Understanding how the shares of Apple Inc. managed to get squashed so badly has much to do with knowing a bit about investor psychology and modern market dynamics. It wasn’t very long ago that shares in AAPL were universally loved – about a year ago now, CNN made it known that Poland, Belgium, Sweden, Saudi Arabia, and Taiwan all had GDPs that were less that Apple’s market value (around $500 billion at the time).
It’s all about probabilities. If absolutely everything is going well, encouraging publicity abounds and everyone you know has both the iPhone and owns the stock, then the only thing that is left to occur is suddenly something (sentiment, earnings disappointments, hurricanes) not-so good-happens which cools investor enthusiasm. When a stock is widely held, the subsequent selling can prove disastrous for all shareholders.
In September of 2012 AAPL traded a tiny bit north of $700 per share and is now in the neighborhood of $420 give or take. Losing 40% of one’s investment in a bull market is painful.
On business television you’ll hear lots of Apple pundits (who still own the stock in their portfolios) say the company is worth far more than the share price would suggest. This may or may not be true, but the fact of the matter is that the share price does represent what it is worth to investors right now! Doesn’t it?
The answer used to be yes, but with the increase in the popularity of short-selling it is difficult to determine nowadays what a company is really worth. In many instances there is absolutely no connection between the actual economic value of a business and its stock price.
Swarming is the term now applied to the crime where an unsuspecting innocent bystander is attacked by several culprits at once, with no known motive. Because swarming at street level involves violence, it is criminal. However in financial markets it is perfectly legal and different because there definitely is a motive. The motive is to rob shareholders of their invested dollars.
In a recent (April 6th, Thomson Reuters: Reuters Insider) interview Bill Ackerman, founder of Pershing Square Capital Management and who is described as an ‘activist’ investor, admitted “There is something inherently shadowy or evil about short-sellers.” Ackerman gained notoriety when he publicly claimed the company Herbalife was nothing more than a pyramid scheme, suggested the stock was worth zero and admitted his company had an enormous short position.
When any company today stumbles (or is perceived to have stumbled) it ignites something akin to a swarming. For example, this quote is from CNBC.com on November 10th, 2012:
“The question has been asked by nearly every Apple watcher following a brutal two-week stretch that began with a worse than expected earnings report, quickened after the ouster of a high-profile executive and culminated with news this week that it had fallen behind competitor Samsung in the smartphone wars.”
Although one might expect the stock to decline under the circumstances, the subsequent pummeling of the share price seems a bit cruel. What happened? Have a gander at this graph of the short interest (the total number of shares that were sold short) since about a year ago. To gain perspective, in April of 2013 the short interest has grown to 20,497,880 shares. The dollar value of this is about the same as the Gross Domestic Product of the entire country of Malta.
In English, short-sellers detected vulnerability, and swarmed AAPL. The irony is that short-sellers borrow the stock from real shareholders (via third parties) in order to sell it on the market. After the selling pressure wreaks havoc on the stock price, the short-seller then buys shares at a much lower price, returns the ‘borrowed’ shares to those real shareholders and keeps the profits.
The irony is that short-sellers claim to be providing a public service. Bill Ackerman was simply exposing a company that he believed (discovered) was misleading its shareholders. He even went so far as to say he didn’t even want the profits – they would be donated to charity. The problem is that it isn’t just some big bad corporation that is punished, but its shareholders and in due course even its employees.
I’ve never claimed to be all that smart, but I just can’t figure out how aggressively attacking a company’s share price, selling stock that the seller doesn’t even own, for the sole purpose of transferring the savings of innocent investors into one’s own coffers (whether it goes to charity of not) is a noble thing. Isn’t it kind of like a bunch of thugs beating someone up and stealing his/her cellphone declaring it was the loner’s own fault for being vulnerable?
How can you stay clear of being a victim?
Avoid owning stocks that have become darlings. When it seems nothing at all can go wrong, it will ,and when it does there’s sure to be a swarming.
If there’s evidence of a growing short interest in a company, best not own the stock.
Instruct your financial institution that your shares are not to be available for securities lending purposes.
In 2004 I wrote a book (with my friend Pamela Clarke and published by Insomniac Press) called Resources Rock: How to Invest and Profit from the Next Global Boom in Natural Resources. Since taxes are fresh in everyone’s mind at this time of year, I thought I’d reproduce a chapter in the book that explains one of Canada’s most flexible and robust tax planning tools. It’s not widely understood but has the advantage of being 100% legitimate – it is written right in our tax code. Here’s the chapter:
“Certainty? In this world, nothing is certain but death and taxes,” said American scientist Benjamin Franklin over two hundred years ago. The only difference these days is that while death is still final, taxes can be deferred or reduced. Canadians didn’t always have to worry about taxes. Income tax was introduced as a temporary measure (sounds like the GST saga) to help cover the country’s military expenses during World War I. By 1948, the wars were over, but the government decided to not surrender. Instead, the Income War Tax Act became the Income Tax Act. Since then, Canadians have had to declare income from all sources, including capital gains on the sale of investments or property. We’re allowed to deduct some expenses and there are a few tax credits, but by and large, there aren’t too many opportunities for us to reduce our taxable income. Taxes are steep and vary greatly depending on where you live.
But that’s not all. You pay tax on everything you earn as well as on everything you buy. Take the price of gas, for example. It was pumped up to over $1.40 a liter in some provinces and more than one-third of the price was taxes: provincial sales tax, GST, and something called the Federal Excise Tax. It hurts even more if you consider that you’re paying for the gas taxes with after-tax dollars. Ouch.
One of the best means of minimizing the pain is to take advantage of all the tax deductions that you can. Standard ones include childcare expenses, family support payments, moving and medical costs, and of course, RRSP contributions. Unfortunately, not too many taxpayers are familiar with the deductions that are available from investing in the “flow-through” shares of junior Canadian resource companies, or ventures that qualify for the Canadian Exploration Expense (CEE). You should consult your tax advisor for precise information on the benefits of these deductions for your portfolio, but in the meantime, here’s a brief introduction to these tax-deductible investments.
Buried deep in the Income Tax Act (Section 66 (1) to be exact) there’s a clause that says:
“A principal-business corporation may deduct, in computing its income for a taxation year, the lesser of (a) the total of such of its Canadian exploration and development expenses as were incurred by it before the end of the taxation year…”
The Section goes on ad nauseam, but only tax accountants need to get into that level of detail. What you do need to know from the clause is that most junior energy and mining companies spend all of their money on exploration programs and usually have little or no revenue. Because they have virtually zero income, they’re not able to use all the tax deductions that they’re entitled to as a resource exploration company. Mining companies are allowed to deduct prospecting, drilling, geological or geophysical expenses, but if they don’t have any revenue, then these deductions remain unclaimed or“wasted”.
In a rare moment of generosity, the government decided to allow exploration companies to give up those tax deductions and pass them on to people who can use them. Companies can bundle the tax deductions with their shares, then sell them to investors and use the proceeds from the sale of these shares to finance their exploration projects. The ventures don’t mind selling off their unused deductions. If they can’t afford to keep digging or drilling, they’ll be out of business anyway. These deductions, sold as shares, are called “flow-through shares” because they transfer the tax deductions from the company to the investor.
In other words, the government allows a tax deduction that would usually only be granted to an exploration venture to be passed on, or “flow-through,” to their investors. It’s a win-win situation as the company gets the money to finance their exploration work while investors can claim up to 100% of their investment as a tax deduction. The government created this program as a means of encouraging people to invest in resource exploration companies. That’s nice of them, but given our incredibly high tax rates, it’s a good idea to understand how investing in exploration—either in flow-through shares, or in shares of a limited partnership that owns a portfolio of flow-through shares—can help you lower your taxable income.
Investors can buy flow-through shares directly from a company, or own them indirectly by purchasing units in a limited partnership specially created to buy shares in a portfolio of several junior exploration companies. Buying units in a limited partnership can be beneficial for individual investors because it gives them the tax deduction from the flow-through shares, in addition to reducing their investment risk. A limited partnership can usually buy a much greater variety of flow-through shares than an individual investor could afford to purchase on their own. Therefore, investors in a limited partnership end up owning shares in a basket of startups, rather than just in one venture. Given that a lot of exploration companies could go bankrupt or walk away from their projects, buying shares in several of them minimizes the risk that you could lose your entire investment. The answer varies from one investor to another, but as long as the exploration company – or companies if they’re in a portfolio owned by a limited partnership – spends all the money they raised from selling flow-through shares on eligible exploration expenses, then almost the entire amount invested in the shares can be deducted.
A word of caution: Don’t let the tax appeal of flow-through shares affect your decision-making skills as an investor. Remember that even though the tax deductions alone are beneficial, you’re still investing in the riskiest side of the resource industry. It is possible for you to lose all your money if the exploration team repeatedly comes up empty-handed. On the other hand, investing in an exploration startup by means of flow-through shares does mitigate the risk of losing your investment to some extent. Depending on your marginal tax rate, the after-tax cost of buying the flow-through shares (or portfolio of flow-through shares) is virtually cut in half, compliments of the government .
In the Economic Statement and Budget Update of October 18, 2000, the Minister of Finance announced a temporary, 15% investment tax credit (applied to eligible exploration expenses) for investors in flow-through shares of mineral exploration companies. Oil and gas exploration companies were excluded. This announcement introduced a credit, known officially as the Investment Tax Credit for Exploration(ITCE), which reduces an investor’s federal income tax for the taxation year during which the investment is made. Although deemed ‘temporary’, after expiring at the end of 2005, the credit was re-introduced effective May 2,2006 and is currently subject to annual review.
The ITCE is a non-refundable tax credit that can be carried back three years or carried forward twenty years. So if you invest in flow-through shares (of mining exploration companies only) this year, you can use the deduction any time up to 20 years in the future, or back three years. It’s a real bonus being able to use this deduction when you need it the most. Keep in mind, however, that the ITCE has to be reported as income in the year after you claimed the tax deductions from the flow-through shares. The only downside is that when you sell your investment, or trigger a “deemed disposition”(which means the government thinks you’ve unloaded the investment even if you haven’t actually sold it), then you’re on the hook for capital gains tax. That’s not so bad, as capital gains tax rates are better than regular income tax rates.
Let’s look at how these tax credit programs can help you reduce your taxes. For example, if you live in Ontario and your annual taxable income is $300,000, and you’re taxed at the highest marginal tax rate of 46.41%, then you’d pay $139,230 in tax. (Of course, to make it simple,we’re unrealistically assuming there are no personal exemptions or other allowable deductions and that all income is taxed at the same rate.) If you invested $50,000 in flow-through shares, and the entire amount qualified as a CEE, then 100% of your investment could be deducted from your taxable income. Your taxable income is reduced to $250,000 and you now owe $116,025 in taxes—a savings of $23,205! That’s a nice chunk of change that stays in your pocket.
It can get even better. If a part of your investment in flow-through shares is with companies that are exploring for metals and minerals that are eligible for the Federal Investment Tax Credit, you’ll get an additional tax credit of $7,500. That extra credit would cut your total tax bill down to $108,525. In a perfect world, you could save yourself $30,705 in taxes. Serious money by any standards.
In addition to these federal government programs, there are several provincial flow-through initiatives that we won’t address here as they vary tremendously from one province to another. Flow-through shares are starting to sound like they’re the best discovery since Chuck Fipke dug up some diamonds in the Northwest Territories. As wonderful as they are, keep in mind that since money is made and taxes are paid in the real world, things aren’t always as rosy as simplified examples in a book on investing. Before buying into the example above, remember that:
Taxes Vary: Everyone pays taxes on a sliding scale, so not all of your income is taxed at the top marginal rate.
Diversify: Your entire portfolio should never be solely invested in just mineral exploration stocks—diversification is advisable even for investors with an incredibly high tolerance for risk.
No Guarantees: An exploration company is obligated to spend 100% of the money it receives from selling flow-through shares on expenditures that qualify for tax deductions, but if for some reason it doesn’t, then you can’t claim 100% of the deductions.
The bottom line is that there are many variables that will influence the impact of flow-through shares on your tax situation. Investment advisors can provide details on the limited partnerships or flow-through shares that are available in the market today. Ask them to help you research and screen limited partnership funds so you end up investing in a portfolio of companies that meets your investment objectives.
That’s the end of the chapter, and before you say this is more complicated than it’s worth let me excessively simplify and round in order to provide an example of how powerful this tool can be.
Imagine you’ve sold an income property for $500,000 and long ago used up your personal capital gains exemption. To keep it simple, you are not subject to minimal tax and are at the highest marginal tax bracket which I will round to 50%. Let’s ignore all the other deductions and stuff too. Your options are:
1. Report the proceeds as income and let the CRA (government) keep half of your money.
2. Invest the entire sum in one (or more) flow-through limited partnerships.
Let’s examine #2. The $500,000 can now be deducted against income, so your taxable income (money going to CRA) is reduced – you keep half at 50% tax rate or (roughly) $250,000. So far you’re no worse off right? Even if your get nothing back (I’ve never seen this happen personally and I’ve managed dozens of these funds myself) you’re no worse off.
Say after two years (the lifespan of most of these funds) you get your whole investment back (it happens). Once the fund is wound up your $500,000 is now subject to capital gains tax (roughly 25% rather than 50%) so you’ll net $375,000. Isn’t keeping the extra $125,000 for yourself worth the effort? Whether you end up with half that amount, or double you are still ahead.
By the way, when a flow-through limited partnership is ‘wound up’ your money is usually rolled into a more liquid mutual fund – you can leave some or all the the money in there and not pay the capital gains taxes until you redeem. If you can afford it, use the tax shelter every year and watch your tax savings grow over time. You will have to pay a tax accountant (since filling out the tax returns correctly is critical and often you have to re-submit them when you receive additional or more precise information from the fund company after-the-fact), and seek advice from a good investment advisor. If either of them tells you not to do it without a really good explanation….it’s because they don’t understand them or want to avoid the added work. Find someone else.