August 2014

The Monthly


With this commentary, we plan to communicate with you every month about our thoughts on the markets, some snap-shots of metrics, a section on behavioural investing and finally an update on some of the people at MacNicol & Associates Asset Management Inc. (MAAM). I hope you enjoy this information, and it allows you to better understand what we see going on in the market place.


 “An investment in knowledge pays the best interest.” – Benjamin Franklin


Market Commentary: Corporate Inversions

An enormously popular trend in the United States, as of late, has been an increasing amount of ‘corporate inversions’. This has been a hotly debated topic, and is also somewhat convoluted of an issue; therefore, we thought it may be of interest to detail what the trend is, why it matters, and the implications of it. 


In short, a corporate inversion is a scenario where a U.S. Corporation will seek out an acquisition of a foreign entity, primarily for the purpose of lowering the amount of tax which it is liable to pay. In such a scenario, the company maintains headquarters and primary operations within the U.S., however, as a result of the deal, the American company is able to legally lower the amount of tax it is required to pay. The attractiveness of this action stems from the fact that the U.S. currently exhibits the highest combined corporate tax rate in the world, reaching nearly 40%, whe

reas many nations such as the Netherlands, Ireland and the U.K., boast much lower rates. Although not a new development, this process has risen in relevance as of late, and become increasingly popular for a number of reasons.  The chart below, put together by Goldman Sachs, graphically displays both the surge in attempted and succesful or pending corporate inversions, based on revenue in billions of dollars. The reason for the large amount of withdrawn inversions are as a result of two high-profile cases this year, pursued by Pfizer and Time Warner, which eventually fell through for a variety of reasons. The  primary question resulting from this chart is: if regulation has not changed since 2004, how come the trend has become so popular in the last few years? Twenty-two companies have pursued corporate inversions since 2011, with approximately 30 more pending. The result of this surge in activity has been that an estimated $950 billion in cash is currently being held overseas by U.S. non-financial companies, due to their unwillingness to repatriate it and suffer American tax, as well as an estimated $2

trillion in unremitted and untaxed foreign earnings.

The two primary arguments as to why this trend has surged as of late are the prevalence of low interest rates, as well as political gridlock in Washington. Low interest rates have allowed companies to access cheap debt, which facilitates all corporate acquisition activity in general. In addition, Obama’s advocacies against the trend have caused companies to realize that the window to pursue tax inversions may be closing. That being said, the fact

that Democrats and Republicans disagree with the right way to fix the issue has allowed the window to stay open for the time being. Although both parties agree that it is an issue that must be addressed, their unwillingness to co-operate, and the unwillingness of

the Republican-dominated Congress to pass any bill which Obama advocates or that may lead to higher taxes, has led to gridlock over the issue and delayed action. As a result of this gridlock, President Obama must either compromise on his proposed plan, or wait until the mid-term elections later this year and hope for an increase in Democratic seats in Congress.


This whole issue ultimately serves as a symbol for an American public who have become increasingly fed up with corporations, who in the mind of many, are not paying their fair share. This is an argument which actually has merit. In 1952, corporations accounted for 32% of Federal revenue; as of 2013, it was less than 10%, while individual income tax’s contribution has remained constant. Additionally, despite the notional combined corporate tax rate of almost 40%, the average effective tax rate paid among profitable companies in 2013 was actually 17%. These statistics suggest that America is in dire need of a revamped and transparent tax system, especially concerning corporations, which has been another idea that President Obama has been a strong supporter of.  Alas, while a step in the right direction, closing the loophole which allows U.S. companies to pursue tax inversion may not be a quick-fix to the issue. According to the ‘stop corporate inversions act of 2014’, limiting these actions could add $20 billion to the U.S. economy over the next 10 years. Although notionally this seems like a l

ot of money, when considering the fact that $4.5 trillion is scheduled to be paid in corporate taxes over the next 10 years, it is a drop in the proverbial bucket. What is a clear takeaway from the recent debate of tax inversions, however, is the idea that a significant and impactful change to the U.S. tax system is likely on the horizon, and that the companies which have pursued actions such as tax inversions in order to artificially game the system and gain a short-term, unsustainable increase to profit, are likely to be the poster-children of the upcoming debate.


The Four Most Dangerous Words in Behavioural Investing:

“This Time is Different”


Following a hiatus on the subject last month, we thought that we would resume our discussion of Behavioural Investing, with a specific focus on the real-world applications of its key teachings. Specifically, we would like to examine the commonly-discussed ‘market bubble’, and what John Templeton described as the ‘four most dangerous words in finance: this time is different’. Once again, the topic and information was obtained through James Montier’s book, “The Little Book of Behavioural Investing”.


When the term ‘market bubble’ is mentioned, the first thing that typically comes to mind is either the recent financial crisis of 2008 or the dot-com bubble in early 2000. However, market bubbles are not a new development by any means, appearing as early as 1637 is the price of tulip bulbs in the Netherlands, with the first equity bubble exhibited in 1720, 118 years after the first stock exchange was founded. By definition, an asset bubble is characterized by a sustained real price movement in excess of two standard deviations from the long-term trend. If markets were efficient, and all available information was correctly priced into asset markets, then statistics say that such events should only occur once every 44 years. In reality, such scale of deviations have occurred over 30 times since 1925, or once every three years; on top of these fact, almost all of these deviations have come crashing down, resulting in a corresponding movement of two standard deviations below the long-term average. Although many high profile figures in the finance world assert that asset bubbles are ‘black swan’ events which remain unpredictable, in his book, James Montier outlines a simple guide to spotting bubbles, which requires no expertise in financial analysis in and of itself. The model was first proposed by John Stuart Mill, and is comprised of five stages:


  • Displacement: An exogenous shock triggers profit opportunities in some sectors, while limiting opportunity in others. Investment and production pick up to exploit these opportunities.


  • Credit creation: The bubble is nurtured by the creation of credit, whether it is personal or corporate, and corporate profits enlarge.


  • Euphoria: Everyone on the sidelines start to buy into some ‘new era’, prices are only seen as going up, and gains are overestimated, while losses are underestimated.


  • Critical Stage: Financial distress emerges, the previously injected credit becomes a problem, insiders cash out, and fraud emerges.


  • Final Stage: Investors reel from the damage to their finances wrought by the bubble, and exit the market, leaving bargain basement asset prices.


Although deceptively simple, there are also a variety of psychological reasons that prevent an investor from following this model. For one, they are overly optimistic; they realize the faults in the market, but believe they will be able to get out of the market before everybody else. Another pitfall, which is prevalent during the ‘euphoria’ stage, is the illusion of safety or control. Investors believe that, because they can quantify their

 risk or potential losses, they will be able to mitigate it. This is also a sales tool heavily relied upon by certain fund managers in order to disguise the risk of their funds. One particular example is a measure known as ‘Value at Risk’, which claims to be able to predict the maximum amount of capital that is at risk within a fund, within a 95% rate of probability. However, Mr. Montier describes the fallacy of this metric quite poignantly with the example of “that is like saying a car’s airbag will save your life, except in the event of a crash”. Additional hurdles which hamper investors  from spotting market bubbles are a focus on the short-term, or myopia, which hamstrings them from focusing on the long-term, and what is known as ‘inattentional(sic) blindness’, where they do not expect to see what they are not looking for. It is important for an investor to remain unbiased and objective when conducting analysis, and always look into the argument against their thesis.


Although the framework is a useful guide, it is also important to note that nobody will be able to forecast the exact point of collapse for a bubble. As such, it is important to maintain a level head; you may miss out on part of the party, but by utilizing sound and objective analysis, you’ll also avoid the hangover.




For the personal section of our Monthly Commentary, we’d like to profile our Senior Vice President and Portfolio Manager, Scott Baker, who has been with the firm 5 years.



Scott lives in Unionville with his wife Heather and his three daughters. His oldest daughter, Elena, is star

ting her first year in the Music program at the University of Toronto this fall. Scott and his family recently got back from a two-week holiday in Ocean Park, Maine, where they spent some of their vacation tracking down family roots reaching back to 1650 in Kittery, Maine.  Scott is an avid skier, as well as a karting and basketball enthusiast, and has recently started training for long-distance running with his daughter Clara. Scott’s wife, Heather, will be starting a new job in the fall teaching Kindergarten at a nearby public school, so things are about to get very busy at the Baker household!



 David A. MacNicol, B.Eng.Sci., CIM, FCSI, President, Portfolio Manager

MacNicol & Associates Asset Management Inc.

August 2014