, the agency targets many companies for the same issue, but it takes time to cycle through them all. The theme of transfer pricing reassessments is common to Cameco and Silver Wheaton. In “Who will settle with CRA next?”, we saw how CRA was auditing companies based on the eligibility of purchased tax losses concurrent with when they converted to corporations from income trusts.

For several years, the CRA had been issuing reassessments to dozens of companies. We used this trend to identify Total Energy Services as a likely candidate to receive a reassessment from CRA. The company received a CRA notice in September 2015, stating that it owed $11.5 million in additional taxes and interest.

By Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE. They run Accountability Research Corp., providing independent equity research to investment advisors across Canada.

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