The Rude Awakening
Wall Street, New York
Friday, November 10, 2006

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• Your views on Canadian tax proposals answered and
  addressed,
  
  
• Placing your value bets where barbarians like to eat,
  
  
• A mini-marketplace for your ideas, gold's bullish
  trajectory, all the market data and plenty more...

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Eric Fry, reporting from somewhere south of the Canadian
border...

More than one week has passed since "Flaherty's Folly." But
even with the passage of time, folly remains folly.

Early last week, the Canadian Finance Minister, Jim
Flaherty, issued a proposal to begin taxing both new and
existing investment trusts – vehicles that previously
enjoyed a tax-free status in Canada. Your editor
immediately scorned the proposal as incompetent and
counter-productive, after which many Rude readers rushed to
Flaherty's defense.

"He had to close the investment trust loophole," they
explained. "We Canadians were losing too much of the tax
money we need to fund our government programs." A slew of
articles in Canada's Globe and Mail expressed similar
sentiments. But what almost no one bothered to explain,
much less mention, was why Flaherty felt it necessary to
betray investors by taxing EXISTING investment trusts. Why
did he not simply close the loophole for new trusts?

Clearly, Flaherty could no longer have sat idly by while
large Canadian companies converted themselves into tax-free
structures. But the need to close the investment trust
loophole did not justify eliminating the entire investment
trust industry. We think Mr. Flaherty made a mistake.

To be clear, we harbor no antipathy toward the man. To the
contrary, his proposal pains us because we fear it will
harm the country he purports to serve. We like Canada...and
we even like Canadians. We are also quite fond of Canadian
resource companies and have been investing in them for more
than two decades. That's why Flaherty's ill-advised
proposal troubles us.

Flaherty's proposal not only destroys investor confidence
in the Canadian financial markets; it not only undermines
confidence in the Canadian dollar; it not only sets in
motion a change of events that will hamper Canadian
economic growth; but it also throws the country wide open
to opportunistic "vulture investors" who will devour many
of Canada's resource assets, without contributing to the
economy's continuing growth and vitality.

Canada just shot herself in the foot...We should not be
surprised if she develops a noticeable limp.

Over to Justice Litle, editor of Outstanding Investments,
for additional insights on the Canadian trust debacle...

A thoughtful subscriber from Toronto writes:

"I am an avid reader of the newsletter and can never wait
for the next insightful issue. However, this time you are
off the mark on your comments on the recent Canadian tax
change announcements. I totally agree that it came out of
the blue, and the secrecy surrounding the decision is
scary, but something had to be done. I have seen the whole
economy being transformed over the last few years as so
many companies were adjusting their models to suit the
income trust arrangement. This is government-incentive
distortion at its worst, and something had to be done. Now
some of our largest banks were considering using this to
avoid paying taxes. The idea might be suitable for certain
mature resource firms, or real estate companies with a
steady cash flow and predictable expenses, but the model
was awful for most firms out there and was picked only for
tax gain reason."

I understand this point of view. The government fears that
Canada will be hollowed out by the income trust model, with
the lion's share of pre-tax corporate income flowing into
the hands of individuals. This view sees the income trust
model as a nifty loophole, opened in the late '90s, that
threatens to become a black hole of lost revenues. As many
Canadians agree that "something had to be done."

I can even understand the abrupt nature in which the
decision was made. Canadian Finance Minister Jim Flaherty
was concerned that any dropped hints might have led to
insider trading - an accusation that dogged the previous
government.

With that said, Flaherty and crew are still making a bad
mess of things, in my opinion. I fear that Flaherty's
actions will do more harm than good on the whole - that
they will be a net negative for the Canadian economy.

Flaherty made a mistake...And he also forgot about the
barbarians at the border.

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Barbarians at the Border
By Justice Litle

The barbarians are amassing along the Canadian border. But
these barbarians don't wear bearskins and wield clubs. They
wear Armani and wield wads of cash. Foreign investors are
preparing to sweep into the beaten-down investment trust
sector, to plunder the valuables and return the booty to
their native lands. Canadians will not enjoy this
plundering very much. Individual investors, however, would
stand to benefit if they purchased selected investment
trusts before the barbarians arrived.

The aptly titled, "Barbarians at the Gate," is a famous
book-turned-movie about one of the biggest private equity
deals in history. In the late '80s, private equity firm
Kohlberg Kravis Roberts bought out RJR Nabisco for $25
billion, a staggering sum that was only recently topped.
(And still hasn't been topped in inflation-adjusted terms.)

The global economy is still awash in a sea of cash and
private equity firms have literally tens of billions to
throw around. They are bigger, badder and hungrier than
ever before. What are a private equity guy's favorite two
words in the world? "Cash flow." What do Canada's income
trusts have in spades? Cash flow. Put the two together and
it's not hard to see: The barbarians are coming.

Private equity guys recently bought Freescale Semiconductor
for $17.6 billion. They bought HCA for $33 billion - the
largest deal ever in noninflation-adjusted terms. That may
soon be topped; Kohlberg Kravis Roberts, of RJR Nabisco
fame, was recently in the hunt to break its own record. The
proposed deal price? A cool $50 billion.

All the Canadian energy trusts put together have a market
value of $60-80 billion. That's a drop in the bucket... a
mere two or three mega-deals by today's standards. The
barbarians are sitting on so much investor cash that they
are literally desperate to deploy it. They are no doubt
drooling over the situation Flaherty created.

For example: On Halloween night, The Globe and Mail
reports, the CEO of KCP Income Fund was heading home to go
trick-or-treating with his kids. In the space of minutes,
he had received half a dozen e-mails on his Blackberry -
all inquiring about his willingness to go private. As soon
as the news was out, the jets were scrambling.

"So what?" You might ask. "What does it matter if the
barbarians take over? Isn't it all the same?"

Well, no.

When an energy trust goes private, for one thing, public
investors no longer get to participate in the revenue
stream. Instead of enriching Canadian citizens and other
small-scale investors, the cash flows to bigwigs in L.A.
and New York. Flaherty got brownie points for offering tax
exemptions to Canadian senior citizens; those exemptions
won't matter much if the trust distribution streams no
longer exist.

More importantly, the "hollowing out" problem is still
there... and arguably gets worse under a barbarian regime.

Private equity firms used to take pride in shaping the
companies they acquired. The old way was to really clean up
a company, improve its efficiency and make a mint by way of
genuine value creation. That still happens, but it's more
and more rare these days. The new model is more akin to
strip-mining: load the target with debt, extract as much
cash as you can and flip it back to the public as quickly
as possible. Under the old-fashioned way, polishing up a
company took years. Not any more. The new record for a
private equity strip 'n' flip is an astonishing three
weeks. 

Private equity guys don't care about the world's energy
future. The name of the game is fees and cash flow, end of
story. They view their acquisitions in the same way credit
card companies view subprime borrowers - as assets to be
leveraged and exploited. If the barbarians can snap up
these trusts like barracudas eating minnows, what do you
think their focus will be? Will they be worried about
growing operations, expanding capex to meet future demand?
Heck no. They'll be cutting costs left and right, forgoing
expenditures wherever they can. If you thought Exxon and BP
were stingy on the capex side, you ain't seen nothing yet. 

Flaherty's proposal not only produced a sweet opportunity
for foreigner buyers, it also created bitter opportunity
for domestic sellers. A lot of Canadian executives now feel
they've been betrayed and abused; this makes the trusts all
the more susceptible to selling out. If the business you
love has been trashed by your government, and your net
worth just took a sizable hit, why not cash out with your
wealth and your dignity intact?

At the end of the day, I can see why Flaherty did what he
did. But I think all his talk of "fairness" and "doing
what's best for Canadians" is probably a bunch of hooey.
Given the opportunity, I would love to ask him: If you were
so upset about big banks and telecoms converting to trusts,
Mr. Flaherty, why didn't you just go after big banks and
telecoms? Is your only policy tool a sledgehammer? Why
didn't you respect the spirit, if not the letter, of your
promise, by grandfathering in existing trusts?

Bottom line: If Canada's energy trusts are taken private en
masse, that could hurt Canadian investors and workers
alike, as cash flows are diverted and capex is cut. If that
doesn't happen - if Flaherty decides to block the
barbarians with restrictive legislation - then he will be
responsible for demoralizing and shrinking an industry that
has less lifeblood and less expansion capability than
before. If such occurs, tax revenue gained from betraying
the trusts could easily be offset by economic activity
lost.

But we individual investors need not trouble ourselves with
such issues; we need merely assess the situation as it
currently exists and respond. The situation as it currently
exists offers compelling value. The high-yielding
investment trusts will continue to pay their high-yields
without taxation until 2011...assuming the barbarians do
not swoop in to take them private in the meantime.

Net-net, seek out the values that would attract a
barbarian.

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[Joel's endnote: Could this possibly have been the Rudest
of all rude weeks? A slew of controversial essays from
Whiskey & Gunpowder's intrepid correspondent, Byron King,
on global warming and some scathing remarks by Justice
Litle and Eric on "Flaherty's folly" would certainly
suggest so. We consider it our duty to deliver the news as
we see it, however irreverent or contentious it may seem.
We are also aware, however, that not everyone agrees all
the time. So, rather than ignore the coin's flipside, we
open the floor to you to say your piece.

The Monday Mailbag's have been a kind of mini marketplace
where Rude individuals are free to exchange ideas without
hindrance from your editors. Often times the opinions
expressed in the Mailbag do not represent those held by
us...which is all the more reason for you to send them
along and more reason still for us to print them.

If you have any thoughts on global warming, Canadian tax,
other investment insights you would like to share or,
indeed, anything Rude related, you may address them to your
time-traveling editor at aussiejoel@the-rude-awakening.com

Cheers,

jOEL

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And the Markets...