INVESTMENT COMMUNITY PERSPECTIVE

Institutions are Really Just Retail

Nearly everyone’s key investor relations focus is the institutional accounts, as this is where stock concentration exists. But when you think about it, whether you are dealing with a mutual fund or a pension fund, the institutional portfolio manager really just represents retail accounts. Perhaps the best way to think about institutional accounts is that they are a collection of retail investors. However, to really understand the pressures on the institutional portfolio manager, you need to listen carefully to your retail shareholders and their brokers. It is extremely important to understand retail in order to understand institutional accounts.

You are Not Alone in Marketing

Much like you go marketing to institutional accounts, portfolio managers go marketing, but they market to retail or retail representatives. Let’s look at this more closely. Mutual funds need to raise capital for investment, and they raise this from retail accounts; they aggregate retail investors. Talk to mutual fund portfolio managers and they will tell you that as well as managing client money, they also must market their funds. They spend a lot of time and effort doing this, typically visiting retail branches and appealing to retail brokers, who in turn advise their clients. As for pension fund managers, they must present to boards that represent the pension holders. And in order to increase their funds under management, they market their services to pension boards. Either way, the competition is fierce for increasing the money under management. Internal funds flows may actually determine whether someone is a buyer or seller of your securities!

Understand What Drives the Driver

Until you more fully understand what is driving the portfolio manager, you are missing some secret sauce to successfully marketing your company. Consider that if retail investors are all clamoring for vanilla ice cream, and your company is chicken pate, no matter how good your chicken pate is, you will have a real struggle. Why? It’s because the mutual fund manager is very attuned to the demands of retail investors, and if they want vanilla ice cream, he is going to deliver vanilla ice cream, and variations of vanilla ice cream. He has to; he does not want to face redemptions. And if the world is crazy about vanilla ice cream, and the value of vanilla ice cream is climbing, while chicken pate is languishing, you can imagine that the pension fund manager will likely have some vanilla ice cream in his portfolio as well, as he will be measured on his performance.

Fad versus Trend

By talking to retail investors, as well as their brokers, you can get insight into retail preferences. The question is: are these preferences fads or are they trends? Fads come and go, but trends matter.

Let’s take a look at a recent phenomenon – the focus on dividends. Is this a fad or a trend? The federal government appeared to think it was a fad; certainly during the ‘trust era’ and when interest in trusts started to get ‘too big’. The government tried to stop this by changing the tax laws. But the underlying demand for yield is a trend, a secular trend. That is why so many companies have been under pressure to pay dividends. The Feds stopped the trusts, but they did not stop the demand for yield. Mutual funds that have concentrated on yield have continued to gather funds under management, whereas most non-yield products have been lucky to hold on to their funds, with many facing redemptions or switching to yield products.

Yield, a Secular Trend

To better understand why yield is a secular trend, you need to understand Canadian demographics, which are really no different than U.S. demographics. The story is dead simple. Baby Boomers are heading into retirement and the requirements of retired investors are fundamentally different than those who are saving for retirement. The Canadian mutual fund and pension fund industry has been a net gatherer of assets from the Baby Boomers for over 50 years. For decades growth stocks were the flavour of the day as the Baby Boomers looked to grow their investment capital. But as the Baby Boomers head for retirement, safety and yield become more important. So guess what, mutual fund managers and pension fund managers are becoming more and more biased towards yield products, because that is what their clients want and need. Couple that with the economic times we have been enduring and you can start to appreciate the demands. Consider that the portfolio manager of tomorrow is going to be very different than the portfolio manager of a decade ago.

Know Your Audience

I am not saying that you have to change your business to a dividend-paying machine, but your management team must be made aware of the demands of the marketplace. The days of ‘we have lots of growth in front of us’ may not play the same as they did in the past. The demands of the audience have changed.

All Yields are Not the Same

Quite simply, Canadian corporate dividend yields are NOT directly comparable to interest yields. In order to grasp the dividend phenomenon, it helps to better understand the economics of dividends for eligible Canadian investors. And that means examining the Canadian dividend tax credit system. Canadian income tax regulations follow the underlying theory of ‘integration’ (the U.S. does not); think of integration as ‘eliminating double taxation’ (it works well but not perfectly.)

Canadian Dividend Tax Credit System

Corporations pay dividends out of income that has been subject to corporate income tax, whereas interest payments are a deductible expense, and have not been subject to corporate income tax. Interest is fully taxed in the hands of the recipient. However, as dividends have already been subject to corporate income tax, taxable Canadian investors are given a credit for the notional income taxes paid on the earnings that gave rise to the dividend. Although complex, and often misunderstood, dividends are ‘grossed up’ when you prepare your personal income tax return, effectively grossed up to the pre-tax income of the corporation. You calculate income taxes based on the grossed up amount of the dividend but are then given a ‘credit’ (the dividend tax credit) for the notional corporate income taxes. The result? A simple example would be that if the Corporation was subject to a 28% corporate income tax rate, and you personally had a marginal income tax rate of 50%, you should only expect to pay an additional 22% tax on the dividend (your 50% tax rate less the 28% previously paid by the corporation.) And that, conceptually, is how it works.

For Canadians, Canadian Dividends can be Subject to Lower Income Taxes

So for eligible Canadian investors, a dividend is subject to incremental income tax, whereas interest is subject to full income tax. Eligible Canadian investors pay less income tax on a dividend, so the yields are not comparable. After tax, a 6% interest yield will leave an eligible Canadian investor with 3%; after tax, a 6% dividend yield will leave an eligible Canadian investor with 4.2% (following the income rates in the example above). So for mutual funds, which are able to ‘pass through’ the dividend tax credit system to eligible Canadian investors, dividend yields are important. But for pension funds, which cannot pass though the dividend tax credits to pensioners (and this is where the dividend tax credit system fails), the dividend and interest yields are comparable. Knowing your audience will certainly help! If your company has bond issues outstanding, consider marketing to those security holders as well, but your pitch will need        to be different.

Personal Tax Planning Tip

Canadian dividend stocks are better held personally (so that you can take advantage of the Canadian Dividend Tax Credit System), whereas interest-paying securities are better held in your RRSP.

Help the Portfolio Managers and Help Yourselves

Ever had portfolio managers ask you to help supply them with industry information? They may want the data to better understand your business, but they may also be using it to better market their services in order to gather more assets under management. In either case, consider the ‘ask’ a compliment, and provide the data. The better you understand the job of portfolio managers, the better you can position your business to meet their clients’ needs; that means understanding their clients – people like you and me.  Knowing   this should give you a different perspective the next time you are talking to retail brokers or retail investors. Doing some homework of this subject can only help you, both personally and as an IRO.


Dirk Lever is Managing Director, Institutional Equity Research, AltaCorp Capital Inc.